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, 2008
 
 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  ̈ 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  ̈
 
 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.
 Large
      accelerated filer  ̈
              
              Accelerated filer ̈Non-accelerated
      filer þ
      (Do not check if a smaller reporting company)
              
              Smaller
      reporting company  ̈
 
 Indicate
by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes  ̈
No þ
 
 Aggregate
market value (on basis of closing bid price) of voting stock held by
non-affiliates as of June 30, 2008: $33,801,763
 
 Number of
the registrant’s shares of common stock outstanding as of February 27,
2009: 14,834,920
 
 Documents Incorporated by
Reference
 
 Portions
of the proxy statement for the 2009 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
  PagePART
      1Item
      1.
                        Business
                        
                        2Item
      1A.
                        Risk
      Factors
                        
                        10Item
      1B.
                        Unresolved
      Staff Comments
                        
                        13Item
      2.
                        Properties
                        
                        13Item
      3.
                        Legal
      Proceedings
                        
                        13Item
      4.
                        Submission
      of Matters to a Vote of Security Holders
                        
                        13PART
      IIItem
      5.
                        Market
      for the Registrant’s Common Equity, Related Stockholder Matters, and
      Issuer Purchases of Equity Securities
                        
                        15Item
      6.
                        Selected
      Financial Data
                        
                        16Item
      7.
                        Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operation
                        
                        17Item
      7A.
                        Qualitative
      and Quantitative Disclosures About Market Risk
                        
                        27Item
      8.
                        Financial
      Statements and Supplementary Data
                        
                        28Item
      9.
                        Changes
      in and Disagreements With Accountants on Accounting and Financial
      Disclosures
                        
                        52Item
      9A.
                        Controls
      and Procedures
                        
                        52Item
      9B.
                        Other
      Information
                        
                        53PART
      IIIItem
      10.
                        Directors,
      Executive Officers, and Corporate Governance
                        
                        54Item
      11.
                        Executive
      Compensation
                        
                        54Item
      12.
                        Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                        
                        54Item
      13.
                        Certain
      Relationships and Related Transactions and Director
      Independence
                        
                        54Item
      14.
                        Principal
      Accountant Fees and Services
                        
                        55PART
      IVItem
      15.
                        Exhibits
      and Financial Statement Schedules
                        
                        56Signatures
                        
                        
                        60Exhibit
      Index
                        
                        
                        61
  1
  PART I
 Item
1.  Business
 
 Energy
Focus Inc. and subsidiaries (“Energy Focus”) design, develop, manufacture,
market, and install lighting systems and customer specific energy efficient
lighting solutions for a wide-range of use in both the general commercial market
and the pool market.  Energy Focus’ lighting technology offers
significant energy savings, heat dissipation and maintenance cost benefits over
conventional lighting for multiple applications.
 
 Overview
 
 During
2008, we engaged in the design, development, manufacturing, marketing, and
installation of energy efficient lighting systems where we served two principal
markets; commercial/industrial lighting and pool lighting.  Our
business strategy has evolved around providing our customer base with turnkey,
comprehensive energy efficient lighting solutions focused on our patented and
proprietary technology.  Our solutions include fiber optic,
light-emitting diode (“LED”), ceramic metal halide (“CMH”), high-intensity
discharge (“HID”), and other highly energy efficient lighting
technologies.  Our strategy also incorporates continued investment in
research into new and emerging energy sources including, but not limited to,
solar energy.  Typical savings of current technology averages 80% in
electricity costs, while providing full-spectrum light closely simulating
daylight colors.
 
 Our
proprietary, large-diameter fiber cables used in our fiber optic 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.
 
 Our
product portfolio has been broadened recently to include offerings within LED,
CMH, and HID product lines.  In 2008, we launched several new lighting
products for application within landscape, dock lighting, and cold storage
markets.  In 2009, our company will continue to broaden these product
lines, into landscape lighting markets for example, as well as explore new
technologies and markets.  These new applications include LED track
lighting and LED replacement for fluorescent light tubes which we expect to
launch during 2009.
 
 Our
long-term strategy is to penetrate the $100 billion lighting market by providing
turnkey, comprehensive energy-efficient lighting solutions.  Our
targeted market segments provide opportunities in the supermarket,
commercial, industrial, and government segments.  The passage of the
Energy Independence and Security Act of 2007 by Congress 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 through 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.  Further, the passage of the American Recovery and
Reinvestment Act of 2009 by Congress authorizes the usage of $50 billion in
government funds for advancement of energy conservation programs and $20 billion
in tax incentives for renewable energy and efficiency.  Provisions of
this Act which have the greatest opportunity to benefit our company
include:
 
 ·
              $13
      billion in loans to subsidize renewable-energy
  projects,
 ·
              $11
      billion toward smart-grid technologies to run the power grid more
      efficiently,
 ·
              $6.3
      billion in state energy-efficient and clean-energy grants,
    and
 ·
              $4.5
      billion to make federal buildings more energy
  efficient.
 
 We will
continue to focus on market niches where the benefits of our lighting solutions
offerings, combined with our technology, are most compelling.  These
market niches include government facilities, retailers, supermarkets, marine
applications, and museums.
 
 We will
also continue to focus on development of our solar technology through our
continuing leadership role in the United States government’s Very High
Efficiency Solar Cell (“VHESC”) Consortium sponsored by the Defense Advanced
Research Projects Agency (“DARPA”).  The purpose of the VHESC project
is to develop 50% or greater efficient solar cell for United States military
applications which would also be available for commercial
application.
 
 Products
 
 We
produce, source, and market a wide variety of lighting technologies to serve two
general markets: commercial lighting and pool lighting.  Our
technology falls into the following categories;
 
 ·
              Metal
      Halide and LED Fiber optic lighting systems (e.g. EFO Docklight,
      EFO-Ice®),
 ·
              LED
      lightings systems (e.g. EFO Docklight, Cold
  Storage),
  2
  In
addition, we also produce customized components such as underwater lenses,
color-changing LED lighting fixtures, LED lighting fixtures, landscape lighting
fixtures, and lighted water features, including waterfalls and laminar-flow
water fountains.  Further, we continue to aggressively penetrate the
government and military lighting markets.  In this regard, our company
has many products being actively marketed to the United States federal
government agencies through the General Services Administration website
(https://www.GSAAdvantage.gov).
 
 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 federal and state 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 continue to embrace our technology as an
      energy-efficient alternative and are promoting our products to their
      customers.  In 2007, Southern California Edison confirmed that
      our patented product “EFO-IceTM” used only 25% of the energy of comparable
      fluorescent lighting systems and 33% of the energy of comparable LED
      systems.
 ·
              Our
      systems continue to be installed in United States Navy
      ships.  As of December 31, 2008, our company’s technology was
      installed on a total of 3 ships.
 ·
              The
      heat source of the fiber optic 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.
 ·
              Our
      products have been featured in magazines and trade journals, including
      LD+A, Architectural Lighting, Architectural Record, Display and Design
      Ideas, Entertainment Engineering, and Visual Merchandising and Store
      Design.
 
 Key
Features of Our Fiber Optic Technology
 
 Components
of Fiber Optic Technology:
 Illuminator.Most
of our legacy commercial fiber optic illuminators deploy our specially designed
metal halide HID lamps.  These lamps provide long life and maximum
brightness.  We are currently developing and deploying LED illuminators for
increased efficiency, versatility, longer life, and increased
features.  Our fiber optic technology can efficiently 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 has 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 fiber, our
system delivers light ranging from 35 to 70 lumens per watt, compared to
approximately 8 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 Fiber Optic System
 
 Energy
Efficiency.Our fiber optic system can provide our
customers with accent lighting that also satisfies government and other
regulatory regulations for energy-efficient lighting.  Fiber optic
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 fiber optic accent light compared to competing lighting
technologies:
 
 Light Source
                    
                    Number
                      equivalent
                      in 70-Watt
                      Fiber
                      Optic
                    
                    
                    Total Watts
                    
                    
                    Estimated
                      Energy
                      Savings %70W
      fiber optic HID accent light
                    
                    
                    1
                    
                    
                    
                    70
                    W
                    
                    
                    —26W
      compact fluorescent down light
                    
                    
                    4
                    
                    
                    
                    104
                    W
                    
                    
                    33
                    %25W
      ceramic metal halide accent light
                    
                    
                    5
                    
                    
                    
                    125
                    W
                    
                    
                    44
                    %50W
      MR-16 halogen accent light
                    
                    
                    8
                    
                    
                    
                    400
                    W
                    
                    
                    83
                    %60W
      incandescent down light
                    
                    
                    7
                    
                    
                    
                    420
                    W
                    
                    
                    83
                    %
 
 The fiber
optic 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 fiber optic systems in selected facilities.
  3
  Color.Today, our
fiber optic 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).  Our new LED illuminators can produce up to 64,000 colors
using a digital
multiplexing (“DMX”) controller.  Both a 70+ color rendering
index (“CRI”) and an 80+ CRI option are 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 fiber optic 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 fiber optic system is able to significantly
reduce maintenance and replacement costs that normally are attributed to
traditional lighting systems.  Our fiber optic 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 fiber optic lamp annually, based on average retail
usage.  In addition, because the fiber optic 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 fiber optic lamp are not
affected by the freezing temperature.  The fiber optic 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 turnkey, comprehensive
energy-efficient lighting systems.  To achieve this objective, we
intend to pursue the following strategies:
 
 ·
              Capitalize on the growing need
      for high return on investment 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 such as
  LED.
 ·
              Focus on increased market
      penetration where the benefits of our technology are most
      compelling.We intend to broaden the penetration of our
      products within commercial, retail, and supermarket channels, which all
      share urgent needs for highly efficient, flexible, and financially
      economical lighting solutions.  Further, we continue to
      aggressively penetrate the government and military lighting
      markets.  To reach our target markets, we are significantly
      increasing both the number and experience level of our direct sales
      employees.  Additionally, we are actively restructuring our
      independent sales representative network to increase sales volume and
      accountability of results.
 ·
              Develop and expand strategic
      relationships.To expedite the awareness of our
      technologies, we continue to actively pursue strategic relationships with
      distributors, energy service companies (“ESCO’s”), lighting designers, and
      contractors who distribute, recommend, and/or install lighting
      systems.  We continue to cultivate relationships with fixture
      manufacturers and other participants in the general lighting
      market.
 ·
              Develop a commercially-viable,
      cost-effective solar technology.Through our on-going
      leadership role in the United States government’s VHESC Consortium
      sponsored by DARPA, we expect to be able to commercialize a solar cell
      technology that will significantly surpass current solar efficiencies
      ranging from 6% - 20%.  Our proven optics technology has already
      shown the ability to achieve approximately 40% efficiency in a
      laboratory environment and we believe that this efficiency, or
      greater, can be achieved on a cost-effective, commercially-viable
      scale.
 
 Sales,
Marketing, and Distribution of our Offerings Portfolio
 
 Products
 
 Our
products are sold through a combination of direct sales employees, 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 products and as such does not prohibit revenue
recognition.
 
 Within
the commercial and pool lighting business units, we continue to focus on
retailers, hotels, museums, general contractors, and specifiers.  Our
recent successes include the Las Vegas New York-New York Hotel, and the Miami
Beach Fontainebleau Hotel.  We also continue our penetration into
Whole Foods and Albertson’s food retailers.  Our typical product 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 selected stores
within the same chain.
  4
 
 Solutions
 
 Our
solutions based sales are designed to enhance total value by providing turnkey,
high-quality, energy-efficient lighting application alternatives that positively
impact customers’ profitability, the environment, and the communities we
serve.  These solutions are sold through our direct sales employees,
and include not only our proprietary energy-efficient lighting systems, but also
sourced lighting systems, energy audits, and service agreements.
 Within
the solutions business unit, we are focusing on multi-location food retailers,
cold storage facilities, retailers, museums, and industrial/commercial real
estate companies.  Our recent successes include projects completed at
a leading regional supplier of cold storage services as well as a building
products supplier.
 As of
December 31, 2008, we had approximately 117 sales and independent sales
representatives throughout the United States and Europe.  We have been
successful in hiring experienced salespeople from leading firms in the industry
including our new Vice President of Sales.
 
 Our ten
largest customers accounted for 32.1% of our net sales for the twelve months
ended December 31, 2008.  In 2008, there was no single customer who
accounted for more than 10.0% 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.  We also perform final
assembly of products acquired from Australia, India, and
Taiwan.  These suppliers supply products on a purchase order
basis.
 
 We
currently purchase our small-diameter stranded fiber from multiple vendors,
including Mitsubishi.  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.
 
 Research
and Development
 
 Research
and development has been a key focus of our company; accordingly, we have
committed substantial resources to this endeavor.  Our research and
development team is dedicated to continuous improvement and innovation of our
current lighting technologies, including fiber optics, LED, and HID
systems.  Further, our research and development team plays a leading
role in the United States government’s VHESC Consortium sponsored by
DARPA.  The purpose of the VHESC project is to develop a 50% greater
efficient solar cell for United States military applications which would be
available for commercial application.
 
 Research
and development expense, net of credits from the government, for the years ended
December 31, 2008, 2007, and 2006 were $2,188,000, $2,907,000 and $2,341,000,
respectively.
 
 Our
recent achievements include:
 
 2008:In November 2008, the
United States Department of Energy named Energy Focus an Energy Star
Partner.  Energy Star is a joint program of the United States’
Environmental Protection Agency and Department of Energy helping Americans save
money and protect the environment through energy efficient products and
practices.  Also in November, DARPA, through their Small Business
Innovation Research (“SBIR”) Program, awarded us a contract to develop Explosion
Proof LED fixtures.  In December, the DARPA SBIR Program awarded us a
contract to develop berth lighting systems that will effectively reset a
sailor’s body clock for environments where the natural circadian rhythm is
frequently disrupted.  The two DARPA SBIR contracts are for a total of
$198,000.  Also in December, we installed high efficiency lighting
fixtures to retrofit 100% of the high-bay lighting in a hangar deck on board an
Arleigh Burke class Naval Destroyer.  This installation followed a
year-long demonstration on board naval vessels that replaced existing
fluorescent, incandescent, and halogen lighting with various LED lighting
solutions.
  5
  2007:In August 2007, the
VHESC Consortium 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 $1,000,000 contract with
E.I. DuPont de Nemours and Company to develop advanced solar cell
technologies.  Additionally, we were awarded additional Phase II
contracts for two DARPA SBIR projects to research lamp coating technologies and
an extruded, large-core fiber processing method.  The two DARPA SBIR
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.
 
 Intellectual
Property
 
 We have a
policy of seeking to protect our intellectual property through patents, license
agreements, trademark registrations, confidential disclosure agreements, and
trade secrets, as management deems appropriate.  As of December 31,
2008, and March 6, 2009 our intellectual property portfolio consisted of
64 and 65, respectively, 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 serves as the basis of national patent
filings in countries of interest.  A total of 15 applications are
pending.  Our issued patents expire at various times between January
2013 and October 2026.   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
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 upon 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 upon 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 2008 was $860,000, compared to
$983,000 at the end of 2007.
 
 Competition
 
 Our
commercial lighting products compete against a variety of lighting products,
including conventional light sources such as incandescent light bulbs, as well
as metal halide lamps, LEDs, compact fluorescent lamps, other fiber optic
lighting systems, and decorative 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.
 
 The
market for lighting energy solutions is fragmented.  We face
competition from lighting manufacturers, distributors, as well as electrical
contractors, lighting maintenance contractors, and other energy services
companies.  We compete primarily on the basis of technology, quality,
light quality and design, client relationships, lighting application knowledge,
energy efficiency, customer service, and marketing support.
  6
  We are pursuing a targeted
type of customer and have products that are uniquely designed to address
opportunities and solve problems experienced by these target
clients.Our solutions business competes with in-house
resources and non-traditional ESCO’s.  We typically do not directly
compete with the traditional ESCO’s due to their focus on the municipality,
university, school, healthcare and federal government markets.  There
are approximately 45 traditional ESCO’s in the United
States.  However, since lighting is almost always an integral solution
in their bundle of energy efficiency measures, many of them are also prospective
clients for our products.  The solutions business may also compete
with lighting maintenance companies because our products often last 5 — 50 times
longer than the products we replace, and thus the maintenance companies see a
reduction in service revenues.  However, these same companies are
often also partners who perform the installation on our projects as well as
potential customers of the products we manufacture.  Principal
competitive factors include the client relationship, price, access to
competitive financing, performance guarantees, and ongoing maintenance
requirements.
 
 We expect
that our ability to compete effectively will depend substantially upon our
ability to successfully provide our customers with greater performance at
reduced costs.  Principal competitors in our markets include large
lamp manufacturers, lighting fixture companies, distributors, and ESCO’s whose
financial resources substantially exceed ours.  These competitors may
introduce new or improved products that may reduce or eliminate some of the
competitive advantage of our products.  We anticipate that the primary
competition to our 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 applications, we compete
primarily with local and regional lighting manufacturers that, in many cases,
are more established in their local markets than our company.  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.  Many companies compete with
us in Asia, including Phillips, Mitsubishi, Bridgestone, and
Toray.  Mitsubishi also sells our BritePak® fiber cables in
Japan.
 
 In 2008,
we introduced numerous new product families, including:
 
 ·
              LED
      MR-16 halogen replacement bulbs,
 ·
              LED
      Cold Storage Globe lamps,
 ·
              LED
      Lamps and Fixtures (“PAL”),
 ·
              LED
      Light Rails,
 ·
              LED
      Docklights,
 ·
              HID
      High Bay Fixtures,
 ·
              Fluorescent
      fixtures, and
 ·
              Compact
      Fluorescent Light Bulbs
 
 In the
pool lighting 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 this 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
lighting business, spa manufacturers install LED lighting systems during the
manufacturing process.  We intend to develop new fiber optic and LED
lighting products that are complementary to traditional pool lights currently
sold by pool equipment suppliers.  To maximize the sales of these new
products, we continue to leverage our well-established presence in the domestic
pool lighting market and are expanding into the international pool lighting
market.
 
 Employees
 
 As of
December 31, 2008, we had 92 full-time employees, 18 of whom are located in
the United Kingdom, 8 in Germany, and 66 in the United States.  We
have 6 employees dedicated to developing technology, research, and product
development.  We also have 37 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
 
 We
operate in a single industry segment where we serve two principal markets;
commercial/industrial lighting and pool lighting.  We market our
products for worldwide distribution primarily through independent sales
representatives and distributors in North America, Europe, and the Far
East.
  7
  Available
Information
 
 Our Web
site is located at http://www.efoi.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
Securities and Exchange Commission (“SEC”).  Information contained on
our Web site is not part of this report.
  8
  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.
 
 EFO®,
Fiberstars®, BritePak®, and EFO-Ice® are our registered
trademarks.  We may 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.
  9
  Item
1A. Risk Factors
 
 Going Concern/Liquidity
Risk:  Our independent public auditing firm has issued an
opinion raising substantial doubt as to our ability to continue as a going
concern throughout 2009.  This opinion stems from the combination of
the worsening global economic crisis, the
historical losses we have incurred leading to an accumulated deficit of
$49,328,000 as of December 31, 2008, our history of not meeting management
budgetary forecasts, and our historical inability to generate sufficient cash
flow to meet obligations and sustain operations without obtaining additional
external financing.  The global credit market crisis has also had a
dramatic effect on our industry and customer base.  The recession in
the United States and Western Europe and the slowdown of economic growth in the
rest of the world created a business environment where it is substantially more
difficult to obtain equity funding and additional non-equity
financing.  Furthermore, this environment has resulted in an increased
risk of customer payment defaults. Our liquidity position, as well as our
operating performance, was negatively affected by these economic and industry
conditions and by other financial and business factors, many of which are beyond
our control.
 
 Management
acknowledges that sustaining our historical level of cash utilization is not
conducive to remaining a viable entity in this environment, and is in the
process of aggressively transforming our business into a turnkey, comprehensive
energy-efficient lighting solutions provider.  In addition, management
continues to aggressively reduce costs, as evidenced in the $1,984,000 decrease
in operating expenses, excluding loss on impairment in 2008, from 2007
levels.  These cost reductions have been achieved while simultaneously
realigning and expanding our sales and marketing organization.  In
this regard, we have been very successful in hiring highly experienced
salespeople from leading “Fortune 500” firms including our new Vice President of
Sales.  Further, we have aligned our entire engineering and research
and development organization around sales and marketing to expedite new product
introductions into our served available markets.  This realignment is
readily evidenced by the 2008 introduction of multiple new products
including;
 
 ·
              MR-16
      halogen replacement bulbs,
 ·
                LED
      Cold Storage Globe lamps,
 ·
              LED
      Lamps and Fixtures (“PAL”),
 ·
              LED
      Light Rails,
 ·
              LED
      Docklights,
 ·
              HID
      High Bay Fixtures,
 ·
              Fluorescent
      fixtures, and
 ·
              Compact
      Fluorescent Light Bulbs
 
 Lastly,
we expect to continue our on-going leadership role in the United States
government’s Very High Efficiency Solar Cell (“VHESC”) Consortium sponsored by
the Defense Advanced Research Projects Agency (“DARPA”) where we expect to be
able to commercialize a solar cell technology that will significantly surpass
current solar efficiencies ranging from 6% - 20%.  Our proven optics
technology has already shown the ability to achieve approximately 40% efficiency
in a laboratory environment and we believe that this efficiency, or
greater, can be achieved on a cost-effective, commercially-viable
scale.
 
 Although
we are optimistic about obtaining the funding necessary for us to continue as a
going concern through internal means, there can be no assurances that this
objective will be successful.  Therefore, in the event that our cash
reserves and bank lines of credit are deemed by management to not be sufficient
to continue to fund operations throughout 2009, we will aggressively pursue one
or more of the following external funding sources:
 
 ·
              obtain
      loans and/or grants available through federal, state, and/or local
      governmental agencies,
 ·
              obtain
      loans and/or grants from various financial
  institutions,
 ·
              obtain
      loans from non-traditional investment capital
    organizations,
 ·
              sale
      and/or disposition of one or more operating units,
  and
 ·
              obtain
      funding from the sale of our common stock or other equity
      instruments.
 
 Obtaining
financing through the above mentioned mechanisms contain risks,
including:
 
 ·
              government
      stimulus and/or grant money is not allocated to us despite our focus on
      the design, development, and manufacturing of energy efficient lighting
      systems,
 ·
              loans
      or other debt instruments may have terms and/or conditions, such as
      interest rate, restrictive covenants, and control or revocation
      provisions, which are not acceptable to management or our Board of
      Directors,
 ·
              the
      current global economic crisis combined with our current financial
      condition may prevent us from being able to obtain any debt
      financing,
 ·
              financing
      may not be available for parties interested in pursuing the acquisition of
      one or more of our operating units,
and
 ·
              additional
      equity financing may not be available to us in the current economic
      environment and could lead to further dilution of shareholder value for
      current shareholders of record.
  10
 
 Global Economic
Risk:  We may continue to be adversely impacted by the weakness
in the general economic environment including the current recessionary and
inflationary pressures.  Deteriorating economic and market conditions
including declines in real estate values and new construction, rising
unemployment, tightened credit markets, and weakened consumer confidence are not
expected to improve during 2009 and may continue to contribute towards weak
product sales.  Specifically, the downturn in housing construction has
adversely affected the sale of pool lighting products, while the consumer credit
crisis may continue to cause retail sales to decrease.  Furthermore,
material and labor costs may increase as a result of inflationary pressures on
certain raw material prices.
 
 We have
significant international activities and customers and plan to continue these
efforts.  These activities subject us to additional business risks
including logistical complexity and the general economic conditions in those
markets.  Because the market for our products tends to be highly
dependent upon general economic conditions, a continued decline in the general
world-wide economic environment is likely to continue to adversely impact our
traditional product based 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 processes,
and developing telecommunications infrastructures.  In addition, some
countries in this region, such as China and Japan, have adopted laws,
regulations, and policies that impose additional restrictions on the ability of
foreign companies to conduct business in their countries or otherwise place them
at a competitive disadvantage in relation to domestic companies.
 
 Competitive
Risk:  Global competition exists in all of the markets we
serve, including our energy solutions market.  A number of companies
offer directly competitive products and services, including colored halogen
lighting for swimming pools and incandescent and fluorescent lighting for
commercial decorative and accent lighting.  We also compete with LED
products in industrial lighting and pool related products.  In
addition, many of our competitors in the pool lighting 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.  Our company
also competes with lighting energy solutions companies.
 
 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, our operating results will be
adversely affected.
 
 Technological
Risk:  The markets for our products are characterized by
rapidly changing technology, evolving industry standards, and speed of new
product introductions.  Our operating results depend on our ability to
develop and introduce new products into existing and emerging markets, and to
reduce the production costs of existing products.  Many of our
strategic initiatives are aimed at developing increasingly complex energy
efficient lighting solutions.  The process of developing this new
technology is complex and uncertain, and if we fail to accurately predict
customers’ changing needs and emerging technological trends, our business could
be harmed.  We must commit significant resources to developing new
products before knowing with certainty that our investments will result in
products the market will accept.  Furthermore, we may not be able to
execute successfully because of technical hurdles that we fail to overcome in a
timely fashion, or a lack of appropriate resources.  This could result
in competitors providing those solutions before we do and loss of market share,
net sales, and earnings.  The success of new products depends on
several factors, including proper new product definition, component costs,
timely completion and introduction of these products, differentiation of new
products from those of our competitors, and market acceptance of these
products.  There can be no assurance that we will successfully
identify new product opportunities, develop and bring new products to market in
a timely manner, or achieve market acceptance of our products or that products
and technologies developed by others will not render our products or
technologies obsolete or noncompetitive.  Specifically, the products
and technologies that we identify as “emerging technologies,” may not prove to
have the market success we anticipate, and we may not successfully identify and
invest in other emerging or advanced technologies as
appropriate.
  11
  Supplier Risk:  We
require substantial amounts of purchased materials from selected
vendors.  With specific materials, we purchase 100% of our requirement
from a single vendor.  Included in purchased materials are small
diameter stranded fiber, plastic fixtures, lamps, reflectors, and power
supplies.  Substantially all of the materials we require are in
adequate supply.  However, the availability and costs of materials may
be subject to change due to, among other things, new laws or regulations,
suppliers’ allocation to other purchasers, interruptions in production by
suppliers, and changes in exchange rates and worldwide price and demand
levels.  Our inability to obtain adequate supplies of materials for
our products at favorable prices could have a material adverse effect on our
business, financial position or results or operations by decreasing our profit
margins and by hindering our ability to deliver products to our customers on a
timely basis.  We have experienced an increase in the costs in certain
petroleum-based materials.  Although we may determine that it is
necessary to pass on the material price increases to our customers, in certain
circumstances, it may not be possible for us to pass on these
increases.  Even if we are able to pass on some or all of these
increases, there may be a delay between when we have to pay for the increases
and when our customers pay us based on the increased prices.  If we
are not able to reduce or eliminate the effect of these cost increases through
lowering other costs of production or successfully implementing price increases
to our customers, such material cost increases could have a negative effect on
our operating and financial results.
 
 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:  In
this climate of global financial and banking crisis, the ability of our
customers to maintain credit availability has become more
challenging.  In particular, certain customers in the pool lighting
market and companies that are highly leveraged represent an increasing credit
risk.  Some customers have reduced their purchases because of these
credit constraints.  Moreover, our disciplined credit policies have,
in some instances, resulted in delayed customer sales.  In 2008, we
experienced an increase in customer bankruptcies and voluntary
liquidations.  Continued deterioration of global economic conditions
could result in additional customer credit constraints, particularly within our
pool lighting market.  These actions could have a materially adverse
effect on our financial condition, operating results, and cash
flows.
 
 Intellectual Property
Risk:  As of December 31, 2008, our intellectual property
portfolio consisted of 64 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 serves as the basis of national patent
filings in countries of interest.  As of December 31, 2008 a total of
15 applications were pending.  Our issued patents expire at various
times between January 2013 and October 2026.  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 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 operating officer, and chief
technical officer.  These and other key employees would be difficult
to replace.  Our future success will also 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.  We have been successful in hiring experienced
energy solutions salespeople from leading firms in the industry including our
new Vice President of Sales.  However, if these individuals are not
successful in achieving our expectations, then planned sales may not occur and
the anticipated revenues may not be realized.
 
 Risk of Losing Governmental Funding
for Research:  Historically, approximately 43.9% of our
research and development efforts have been supported directly by government
funding.  In 2008, approximately 29.0% of our 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 technology and products at their current
levels, if at all.  If we are unable to support our 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, we 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 proceedings 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 lighting 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.
  12
  Item
1B. Unresolved Staff Comments
 
 None
 
 Item
2. Properties
 
 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 April 2011.  Approximately 12,000 square
feet of this space is subleased to another tenant through June
2010.  We also have leased sales facilities in Pleasanton, California,
and Berkshire, United Kingdom.  We also own a sales and 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, 2008, there were no matters
submitted to a vote of security holders.
  13
  Executive
Officers of the Registrant
 
 The
following is the name, age, and present position of each of our executive
officers, as well as all prior positions held by each of them during the last
five years and when each of them were first elected or appointed as an executive
officer.
 
 Name
                  
                  Age
                  
                  Current Position and Business
      ExperienceJoseph
      G. Kaveski
                  
                  48
                  
                  Chief Executive Officer and
      Director – May 2008 to present. Prior to joining Energy Focus, Mr.
      Kaveski led his own strategic engineering consulting business, TGL
      Company.  As a consultant he worked with equity investors and
      publicly traded companies on strategic initiatives and
      planning.  Other corporations Mr. Kaveski has worked for include
      Johnson Controls, Inc. where he was Vice President of Energy Management
      Solutions and Strategic Projects.John
      M. Davenport
                  
                  63
                  
                  President and Director– May 2008
      to present. Chief Executive Officer – July 2005 to May
      2008.  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.Eric
      M. Hilliard
                  
                  41
                  
                  Chief Operating Officer and
      Vice President – November 2006 to present. Prior to joining Energy
      Focus, Mr. Hilliard served as a 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
      2002Nicholas
      G. Berchtold
                  
                  42
                  
                  Chief Financial Officer and
      Vice President of Finance – July 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
      R. Buelow
                  
                  36
                  
                  Chief Technology Officer,
      General Manager, and Vice President– July 2005 to present. Vice
      President of 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.
  14
  PART II
 
 Item
5. Market for the Registrant’s Common Equity, Related Stockholder Matters, and
Issuer Purchases of Equity Securities
 
 Our
common stock trades on the Nasdaq Global 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
                    
                    
                    LowFirst
      quarter 2007
                    
                    $
                    8.75
                    
                    
                    $
                    5.20Second
      quarter 2007
                    
                    
                    7.52
                    
                    
                    
                    5.60Third
      quarter 2007
                    
                    
                    7.85
                    
                    
                    
                    4.60Fourth
      quarter 2007
                    
                    
                    9.95
                    
                    
                    
                    4.80First
      quarter 2008
                    
                    $
                    7.31
                    
                    
                    $
                    2.31Second
      quarter 2008
                    
                    
                    2.94
                    
                    
                    
                    1.78Third
      quarter 2008
                    
                    
                    2.75
                    
                    
                    
                    1.45Fourth
      quarter 2008
                    
                    
                    2.57
                    
                    
                    
                    1.00
  There
were approximately 111 holders of record of our common stock as of March 10,
2009, and we estimate that at that date there were approximately 2,371
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 in equity securities that required stockholder
approval during 2008.  On March 14, 2008, the company closed a private
placement of its common shares and warrants that raised $9,335,000, net of
expenses.  Stockholder approval was not required or
sought.  Options exercised during 2008 were all issued prior to
calendar year 2008.
  15
  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,
                              
                              2008
                              
                              
                              2007
                              
                              
                              2006
                              
                              
                              2005
                              
                              
                              2004OPERATING
      SUMMARYNet
      sales
                              
                              $
                              22,950
                              
                              
                              $
                              22,898
                              
                              
                              $
                              27,036
                              
                              
                              $
                              28,337
                              
                              
                              $
                              29,731Gross
      profit
                              
                              
                              5,503
                              
                              
                              
                              6,282
                              
                              
                              
                              7,785
                              
                              
                              
                              10,626
                              
                              
                              
                              11,511As
      a percentage of net sales
                              
                              
                              24.0
                              %
                              
                              
                              27.4
                              %
                              
                              
                              28.8
                              %
                              
                              
                              37.5
                              %
                              
                              
                              38.7
                              %Net
      research and development expenses
                              
                              
                              2,188
                              
                              
                              
                              2,907
                              
                              
                              
                              2,341
                              
                              
                              
                              2,190
                              
                              
                              
                              1,188As
      a percentage of net sales
                              
                              
                              9.5
                              %
                              
                              
                              12.7
                              %
                              
                              
                              8.7
                              %
                              
                              
                              7.7
                              %
                              
                              
                              4.0
                              %Sales
      and marketing expenses
                              
                              
                              8,551
                              
                              
                              
                              9,789
                              
                              
                              
                              9,774
                              
                              
                              
                              9,595
                              
                              
                              
                              8,595As
      a percentage of net sales
                              
                              
                              37.3
                              %
                              
                              
                              42.8
                              %
                              
                              
                              36.2
                              %
                              
                              
                              33.9
                              %
                              
                              
                              28.9
                              %General
      and administrative expenses
                              
                              
                              5,080
                              
                              
                              
                              4,651
                              
                              
                              
                              4,956
                              
                              
                              
                              3,135
                              
                              
                              
                              2,459As
      a percentage of net sales
                              
                              
                              22.1
                              %
                              
                              
                              20.3
                              %
                              
                              
                              18.3
                              %
                              
                              
                              11.1
                              %
                              
                              
                              8.3
                              %Loss
      on impairment
                              
                              
                              4,305
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —As
      a percentage of net sales
                              
                              
                              18.8
                              %
                              
                              
                              —
                              %
                              
                              
                              —
                              %
                              
                              
                              —
                              %
                              
                              
                              —
                              %Restructure
      expenses
                              
                              
                              —
                              
                              
                              
                              456
                              
                              
                              
                              734
                              
                              
                              
                              3,120
                              
                              
                              
                              —As
      a percentage of net sales
                              
                              
                              —
                              %
                              
                              
                              2.0
                              %
                              
                              
                              2.7
                              %
                              
                              
                              11.0
                              %
                              
                              
                              —
                              %Loss
      before tax
                              
                              
                              (14,698
                              )
                              
                              
                              (11,127
                              )
                              
                              
                              (9,537
                              )
                              
                              
                              (7,314
                              )
                              
                              
                              (762
                              )As
      a percentage of net sales
                              
                              
                              (64.0
                              )%
                              
                              
                              (48.6
                              )%
                              
                              
                              (35.3
                              )%
                              
                              
                              (25.8
                              )%
                              
                              
                              (2.6
                              )%Net
      loss
                              
                              
                              (14,448
                              )
                              
                              
                              (11,317
                              )
                              
                              
                              (9,650
                              )
                              
                              
                              (7,423
                              )
                              
                              
                              (704
                              )As
      a percentage of net sales
                              
                              
                              (63.0
                              )%
                              
                              
                              (49.4
                              )%
                              
                              
                              (35.7
                              )%
                              
                              
                              (26.2
                              )%
                              
                              
                              (2.4
                              )%Net
      loss per shareBasic
                              
                              $
                              (1.02
                              )
                              
                              $
                              (0.98
                              )
                              
                              $
                              (0.85
                              )
                              
                              $
                              (0.90
                              )
                              
                              $
                              (0.10
                              )Diluted
                              
                              $
                              (1.02
                              )
                              
                              $
                              (0.98
                              )
                              
                              $
                              (0.85
                              )
                              
                              $
                              (0.90
                              )
                              
                              $
                              (0.10
                              )Shares
      used in per share calculation:Basic
                              
                              
                              14,182
                              
                              
                              
                              11,500
                              
                              
                              
                              11,385
                              
                              
                              
                              8,223
                              
                              
                              
                              7,269Diluted
                              
                              
                              14,182
                              
                              
                              
                              11,500
                              
                              
                              
                              11,385
                              
                              
                              
                              8,223
                              
                              
                              
                              7,269FINANCIAL
      POSITION SUMMARYTotal
      assets
                              
                              $
                              23,652
                              
                              
                              $
                              29,125
                              
                              
                              $
                              40,592
                              
                              
                              $
                              46,209
                              
                              
                              $
                              27,018Cash
      and cash equivalents
                              
                              
                              10,568
                              
                              
                              
                              8,412
                              
                              
                              
                              15,968
                              
                              
                              
                              23,578
                              
                              
                              
                              3,609Working
      capital
                              
                              
                              12,514
                              
                              
                              
                              12,512
                              
                              
                              
                              22,410
                              
                              
                              
                              31,530
                              
                              
                              
                              14,541Credit
      line borrowings
                              
                              
                              1,904
                              
                              
                              
                              1,159
                              
                              
                              
                              1,124
                              
                              
                              
                              47
                              
                              
                              
                              —Current
      portion of long-term borrowings
                              
                              
                              54
                              
                              
                              
                              1,726
                              
                              
                              
                              778
                              
                              
                              
                              342
                              
                              
                              
                              38Long-term
      borrowings
                              
                              
                              245
                              
                              
                              
                              314
                              
                              
                              
                              1,862
                              
                              
                              
                              1,089
                              
                              
                              
                              484Shareholders’
      equity
                              
                              
                              16,789
                              
                              
                              
                              21,618
                              
                              
                              
                              30,880
                              
                              
                              
                              38,184
                              
                              
                              
                              21,202Common
      shares outstanding
                              
                              
                              14,835
                              
                              
                              
                              11,623
                              
                              
                              
                              11,394
                              
                              
                              
                              11,270
                              
                              
                              
                              7,351
  16
  Item
7. Management’s Discussion and Analysis of Financial Condition and Results of
Operation
 
 Overview
 
 We
engaged in the design, development, manufacturing, marketing, and installation
of energy-efficient lighting systems where we served two principal markets;
commercial/industrial lighting and pool lighting.  Our business
strategy evolved into providing our customers with turnkey, comprehensive
energy-efficient lighting solutions which included, but were not limited to, our
patented and proprietary technology.  Our solutions included fiber
optic, light-emitting diode (“LED”), ceramic metal halide (“CMH”),
high-intensity discharge (“HID”), and other highly energy efficient lighting
technologies.  Our strategy also incorporated continued investment in
research into new and emerging energy sources including, but not limited to,
solar energy.  Typical savings of current technology averages 80% in
electricity costs, while providing full-spectrum light closely simulating
daylight colors.
 
 During
the course of 2008 we:
 
 ·
              appointed
      a new Chief Executive Officer, Joseph G. Kaveski, under whom we
      aggressively realigned our organization to focus on enhanced sales and
      marketing efforts while implementing aggressive cost reductions in all
      areas of the business, and increasing our investment in sales personnel,
      marketing collateral, and product
displays.
 ·
              formally
      opened a state-of-the-art sustainable lighting solutions showroom in
      Solon, Ohio, where customers, lighting specialists, designers, and
      installers are able to experience our technology in a variety of
      application settings, which further helps cement our relationships within
      the markets we serve.
 ·
              re-energized
      the brand name Fiberstars by aligning both the pool and commercial
      lighting sales organizations, including customer service, under the
      leadership of the new Vice President of Sales, Steve
      Gasperson.
 ·
              undertook
      the global marketing of the business under the Energy Focus brand with the
      common goal of providing advanced high quality lighting energy solutions
      that positively impact our customers’ bottom line, the environment, and
      the communities we serve.
 ·
              became
      eligible to market products to the federal government through its General
      Services Administration (“GSA”) website (www.GSAAdvantage.gov)
      and as of March 13, 2009, we have four product families, comprised of 18
      individual products, currently listed on the
  website.
 
 In
November 2008, the United States Department of Energy named us an Energy Star
Partner on selected products.  Energy Star is a joint program of the
United States’ Environmental Protection Agency and Department of Energy helping
Americans save money and protect the environment through energy efficient
products and practices.  Also in November, the Defense Advanced
Research Projects Agency (“DARPA”), through their Small Business Innovation
Research (“SBIR”) Program, awarded us a contract to develop explosion proof LED
fixtures.  In December, the DARPA SBIR Program awarded us an
additional contract to develop berth lighting systems that will effectively
reset a military service member’s natural body rhythms to artificially created
environments.  These systems will be tested initially by the United
States Navy.  The two DARPA SBIR contracts are for a total of
$198,000.  Also in December, we installed high efficiency lighting
fixtures to retrofit 100% of the high-bay lighting in a hangar deck on board an
Arleigh Burke class Naval Destroyer.  This installation followed a
yearlong demonstration on board naval vessels that replaced existing
fluorescent, incandescent, and halogen lighting with various LED lighting
solutions.
 
 Results
of Operations
 
 Net
Sales
 
 Our sales
breakdowns, by product lines, with EFO products as a separate line item, are as
follows (in thousands):
 
 Product
Line Breakdown
  Year Ended December 31,2008
                      
                      
                      2007
                      
                      
                      2006EFO
                      
                      $
                      10,888
                      
                      
                      $
                      7,011
                      
                      
                      $
                      5,316Traditional
      Pool
                      
                      
                      5,034
                      
                      
                      
                      9,002
                      
                      
                      
                      11,958Traditional
      Commercial Lighting
                      
                      
                      7,028
                      
                      
                      
                      6,885
                      
                      
                      
                      9,762Total
                      
                      $
                      22,950
                      
                      
                      $
                      22,898
                      
                      
                      $
                      27,036
 
 EFO sales
reported in 2006 have been reclassified for comparability with EFO products
included in 2008 and 2007.
 
 Net sales
increased less than 1% to $22,950,000 for the twelve months ended December 31,
2008.  The increase was primarily a result of a $2,281,000 increase in
net sales by our European subsidiaries, as well as an increase of $1,569,000 in
United States traditional and EFO commercial lighting and government EFO
lighting sales.  These increases were offset by a $3,798,000 decrease
in traditional pool and EFO pool lighting sales.During 2008, $1,292,000
of revenue was recognized from the delivery of certain milestones to E.I. DuPont
de Nemours and Company as part of the Very High Efficiency Solar Cell (“VHESC”)
Consortium being funded by DARPA.
  17
   EFO sales
were $10,888,000 for the twelve months ended December 31, 2008, or 47.4% of
total net sales, compared to $7,011,000 for 2007 and $5,316,000 for
2006.  EFO sales in 2008, 2007, and 2006 include sales from EFO fiber
optic lighting, EFO LED, EFO Controls, and EFO Government
products.  In 2008, international sales increased significantly to
exceed comparable 2007 and 2006 levels resulting from improved penetration of
EFO in the Middle East and India construction markets.  However,
deteriorating global economic conditions within the housing and construction
industries did have an adverse impact on the magnitude of our continued
expansion within the Middle East and India markets during the second half of
2008.
 
 In 2007,
net sales decreased by 15.3% to $22,898,000, compared to $27,036,000 in
2006.  The 2007 decrease was a result of lower sales of pool products,
excluding EFO, of 24.7%, or $2,956,000, and commercial lighting products of
29.5%, or $2,877,000, which was partially offset by increased sales of EFO
products of 31.9%, or $1,695,000.  The decrease in traditional pool
lighting sales was due primarily to a 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 United States and
Germany.
 
 International
Sales
 
 We have
foreign manufacturing operations in the United Kingdom and Germany, and revenue
and expenses from these operations are denominated in local currency,
thereby creating exposures to changes in exchange rates.  Fluctuations
in these operations’ respective currencies may have an impact on our business,
results of operations, and financial position.  We currently do not
use financial instruments to hedge our exposure to exchange rate fluctuations
with respect to our international operations.  As a result, we
may experience substantial foreign currency translation gains or losses
due to the volatility of other currencies compared to the United States
dollar, which may positively or negatively affect our results of operations
attributed to these operations.  International sales accounted for
approximately 43.8% of net sales in 2008, as compared to 34.7% of net sales in
2007 and 30.6% in 2006.  The impact of changes in foreign currency
exchange rates resulted in a reduction in reported net sales for 2008 of
$406,000 from 2007 levels as compared to an increase in reported net sales for
2007 of $759,000 from 2006 levels.  On a local currency basis, net
sales increased 27.4% for our international operations from 2007
levels.  The breakdown of our international sales is as follows (in
thousands):
 
 Year Ended December 312008
                      
                      
                      2007
                      
                      
                      2006United
      States Domestic
                      
                      $
                      12,902
                      
                      
                      $
                      14,949
                      
                      
                      $
                      18,776Germany
                      
                      
                      2,918
                      
                      
                      
                      3,136
                      
                      
                      
                      2,998United
      Kingdom
                      
                      
                      6,764
                      
                      
                      
                      4,265
                      
                      
                      
                      4,817Others
                      
                      
                      366
                      
                      
                      
                      548
                      
                      
                      
                      445Total
      Sales
                      
                      $
                      22,950
                      
                      
                      $
                      22,898
                      
                      
                      $
                      27,036
 
 Gross
Profit
 
 We had
gross profit of $5,503,000 in 2008, a decrease of 12.4%, compared to $6,282,000
in 2007.  Total gross profit as a percentage of total net sales was
24.0% in 2008, compared to 27.4% in 2007.  Included in the 2008 gross
profit is total expense in the amount of $1,071,000 related to our modification
of the definition of slow-moving and obsolete inventory
reserve.  Management deems this increase appropriate as technology
within the lighting industry continues to accelerate.  Gross profit
was also favorably impacted by a mid-year price increase within the commercial
lighting business unit.  For 2009, we intend to continue to combat
global economic pressures by focusing sales resources in new and existing market
channels including food retailers, cold storage, and government
facilities.  Further, we will continue to implement strategic sourcing
and operational cost reductions on a global basis.  Selected price
increases will also be implemented.
 
 In 2007,
we had gross profit of $6,282,000, compared to $7,785,000 in 2006. As a
percentage of sales, the gross profit for 2007, was 27.4% compared to 28.8% in
2006.  Lower margins from commercial lighting and pool sales
contributed towards much of the decline in 2007.
  18
  Operating
Expenses
 Research
and Development
 
 Gross
research and development expenses were $3,083,000 in 2008, a 10.0% decrease from
$3,424,000 in 2007.Gross research and
development expenses were $3,424,000 in 2007, a 3.7% decrease from $3,556,000 in
2006.  The decrease in 2008 was primarily due to a $145,000 decrease
in salaries and benefits, and a $195,000 decrease in project related
costs.  The decrease in 2007 from 2006 levels was primarily due to a
decrease in temporary labor and consultant fees of $369,000, offset by an
increase in salaries and benefits of $193,000.  Our research and
development expenses are reduced on a proportional performance basis under DARPA
SBIR development contracts.  These contracts were signed in 2007, for
a total of $1,500,000 to be reimbursed over the two-year life of the
contracts.   The gross and net research and development spending
along with credits from government contracts is shown in the following table (in
thousands):
  Year ended December 31,2008
                        
                        
                        2007
                        
                        
                        2006Gross
      R& D Expense and Government Reimbursement:Gross
      Expenses for R&D
                        
                        $
                        3,083
                        
                        
                        $
                        3,424
                        
                        
                        $
                        3,556Deduct:
      Incurred and Accrued Credits from Government Contracts
                        
                        
                        (895
                        )
                        
                        
                        (517
                        )
                        
                        
                        (1,215
                        )Net
      R&D Expenses
                        
                        $
                        2,188
                        
                        
                        $
                        2,907
                        
                        
                        $
                        2,341Total
      Credits Received and Revenue Recognized on Government
      Projects:Incurred
      and Accrued Credits from Government Contracts
                        
                        $
                        895
                        
                        
                        $
                        517
                        
                        
                        $
                        1,215Revenue
      Recognized for Completed Deliveries
                        
                        
                        1,670
                        
                        
                        
                        542
                        
                        
                        
                        1,979Net
      Credits Received and Revenue Recognized
                        
                        $
                        2,565
                        
                        
                        $
                        1,059
                        
                        
                        $
                        3,194
  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 amount of credits incurred and accrued from government
contracts were $895,000 in 2008, compared to $517,000 in 2007, and $1,215,000 in
2006.  Net research and development expenses were 9.5% of sales in
2008, compared to 12.7% of sales in 2007, and 8.7% in 2006.
 
 When the
government contract is for the delivery of a product or service, we recognize
revenue from those government projects according to proportional performance
method or actual deliveries made.  Costs related to the completion of
the sale are charged to cost of sales.  In 2008, revenue recognized
from completed deliveries was $1,670,000.  The revenue recognized for
completed deliveries of products or services was $542,000 in 2007 and $1,979,000
in 2006.  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 2008,
our net credits were $2,565,000, compared to $1,059,000 in 2007 and $3,194,000
in 2006.
 
 Sales
and Marketing
 
 Sales and
marketing expenses were $8,551,000 in 2008, compared to $9,789,000 in 2007, a
decrease of 12.7%.  In 2008, sales and marketing expenses for pool
lighting amounted to $2,149,000, or 25.1% of total sales and marketing cost,
whereas sales and marketing expense for commercial lighting was $6,402,000, or
74.9% of total marketing costs.  The decrease in 2008 was primarily a
result of a $693,000 decrease in salaries and benefits, a $406,000 decrease in
advertising and trade show expenses, and a $133,000 decrease in expenses related
to stock-based compensation.  Contributing to the overall decrease in
salaries versus 2007 levels was the termination of the Vice President of Pool
Lighting Sales, and the subsequent reorganization of the pool lighting,
commercial lighting, and customer service organizations under new
leadership.  This reorganization enabled us to re-energize the
Fiberstars brand name under common leadership.  Further, we have
aggressively recruited experienced energy solutions focused salespeople from
leading firms in the industry, and have successfully hired a new Vice President
of Sales and seasoned account executives.  These new employees,
combined with our sales consultants, possess more than 211 years of energy
solutions/business development experience.
 
 In 2007,
sales and marketing expenses were $9,789,000, an increase of less than 1.0%
compared to the $9,774,000 in 2006.  In 2007, sales and marketing
expenses for pool lighting amounted to $2,676,000, or 27.3% of total sales and
marketing cost, whereas sales and marketing expense for commercial lighting was
$7,113,000, or 72.7% of total marketing costs.   In 2006, sales
and marketing expenses for pool lighting amounted to $3,087,000, or 31.6% of
total sales and marketing cost, whereas sales and marketing expense for
commercial lighting was $6,687,000, or 68.4% of total marketing
costs.
  19
  General
and Administrative
 General
and administrative expenses were 22.1% of sales in 2008, compared to 20.3% of
sales in 2007, and 18.3% of sales in 2006. General and administrative expenses
were $5,080,000 in 2008, a 9.2% increase, as compared to $4,651,000 in
2007.  This increase was largely a result of a $604,000 increase in
salaries and benefits primarily due to the May 2008 appointment of our new Chief
Executive Officer as well as the reclassification of certain executives out of
manufacturing and research and development.  Also causing the increase
was a $95,000 increase in audit and legal service fees and a $71,000 increase in
travel expenses.  These increases were offset by reductions in
temporary labor and consulting fees, professional service fees, and bad debt
expense.
 
 General
and administrative expenses were $4,651,000 in 2007, a 6.2% decrease, as
compared to $4,956,000 in 2006.  This decrease 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 for bad debts which was
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 $4,137,000, a decrease of 16.5% from 2006.
 
 In the
fourth quarter of 2008, as a result of our annual test for impairment required
under SFAS 142, and based on an assessment of its present and future operations,
we recognized a non-cash expense of $4,305,000 for the impairment of our
goodwill.  The goodwill was originally recorded at the time of the
acquisitions of Fiber Optic International, Crescent Lighting Limited, LBM
Lichleit-Fasertechnik, Unison Fiber Optic Lighting Systems, and Lightly
Expressed Limited.  As of December 31, 2008, we have no remaining
goodwill on our books.  There was no impairment of goodwill in 2007 or
2006.
 
 The
restructuring expenses in 2007 were $456,000, compared to $734,000 in 2006, a
decrease of 37.9 %. The 2007 cost is associated with relocating the fiber
production operation from Mexico to Solon, Ohio.  The 2006
restructuring costs were for the relocation of the corporate headquarters from
Fremont, California to Solon, Ohio.
 
 Excluding
the non-cash loss on impairment charge of $4,305,000 in 2008, total operating
expenses decreased $1,984,000, or 11.1%, from 2007 levels.
 Other
Income and Expenses
 
 We had
interest income of $208,000 and interest expense of $198,000 in
2008.  Interest income consists of interest earned on
deposits.  Interest expense is for bank interest on our line of
credit, equipment loans, and on a building loan for our corporate office in
Germany.  Our interest income was $605,000 in 2007, compared to
$760,000 in 2006.  Our interest expense was $321,000 in 2007, compared
to $277,000 in 2006.
 
 We have
certain long-term leases.  Payments due under these leases are
disclosed below and in Note 8 in the Consolidated Financial Statements and
related notes included elsewhere in this report.
 
 Income
Taxes
 
 We have a
full valuation allowance against our United States and German deferred tax
assets. The net deferred tax assets for 2008 amounted to $15,000 and were for
our United Kingdom subsidiary, which reported income in 2008 and has been
profitable prior to 2007.  The income tax benefit from the United
States operations in 2008 relates to the reversal of the 2007 deferred tax
liability of $252,000 for goodwill as a result of the book
impairment.  There were no Federal tax expenses for the United States
operations in 2008, as any expected benefits were offset by an increase in the
valuation allowance.  A tax provision of $2,000 was recorded for our
United Kingdom operation, and no tax benefits were recorded for the 2008 German
operations loss.
 
 For 2007,
we had 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 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
United States, 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 United States 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 for 2006.
  20
  Net
Loss
 
 The net
loss was $14,448,000, an increase of 27.7% from our net loss of $11,317,000 in
2007.  Included in the 2008 net loss is total expense in the amount of
$1,071,000 related to our increase in slow-moving and obsolete inventory
reserves.  Also included in the 2008 net loss is a non-cash expense of
$4,305,000 for the impairment of our goodwill.
 
 For 2007,
the net loss of $11,317,000 was an increase of 17.3% compared to the net loss of
$9,650,000 in 2006.
 
 Liquidity
and Capital Resources
 
 Cash
      and Cash Equivalents
 
 At
December 31, 2008, our cash and cash equivalents were $10,568,000, compared
to $8,412,000 at December 31, 2007.  We had $245,000 in long-term
borrowings and $1,958,000 in short-term borrowings as of December 31,
2008.  We had $314,000 in long-term borrowings and $2,885,000 in
short-term borrowings as of December 31, 2007.
 
 On March
14, 2008, we received an additional $9,335,000 in equity financing, net of
expenses.  The investment was made by several current Energy Focus
shareholders.  These investors agreed to an at-market purchase of
approximately 3,184,000 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 comprised one share of our common stock, par value $0.0001 per share, and
one warrant to purchase one share of our common stock at an exercise price of
$3.08 per share.  The warrants were immediately separable from the
units, immediately exercisable, and will expire March 14, 2013.  This
additional financing is being used to fund working capital requirements and
perform additional research and development.
 
 Cash
      Used in Operating Activities
 
 Net cash
used by operating activities primarily consists of net loss adjusted by non-cash
items, including depreciation, amortization, stock-based compensation, loss on
impairment, and the effect of changes in working capital.  Cash
decreased during 2008, by a net loss of $14,448,000, compared to net losses of
$11,317,000 and $9,650,000 for 2007, and 2006 respectively.  After
adjustments, net cash used by operating activities was $5,830,000 in 2008,
compared to $7,502,000 for 2007 and $7,184,000 in 2006.
 
 Our
efforts to manage working capital provided cash of $1,601,000, net of the
increase in inventory reserve, during 2008 by reducing accounts receivable and
inventory, as well as an increase in accounts payable and accrued
expenses.  In 2007, cash in the amount of $3,501,000 was provided by
reducing accounts receivable and inventory, offset by a use of $2,365,000 of
cash by decreasing accounts payable and accrued expenses.
 
 Cash
      (Used in) Provided by Investing
Activities
 
 In 2008,
there was a usage of cash of $395,000 for the purchase of fixed
assets.  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, also
due to net sales of short-term investments totaling $5,761,000, partially offset
by the acquisition of fixed assets of $3,703,000.
 
 Cash
      Provided by Financing Activities
 
 In 2008,
the net contribution to cash from financing activities was $8,493,000, compared
to $407,000 in 2007 and $2,908,000 in 2006. Proceeds from stock issuances, net
of expenses, provided $9,335,000 in cash in 2008.  Also in 2008,
additional bank borrowings of $5,633,000 were reduced by debt payments of
$6,608,000.  In 2007, proceeds from issuances provided $964,000 in
cash, and additional bank borrowings of $289,000 were reduced by debt payments
of $908,000.  During 2006, the net cash contribution 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.
 
 As a
result of the cash used in operating and financing activities, and the cash
provided by investing activities, there was a net increase in cash in 2008 of
$2,156,000 that resulted in an ending cash balance of $10,568,000 as of December
31, 2008.  This compares to a net increase in cash of $4,707,000 in
2007, resulting in an ending cash balance of $8,412,000 at the end of 2007, and
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.
  21
  Effective
October 15, 2008, we entered into a one year credit agreement with Silicon
Valley Bank (“SVB”)  incorporating a $4,000,000 revolving line of
credit which replaced all existing facilities including the United States term
loans.  This new line of credit includes a $1,500,000 sub-limit for
cash management products, letters of credit, and foreign
exchange.  Under this new agreement, all domestic existing term loans
and revolving credit lines were repaid and funded by this new borrowing
arrangement.  The amount of borrowing available to us is the lesser of
$4,000,000 or the sum of the following:
 
 ·
              up
      to a 75% advance rate against eligible accounts receivable, as defined by
      the agreement,
 ·
              up
      to 50% of our cash balance in deposit at SVB, capped at $1,500,000,
      and
 ·
              up
      to a 75% advance rate against eligible Early Buy accounts receivable, as
      defined by the agreement, capped at
$500,000.
 
 Borrowings
under this agreement are collateralized by our assets, including intellectual
property and bears interest at the SVB Prime Rate plus 1.00%.  If we
terminate the facility prior to maturity, we will be required to pay a 1.00%
termination fee.  We are required to maintain 85% of our cash and cash
equivalents in operating and investment accounts with SVB and its
affiliates.  We are required to comply with certain covenant
requirements, including a tangible net worth covenant.  As of December
31, 2008, we were not in compliance with the tangible net worth covenant
requirement.  At December 31, 2008, the interest rate was 5.00%, and
we had borrowings under the line of credit of $1,776,000, and available
borrowings of $263,000.
 
 Effective
January 31, 2009, we entered into a First Loan Modification and Forbearance
Agreement with SVB which modified the one year credit agreement entered into on
October 15, 2008.  This modification to the terms of the 2008 credit
agreement states that borrowings are collateralized by our assets, including
intellectual property and bears interest at the SVB Prime Rate plus
1.50%.  SVB also agreed to forebear from exercising its rights and
remedies against us as a result of violating its tangible net worth covenant as
of December 31, 2008.  We are currently working with SVB to revise our
tangible net worth covenant.
 
 For 2007,
our bank line of credit in the United States was based on an agreement with SVB
dated August 15, 2005.  It was amended on July 25, 2008, and on
September 15, 2008.  The most recent amendment extended the credit
agreement through October 15, 2008.  The total credit facility was for
$5,000,000 and incorporated both a revolving line of credit and term
loan.  The interest rate was 7.75% at December 31,
2007.  The rate was the same for both the term loan and line of
credit.  Borrowings under the SVB Agreement were collateralized by our
assets and intellectual property.  Specific borrowings under the
revolver were tied to accounts receivable, and we were required to comply with
certain covenants with respect to effective net worth and financial
ratios.  We had borrowings under the revolving line of credit of
$973,000 at December 31, 2007, which was classified as a current
liability.  We had total borrowings of $1,672,000 under the term loan
portion of the agreement as of December 31, 2007, which was classified as a
current liability. We paid an unused line fee of 0.25% against any unused daily
balance during the year.
 
 Through
our subsidiary in the United Kingdom, we maintain a bank overdraft facility of
$365,000 (in British pounds sterling, based on the exchange rate at December 31,
2008) under an agreement with Lloyds Bank Plc.  There were no
borrowings against this facility as of December 31, 2008 or December 31,
2007.  The facility is renewed annually on January 1. The interest
rate on the facility was 7.25% at December 31, 2008, and 7.75% at December 31,
2007.
 
 Through
our German subsidiary, we maintain a credit facility under an agreement with
Sparkasse Neumarkt Bank.  This credit facility was put in place to
finance the building of offices in Berching, Germany, which are owned and
occupied our German subsidiary.  In November, 2008, we began
discussions with Sparkasse Neumarkt Bank related to the restructuring of the
current credit facility.  It was agreed that additional investment in
our German subsidiary would be made in 2009 as a precondition to maintaining the
current facility structure.  As of December 31, 2008, we had
borrowings of $299,000 (in Euros, based on the exchange rate at December 31,
2008) and $368,000 as of December 31, 2007 (in Euros, based on the exchange rate
at December 31, 2007) against this credit facility, due December,
2013.  The interest rate was 5.49% at December 31, 2008 and December
31, 2007.  In addition, the company’s German subsidiary has a
revolving line of credit for $209,000 (in Euros, based on the exchange rate at
December 31, 2008) with Sparkasse Neumarkt Bank.  As of December 31,
2008, there were borrowings against this facility of $128,000 (in Euros, based
on the exchange rate at December 31, 2008), compared to $186,000 at December 31,
2007 (in Euros, based on the exchange rate at December 31, 2007).  The
revolving facility is renewed annually on January 1.  Interest rates
on this line of credit were 11.00% at December 31, 2008 and 10.75% at December
31, 2007.  At December 31, 2008, the $128,000 revolving line of credit
is a current liability.
  22
  Contractual
Obligations
 
 The
following summarizes our contractual obligations as of December 31, 2008,
consisting of current and future payments for borrowings by our German
subsidiary, borrowings under a credit agreement 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
                      USA
      CreditAgreement
                    
                    
                    Non-
                      Cancelable
                      Operating
                      Leases2009
                    
                    $
                    182
                    
                    
                    $
                    1,776
                    
                    
                    $
                    7672010
                    
                    
                    57
                    
                    
                    
                    —
                    
                    
                    
                    7242011
                    
                    
                    61
                    
                    
                    
                    —
                    
                    
                    
                    2012012
                    
                    
                    64
                    
                    
                    
                    —
                    
                    
                    
                    49Thereafter
                    
                    
                    63
                    
                    
                    
                    —
                    
                    
                    
                    190$
                    427
                    
                    
                    $
                    1,776
                    
                    
                    $
                    1,931
 
 Off-Balance
Sheet Arrangements
 
 We had no
off-balance sheet arrangements as of December 31, 2008 or
2007.
 
 Going
Concern
 
 We
have incurred losses which have been attributable to operational
performance, restructuring, and other charges such as the impairment of
goodwill, which has led to negative cash flows and violations of bank debt
compliance.  Further, we have not historically met management
budgetary forecasts.  We have managed our liquidity during this time
through a series of cost reduction initiatives, bank lines of credit borrowings,
and capital market transactions.  However, the global credit market
crisis has had a dramatic effect on our industry and customer
base.  The recession in the United States and Western Europe and the
slowdown of economic growth in the rest of the world has created a business
environment where it is substantially more difficult to obtain equity funding
and additional non-equity financing.  Furthermore, this environment
has resulted in an increased risk of customer payment
defaults.    Our liquidity position, as well as our
operating performance, was negatively affected by these economic and industry
conditions and by other financial and business factors, many of which are beyond
our control.
 
 Management
acknowledges that sustaining our historical level of cash utilization is not
conducive to remaining a viable entity in this environment, and is in the
process of aggressively transforming our business into a turnkey, comprehensive
energy-efficient lighting solutions provider.  In addition, management
continues to aggressively reduce costs, as evidenced in the $1,984,000 decrease
in operating expenses, excluding loss on impairment in 2008, from 2007
levels.  These cost reductions have been achieved while simultaneously
realigning and expanding our sales and marketing organization.  In
this regard, we have been very successful in hiring highly experienced
salespeople from leading “Fortune 500” firms including our new Vice President of
Sales.  Further, we have aligned our entire engineering and research
and development organization around sales and marketing to expedite new product
introductions into our served available markets.  This realignment is
readily evidenced by the 2008 introduction of multiple new products
including;
 
 ·
                MR-16
      halogen replacement bulbs,
 ·
                  LED
      Cold Storage Globe
lamps,
 ·
              LED
      Lamps and Fixtures (“PAL”),
 ·
              LED
      Light Rails,
 ·
              LED
      Docklights,
 ·
              HID
      High Bay Fixtures,
 ·
              Fluorescent
      fixtures, and
 ·
              Compact
      Fluorescent Light Bulbs
 
 Lastly,
we expect to continue our on-going leadership role in the United States
government’s Very High Efficiency Solar Cell (“VHESC”) Consortium sponsored by
the Defense Advanced Research Projects Agency (“DARPA”) where we expect to be
able to commercialize a solar cell technology that will significantly surpass
current solar efficiencies ranging from 6% - 20%.  Our proven optics
technology has already shown the ability to achieve approximately 40% efficiency
in a laboratory environment and we believe that this efficiency, or
greater, can be achieved on a cost-effective, commercially-viable
scale.
  23
  Although
we are optimistic about obtaining the funding necessary for us to continue as a
going concern through internal means, there can be no assurances that this
objective will be successful.  Therefore, in the event that our cash
reserves and bank lines of credit are deemed by management to not be sufficient
to continue to fund operations throughout 2009, we will aggressively pursue one
or more of the following external funding sources:
 
 ·
              obtain
      loans and/or grants available through federal, state, and/or local
      governmental agencies,
 ·
              obtain
      loans and/or grants from various financial
  institutions,
 ·
              obtain
      loans from non-traditional investment capital
    organizations,
 ·
              sale
      and/or disposition of one or more operating units,
  and
 ·
              obtain
      funding from the sale of our common stock or other equity
      instruments.
 
 Obtaining
financing through the above mentioned mechanisms contain risks,
including:
 
 ·
              government
      stimulus and/or grant money is not allocated to us despite our focus on
      the design, development, and manufacturing of energy efficient lighting
      systems,
 ·
              loans
      or other debt instruments may have terms and/or conditions, such as
      interest rate, restrictive covenants, and control or revocation
      provisions, which are not acceptable to management or our Board of
      Directors,
 ·
              the
      current global economic crisis combined with our current financial
      condition may prevent us from being able to obtain any debt
      financing,
 ·
              financing
      may not be available for parties interested in pursuing the acquisition of
      one or more of our operating units,
and
 ·
              additional
      equity financing may not be available to us in the current economic
      environment and could lead to further dilution of shareholder value for
      current shareholders of record.
 
 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 proportional performance basis or installation have been
      completed,
 ·
              price
      to the buyer is fixed or determinable,
and
 ·
              collectability
      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,
and
 ·
              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.
  24
  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:
 
 ·
              proportional
      performance 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.  These
allowances are based on past history and historical trends, current economic
conditions, and contractual terms.  Our distributor’s obligation to us
is not contingent upon the resale of our products and as such does not prohibit
revenue recognition.
 
 Allowances
for Doubtful Accounts, Returns, and Discounts
 
 We
establish allowance for doubtful accounts and returns 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.
 
 In 2008,
the total allowance was $486,000, with $356,000 related to accounts receivable
and $130,000 related to sales return.  In 2007, the total allowance
had a balance of $848,000 with $698,000 related to accounts receivable and
$150,000 related to sales return.
 
 The
company reviews these allowance accounts periodically and adjusts them according
to current conditions.
 
 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 fifteen
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.
 
 We
performed our annual goodwill impairment test at December 31,
2008.  The impairment test first utilized a market capitalization
methodology to calculate the fair value of our goodwill as of the test date,
which was less than its respective carrying value, indicating
impairment.  As a result, we performed Step two of our impairment
analysis.  Based on the results of the impairment test, we recorded a
non-cash impairment charge for goodwill of $4,305,000 in the fourth quarter of
2008, which represents the entire carrying balance of goodwill, net of foreign
currency translation.
 
 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 2008, 2007, and 2006, we charged
$1,503,000, $677,000, and $868,000, respectively, to cost of sales for excess
and obsolete inventories.  Included in 2008 is total expense in the
amount of $1,071,000 related to our modification of the definition of
slow-moving and obsolete inventory reserve.  Management deems this
increase appropriate as technology developments within the lighting industry
continues to accelerate.  Adjustments to our estimates, such as
forecasted sales and expected product lifecycles, could harm our operating
results and financial position.
  25
  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, 2008, 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,
we are 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.  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
$715,000 in 2008, $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.  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 estimated expected life
of the option is calculated based on the contractual life of the option, the
vesting life of the option, and historical exercise patterns of vested
options.  The volatility estimates are calculated using historical
pricing experience.
 
 Recently
Issued Accounting Pronouncements
 
 Accounting
Pronouncements Pending Adoption at December 31, 2008
 
 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 was effective for fiscal
years beginning after November 15, 2007 (effective January 1, 2008, for our
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.  We adopted the financial assets and
liabilities portion of this FASB and it had no effect.  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 (January 1, 2009, for our company).  Early adoption
of FAS 157 for nonfinancial assets and liabilities within the scope of the new
guidance is permitted.  Management is evaluating the effect that this
guidance may have on our overall financial position or results of operations and
we do not anticipate that it will have a significant impact.
 
 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 our company).  Early
adoption is prohibited.  Management is evaluating the effect that this
guidance may have on our overall financial position or results of operations and
we do not anticipate that it will have a significant impact.
  26
  In
December 2007, the FASB issued FAS No. 160, “Non-controlling Interests in
Consolidated Financial Statements, an Amendment of ARB No. 51” (FAS
160).  The new pronouncement requires all entities to report
non-controlling (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 our
company).  Early adoption is prohibited.  Management is
evaluating the effect that this guidance may have on our overall financial
position or results of operations and we do not anticipate that it will have a
significant impact.
 
 Accounting
Pronouncements Adopted in 2008
 
 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 was effective
for fiscal years beginning after November 15, 2007 (effective January 1, 2008,
for our company).  We have elected to not apply this fair value option
to any of our existing assets or liabilities.  However, we may adopt
this guidance for assets or liabilities in the future as permitted under FAS No.
159.
 
 Item
7A. Qualitative and Quantitative Disclosures About Market Risk
 
 As of
December 31, 2008, we had $604,000 in cash held in foreign currencies based on
the exchange rates at December 31, 2008.  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, 2008, we had borrowings of $128,000 (in Euros, based on the
exchange rate at December 31, 2008) against a credit facility secured by real
property owned by our German subsidiary.  As of December 31, 2007, we
had $186,000 (in Euros, based on the exchange rate at December 31, 2007)
borrowed against this credit facility.
  27


Item
8.  Financial Statements and Supplementary Data
 
 TABLE
OF CONTENTS
 
 PageReport
      of Independent Registered Public Accounting Firm
                                29Consolidated
      Balance Sheets as of December 31, 2008 and 2007
                                30Consolidated
      Statements of Operations for the years ended December 31, 2008, 2007, and
      2006
                                31Consolidated
      Statements of Comprehensive Income (Loss) for the years ended December 31,
      2008, 2007, and 2006
                                32Consolidated
      Statements of Shareholders’ Equity for the years ended December 31, 2008,
      2007, and 2006
                                33Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2008, 2007, and
      2006
                                34Notes
      to Consolidated Financial Statements for December 31, 2008, 2007, and
      2006
                                35
  28
  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, 2008 and 2007 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, 2008.  Our audits of the basic financial
statements included the financial statement schedule listed in the index
appearing underItem 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.The Company is not
required to have, nor were we engaged to perform an audit of its internal
control over financial reporting.Our audit included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over financial reporting.  Accordingly, we express no
such opinion.An
audit also includes examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements, 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, 2008 and 2007, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2008 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 as a whole, presents fairly, in all material respects, the
information set forth therein.
 
 The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern. As discussed in Note 2, the
Company incurred a net loss of $14,448,000 during the year ended December 31,
2008, negative cash flows from operations of $5,830,000 and, the Company’s cash
on-hand was $10,568,000 as of December 31, 2008.  In addition as
discussed in Note 7, the Company’s line of credit is due in
2009.  These factors, among others, as discussed in Note 2 to the
financial statements raise substantial doubt about the Company’s ability to
continue as a going concern.  Management’s plans in regard to these
matters are also described in Note 2. The consolidated financial statements do
not include any adjustments that might result from the outcome of this
uncertainty.
  /s/ GRANT
THORNTON LLP
 
 Cleveland,
Ohio
 March 30,
2009
  29
 
 ENERGY
FOCUS, INC.
 CONSOLIDATED
BALANCE SHEETS
 As
of December 31,
 (amounts
in thousands except share and per share amounts)
 
 2008
                  
                  
                  2007ASSETSCurrent
      assets:Cash
      and cash equivalents
                  
                  $
                  10,568
                  
                  
                  $
                  8,412Accounts
      receivable trade, net of allowances for doubtful accounts of $356 in 2008
      and $698 in 2007
                  
                  
                  2,668
                  
                  
                  
                  3,698Inventories,
      net
                  
                  
                  5,539
                  
                  
                  
                  6,888Prepaids
      and other current assets
                  
                  
                  276
                  
                  
                  
                  393Total
      current assets
                  
                  
                  19,051
                  
                  
                  
                  19,391Fixed
      assets, net
                  
                  
                  4,459
                  
                  
                  
                  5,336Goodwill,
      net
                  
                  
                  —
                  
                  
                  
                  4,359Other
      assets
                  
                  
                  142
                  
                  
                  
                  39Total
      assets
                  
                  $
                  23,652
                  
                  
                  $
                  29,125LIABILITIESCurrent
      liabilities:Accounts
      payable
                  
                  $
                  2,767
                  
                  
                  $
                  2,277Accruals
      and other current liabilities
                  
                  
                  1,621
                  
                  
                  
                  1,473Deferred
      revenue
                  
                  
                  191
                  
                  
                  
                  244Credit
      line borrowings
                  
                  
                  1,904
                  
                  
                  
                  1,159Current
      portion of long-term bank borrowings
                  
                  
                  54
                  
                  
                  
                  1,726Total
      current liabilities
                  
                  
                  6,537
                  
                  
                  
                  6,879Other
      deferred liabilities
                  
                  
                  81
                  
                  
                  
                  62Deferred
      tax liabilities
                  
                  
                  —
                  
                  
                  
                  252Long-term
      bank borrowings
                  
                  
                  245
                  
                  
                  
                  314Total
      liabilities
                  
                  
                  6,863
                  
                  
                  
                  7,507SHAREHOLDERS’
      EQUITYPreferred
      stock, par value $0.0001 per share:Authorized:
      2,000,000 shares in 2008 and 2007Issued
      and outstanding: no shares in 2008 and 2007Common
      stock, par value $0.0001 per share:Authorized:
      30,000,000 shares in 2008 and 2007Issued
      and outstanding: 14,835,000 shares in 2008 and 11,623,000 shares in
      2007
                  
                  
                  1
                  
                  
                  
                  1Additional
      paid-in capital
                  
                  
                  65,865
                  
                  
                  
                  55,682Accumulated
      other comprehensive income
                  
                  
                  251
                  
                  
                  
                  815Accumulated
      deficit
                  
                  
                  (49,328
                  )
                  
                  
                  (34,880
                  )Total
      shareholders’ equity
                  
                  
                  16,789
                  
                  
                  
                  21,618Total
      liabilities and shareholders’ equity
                  
                  $
                  23,652
                  
                  
                  $
                  29,125
 
 The
accompanying notes are an integral part of these financial
statements
  30
  ENERGY
FOCUS, INC.
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 For
the years ended December 31,
 (amounts
in thousands except per share amounts)
 
 2008
                    
                    
                    2007
                    
                    
                    2006Net
      sales
                    
                    $
                    22,950
                    
                    
                    $
                    22,898
                    
                    
                    $
                    27,036Cost
      of sales
                    
                    
                    17,447
                    
                    
                    
                    16,616
                    
                    
                    
                    19,251Gross
      profit
                    
                    
                    5,503
                    
                    
                    
                    6,282
                    
                    
                    
                    7,785Operating
      expenses:Gross
      research and development
                    
                    
                    3,083
                    
                    
                    
                    3,424
                    
                    
                    
                    3,556Deduct
      credits from government contracts
                    
                    
                    (895
                    )
                    
                    
                    (517
                    )
                    
                    
                    (1,215
                    )Net
      research and development expense
                    
                    
                    2,188
                    
                    
                    
                    2,907
                    
                    
                    
                    2,341Sales
      and marketing
                    
                    
                    8,551
                    
                    
                    
                    9,789
                    
                    
                    
                    9,774General
      and administrative
                    
                    
                    5,080
                    
                    
                    
                    4,651
                    
                    
                    
                    4,956Loss
      on impairment
                    
                    
                    4,305
                    
                    
                    
                    —
                    
                    
                    
                    —Restructuring
      expenses
                    
                    
                    —
                    
                    
                    
                    456
                    
                    
                    
                    734Total
      operating expenses
                    
                    
                    20,124
                    
                    
                    
                    17,803
                    
                    
                    
                    17,805Loss
      from operations
                    
                    
                    (14,621
                    )
                    
                    
                    (11,521
                    )
                    
                    
                    (10,020
                    )Other
      income (expense):Other
      income (expense)
                    
                    
                    (87
                    )
                    
                    
                    110
                    
                    
                    
                    —Interest
      income
                    
                    
                    10
                    
                    
                    
                    284
                    
                    
                    
                    483Net
      loss before income taxes
                    
                    
                    (14,698
                    )
                    
                    
                    (11,127
                    )
                    
                    
                    (9,537
                    )Benefit
      from (provision for) income taxes
                    
                    
                    250
                    
                    
                    
                    (190
                    )
                    
                    
                    (113
                    )Net
      loss
                    
                    $
                    (14,448
                    )
                    
                    $
                    (11,317
                    )
                    
                    $
                    (9,650
                    )Net
      loss per share—basic and diluted
                    
                    $
                    (1.02
                    )
                    
                    $
                    (0.98
                    )
                    
                    $
                    (0.85
                    )Shares
      used in per share calculation—basic and diluted
                    
                    
                    14,182
                    
                    
                    
                    11,500
                    
                    
                    
                    11,385
  The
accompanying notes are an integral part of these financial
statements.
  31
  ENERGY
FOCUS, INC.
 CONSOLIDATED
STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
 For
the years ended December 31,
 (amounts
in thousands)
 
 2008
                  
                  
                  2007
                  
                  
                  2006Net
      loss
                  
                  $
                  (14,448
                  )
                  
                  $
                  (11,317
                  )
                  
                  $
                  (9,650
                  )Other
      comprehensive income:Foreign
      currency translation adjustments
                  
                  
                  (564
                  )
                  
                  
                  283
                  
                  
                  
                  507Net
      unrealized (loss) gain on securities
                  
                  
                  —
                  
                  
                  
                  (69
                  )
                  
                  
                  53Comprehensive
      loss
                  
                  $
                  (15,012
                  )
                  
                  $
                  (11,103
                  )
                  
                  $
                  (9,090
                  )
  The
accompanying notes are an integral part of these financial
statements.
  32
  ENERGY
FOCUS, INC.
 CONSOLIDATED
STATEMENTS OF SHAREHOLDERS’ EQUITY
 For
the years ended December 31, 2008, 2007, and 2006
 (amounts
in thousands)
 
 Notes
                              
                              
                              Accumulated
                              
                              
                              RetainedAdditional
                              
                              
                              Unearned
                              
                              
                              Receivable
                              
                              
                              Other
                              
                              
                              EarningsCommon
      Stock
                              
                              
                              Paid-in
                              
                              
                              Stock-Based
                              
                              
                              from
                              
                              
                              Comprehensive
                              
                              
                              (AccumulatedShares
                              
                              
                              Amount
                              
                              
                              Capital
                              
                              
                              Compensation
                              
                              
                              Shareholder
                              
                              
                              Income
                              
                              
                              Deficit)
                              
                              
                              TotalBalances,
      December 31, 2005
                              
                              
                              11,270
                              
                              
                              $
                              1
                              
                              
                              $
                              52,514
                              
                              
                              $
                              (397
                              )
                              
                              $
                              (62
                              )
                              
                              $
                              41
                              
                              
                              $
                              (13,913
                              )
                              
                              $
                              38,184Reclassification
      of unearned stock-based compensation upon FAS-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 option 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 option purchase plan
                              
                              
                              3
                              
                              
                              
                              
                              
                              
                              
                              18
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              18Stock-based
      compensation
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              877
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              877Net
      unrealized gain 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
                              )
                              
                              $
                              21,618Private
      investment public equity, net of expenses of $255
                              
                              
                              3,184
                              
                              
                              
                              
                              
                              
                              
                              9,335
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              9,335Exercise
      of common stock options
                              
                              
                              23
                              
                              
                              
                              
                              
                              
                              
                              126
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              126Issuance
      of common stock under employee stock option purchase plan
                              
                              
                              5
                              
                              
                              
                              
                              
                              
                              
                              7
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              7Stock-based
      compensation
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              715
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              715Foreign
      currency translation adjustment
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (564
                              )
                              
                              
                              
                              
                              
                              
                              (564
                              )Net
      loss
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (14,448
                              )
                              
                              
                              (14,448
                              )Balances,
      December 31, 2008
                              
                              
                              14,835
                              
                              
                              $
                              1
                              
                              
                              $
                              65,865
                              
                              
                              $
                              -
                              
                              
                              $
                              -
                              
                              
                              $
                              251
                              
                              
                              $
                              (49,328
                              )
                              
                              $
                              16,789
 
 The
accompanying notes are an integral part of these financial
statements.
  33
  ENERGY
FOCUS, INC.
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 For
the years ended December 31,
 (amounts
in thousands)
 
 2008
                  
                  
                  2007
                  
                  
                  2006Cash
      flows from operating activities:Net
      loss
                  
                  $
                  (14,448
                  )
                  
                  $
                  (11,317
                  )
                  
                  $
                  (9,650
                  )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Loss
      on impairment of goodwill
                  
                  
                  4,305
                  
                  
                  
                  —
                  
                  
                  
                  —Depreciation
                  
                  
                  1,233
                  
                  
                  
                  1,236
                  
                  
                  
                  1,197Stock-based
      compensation
                  
                  
                  715
                  
                  
                  
                  877
                  
                  
                  
                  1,118Unrealized
      loss (gain) from marketable securities
                  
                  
                  —
                  
                  
                  
                  69
                  
                  
                  
                  (53
                  )Gain
      (loss) on sale of fixed asset
                  
                  
                  1
                  
                  
                  
                  (1
                  )
                  
                  
                  —Deferred
      taxes
                  
                  
                  (255
                  )
                  
                  
                  177
                  
                  
                  
                  63Deferred
      revenue
                  
                  
                  (53
                  )
                  
                  
                  244
                  
                  
                  
                  —Changes
      in assets and liabilities:Accounts
      receivable, trade
                  
                  
                  825
                  
                  
                  
                  2,554
                  
                  
                  
                  278Inventories
                  
                  
                  1,037
                  
                  
                  
                  947
                  
                  
                  
                  351Prepaid
      and other current assets
                  
                  
                  108
                  
                  
                  
                  (54
                  )
                  
                  
                  558Other
      assets
                  
                  
                  (112
                  )
                  
                  
                  131
                  
                  
                  
                  (99
                  )Accounts
      payable
                  
                  
                  553
                  
                  
                  
                  (1,942
                  )
                  
                  
                  1,510Accruals
      and other current liabilities
                  
                  
                  261
                  
                  
                  
                  (423
                  )
                  
                  
                  (2,457
                  )Total
                  
                  
                  8,618
                  
                  
                  
                  3,815
                  
                  
                  
                  2,466Net
      cash used in operating activities
                  
                  
                  (5,830
                  )
                  
                  
                  (7,502
                  )
                  
                  
                  (7,184
                  )Cash
      flows from investing activities:Sale
      of short-term investments
                  
                  
                  —
                  
                  
                  
                  49,441
                  
                  
                  
                  114,595Purchase
      of short-term investments
                  
                  
                  —
                  
                  
                  
                  (37,090
                  )
                  
                  
                  (108,834
                  )Proceeds
      from sale of fixed assets
                  
                  
                  —
                  
                  
                  
                  33
                  
                  
                  
                  —Acquisition
      of fixed assets
                  
                  
                  (395
                  )
                  
                  
                  (542
                  )
                  
                  
                  (3,703
                  )Net
      cash (used in) provided by investing activities
                  
                  
                  (395
                  )
                  
                  
                  11,842
                  
                  
                  
                  2,058Cash
      flows from financing activities:Proceeds
      from issuances of common stock
                  
                  
                  9,335
                  
                  
                  
                  —
                  
                  
                  
                  —Proceeds
      from exercise of stock options
                  
                  
                  133
                  
                  
                  
                  964
                  
                  
                  
                  651Repayment
      of loan made to shareholder
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  62Proceeds
      from credit line borrowings
                  
                  
                  5,633
                  
                  
                  
                  129
                  
                  
                  
                  1,077Proceeds
      from long-term borrowings
                  
                  
                  —
                  
                  
                  
                  160
                  
                  
                  
                  1,609Payments
      of credit line borrowings
                  
                  
                  (4,882
                  )
                  
                  
                  (107
                  )
                  
                  
                  —Payments
      of long-term borrowings
                  
                  
                  (1,726
                  )
                  
                  
                  (801
                  )
                  
                  
                  (491
                  )Other
      liabilities
                  
                  
                  —
                  
                  
                  
                  62
                  
                  
                  
                  —Net
      cash provided by financing activities
                  
                  
                  8,493
                  
                  
                  
                  407
                  
                  
                  
                  2,908Effect
      of exchange rate changes on cash
                  
                  
                  (112
                  )
                  
                  
                  (40
                  )
                  
                  
                  369Net
      increase (decrease) in cash and cash equivalents
                  
                  
                  2,156
                  
                  
                  
                  4,707
                  
                  
                  
                  (1,849
                  )Cash
      and cash equivalents, beginning of year
                  
                  
                  8,412
                  
                  
                  
                  3,705
                  
                  
                  
                  5,554Cash
      and cash equivalents, end of year
                  
                  $
                  10,568
                  
                  
                  $
                  8,412
                  
                  
                  $
                  3,705Supplemental
      InformationInterest
      Paid
                  
                  $
                  198
                  
                  
                  $
                  334
                  
                  
                  $
                  248Non-cash
      investing activities:Fully
      depreciated assets disposed of
                  
                  $
                  35
                  
                  
                  $
                  205
                  
                  
                  $
                  79
  The
accompanying notes are an integral part of these financial
statements.
  34
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 1.
              Nature
      of Operations
 
 Energy
Focus Inc. and subsidiaries (“the company”) design, develop, manufacture,
market, and install lighting systems and customer specific energy efficient
lighting solutions for a wide-range use in both the general commercial market
and the pool market.  The company’s lighting technology offers
significant energy savings, heat dissipation and maintenance cost benefits over
conventional lighting for multiple applications.  The company’s
solutions include fiber optic (“EFO”), light-emitting diode (“LED”), ceramic
metal halide (“CMH”), high-intensity discharge (“HID”), and other highly energy
efficient lighting technologies.  The company’s strategy also
incorporated continued investment in research into new and emerging energy
sources including, but not limited to, solar energy.  Typical savings
of current technology averages 80% in electricity costs, while providing
full-spectrum light closely simulating daylight colors.
 
 2.
              Summary
      of Significant Accounting Policies
 
 The
significant accounting policies of Energy Focus, which are summarized below, are
consistent with generally accepted accounting principles and reflect practices
appropriate to the business in which it operates.
 
 Use of Estimates
 
 The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting
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.
 
 Reclassifications
 
 Certain
prior year amounts have been reclassified to be consistent with the current year
presentation.
 
 Basis
of Presentation
 
 The
consolidated financial statements (“financial statements”) include the accounts
of the company and its subsidiaries, Crescent Lighting Limited located in the
United Kingdom and LBM Lichtleit-Fasertechnik (“LBM”) located in
Germany.  All significant inter-company balances and transactions have
been eliminated.
 
 Going
Concern
 
 The
accompanying financial statements have been prepared assuming that the company
will continue as a going concern.  The company has incurred losses
over the last several years which have been attributableto operational
performance, restructuring, and other charges such as the impairment of
goodwill, which has led to negative cash flows and violations of bank debt
compliance.  Further, the company has not historically
met management budgetary forecasts.  The company has managed its
liquidity during this time through a series of cost reduction initiatives, bank
lines of credit borrowings, and capital market transactions.  However,
the global credit market crisis has had a dramatic effect on its industry and
customer base.  The recession in the United States and Western Europe
and the slowdown of economic growth in the rest of the world has created a
business environment where it is substantially more difficult to obtain equity
funding and additional non-equity financing.  Furthermore, this
environment has resulted in an increased risk of customer payment
defaults.    The company’s liquidity position, as well as
its operating performance, was negatively affected by these economic and
industry conditions and by other financial and business factors, many of which
were beyond its control.
  35
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 Management
acknowledges that sustaining our historical level of cash utilization is not
conducive to remaining a viable entity in this environment, and is in the
process of aggressively transforming our business into a turnkey, comprehensive
energy-efficient lighting solutions provider.  In addition, management
continues to aggressively reduce costs, as evidenced in the $1,984,000 decrease
in operating expenses, excluding loss on impairment in 2008, from 2007
levels.  These cost reductions have been achieved while simultaneously
realigning and expanding our sales and marketing organization.  In
this regard, we have been very successful in hiring highly experienced
salespeople from leading “Fortune 500” firms including our new Vice President of
Sales.  Further, we have aligned our entire engineering and research
and development organization around sales and marketing to expedite new product
introductions into our served available markets.  This realignment is
readily evidenced by the 2008 introduction of multiple new products
including;
 
 ·
              MR-16
      halogen replacement bulbs,
 ·
                LED
      Cold Storage Globe lamps,
 ·
              LED
      Lamps and Fixtures (“PAL”),
 ·
              LED
      Light Rails,
 ·
              LED
      Docklights,
 ·
              HID
      High Bay Fixtures,
 ·
              Fluorescent
      fixtures, and
 ·
              Compact
      Fluorescent Light Bulbs
 
 Lastly,
we expect to continue our on-going leadership role in the United States
government’s Very High Efficiency Solar Cell (“VHESC”) Consortium sponsored by
the Defense Advanced Research Projects Agency (“DARPA”) where we expect to be
able to commercialize a solar cell technology that will significantly surpass
current solar efficiencies ranging from 6% - 20%.  Our proven optics
technology has already shown the ability to achieve approximately 40% efficiency
in a laboratory environment and we believe that this efficiency, or
greater, can be achieved on a cost-effective, commercially-viable
scale.
 
 Although
we are optimistic about obtaining the funding necessary for us to continue as a
going concern through internal means, there can be no assurances that this
objective will be successful.  Therefore, in the event that our cash
reserves and bank lines of credit are deemed by management to not be sufficient
to continue to fund operations throughout 2009, we will aggressively pursue one
or more of the following external funding sources:
 
 ·
              obtain
      loans and/or grants available through federal, state, and/or local
      governmental agencies,
 ·
              obtain
      loans and/or grants from various financial
  institutions,
 ·
              obtain
      loans from non-traditional investment capital
    organizations,
 ·
              sale
      and/or disposition of one or more operating units,
  and
 ·
              obtain
      funding from the sale of our common stock or other equity
      instruments.
 
 Obtaining
financing through the above mentioned mechanisms contain risks,
including:
 
 ·
              government
      stimulus and/or grant money is not allocated to us despite our focus on
      the design, development, and manufacturing of energy efficient lighting
      systems,
 ·
              loans
      or other debt instruments may have terms and/or conditions, such as
      interest rate, restrictive covenants, and control or revocation
      provisions, which are not acceptable to management or our Board of
      Directors,
 ·
              the
      current global economic crisis combined with our current financial
      condition may prevent us from being able to obtain any debt
      financing,
 ·
              financing
      may not be available for parties interested in pursuing the acquisition of
      one or more of our operating units,
and
 ·
              additional
      equity financing may not be available to us in the current economic
      environment and could lead to further dilution of shareholder value for
      current shareholders of record.
 
 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 proportional performance basis or installation has been
      completed,
 ·
              price
      to the buyer is fixed or determinable,
and
 ·
              collectability
      is reasonably assured.
  36
 
 ENERGY FOCUS,
INC.
 NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS
 December 31, 2008, 2007, and
2006
  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
  and
 ·
              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:
 
 ·
              proportional
      performance 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
 
 The
company 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.  These
allowances are based on past history and historical trends, current economic
conditions, and contractual terms.
 
 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 $9,964,000 in
cash on deposit with Silicon Valley Bank in the United States as of December 31,
2008.  The remaining cash of the company is on deposit with European
based banks in the United Kingdom and Germany.
 
 Short-Term
Investments
 
 At
December 31, 2008 and December 31, 2007, we had no short-term
investments.  All monies were invested in money market funds and
therefore classified as cash and cash equivalents.
 
 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 $1,503,000, $677,000, and $868,000 in 2008, 2007, and 2006,
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 thirty 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 management deems that they have become uncollectible, and
payments subsequently received on such receivables are credited to the allowance
for doubtful accounts.  The company does not generally require
collateral from its customers.
  37
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 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, 2008, 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
 
 Fixed
assets are stated at cost and include expenditures for additions and major
improvements.  Expenditures for repairs and maintenance are charged to
operations as incurred.  The company uses the straight-line method of
depreciation over their estimated useful lives of the related assets (generally
two to fifteen years) for financial reporting purposes.  Accelerated
methods of depreciation are used for federal income tax
purposes.  When assets are sold or otherwise disposed of, the cost and
accumulated depreciation are removed from the accounts and any gain or loss is
reflected in the consolidated statement of operations.
 
 Long-lived
assets are reviewed for impairment whenever events or circumstances indicate the
carrying amount may not be recoverable. Events or circumstances that would
result in an impairment review primarily include operations reporting losses, a
significant change in the use of an asset, or the planned disposal or sale of
the asset.  The asset would be considered impaired when the future net
undiscounted cash flows generated by the asset are less than its carrying
value.  An impairment loss would be recognized based on the amount by
which the carrying value of the asset exceeds its fair value, as determined by
quoted market price (if available) or the present value of expected future cash
flows.
 
 The
company performed its annual goodwill impairment test at December 31,
2008.  The impairment test first utilized a market capitalization
methodology to calculate the fair value of its goodwill as of the test date,
which was less than its respective carrying value, indicating
impairment.  As a result, the company performed Step two of its
impairment analysis.  Based on the results of the impairment test, the
company recorded a non-cash impairment charge for goodwill of $4,305,000 in the
fourth quarter of 2008, which represents the entire carrying balance of
goodwill, net of foreign currency translation.
 
 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.
 
 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 $250,000 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 company’s cash
balances exceed the amounts insured by the FDIC.  As of December 31,
2008, 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 and solutions services through a combination of
direct sales employees, independent sales representatives, and various
distributors in different geographic markets throughout the
world.  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.
  38
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 At
December 31, 2008, one customer accounted for 12.8% of the net accounts
receivable, and no single customer accounted for more than 10% of net accounts
receivable at December 31, 2007.  For the year ended December 31, 2008
and 2007, no single customer accounted for more than 10% of net
sales.  For the year ended December 31, 2006, one customer accounted
for 11% of net sales.
 
 The
company currently purchases its small-diameter stranded fiber from multiple
vendors.  There are 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 requires substantial amounts of purchased materials from selected
vendors.  With specific materials, the company purchases 100% of its
requirement from a single vendor.  Included in purchased materials are
small diameter stranded fiber, plastic fixtures, lamps, reflectors, and power
supplies.  Substantially all of the materials the company requires are
in adequate supply.   However, the availability and costs of
materials may be subject to change due to, among other things, new laws or
regulations, suppliers’ allocation to other purchasers, interruptions in
production by suppliers, and changes in exchange rates and worldwide price and
demand levels.  The company’s inability to obtain adequate supplies of
materials for its products at favorable prices could have a material adverse
effect on its business, financial position, or results of operations by
decreasing our profit margins and by hindering its ability to deliver products
to its customers on a timely basis.
 
 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’s research and development
expenses are reduced on a proportional performance basis under Defense Advanced
Research Projects Agency ("DARPA") Small Business Innovation Research ("SBIR")
development contracts. These contracts were signed in 2007, for a total of
$1,500,000 to be reimbursed over the two-year life of the
contracts.
 
 Credits
received from government contracts for research for which the company is the
beneficiary during the fiscal year are recorded as a reduction to research and
development expense.
 
 When the
government contract is for the delivery of a product or service, the company
recognizes revenue from those government projects according to proportional
performance method or actual deliveries made.  Costs related to the
completion of the sale are charged to cost of sales in the same period in which
the revenue is recognized.
 
 Earnings
(Loss) 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 and warrants, unless the effect would be
anti-dilutive.
 
 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 31,2008
                      
                      
                      2007
                      
                      
                      2006Numerator—Basic
      and Diluted loss per shareNet
      loss
                      
                      $
                      (14,448
                      )
                      
                      $
                      (11,317
                      )
                      
                      $
                      (9,650
                      )Denominator—Basic
      and Diluted loss per shareWeighted
      average shares outstanding
                      
                      
                      14,182
                      
                      
                      
                      11,500
                      
                      
                      
                      11,385Basic
      and diluted loss per share
                      
                      $
                      (1.02
                      )
                      
                      $
                      (0.98
                      )
                      
                      $
                      (0.85
                      )
  Options
and warrants to purchase approximately 5,329,000 shares, 1,547,000 shares, and
1,690,000 shares of common stock were outstanding at December 31, 2008, 2007,
and 2006, respectively, but were not included in the calculation of diluted loss
per share because their inclusion would have been
anti-dilutive.
  39
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 Stock-Based
Compensation
 
 The
company accounts for stock-based compensation following FAS No. 123(R),
Share-Based Payment (“FAS No. 123(R)”).   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.  For the years ended December 31, 2008, 2007, and 2006, the
company recorded compensation expense of $715,000, $877,000, and $1,118,000,
respectively.  At December 31, 2005, the company had unamortized
compensation expense of $397,000.  This amount is now part of total
unearned compensation of $1,293,000 remaining at December 31,
2008.  The remaining weighted average life is approximately 1.8 years
as of December 31, 2008.   These costs will be charged to
expense, amortized on a straight-line method, in future periods in accordance
with FAS No. 123(R) accounting.  At December 31, 2008, the intrinsic
value of total options outstanding was zero, as the market price per common
share of stock was $1.15, which was below the exercise price of all stock option
grants.
 
 The
expenses for 2008, 2007, and 2006 include both the costs of awards granted in
those 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 estimated expected
life of the option is calculated based on contractual life of the option, the
vesting life of the option, and historical exercise patterns of vested
options.  The volatility estimates are calculated using historical
pricing experience.
 
 As of
December 31, 2008, the company has two stock-based employee compensation
plans, which are described more fully in Note 9.  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 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 2008, 2007, and
2006.
 
 2008
                      
                      
                      2007
                      
                      
                      2006Fair
      value of options issued
                      
                      $
                      1.04
                      
                      
                      $
                      3.01
                      
                      
                      $
                      3.50Exercise
      price
                      
                      $
                      1.91
                      
                      
                      $
                      6.30
                      
                      
                      $
                      7.09Expected
      life of option
                      
                      4.0
      years
                      
                      
                      4.0
      years
                      
                      
                      4.0
      yearsRisk-free
      interest rate
                      
                      
                      2.36
                      %
                      
                      
                      4.35
                      %
                      
                      
                      4.86
                      %Expected
      volatility
                      
                      
                      72.53.
                      %
                      
                      
                      56.29
                      %
                      
                      
                      58.53
                      %Dividend
      yield
                      
                      
                      0
                      %
                      
                      
                      0
                      %
                      
                      
                      0
                      %
 
 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).
 
 Advertising
Expenses
 
 The
company expenses the costs of advertising, which consists of costs for the
placement of advertisements in various media. Advertising expenses were
$601,000, $464,000, and $415,000 for the years ended December 31, 2008,
2007, and 2006, respectively.
  40
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 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 the costs of replacement products.  A liability for the estimated
future costs under product warranties is maintained for products outstanding
under warranty and is included in accruals and other liabilities in the
Consolidated Balance Sheet.  The warranty activity for the respective
years is as follows (in thousands):
 
 Year Ended
                      December 31,2008
                    
                    
                    2007Balance
      at the beginning of the year
                    
                    $
                    212
                    
                    
                    $
                    230Accruals
      for warranties issued
                    
                    
                    342
                    
                    
                    
                    381Settlements
      made during the year (in cash or in kind)
                    
                    
                    (262
                    )
                    
                    
                    (399
                    )Balance
      at the end of the year
                    
                    $
                    292
                    
                    
                    $
                    212
 
 Accounting
Pronouncements Pending Adoption at December 31, 2008
 
 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 was 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.  The company adopted the
financial assets and liabilities portion of  this FASB and it had no
effect.  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 (January 1, 2009, for the
company).  Early adoption of FAS 157 for nonfinancial assets and
liabilities within the scope of the new guidance is
permitted.  Management is evaluating the effect that this guidance may
have on the company’s overall financial position or results of operations and
the company does not anticipate that it will have a significant
impact.
 
 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 effect that this guidance may have on
the company’s overall financial position or results of operations and we do not
anticipate that it will have a significant impact.
 
 In
December 2007, the FASB issued FAS No. 160, “Non-controlling Interests in
Consolidated Financial Statements, an Amendment of ARB No. 51” (FAS 160). The
new pronouncement requires all entities to report non-controlling (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 the company).  Early adoption is
prohibited.  Management is evaluating the effect that this guidance
may have on the company’s overall financial position or results of operations
and we do not anticipate that it will have a significant impact.
 
 Accounting
Pronouncements Adopted in 2008
 
 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 was 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.
  41
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 3.
              Inventories(in
      thousands):
 
 December 31,2008
                      
                      
                      2007Raw
      materials
                      
                      $
                      4,738
                      
                      
                      $
                      5,965Inventory
      reserve
                      
                      
                      (1,795
                      )
                      
                      
                      (713
                      )Finished
      goods
                      
                      
                      2,596
                      
                      
                      
                      1,636$
                      5,539
                      
                      
                      $
                      6,888
 
 4.
              Fixed Assets(in
      thousands):
 
 December 31,2008
                    
                    
                    2007Equipment
      (useful life 3 – 15 years)
                    
                    $
                    8,632
                    
                    
                    $
                    8,654Tooling
      (useful life 2 – 5 years)
                    
                    
                    2,752
                    
                    
                    
                    2,751Furniture
      and fixtures (useful life 5 years)
                    
                    
                    200
                    
                    
                    
                    225Computer
      software (useful life 3 years)
                    
                    
                    483
                    
                    
                    
                    417Leasehold
      improvements (the shorter of useful life or lease life)
                    
                    
                    1,639
                    
                    
                    
                    1,576Construction
      in progress
                    
                    
                    60
                    
                    
                    
                    2013,766
                    
                    
                    
                    13,643Less
      accumulated depreciation and amortization
                    
                    
                    (9,307
                    )
                    
                    
                    (8,307
                    )$
                    4,459
                    
                    
                    $
                    5,336
  5.
              Goodwill
 
 The
company performed its annual goodwill impairment test at December 31,
2008.  The impairment test first utilized a market capitalization
methodology to calculate the fair value of its goodwill as of the test date,
which was less than its respective carrying value, indicating
impairment.  As a result, the company performed Step two of its
impairment analysis.  Based on the results of the impairment test, the
company recorded a non-cash impairment charge for goodwill of $4,305,000 in the
fourth quarter of 2008, which represents the entire carrying balance of
goodwill, net of foreign currency translation.
 
 The
changes in the carrying amounts of goodwill for the years ended
December 31, 2008 and 2007 were as follows (in thousands):
 
 GoodwillNet
                            Carrying
                            AmountBalance
      as of December 31, 2006
                          
                          $
                          4,247Foreign
      currency translation
                          
                          
                          112Balance
      as of December 31, 2007
                          
                          $
                          4,359Impairment
                          
                          
                          (4,305
                          )Foreign
      currency translation
                          
                          
                          (54
                          )Balance
      as of December 31, 2008
                          
                          $
                          —
  6.
              Accruals and Other Current
      Liabilities (in thousands):
 
 December 31,2008
                        
                        
                        2007Accrued
      sales commissions and incentives
                        
                        $
                        325
                        
                        
                        $
                        445Accrued
      warranty expense
                        
                        
                        292
                        
                        
                        
                        212Accrued
      professional fees
                        
                        
                        218
                        
                        
                        
                        302Accrued
      employee benefits
                        
                        
                        387
                        
                        
                        
                        260Accrued
      rent
                        
                        
                        26
                        
                        
                        
                        19Accrued
      taxes
                        
                        
                        201
                        
                        
                        
                        116Accrued
      other expenses
                        
                        
                        172
                        
                        
                        
                        119$
                        1,621
                        
                        
                        $
                        1,473
  42
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 7.
              Bank
      Borrowings
 
 Effective
October 15, 2008, the company entered into a one year credit agreement with
Silicon Valley Bank (“SVB”)  incorporating a $4,000,000 revolving line
of credit which replaced all existing facilities including the United States
term loans.  This new line of credit includes a $1,500,000 sub-limit
for cash management products, letters of credit, and foreign
exchange.  Under this new agreement, all domestic existing term loans
and revolving credit lines were repaid and funded by this new borrowing
arrangement.  The amount of borrowing available to the company is the
lesser of $4,000,000 or the sum of the following:
 
 ·
              up
      to a 75% advance rate against eligible accounts receivable, as defined by
      the agreement,
 ·
              up
      to 50% of our cash balance in deposit at SVB, capped at $1,500,000,
      and
 ·
              up
      to a 75% advance rate against eligible Early Buy accounts receivable, as
      defined by the agreement, capped at
$500,000.
 
 Borrowings
under this agreement are collateralized by its assets, including intellectual
property and bears interest at the SVB Prime Rate plus 1.00%.  If the
company terminates the facility prior to maturity, it will be required to pay a
1.00% termination fee.  The company is required to maintain 85% of its
cash and cash equivalents in operating and investment accounts with SVB and its
affiliates.  The company is required to comply with certain covenant
requirements, including a tangible net worth covenant.  As of December
31, 2008, the company was not in compliance with the tangible net worth covenant
requirement.  At December 31, 2008, the interest rate was 5.00%,
and  the company had borrowings under the line of credit of
$1,776,000, and available borrowings of $263,000..
 
 Effective
January 31, 2009, the company entered into a First Loan Modification and
Forbearance Agreement with SVB which modified the one year credit agreement
entered into on October 15, 2008.  This modification to the terms of
the 2008 credit agreement states that borrowings are collateralized by our
assets, including intellectual property and bears interest at the SVB Prime Rate
plus 1.50%.  SVB also agreed to forebear from exercising its rights
and remedies against the company as a result of violating its tangible net worth
covenant as of December 31, 2008.  We are currently working with SVB
to revise our tangible net worth covenant.
 
 For 2007,
the company’s bank line of credit in the United States was based on an agreement
with SVB dated August 15, 2005.  It was amended on July 25, 2008, and
on September 15, 2008.  The most recent amendment extended the credit
agreement through October 15, 2008.  The total credit facility was for
$5,000,000 and incorporated both a revolving line of credit and term
loan.  The interest rate was 7.75% at December 31,
2007.  The rate was the same for both the term loan and line of
credit.  Borrowings under the SVB Agreement were collateralized by the
company’s assets and intellectual property.  Specific borrowings under
the revolver were tied to accounts receivable, and the company was 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, which was classified as 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 has been
classified as a current liability.  The company paid an unused line
fee of 0.25% against any unused daily balance during the year.
 
 Through
the company’s United Kingdom subsidiary, the company maintains a bank overdraft
facility of $365,000 (in British pounds sterling, based on the exchange rate at
December 31, 2008) under an agreement with Lloyds Bank Plc. There were no
borrowings against this facility as of December 31, 2008 or December 31, 2007.
The facility is renewed annually on January 1. The interest rate on the facility
was 7.25% at December 31, 2008, and 7.75% at December 31, 2007.
 
 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 offices in Berching, Germany, which are owned and
occupied by the company’s German subsidiary.  In November, 2008, the
company began discussions with Sparkasse Neumarkt Bank related to the
restructuring of the current credit facility.  It was agreed that
additional investment in its German subsidiary would be made in 2009 as a
precondition to maintaining the current facility structure.  As of
December 31, 2008, the company had borrowings of $299,000 (in Euros, based on
the exchange rate at December 31, 2008) and $368,000 as of December 31, 2007 (in
Euros, based on the exchange rate at December 31, 2007) against this credit
facility, due December, 2013. The interest rate was 5.49% at December 31, 2008
and December 31, 2007. In addition, the company’s German subsidiary has a
revolving line of credit for $209,000 (in Euros, based on the exchange rate at
December 31, 2008) with Sparkasse Neumarkt Bank. As of December 31, 2008, there
were borrowings against this facility of $128,000 (in Euros, based on the
exchange rate at December 31, 2008), compared to $186,000 at December 31, 2007
(in Euros, based on the exchange rate at December 31, 2007). The revolving
facility is renewed annually on January 1.  Interest rates on this
line of credit were 11.00% at December 31, 2008 and 10.75% at December 31, 2007.
The $128,000 revolving line of credit is a current liability.
 
  43
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 Future
maturities of remaining borrowings are (in thousands):
 Year Ending December 31,
                        
                        United States
                        
                        
                        Germany
                        
                        
                        Total2009
                        
                        $
                        1,776
                        
                        
                        $
                        182
                        
                        
                        $
                        1,9582010
                        
                        
                        —
                        
                        
                        
                        57
                        
                        
                        
                        572011
                        
                        
                        —
                        
                        
                        
                        61
                        
                        
                        
                        612012
                        
                        
                        —
                        
                        
                        
                        64
                        
                        
                        
                        642013
                        
                        
                        —
                        
                        
                        
                        63
                        
                        
                        
                        63Total
      Commitment
                        
                        $
                        1,776
                        
                        
                        $
                        427
                        
                        
                        $
                        2,203
  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):
 
 Ending December 31,
                    
                    Gross
      Lease
                      Commitments
                    
                    
                    Sublease
                      Payments
                    
                    
                    Minimum Lease
                      Commitments2009
                    
                    $
                    838
                    
                    
                    $
                    (71
                    )
                    
                    $
                    7672010
                    
                    
                    795
                    
                    
                    
                    (36
                    )
                    
                    
                    7592011
                    
                    
                    272
                    
                    
                    
                    —
                    
                    
                    
                    2722012
                    
                    
                    49
                    
                    
                    
                    —
                    
                    
                    
                    492013
      – 2017
                    
                    
                    190
                    
                    
                    
                    —
                    
                    
                    
                    190Total
      minimum lease payments
                    
                    $
                    2,144
                    
                    
                    $
                    (107
                    )
                    
                    $
                    2,037
 
 These
leases included certain escalation clauses; thus, rent expense was recorded on a
straight-line basis.  Consolidated net rent expense was $933,000,
$998,000, and $828,000 for the years ended December 31, 2008, 2007, and
2006, respectively. Beginning in 2006, a portion of our Solon facility has been
subleased.  For 2008, 2007, and 2006, the gross rent was reduced by
$71,000, $75,000 and $67,000 of sublease rentals, respectively.
 
 At
December 31, 2008, a letter of credit in the amount of $306,000 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 on its outstanding
loan with Sparkasse Neumarkt Bank.
 
 9.
              Shareholders’
      Equity
 
 Common
Stock
 
 The
company did not have any notes receivable from shareholders in 2008 or
2007.  During 2006, the company had a shareholder note receivable of
$62,000 for warrants exercised in 2005 and paid for in 2006.
  44


ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 Warrants
 
 The
company issued 3,566,440 warrants on March 14, 2008 as part of a private
placement equity financing.  Those warrants are fully exercisable and
will expire on March 14, 2013.  There were no warrants issued by the
company in 2007 and 2006.  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.   The activity relating to
previously issued warrants is as follows:
 
 Warrants
                            Outstanding
                            Shares
                          
                          
                          Warrants
                            Outstanding
                            Exercise Price
                          
                          
                          Warrants
                            Exercisable
                          
                          
                          Amount(in thousands)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
                          
                          
                          $
                          1,220Warrants
      issued
                          
                          
                          3,566,440
                          
                          
                          $
                          3.08
                          
                          
                          
                          3,566,440
                          
                          
                          
                          10,985Balance,
      December 31, 2008
                          
                          
                          3,837,639
                          
                          
                          $
                          3.08
      – 4.50
                          
                          
                          
                          3,837,639
                          
                          
                          $
                          12,205
 
 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 non-statutory 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 outstanding 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 could have been either incentive stock
options or non-statutory stock options. The plan administrator (the Board of
Directors or a committee of the Board) determined 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
 
 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 non-statutory 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.
  45
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 On May 6,
2008, an individual was granted an incentive stock option under the 2004 Plan to
purchase 100,000 shares of our common stock at an exercise price of $2.00 per
share.  At that time, only 59,000 shares were available for grant
under the plan.  In order to provide enough shares to cover the
grants, the individual was asked to surrender 141,000 shares under an option
granted to him on June 28, 2005 at an exercise price of $9.60 per
share.  This modification of options required the company to recognize
additional stock-based compensation of $88,000 over the remaining vesting period
of the June 28, 2005 option.
 
 2008
Stock Incentive Plan
 
 On
September 30, 2008, the company’s shareholders approved its 2008 Incentive Stock
Plan.  Under the Plan, the maximum aggregate number of stock options
awarded shall not exceed 1,000,000 shares, plus any shares remaining available
for grant under existing plans.  Under existing plans, only a limited
number of shares remain available for grant.
 
 Options
outstanding under all plans have a contractual life between five and ten years,
and vesting periods between one and four years.
 
 Option
activity under all plans comprised (in thousands, except per share
data):
 
 Options
                      Available
                      for Grant
                    
                    
                    Number of
                      Shares
                      Outstanding
                    
                    
                    Weighted
                      Average Exercise
                      Price Per ShareBalance,
      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
                    
                    
                    (259
                    )
                    
                    
                    259
                    
                    
                    $
                    6.30Cancelled
                    
                    
                    136
                    
                    
                    
                    (136
                    )
                    
                    $
                    6.96Exercised
                    
                    
                    —
                    
                    
                    
                    (140
                    )
                    
                    $
                    4.66Balance,
      December 31, 2007
                    
                    
                    67
                    
                    
                    
                    1,276
                    
                    
                    $
                    7.07Granted
                    
                    
                    (477
                    )
                    
                    
                    477
                    
                    
                    $
                    1.91Cancelled
                    
                    
                    238
                    
                    
                    
                    (238
                    )
                    
                    $
                    8.22Exercised
                    
                    
                    —
                    
                    
                    
                    (23
                    )
                    
                    $
                    3.27Additional
      shares reserved
                    
                    
                    1,000
                    
                    
                    
                    —
                    
                    
                    
                    —Balance,
      December 31, 2008
                    
                    
                    828
                    
                    
                    
                    1,492
                    
                    
                    $
                    5.29
  At
December 31, 2008, options to purchase 771,000 shares of common stock were
exercisable at a weighted-average fair value of $2.95.  At December
31, 2008, options to purchase 1,492,000 shares were outstanding, with a
weighted-average fair value of $2.40.  All options exercised during
2008 had no intrinsic value as the market price per share of common stock at the
date of exercise was below the per share exercise price.  All
outstanding options, both exercisable and non-exercisable, have no intrinsic
value as the market price per share of common stock of $1.15 at December 31,
2008 was below the per share exercise price of all grants to date.
 
 At
December 31, 2007, options to purchase 801,000 shares of common stock were
exercisable at a weighted-average fair value of $3.41, and a total intrinsic
value of $764,000.  At December 31, 2007, total outstanding shares
were 1,276,000, with a weighted-average fair value of $3.36, and a total
intrinsic value of $1,172,000.
  46
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 OPTIONS OUTSTANDING
                    
                    
                    OPTIONS CURRENTLY
                      EXERCISABLERange of
                      Exercise Prices
                    
                    Number
                      of Shares
                      Outstanding
                    
                    
                    Weighted-
                      Average
                      Remaining
                      Contractual
                      Life
                    
                    
                    Weighted
                      Average
                      Exercise Price
                    
                    
                    Number
                      Exercisable
                    
                    
                    Weighted-
                      Average
                      Remaining
                      Contractual
                      Life
                    
                    
                    Weighted-
                      Average
                      Exercise
                      Price(in thousands)
                    
                    
                    (in years)
                    
                    
                    
                    
                    
                    (in thousands)
                    
                    
                    (in years)$1.37
      – $4.80
                    
                    
                    666
                    
                    
                    
                    7.9
                    
                    
                    $
                    2.45
                    
                    
                    
                    191
                    
                    
                    
                    3.8
                    
                    
                    $
                    3.74$5.38
      – $7.19
                    
                    
                    464
                    
                    
                    
                    7.7
                    
                    
                    $
                    6.57
                    
                    
                    
                    258
                    
                    
                    
                    7.1
                    
                    
                    $
                    6.72$7.23
      – $9.50
                    
                    
                    227
                    
                    
                    
                    6.6
                    
                    
                    $
                    7.87
                    
                    
                    
                    198
                    
                    
                    
                    6.4
                    
                    
                    $
                    7.94$9.60
      – 12.00
                    
                    
                    135
                    
                    
                    
                    7.7
                    
                    
                    $
                    10.60
                    
                    
                    
                    124
                    
                    
                    
                    7.8
                    
                    
                    $
                    10.651,492
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    771
  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, 2008, 2007, and 2006,
103,000 shares, 98,000 shares, and 95,000 shares had been issued under this plan
since inception, respectively.
 
 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.
 
 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 limitations remained
open, and the company did not have any unrecognized tax benefits. At
December 31, 2008, there have been no changes to the liability for
uncertain tax positions, and there are no unrecognized tax
benefits.
   47
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 The
company files income tax returns in the United States federal jurisdiction,
as well as in various states and foreign jurisdictions. With few exceptions, the
company is no longer subject to United States federal, state, and local, or
non-United States 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 31,2008
                    
                    
                    2007
                    
                    
                    2006CurrentFederal
                    
                    $
                    —
                    
                    
                    $
                    —
                    
                    
                    $
                    —Foreign
                    
                    
                    —
                    
                    
                    
                    (13
                    )
                    
                    
                    (50
                    )State
                    
                    
                    (6
                    )
                    
                    
                    —
                    
                    
                    
                    —(6
                    )
                    
                    
                    (13
                    )
                    
                    
                    (50
                    )DeferredFederal
                    
                    
                    238
                    
                    
                    
                    (162
                    )
                    
                    
                    (74
                    )Foreign
                    
                    
                    4
                    
                    
                    
                    —
                    
                    
                    
                    12State
                    
                    
                    14
                    
                    
                    
                    (15
                    )
                    
                    
                    (1
                    )256
                    
                    
                    
                    (177
                    )
                    
                    
                    (63
                    )Benefit
      from (provision for) income taxes
                    
                    $
                    250
                    
                    
                    $
                    (190
                    )
                    
                    $
                    (113
                    )
 
 The
following table shows the geographic components of pretax income (loss) between
United States and foreign subsidiaries (in thousands):
  December 31,2008
                    
                    
                    2007
                    
                    
                    2006United
      States
                    
                    $
                    (12,907
                    )
                    
                    $
                    (10,593
                    )
                    
                    $
                    (9,510
                    )Foreign
      subsidiaries
                    
                    
                    (1,791
                    )
                    
                    
                    (534
                    )
                    
                    
                    (27
                    )$
                    (14,698
                    )
                    
                    $
                    (11,127
                    )
                    
                    $
                    (9,537
                    )
 
 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 31,2008
                    
                    
                    2007
                    
                    
                    2006United
      States statutory rate
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %State
      Taxes (net of federal tax benefit)
                    
                    
                    —
                    %
                    
                    
                    1.9
                    %
                    
                    
                    2.0
                    %Valuation
      allowance
                    
                    
                    (31.1
                    )%
                    
                    
                    (38.2
                    )%
                    
                    
                    (39.0
                    )%Other
                    
                    
                    (1.2
                    )%
                    
                    
                    0.6
                    %
                    
                    
                    1.8
                    %1.7
                    %
                    
                    
                    (1.7
                    )
      %
                    
                    
                    (1.2
                    )%
 
 The tax
effects of temporary differences that give rise to significant portions of the
deferred tax assets are as follows (in thousands):
 
 December 31,2008
                          
                          
                          2007
                          
                          
                          2006Allowance
      for doubtful accounts
                          
                          $
                          92
                          
                          
                          $
                          218
                          
                          
                          $
                          113Accrued
      expenses and other reserves
                          
                          
                          1,905
                          
                          
                          
                          1,233
                          
                          
                          
                          1,097Tax
      credits, Deferred R&D, and other
                          
                          
                          833
                          
                          
                          
                          202
                          
                          
                          
                          154Net
      operating loss
                          
                          
                          15,807
                          
                          
                          
                          12,413
                          
                          
                          
                          8,328Valuation
      allowance
                          
                          
                          (18,622
                          )
                          
                          
                          (14,054
                          )
                          
                          
                          (9,680
                          )Total
      deferred tax asset
                          
                          
                          15
                          
                          
                          
                          12
                          
                          
                          
                          12Deferred
      tax liabilities associated with indefinite-lived
    intangibles
                          
                          
                          —
                          
                          
                          
                          (252
                          )
                          
                          
                          (75
                          )Net
      total deferred taxes
                          
                          $
                          15
                          
                          
                          $
                          (240
                          )
                          
                          $
                          (63
                          )
  48
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 The
company has a full valuation allowance against its United States and German
deferred tax assets. The net deferred tax assets for 2008 amounted to $15,000
and were for the company’s United Kingdom subsidiary, which reported income in
2008 and has been profitable prior to 2007. The net deferred liabilities were $0
at December 31, 2008, compared to $252,000 at December 31, 2007.  The
income tax benefit from the United States operations in 2008 relates to the
reversal of the 2007 deferred tax liability of $252,000 for intangibles as a
result of the book impairment. There were no Federal tax expenses for the United
States operations in 2008, as any expected benefits were offset by an increase
in the valuation allowance.  No tax benefits were recorded for the
2008 German operations loss.
 
 As of
December 31, 2008, the company has a net operating loss carry-forward of
approximately $42,800,000 for federal, state and local income tax purposes.
If not utilized, these carry-forwards will begin to expire in 2020 for federal
and has begun to expire for state and local 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 carry-forwards will not be realized.
 
 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 contractors in North America, Europe and the Far East.
 
 A summary
of geographic sales is as follows (in thousands):
 
 Years Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006United
      States Domestic
                    
                    $
                    12,902
                    
                    
                    $
                    14,949
                    
                    
                    $
                    18,776Other
      Countries
                    
                    
                    10,048
                    
                    
                    
                    7,949
                    
                    
                    
                    8,260$
                    22,950
                    
                    
                    $
                    22,898
                    
                    
                    $
                    27,036
  A summary
of sales by product line is as follows (in thousands):
 
 Years Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Pool
      Lighting
                    
                    $
                    7,204
                    
                    
                    $
                    11,002
                    
                    
                    $
                    13,364Commercial
      Lighting
                    
                    
                    15,746
                    
                    
                    
                    11,896
                    
                    
                    
                    13,672$
                    22,950
                    
                    
                    $
                    22,898
                    
                    
                    $
                    27,036
 
 A summary
of geographic long-lived assets (fixed assets) is as follows (in thousands):
 
 December 31,2008
                    
                    
                    2007United
      States Domestic
                    
                    $
                    3,726
                    
                    
                    $
                    7,791Germany
                    
                    
                    540
                    
                    
                    
                    1,773Other
      Countries
                    
                    
                    193
                    
                    
                    
                    111$
                    4,459
                    
                    
                    $
                    9,675
 
 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 2008, 2007, or 2006.
  49
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 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.
 
 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.  No expenses were
recorded during the twelve months ending December 31, 2008, nor were any
payments made to Mr. Brite.  Payments for the twelve months ending
December 31, 2007, were $13,690, compared to $50,000 in 2006.
 
 Gensler
Architecture, Design, and Planning, P.C., a New York professional corporation
(“Gensler”), provided contract services to the company in the areas of fixture
design and marketing, targeted at expanding the market for the company’s
EFOTM
products.  Mr. Jeffrey Brite, an employee of Gensler, was a member of
the company’s Board of Directors through March 7, 2007. The company had entered
into a three-year consulting agreement with Gensler, effective December 15,
2004. Gensler agreed to assist the company’s marketing group with matters of
structure, procedure and practices as they relate to the design, real estate,
and procurement communities, and advise the company on strategies to enhance its
visibility and image within the design and construction community as a
manufacturer of preferred technology.  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,
which were paid during the first quarter of 2008.  Payments total
$37,500 for the twelve months ending December 31, 2007, compared to $50,000 in
2006.
 
 On
February 3, 2006, the company had entered into a consulting agreement with David
Ruckert, a member of its Board of Directors. Mr. Ruckert was paid $76,000 during
the year ending December 31, 2007 and $110,000 during the year ending December
31, 2006 under this agreement.   This agreement was terminated on
June 30, 2007.  No payments were made to Mr. Ruckert during the twelve
months ending December 31, 2008.  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 the year ending December 31, 2008, compared to
$30,000 during 2007, and $15,000 during 2006.
 
 On
October 19, 2007, the company entered into a management agreement with Barry
Greenwald, former General Manager of its Pool Lighting Division. Under this
agreement, the company was to pay Mr. Greenwald nonrefundable amounts totaling
$309,000 of additional compensation, of which $77,000 was paid on November 1,
2007, and $77,000 was paid on March 14, 2008. Upon Mr. Greenwald’s termination
on January 17, 2008, the balance of $155,000 would have been paid in 36 monthly
installments commencing on January 1, 2009, subject to certain conditions being
met by Mr. Greenwald.  Mr. Greenwald failed to meet these certain
conditions, so the accrued liability of $155,000 was reversed during the twelve
months ending December 31, 2008.
  50
  ENERGY
FOCUS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007, and 2006
 
 On March
14, 2008, the company received an additional $9,335,000 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 were immediately separable from the units and immediately exercisable,
and will expire five years after the date of their issuance. This additional
financing is being 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 were members of our Board of
Directors, at the time of the transaction, and who invested approximately
$100,000 in the aggregate.
 
 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, 2008.  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)
 
 2008 QUARTERS ENDED
                    
                    DEC. 31
                    
                    
                    SEP. 30
                    
                    
                    JUN. 30
                    
                    
                    MAR. 31Net
      sales
                    
                    $
                    4,140
                    
                    
                    $
                    6,357
                    
                    
                    $
                    7,616
                    
                    
                    $
                    4,837Gross
      profit
                    
                    
                    (494
                    )
                    
                    
                    2,310
                    
                    
                    
                    2,443
                    
                    
                    
                    1,244As
      a percent of net sales
                    
                    
                    (11.9
                    )%
                    
                    
                    36.3
                    %
                    
                    
                    32.1
                    %
                    
                    
                    25.7
                    %Net
      loss
                    
                    
                    (7,776
                    )
                    
                    
                    (1,584
                    )
                    
                    
                    (1,639
                    )
                    
                    
                    (3,449
                    )As
      a percent of net sales
                    
                    
                    (187.8
                    )%
                    
                    
                    (24.9
                    )%
                    
                    
                    (21.5
                    )%
                    
                    
                    (71.3
                    )%Net
      loss per share:Basic
                    
                    $
                    (0.52
                    )
                    
                    $
                    (0.11
                    )
                    
                    $
                    (011
                    )
                    
                    $
                    (0.28
                    )Diluted
                    
                    $
                    (0.52
                    )
                    
                    $
                    (0.11
                    )
                    
                    $
                    (0.11
                    )
                    
                    $
                    (0.28
                    )
  2007 QUARTERS ENDED
                        
                        DEC. 31
                        
                        
                        SEP. 30
                        
                        
                        JUN. 30
                        
                        
                        MAR. 31Net
      sales
                        
                        $
                        5,440
                        
                        
                        $
                        5,745
                        
                        
                        $
                        6,704
                        
                        
                        $
                        5,009Gross
      profit
                        
                        
                        544
                        
                        
                        
                        1,988
                        
                        
                        
                        2,280
                        
                        
                        
                        1,470As
      a percent of net sales
                        
                        
                        10.0
                        %
                        
                        
                        34.6
                        %
                        
                        
                        34.0
                        %
                        
                        
                        29.4
                        %Net
      loss
                        
                        
                        (3,666
                        )
                        
                        
                        (3,175
                        )
                        
                        
                        (1,870
                        )
                        
                        
                        (2,606
                        )As
      a percent of net sales
                        
                        
                        (67.4
                        )%
                        
                        
                        (55.3
                        )%
                        
                        
                        (27.9
                        )%
                        
                        
                        (52.0
                        )%Net
      loss per share:Basic
                        
                        $
                        (0.31
                        )
                        
                        $
                        (0.28
                        )
                        
                        $
                        (0.16
                        )
                        
                        $
                        (0.23
                        )Diluted
                        
                        $
                        (0.31
                        )
                        
                        $
                        (0.28
                        )
                        
                        $
                        (0.16
                        )
                        
                        $
                        (0.23
                        )
  51
  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 fourth
quarter including the hiring of a new Corporate Controller, the elimination of
the Manager of Accounting position, and the establishment of the newly created
position of Manager of Financial Reporting and Internal
Controls.  Prior to joining Energy Focus, our Corporate Controller had
over twenty years of accounting and management experience with various
manufacturing, service related, and distribution companies.  Previous
roles held by our Corporate Controller included Chief Financial Officer of a
publicly-traded company, and Corporate Controller at a $300 million lighting
distributor.  Further, our Manager of Financial Reporting and Internal
Controls has significant Securities and Exchange Commission (“SEC”) reporting
experience with publicly-traded companies, and is accountable for the
coordination of the internal control testing process.  Our internal
controls have not been affected materially by these changes, and we continue to
review and test our internal control environment on a quarterly
basis.  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 Rule 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 cannot 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,
2008.
  52
  Attestation
Report of Independent Registered Public Accounting Firm
 
 This
annual report does not include an attestation report of our independent
registered public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by our
independent public accounting firm pursuant to the rules of the SEC that permit
us to provide only management’s report in this annual report.
 
 Item
9B. Other Information
 
 On March
14, 2008, the company received an additional $9,335,000 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 were immediately separable from the units and immediately
exercisable, and will expire five years after the date of their
issuance.  This additional financing is being 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 were members of its
Board of Directors, at the time of the transaction, and who invested
approximately $100,000 in the aggregate.
  53
  PART III
 
 Item
10. Directors, Executive Officers, and Corporate Governance
 
 Directors
 
 The
information regarding our directors is set forth under the caption entitled
“Election of Directors” in our Proxy Statement for our 2009 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 2008.
 
 Executive
Officers
 
 The
information regarding our executive officers is set forth under the caption
entitled “Executive Officers of the Registrant” following Item 4, in Part I, 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
Code of Ethics and Business Conduct 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 section 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
and related stockholder matters 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 and
director independence required by this item is incorporated herein by
reference to the information in our Proxy Statement under the caption “Certain Transactions” and
“Director
Independence.”
  54
  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.”
  55
  PART IV
 Item
15. Exhibits and Financial Statement Schedules
 
 (a)
              (1) Financial
      Statements
 
 The
financial statements required by this Item 15(a)(1) are set forth in Item
8.
 
 (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 (amounts in thousands)
  Description
                      
                      Balance at
                        Beginning
                        of
                        Year
                      
                      
                      Charges
                        to Revenue
                      
                      
                      Charges
                        to Expenses
                      
                      
                      Deductions
                      
                      
                      Balance at
                        End of YearYear
      Ended December 31, 2008Allowance
      for doubtful accounts and returns
                      
                      $
                      848
                      
                      
                      $
                      —
                      
                      
                      $
                      245
                      
                      
                      $
                      607
                      
                      
                      $
                      486Valuation
      allowance for deferred tax assets
                      
                      
                      14,054
                      
                      
                      
                      —
                      
                      
                      
                      4,568
                      
                      
                      
                      —
                      
                      
                      
                      18,622Year
      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
                      
                      
                      
                      —
                      
                      
                      
                      9,680
  56
  (3) Exhibits
 
 Exhibit
                              Number
                            
                            Description
      of Documents2.1
                            
                            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 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 filed on 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 8-K 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 on November 27,
      2006).3.4
                            
                            Certificate
      of Ownership and Merger, Merging Energy Focus, Inc., a Delaware
      corporation, into Fiberstars, Inc., a Delaware corporation (incorporated
      by reference to Exhibit 3.1 to the Registrant’s Quarterly Report on Form
      10-Q filed on May 10, 2007).4.1
                            
                            Form of
      Warrant for the purchase of shares of common stock (incorporated by
      reference to Exhibit 99.3 to the Registrant’s Current Report on
      Form 8-K filed on June 19, 2003).4.2
                            
                            Form of
      Common Stock Certificate (incorporated by reference to Exhibit 4.1 to
      the Registrant’s Current Report on Form 8-K filed on November 27,
      2006)4.3
                            
                            Rights
      Agreement dated as of October 25, 2006 between the Registrant and Mellon
      Investor Services, LLC, as rights agent (incorporated by reference to
      Exhibit 4.2 to the Registrant’s Current Report on Form 8-K filed on
      November 27, 2006).4.4
                            
                            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 on November 27, 2006).4.5
                            
                            Form
      of Warrant for the purchase of shares of common stock (incorporated by
      reference to Exhibit 1.2 to the Registrant’s Current Report on Form 8-K
      filed on March 19, 2008).4.6
                            
                            Amendment
      No. 1 to Rights Agreement between the Registrant and Mellon Investment
      Services, LLC, as rights agent, dated as of March 12, 2008 (incorporated
      by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K
      filed on March 19, 2009).10.1†
                            
                            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).10.2
                            
                            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)).10.3*
                            
                            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).10.4*
                            
                            Three
      -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-K405
      filed on April 2, 2001).10.5
                            
                            Securities
      Purchase Agreement dated June 17, 2003 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).10.6†
                            
                            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 filed on March 30, 2004).10.7
                            
                            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 filed on March 30, 2004).10.8
                            
                            Production
      Share Agreement dated October 9, 2003 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-Kfiled on March 30,
      2004).10.9†
                            
                            Consulting
      Agreement effective as of December 15,, 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
      filed on March 31, 2006).10.10†
                            
                            Consulting
      Agreement effective as of December 15, 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 filed on March 31,
      2006).10.11
                            
                            Loan
      and Security Agreement between Silicon Valley Bank and the Registrant
      dated August 15, 2005 (incorporated by reference to Exhibit 10.1
      to the Registrant’s Current Report on Form 8-K filed on
      August 18, 2005).10.12†
                            
                            Employment
      Agreement between the Registrant and John M. Davenport dated July 1,
      2005 (incorporated by reference from Exhibit 10.2 to the Registrant’s
      Quarterly Report on Form 10-Q filed on November 14,
      2005).10.13†
                            
                            Severance
      Agreement between the Registrant and David N. Ruckert dated
      September 16, 2005 (incorporated by reference to Exhibit 10.3 to
      the Registrant’s Quarterly Report on Form 10-Q filed on
      November 14,
2005).
  57
 
 10.14*
                
                Fiberstars
      Development Agreement between the Registrant and Advanced Lighting
      Technologies, Inc. dated September 19, 2005 (incorporated by
      reference to Exhibit 10.4 to the Registrant’s Quarterly Report on
      Form 10-Q filed on November 14, 2005).10.15*
                
                ADLT
      Development Agreement between the Registrant and Advanced Lighting
      Technologies, Inc. dated September 19, 2005 (incorporated by
      reference to Exhibit 10.5 to the Registrant’s Quarterly Report on
      Form 10-Q filed on November 14, 2005).10.16*
                
                Equipment
      Purchase and Supply Agreement between the Registrant and Deposition
      Sciences, Inc. dated September 19, 2005 (incorporated by
      reference to Exhibit 10.6 to the Registrant’s Quarterly Report on
      Form 10-Q filed on November 14, 2005).10.17
                
                Cross-License
      Agreement between the Registrant and Advanced Lighting
      Technologies, Inc. dated September 19, 2005 (incorporated by
      reference to  Exhibit 10.7 to the Registrant’s Quarterly
      Report on Form 10-Q filed on November 14,
  2005).10.18
                
                Master
      Services Agreement between the Registrant and Advanced Lighting
      Technologies, Inc. dated September 19, 2005 (incorporated by
      reference to Exhibit 10.8 to the Registrant’s Quarterly Report on
      Form 10-Qfiled on November 14, 2005).10.19
                
                First
      Amendment to Production Share Agreement, effective as of August 17,
      2005, among the Registrant, North American Production Sharing, Inc.,
      and Industrias Unidas de B.C., S.A. de C.V. (incorporated by reference to
      Exhibit 10.1 to the Registrant’s Current Report on Form 8-K
      filed on October 25, 2005).10.20
                
                Sublease
      between Venture Lighting International, Inc. and the Registrant dated
      as of November 11, 2005 (incorporated by reference to
      Exhibit 10.1 to the Registrant’s Current Report on Form 8-K
      filed on November 17, 2005).10.21
                
                Amended
      and Restated Loan and Security Agreement between the Registrant and
      Silicon Valley Bank dated December 30, 2005 (incorporated by
      reference to Exhibit 10.1 to the Registrant’s Current Report on
      Form 8-K filed on January 6, 2006).10.22†
                
                Consulting
      Agreement between the Registrant and David N. Ruckert dated as of February
      3, 2006 (incorporated by reference to Exhibit 10.1 to the
      Registrant’s Quarterly Report on Form 10-Q filed on May 15,
      2006).10.23*
                
                Equipment
      Purchase and Product Supply Agreement entered into as of May 25, 2006
      between the Registrant and Deposition Sciences, Inc. (incorporated by
      reference to Exhibit 10.1 to Amendment No. 2 to the Registrant’s
      Quarterly Report on Form 10-Q filed on March 6,
  2009).10.24
                
                Modification
      to Sublease between the Registrant and Keystone Ruby,
      LLC. (incorporated by reference to Exhibit 10.2 to the
      Registrant’s Quarterly Report on Form 10-Q filed on August 11,
      2006).10.25
                
                Amendment
      No. 1 to Amended and Restated Loan and Security Agreement between the
      Registrant 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 filed on November 14,
      2006).10.26†
                
                First
      Amendment to Consulting Agreement between the Registrant and David N.
      Ruckert dated as of February 3, 2007 (incorporated by reference to Exhibit
      10.32 to the Registrant’s Annual Report on Form 10-K filed on March 16,
      2007).10.27†
                
                Form
      of Indemnification Agreement for directors and officers of the Registrant
      (incorporated by reference to Exhibit 10.31 of the Registrant’s Annual
      Report on Form 10-K filed on March 16, 2007).10.28
                  
                  
                  10.29
                
                Amendment
      No. 4 to Amended and Restated Loan and Security Agreement between Silicon
      Valley Bank and the Registrant dated as of October 1, 2007 (incorporated
      by reference to Exhibit 10.39 to the Registrant’s Annual Report on Form
      10-K filed on March 17, 2008).
                  Amendment
      No. 5 to Amended and Restated Loan and Security Agreement between Silicon
      Valley Bank and Registrant dated as of January 29, 2008(incorporated by
      reference to Exhibit 10.39 to the Registrant’s Annual Report on Form 10-K
      filed on March 17, 2008).10.30
                
                Management
      Agreement between Barry R. Greenwald and the Registrant dated as of
      October 19, 2007 (incorporated by reference to Exhibit 10.39 to the
      Registrant’s Annual Report on Form 10-K filed on March 17,
      2008).10.31
                
                Form
      of Securities Purchase Agreement dated as of March 14, 2008 (incorporated
      by reference to Exhibit 1.1 to the Registrant’s Current Report on Form 8-K
      filed on March 19, 2008).10.32
                
                Second
      Amended and Restated Loan and Security Agreement between the Registrant
      and Silicon Valley Bank dated as of October 15, 2008 (incorporated by
      reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form
      10-Q filed on November 7, 2008).10.33†
                
                1994
      Stock Option Plan, amended as of May 24, 2000 (incorporated by reference
      to Exhibit 99.1 to the Registrant’s Registration Statement on Form S-8
      (Commission File No. 333-52042) filed on December 18,
    2000).10.34†
                
                1994
      Director’s Stock Option Plan, amended as of May 12, 1999 (incorporated by
      reference to Exhibit 99.2 to the Registrant’s Registration Statement on
      Form S-8 (Commission File No. 333-52042) filed on December 18,
      2000).10.35†
                
                2004
      Stock Incentive Plan (incorporated by reference to Exhibit 99.1 to the
      Registrant’s Registration Statement on Form S-8 (Commission File No.
      333-122-686) filed on February 10, 2005).10.36†
                
                2008
      Incentive Stock Plan (incorporated by reference to Appendix D to the
      Registrant’s Definitive Proxy Statement filed on August 8,
      2008).21.1
                
                Significant
      Subsidiaries of the Registrant (filed with this
Report).23.1
                  24.1
                
                Consent
      of Grant Thornton LLP, Independent Registered Public Accounting Firm
      (filed with this Report).
                  Power
      of Attorney (filed with this Report).31.1
                
                Rule 13a-14(a) Certification
      by Chief Executive Officer (filed with this
  Report).
  58
 
 31.2
                
                Rule 13a-14(a) Certification
      by Chief Financial Officer (filed with this Report).32.1
                  32.2
                
                Section
      1350 Certification of Chief Executive Officer (filed with this
      Report).
                  Section
      1350 Certification of Chief Financial Officer (filed with this
      Report).
 
 *           Confidential
treatment has been granted with respect to certain portions of this
agreement.
 †           Management
contract or compensatory plan or arrangement.
  59
  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 31, 2009
              
              By:
              
              /s/
      JOSEPH G. KAVESKIJoseph
      G. KaveskiChief
      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 31, 2009.
 
 Signature
                        
                        Title/s/
      JOSEPH G. KAVESKI
                        
                        Chief
      Executive Officer and DirectorJoseph
      G. Kaveski
                        
                        (Principal
      Executive Officer)/s/
      JOHN M. DAVENPORT
                        
                        President
      and DirectorJohn
      M. Davenport/s/
      NICHOLAS G. BERCHTOLD
                        
                        Vice
      President of Finance and Chief Financial OfficerNicholas
      G. Berchtold
                        
                        (Principal Financial and
      Accounting Officer)*/s/
      LAURENCE V. GODDARD
                        
                        DirectorLaurence
      V. Goddard*/s/
      J. JAMES FINNERTY
                        
                        DirectorJ.
      James Finnerty*/s/
      MICHAEL A. KASPER
                        
                        DirectorMichael
      A. Kasper*/s/
      PAUL VON PAUMGARTTEN
                        
                        DirectorPaul
      Von Paumgartten/s/
      PHILIP E. WOLFSON
                        
                        DirectorPhilip
      E. Wolfson*/s/
      DAVID N. RUCKERT
                        
                        DirectorDavid
      N. Ruckert
 
 *The
undersigned, by signing his name, signs this Report on March 31, 2009 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/ JOSEPH G.
KAVESKI
 Joseph G.
Kaveski, Attorney-in-Fact.
  60
  Exhibit
Index
 
 Exhibit
                              Number
                            
                            Description
      of Documents2.1
                            
                            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 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 filed on 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 8-K 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 on November 27,
      2006).3.4
                            
                            Certificate
      of Ownership and Merger, Merging Energy Focus, Inc., a Delaware
      corporation, into Fiberstars, Inc., a Delaware corporation (incorporated
      by reference to Exhibit 3.1 to the Registrant’s Quarterly Report on Form
      10-Q filed on May 10, 2007).4.1
                            
                            Form of
      Warrant for the purchase of shares of common stock (incorporated by
      reference to Exhibit 99.3 to the Registrant’s Current Report on
      Form 8-K filed on June 19, 2003).4.2
                            
                            Form of
      Common Stock Certificate (incorporated by reference to Exhibit 4.1 to
      the Registrant’s Current Report on Form 8-K filed on November 27,
      2006)4.3
                            
                            Rights
      Agreement dated as of October 25, 2006 between the Registrant and Mellon
      Investor Services, LLC, as rights agent (incorporated by reference to
      Exhibit 4.2 to the Registrant’s Current Report on Form 8-K filed on
      November 27, 2006).4.4
                            
                            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 on November 27, 2006).4.5
                            
                            Form
      of Warrant for the purchase of shares of common stock (incorporated by
      reference to Exhibit 1.2 to the Registrant’s Current Report on Form 8-K
      filed on March 19, 2008).4.6
                            
                            Amendment
      No. 1 to Rights Agreement between the Registrant and Mellon Investment
      Services, LLC, as rights agent, dated as of March 12, 2008 (incorporated
      by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K
      filed on March 19, 2009).10.1†
                            
                            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).10.2
                            
                            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)).10.3*
                            
                            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).10.4*
                            
                            Three
      -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-K405
      filed on April 2, 2001).10.5
                            
                            Securities
      Purchase Agreement dated June 17, 2003 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).10.6†
                            
                            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 filed on March 30, 2004).10.7
                            
                            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 filed on March 30, 2004).10.8
                            
                            Production
      Share Agreement dated October 9, 2003 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-Kfiled on March 30,
      2004).10.9†
                            
                            Consulting
      Agreement effective as of December 15, 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
      filed on March 31, 2006).10.10†
                            
                            Consulting
      Agreement effective as of December 15,, 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 filed on March 31,
      2006).10.11
                            
                            Loan
      and Security Agreement between Silicon Valley Bank and the Registrant
      dated August 15, 2005 (incorporated by reference to Exhibit 10.1
      to the Registrant’s Current Report on Form 8-K filed on
      August 18, 2005).10.12†
                            
                            Employment
      Agreement between the Registrant and John M. Davenport dated July 1,
      2005 (incorporated by reference from Exhibit 10.2 to the Registrant’s
      Quarterly Report on Form 10-Q filed on November 14,
      2005).10.13†
                            
                            Severance
      Agreement between the Registrant and David N. Ruckert dated
      September 16, 2005 (incorporated by reference to Exhibit 10.3 to
      the Registrant’s Quarterly Report on Form 10-Q filed on
      November 14,
2005).
  61
 
 10.14*
                
                Fiberstars
      Development Agreement between the Registrant and Advanced Lighting
      Technologies, Inc. dated September 19, 2005 (incorporated by
      reference to Exhibit 10.4 to the Registrant’s Quarterly Report on
      Form 10-Q filed on November 14, 2005).10.15*
                
                ADLT
      Development Agreement between the Registrant and Advanced Lighting
      Technologies, Inc. dated September 19, 2005 (incorporated by
      reference to Exhibit 10.5 to the Registrant’s Quarterly Report on
      Form 10-Q filed on November 14, 2005).10.16*
                
                Equipment
      Purchase and Supply Agreement between the Registrant and Deposition
      Sciences, Inc. dated September 19, 2005 (incorporated by
      reference to Exhibit 10.6 to the Registrant’s Quarterly Report on
      Form 10-Q filed on November 14, 2005).10.17
                
                Cross-License
      Agreement between the Registrant and Advanced Lighting
      Technologies, Inc. dated September 19, 2005 (incorporated by
      reference to Exhibit 10.7 to the Registrant’s Quarterly Report on
      Form 10-Q filed on November 14, 2005).10.18
                
                Master
      Services Agreement between the Registrant and Advanced Lighting
      Technologies, Inc. dated September 19, 2005 (incorporated by
      reference to Exhibit 10.8 to the Registrant’s Quarterly Report on
      Form 10-Qfiled on November 14, 2005).10.19
                
                First
      Amendment to Production Share Agreement, effective as of August 17,
      2005, among the Registrant, North American Production Sharing, Inc.,
      and Industrias Unidas de B.C., S.A. de C.V. (incorporated by reference to
      Exhibit 10.1 to the Registrant’s Current Report on Form 8-K
      filed on October 25, 2005).10.20
                
                Sublease
      between Venture Lighting International, Inc. and the Registrant dated
      as of November 11, 2005 (incorporated by reference to
      Exhibit 10.1 to the Registrant’s Current Report on Form 8-K
      filed on November 17, 2005).10.21
                
                Amended
      and Restated Loan and Security Agreement between the Registrant and
      Silicon Valley Bank dated December 30, 2005 (incorporated by
      reference to Exhibit 10.1 to the Registrant’s Current Report on
      Form 8-K filed on January 6, 2006).10.22†
                
                Consulting
      Agreement between the Registrant and David N. Ruckert dated as of February
      3, 2006 (incorporated by reference to Exhibit 10.1 to the
      Registrant’s Quarterly Report on Form 10-Q filed on May 15,
      2006).10.23*
                
                Equipment
      Purchase and Product Supply Agreement entered into as of May 25, 2006
      between the Registrant and Deposition Sciences, Inc. (incorporated by
      reference to Exhibit 10.1 to Amendment No. 2 to the Registrant’s
      Quarterly Report on Form 10-Q filed on March 6,
  2009).10.24
                
                Modification
      to Sublease between the Registrant and Keystone Ruby,
      LLC. (incorporated by reference to Exhibit 10.2 to the
      Registrant’s Quarterly Report on Form 10-Q filed on August 11,
      2006).10.25
                
                Amendment
      No. 1 to Amended and Restated Loan and Security Agreement between the
      Registrant 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 filed on November 14,
      2006).10.26†
                
                First
      Amendment to Consulting Agreement between the Registrant and David N.
      Ruckert dated as of February 3, 2007 (incorporated by reference to Exhibit
      10.32 to the Registrant’s Annual Report on Form 10-K filed on March 16,
      2007).10.27†
                
                Form
      of Indemnification Agreement for directors and officers of the Registrant
      (incorporated by reference to Exhibit 10.31 of the Registrant’s Annual
      Report on Form 10-K filed on March 16, 2007).10.28
                  
                  
                  10.29
                
                Amendment
      No. 4 to Amended and Restated Loan and Security Agreement between Silicon
      Valley Bank and the Registrant dated as of October 1, 2007 (incorporated
      by reference to Exhibit 10.39 to the Registrant’s Annual Report on Form
      10-K filed on March 17, 2008).
                  Amendment
      No. 5 to Amended and Restated Loan and Security Agreement between Silicon
      Valley Bank and Registrant dated as of January 29, 2008(incorporated by
      reference to Exhibit 10.39 to the Registrant’s Annual Report on Form 10-K
      filed on March 17, 2008).10.30
                
                Management
      Agreement between Barry R. Greenwald and the Registrant dated as of
      October 19, 2007 (incorporated by reference to Exhibit 10.39 to the
      Registrant’s Annual Report on Form 10-K filed on March 17,
      2008).10.31
                
                Form
      of Securities Purchase Agreement dated as of March 14, 2008 (incorporated
      by reference to Exhibit 1.1 to the Registrant’s Current Report on Form 8-K
      filed on March 19, 2008).10.32
                
                Second
      Amended and Restated Loan and Security Agreement between the Registrant
      and Silicon Valley Bank dated as of October 15, 2008 (incorporated by
      reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form
      10-Q filed on November 7, 2008).10.33†
                
                1994
      Stock Option Plan, amended as of May 24, 2000 (incorporated by reference
      to Exhibit 99.1 to the Registrant’s Registration Statement on Form S-8
      (Commission File No. 333-52042) filed on December 18,
    2000).10.34†
                
                1994
      Director’s Stock Option Plan, amended as of May 12, 1999 (incorporated by
      reference to Exhibit 99.2 to the Registrant’s Registration Statement on
      Form S-8 (Commission File No. 333-52042) filed on December 18,
      2000).10.35†
                
                2004
      Stock Incentive Plan (incorporated by reference to Exhibit 99.1 to the
      Registrant’s Registration Statement on Form S-8 (Commission File No.
      333-122-686) filed on February 10, 2005).10.36†
                
                2008
      Incentive Stock Plan (incorporated by reference to Appendix D to the
      Registrant’s Definitive Proxy Statement filed on August 8,
      2008).21.1
                
                Significant
      Subsidiaries of the Registrant (filed with this
Report).23.1
                  24.1
                
                Consent
      of Grant Thornton LLP, Independent Registered Public Accounting Firm
      (filed with this Report).
                  Power
      of Attorney (filed with this Report).31.1
                
                Rule 13a-14(a) Certification
      by Chief Executive Officer (filed with this
  Report).
  62
 
 31.2
                
                Rule 13a-14(a) Certification
      by Chief Financial Officer (filed with this Report).32.1
                  32.2
                
                Section
      1350 Certification of Chief Executive Officer (filed with this
      Report).
                  Section
      1350 Certification of Chief Financial Officer (filed with this
      Report).


*           Confidential
treatment has been granted with respect to certain portions of this
agreement.
 †           Management
contract or compensatory plan or arrangement.
  63