**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-K**

 

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**ý****                          ****ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the fiscal year ended December 31, 2004**

 

**OR**

 

**o****                          ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the transition period from          to          **

 

**Commission File Number: 000-51071**

 

**ORANGE 21 INC.**

(Exact name of Registrant as specified in its charter)

 
| **Delaware**                                                    | ** ** | **33-0580186**                                             |
|-----------------------------------------------------------------|------------|------------------------------------------------------------|
| (State or other jurisdiction of incorporation  or organization) |       | (IRS Employer Identification No.)                          |
|                                                            |       |                                                       |
|                                                            |       |                                                       |
| **2070 Las Palmas Drive,  Carlsbad, CA 92009**                  | ** ** | **(760) 804-8420**                                         |
| (Address of principal executive offices)                        |       | (Registrant’s telephone number, including  area code) |

 

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

 

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

**Common Stock, par value $0.0001 per share**

 

Indicate by check mark whether the Registrant(1) has filed all reports required by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the Registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days.  Yes ý  No o

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K (Section 229.405 of thischapter) is not contained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the Registrant is anaccelerated filer (as defined in Rule 12b-2 of the Act). Yes o  No ý

 

The aggregate market value of the Registrant’s CommonStock held by non-affiliates (based upon the closing sale price on the NasdaqNational Market on December 31, 2004) was $62,412,050.  The Registrant’s Common Stock was notpublicly traded as of the last day of its most recently completed second fiscalquarter.

 

As of February 24, 2005, there were 8,012,483 sharesof Common Stock, par value $0.0001 per share, issued and outstanding.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Items 10 (as to directors and Section 16(a)Beneficial Ownership Reporting Compliance), 11, 12, 13 and 14 of Part IIIincorporate by reference information from the Registrant’s proxy statement tobe filed with the Securities and Exchange Commission in connection with thesolicitation of proxies for the Registrant’s 2005 Annual Meeting ofStockholders.

 

 

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**ORANGE21 INC. AND SUBSIDIARIES**

** **

**TABLEOF CONTENTS**

** **

**2004FORM 10-K**

** **
| **PART I**    | ** **                                                                                                | **1**  |
|---------------|-----------------------------------------------------------------------------------------------------------|--------|
|          | Item  1. Business                                                                                         | 1      |
|          | Item  2. Properties                                                                                       | 11     |
|          | Item  3. Legal Proceedings                                                                                | 12     |
|          | Item  4. Submission of Matters to a Vote of Security Holders                                              | 12     |
|          |                                                                                                      |   |
| **PART II**   | ** **                                                                                                | **14** |
|          | Item  5. Market for Registrant’s Common Equity and Related Stockholder Matters                       | 14     |
|          | Item  6. Selected Consolidated Financial Data                                                             | 16     |
|          | Item 7. Management’s Discussion and Analysis of  Financial Condition and Results of Operations       | 17     |
|          | Item 7A. Quantitative and Qualitative Disclosures  about Market Risk                                      |   |
|          | Item 8. Financial Statements and Supplementary  Data                                                      | 37     |
|          | Item 9. Changes In and Disagreements With  Accountants on Accounting and Financial Disclosure             | 37     |
|          | Item 9A. Controls and Procedures                                                                          | 37     |
|          | Item 9B. Other Information                                                                                |   |
|          |                                                                                                      |   |
| **PART  III** | ** **                                                                                                | **38** |
|          | Item 10. Directors and Executive Officers of  the Registrant                                              | 38     |
|          | Item 11. Executive Compensation                                                                           | 38     |
|          | Item 12. Security Ownership of Certain  Beneficial Owners and Management and Related Stockholders Matters | 38     |
|          | Item 13. Certain Relationships and Related  Transactions                                                  | 39     |
|          | Item 14. Principal Accountant Fees and Services                                                           | 39     |
|          |                                                                                                      |   |
| **PART IV**   | ** **                                                                                                | **39** |
|          | Item 15. Exhibits, Financial Statement  Schedules                                                         | 39     |

 

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# **PARTI**

# ** **

## **Item 1**. Business

## ** **

**Overview**

 

*This Annual Report on Form 10-K(this “Annual Report”) contains forward-looking statements that involve anumber of risks and uncertainties. These forward-looking statements include,but are not limited to, statements and predictions as to our expectationsregarding our operating expenses, sales and operations, anticipated cash needs,capital requirements and capital expenditures, needs for additional financing,use of working capital, the benefits of our Italian operations, plans forfuture products and services and for enhancements of existing products andservices, anticipated growth strategies, ability to attract customers, sourcesof net sales, anticipated trends and challenges in our business and the marketsin which we operate, the adequacy of our facilities, the impact of economic andindustry conditions on our customers and our business, customer demand, ourcompetitive position, critical accounting policies and the impact of recentaccounting pronouncements. Additional forward-looking statements include, butare not limited to, statements pertaining to other financial items, plans,strategies or objectives of management for future operations, our financialcondition or prospects, and any other statement that is not historical fact,including any statement which is preceded by the word “may,” “might,” “will,” “intend,”“should,” “could,” “can,” “would,” “expect,” “believe,” “estimate,” “predict,” “potential,”“plan,” or any similar word. For all of such forward-looking statements, weclaim the protection of the Private Securities Litigation Reform Act of 1995.Actual events or results may differ materially from our expectations. Importantfactors that could cause actual results to differ materially from those statedor implied by our forward-looking statements include, but are not limited to,the impact of changes in demand for our products, our effectiveness in managingmanufacturing processes and costs and expansion of our operations, the degreeto which we are able to utilize available manufacturing capacity, the impact ofcompetition and of technological advances, and costs associated with, andoutcome of, any pending litigation proceedings, and the risks set forth belowunder Item 7, “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Factors That May Affect Future Operating Results.” Theseforward-looking statements represent our judgment as of the date hereof. Wedisclaim any intent or obligation to update these forward-looking statements.*

 

*This report contains statisticaldata that we obtained from industry publications and reports.  These industry publications generallyindicate that they have obtained their information from sources believed to bereliable, but do not guarantee the accuracy and completeness of theirinformation.  Although we believe thatthe publications are reliable, we have not independently verified their data.*

 

*We own various trademarks andtrade names used in our business, such as “Orange 21,” “Spy,” “Scoop,” “E Eyewear,”“Dri-Force,” “ARC,” “Trident,” “SAS” and “Isotron.”  Other trademarks referenced herein are theproperty of their respective owners.*

 

### **We design, develop and marketpremium products for the action sports and youth lifestyle markets.  Our principal products, sunglasses andgoggles, are marketed under our brand, Spy Optic.  These products target the action sportsmarket, including surfing, skateboarding and snowboarding, and the youthlifestyle market within fashion, music and entertainment.  Our participation in these target markets andgrassroots marketing strategies give our Spy brand relevance and authenticitywith our target demographic, individuals born between approximately 1977 and1994, or Generation Y.  We have built ourSpy brand by developing innovative, proprietary products that utilizehigh-quality materials, handcrafted manufacturing processes and engineeredoptical lens technology to convey performance, style, quality, and value.  We sell our products in approximately 4,600retail locations in the United States and internationally through approximately2,500 retail locations serviced by our international distributors and us.  We have developed strong relationships withkey multi-store action sport and youth lifestyle retailers in the UnitedStates, such as Cycle Gear, Inc., No Fear, Inc., Pacific Sunwear of California,Inc., Sun Shade Optique, Tilly’s Clothing, Shoes & Accessories and Zumiez,Inc., and a strategically selective collection of specialized surf, skate,snow, BMX, mountain bike and motocross stores.**

### ** **

We were incorporated as Sports Colors, Inc. inCalifornia in August 1992. From August 1992 until April 1994, wehad no operations. In April 1994, we changed our name to SpyOptic, Inc. and commenced operations. In November 2004, wereincorporated in Delaware and changed our name to Orange 21 Inc. Theinformation contained in, or that 

 

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can be accessed through, our website is not a part ofthis Annual Report. References in this Annual Report to “we,” “our,” “us” and “Orange21” refer to Orange 21 Inc. and our consolidated subsidiaries, SpyOptic, S.r.l. and Spy Optic, Inc., except where it is made clear that the termmeans only the parent company.

 

### **Target Market**

### ** **

Individuals born between approximately 1977 and 1994, more commonlyreferred to as Generation Y, represent the core of our target demographic.Generation Y is a powerful demographic supported by solid growth and spendingpower. Comprising more than 73 million people within the United States, ornearly 26% of the U.S. population, Generation Y represents the second largestdemographic next to the Baby Boomer generation. The U.S. Census Bureauestimates that Generation Y will represent as much as 41% of the U.S.population by the end of the decade. Individuals ranging in age from 13 to 19account for the largest segment of the Generation Y demographic, orapproximately 40% of the total, and are growing at a rate nearly twice as fastas the overall population. Annual spending in this age group has climbed nearly61% since 1995, reaching approximately $175 billion in 2003, with direct(i.e., our consumer) and indirect (i.e., the parents of our consumers)purchasing power that is estimated to exceed $650 billion annually by theend of the decade. We believe this combination of Generation Y’s youth andpurchasing power have made it a powerful driver of trends in fashion, music andsports.

 

We have initiallytargeted the action sports and youth lifestyle markets due to their popularitywith Generation Y and the need for premium quality, high performance eyewear asan integral feature of that participation. Action sports such as surfing,skateboarding, and snowboarding have grown at an average annual rate of 9%since 1998 and are substantially made up of Generation Y participants. Incontrast, participation in traditional team sports, such as baseball,basketball, and football has decreased over that same period.

 

We believe the nexusbetween Generation Y and action sports generates tremendous crossover appealbetween sport and fashion in our target demographic, members of Generation Ywho are seeking premium quality eyewear products. The need for high performanceeyewear products within action sports and the influence of the athletes in suchaction sports has fueled our growth and led to strong appeal for our productsand brand recognition. We have leveraged this success into expanding ourproduct lines into fashion forward designs for the youth lifestyle market.

 

**Business Strategy**

 

Our long-term goalis to capitalize on the strengths of our growing consumer brands by providingconsumers with stylish, high-quality, performance-driven products. We seek todifferentiate our brand by offering diverse product lines that emphasizeauthenticity, functionality, quality and comfort. In pursuit of this goal, we arepursuing the following operating and growth strategies that provide theframework for our future growth, while maintaining the quality and integrity ofour brands.

 

**OperatingStrategy**

 

•                  *Drive Product Demand Through Premium Quality andInnovative Design.*    We believe our reputationfor premium quality, innovation and technical leadership distinguishes ourproducts from those of our competitors and provides us with significantcompetitive advantages. Our sunglasses are forged from materials such asgrilamid, propionate and acetate, which we believe are superior to thematerials used by many of our competitors. These materials provide productcharacteristics such as flexible sport frames, more comfortable fashion framesand, in the case of acetate, allow us to hand cut and polish our fashionframes. Our use of hand painting techniques and specialized trims, includingmetal logos, hinges and temple plates, create unique premium sunglasses andgoggles. We intend to continue developing innovative styles and products inorder to preserve and strengthen our leadership position as having aprogressive action sports and youth lifestyle brand.

 

•                  *Sustain Brand Authenticity.*    Tosustain the authenticity of our Spy brand, our grassroots marketing programsfeature advertising in action sports and youth lifestyle media at a globallevel, participation in and sponsorship of hundreds of events annually and sponsorshipof action sports athletes. Our advertising campaign, found in print media suchas Surfer, Transworld Snowboarding and Racer X magazines, fuses

 

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athletes,lifestyle, innovative product photography and our unique style. Our approach toevent marketing utilizes our fleet of Spy branded vehicles to showcase ourproducts and athletes at events such as the X Games, the Zumiez Couch Tour,Wakestock, the U.S. Open of Surfing and the Whistler Ski and SnowboardFestival.

 

•                  *Actively Manage Retail Relationships.*    Wemanage the retail sales process by monitoring customer sales and inventorylevels by product category and style to ensure optimal brand representation andproduct offerings. Our sales programs, including in-store clinics,point-of-purchase displays and marketing materials, assist our authorizedretailers in promoting the authenticity of our brands and products and maximizethe implementation of our consumer marketing initiatives. We will continue todevelop a strategically selective, specialty-focused retail base to ensurebrand authenticity and to prevent over-saturation of our brands. As a result,we believe we enjoy close relationships with our retailers, which enables us toinfluence the assortment and positioning of our products and to optimizeinventory mix.

 

•                  *MaintainStrategic Product Manufacturing Relationship.*    Wemaintain a close strategic alliance with our principal manufacturer located inItaly.  In turn, this manufacturermaintains a focus on premium eyewear manufacturing processes to supply ourproducts. By outsourcing our product manufacturing to a third-party with whichwe maintain a close, strategic alliance, we are able to focus on designing anddeveloping innovative, stylish and performance-driven products on a timely,cost-effective basis.

 

**GrowthStrategy**

 

•                  *ExpandDomestic Distribution and Brand Recognition Outside of California*.    Webelieve that significant opportunities exist to increase our sales by expandingdomestic distribution of our products. In 2002, 2003 and 2004, approximately 58%,48% and 51%, respectively, of our domestic business was derived from saleswithin the state of California. We plan to increase significantly our marketingand distribution efforts throughout the United States by expanding our internaland external sales teams and growing our distribution base.

 

•                  *ExpandInternational Distribution.*    We believesignificant opportunities exist to increase our sales outside of the UnitedStates, and we are actively expanding distribution worldwide. In 2002, 2003 and2004, approximately 32%, 24% and 26%, respectively, of our total net sales werederived from sales outside of the United States. To increase marketing for ourbrands abroad, we have developed a unique distribution model, which we refer toas our hybrid model that allows our distributors to focus their efforts onregional sales and marketing while we provide the fulfillment of orders fromour European distribution center. This model mitigates our distributors’ inventoryrisk and enables them to invest in brand building programs within theirterritories.  In selected markets such asCanada, Italy and France, we use a direct distribution model instead of ourhybrid model, because we believe that the strength of our Spy brand in thosecountries creates an opportunity for greater growth through the use of thisdirect sales market.

 

•                  *IntroduceNew Products and Product Lines Under Our Existing Brands.*    Weintend to increase our sales by developing and introducing new products andproduct lines under our existing brands that embody our standards of design,performance, value and quality. On March 23, 2005, we launched apremium-priced, handmade fashion sunglass collection, which we expect willoffer an additional revenue stream and access to an expanded demographic. Ourpremium collection will be positioned at the top of our product matrix and willhighlight the best of our quality, innovative detailing and design elements. Wealso intend to expand our women’s product line and to launch several productlines within the optical prescription eyewear market.

 

•                  *Buildor Acquire New Brands.*    We intend to continuefocusing on developing or acquiring new brands that we believe complement ouraction sports and youth lifestyle brands. We believe that brand acquisitionopportunities currently exist in the action sports and youth lifestyle marketsthat would allow us to expand both our product offerings and our targetdemographics. For example, we have entered into an agreement with DaleEarnhardt, Jr., pursuant to which we obtained the right to design and sella Dale

 

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Earnhardt, Jr.branded signature series of our sunglass products. We launched this new brandin late February 2005 with a full roll out planned in spring of 2005.

 

### **Products**

### ** **

We design, developand market premium eyewear products, apparel and accessories. Our currentproduct matrix consists of seven product categories, including fashionsunglasses, women-specific sunglasses, performance sport sunglasses, snowgoggles, motocross goggles, apparel and accessories.

 

*Fashion Sunglasses*

 

We currently offer 12models of fashion sunglass products. The majority of our fashion sunglassframes are constructed of propionate or acetate, which enable us to producesmooth, dense products that are adjustable to the contours of each individual’sface and are very comfortable to wear. We are one of the few brands in theaction sports and youth lifestyle markets to offer high-quality fashionsunglass frames constructed from propionate or acetate. These frames areengineered utilizing a wide variety of unique colorations and color fades thatare created and/or polished for a high-gloss finish. The majority of ourfashion sunglass frames, including all color fades, are hand painted in Italy.We also incorporate adjustable wire-core temples into most of our fashionsunglass products so that our sunglass frames will provide a more custom fitfor each individual. In addition, we offer sunglass frames forged from nickelsilver alloy that are lightweight and pliable, yet strong. Retail prices forthese models range from $70 to $140.

 

*Women-Specific Sunglasses*

 

We currently offer sevenmodels of women-specific sunglass products. A majority of these models areconstructed of propionate, which are engineered utilizing a wide variety ofunique colorations and color fades that are polished for a high-gloss finish.The majority of our women-specific sunglass frames, including all color fades,are hand painted in Italy. Other materials utilized in this product lineinclude grilamid and galvanized nickel silver. Retail prices for these modelsrange from $80 to $125.

 

*Performance SportSunglasses*

 

We currently offer sixmodels of Spy branded performance sport sunglass products, which are designedto meet the demands of action sports athletes while offering innovativestyling. The frames of all six models are constructed from injection-moldedgrilamid, an exceptionally lightweight material that is shatter-resistant andremains pliable in all weather conditions. All of these models incorporate ourpatented Scoop airflow technology, contain our ARC lenses and are engineered toincorporate interchangeable lenses. Most models also are available with ourTrident polarized lenses and Hytrel rubber on the bridge and temple tips of theframes to prevent slippage. Retail prices for these models range from $75 to $125.We also recently launched our new line of Dale Earnhardt, Jr. signaturesunglasses, which retail for $ 65.00 and are marketed under the brand E Eyewear.

 

*Snow Goggles*

 

We currently offersix models of snow goggle products. All of our models of snow goggles areconstructed of injected polyurethane, incorporate our patented Scoop airflowtechnology, anti-fog lens construction and Isotron foam, and offer 100%ultraviolet, or UV, protection. Two of the models utilize our ARC spherical,dual-lens system, while the other models utilize cylindrical, dual-pane lenstechnology. Retail prices for these models range from $50 to $150.

 

*Motocross Goggles*

 

We currently offerthree models of motocross goggles. Similar to our line of snow goggles, ourmotocross goggles are constructed of injected polyurethane and incorporate our patentedScoop airflow technology, Isotron foam and GE Lexan hard-coatedscratch-resistant lenses. For perspiration absorption, we use either ourmoisture-wicking Dri-Force fleece, which is bonded to our Isotron foam, or ourtwo-stage Sweat Absorption System. All of the models of motocross gogglesutilize our high-quality, anti-fog coating and are compatible with tear-offlens systems. Retail prices for these models range from $30 to $68.

 

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*Apparel*

 

Our men’s and women’sapparel collections consist of a variety of shirts, fleece clothing and hatsthat are released on a seasonal basis. We believe that our apparel collectionsprovide brand recognition by echoing the innovative and unique designs of oureyewear products. Retail prices for our apparel collections range from $18 to $52.

 

*Accessories*

 

We offer a fullrange of accessories, including sunglass and goggle cases, lens replacementkits, wallets, belts, backpacks and gear bags. Our lens replacement kits enableconsumers to interchange the color of lenses in our performance eyewearproducts to adjust to various light conditions. Retail prices for ouraccessories range from $18 to $150.

 

### **Sales andDistribution**

### ** **

Our distributionstrategy is based on our belief that the integrity and success of our brands isdependent on strategic growth and careful selection of the retail accountswhere our products are merchandised and sold. We sell our products inapproximately 4,600 retail locations in the United States and internationallythrough approximately 2,500 retail locations serviced by us and ourinternational distributors. Although we intend to increase our distributionwithin the action sports and youth lifestyle markets, we believe that thelargest growth opportunity for our brands is in the sunglass-focused distributionchannel, including sunglass specialty and optical retailers. As a result, weintend to devote substantial resources towards growing sales of our products tothese types of retail accounts.

 

For the fiscal yearended December 31, 2002, 26% of our net sales were to our ten largestcustomers, which included****five internationaldistributors. For the fiscal year ended December 31, 2003, 20% of our netsales were to our ten largest customers, which included two internationaldistributors. For the fiscal year ended December 31, 2004, 20% of our netsales were to our ten largest customers, which included three internationaldistributors. In fiscal year ended December 31, 2002 we had one customerindividually account for 10% of our net sales. For each of the fiscal years ended December 31, 2003 and 2004, wedid not have any single customer or group of related customers that represented7% or more of our net sales.

 

*Domestic Sales andDistribution*

 

We sell our productsto retailers who merchandise our products in a manner consistent with the imageof our brands and the quality of our products. We have developed long-termrelationships with key multi-store action sport and youth lifestyle retailersin the United States, such as Cycle Gear, Inc., No Fear, Inc.,Pacific Sunwear of California, Inc., Sun Shade Optique, Tilly’s Clothing,Shoes & Accessories and Zumiez, Inc., and a large collection ofaction sport retailers that focus on surfing, skateboarding, snowboarding, BMX,snow skiing, motocross, wakeboarding and mountain biking. We have entered intodealer arrangements with our retailers pursuant to which they issue a purchaseorder for our products. These arrangements do not contain minimum purchasecommitments and can be terminated by either party at any time. In order to berecognized as having premium brands, we generally elect to sell throughspecialty stores instead of mass discount and general sporting goods retailchains. This has enabled us to maintain brand authenticity by partnering withretailers who share the same focus on influential action sport-oriented youth.Our domestic sales force consists of approximately 27 independent,non-exclusive field sales representatives, 14 independent, exclusive fieldsales representatives, seven internal regional sales managers and twelveinternal sales and customer service representatives.

 

We require ourretailers and distributors to maintain specific standards in representing ourbrands at the point of sale, including minimum inventory levels,point-of-purchase branding, authorized dealer identification and an agreementthat ensures store inventory is consistent with our current product collection.Our retailers also must agree not to resell or divert products throughunauthorized channels of distribution. To preserve and enhance our brands,retailers not adhering to strict guidelines are coached to ensure compliance tosuch guidelines. Retailers that are not able to comply with such guidelines areeliminated from our authorized dealer network.

 

We understand thatour retail partners represent the link between our brands and the consumer;therefore, we have focused on building relationships with buyers, merchandisersand retail sales staff. Our retail marketing and sales support teams ensurethat our sales representatives and retailers have the tools, knowledge andsupport to sell our products. We provide dealer catalogs, clinic tools,displays, point-of-purchase materials, dealer mailings, sales representativetraining and an in-house sales support staff to ensure that we focus on allaspects of selling our products

 

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and building relationships with ourretailers. We also utilize a unique regional fleet of mobile sales supportvehicles operated by key sales representatives. These vehicles effectivelypromote our brands at regional action sports events and provide a variety ofretailer support services, including inventory replenishment, warrantyreplacement, billing, merchandising and onsite training.

 

*International Sales andDistribution*

 

Our products arecurrently sold in over 35 countries outside of the United States, whichaccounted for 32%****of our total net sales for thefiscal year ended 2002, 24% of our total net sales for the fiscal year ended December 31,2003 and 26% of our total net sales for the fiscal year ended December 31,2004. Substantially all of our sales, marketing, and distribution activitiesoutside of the United States, Canada, and Latin America are serviced directlyby our wholly owned European subsidiary, Spy Optic, S.r.l., located in Varese,Italy. Substantially all of our international sales are generated by ourinternational distributors. Our international distributors utilize anindependent sales force consisting of over 150 non-exclusive salesrepresentatives in Europe and the Asia/Pacific region. This localrepresentation allows us to ensure that each region is provided with themarketing, sales support and product mix that is complementary to the needs ofretailers within their respective territories.

 

In addition to ourtraditional distribution model, we are developing two models of internationaldistribution which do not rely exclusively upon our international distributorsand their sales representatives. The first method consists of collaboratingwith international distributors or sales agencies to eliminate duplicatesupply-chain infrastructure, which we refer to as our Hybrid Distributionprogram. We provide marketing oversight, as well as internal operationalfunctions such as shipping products from our U.S. or Italian distributioncenters directly to the retailer, while our regional distributors providesales, customer service and collections functions. This distribution modeleliminates our fixed cost risks associated with maintaining a directinternational sales team. Partnerships with regional distributors or salesagencies also provide us with feedback that we can utilize to conduct regionalsales and marketing initiatives specific to a particular sales territory. As ofDecember 31, 2004, we had three  regional distributors or sales agencies thatwere utilizing our Hybrid Distribution program. Pan-European implementation ofthis program is projected to be completed by the end of 2006.

 

Our second method ofinternational distribution consists of targeting sales territories whereproduct demand is expected to support establishing direct operations in suchterritory, which we refer to as our Dealer Direct program. This programutilizes regional independent or employee sales representatives that provideall on-site retail services, while we provide all marketing, accounting andfulfillment operations. Fulfillment services can be provided by our U.S. orItalian distribution centers, depending on the location of the Dealer Directterritory. We successfully tested the Dealer Direct program in Canada through over600 retail accounts in 2003, and we intend to expand use of this distributionmodel into other territories where sales volume and logistics costs permit.****In January, 2005, we announced that we are converting ourdistribution model in Italy and France from our Hybrid Distribution to ourDealer Direct model.  We believe that thereis sufficient demand for our products in Italy and France such that using theDealer Direct model in those countries will allow us to better service andgreatly expand our customer networks in those countries.

 

### **Promotion andAdvertising**

### ** **

All marketing andbranding is managed by our in-house staff, which enables us to deliver atargeted, consistent and recognized advertising message. Our commitment tomarketing at the grassroots level in the action sports market and the youthlifestyle market within fashion, music and entertainment is the foundation ofthe promotion and advertising of our brands and products. We focus ourmarketing efforts on Generation Y, which is one of the most influential andgrowing demographics in contemporary culture. We seek to increase our brands’support and influence within the action sports and youth lifestyle marketsthrough our athlete sponsorship program, a variety of consumer printadvertising campaigns and grassroots marketing initiatives, such as sponsorshipof action sports events and promotional vehicle tours.

 

We employ managersfor the surf, skate, snowboard, motocross, downhill mountain bike, BMX, ski andwakeboard sectors of the action sports market, each of whom possesses expertisewithin his or her specific sport. Many of our managers were professionalathletes and remain immersed within their specific sports. Our managers are responsiblefor selecting sponsored athletes, grassroots marketing and event initiatives,maintaining industry relationships and directing print advertising within theirsegment. We are extremely selective with athlete sponsorship and only signathletes who we believe are able to influence youth culture on a regional orglobal level. Some of our

 

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athletes include: surfers Keith and ChrisMalloy; snowboarders Marc Frank Montoya and Todd Richards; skateboarders RobDyrdek and Danny Way; motocross rider Jeremy McGrath; BMX athlete JamieBestwick; wakeboarder Parks Bonifay; freestyle skier David Crichton; anddownhill mountain biker Sam Hill. In addition, we have entered into anagreement with Dale Earnhardt, Jr., pursuant to which we obtained theright to design and sell a Dale Earnhardt, Jr. branded signature series ofour sunglass products. We launched this new brand in late February 2005with a full roll out planned in spring of 2005.

 

We sponsor  regional and national action sports eventsand employ a vehicle-marketing program to drive the growth of our brands attrade shows and action sports, music and lifestyle events. Our vehiclemarketing program primarily consists of promotional tour buses and eight regionalsales vehicles, which we utilize to create a dynamic and unique eventexperience. We also have given away a Spy-branded wakeboarding boat in each ofthe previous two years in conjunction with Air Nautique and AllianceWakeboarding Magazine.

 

Our advertisingcampaign fuses athletes, lifestyle, innovative product photography and ourunique style. We utilize the exposure generated by our athletes as an editorialendorsement of product performance and style. Major trade magazines, includingTransworld Snowboarding Business and Snow Industries of America Daily News,publish special product reports, including reports featuring our products, inconjunction with international and domestic action sport, optical or fashiontrade shows. We take advantage of this by strategically timing product releasesto coincide with these trade shows and eyewear dealers’ purchasing schedules.We also attend most of the major action sport, optical and fashion trade showsin North America, Europe and the Asia/Pacific region to promote our brands andproducts.

 

### **Product Design andDevelopment**

### ** **

### **Our products are designed for individuals who embracethe action sports and youth lifestyle markets. We believe our most valuableinput comes from our managers, employees, sponsored athletes and  sales representatives who are activelyinvolved in action sports. This connection with the action sports and youthlifestyle markets continue to be the driving force for the design andperformance features of our products and is key to our reputation forinnovative and authentic product designs.**

### ** **

In order to respondeffectively to changing consumer preferences, we attempt to stay abreast ofemerging lifestyle and fashion trends in the action sports and youth lifestylemarkets. Our design teams constantly monitor regional and global fashion inorder to identify trends that may be incorporated into future product designs.

 

Every eyewear designstarts with a hand-drawn sketch, which is then converted into acomputer-rendered technical drawing. The computer-rendered technical drawing isthen fabricated into a hand-finished prototype. This prototype is extensivelyanalyzed and measured through laboratory and field-testing to ensure that itreflects the design integrity of the original sketch and that the fit meets ourexacting standards. In addition, we often incorporate key changes andimprovements for our eyewear through input from our managers, employees,sponsored athletes and  salesrepresentatives. Once the prototype is thoroughly tested and optimized, thedesign is translated into a hand-polished, steel injection-mold.

 

We differentiate ourproducts from those of our competitors by incorporating innovative designs,advanced optical technology, and premium components and materials. In certaininstances, we believe that such innovations have allowed us to grow consumeracceptance of our products with only nominal increases in manufacturing costs.We believe that the substantial experience of our design team will greatlyenhance our ability to maintain our position as having leading brands in theaction sports and youth lifestyle markets and to expand the scope of ourproduct lines.

 

We have entered intoan agreement with our primary product designer, Jerome Mage, through hisbusiness Mage Design LLC, for the design and development of our eyewear,apparel and accessory product lines. Mr. Mage has agreed to provide hisservices to us as an independent consultant through December 31, 2008, andto be bound by confidentiality obligations. Mr. Mage has also agreed not toprovide design services to any entity that is engaged principally in thebusiness of designing, manufacturing or selling sunglasses, goggles or otheroptical products during the term of the agreement. Mr. Mage is developingproducts for the Spy Optic and E Eyewear brands.  Under the agreement, Mr. Mage assignsall ideas, inventions and other intellectual property rights created ordeveloped on our behalf during the term of the agreement to us. The agreementmay be terminated by either party if the other party defaults or breaches amaterial provision of the agreement.

 

7

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**Product Technologies**

 

*Scoop Airflow Technology*

 

Our patented airflowsystem is referred to as Scoop airflow technology. The Scoop ventilation systemforces air through strategically placed vents on goggle and sunglass frames,which reduces pressure and eliminates fogging. Our Scoop technology isprotected by five U.S. patents. Currently, we license our Scoop technology toone sunglass company on a non-exclusive basis. We do not receive any materialamount of revenue from this license at present.

 

*Sunglass Lens Technology*

 

Our Accurate RadiusCurvature, or ARC, prismatic lenses are utilized in most of our sunglass framesto provide optically correct, distortion-free vision and a total absence ofprismatic aberration and astigmatism. Our ARC lens becomes thinner as it movesaway from the optical center of the lens, thereby complementing the naturalcurvature of the human eye to provide clarity at all angles of vision,eliminate distortion and selectively filter out light waves that cause eyefatigue and discomfort. The lens properties, combined with high-quality,vacuum-applied surface coatings, manipulate the light spectrum to ensuremaximum visual performance with no distortion. We also offer a number ofsurface coatings to achieve different lens colors by absorbing and reflectingdifferent wavelengths in the light spectrum. In addition, we integratefiltering agents into our lens manufacturing process to provide eye protectionin every type of environment. All of our lenses provide complete UV protection,including UVA, UVB, and UVC energy wavelengths, and provide powerful protectionagainst the harmful effects of all types of solar radiation.

 

Some of our productsincorporate high-quality injected polarized lenses. Our Trident polarizedlenses diffuse glare through the use of a highly advanced polarizing filterplaced between two injected lens layers, allowing incredible clarity even inthe harshest conditions and effectively eliminating almost all blinding glare.

 

*Snow Goggle Technology*

 

•                  *ARC Spherical Goggle Lenses*.    Our ARC sphericalgoggle lenses employ the same technology as our sunglass lenses. Our gogglelenses consist of an integrated dual lens system that enables the inner lens toconform to body temperature and the outer lens to conform to environmentaltemperature to eliminate fogging of the lenses. The outer lens is ahigh-density, scratch-resistant injected ARC  polycarbonate lens. The thermal spacer betweenthe two lenses consists of an engineered acrylic-based bonding agent andclosed-cell foam gasket. The inner lens is made of spherically thermoformed,anti-fog impregnated propionate.

 

•                  *Isotron Foam*.    The interior lining of oursnow goggles where they make contact with an individual’s face, which we referto as Isotron foam, is engineered from high-quality, ergonomic thermoformedfoam to provide each user with a comfortable, custom fit and a superior sealaround his or her face. Our Isotron foam on the Orbit model works inconjunction with our Dri-Force fleece to wick moisture away from an individual’sface.

 

*Motocross GoggleTechnology*

 

•                  *Engineered Visual Optics*.    We use polycarbonate hard-coated, scratch-resistant extrudedlens material on all of our motocross goggles. All lenses are cut precisely foran exact fit between the lens and the frames. We also impregnate a high-qualityanti-fog coating into the internal surface of the lenses on our motocrossgoggles which cannot be wiped off. The hard coating on the external surface ofour lenses prevents scratching.

 

•                  *Tear-Offs*.    We utilize engineeredthin, antistatic, low-haze tear-off lens sheets to be used with our motocrossgoggles to enable riders to retain a clear field of vision. This ultra-thinmaterial enables a rider to stack these lens sheets onto the goggle lens andtear them off while riding in order to maintain a clear field of vision withouthaving to wipe off the goggle lens.

 

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•                  *Isotron Foam*.    Our motocross goggles,like our snowboard goggles, utilize our Isotron foam to create a comfortable,ergonomic fit and superior seal around an individual’s face. Our Alloy SASmodel utilizes our Dri-Force fleece, which is bonded to single density Isotronfoam, and is designed to be used with our two-stage Sweat Absorption System.All of our motocross goggles also utilize high-density filter foam to preventdust and dirt from entering the rider’s field of vision and to enhance aircirculation to minimize fogging of the lens.

 

•                  *Sweat Absorption System*.    Wehave developed a two-stage moisture-wicking system that absorbs significantlymore perspiration than our standard fleece-lined Isotron foam, which we referto as Sweat Absorption System, or SAS. Our SAS consists of a removable padwhich can be replaced at any time to prevent perspiration from entering a user’seyes. We have submitted a patent application for our SAS.

 

### **Manufacturing**

### ** **

We have createdstrategic alliances with manufacturers of eyewear products that providestate-of-the-art manufacturing, innovative hand-finished detailing and finishesand strict quality control standards. These relationships enable us to react tomarket trends much faster than competitors because we are not required totransition internal manufacturing resources.

 

We manufacture a substantialmajority of our products through two manufacturers, LEM S.r.l., or LEM, andIntersol S.r.l. or Intersol, both of which are located near our European facilityin Italy. Our manufacturing partners are independently owned and operated;however, our agreement with our principal manufacturing partner, LEM, providesthat LEM cannot manufacture sunglasses or goggles for Arnette, Dragon,Electric, Oakley, Quiksilver and Von Zipper. LEM also is bound by exclusivityand confidentiality obligations with respect to our proprietary information andprocesses. During the term of our agreement with LEM, which presently terminateson October 31, 2006, we are required to purchase some of our sunglass andgoggle products exclusively from LEM, and we are required to purchase minimumquantities of such products on a monthly and annual basis. We also haveacquired an option to purchase LEM, which we can exercise at any time up to December 31,2005. We presently rely upon LEM for the manufacture of a substantial majorityof our sunglass products, and we expect that we will rely on LEM for themanufacture of an increasing portion of such products.

 

Our sunglassmanufacturing process begins with fabrication of the eyewear frames. The finalmold for each model of our eyewear products is injected with intensely heatedmaterials, such as grilamid or propionate. The components of each frame arethen placed in a wood chip or ceramic chip tumbling machine for up to48 hours to ensure that every frame piece is completely smooth without anyimperfections. Each frame is then inspected and hand polished. After thetumbling process, the frames are washed in high-speed ultra-sonic vibrationmachines to ensure that each piece is completely clean and dust-free prior tothe extensive painting process.

 

Our highlyspecialized painting process includes up to five layers of paint; substantiallyall of which are applied by hand. Each of these layers includes an elaborate,multi-day painting, drying and curing process. We also hand set all of ourpolished metal logos and accents. Our lenses are cut and inserted into frameswith exacting standards. The machinery used to cut each lens ensures that ourproducts will perform to the highest optical standards.

 

Once the assemblyprocess is completed, we test all of our products for optical clarity based onU.S., European and Australian standards. The American National StandardsInstitute and the American Society for Testing and Materials have establishedspecific testing criteria for eyewear. These tests analyze product safety andprovide quantitative measure of optical quality, UV protection, lighttransmission and impact resistance. In addition, we perform a broad range ofeyewear durability testing and mechanical integrity testing that includesextremes of UV, heat, condensation and humidity. Our testing process alsoutilizes a laser-based lens testing technique to ensure that  our lenses meet a variety of opticaldistortion standards. After lens testing, each product is inspected for paintquality, fit, finish and overall appearance.

 

Our gogglemanufacturing process begins with the fabrication of the goggle frame. Thefinal mold for each goggle model is injected with intensely heated PVC or polyurethane.The frame components are then carefully washed using proprietary cleaningprocesses that ensure secure paint adherence. After cleaning, each frame issubjected to our

 

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extensive painting process, which caninclude up to four layers of paint and often includes a proprietary method ofprinting custom paint designs. Many of our products are assembled using a sonicwelding process to ensure a secure bond between materials, and all of our metallogos and details are hand painted and set into the frame. All of our gogglesutilize what we believe to be the highest quality materials and components fromthe most reputable suppliers in the industry. Our lenses are carefullyassembled using specialized machinery to ensure strict anti-fogging lensperformance.

 

Once the assemblyprocess is completed, we test our goggles to ensure they meet and exceed allinternational directives for goggle safety and performance. These directivesanalyze product safety by testing for impact resistance, anti-fog protection,light transmission, UV protection and quality of frame materials. In additionto independent laboratory testing, we perform extensive proprietary testing ateach of our manufacturers, including analyzing our goggles for productstrength, wear and accelerated weather testing. Prior to shipment, each goggleis inspected for paint quality, fit, finish and overall appearance.

 

Each of our appareland accessory manufacturers is carefully selected based upon quality standards,manufacturing methods and ability to produce custom designed products. Allapparel and accessories are manufactured to exacting standards andspecifications using high-quality materials. Treatments and fits are carefullyinspected upon receipt, and products that do not fall within our specificationsheets are rejected. To ensure quality, we require our manufacturers to sourcespecific fabrics, buckles, labels, micro-injected logos and other materials.

 

**Customers**

 

Our products arecurrently sold in the United States and in more than 35 countries in the restof the world. Our customer base reflects our heritage and influence across theaction sports and youth lifestyle markets and a distribution strategy whichfocuses on action sport and youth lifestyle retailers.

 

For the fiscal yearended December 31, 2002, we derived 68% of our net sales in the UnitedStates and 32% of our net sales in the rest of the world. For the fiscal yearended December 31, 2003, we derived 76% of our net sales in the UnitedStates and 24% of our net sales in the rest of the world. For the fiscal yearended December 31, 2004, we derived 74% of our net sales in the UnitedStates and 26% of our net sales in the rest of the world. For purposes of thesecalculations, we attribute sales using customer locations as opposed toshipping point.

 

Our net sales arespread over a large customer base. For fiscal years ended December 31,2002, 2003 and 2004, 26%, 20% and 20% of our net sales were from our tenlargest customers, respectively. One customer individually accounted for 10% ofour net sales in the fiscal year ended December 31, 2002.  No single customer accounted for more than 7%of our net sales during each of the fiscal years ended December 31, 2003 and2004.

 

**Government Regulation**

 

Our products are subject to governmental health safetyregulations in most countries where they are sold, including the United Statesand the European Union, as well as import duties and tariffs on products beingimported into countries outside of the United States. In addition, we aresubject to various state and federal regulations generally applicable tosimilar businesses. We regularly inspect our production techniques andstandards to ensure compliance with applicable requirements.

 

**Intellectual Property**

 

We use a combinationof patent, trademark, copyright, trade secret and trade dress laws, includingconfidentiality agreements, to aggressively protect our intellectual property,including product designs, product research and development and recognizedtrademarks. We have five U.S. patents for our Scoop airflow technology, whichexpire between August 2012 and November 2015. We have 19 U.S. designpatents with respect to our products as follows: 15 regarding certain of oursunglasses, one regarding certain of our goggles, two regarding certain of oursunglass cases and one regarding our eyewear retail display cases. Our designpatents expire from February 2010 to August 2012. We also havesubmitted a patent application for our sweat absorption system utilized in ourmotocross goggles. We will continue to file patents on our inventions that aresignificant to our business and pursue trademarks where applicable.

 

Orange 21, Spy,Scoop, Dri-Force, ARC, Trident, SAS and Isotron are trademarks of Orange 21Inc.  We have applied for a trademark onthe name E Eyewear.  As of December 31,2004, we have been unable to register Spy

 

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as a trademark for our products in every marketin which we do business. In addition, we have no trademark registrations forSpy with respect to the accessory products currently being sold under our Spy brand.

 

We also activelycombat counterfeiting through monitoring of the global marketplace. We utilizeour employees, sales representatives, distributors and retailers to policeagainst infringing products by encouraging them to notify us of any suspectproducts, confiscating counterfeit products and assisting law enforcementagencies. Our sales representatives are also educated on our patents and tradedress and assist in preventing potentially infringing products from obtainingretail shelf space.

 

### **Competition**

### ** **

We compete withmostly smaller sunglass and goggle brands in various niches of the actionsports market and a limited number of larger competitors, such as Arnette,Oakley and Smith Optics. We also compete with broader youth lifestyle brandsthat offer eyewear products, such as Hurley International and Quiksilver. Inboth markets, we compete primarily on the basis of design, performance, price, value,quality, brand name, marketing and distribution.

 

We also compete inthe broader fashion sunglass sector of the eyewear market, which is fragmentedand highly competitive. The major competitive factors include fashion trends,brand recognition, distribution channels and the number and range of productsoffered. We compete with a number of brands in this sector of the market,including Armani, Christian Dior, Dolce & Gabbana, Gucci, Prada andVersace.

 

We believe that ourprincipal competitive advantages are quality, design, performance, brand name,and value. We believe that many of our competitors enjoy significantly greaterfinancial resources than we have, which enables them to promote their productsmore heavily than we can. Also, many of our competitors have greater brandrecognition, a longer operating history and more comprehensive product linesthan us.

 

### **Backlog**

### ** **

Historically, purchases of sunglass and motocross eyewear products have notinvolved significant pre-booking activity. Purchases of our snow goggle products are generally pre-booked andshipped primarily from August to October. At December 31, 2002, 2003and 2004 we had a backlog, including backorders (merchandise remainingunshipped beyond its scheduled shipping date), of approximately $1.6 million,$700,000 and $1 million.

 

### **Seasonality**

### ** **

Our net salesfluctuate from quarter to quarter as a result of changes in demand for ourproducts. Historically, we have experienced greater net sales in the secondhalf of the fiscal year as a result of the seasonality of our customers and themarkets in which we sell our products. We generally sell more of our sunglassproducts in the first half of the fiscal year and a majority of our goggleproducts in the last half of the fiscal year. We anticipate that this seasonalimpact on our net sales is likely to continue. As a result, our net sales andoperating results have fluctuated significantly from period-to-period in thepast and are likely to do so in the future.

 

### **Employees**

### ** **

As of December 31,2004, we employed 94 full-time employees, including 85 full-time employees inthe United States and nine full-time employees in the rest of the world. Thisaggregate number of employees consists of 44 in sales and marketing, 17 ingeneral and administration, three in design and development and 30 inmanufacturing support and fulfillment operations. We have never had a workstoppage. We consider our employee relations to be good.

 

## **Item 2**. Properties

## ** **

Our corporateheadquarters totals 30,556 square feet and is located in Carlsbad, Californiaunder a lease that expires in May 2005. Our monthly rent for this facilityis $19,830 per month through the expiration of the lease in May 2005. Wehave an agreement with our landlord to extend our lease through December 31,2005 that includes an option to extend the lease term for one year through December 31,2006.  Estimated monthly rent beginning June 1,2005 will be approximately $23,000.  Wealso lease an approximately 8,880 square foot office and warehouse facility inVarese, Italy, which we use primarily for international sales and distribution.We pay monthly rent of approximately

 

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$4,400 for the lease on this facility, whichexpires in September 2009; however, we have an option to terminate thislease upon six months’ notice.  Inaddition, we utilize some third party warehousing in both the US and Italy.

 

We believe ourfacilities are adequate for our current needs and that suitable additional orsubstitute space will be available to accommodate foreseeable expansion of ouroperations or to move our operations in the event one or more of our leases canno longer be renewed on commercially reasonable terms.

 

## **Item 3**. LegalProceedings

## ** **

On March 7, 2005, Oakley, Inc. filed a complaintagainst us in the United States District Court, Central District of California(case SACV 05-219 AHS).  In itscomplaint, Oakley alleges that the sale of certain of our product stylesconstitutes patent infringement, trademark infringement, trade dressconfiguration infringement, false designation of origin, false description orrepresentation of goods and/or unfair competition.  In its complaint, Oakley seeks thefollowing:  a determination that itsasserted intellectual property rights are enforceable and that we haveinfringed such rights; an injunction, during the course of the lawsuit andthereafter, restraining us from certain activities alleged to infringe itsrights; an assessment of damages against us for the alleged infringement (includingtreble damages for alleged intentional infringement); our destruction ofallegedly infringing products and materials; and recovery from us of itsattorneys fees and costs.  The lawsuithas only recently commenced (for instance, we have not yet filed an answer tothe complaint) and we presently have no estimate of any potential loss or rangeof loss with respect to the lawsuit or any estimate as to the potential costsof defending against the lawsuit.  However,we have reviewed the claims made by Oakley, we believe them to be without meritand we intend to vigorously defend ourselves against the lawsuit.

 

We, our directors and certain of our officers have recently been namedas defendants in a stockholder class action lawsuit filed in the United StatesDistrict Court for the Southern District of California. The complaint purportsto seek unspecified damages on behalf of an alleged class of persons whopurchased our common stock pursuant to our registration statement we filed inconnection with our public offering of stock on December 14, 2005.  The complaint alleges that we and ourofficers and directors violated federal securities laws by failing to disclosematerial information about the status of our European operations and whethercertain of our products infringe on the intellectual property rights of Oakley,Inc. in that registration statement.  Wehave not yet formally responded to this action and no discovery has beenconducted. However, based on the facts presently known, our management believeswe have meritorious defenses to this action and intends to vigorously defend againstthe action.  Based on our insurance coverages,our costs related to this action could range from $0 to $250,000.

 

From time to time, we are involved in otherlegal proceedings incidental to our business, but at this time we are not partyto any such litigation that is material to our business.

 

## **Item 4**. Submissionof Matters to a Vote of Security Holders

## ** **

In connection with our recently completed IPO, theshareholders of Spy Optic, Inc. (our predecessor corporation) or the “CaliforniaCorporation,” approved the reincorporation of our company from California toDelaware, which was effected by merging the California Corporation with andinto Orange 21 Inc., or the “Delaware Corporation.”  In connection with our reincorporation, ourstockholders approved a form of Indemnification Agreement for our officers anddirectors.  Subsequent to thereincorporation and merger, our stockholders approved an amendment andrestatement of our certificate of incorporation and our bylaws and the adoptionof our 2004 Stock Plan. Following completion of the reincorporation, weincorporated Spy Optic, Inc. in California as a wholly owned subsidiary.

 

All of these approvals were effected by writtenconsents of our stockholders, prior to the IPO, in December 2004.  The number of shares cast in favor of thereincorporation was 3,759,879.  Therewere no shares cast against, or abstaining from, the vote with respect to thereincorporation.  The number of sharescast in favor of the approval of the Indemnification Agreement was 3,754,092which represented 74.9% of the shares held by disinterested stockholders withrespect to the Indemnification Agreement. The number of votes cast in favor ofthe amendment of our certificate of incorporation and bylaws was 3,644,198.  There were no votes cast against, orabstaining from, the vote with respect to the amendment of our certificate ofincorporation and bylaws.  The number ofvotes in favor of the adoption of our 2004 Stock Plan was 3,644,198.  There were no votes cast against, orabstaining from, the vote with respect to the approval of our 2004 Stock Plan.

 

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### **Executive Officers**

### ** **

The executive officers of the Company are as follows:

 

*BarryBuchholtz*, age 34, joined us inSeptember 1997 as our Chief Operations Officer and served as our Presidentfrom January 2000 until July 2004. In July 2004,Mr. Buchholtz was promoted to Chief Executive Officer and was elected toour board of directors. From February 1996 to September 1997,Mr. Buchholtz was a partner in Global Management Group, a computerindustry consulting firm to companies such as Dow Jones, Telerate and AndreaElectronics. From June 1993 to January 1996, Mr. Buchholtz wasVice President, Operations for Vision Technologies, LLC, a manufacturer ofpersonal computers and peripherals. From June 1988 to May 1993,Mr. Buchholtz was Chief Operating Officer for Syntax Computer Corp., amanufacturer of personal computers and peripherals. From 1987 to 1988,Mr. Buchholtz was Vice President, Operations for Kaypro Corporation, amanufacturer of personal computers and peripherals.

 

*MichaelBrower,* age 47, joined us in September 2003as our Chief Financial Officer. From July 2001 to July 2003,Mr. Brower was Chief Operating Officer and Chief Financial Officer ofThink Outside, a developer and distributor of mobile computing accessoryproducts. From April 2000 to June 2001, Mr. Brower was ChiefFinancial Officer of Keylime Software, Inc., a web analytics company. From1993 through 1999, Mr. Brower held various positions with Odyssey Golf, amanufacturer of golf equipment, including Chief Financial Officer, VicePresident and General Manager and Executive Vice President. Mr. Browerbegan his professional career as a staff accountant with KPMG LLP.

 

*JohnGothard*, age 45, joined us in March 2001 as our VicePresident, North American Sales. From July 1997 to February 2001,Mr. Gothard was Director of Sales for Arnette, an action sports company.From February 1995 to June 1997, Mr. Gothard was National SalesManager of SMP Clothing, an action sports company. From October 1990 to January 1995,Mr. Gothard was Managing Director of the wetsuit product line forQuiksilver, Inc., an action sports company. From February 1982 to September 1990,Mr. Gothard was a sales representative for O’Neill, Inc., an actionsports company.

 

*GrantGuenther,* age 31, joined us in October 2002as our Vice President, Marketing. From December 1999 to September 2002,Mr. Guenther was Director of Marketing at Scott USA, a winter sports,motor sports and cycling brand. From August 1996 to May 1999,Mr. Guenther held various marketing and sales support positions atNike, Inc.

 

*KarlHingel*, age 35, joined us in February 2004 as our Vice President,International. From May 1994 to August 2003, Mr. Hingel heldvarious positions at Oakley, Inc., an action sports company, most recentlyserving as Director of Global Development.

 

*Richard Marshall*, age 46, joinedus in March 2005 as our Vice President of Operations. From 2003 until February2005, Mr. Marshall served as Senior Director of Operations for AdvancedMarketing Services, Inc..  From 1993until 2002 Mr. Marshall served as Director of Operations for Newell WindowFashions UK, a division of Newell Rubbermaid. From 1992 until 1993, Mr. Marshall served as Distribution Manager at Sigma-AldrichCorporation.  From 1990 until 1991, Mr.Marshall served as Marketing Equipment Manager at The Pepsi-Cola Company.  From 1988 until 1990, Mr. Marshall served as DistributionTeam Leader at Johnson and Johnson.

 

*Gary Kopren*, age 40, joined us in June 1998 as ourDirector of Operations and was promoted to Vice President, Operations inFebruary 2000.  From July 1983 to May1998, Mr. Kopren was Director of Operations of PW Industries, Inc., an apparelmanufacturer.  In March, 2005, Mr. Koprenwas reassigned to serve as our Director of Manufacturing.

 

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# **PARTII**

 

## **Item 5**. Market forRegistrant’s Common Equity and Related Stockholder Matters

## ** **

Our common stock, par value $0.0001 (“Common Stock”), begantrading on the Nasdaq National Market (“Nasdaq”) on December 14, 2004 inconnection with our initial public offering (trading symbol “ORNG”).  As of March 29, 2005, the closing salesprice for the Common Stock was $6.40.  Thefollowing table sets forth, for the periods indicated, the range of high andlow sales prices for our Common Stock on the Nasdaq National Market:

 
| ** **                                                               | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------------------------------------------------|------------|----------|------------|---------|------------|
| Fourth Quarter,  2004 (December 14, 2004 to December 31, 2004) |       | 10.95    |       | 9.65    |       |
| First Quarter,  2005 (January 1, 2005 to March 29, 2005)       |       | 11.50    |       | 5.84    |       |

 

Stockholders of record on February 24, 2005numbered approximately 128.  Many of theshares of our Common Stock are held by brokers and other institutions on behalfof stockholders; therefore, we are unable to estimate the total number ofbeneficial owners represented by these stockholders of record.  We have never declared or paid any cashdividend on our Common Stock, nor do we currently intend to pay any cashdividend on our Common Stock in the foreseeable future.  We expect to retain our earnings, if any, forthe growth and development of our business. In addition, the terms of our credit facility limit our ability to paycash dividends on our Common Stock.  Adescription of our credit facility can be found in this Annual Report underItem 7 under the caption “Liquidity and Capital Resources” and Item 8 -Financial Statements.

 

**SecuritiesAuthorized for Issuance Under Compensation Plans**

 

Informationregarding securities authorized for issuance under our equity compensationplans can be found under Item 12 of this Annual Report.

 

**Recent Sales ofUnregistered Securities**

 

**In May and June 2004, we sold 358,438shares of our Common Stock to 26 accredited or sophisticated investors at aprice of $4.80 per share for aggregate consideration of $1,720,500.  In February through April 2004, we issued13,541 shares of our Common Stock upon the conversion of $65,000 in outstandingconvertible promissory notes held by two accredited stockholders.  The issuances of these shares of Common Stockwere considered to be exempt from registration under the federal Securities Actof 1933 in reliance on Section 4(2) of the Securities Act, and RegulationD promulgated thereunder, as transactions by an issuer not involving a publicoffering.  The recipients of shares of CommonStock represented their intention to acquire the shares for investment only andnot with a view to, or for sale in connection with, any distribution thereof,and appropriate legends were affixed to the certificates representing theshares issued in these transactions.  Allrecipients had adequate access to information about us through theirrelationships with us.**

 

**In August and September 2004,options with respect to 184,375 shares of our Common Stock, held by sevenindividuals, were exercised at prices between $1.60 and $3.20 per share,resulting in the issuance and sale by us of 184,375 shares of our Common Stock. **The issuances of theoptions and Common Stock were considered to be exempt from registration underthe Securities Act in reliance on Rule 701 promulgated under Section 3(b)of the Securities Act as transactions under compensatory benefit plans andcontracts relating to compensation as provided under such Rule 701. Therecipients of securities in each of these transactions represented theirintention to acquire the securities for investment only and not with a view to,or for sale in connection with, any distribution thereof. All recipients hadadequate access to information about us through their relationship with us.

 

In October 2004,20,833 shares of our Common Stock were distributed to an accredited orsophisticated individual as result of the conversion of a $100,000 note payablethat was maturing.  The issuance of theseshares of Common Stock was considered to be exempt from registration under theSecurities Act in reliance on Section 4(2) of the Securities Act as a transactionby an issuer not involving a public offering. The recipient of shares of Common

 

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Stock represented an intention to acquire the sharesfor investment only and not with a view to, or for sale in connection with, anydistribution thereof, and appropriate legends were affixed to the certificatesrepresenting such shares.  The recipienthad adequate access to information about the Registrant through its relationshipwith the Registrant.

 

**Use of Proceeds fromRegistered Securities**

 

**We registered 4,000,000 shares of our CommonStock in connection with our initial public offering (“IPO”) under theSecurities Act of 1933 (3,000,000 shares for us and 1,000,000 shares for ourselling stockholder) (including the exercise by the underwriters, in January 2005,of their option to purchase 520,000 shares to cover over-allotments).  The Securities and Exchange Commission (“SEC”)declared our Registration Statement on Form S-1 (File No. 333-119024), asamended, effective on December 13, 2004. The net offering proceeds to us after offering costs of approximately $1.7million and expenses of $1.1 million were $18.9 million.  This excludes the exercise by ourunderwriters of their over-allotment purchase option in January 2005.  A portion of the proceeds have been used topay an investor note of $200,000 and to pay down bank lines of credit of approximately$8.5 million.  Aside from use of aportion of the remaining proceeds to meet operating expenses, the balance of theproceeds remain available for use by us.**

 

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## **Item 6**. SelectedConsolidated Financial Data

 

The following selectedconsolidated financial data is qualified by reference to, and should be read inconjunction with, “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and the Consolidated Financial Statements andrelated Notes included in Item 8 of this Annual Report. The selectedconsolidated statements of income data as of December 31, 2004, 2003 and2002 and selected consolidated balance sheet data as of December 31, 2004and 2003 are derived from audited consolidated financial statements includedelsewhere in this Annual Report. The selected consolidated statement of incomedata as of December 31, 2001 and selected consolidated balance sheet dataas of December 31, 2002 and 2001 were derived from audited consolidatedfinancial statements not included in this Annual Report. The selectedconsolidated statement of income data as of December 31, 2000 and selectedconsolidated balance sheet data as of December 31, 2000 were derived fromunaudited consolidated financial statements not included in this AnnualReport.  Our historical results are notnecessarily indicative of our future results.

 
| ** **                                            | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                            | ** ** | **2000**                         | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                            | ** ** | **(unaudited)**                  | ** ** | **(in thousands, except share and per share data)** | ** ** |
| **Consolidated  Statements of Income Data:**          |       |                             |       |   |   |   |   |   |   |   |   |
| Net sales                                             |       | $                                | 14,137     |   | $ | 17,157 |   | $ | 22,294 |   | $ | 27,404 |   | $ | 33,563 |   |
| Cost of sales                                         |       | 6,691                            |       | 8,700 |   | 10,848 |   | 13,186 |   | 15,530 |   |
| Gross Profit                                          |       | 7,446                            |       | 8,457 |   | 11,446 |   | 14,218 |   | 18,033 |   |
| Operating  expenses:                                  |       |                             |       |   |   |   |   |   |   |   |   |
| Sales and  marketing                                  |       | 3,732                            |       | 4,598 |   | 6,047 |   | 8,075 |   | 10,392 |   |
| General and  administrative                           |       | 1,861                            |       | 2,366 |   | 3,000 |   | 3,775 |   | 4,563 |   |
| Shipping and  warehousing                             |       | 386                              |       | 353 |   | 532 |   | 771 |   | 990 |   |
| Research and  development                             |       | 101                              |       | 131 |   | 252 |   | 264 |   | 512 |   |
| Total operating  expenses                             |       |                             | 6,080      |   |   | 7,448 |   |   | 9,831 |   |   | 12,885 |   |   | 16,457 |   |
| Income from  operations                               |       |                             | 1,366      |   |   | 1,009 |   |   | 1,615 |   |   | 1,333 |   |   | 1,576 |   |
| Other income  (expense):                              |       |                             |       |   |   |   |   |   |   |   |   |
| Interest expense                                      |       | (391                             | )          | (331 | ) | (393 | ) | (484 | ) | (398 | ) |
| Foreign currency  transaction gain                    |       | —                           |       | 8 |   | 326 |   | 290 |   | 528 |   |
| Other income  (expense)                               |       | (112                             | )          | 185 |   | 30 |   | 50 |   | 35 |   |
| Total other  income (expense)                         |       |                             | (503       | ) |   | (138 | ) |   | (37 | ) |   | (144 | ) |   | 165 |   |
| Income before  income taxes                           |       | 863                              |       | 871 |   | 1,578 |   | 1,189 |   | 1,741 |   |
| Income tax  provision (benefit)                       |       | (1,565                           | )          | 142 |   | 667 |   | 689 |   | 934 |   |
| Net income                                            |       | $                                | 2,428      |   | $ | 729 |   | $ | 911 |   | $ | 500 |   | $ | 807 |   |
| Net income per common  share                          |       |                             |       |   |   |   |   |   |   |   |   |
| Basic                                                 |       | $                                | 0.69       |   | $ | 0.19 |   | $ | 0.21 |   | $ | 0.11 |   | $ | 0.17 |   |
| Diluted                                               |       | $                                | 0.67       |   | $ | 0.18 |   | $ | 0.19 |   | $ | 0.11 |   | $ | 0.16 |   |
| Shares used in  computing net income per common share |       |                             |       |   |   |   |   |   |   |   |   |
| Basic                                                 |       | 3,522,687                        |       | 3,848,287 |   | 4,306,742 |   | 4,426,056 |   | 4,643,320 |   |
| Diluted                                               |       | 3,624,250                        |       | 3,949,850 |   | 4,785,044 |   | 4,617,609 |   | 4,973,252 |   |

 

16

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| ** **                            | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| ** **                            | ** ** | **2000**                         | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                            | ** ** | **(unaudited)**                  | ** ** | **(in thousands )** | ** ** |
| ** **                            | ** ** | ** **                       | ** ** |
| **Consolidated  Balance Sheet Data:** |       |                             |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents            |       | $                                | 103        |   | $ | 668 |   | $ | 574 |   | $ | 581 |   | $ | 11,477 |   |
| Working capital                       |       | 2,380                            |       | 3,961 |   | 4,958 |   | 5,049 |   | 28,400 |   |
| Total assets                          |       | 10,768                           |       | 13,028 |   | 17,573 |   | 21,041 |   | 37,524 |   |
| Long-term debt,  less current portion |       | 20                               |       | 42 |   | 86 |   | 341 |   | 198 |   |
| Total  stockholders’ equity      |       | 4,987                            |       | 6,981 |   | 8,731 |   | 9,507 |   | 31,900 |   |
|                                       |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

## **Item 7**. Management’sDiscussion and Analysis of Financial Condition and Results of Operations

 

**Overview**

 

We design, developand market premium products for the action sports and youth lifestyle markets.Our principal products, sunglasses and goggles, are marketed under our brand,Spy Optic. These products target the action sports market, including surfing,skateboarding and snowboarding, and the youth lifestyle market within fashion,music and entertainment. We have built our Spy brand by developing innovative,proprietary products that utilize high-quality materials, handcraftedmanufacturing processes and engineered optical lens technology to conveyperformance, style, quality and value. We sell our products in approximately 4,600retail locations in the United States and internationally through approximately2,500 retail locations serviced by us and our international distributors. Wehave developed strong relationships with key multi-store action sport and youthlifestyle retailers in the United States, such as Cycle Gear, Inc., NoFear, Inc., Pacific Sunwear of California, Inc., Sun Shade Optique,Tilly’s Clothing, Shoes & Accessories and Zumiez, Inc., and astrategically selective collection of specialized surf, skate, snow, BMX,mountain bike and motocross stores.

 

We focus our marketing and sales efforts onthe action sports and youth lifestyle markets, and specifically, individualsborn between approximately 1977 and 1994, or Generation Y. We separate oureyewear products into two groups: sunglasses, which include fashion,performance sport and women-specific sunglasses, and goggles, which includesnow and motocross goggles. In addition, we sell branded apparel andaccessories. In managing our business, our management is particularly focusedon ensuring that our product designs are keyed to current trends in the fashionindustry, incorporate the most advanced technologies to enhance performance andprovide value to our target market.

 

We began as a grassroots brand in SouthernCalifornia and entered the action sports and youth lifestyle markets withinnovative and performance-driven products and an authentic connection to theaction sports and youth lifestyle markets. We have a wholly owned subsidiaryincorporated in Italy, Spy Optic, S.r.l., and a wholly owned subsidiaryincorporated in California, Spy Optic, Inc., which we consolidate in ourfinancial statements. We rely exclusively on an independent third-partyconsultant for the design of our products. In addition, we maintain asemi-exclusive relationship with our primary manufacturer. We were incorporatedas Sports Colors, Inc. in California in August 1992. FromAugust 1992 to April 1994, we had no operations. In April 1994,we changed our name to Spy Optic, Inc. In November 2004, we reincorporatedin Delaware and changed our name to Orange 21 Inc.

 

*Net Sales*

 

Our net sales are derived primarily from thesale of sunglasses, snow and motocross goggles, and apparel and accessories.

 

*Cost of Sales and GrossProfit*

 

Our cost of sales consists primarily offinished product, retail packaging and shipping costs. Other costs includecosts associated with the purchasing function of our products, quality controland realized gains and losses on currency contracts, primarily in Euros, usedto hedge our purchase risk on inventories. Our gross profit consists of netsales less cost of sales.

 

17

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*Sales and MarketingExpense*

 

Our sales and marketing expense consistsprimarily of wages and related payroll and employee benefit costs,point-of-purchase expenses (depreciation) and store display and promotionalitems, athlete contracts and royalty expenses, advertising costs and trade showexpenses. Advertising costs are expensed as incurred.

 

*General and AdministrativeExpense*

 

Our general and administrative expenseconsists primarily of wages and related payroll and employee benefit costs,facility costs, business insurance, bad debt expense, utilities, legal andaccounting professional fees, other facility-related costs includingdepreciation, and other general corporate expenses.

 

*Shipping and WarehousingExpense*

 

Shipping and warehousing expense consistsprimarily of wages and related payroll and employee benefit costs, packagingsupplies, third-party warehousing costs, facility costs and utilities.

 

*Research and DevelopmentExpense*

 

Research and development expense consistsprimarily of wages and related payroll and employee benefit costs, consultingfees to Mage Design, travel expenses and prototype and sample expenses.

 

**Critical AccountingPolicies and Estimates**

 

Management’s Discussion and Analysis ofFinancial Condition and Results of Operations is based upon our consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States. The preparation ofconsolidated financial statements requires that we make estimates and judgmentsthat affect the reported amounts of assets, liabilities, net sales and expensesand related disclosures. On an ongoing basis, we evaluate our estimates, includingthose related to inventories, sales returns, income taxes, accounts receivableallowances and warranty. We base our estimates on historical experience,performance metrics and various other assumptions that we believe to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results will differ from theseestimates under different assumptions or conditions.

 

We apply the following critical accountingpolicies in the preparation of our consolidated financial statements:

 

*Revenue Recognition*

 

Our net sales are derived principally fromthe sale of sunglass and goggle products. Net sales are recognized at the timeof shipment, when title and the risks and rewards of ownership of the goodshave been assumed by the customer, or upon receipt by the customer, dependingon the terms of the purchase order. Net sales consist of the sales price forthe items sold, plus shipping costs upon shipment of customer orders, net ofestimated refunds.

 

*Reserve for Refunds andReturns*

 

We reserve for estimated future refunds andreturns at the time of shipment based upon historical data. We adjust reservesas we consider necessary. We make judgments as to our ability to collectoutstanding receivables and provide allowances for anticipated bad debts andrefunds. Provisions are made based upon a review of all significant outstandinginvoices and overall quality and age of those invoices not specificallyreviewed. In determining the provision for invoices not specifically reviewed,we analyze collection experience, customer credit-worthiness and currenteconomic trends. If the data used to calculate these allowances does not reflectour future ability to collect outstanding receivables, an adjustment in thereserve for refunds may be required.

 

*Inventories*

 

Inventories consist primarily of finishedproducts, including sunglasses, goggles, apparel and accessories, productcomponents such as replacement lens, purchasing and quality control costs, andpackaging and shipping

 

18

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materials.Inventory items are carried on the books at the lower of cost or market usingthe first in first out method of inventory. Periodic physical counts ofinventory items are conducted to help verify the balance of inventory. Areserve is maintained for obsolete inventory.

 

*Research and Development*

 

We expense research and development costs asincurred. We capitalize product molds and tooling and depreciate these costsover the useful life of the asset.

 

*Income Taxes*

 

We account for income taxes pursuant to theasset and liability method, whereby deferred tax assets and liabilities arecomputed at each balance sheet date for temporary differences between theconsolidated financial statement and tax basis of assets and liabilities thatwill result in taxable or deductible amounts in the future based on enactedlaws and rates applicable to the periods in which the temporary differences areexpected to affect taxable income.  Weconsider future taxable income and ongoing, prudent and feasible tax planningstrategies in assessing the value of its deferred tax assets.  If we determine that it is more likely thannot that these assets will not be realized, we will reduce the value of theseassets to their expected realizable value, thereby decreasing net income.  Evaluating the value of these assets isnecessarily based on our management’s judgment. If we subsequently determined that the deferred tax assets, which hadbeen written down, would be realized in the future, the value of the deferredtax assets would be increased, thereby increasing net income in the period whenthat determination was made.  See Note 10in the Notes to Consolidated Financial Statements.

 

*Foreign Currency*

 

The functional currency of our wholly ownedsubsidiary, Spy Optic, S.r.l., and our Canadian division is the local currency.  Accordingly, we are exposed to transactiongains and losses that could result from changes in foreign currency.  Assets and liabilities denominated in foreigncurrencies are translated at the rate of exchange on the balance sheetdate.  Revenues and expenses aretranslated using the average exchange rate for the period.  Gains and losses from translation of foreignsubsidiary financial statements are included in accumulated other comprehensiveincome (loss). Gains and losses resulting from foreign currency transactions andunrealized gains or losses on currency contracts are included in foreigncurrency transaction gain or loss on the consolidated statements of income.

 

### **Results of Operations**

### ** **

Thefollowing tables set forth our operating results as a percentage of net salesfor the periods indicated:

 
| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|
| ** **                                  | ** ** | **2002**                         | ** ** | **2003** | ** ** | **2004** | ** ** |
| **Consolidated  Statement of Income Data:** |       |                             |       |   |   |   |   |
| Net sales                                   |       | 100.0                            | %          | 100.0 | % | 100.0 | % |
| Cost of sales                               |       | 48.7                             |       | 48.1 |   | 46.3 |   |
| Gross profit                                |       | 51.3                             |       | 51.9 |   | 53.7 |   |
|                                        |       |                             |       |   |   |   |   |
| Operating  expenses:                        |       |                             |       |   |   |   |   |
| Sales and  marketing                        |       | 27.1                             |       | 29.5 |   | 31.0 |   |
| General and  administrative                 |       | 13.5                             |       | 13.8 |   | 13.6 |   |
| Shipping and  warehousing                   |       | 2.4                              |       | 2.8 |   | 2.9 |   |
| Research and  development                   |       | 1.1                              |       | 1.0 |   | 1.5 |   |
| Total operating  expenses                   |       | 44.1                             |       | 47.1 |   | 49.0 |   |
| Income from  operations                     |       | 7.2                              |       | 4.8 |   | 4.7 |   |
| Other (expense)  income                     |       | (0.2                             | )          | (0.5 | ) | 0.5 |   |
| Income before  income taxes                 |       | 7.0                              |       | 4.3 |   | 5.2 |   |
| Income tax  provision                       |       | 3.0                              |       | 2.5 |   | 2.8 |   |
| Net income                                  |       | 4.0                              | %          | 1.8 | % | 2.4 | % |

 

19

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**Year Ended December 31, 2004Compared to Year Ended December 31, 2003**

 

*Net Sales*

 

Net sales increased 22% to $33.6 millionin fiscal 2004 from $27.4 million in fiscal 2003. The increase in netsales was the result of the introduction of several new styles and expandeddomestic distribution. Based on attributing sales using customer locationinstead of point of shipping, net sales increased in the United States by $4.1 million,or 20%, due to increased brand recognition and market penetration. Net sales increasedin the rest of the world by $2.1 million, or 31%, based upon an increasein sales of our products in Canada of $841,000 and $1.3 million in othercountries.  Approximately 9% of theinternational sales growth was attributable to a weaker U.S dollar.  Net sales in the United States represented 74%and 76% of total net sales for fiscal 2004 and fiscal 2003, respectively.  Net sales in the rest of the worldrepresented 26% and 24% of total net sales for fiscal 2004 and fiscal 2003,respectively. Sunglass unit shipments increased 12% with an 11% increase in theaverage sales price.  Goggle unitshipments increased 14% with a 3% increase in the average sales price. Thesales mix on a dollar basis for fiscal 2004 was 59% for sunglasses, 32% forgoggles and 9% for apparel and accessories. The sales mix on a dollar basis forfiscal 2003 was 58% for sunglasses, 33% for goggles and 9% for apparel andaccessories. At December 31, 2004, we had received orders equal toapproximately $1 million and we expect to fulfill such orders during the next threemonths.

 

*Cost of Sales and GrossProfit*

 

Gross profit increased 27% to $18 millionin fiscal 2004 from $14.2 million in fiscal 2003. The increase in absolutedollars was due primarily to the increase in sales volume. As a percentage ofnet sales, gross profit was 54% in fiscal 2004, as compared to 52% in fiscal2003. As a percentage of net sales, the increase in gross profit was due primarilyto a slightly higher sunglass product sales mix, higher average sales prices onour sunglass and goggle products, a positive effect of a weaker dollar, and adecrease in purchasing and quality control expenses.  This offset the unfavorable impact on grossmargins caused by product purchases made in euros.

 

We expect that our gross profit willfluctuate in the future as we expand into new product categories based on ourproduct mix, product costs, shipping costs, product return and refund rates andhandling and packaging costs for the various products.

 

*Sales and MarketingExpense*

 

Sales and marketing expense increased 29% to$10.4 million in fiscal 2004 from $8.1 million in fiscal 2003. Theincrease in sales and marketing expense primarily was due to increased sales andmarketing compensation and related payroll taxes of $580,000, increasedcommission expense of $612,000 due to the year-over-year sales increase,increased payments to athletes pursuant to endorsement agreements of $146,000,increased point-of-purchase and sales display expenses of $598,000, increasedtravel expenses of $114,000, and an increase in promotional product and otheractivities of $144,000. As a percentage of net sales, sales and marketingexpense was 31% in fiscal 2004, up from 30% in fiscal 2003.

 

We expect sales and marketing expense tocontinue to increase in absolute dollars and to increase as a percentage of netsales as a result of continued expansion of our sales and marketing effortsoutside of California.

 

*General and AdministrativeExpense*

 

General and administrative expense increased21% to $4.6 million in fiscal 2004 from $3.8 million in fiscal 2003.The increase in general and administrative expense primarily was due toincreases in wages and related payroll taxes of $431,000, increaseddepreciation expense of $66,000, increased financing charges of $39,000,increased collection costs of $32,000, increased franchise taxes relatedprimarily to the reincorporation in Delaware of $43,000, and increased legaland accounting fees of $223,000. As a percentage of net sales, general andadministrative expense remained unchanged at 14% in each of fiscal 2004 and fiscal2003.

 

20

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We expect general and administrative expenseto continue to increase in absolute dollars as a result of continued expansionof our administrative infrastructure in support of a broader product portfolioand increased expenses associated with being a public company.

 

*Shipping and WarehousingExpense*

 

Shipping and warehousing expense increased 28%to $990,000 in fiscal 2004 from $771,000 in fiscal 2003. The increase was due primarilyto increased compensation and related payroll taxes of $102,000, increasedtemporary labor of $208,000 primarily related to our foreign subsidiary,increased benefit costs of $31,000, increased supplies expense of $17,000,offset by a reduction in third-party warehousing expenses of $162,000 dueprimarily to our establishment of our own distribution center in Italy.  As a percentage of net sales, shipping andwarehousing expense remained relatively unchanged at 3% in each of fiscal 2004and fiscal 2003.

 

We expect shipping and warehousing expenseto increase in absolute dollars if our net sales increase but to decrease as apercentage of net sales as a result of leveraging the fixed expense overgreater net sales.

 

*Research and DevelopmentExpense*

 

Research and development expense increased 94%to $512,000 in fiscal 2004 from $264,000 in fiscal 2003. The increase was due primarilyto increased compensation and related payroll taxes of $159,000, and increased consultingfees of $63,000. As a percentage of net sales, research and development expensewas 2% in fiscal 2004, up from 1% in fiscal 2003.

 

We expect research and development expenseto increase in absolute dollars in the future as a result of increasedinvestments in existing and new product offerings.

 

*Other Income (Expense)*

 

Other income was $165,000 in fiscal 2004compared to other expense of $144,000 in fiscal 2003. The increase in other incomein fiscal 2004 was due primarily to an increase in the foreign currency transactiongain of $238,000 due to a strengthening Euro, a reduction in interest expensesof $86,000 due primarily to lower usage and lower interest rates on bank linesof credit, offset by a decrease in net royalty fees and other miscellaneousincome of approximately $14,000.

 

*Income Tax Provision*

 

The income tax provision for fiscal 2004 was$934,000 compared to $689,000 in fiscal 2003. The effective tax rate for fiscalyear 2004 was 54% compared to 58% in fiscal 2003.  The increase in the provision for income tax wasdue primarily to an increase in pretax income with a reduction in the benefitof NOL carryforwards, and income tax expenses related to our Spanish subsidiarythat was dissolved in 2004 and our foreign subsidiary in Italy.

 

*Net Income*

 

Net income increased 61% to $807,000 in fiscal2004 from $500,000 in fiscal 2003.  Theincrease was due primarily to increased profitability from operations of$243,000, an increase in other income of $309,000 offset by taxes related to aforeign subsidiary that was closed.

 

**Year Ended December 31, 2003Compared to Year Ended December 31, 2002**

 

*Net Sales*

 

Net sales increased 23% to$27.4 million in fiscal 2003 from $22.3 million in fiscal 2002. Theincrease in net sales was the result of the introduction of several new stylesand expanded domestic distribution. Based on attributing sales using customerlocation instead of point of shipping, net sales increased in the United Statesby $6.3 million, or 31%, due to increased brand recognition and marketpenetration. Net sales decreased in the rest of the world by $1.2 million,or 15%, due to a decrease in sales of our products in Japan of $403,000 and$797,000 in other countries

 

21

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because ofpoor distributor performance and a disproportionate investment in our domesticsales during this period. Net sales in the United States represented 76% and68% of total net sales for fiscal 2003 and fiscal 2002, respectively.  Net sales in the rest of the worldrepresented 24% and 32% of total net sales for fiscal 2003 and fiscal 2002,respectively.  Sunglass unit shipmentsincreased 30% with a 2% increase in the average sales price. Goggle unitshipments increased 31% with a 7% increase in the average sales price. Thesales mix on a dollar basis for fiscal 2003 was 58% for sunglasses, 33% forgoggles and 9% for apparel and accessories. The sales mix on a dollar basis forfiscal 2002 was 57% for sunglasses, 32% for goggles and 11% for apparel andaccessories.

 

*Cost of Sales and GrossProfit*

 

Gross profit increased 24% to$14.2 million in fiscal 2003 from $11.4 million in fiscal 2002. Theincrease in absolute dollars was due primarily to the increase in sales volume.As a percentage of net sales, gross profit was 52% in fiscal 2003, as comparedto 51% in fiscal 2002. As a percentage of net sales, the increase in grossprofit was due to a slightly higher sunglass product sales mix.

 

*Sales and MarketingExpense*

 

Sales and marketing expense increased 34% to$8.1 million in fiscal 2003 from $6.0 million in fiscal 2002. Theincrease in sales and marketing expense primarily was due to increased salescompensation of $214,000, increased commission expense of $609,000 due to theyear-over-year sales increase, increased payments to athletes pursuant toendorsement agreements of $98,000, increased point-of-purchase and salesdisplay expenses of $265,000, a reduction in sponsorship income of $148,000,increased trade show expenses of $132,000 and other promotional activities. Asa percentage of net sales, sales and marketing expense was 30% in fiscal 2003,up from 27% in fiscal 2002.

 

*General and AdministrativeExpense*

 

General and administrative expense increased26% to $3.8 million in fiscal 2003 from $3.0 million in fiscal 2002.The increase in general and administrative expense primarily was due toincreases in wages and related payroll taxes of $73,000, increased employeebenefit expenses of $22,000, increased depreciation expense of $90,000,increased business insurance expenses of $124,000 and increased consulting feesof $180,000. As a percentage of net sales, general and administrative expensewas 14% in fiscal 2003, up from 13% in fiscal 2002.

 

*Shipping and WarehousingExpense*

 

Shipping and warehousing expense increased45% to $771,000 in fiscal 2003 from $532,000 in fiscal 2002. The increase wasdue primarily to increased wages and related payroll and employee benefitsexpenses and third-party warehousing expenses to support increased net sales.As a percentage of net sales, shipping and warehousing expense was 3% in fiscal2003, up from 2% in fiscal 2002.

 

*Research and DevelopmentExpense*

 

Research and development expense increased5% to $264,000 in fiscal 2003 from $252,000 in fiscal 2002. The increase wasdue primarily to consulting fees. As a percentage of net sales, research anddevelopment expense remained unchanged at 1% in each of fiscal 2003 and fiscal2002.

 

*Other (Expense) Income*

 

Other expense was $144,000 in fiscal 2003compared to other expense of $37,000 in fiscal 2002. The increase in otherexpense in fiscal 2003 primarily was due to increased interest expense of$91,000 related to increased lines of credit and loans from private lenders, areduction in the foreign currency transaction gain due to a strengthening Euroand less profitable operations with our foreign subsidiary of $36,000.

 

*Income Tax Provision*

 

The income tax provision in fiscal 2003 was$689,000 compared to $667,000 in fiscal 2002. The effective tax rate for fiscalyear 2003 was 58% compared to 42% in fiscal 2002.  The increase in the provision for income tax wasprimarily due to a provision for foreign taxes related to our former subsidiarylocated in Spain for fiscal 2001 of $95,000 which was accrued in fiscal 2003.

 

22

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*Net Income*

 

Net income decreased 45% to $500,000 infiscal 2003 from $911,000 in fiscal 2002. The decrease was due primarily to a decrease in profitability fromoperations of $283,000, as a result primarily of increased sales and marketingexpenses, an increase in other expense of $106,000, as a result of primarily anincrease in interest expenses, and a higher effective income tax rate.

 

### **Liquidity and CapitalResources**

### ** **

Since our inception, we have financed ouroperations primarily through sales of our common stock and borrowings under ourcredit facilities and from private lenders.

 

The following table sets forth, for theperiods indicated, our net cash flows provided by (used in) operating,investing and financing activities, our period-end cash and cash equivalentsand other operating measures (in thousands, except for days sales outstandingand inventory turnover): 
| ** **                                     | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **2002**                     | ** ** | **2003** | ** ** | **2004** | ** ** |
| Cash flow (used  in) from operating activities |       | $                            | (343       | ) | $ | 366 |   | $ | (1,022 | ) |
| Cash flow (used  in) from investing activities |       | (2,016                       | )          | (2,544 | ) | (1,669 | ) |
| Cash flow from  financing activities           |       | 2,212                        |       | 1,939 |   | 13,447 |   |
| Cash and cash  equivalents at year end         |       | 574                          |       | 581 |   | 11,477 |   |
|                                           |       |                         |       |   |   |   |   |
| Days sales  outstanding                        |       | 70                           |       | 74 |   | 81 |   |
| Inventory  turnover                            |       | 2.00                         |       | 1.99 |   | 1.68 |   |
|                                                |            |                              |            |  |  |  |  |  |  |  |

 

Our principal sources of liquidity are ourcash and lines of credit, as well as cash flow we generate from operations. At December31, 2003 and 2004, we had unused lines of credit of $925,000 and $8 million,respectively.

 

Cash provided by or used in operating activitiesconsists primarily of net income adjusted primarily for certain non-cash itemsincluding depreciation, amortization, deferred income taxes, provision for baddebts, stock compensation expense and the effect of changes in working capitaland other activities. Cash used in operating activities in fiscal 2004 was $1.0million and consisted of net income of $807,000, adjustments for non-cash itemsof approximately $2.4 million, and $4.2 million used by working capital andother activities. Working capital and other activities consisted primarily ofan increase in accounts receivables of $1.9 million and an increase ininventory of $5.1 million due to the net sales increase for the period andpurchases for our 2005 product lines, offset by the collection of a relatedparty receivable as a result of the public offering of $845,000, an increase inaccounts payable and accrued liabilities of $1.3 million due to deferred vendorpayments and improved vendor payment terms, and an increase in our income taxpayable due to our taxable income related to our U.S. and foreign operations of$607,000.

 

Cash provided by operating activities infiscal 2003 was $366,000 and consisted of net income of $500,000, adjustmentsfor non-cash items of $2.3 million, and $2.4 million used for working capitaland other activities. Working capital and other activities consisted primarilyof an increase in accounts receivable of $2.5 million due to the increase insales, an increase in a related party receivable of $524,000, and an increasein an income tax receivable of $426,000, offset by an increase in accountspayable and accrued expenses of $943,000 due to increased sales and operatingexpenses.

 

Cash used in operating activities in fiscal2002 was $343,000 and consisted of net income of $911,000, adjustments fornon-cash items of $1.7 million, and $3 million used by working capital andother activities. Working capital and other activities consisted primarily ofan increase of $796,000 in accounts receivable due to an increase in sales, anincrease in a related party receivable of $277,000, an increase in inventoryand prepaid expenses of $3 million due to an increase in actual and forecastedfuture sales, offset by an increase in accounts payable and accrued expenses of$1.1 million due to an increase in sales and operating expenses.

 

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Cash used in investing activities in fiscal2004 was $1.7 million and was attributable primarily to capital expenditures of$1.6 million.  Capital expenditures wereprimarily for the purchase of retail point-of-purchase displays.  Cash used in investing activities in fiscal2003 of $2.5 million was due primarily to capital expenditures of $2.7 million,offset by proceeds on the sale of a fixed asset of $135,000. Capitalexpenditures were mainly for the purchase of retail point-of-purchase displays.Cash used in investing activities for fiscal 2002 was $2.0 million, and wasattributable to capital expenditures which primarily consisted of retailpoint-of-purchase displays and sales and marketing vehicles.

 

Cash provided by financing activities in fiscal2004 of $13.4 million was due primarily to the sale of common stock andexercised stock options of $21 million, offset by net payments on bank lines ofcredit and private lender debt of $7.5 million. Cash provided by financingactivities in fiscal 2003 of $1.9 million was primarily due to increases inusage of our bank lines of credit of $2.2 million and a net increase in privatelender debt of $380,000, offset against net payments on term debt of $509,000. Cashprovided by financing activities in fiscal 2002 of $2.2 million was primarily attributableto increases in bank lines of credit and other debt of $2.2 million and the saleof common stock of $303,000, offset by payments on private lender debt of$200,000.

 

*Contractual obligationsand commitments*

 

As of December 31, 2004,we had no off-balance sheet arrangements as defined in Item 303(a)(4) of theSEC’s Regulation S-K. The following summarizes our contractual obligations at December31, 2004 and the effect those obligations are expected to have on our liquidityand cash flow in future periods (in thousands):

 
| ** **                     | ** ** | **Payments Due by Period** | ** ** |
|--------------------------------|------------|----------------------------|------------|
| **Contractual Obligations**    | ** ** | **Total**                  | ** ** | **Less than  1 year** | ** ** | **1 to 3  years** | ** ** | **3 to 5  years** | ** ** | **More than  5 years** | ** ** |
| Short-term  borrowings         |       | $                          | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Long-term debt                 |       | 292                        |       |   | 125 |   |   | 167 |   | — |   | — |   |
| Operating leases  (facilities) |       | 400                        |       | 292 |   | 82 |   |   | 26 |   | — |   |
| Capital leases  (equipment)    |       | 82                         |       | 44 |   | 36 |   | 2 |   | — |   |
| Other contractual  commitments |       | 1,147                      |       | 416 |   | 306 |   | 170 |   |   | 255 |   |
| Total                          |       | $                          | 1,921      |   | $ | 877 |   | $ | 591 |   | $ | 198 |   | $ | 255 |   |

 

Our principal capital commitments consist ofa term loan, obligations under leases for our facilities, equipment andvehicles, and minimum payments related to long-term athlete contracts.

 

The contractual commitment amounts in thetable above are associated with enforceable, legally binding agreements thatspecify all significant terms, including: fixed or minimum services; fixed,minimum or variable price provisions; and the approximate timing of thetransaction. The commitments represent primarily athlete endorsements.  Purchase orders are not included in the tableabove. Our purchase orders represent authorizations to purchase rather thanbinding agreements. Obligations under contracts that we may terminate without asignificant penalty are also not included in the table above.

 

*Credit Facilities*

 

In October 2001, weentered into a $4.6 million loan facility with Comerica Bank-California, orComerica, to fund working capital requirements for our operations. In March2003, we increased this loan facility to $6.0 million.  In July 2002, we entered into a $1.0 millionloan facility with Comerica to fund working capital requirements and growth ofoperations.  In November 2003, we enteredinto a $1.0 million loan facility with Comerica to finance our working capitalrequirements and growth of operations. This loan facility was paid off in itsentirety in June 2004.

 

In August 2004, weconsolidated our loan facilities described above and increased our loanfacility by $1.0 million to an aggregate amount of $8.0 million. This loanfacility expires in June 2005.  InNovember 2004, we amended our line of credit to extend the amount we couldborrow under the line by $1.0 million, which we began to borrow upon theclosing of such amendment. In connection with this amendment, we issuedComerica a warrant to purchase up to approximately 1.5% of our outstandingcapital stock, which warrant will become exercisable upon a breach of certainmaterial terms of our loan agreement or if we have failed to repay the $1.0 millionby September 30, 2005. We repaid the $1.0 million immediately after theclosing of our initial public offering and the warrant issued to Comerica wasthereafter cancelled.  We also paid downamounts outstanding on the other line of credit upon the close of our

 

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initial public offering.  At December 31, 2003 and 2004, amountsoutstanding under lines of credit amounted to $7.1 million and zerorespectively.

 

In March 2003, weentered into a $500,000 term loan with Comerica to finance the acquisition ofvehicles for marketing activities. At December 31, 2004, borrowings under thisloan accrue interest at a rate equal to Comerica’s prime rate plus a margin of1%. Amounts outstanding under this loan are due on a monthly basis for the termof the loan. As of December 31, 2003 and 2004, our outstanding indebtednesswith respect to this loan with Comerica was $406,000 and $292,000respectively.  The term loan is due tomature in March 2007.

 

In September 2001, weentered into a $400,000 facility with Comerica to engage in forward exchange inorder to hedge our foreign exchange exposure, primarily our product purchasesfrom our Italian suppliers in euros. This facility allowed us to purchase up to$4.0 million in currency contracts. In August 2004, we increased the foreignexchange facility to $500,000, which provides up to $5.0 million in purchasesof foreign exchange contracts. In December 2004, the foreign exchange facilitywas increased to $750,000, which provides up to $7.5 million in purchases offoreign exchange contracts.  This foreignexchange facility is due to mature in June 2005. As of December 31, 2004, ourtotal outstanding currency contracts under this facility converted to U.S.dollars was $4.1 million.  Thisrepresents approximately 3.1 million Euro foreign currency contracts atDecember 31, 2004.

 

All of our loanfacilities and term loans with Comerica described above are secured by all ofour assets, excluding our intellectual property. We also have agreed to thefollowing material covenants:

 

• we must maintain a ratio of currentassets to current liabilities of at least 1.25 to 1;

 

• we must maintain a ratio of totalliabilities to tangible net worth of not more than 2 to 1;

 

• we must maintain a ratio of totalliabilities to tangible net worth of not more than 1.75 to 1 in order to avoida borrowing base calculation;

 

• we must maintain a ratio of quick assetsto current liabilities of at least 0.50 to 1;

 

• we must maintain a tangible net worthof not less than $8.6 million, to be increased on a quarterly basis by 50% ofthe aggregate net income of each fiscal quarter and 100% of capital infusions,including any subordinated debt;

 

• we must maintain an annual minimumprofit of $500,000 and cannot have more than two consecutive quarterly losses;

 

• we must provide Comerica with periodicfinancial reports;

 

• we must maintain minimum insurancecoverage; and

 

• we cannot pay dividends or make anyother distributions or payments without Comerica’s prior written consent.

 

At December 31, 2003,we were in violation of a non-financial covenant. The covenant required auditedfinancial statements within 120 days of our year-end. We obtained a waiverdated July 1, 2004 and provided audited financial statements at that time.  At December 31, 2004 we were in compliancewith all covenants.

 

In addition to loanfacilities, we have relied upon loans from private lenders to fund our workingcapital needs. As of December 31, 2003 our private lender debt totaled $445,000.In 2004, $165,000 of this debt was converted to common stock and $280,000repaid, with the final payment of $200,000 occurring at the close of ourinitial public offering.  At December 31,2004, there was no private lender debt outstanding.

 

We believe that ourcash on hand, cash expected to be generated from operations during our currentfiscal year and available loan facilities will be sufficient to enable us tomeet our financing and operating requirements for at least the next 18 months.Changes in operating plans, lower than anticipated net sales, increasedexpenses or other

 

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events, including those in “Risk Factors,” maycause us to seek additional debt or equity financing in the future. Our futurecapital requirements will depend on many factors, including our rate of netsales growth, the expansion of our sales and marketing activities and thecontinuing market acceptance of our product designs. Although currently we arenot a party to any agreement or letter of intent with respect to potentialinvestments in, or acquisitions of, complementary businesses, products ortechnologies, we may enter into these types of arrangements in the future,which could require us to seek additional equity or debt financing. The sale ofadditional equity securities or convertible debt securities would result inadditional dilution of our stockholders. Additional debt would result inincreased interest expense and could result in covenants that would restrictour operations. We have not made arrangements to obtain additional financingand there is no assurance that such financing, if required, will be availablein amounts or on terms acceptable to us, if at all.

 

*Deferred Taxes*

 

                In assessing the realization ofdeferred tax assets, management considers whether it is more likely than notthat some portion or all of the deferred tax assets will not be realized. Theultimate realization of deferred tax assets is dependent upon the generation offuture taxable income during the periods in which those temporary differencesbecome deductible. Management considers the scheduled reversal of deferred taxliabilities, projected future taxable income, and tax planning strategies inmaking this assessment. Based on the level of historical operating results andprojections for the taxable income for the future, management has determinedthat it is more likely than not that the deferred tax assets, net of thevaluation allowance, will be realized. Accordingly, the Company has recorded novaluation allowance for its U.S. operations at December 31, 2003. TheCompany has recorded a $95,000 and $378,000 valuation allowance for its whollyowned subsidiary, Spy Optic, S.r.l. at December 31, 2003 and 2004,respectively.

 

### **7A. Quantitative and Qualitative Disclosure About Market Risk**

### ** **

*InterestRate Risk*

 

Market risk representsthe risk of loss arising from adverse changes in market rates and foreign exchangerates. At December 31, 2004, we had $292,000 outstanding under our loanfacilities with Comerica. We had unused lines of credit with Comerica of $8million.  The amounts outstanding underthese loan facilities at any time may fluctuate and we may from time to time besubject to refinancing risk. We do not believe that a change of 100 basispoints in interest rate would have a material effect on our results ofoperations or financial condition.

 

*ForeignCurrency Risk*

 

We operate our businessand derive a substantial portion of our net sales outside of the United States.In fiscal 2002, 2003 and 2004, we derived 32%, 24% and 26% of our net sales inthe rest of the world.  We also purchase amajority of our products in transactions denominated in Euros. As a result, weare exposed to movements in foreign currency exchange rates between the localcurrencies of the foreign markets in which we operate and the U.S. dollar. Ourforeign currency exposure is generally related to Europe. A strengthening ofthe Euro relative to the U.S. dollar or to other currencies in which we receiverevenues could impact negatively the demand for our products, could increaseour manufacturing costs and could reduce our results of operations. Inaddition, we manufacture a substantial amount of our sunglass and goggleproducts in Italy. Because these purchases are paid in Euros, we face currencyrisk. A strengthening Euro could negatively affect the cost of our products andreduce our gross profit margins.

 

To hedge our purchaserisk, we utilize forward foreign exchange contracts with durations of three to fivemonths. As of December 31, 2004, we had purchased a total of 3.1 million Euroforeign currency contracts at an average Euro rate of 1.33 Euro to U.S.dollar.  The exchange rate for the Euro to the U.S. dollar ranged from 1.18 to1.37 in fiscal 2004 with an average of 1.24.

 

 

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### **Recently IssuedAccounting Pronouncements**

### ** **

On December 16, 2004, theFASB issued SFAS No. 123R, *Share-Based Payment.*  SFAS No. 123R requires companies to expensethe value of employee stock options and similar awards.  The cost of the awards will be measured atthe fair value on the awards’ grant date, based on the estimated number ofawards that are expected to vest. Compensation cost for awards that vest would not be reversed if theawards expire without being exercised. When measuring fair value, companies can choose an option-pricing modellike Black-Scholes or binominal models. The effective date for public companies is interim and annual periodsbeginning after June 15, 2005, and applies to all outstanding and unvestedshare based payment awards at a company’s adoption date.  The adoption of SFAS No. 123R for estimatedunvested options at the adoption date is not expected to have a material effecton our consolidated financial statements. Our compensation committee is considering various options in response tothis new pronouncement.  As a result, theimpact to our consolidated financial statements for future share based paymentawards has not been determined.

 

In November 2004, theFinancial Accounting Standards Board (FASB) issued FASB Statement No. 151, *Inventory Costs – an amendment of ARB No. 43, Chapter4*(FAS 151), which isthe result of its efforts to converge U.S. accounting standards for inventorieswith International Accounting Standards. FAS 151 requires abnormal amounts of idle facility expense,freight, handling costs, and wasted material (spoilage) to be recognized ascurrent-period charges. It also requires that allocation of fixed productionoverheads to the costs of conversion be based on the normal capacity of theproduction facilities**.**FAS 151 will be effective forinventory costs incurred during fiscal years beginning after June 15,2005.  The adoption of FAS 151 is notexpected to have a material effect on our financial position, results ofoperations or cash flows.

 

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**FACTORSTHAT MAY AFFECT RESULTS**

 

**Risks Related to OurBusiness**

 

**If we are unable tocontinue to develop innovative and stylish products, demand for our productsmay decrease.**

 

The action sports and youth lifestylemarkets are subject to constantly changing consumer preferences based onfashion and performance trends. Our success depends largely on the continuedstrength of our brands and our ability to continue to introduce innovative andstylish products that are accepted by consumers in our target markets. We mustanticipate the rapidly changing preferences of consumers and provide productsthat appeal to their preferences in a timely manner while preserving therelevancy and authenticity of our brands. Achieving market acceptance for newproducts may also require substantial marketing and product development effortsand expenditures to create consumer demand. Decisions regarding product designsmust be made several months in advance of the time when consumer acceptance canbe measured. If we do not continue to develop innovative and stylish productsthat provide greater performance and design attributes than the products of ourcompetitors and that are accepted by our targeted consumers, we may losecustomer loyalty, which could result in a decline in our net sales and marketshare.

 

**We may not be able tocompete effectively, which will cause our net sales and market share todecline.**

 

The action sports and youth lifestylemarkets in which we compete are intensely competitive. We compete with smallersunglass and goggle brands in various niches of the action sports market and alimited number of larger competitors, such as Arnette, Oakley and Smith Optics.We also compete with broader youth lifestyle brands that offer eyewearproducts, such as Hurley International and Quiksilver, and in the broaderfashion sunglass sector of the eyewear market, which is fragmented and highlycompetitive. We compete with a number of brands in these sectors of the market,including Armani, Christian Dior, Dolce & Gabbana, Gucci, Prada andVersace. In both markets, we compete primarily on the basis of fashion trends,design, performance, value, quality, brand recognition, marketing anddistribution channels.

 

The purchasing decisions of consumers arehighly subjective and can be influenced by many factors, such as marketingprograms, product design and brand image. Several of our competitors enjoysubstantial competitive advantages, including greater brand recognition, alonger operating history, more comprehensive lines of products and greaterfinancial resources for competitive activities, such as sales and marketing,research and development and strategic acquisitions. Our competitors may enterinto business combinations or alliances that strengthen their competitivepositions or prevent us from taking advantage of such combinations or alliances.They also may be able to respond more quickly and effectively than we can tonew or changing opportunities, technologies, standards or consumer preferences.

 

**If our marketing effortsare not effective, our brands may not achieve the broad recognition necessaryto our success.**

 

We believe that broader recognition andfavorable perception of our brands, and in particular, our Spy brand, bypersons ranging in age from 10 to 27 is essential to our future success.Accordingly, we intend to continue an aggressive brand strategy through avariety of marketing techniques, including athlete sponsorship, sponsorship ofsurfing, snowboarding, skateboarding, wakeboarding, BMX, downhill mountainbiking and motocross events, vehicle marketing, internet and print media,action sports industry relationships, sponsorship of concerts and musicfestivals and celebrity endorsements, to foster an authentic action sports andyouth lifestyle company culture. If we are unsuccessful, these expenses maynever be offset, and we may be unable to increase net sales. Successfulpositioning of our brands will depend largely on:

 

•                  the successof our advertising and promotional efforts;

 

•                  preservationof the relevancy and authenticity of our brands in our target demographic; and

 

•                  our abilityto continue to provide innovative, stylish and high-quality products to ourcustomers.

 

To increase brand recognition, we mustcontinue to spend significant amounts of time and resources on advertising andpromotions. These expenditures may not result in a sufficient increase in netsales to cover such

 

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advertisingand promotional expenses. In addition, even if brand recognition increases, ourcustomer base may decline or fail to increase and our net sales may notcontinue at present levels and may decline.

 

**If we are unable toleverage our business strategy successfully to develop new products, ourbusiness may suffer.**

 

We are evaluating potential entries into orexpansion of new product offerings, such as handmade fashion sunglasses andprescription eyewear frames. In expanding our product offerings, we intend toleverage our sales and marketing platform and customer base to develop theseopportunities. While we have been successful promoting our sunglasses andgoggles in our target markets, we cannot predict whether we will be successfulin gaining market acceptance for any new products that we may develop. Inaddition, expansion of our business strategy into new product offerings willrequire us to incur significant sales and marketing expenses. Theserequirements could strain our management and financial and operationalresources. Additional challenges that may affect our ability to expand ourproduct offerings include our ability to:

 

•                  increase awarenessand popularity of our existing Spy brand;

 

•                  establishawareness of any new brands we may introduce or acquire, including our DaleEarnhardt, Jr. brand E Eyewear and our Handcrafted Collection;

 

•                  increasecustomer demand for our existing products and establish customer demand for anynew product offering, including E Eyewear;

 

•                  attract,acquire and retain customers at a reasonable cost;

 

•                  achieve andmaintain a critical mass of customers and orders across all of our productofferings;

 

•                  maintain orimprove our gross margins; and

 

•                  competeeffectively in highly competitive markets.

 

We may not be able to address successfullyany or all of these challenges in a manner that will enable us to expand ourbusiness in a cost-effective or timely manner. If new products we may developare not received favorably by consumers, our reputation and the value of our brandscould be damaged. The lack of market acceptance of new products we may developor our inability to generate satisfactory net sales from any new products tooffset their cost could harm our business.

 

**Our business could beimpacted negatively if our sales are concentrated in a small number of popularproducts.**

 

If sales become concentrated in a limitednumber of our products, we could be exposed to risk if consumer demand for suchproducts were to decline. In the fiscal years ended December 31, 2002,2003 and 2004, 57%, 58% and 59%, respectively, of our net sales were derivedfrom sales of our sunglass products and 32%, 33% and 32%, respectively, of ournet sales were derived from sales of our goggle products. In addition, in thefiscal years ended December 31, 2002, 2003 and 2004, 15%, 14% and 17%,respectively, of our net sales related to our sunglass products were derivedfrom two models of our product line. As a result of these concentrations in netsales, our operating results could be harmed if sales of any of these productswere to decline substantially and we were not able to increase sales of otherproducts to replace such lost sales.

 

**Our business could beharmed if we fail to maintain proper inventory levels.**

 

We place orders with our manufacturers forsome of our products prior to the time we receive orders for these productsfrom our customers. We do this to minimize purchasing costs, the time necessaryto fill customer orders and the risk of non-delivery. We also maintain aninventory of selected products that we anticipate will be in high demand. Wemay be unable to sell the products we have ordered in advance frommanufacturers or that we have in our inventory. Inventory levels in excess ofcustomer demand may result in inventory write-downs, and the sale of excessinventory at discounted prices could significantly impair our brand image andharm our operating results and financial condition. Conversely, if weunderestimate consumer demand for our products or if our manufacturers fail tosupply

 

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the qualityproducts that we require at the time we need them, we may experience inventoryshortages. Inventory shortages might delay shipments to customers, negativelyimpact retailer and distributor relationships and diminish brand loyalty,thereby harming our business. For example, in fiscal 2003, we experienced adelay of two months in the delivery of goggle shipments, which we believe mayhave reduced our net sales in the third quarter of fiscal 2003 by lessthan 5%.

 

**If we are unable to recruitand retain key personnel necessary to operate our business, our ability todevelop and market our products successfully may be harmed.**

 

We are heavily dependent on our currentexecutive officers and management. The loss of any key employee or theinability to attract or retain qualified personnel, including product designand sales and marketing personnel, could delay the development and introductionof, and harm our ability to sell, our products and damage our brands. Webelieve that our future success is highly dependent on the contributions ofBarry Buchholtz, our Chief Executive Officer. We have entered into anemployment agreement with Mr. Buchholtz; however, we cannot be certainthat he will not be recruited by our competitors or otherwise terminate hisrelationship with us. The loss of the services of Mr. Buchholtz would bevery difficult to replace. Our future success may also depend on our ability toattract and retain additional qualified management, design and sales andmarketing personnel. We do not carry key man insurance.

 

**If we are unable to retainthe services of our primary product designer, our ability to design and developnew products likely will be harmed.**

 

We are heavily dependent on our primaryproduct designer, Jerome Mage, for the design and development of our eyewearproducts. Mr. Mage provides his services to us as an independentconsultant through his business, Mage Design. We cannot be certain thatMr. Mage will not be recruited by our competitors or otherwise terminatehis relationship with us. If Mr. Mage terminates his relationship with us,we will need to obtain the services of another qualified product designer todesign our eyewear products, and even if we are able to locate a qualifiedproduct designer, we may not be able to agree on commercially reasonable termsacceptable to us, if at all. If we were to enter into an agreement with aqualified product designer, we could experience a delay in the design anddevelopment of new sunglass and goggle product lines, and we may not experiencethe same level of consumer acceptance with any such product offerings. Any suchdelay in the introduction of new product lines or the failure by customers toaccept new product lines could reduce our net sales.

 

**If we are unable tomaintain and expand our endorsements by professional athletes, our ability tomarket and sell our products may be harmed.**

 

A key element of our marketing strategy hasbeen to obtain endorsements from prominent action sports athletes to sell ourproducts and preserve the authenticity of our brands. We generally enter intoendorsement contracts with our athletes for terms of one to three years. Therecan be no assurance that we will be able to maintain our existing relationshipswith these individuals in the future or that we will be able to attract newathletes or public personalities to endorse our products in order to grow ourbrands or product categories. Further, we may not select athletes that aresufficiently popular with our target demographics or successful in theirrespective action sports. Even if we do select successful athletes, we may notbe successful in negotiating commercially reasonable terms with thoseindividuals. If we are unable in the future to secure athletes or arrangeathlete endorsements of our products on terms we deem to be reasonable, we maybe required to modify our marketing platform and to rely more heavily on otherforms of marketing and promotion which may not prove to be as effective asendorsements. In addition, negative publicity concerning any of our sponsoredathletes could harm our brands and adversely impact our business.

 

**Any interruption ortermination of our relationships with our manufacturers could harm ourbusiness.**

 

Our principal manufacturers are located inItaly. We do not have long-term agreements with any of our manufacturers. Ouragreement with our primary manufacturer, LEM S.r.l., requires us to purchase aminimum amount of products from LEM monthly and annually and allows eitherparty to terminate the agreement for any reason upon 180 days’ notice. Wecannot be certain that we will not experience difficulties with thismanufacturer or our other manufacturers, such as reductions in the availabilityof production capacity, errors in complying with product specifications,insufficient quality control, failures to meet production deadlines orincreases in manufacturing costs and failures to comply with our requirementsfor the proper utilization of our intellectual property. If our relationshipwith any of our manufacturers is interrupted or terminated for any reason,including the failure of any manufacturer to

 

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be able toperform its obligations under our agreement or the termination of our agreementby any of our manufacturers, we would need to locate alternative manufacturingsources. The establishment of new manufacturing relationships involves numerousuncertainties, and we cannot be certain that we would be able to obtainalternative manufacturing sources in a manner that would enable us to meet ourcustomer orders on a timely basis or on satisfactory commercial terms. If weare required to change any of our major manufacturers, we would likelyexperience increased costs, substantial disruptions in the manufacture andshipment of our products and a loss of net sales.

 

We purchase substantially all of ourproducts from two manufacturers, LEM S.r.l. and Intersol S.r.l.  In the fiscal years ended December 31,2002, 2003 and 2004, we purchased approximately 89%, 78% and 64%, respectively,of these products from LEM and approximately 11%, 15% and 17%, respectively, ofthese products from Intersol.  We expectin the future that the portion of our products manufactured by LEM willincrease and the portion of our products manufactured by Intersol willdecrease.  Accordingly, any ability todiffuse potential manufacturer-related risks noted above, and to attenuate thepotentially debilitating effect on our business and results of operations, isthereby lessened - thus augmenting the risks.

 

**Our manufacturers must beable to continue to procure raw materials and we must continue to receivetimely deliveries from our manufacturers to sell our products profitably.**

 

The capacity of our manufacturers tomanufacture our products is dependent upon the availability of raw materialsused in the fabrication of eyeglasses. Our manufacturers have experienced inthe past, and may experience in the future, shortages of raw materials, whichhave resulted in delays in deliveries of our products by our manufacturers ofup to several months. For example, in fiscal 2003, we experienced a delay of twomonths in the delivery of goggle shipments due to manufacturing problems. Webelieve the delay may have reduced our net sales in the third quarter of fiscal2003 by less than 5%. Any shortage of raw materials or inability of amanufacturer to manufacture or ship our products in a timely manner, or at all,could impair our ability to ship orders of our products in a timely manner andcould cause us to miss the delivery requirements of our customers. As a result,we could experience cancellation of orders, refusal to accept deliveries or areduction in purchase prices, any of which could harm our net sales, results ofoperations and reputation.

 

**Any failure to maintainongoing sales through our independent sales representatives could harm ourbusiness.**

 

We sell our products through our directsales team and a network of 41 independent sales representatives. We rely onthese independent sales representatives to provide customer contacts and marketour products directly to our customer base. Our independent salesrepresentatives are not obligated to continue selling our products, and theymay terminate their arrangements with us at any time with limited notice. Ourability to maintain or increase our net sales will depend in large part on oursuccess in developing and maintaining relationships with our independent salesrepresentatives. It is possible that we may not be able to maintain or expandthese relationships successfully or secure agreements with additional salesrepresentatives on commercially reasonable terms, or at all. Any failure todevelop and maintain our relationships with our independent salesrepresentatives and any failure of our independent sales representatives toeffectively market our products could harm our net sales.

 

**We face business, political,operational, financial and economic risks because a significant portion of ouroperations and sales are to customers outside of the United States.**

 

Our European operations are located inItaly, and our primary manufacturers are located in Italy. In the fiscal yearsended December 31, 2002, 2003 and 2004, we derived 68%, 76% and 74% of ournet sales in the United States based on attributing sales using customerlocation (as opposed to shipping point) and 32%, 24% and 26% of our net salesin the rest of the world, primarily in Australia, Canada, France, Japan andSpain. We are subject to risks inherent in international business, many ofwhich are beyond our control, including:

 

•                  difficultiesin obtaining domestic and foreign export, import and other governmentalapprovals, permits and licenses and compliance with foreign laws, includingemployment laws;

 

•     difficultiesin staffing and managing foreign operations, including cultural differences inthe conduct of business, labor and other workforce requirements;

 

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•     transportationdelays and difficulties of managing international distribution channels;

 

•     longerpayment cycles for, and greater difficulty collecting, accounts receivable;

 

•     traderestrictions, higher tariffs or the imposition of additional regulationsrelating to import or export of our products;

 

•     unexpectedchanges in regulatory requirements, royalties and withholding taxes thatrestrict the repatriation of earnings and effects on our effective income taxrate due to profits generated or lost in foreign countries;

 

•     political andeconomic instability, including wars, terrorism, political unrest, boycotts,curtailment of trade and other business restrictions; and

 

•     difficultiesin obtaining the protections of the intellectual property laws of othercountries.

 

Any of these factors could reduce our netsales, decrease our gross margins or increase our expenses.

 

**Fluctuations in foreigncurrency exchange rates could harm our results of operations.**

 

We sell a majority of our products intransactions denominated in U.S. dollars; however, we purchase substantiallyall of our products from our independent manufacturers in transactionsdenominated in Euros. As a result, if the U.S. dollar were to weaken againstthe Euro, our cost of sales could increase substantially. We also are exposedto gains and losses resulting from the effect that fluctuations in foreigncurrency exchange rates have on the reported results in our consolidatedfinancial statements due to the translation of the operating results andfinancial position of our Italian subsidiary, Spy Optic, S.r.l., and due to netsales in Canada.  Between January 1,2002 and December 31, 2004, the Euro to U.S. dollar exchange rate has ranged from0.86 to 1.37. Between January 1, 2002 and December 31, 2004, the Canadiandollar to U.S. dollar exchange rate has ranged from 0.62 to 0.85.  For the fiscal years ended December 31,2002, 2003 and 2004, we had an unrealized foreign currency gain of approximately$326,000, $290,000 and $529,000, representing 1%, 1% and 2% of our net sales,respectively.  As of December 31, 2004, wehad purchased a total of 3.1 million Euro foreign currency contracts at anaverage Euro rate of 1.33 Euro to U.S. dollar.

 

**We may experience conflictsof interest with our significant stockholder, No Fear, Inc., which couldharm our other stockholders.**

 

Upon completion of our initial publicoffering, No Fear, Inc. beneficially owned approximately 14% of ouroutstanding common stock. As a result of No Fear’s ownership interest, No Fearhas the ability to influence who is elected to our board of directors each yearand, through those directors, to influence our management, operations andpotential significant corporate actions. In addition, as a purchaser of ourproducts, No Fear accounted for approximately $447,000, $660,000 and $927,000of our net sales for the fiscal years ended December 31, 2002, 2003 and2004, respectively. No Fear may have interests that conflict with, or are differentfrom, the interests of our other stockholders. These conflicts of interestcould include potential competitive business activities, corporateopportunities, indemnity arrangements, registration rights, sales ordistributions by No Fear of our common stock and the exercise by No Fear of itsability to influence our management and affairs. Further, this concentration ofownership may discourage, delay or prevent a change of control of our company,which could deprive our other stockholders of an opportunity to receive apremium for their stock as part of a sale of our company, could harm the marketprice of our common stock and could impede the growth of our company. Ourcertificate of incorporation does not contain any provisions designed tofacilitate resolution of actual or potential conflicts of interest or to ensurethat potential business opportunities that may become available to both No Fearand us will be reserved for or made available to us. If these conflicts ofinterest are not resolved in a manner favorable to our stockholders, ourstockholders’ interests may be substantially harmed.

 

In addition, Mark Simo, the Chairman of our boardof directors, serves as the Chief Executive Officer and Chairman of the boardof directors of No Fear and owns approximately 31% of No Fear’s outstandingcommon stock. As a result of his position in No Fear, Mr. Simo may faceconflicts of interest in connection with transactions between us and No Fear.

 

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**If we fail to secure orprotect our intellectual property rights, competitors may be able to use ourtechnologies, which could weaken our competitive position, reduce our net salesor increase our costs.**

 

We rely on patent, trademark, copyright,trade secret and trade dress laws to protect our proprietary rights withrespect to product designs, product research and trademarks. Our efforts toprotect our intellectual property may not be effective and may be challenged bythird parties. Despite our efforts, third parties may have violated and may inthe future violate our intellectual property rights. In addition, other partiesmay independently develop similar or competing technologies. If we fail toprotect our proprietary rights adequately, our competitors could imitate ourproducts using processes or technologies developed by us and therebypotentially harm our competitive position and our financial condition. We arealso susceptible to injury from parallel trade (i.e., gray markets) andcounterfeiting of our products, which could harm our reputation for producinghigh-quality products from premium materials. Infringement claims and lawsuitslikely would be expensive to resolve and would require substantial managementtime and resources. Any adverse determination in litigation could subject us tothe loss of our rights to a particular patent, trademark, copyright or tradesecret, could require us to obtain licenses from third parties, could preventus from manufacturing, selling or using certain aspects of our products orcould subject us to substantial liability, any of which would harm our resultsof operations.

 

Since we sell our products internationallyand are dependent on foreign manufacturing in Italy and China, we also aredependent on the laws of foreign countries to protect our intellectualproperty. These laws may not protect intellectual property rights to the sameextent or in the same manner as the laws of the United States. Although we willcontinue to devote substantial resources to the establishment and protection ofour intellectual property on a worldwide basis, we cannot be certain that theseefforts will be successful or that the costs associated with protecting ourrights abroad will not be extensive. As of the date of this Annual Report, wehave been unable to register Spy as a trademark for our products in a fewselected markets in which we do business. In addition, although we have filedapplications for federal registration, we have no trademark registrations forSpy for our accessory products currently being sold. We may face significantexpenses and liability in connection with the protection of our intellectualproperty rights both inside and outside of the United States and, if we areunable to successfully protect our intellectual property rights or resolve anyconflicts, our results of operations may be harmed.

 

**We may be subject to claimsby third parties for alleged infringement of their proprietary rights, whichare costly to defend, could require us to pay damages and could limit our abilityto use certain technologies in the future.**

 

From time to time, we may receive notices ofclaims of infringement, misappropriation or misuse of other parties’proprietary rights. Some of these claims may lead to litigation. Anyintellectual property lawsuit, whether or not determined in our favor orsettled, could be costly, could harm our reputation and could divert ourmanagement from normal business operations. Adverse determinations inlitigation could subject us to significant liability and could result in theloss of our proprietary rights. A successful lawsuit against us could alsoforce us to cease sales or to develop redesigned products or brands. Inaddition, we could be required to seek a license from the holder of theintellectual property to use the infringed technology, and it is possible thatwe may not be able to obtain a license on reasonable terms, or at all. If weare unable to redesign our products or obtain a license, we may have todiscontinue a particular product offering. If we fail to develop anon-infringing technology on a timely basis or to license the infringedtechnology on acceptable terms, our business, financial condition and resultsof operations could be harmed.

 

On March 7, 2005, Oakley,Inc, one of our major competitors, filed a lawsuit alleging patent trade dressand trademark infringement, unfair competition, and false designation oforigin.  The lawsuit specificallyidentifies three of our product styles which accounted for less than 4% of ourtotal net sales for 2004.  While webelieve the lawsuit is without merit and that the ultimate outcome of thisproceeding will not have a material adverse effect on our consolidated balancesheet and statements of income and cash flows, litigation is subject toinherent uncertainties.

 

**If we fail to manage anygrowth that we might experience, our business could be harmed and we may haveto incur significant expenditures to address this growth.**

 

We have experienced significant growth,which has placed, and may continue to place, a significant strain on ourmanagement and operations. If we continue to experience growth in ouroperations, our operational and financial systems, procedures and controls mayneed to be expanded and we may need to train and manage an increasing number ofemployees, any of which will distract our management team from our businessplan and involve increased

 

33

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expenses. Ourfuture success will depend substantially on the ability of our management teamto manage any growth effectively. These challenges may include:

 

•     maintainingour cost structure at an appropriate level based on the net sales we generate;

 

•     implementingand improving our operational and financial systems, procedures and controls;

 

•     managingoperations in multiple locations and multiple time zones; and

 

•     ensuring thedistribution of our products in a timely manner.

 

**We incur significantexpenses as a result of being a public company.**

 

We incur significant legal, accounting,insurance and other expenses as a result of being a public company. TheSarbanes-Oxley Act of 2002, as well as new rules subsequently implemented bythe SEC and Nasdaq, have required changes in corporate governance practices ofpublic companies. These new rules and regulations have, and will continue, toincrease our legal and financial compliance costs and make some activities moretime-consuming and costly. These new rules and regulations have also made, andwill continue to make, it more difficult and more expensive for us to obtaindirector and officer liability insurance.

 

**We may not addresssuccessfully problems encountered in connection with any future acquisitions,which could result in operating difficulties and other harmful consequences.**

 

We have obtained an option exercisablethrough December 2005 to acquire our primary manufacturer, although wehave no present intention of exercising such option. We expect to continue toconsider other opportunities to acquire or make investments in othertechnologies, products and businesses that could enhance our capabilities,complement our current products or expand the breadth of our markets orcustomer base, although we have no specific agreements with respect topotential acquisitions or investments. We have limited experience in acquiringother businesses and technologies. Potential and completed acquisitions andstrategic investments involve numerous risks, including:

 

•     problemsassimilating the purchased technologies, products or business operations;

 

•     problemsmaintaining uniform standards, procedures, controls and policies;

 

•     unanticipatedcosts associated with the acquisition;

 

•     diversion ofmanagement’s attention from our core business;

 

•     harm to ourexisting business relationships with manufacturers and customers;

 

•     risksassociated with entering new markets in which we have no or limited priorexperience; and

 

•     potentialloss of key employees of acquired businesses.

 

If we fail to properly evaluate and executeacquisitions and strategic investments, our management team may be distractedfrom our day-to-day operations, our business may be disrupted and our operatingresults may suffer. In addition, if we finance acquisitions by issuing equityor convertible debt securities, our stockholders would be diluted.

 

**Our eyewear products maysubject us to product liability claims, which are expensive to defend and mayrequire us to pay damages.**

 

Due to the nature of our products and theactivities in which our products may be used, we may be subject to productliability claims, including claims for serious personal injury. Although we arenot involved presently in any product liability claim, successful assertionagainst us of one or a series of large claims could harm our business.

 

34

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**Risks Related to the Marketfor Our Common Stock**

 

**Our stock price may bevolatile, and you may not be able to resell our shares at a profit or at all.**

 

The trading price of our common stock fluctuatesdue to the factors discussed in this section and elsewhere in this AnnualReport. The trading market for our common stock also is influenced by theresearch and reports that industry or securities analysts publish about us orour industry. If one or more of the analysts who cover us were to publish anunfavorable research report or to downgrade our stock, our stock price likelywould decline. If one or more of these analysts were to cease coverage of ourcompany or fail to regularly publish reports on us, we could lose visibility inthe financial markets, which in turn could cause our stock price or tradingvolume to decline.

 

**Fluctuations in ouroperating results on a quarterly and annual basis could cause the market priceof our common stock to decline.**

 

Our operating results fluctuate from quarterto quarter as a result of changes in demand for our products, our effectivenessin managing our suppliers and costs, the timing of the introduction of newproducts and weather patterns. Historically, we have experienced greater netsales in the second half of the fiscal year as a result of the seasonality ofour customers and the markets in which we sell our products, and our first andfourth quarters have traditionally been our weakest operating quarters due toseasonality. We generally sell more of our sunglass products in the first halfof the fiscal year and a majority of our goggle products in the last half ofthe fiscal year. We anticipate that this seasonal impact on our net sales islikely to continue. As a result, our net sales and operating results havefluctuated significantly from period to period in the past and are likely to doso in the future. These fluctuations could cause the market price of our commonstock to decline. You should not rely on period-to-period comparisons of ouroperating results as an indication of our future performance. In futureperiods, our net sales and results of operations may be below the expectationsof analysts and investors, which could cause the market price of our commonstock to decline.

 

Our expense levels in the future will bebased, in large part, on our expectations regarding net sales. Many of ourexpenses are fixed in the short term or are incurred in advance of anticipatedsales. We may not be able to decrease our expenses in a timely manner to offsetany shortfall of sales.

 

**Future sales of our commonstock in the public market could cause our stock price to fall.**

 

Sales of our common stock in the publicmarket, or the perception that such sales might occur, could cause the marketprice of our common stock to decline. As of February 24, 2005, we have 8,012,483shares of common stock outstanding and 803,721 shares subject to unexercisedoptions to purchase shares of common stock that are fully vested.  Of these outstanding shares, 4,000,000 areeligible for resale and 4,012,483 shares will be available for resale on June 15,2004 (i.e., following expiration of the lock-up agreements the underwritersentered into with the holders of our common stock in connection with ourinitial public offering), subject to certain volume limitations.  In addition, in connection with our initialpublic offering, we agreed to issue Roth Capital Partners, LLC, a warrant topurchase up to approximately 147,000 shares of common stock.

 

Any or all of the shares subject to the lock-upagreements may be released prior to expiration of the 180-day lock-up period atthe discretion of Roth Capital Partners, LLC. To the extent shares are releasedbefore the expiration of the lock-up period and these shares are sold into themarket, the market price of our common stock could decline.

 

**Delaware law and ourcorporate charter and bylaws contain anti-takeover provisions that could delayor discourage takeover attempts that stockholders may consider favorable.**

 

Provisions in our certificate ofincorporation and bylaws may have the effect of delaying or preventing a changeof control or changes in our management. These provisions include thefollowing:

 

•     theestablishment of a classified board of directors requiring that not alldirectors be elected at one time;

 

•     the size ofour board of directors can be expanded by resolution of our board of directors;

 

•     any vacancyon our board can be filled by a resolution of our board of directors;

 

•     advancenotice requirements for nominations for election to the board of directors orfor proposing matters that can be acted upon at a stockholders’ meeting;

 

35

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•      the ability of the board of directors toalter our bylaws without obtaining stockholder approval;

 

•      the ability of the board of directors toissue and designate the rights of, without stockholder approval, up to5,000,000 shares of preferred stock, which rights could be senior to those ofcommon stock; and

 

•      the elimination of the right of stockholdersto call a special meeting of stockholders and to take action by writtenconsent.

 

In addition, because we reincorporated in Delaware, we are governed bythe provisions of Section 203 of the Delaware General Corporation Law, orDelaware law. These provisions may prohibit large stockholders, in particularthose owning 15% or more of our outstanding voting stock, from merging orcombining with us. The provisions in our charter, bylaws and under Delaware lawcould discourage potential takeover attempts and could reduce the price thatinvestors might be willing to pay for shares of our common stock in the future,resulting in the market price being lower than it would without theseprovisions.

** **

**We are party to securitieslitigation that distracts our management, is expensive to conduct and seeks adamage award against us.**

 

We, our directors and certain of our officers have recently been namedas defendants in a stockholder class action lawsuit filed in the United StatesDistrict Court for the Southern District of California. The complaint purportsto seek unspecified damages on behalf of an alleged class of persons whopurchased our common stock pursuant to our registration statement we filed inconnection with our public offering of stock on December 14, 2005.  The complaint alleges that we and ourofficers and directors violated federal securities laws by failing to disclosematerial information about the status of our European operations and whethercertain of our products infringe on the intellectual property rights of Oakley,Inc. in that registration statement.  Wehave not yet formally responded to this action and no discovery has beenconducted. However, based on the facts presently known, our management believeswe have meritorious defenses to this action and intends to vigorously defendthe action. This litigation presents a distraction to our management,and is expensive to conduct.  Based ofour insurance coverages, our costs related to this action could range from $0to $250,000.  This could negativelyaffect our operating results.

 

36

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## **Item 8**. FinancialStatements and Supplementary Data

** **

**ORANGE 21 INC. ANDSUBSIDIARIES**

** **

**Index toConsolidated Financial Statements**

** **
|                                                           | **Page** |
|----------------------------------------------------------------|----------|
| Report of Independent  Registered Certified Public Accountants | F-2      |
| Consolidated Financial Statements:                             |     |
| Consolidated Balance  Sheets                                   | F-4      |
| Consolidated  Statements of Income                             | F-5      |
| Consolidated  Statements of Stockholders’ Equity          | F-6      |
| Consolidated  Statements of Cash Flows                         | F-7      |
| Notes to  Consolidated Financial Statements                    | F-9      |

 

F-1

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Report of Independent RegisteredCertified Public Accountants

 

To the Board of Directors and Stockholders of

Orange 21 Inc. and Subsidiaries

Carlsbad, California

 

We have audited the accompanying consolidated balance sheet of Orange21 Inc. (a Delaware corporation) and its subsidiaries as of December 31, 2004,and the related consolidated statements of income, stockholders’ equity andcash flows for the year then ended. We have also audited the financialstatement schedule listed at Item 15(a). These consolidated financialstatements and the schedule are the responsibility of the Company’s management.Our responsibility is to express an opinion on these consolidated financialstatements and the schedule based on our audit.

 

We conducted our audit in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. The Company is notrequired to have, nor were we engaged to perform, an audit of its internalcontrol over financial reporting. Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion.  An audit alsoincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall presentation of the financial statements. Webelieve that our audit provides a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the consolidated financial positionof Orange 21 Inc. and its subsidiaries as of December 31, 2004, and theconsolidated results of their operations and their cash flows for the year thenended, in conformity with accounting principles generally accepted in theUnited States of America. Also, in our opinion, the schedule presents fairly,in all material respects, the information set forth therein.

 

/s/ Mayer Hoffman McCann P.C.

San Diego, California

March 11, 2005, except for Note 13 for which the date is March 29, 2005

 

 

F-2

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Report of IndependentRegistered Certified Public Accountants

 

To the Board of Directors and Stockholders of

Orange 21 Inc. and Subsidiary

Carlsbad, California

 

We have audited the accompanying consolidated balance sheet of Orange21 Inc. (a Delaware corporation) and its subsidiary as of December 31, 2003,and the related consolidated statements of income, stockholders’ equity andcash flows for each of the two years in the period ended December 31, 2003. Wehave also audited the financial statement schedule listed at Item 15(a). Theseconsolidated financial statements and the schedule are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on theseconsolidated financial statements and the schedule based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall presentation of the financial statements. We believethat our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the consolidated financial positionof Orange 21 Inc. and its subsidiary as of December 31, 2003, and theconsolidated results of their operations and their cash flows for each of thetwo years in the period ended December 31, 2003, in conformity with accountingprinciples generally accepted in the United States of America. Also, in ouropinion, the schedule presents fairly, in all material respects, theinformation set forth therein.

 

/s/ Nation Smith Hermes Diamond, APC

San Diego, California

September 13, 2004, except for the first paragraph of Note 1 for

which the date is November 29, 2004

 

 

 

F-3

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**ORANGE 21 INC.AND SUBSIDIARIES**

** **

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                               | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                                                                                                                               | ** ** | **2003**         | ** ** | **2004** | ** ** |
| **Assets**                                                                                                                                                               |       |             |       |   |   |
| Current assets                                                                                                                                                           |       |             |       |   |   |
| Cash and cash equivalents                                                                                                                                                |       | $                | 581,207    |   | $ | 11,476,828 |   |
| Accounts receivable—net                                                                                                                                             |       | 6,635,277        |       | 8,244,910 |   |
| Inventories                                                                                                                                                              |       | 6,669,307        |       | 11,814,846 |   |
| Prepaid expenses and other current assets                                                                                                                                |       | 1,199,500        |       | 1,073,181 |   |
| Income taxes receivable                                                                                                                                                  |       | 65,025           |       | — |   |
| Deferred income taxes                                                                                                                                                    |       | 985,000          |       | 1,074,000 |   |
| Total current assets                                                                                                                                                     |       | 16,135,316       |       | 33,683,765 |   |
| Property and equipment—net                                                                                                                                          |       | 3,893,438        |       | 3,687,907 |   |
| Due from related party                                                                                                                                                   |       | 845,057          |       | — |   |
|                                                                                                                                                                     |       |             |       |   |   |
| Intangible assets, net of accumulated amortization of $264,633 and  $318,332 at December 31, 2003 and 2004, respectively                                            |       | 167,214          |       | 152,543 |   |
|                                                                                                                                                                     |       |             |       |   |   |
| Total assets                                                                                                                                                             |       | $                | 21,041,025 |   | $ | 37,524,215 |   |
| **Liabilities and  Stockholders’ Equity**                                                                                                                           |       |             |       |   |   |
| Current liabilities                                                                                                                                                      |       |             |       |   |   |
| Line of credit                                                                                                                                                           |       | $                | 7,075,000  |   | $ | — |   |
| Current portion of notes payable                                                                                                                                         |       | 190,000          |       | 125,000 |   |
| Notes payable to stockholders                                                                                                                                            |       | 380,000          |       | — |   |
| Current portion of capitalized leases                                                                                                                                    |       | 39,505           |       | 37,370 |   |
| Accounts payable                                                                                                                                                         |       | 2,031,958        |       | 2,243,955 |   |
| Accrued expenses and other liabilities                                                                                                                                   |       | 1,369,820        |       | 2,433,371 |   |
| Income taxes payable                                                                                                                                                     |       | —           |       | 443,619 |   |
| Total current liabilities                                                                                                                                                |       | 11,086,283       |       | 5,283,315 |   |
| Notes payable, less current portion                                                                                                                                      |       | 281,250          |       | 166,667 |   |
| Capitalized leases, less current portion                                                                                                                                 |       | 59,527           |       | 31,369 |   |
| Deferred income taxes                                                                                                                                                    |       | 107,000          |       | 143,000 |   |
| Total liabilities                                                                                                                                                        |       | 11,534,060       |       | 5,624,351 |   |
| Commitments and contingencies                                                                                                                                            |       |             |       |   |   |
| Stockholders’ equity                                                                                                                                                |       |             |       |   |   |
| Preferred stock; par value $0.0001; 5,000,000 authorized                                                                                                                 |       | —           |       | — |   |
| Common stock; par value $0.0001; 100,000,000 shares authorized;  4,434,067 and 7,491,218 shares issued and outstanding at December 31,  2003 and 2004, respectively |       | 10,117,798       |       | 747 |   |
| Additional paid-in  capital                                                                                                                                              |       | 92,353           |       | 31,655,426 |   |
| Accumulated other comprehensive income                                                                                                                                   |       | 298,100          |       | 437,673 |   |
| Accumulated deficit                                                                                                                                                      |       | (1,001,286       | )          | (193,982 | ) |
| Total stockholders’ equity                                                                                                                                          |       | 9,506,965        |       | 31,899,864 |   |
|                                                                                                                                                                     |       | $                | 21,041,025 |   | $ | 37,524,215 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

F-4

----

 

**ORANGE 21 INC. AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OFINCOME**

 
| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|
| ** **                                 | ** ** | **2002**                         | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net sales                                  |       | $                                | 22,294,290 |   | $ | 27,404,069 |   | $ | 33,563,443 |   |
| Cost of sales                              |       | 10,847,589                       |       | 13,186,178 |   | 15,530,588 |   |
| Gross profit                               |       | 11,446,701                       |       | 14,217,891 |   | 18,032,855 |   |
| Operating expenses                         |       |                             |       |   |   |   |   |
| Sales and marketing                        |       | 6,047,254                        |       | 8,074,512 |   | 10,391,611 |   |
| General and administrative                 |       | 2,999,964                        |       | 3,775,454 |   | 4,563,612 |   |
| Shipping and warehousing                   |       | 531,679                          |       | 771,394 |   | 990,398 |   |
| Research and development                   |       | 251,839                          |       | 263,923 |   | 511,601 |   |
| Total operating expenses                   |       | 9,830,736                        |       | 12,885,283 |   | 16,457,222 |   |
| Income from operations                     |       | 1,615,965                        |       | 1,332,608 |   | 1,575,633 |   |
| Other income (expense)                     |       |                             |       |   |   |   |   |
| Interest expense                           |       | (393,143                         | )          | (484,239 | ) | (398,164 | ) |
| Foreign currency transaction gain          |       | 325,562                          |       | 289,965 |   | 528,243 |   |
| Other income—net                      |       | 30,111                           |       | 50,763 |   | 35,162 |   |
| Total other income (expense)               |       | (37,470                          | )          | (143,511 | ) | 165,241 |   |
| Income before income taxes                 |       | 1,578,495                        |       | 1,189,097 |   | 1,740,874 |   |
| Income tax provision                       |       | 667,000                          |       | 689,000 |   | 933,570 |   |
| Net income                                 |       | $                                | 911,495    |   | $ | 500,097 |   | $ | 807,304 |   |
| Net income per common share                |       |                             |       |   |   |   |   |
| Basic                                      |       | $                                | 0.21       |   | $ | 0.11 |   | $ | 0.17 |   |
| Diluted                                    |       | $                                | 0.19       |   | $ | 0.11 |   | $ | 0.16 |   |
| Weighted average common shares outstanding |       |                             |       |   |   |   |   |
| Basic                                      |       | 4,306,742                        |       | 4,426,056 |   | 4,643,320 |   |
| Diluted                                    |       | 4,785,044                        |       | 4,617,609 |   | 4,973,252 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F-5

----

 

**ORANGE 21 INC. AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY**

 
| ** **                                                                                        | ** **           | **Common Stock**** ** | ** **           | **Additional  Paid-in  Capital**** ** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)**** ** | ** ** | **Accumulated  Deficit**** ** | ** ** | **Total**** ** | ** ** |
|---------------------------------------------------------------------------------------------------|----------------------|----------------------------|----------------------|--------------------------------------------|------------|----------------------------------------------------------------|------------|------------------------------------|------------|---------------------|------------|
| ** **                                                                                        | **Shares**** ** | ** **                 | **Amount**** ** |
| **Balance at January 1, 2002**                                                                    |                 | 4,201,828                  |                 | $                                          | 9,395,850  |                                                           | $          | —                             |       | $                   | (1,508     | ) | $ | (2,412,878 | ) | $ | 6,981,464 |   |
| Issuance of common stock                                                                          |                 | 89,750                     |                 | 303,300                                    |       | —                                                         |       | —                             |       | —              |       | 303,300 |   |
| Conversion of issuable common stock to common stock                                               |                 | 28,125                     |                 | 90,000                                     |       | —                                                         |       | —                             |       | —              |       | 90,000 |   |
| Conversion of notes payable, notes payable to stockholders, and  accrued expenses to common stock |                 | 103,276                    |                 | 310,548                                    |       | —                                                         |       | —                             |       | —              |       | 310,548 |   |
| Beneficial conversion feature on note payable                                                     |                 | —                     |                 | —                                     |       | 81,021                                                         |       | —                             |       | —              |       | 81,021 |   |
| Comprehensive income:                                                                             |                 |                       |                 |                                       |       |                                                           |       |                               |       |                |       |   |   |
| Foreign currency translation adjustment                                                           |                 | —                     |                 | —                                     |       | —                                                         |       | 53,239                             |       | —              |       | 53,239 |   |
| Net income                                                                                        |                 | —                     |                 | —                                     |       | —                                                         |       | —                             |       | 911,495             |       | 911,495 |   |
| Comprehensive income                                                                              |                 | —                     |                 | —                                     |       | —                                                         |       | 53,239                             |       | 911,495             |       | 964,734 |   |
| **Balance at December 31, 2002**                                                                  |                 | 4,422,979                  |                 | $                                          | 10,099,698 |                                                           | $          | 81,021                             |       | $                   | 51,731     |   | $ | (1,501,383 | ) | $ | 8,731,067 |   |
| Issuance of common stock                                                                          |                 | 4,688                      |                 | 22,500                                     |       | —                                                         |       | —                             |       | —              |       | 22,500 |   |
| Exercise of stock options                                                                         |                 | 12,500                     |                 | 20,000                                     |       | —                                                         |       | —                             |       | —              |       | 20,000 |   |
| Repurchase of common stock                                                                        |                 | (6,100                     | )                    | (24,400                                    | )          | —                                                         |       | —                             |       | —              |       | (24,400 | ) |
| Compensation relating to issuance of stock options                                                |                 | —                     |                 | —                                     |       | 11,332                                                         |       | —                             |       | —              |       | 11,332 |   |
| Comprehensive income:                                                                             |                 |                       |                 |                                       |       |                                                           |       |                               |       |                |       |   |   |
| Foreign currency translation adjustment                                                           |                 | —                     |                 | —                                     |       | —                                                         |       | 246,369                            |       | —              |       | 246,369 |   |
| Net income                                                                                        |                 | —                     |                 | —                                     |       | —                                                         |       | —                             |       | 500,097             |       | 500,097 |   |
| Comprehensive income                                                                              |                 | —                     |                 | —                                     |       | —                                                         |       | 246,369                            |       | 500,097             |       | 746,466 |   |
|                                                                                              |                 |                       |                 |                                       |       |                                                           |       |                               |       |                |       |   |   |
| **Balance at December 31, 2003**                                                                  |                 | 4,434,067                  |                 | $                                          | 10,117,798 |                                                           | $          | 92,353                             |       | $                   | 298,100    |   | $ | (1,001,286 | ) | $ | 9,506,965 |   |
| Issuance of common stock                                                                          |                 | 358,438                    |                 | 1,705,500                                  |       | —                                                         |       | —                             |       | —              |       | 1,705,500 |   |
| Issuance of common stock upon initial public offering, net of offering  costs                     |                 | 2,480,000                  |                 | 248                                        |       | 18,913,550                                                     |       | —                             |       | —              |       | 18,913,798 |   |
| Exercise of stock options                                                                         |                 | 184,375                    |                 | 360,000                                    |       | —                                                         |       | —                             |       | —              |       | 360,000 |   |
| Conversion of notes payable to common stock                                                       |                 | 34,374                     |                 | 165,000                                    |       | —                                                         |       | —                             |       | —              |       | 165,000 |   |
| Compensation relating to issuance of options                                                      |                 | —                     |                 | —                                     |       | 203,192                                                        |       | —                             |       | —              |       | 203,192 |   |
| Tax benefit related to exercise of stock option                                                   |                 | —                     |                 | —                                     |       | 98,532                                                         |       | —                             |       | —              |       | 98,532 |   |
| Exchange of shares of common stock upon incorporation in Delaware                                 |                 | (36                        | )                    | (12,347,799                                | )          | 12,347,799                                                     |       | —                             |       | —              |       | — |   |
| Comprehensive income:                                                                             |                 |                       |                 |                                       |       |                                                           |       |                               |       |                |       |   |   |
| Foreign currency translation adjustment                                                           |                 | —                     |                 | —                                     |       | —                                                         |       | 139,573                            |       | —              |       | 139,573 |   |
| Net income                                                                                        |                 | —                     |                 | —                                     |       | —                                                         |       | —                             |       | 807,304             |       | 807,304 |   |
| Comprehensive income                                                                              |                 | —                     |                 | —                                     |       | —                                                         |       | 139,573                            |       | 807,304             |       | 946,877 |   |
| **Balance at December 31, 2004**                                                                  |                 | 7,491,218                  |                 | $                                          | 747        |                                                           | $          | 31,655,426                         |       | $                   | 437,673    |   | $ | (193,982 | ) | $ | 31,899,864 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F-6

----

 

**ORANGE 21 INC. AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OFCASH FLOWS**

 
| ** **                                                                                   | ** ** | **Year Ended December 31,**** ** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                   | ** ** | **2002**                              | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                   | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Cash flows from operating activities**                                                     |       |                                  |       |   |   |   |   |
| Net income                                                                                   |       | $                                     | 911,495    |   | $ | 500,097 |   | $ | 807,304 |   |
| Adjustments to reconcile net income to net cash provided by (used in)  operating activities: |       |                                  |       |   |   |   |   |
| Depreciation and amortization                                                                |       | 1,094,214                             |       | 1,531,145 |   | 1,921,233 |   |
| Deferred income taxes                                                                        |       | 177,311                               |       | 372,000 |   | (53,000 | ) |
| Provision for bad debts                                                                      |       | 350,978                               |       | 349,112 |   | 300,470 |   |
| Stock-based compensation                                                                     |       | —                                |       | 11,332 |   | 203,192 |   |
| Loss on sale of fixed assets                                                                 |       | —                                |       | 5,320 |   | 404 |   |
| Non-cash interest expense                                                                    |       | 81,021                                |       | — |   | — |   |
| Change in operating assets and liabilities:                                                  |       |                                  |       |   |   |   |   |
| Accounts receivable                                                                          |       | (796,149                              | )          | (2,496,420 | ) | (1,910,103 | ) |
| Inventories                                                                                  |       | (2,356,354                            | )          | (75,182 | ) | (5,145,539 | ) |
| Prepaid expenses and other current assets                                                    |       | (647,924                              | )          | 78,654 |   | 126,319 |   |
| Due from related party                                                                       |       | (276,836                              | )          | (524,195 | ) | 845,057 |   |
| Other assets                                                                                 |       | —                                |       | 96,445 |   | — |   |
| Accounts payable                                                                             |       | 470,852                               |       | 395,481 |   | 211,997 |   |
| Accrued expenses and other liabilities                                                       |       | 647,939                               |       | 547,888 |   | 1,063,551 |   |
| Income tax payable/receivable                                                                |       | —                                |       | (425,790 | ) | 607,176 |   |
| Net cash provided by (used in) operating activities                                          |       | (343,453                              | )          | 365,887 |   | (1,021,939 | ) |
| **Cash flows from investing activities**                                                     |       |                                  |       |   |   |   |   |
| Purchases of fixed assets                                                                    |       | (999,333                              | )          | (1,789,228 | ) | (692,853 | ) |
| Purchases of fixed assets from related parties                                               |       | (980,000                              | )          | (861,000 | ) | (952,093 | ) |
| Loans to related parties                                                                     |       | —                                |       | — |   | (467,500 | ) |
| Proceeds from repayment of loans to related parties                                          |       | —                                |       | — |   | 467,500 |   |
| Proceeds from sale of fixed assets                                                           |       | —                                |       | 135,000 |   | 15,000 |   |
| Purchases of intangibles                                                                     |       | (36,271                               | )          | (29,072 | ) | (39,027 | ) |
| Net cash used in investing activities                                                        |       | (2,015,604                            | )          | (2,544,300 | ) | (1,668,973 | ) |
| **Cash flows from financing activities**                                                     |       |                                  |       |   |   |   |   |
| Line of credit borrowings                                                                    |       | 2,768,674                             |       | 2,190,000 |   | 5,650,868 |   |
| Line of credit repayments                                                                    |       | (732,472                              | )          | — |   | (12,725,868 | ) |
| Principal payments on notes payable                                                          |       | —                                |       | (1,033,928 | ) | (114,583 | ) |
| Proceeds from issuance of notes payable                                                      |       | 150,000                               |       | 525,000 |   | — |   |
| Proceeds from issuance of notes payable to stockholders                                      |       | —                                |       | 380,000 |   | — |   |
| Principal payments on notes payable to stockholders                                          |       | (200,000                              | )          | — |   | (280,000 | ) |
| Principal payments on capital leases                                                         |       | (77,352                               | )          | (139,851 | ) | (62,753 | ) |
| Repurchase of common stock                                                                   |       | —                                |       | (24,400 | ) | — |   |
| Proceeds from sale of common stock                                                           |       | 303,300                               |       | 22,500 |   | 20,619,296 |   |
| Proceeds from exercise of stock options                                                      |       | —                                |       | 20,000 |   | 360,000 |   |
| Net cash provided by financing activities                                                    |       | 2,212,150                             |       | 1,939,321 |   | 13,446,960 |   |
| Effect of exchange rate changes on cash and cash equivalents                                 |       | 53,239                                |       | 246,369 |   | 139,573 |   |
| Net increase (decrease) in cash and cash equivalents                                         |       | (93,668                               | )          | 7,277 |   | 10,895,621 |   |
| Cash and cash equivalents at beginning of year                                               |       | 667,598                               |       | 573,930 |   | 581,207 |   |
| Cash and cash equivalents at end of year                                                     |       | $                                     | 573,930    |   | $ | 581,207 |   | $ | 11,476,828 |   |
| Supplemental disclosures of cash flow information:                                           |       |                                  |       |   |   |   |   |
| Cash paid during the year for:                                                               |       |                                  |       |   |   |   |   |
| Interest                                                                                     |       | $                                     | 389,209    |   | $ | 542,090 |   | $ | 448,126 |   |
| Income taxes                                                                                 |       | $                                     | 178,800    |   | $ | 114,790 |   | $ | 321,303 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

 

F-7

----

 

Non-cash Investing and Financing Activities:

 

The Company acquired approximately $168,000,$81,000 and $32,000 of fixed assets under capital lease agreements during 2002,2003 and 2004.

 

The Company converted $250,000 and $165,000of notes payable into common stock during 2002 and 2004, respectively.

 

The Company had a non-cash income taxbenefit in the amount of approximately $99,000 during 2004 related to theexercise of stock options.

 

The Company converted $90,000 of issuablecommon stock into common stock during 2002.

 

The Company converted approximately $80,000of accounts payable and accrued expenses into notes payable during 2002.

 

The Company converted approximately $60,000of accrued expenses into common stock during 2002.

 

The accompanying notes are an integral partof these consolidated financial statements.

 

 

F-8

----

 

**ORANGE 21  INC. AND SUBSIDIARIES**

** **

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

** **

**1.****            ****Organization and Significant Accounting Policies**

 

*Description of Business*

 

Orange 21 Inc. (the “Company”) was originally formed as a Californiacorporation in 1992. On November 29, 2004, upon reincorporation in theState of Delaware, the Company changed its name from Spy Optic, Inc. toOrange 21 Inc. and the Board of Directors of the Company approved a 16 to1 reverse stock split and authorized 5,000,000 shares of preferred stock. Allfinancial data and share data in these consolidated financial statements give retroactiveeffect to this split. The financial and share data do not include the effect ofan aggregate of 36 shares purchased in connection with the reverse stock splitin lieu of issuing fractional shares to stockholders. The Company is adesigner, manufacturer, and distributor of high quality and high performanceproducts for the action sports and lifestyle markets. The Company’s currentproduct offerings include sunglasses, snow and motocross goggles, and brandedapparel and accessories. Spy Optic, S.r.l., a wholly owned subsidiary, wasincorporated in Italy in July 2001. Spy Optic, S.r.l. manages thedistribution, sales, customer service and administration for the Company’s businessoutside of North America.  Spy Optic,Inc., a California corporation, was formed on December 20, 2004.

 

*Basis of Presentation*

 

The consolidated financial statements include the accounts of theCompany and its wholly owned subsidiaries, Spy Optic, S.r.l. and Spy Optic,Inc. All significant intercompany accounts and transactions have beeneliminated in the consolidated financial statements.

 

*Use of Estimates*

 

The preparation of the consolidated financial statements in conformitywith generally accepted accounting principles in the United States requiresmanagement to make estimates and assumptions that affect certain reportedamounts and disclosures. Significant estimates used in preparing theseconsolidated financial statements include those assumed in computing thecarrying value of displays, allowance for doubtful accounts receivable, reservefor obsolete inventory, reserve for sales returns, and the valuation allowanceon deferred tax assets. Accordingly, actual results could differ from thoseestimates.

 

*Cash and Cash Equivalents*

 

The Company considers all highly liquid investments with originalmaturities of three months or less to be cash equivalents.

 

*Accounts Receivable andAllowance for Doubtful Accounts*

 

The Company performs ongoing credit evaluations of its customers andadjusts credit limits based upon payment history and the customer’s currentcreditworthiness, as determined by the Company’s review of its current creditinformation. The Company continuously monitors its customer collections andpayments and maintains a provision for estimated credit losses based upon theCompany’s historical experience and any specific customer collection issuesthat have been identified. While such credit losses have historically beengenerally within the expectations and the provisions established by theCompany, there can be no assurances that the Company will continue toexperience the same credit loss rates that have been experienced in the past.

 

*Inventories*

 

Inventories are stated at the lower of cost or market using the first-infirst-out method of accounting.

 

F-9

----

 

*Property and Equipment*

 

Property and equipment are recorded at cost and are depreciated over theestimated useful lives of the assets (generally three to five years) using thestraight-line method. Amortization of leasehold improvements is computed on thestraight-line method over the shorter of the remaining lease term or theestimated useful lives of the assets. Expenditures for repairs and maintenanceare expensed as incurred. Gains and losses from the sale or retirement ofproperty and equipment are charged to operations in the period realized orincurred.

 

*Intangible Assets*

 

The Company adopted the provisions of Statement of Financial AccountingStandard (“SFAS”) No. 142, “*Goodwilland Other Intangible Assets,*” effective January 1, 2002.Intangible assets consist of trademarks and patents that are being amortized ona straight-line basis over eight years. Amortization expense was approximately$46,000, $49,000 and $54,000 for the years ended December 31, 2002, 2003and 2004, respectively.  Amortizationexpense related to intangible assets at December 31, 2004 in each of the nextfive years and beyond is expected to be incurred as follows:

 
| 2005       |   | $      | 54,000  |   |
|------------|--------|--------|---------|--------|
| 2006       |   | 25,000 |    |
| 2007       |   | 19,000 |    |
| 2008       |   | 15,000 |    |
| 2009       |   | 14,000 |    |
| Thereafter |   | 25,543 |    |
|       |   | $      | 152,543 |   |

 

At December 31, 2002, 2003 and 2004, no impairment of theintangible assets had occurred and the amortization periods remain appropriate.

 

*Revenue Recognition*

 

Revenue is recognized when title passes to the buyer, generally uponshipment of products to the Company’s customers. The Company provides anallowance for estimated returns based on management’s estimates and experience.Provisions for returns and other adjustments are provided for in the sameperiod in which the related sales are recorded.

 

*Advertising*

 

The Company expenses advertising costs as incurred. Total advertisingexpense was approximately $319,000, $343,000 and $432,000 for the years endedDecember 31, 2002, 2003 and 2004, respectively.

 

*Financial Instruments*

 

The Company’s financial instruments consist primarily of cash, accountsreceivable, accounts payable, and notes payable. These financial instrumentsare stated at their respective carrying values, which approximate their fairvalues.

 

*Derivative FinancialInstruments*

 

The Company periodically enters into foreign currency forward contractsfor a portion of its anticipated purchases denominated in foreign currencies tohedge price changes associated with fluctuations in market prices. All 

 

F-10

----

 

derivativesare recorded on the consolidated balance sheet at their fair value. As theCompany’s forward contracts do not qualify for hedge accounting, changes in thefair value of the Company’s forward contracts are recorded in other income(expense) net in the accompanying consolidated statements of operations. Forthe years ended December 31, 2002, 2003 and 2004, the Company recorded anunrealized gain (loss) on its foreign currency hedge contracts of $38,000,$60,000 and ($29,000), respectively.

 

*Shipping and HandlingCosts*

 

The Company records shipping and handling costs charged to customers asrevenue and shipping and handling costs to cost of sales as incurred.

 

*Product Warranty*

 

The Company warrants its products for one year. The standard warrantyrequires the Company to replace any product or portion thereof that is deemed amanufacturer’s defect. The Company’s product warranty accrual reflectsmanagement’s best estimate of probable liability under its product warranties,and is included in accrued expenses. Management determines the warranty accrualbased on historical information.

 

Changes in product warranty accrual for the years endedDecember 31, 2002, 2003 and 2004 were as follows:

 
| ** ** | ** ** | **Warranty  Accrual  Balance at  January 1**** ** | ** ** | **Warranty  Expenditures**** ** | ** ** | **Provision for  Estimated  Warranty  Cost**** ** | ** ** | **Warranty  Accrual  Balance at  December 31**** ** | ** ** |
|------------|------------|-------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| 2002       |       | $                                                           | —     |                                 | $          | (31,000                                                | )          | $                                                             | 35,000     |   | $ | 4,000 |   |
| 2003       |       | 4,000                                                       |       | (56,000                              | )          | 56,000                                                 |       | 4,000                                                         |       |
| 2004       |       | 4,000                                                       |       | (59,000                              | )          | 59,000                                                 |       | 4,000                                                         |       |
|            |            |                                                             |            |                                      |            |                                                        |            |                                                               |            |  |  |  |  |

 

*Research and DevelopmentCosts*

 

The Company expenses research and development costs as incurred.

 

*Net Income Per Share*

 

Basic net  income per share iscomputed by dividing net income by the weighted-average number of common sharesoutstanding for the fiscal period. Diluted net income per share is computedgiving effect to all potential dilutive common stock, including options andconvertible notes.

 

A reconciliation of the numerator and denominator used in thecalculation of basic and diluted net income per share is as follows (inthousands):

 

| ** **                                                                                           | ** ** | **Year Ended December 31,**** ** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                           | ** ** | **2002**** **                    | ** ** | **2003**** ** | ** ** | **2004**** ** | ** ** |
| Numerator:                                                                                           |       |                                  |       |   |   |   |   |
| Net income                                                                                           |       | $                                     | 911        |   | $ | 500 |   | $ | 807 |   |
| Interest on convertible notes                                                                        |       | 50                                    |       | — |   | — |   |
| Adjusted net income                                                                                  |       | $                                     | 961        |   | $ | 500 |   | $ | 807 |   |
| Denominator:                                                                                         |       |                                  |       |   |   |   |   |
| Weighted-average shares outstanding for basic earnings per share                                     |       | 4,307                                 |       | 4,426 |   | 4,643 |   |
| Effect of dilutive securities:                                                                       |       |                                  |       |   |   |   |   |
| Employee stock options                                                                               |       | 200                                   |       | 192 |   | 330 |   |
| Convertible notes                                                                                    |       | 278                                   |       | — |   | — |   |
| Adjusted weighted-average shares outstanding and assumed conversions  for diluted earnings per share |       | 4,785                                 |       | 4,618 |   | 4,973 |   |

 

F-11

----

 

*Foreign Currency*

 

The functional currency of Spy Optic, S.r.l. and the Company’s Canadiandivision is the local currency, and therefore, gains and losses resulting fromforeign currency translation are accumulated as a separate component ofconsolidated stockholders’ equity as accumulated other comprehensive income(loss). Unrealized gains and losses resulting from foreign currencytransactions are included in foreign currency transaction gain or loss on theconsolidated statements of income. Realized foreign currency transactions gainsand losses resulting from inventory purchases are recorded in cost of sales.All assets and liabilities denominated in foreign currency are translated intoU.S. dollars at the exchange rate on the balance sheet date. Revenues andexpenses are translated at the average exchange rate during the period.

 

*Income Taxes*

 

The Company accounts for income taxes pursuant to the asset andliability method, whereby deferred tax assets and liabilities are computed ateach balance sheet date for temporary differences between the consolidatedfinancial statements and tax basis of assets and liabilities that will resultin taxable or deductible amounts in the future based on enacted laws and ratesapplicable to the periods in which the temporary differences are expected toaffect taxable income. Valuation allowances are established when necessary toreduce deferred tax assets to the amounts expected to be realized. The incometax provision or benefit is the tax payable or refundable amount for the periodplus or minus the change during the period in deferred tax assets andliabilities.

 

*Stock Options*

 

The Company applies Accounting Principles Board (“APB”) OpinionNo. 25, “Accounting for Stock Issued to Employees,” and relatedInterpretations in accounting for its stock options. Under APB No. 25,compensation cost is recognized for stock options granted to employees when theoption price is less than the market price of the underlying common stock onthe date of grant.

 

SFAS No. 123, “Accounting for Stock-Based Compensation,” and SFASNo. 148, “Accounting for Stock-Based Compensation-Transition and disclosure,”require the Company to provide pro forma information regarding net income as ifcompensation cost for the Company’s stock option plans had been determined inaccordance with the fair value based method prescribed in SFAS No. 123. Toprovide the required pro forma information, the Company 

 

F-12

----

 

estimates thefair value of each stock option at the grant date by using the Black-Scholesoption-pricing model. SFAS No. 148 also provides for alternative methodsof transition for a voluntary change to the fair value based method ofaccounting for stock-based employee compensation. The Company has elected tocontinue to account for stock based compensation under APB No. 25. Forstock options granted to employees, the fair value of each option is estimatedon the date of grant using the Black-Scholes option pricing model with thefollowing weighted-average assumptions: risk-free interest rates ranging from3.0% to 4.9%, volatility ranging from 0% to 50% for all periods and an expectedlife of 5 years.

 

If compensation cost for the Company’s stock options had been determinedbased on their fair value at the grant dates consistent with the method of SFASNo. 123, the Company’s net income would have been adjusted to the proforma amounts indicated below:

 

| ** **                           | ** ** | **Years Ended December 31,**** ** | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|
| ** **                           | ** ** | **2002**** **                     | ** ** | **2003**** ** | ** ** | **2004**** ** | ** ** |
| Net income, as reported              |       | $                                      | 911,495    |   | $ | 500,097 |   | $ | 807,304 |   |
| Pro forma stock-based compensation   |       | 25,688                                 |       | 12,400 |   | 2,099,701 |   |
| Pro forma net income (loss)          |       | $                                      | 885,807    |   | $ | 487,697 |   | $ | (1,292,397 | ) |
|                                 |       |                                   |       |   |   |   |   |
| Basic net income (loss) per share:   |       |                                   |       |   |   |   |   |
| As reported                          |       | $                                      | 0.21       |   | $ | 0.11 |   | $ | 0.17 |   |
| Pro forma                            |       | $                                      | 0.21       |   | $ | 0.11 |   | $ | (0.28 | ) |
| Diluted net income (loss) per share: |       |                                   |       |   |   |   |   |
| As reported                          |       | $                                      | 0.19       |   | $ | 0.11 |   | $ | 0.16 |   |
| Pro forma                            |       | $                                      | 0.19       |   | $ | 0.11 |   | $ | (0.28 | ) |

 

The Company applies SFAS No. 123 in valuing options granted toconsultants and estimates the fair value of such options using theBlack-Scholes option-pricing model. The fair value is recorded as consultingexpense as services are provided. Options granted to consultants for whichvesting is contingent based on future performance are measured at their thencurrent fair value at each period end, until vested.  The Company used the following weightedaverage assumptions for consultant options vesting during 2004: risk freeinterest rates ranging from 3.0% to 4.9%, volatility ranging from 0% to 50%,and expected lives ranging from one to five years.

 

*Licenses and Royalties*

 

The Company has one license and several royalty agreements with thirdparties. The license agreement is for the use of the trademark “Spy” for use inJapan and payments are based on a percentage of net sales. The agreementexpires in March 2006 at which time the Company can acquire the trademarkat a price calculated with a pre-established formula based on past royaltiespaid.  Royalty agreements representagreements that the Company has with several athletes to use them in endorsingor advertising several of its products.

 

*Impairment of Long-LivedAssets*

 

Effective January 1, 2002, the Company adopted the provisions ofSFAS No. 144, “*Accounting for theImpairment or Disposal of Long-Lived Assets*.” SFAS No. 144 didnot have a material impact on the Company’s consolidated financial position orresults of operations. In accordance with SFAS No. 144, the Companyestimates the future undiscounted cash flows derived from an asset to assesswhether or not a potential impairment exists when 

 

F-13

----

 

events orcircumstances indicate the carrying value of a long-lived asset may differ. Animpairment loss is recognized when the undiscounted future cash flows are lessthan its carrying amount.

 

*NewAccounting Standards*

 

In November 2004, theFinancial Accounting Standards Board (FASB) issued FASB Statement No. 151, *Inventory Costs – an amendment of ARB No. 43, Chapter4*(FAS 151), which isthe result of its efforts to converge U.S. accounting standards for inventorieswith International Accounting Standards. FAS 151 requires abnormal amounts of idle facility expense,freight, handling costs, and wasted material (spoilage) to be recognized ascurrent-period charges. It also requires that allocation of fixed productionoverheads to the costs of conversion be based on the normal capacity of theproduction facilities**.**FAS 151 will be effective forinventory costs incurred during fiscal years beginning after June 15,2005.  The adoption of FAS 151 is notexpected to have a material effect on our financial position, results ofoperations or cash flows.

 

On December 16, 2004, the FASB issued SFAS No.123R, Share-Based Payment.  SFAS No. 123Rrequires companies to expense the value of employee stock options and similarawards.  The cost of the awards will bemeasured at the fair value on the awards’ grant date, based on the estimatednumber of awards that are expected to vest. Compensation cost for awards that vest would not be reversed if theawards expire without being exercised. When measuring fair value, companies can choose an option-pricing modellike Black-Scholes or binominal models. The effective date for public companies is interim and annual periodsbeginning after June 15, 2005, and applies to all outstanding and unvestedshare based payment awards at a company’s adoption date.  The adoption of SFAS No. 123R for estimatedunvested options at the adoption date is not expected to have a material effecton our consolidated financial statements. The Company’s compensation committee is considering various options inresponse to this new pronouncement.  As aresult, the impact to the Company’s consolidated financial statements forfuture share based payment awards has not been determined.

 

*Reclassifications*

 

Certain amounts in the 2002 financial statements have been reclassifiedto conform with the 2003 and 2004 classifications. These reclassifications haveno effect on reported net income.

 

**2.****            ****Accounts Receivable**

 

Accounts receivable consisted of the following:

 

| ** **                           | ** ** | **December 31,**** ** | ** ** |
|--------------------------------------|------------|----------------------------|------------|
| ** **                           | ** ** | **2003**                   | ** ** | **2004**** ** | ** ** |
| Trade receivables                    |       | $                          | 7,892,765  |   | $ | 10,002,777 |   |
| Less allowance for doubtful accounts |       | (498,711                   | )          | (567,541 | ) |
| Less allowance for returns           |       | (758,777                   | )          | (1,190,326 | ) |
|                                 |       |                       |       |   |   |
|                                 |       | $                          | 6,635,277  |   | $ | 8,244,910 |   |

** **

**3.****            ****Inventories**

 

Inventories consisted of the following:

 

| ** **     | ** ** | **December 31,**** ** | ** ** |
|----------------|------------|----------------------------|------------|
| ** **     | ** ** | **2003**                   | ** ** | **2004**** ** | ** ** |
| Raw materials  |       | $                          | 1,161,156  |   | $ | 455,029 |   |
| Finished goods |       | 5,508,151                  |       | 11,359,817 |   |
|           |       |                       |       |   |   |
|           |       | $                          | 6,669,307  |   | $ | 11,814,846 |   |

 

The Company’s inventory balances are net of an allowance forobsolescence of approximately $705,000 and $1,109,000 at December 31, 2003and 2004, respectively.

 

F-14

----

 

**4.****            ****Property and Equipment**

 

Property and equipment consisted of the following:

 

| ** **                                     | ** ** | **December 31,**** ** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|
| ** **                                     | ** ** | **2003**                   | ** ** | **2004** | ** ** |
| Displays                                       |       | $                          | 3,220,320  |   | $ | 4,348,440 |   |
| Molds and tooling                              |       | 1,122,662                  |       | 1,317,409 |   |
| Computer equipment                             |       | 636,982                    |       | 719,379 |   |
| Vehicles                                       |       | 571,313                    |       | 645,387 |   |
| Furniture and fixtures                         |       | 242,907                    |       | 344,182 |   |
| Leasehold improvements                         |       | 222,197                    |       | 283,019 |   |
|                                           |       | 6,016,381                  |       | 7,657,816 |   |
| Less accumulated depreciation and amortization |       | (2,122,943                 | )          | (3,969,909 | ) |
|                                           |       | $                          | 3,893,438  |   | $ | 3,687,907 |   |

 

Depreciation and amortization expense was approximately $1,048,000,$1,482,000, and $1,868,000 for the years ended December 31, 2002, 2003 and2004, respectively.

 

**5.****            ****Accrued Expenses**

 

Accrued expenses consisted of the following:

 
| ** **                              | ** ** | **December 31,** | ** ** |
|-----------------------------------------|------------|------------------|------------|
| ** **                              | ** ** | **2003**         | ** ** | **2004** | ** ** |
| Production and warehouse                |       | $                | 87,676     |   | $ | 723,113 |   |
| Commissions                             |       | 266,225          |       | 361,735 |   |
| Professional fees                       |       | 148,242          |       | 398,134 |   |
| Compensation and benefits               |       | 396,878          |       | 381,674 |   |
| Sales and marketing                     |       | 71,216           |       | 185,467 |   |
| Unrealized foreign currency adjustments |       | 179,354          |       | 149,843 |   |
| Other                                   |       | 124,976          |       | 92,210 |   |
| Customer deposit                        |       | —           |       | 91,547 |   |
| Rent                                    |       | 74,257           |       | 31,053 |   |
| Sales tax                               |       | 20,996           |       | 17,052 |   |
| Interest                                |       | —           |       | 1,543 |   |
|                                    |       |             |       |   |   |
|                                    |       | $                | 1,369,820  |   | $ | 2,433,371 |   |

** **

**6.****            ****Lines of Credit**

 

Lines of credit consisted of the following:

 
| ** **                                                                                                                                                                                                                                                   | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                                                                                                                                                                                                                   | ** ** | **2003**         | ** ** | **2004** | ** ** |
| Line of credit with a bank; interest at prime plus 1% (5% at  December 31, 2003); secured by all of the assets of the Company excluding  intellectual property rights; interest is paid monthly and the principal  matures on June 5, 2005              |       | $                | 6,000,000  |   | $ | — |   |
| Line of credit with a bank; interest at prime plus 2% (6% at  December 31, 2003); secured by all of the assets of the Company  excluding intellectual property rights; interest is paid monthly;  consolidated with other line of credit in August 2004 |       | 1,000,000        |       | — |   |
| Line of credit with a bank; interest at prime plus 5% (9% at December  31, 2003); secured by all of the assets of the Company excluding intellectual  property rights; interest is paid monthly and the principal matured on June  30, 2004                  |       | 75,000           |       | — |   |
|                                                                                                                                                                                                                                                         |       | $                | 7,075,000  |   | $ | — |   |

 

F-15

----

 

On December 2, 2004, the Company received from the bank a line of creditincrease of $1 million.  The lineincrease had an interest rate of prime plus 5%, matured September 30, 2005, andif not paid by maturity, the bank would receive warrants equal to 1.5% of theCompany’s fully diluted capital stock of the Company.  The line of credit increase along with allother advances on bank lines of credit were repaid in December from proceedsfrom the Company’s initial public offering. At December 31, 2003 and 2004 the Company had unused lines of credit of$925,000 and $8 million, respectively.

 

The financial agreements contain certainfinancial and non-financial covenants. At December 31, 2004, managementbelieves the Company was not in violation of any financial covenants.

 

The Company also has available letter of credit accommodations, with anypayments made by the financial institution to any issuer thereof and/or relatedparties in connection with the letter of credit accommodations to constituteadditional revolving loans to the Company and the amount of all outstandingletter of credit accommodations not to exceed $2.0 million. There were nooutstanding letters of credit at December 31, 2003 and 2004, respectively.

 

**7.****            ****Notes Payable**

 

Notes payable consisted of the following:

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **2003**         | ** ** | **2004**** ** | ** ** |
| Various secured convertible notes payable to stockholders and private  parties; bearing interest at 6% to 12% per annum; subordinated to all claims  of the bank; convertible into shares of common stock at option of holder at  conversion prices ranging from $2.98 to $4.80 per share; secured by all of  the assets of the Company excluding intellectual property rights; interest is  paid monthly or quarterly; principal matures at various dates in 2004; one  note is callable upon 30 days’ notice or completion of the Company’s initial  public offering |       | $                | 445,000    |   | $ | — |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |       |             |       |   |   |   |   |
| Note payable to bank; interest at prime plus 1% (6.25% at  December 31, 2004); secured by all of the assets of the Company  excluding intellectual property rights; principal of approximately $10,000  plus interest is due monthly over a four-year period through March 21, 2007                                                                                                                                                                                                                                                                                         |       | 406,250          |       | 291,667 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |       |             |       |   |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |       | 851,250          |       | 291,667 |   |
| Less current portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |       | (570,000         | )          | (125,000 | ) |
| Long-term portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |       | $                | 281,250    |   | $ | 166,667 |   |

 

F-16

----

 

Future annual maturities of notes payableare as follows: 

 

| Year Ending December 31, |   |    |    |
|--------------------------|--------|---------|---------|
| 2005                     |   | $       | 125,000 |   |
| 2006                     |   | 125,000 |    |
| 2007                     |   | 41,667  |    |
| Total                    |   | $       | 291,667 |   |

** **

**8.****            ****Common Stock**

 

In December 2004, the Company sold 2,480,000 shares ofcommon stock in an initial public offering. The net offering proceeds after deducting expenses and costs of theoffering were approximately $18.9 million.

 

As part of the offering, the Company's underwritersreceived 147,000 warrants for common stock at an exercise price of $10.50.  The warrants vest in December 2005 and expirein December 2009.

 

During 2004, 34,374 shares of common stock weredistributed to individuals as a result of the conversion of $165,000 in notespayable.

 

In August and September 2004, options with respect to184,375 shares of common stock, held by seven individuals, were exercised atprices between $1.60 and $3.20 per share, resulting in the issuance and sale of184,375 shares of common stock, for aggregate proceeds of $360,000.

 

During May andJune 2004, the Company sold an aggregate of 358,438 shares of common stockfor total net proceeds of approximately $1,705,500.

 

During 2003, the Company issued 4,688 shares of common stock at $4.80per share to a private investor. In addition, stock options for 12,500 shares wereexercised at $1.60 per share. The Company also repurchased 6,100 shares ofcommon stock from an investor at $4.00 per share.

 

During 2002, the Company issued 79,688 shares of common stock at $3.20per share, and issued 10,062 shares of common stock at $4.80 per share toprivate investors, and converted rights to receive 28,125 shares of commonstock into such number of shares of common stock at $3.20 per share. Inaddition, the Company issued 103,276 shares of common stock to privateinvestors and current stockholders for the conversion of outstanding notespayable and other accrued payables in the amount of $310,548.

 

**9.****            ****Stock Options**

 

In December 2004, the Board of Directors of the Company adopted, and thestockholders of the Company approved, the 2004 Stock Incentive Plan.  The plan provides for the grant of incentivestock options to employees only, and restricted stock, stock units,nonstatutory options or SARS to employees, consultants, and outsidedirectors.  The plan is administered bythe Compensation Committee.  The Committeedetermines the vesting period, exercise price, and other details for eachaward.

 

Prior to the adoption of the 2004 Stock Incentive Plan, the Company hadperiodically granted nonqualified common stock options to certain employees andofficers of the Company. These stock options generally vest ratably over afive-year period and expire ratably five years after each vesting date.Generally, the exercise price of all stock 

 

F-17

----

 

optionsgranted equaled the fair value of the common stock on the date of grant, whichresulted in no compensation expense when the stock options are issued.

 

In August 2003, stock options exercisable for a total of 69,375shares of common stock were issued to replace stock options expiring at thattime. The replacement options were issued at the original exercise prices whichwere below the Company’s current stock price as determined by the Board of Directors.As a result, the Company was to record total compensation expense of $170,000over the five year vesting period. A total of $11,000 in stock compensationexpense was recorded for the year ended December 31, 2003.  The replacement options had a provision inthat upon an initial public offering, all options that had not vested wouldbecome fully vested effective upon the offering.  As a result, the remaining compensationexpense related to the replacement options of approximately $159,000 wasrecorded for the year ended December 31, 2004.

 

In August and September 2004, stock options exercisable for 184,375 sharesof common stock were exercised for total proceeds of $360,000.

 

On December 13, 2004, stock options exercisable for a total of 500,000 sharesof common stock were granted to certain employees, officers, and Directorsunder the 2004 Stock Incentive Plan.  Thestock options were fully vested upon grant and expire in 10 years.  The per share exercise price of the stockoptions was $8.75 which equaled the fair value of the common stock on the dateof grant.  As a result there was nocompensation expense upon issuance of the stock options.

 

During 2004, the Company incurred compensation expense related tocertain stock options issued to a non-employee as a result of the Company’sinitial public offering and due to a change in certain options issued to anemployee that had separated from the Company. The total compensation expense that was recorded for the year endedDecember 31, 2004 related to these stock options was approximately $45,000.

 

A summary of stock option activity is as follows: 

 

| ** **                                     | ** ** | **Number of shares**** ** | ** ** | **Weighted average  exercise price**** ** | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|------------------------------------------------|------------|
| ** **                                     | ** ** | ** **                     | ** ** | ** **                                     | ** ** |
| Options outstanding at December 31, 2001       |       | 318,409                        |       | $                                              | 2.24       |   |
| Granted (weighted-average fair value of $0.64) |       | 117,187                        |       | $                                              | 3.20       |   |
| Exercised                                      |       | (7,812                         | )          | $                                              | 3.20       |   |
| Options outstanding at December 31, 2002       |       | 427,784                        |       | $                                              | 2.40       |   |
| Granted (weighted-average fair value of $1.60) |       | 159,375                        |       | $                                              | 3.68       |   |
| Exercised                                      |       | (12,500                        | )          | $                                              | 1.60       |   |
| Forfeited                                      |       | (68,750                        | )          | $                                              | 2.40       |   |
| Options outstanding at December 31, 2003       |       | 505,909                        |       | $                                              | 3.04       |   |
| Granted (weighted-average fair value of $3.40) |       | 568,437                        |       | $                                              | 8.27       |   |
| Exercised                                      |       | (184,375                       | )          | $                                              | 1.95       |   |
| Options outstanding at December 31, 2004       |       | 889,971                        |       | $                                              | 6.58       |   |

 

The following table summarizes information about stock optionsoutstanding:

 

As of December 31, 2004:

 

 

F-18

----

 
| ** **                                    | ** ** | **Options Outstanding**           | ** ** | ** **                                                            | ** **                        | ** **                                        | ** **                                       |
|-----------------------------------------------|------------|-----------------------------------|------------|-----------------------------------------------------------------------|-----------------------------------|---------------------------------------------------|--------------------------------------------------|
| ** **                                    | ** ** | **Number  Outstanding**** ** | ** ** | **Weighted- Average  Remaining  Contractual  Life (Years)**** ** | ** **                        | **Weighted-  Average  Exercise  Price**** ** | ** **                                       | **Options Exercisable** | ** ** |
| **Range  of Exercise  Prices**** ** | ** ** | ** **                        | ** ** | ** **                                                            | **Number  Outstanding**** ** | ** **                                        | **Weighted  Average  Exercise  Price**** ** | ** ** |
| $                                             | 1.60       |                              | 46,875     |                                                                  | 5.33                              |                                              | $                                                | 1.60 |   | 46,875 |   | $ | 1.60 |   |
| $                                             | 3.20       |                              | 152,784    |                                                                  | 3.22                              |                                              | $                                                | 3.20 |   | 152,784 |   | $ | 3.20 |   |
| $                                             | 4.80       |                              | 190,312    |                                                                  | 3.96                              |                                              | $                                                | 4.80 |   | 104,062 |   | $ | 4.80 |   |
| $                                             | 8.75       |                              | 500,000    |                                                                  | 10.00                             |                                              | $                                                | 8.75 |   | 500,000 |   | $ | 8.75 |   |
|                                          |       | 889,971                           |       | 7.30                                                                  |                              | $                                                 | 6.58                                             |   | 803,721 |   | $ | 6.77 |   |

 

**10.          IncomeTaxes**

 

Income tax expense (benefit) attributed to income from operationsconsists of:

 
| ** **           | ** ** | **Year Ended December 31,**** ** | ** ** |
|----------------------|------------|--------------------------------------------|------------|
| ** **           | ** ** | **2002**                                   | ** ** | **2003** | ** ** | **2004** | ** ** |
| Current              |       |                                       |       |   |   |   |   |
| Federal              |       | $                                          | —     |   | $ | 19,000 |   | $ | 628,570 |   |
| State                |       | 76,000                                     |       | 149,000 |   | 193,000 |   |
| Foreign              |       | 413,000                                    |       | 149,000 |   | 165,000 |   |
| Total                |       | 489,000                                    |       | 317,000 |   | 986,570 |   |
|                 |       |                                       |       |   |   |   |   |
| Deferred             |       |                                       |       |   |   |   |   |
| Federal              |       | 185,000                                    |       | 414,000 |   | 9,000 |   |
| State                |       | (7,000                                     | )          | (42,000 | ) | (62,000 | ) |
| Foreign              |       | —                                     |       | — |   |   |   |
| Total                |       | 178,000                                    |       | 372,000 |   | (53,000 | ) |
| Income tax provision |       | $                                          | 667,000    |   | $ | 689,000 |   | $ | 933,570 |   |

 

The components that comprise deferred tax assets and liabilities atDecember 31, 2003 and 2004 are as follows: 

 
| ** **                                        | ** ** | **2003**** ** | ** ** | **2004**** ** | ** ** |
|---------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| Deferred tax assets:                              |       |               |       |               |       |
| NOL carryforwards                                 |       | $                  | 446,000    |               | $          | — |   |
| Allowance for doubtful accounts                   |       | 144,000            |       | 155,000            |       |
| Compensation and vacation accrual                 |       | 70,000             |       | 73,000             |       |
| Unearned advertising revenue                      |       | —             |       | 1,000              |       |
| Reserve for returns and allowances                |       | 241,000            |       | 382,000            |       |
| Unrealized foreign currency loss                  |       | 29,000             |       | 158,000            |       |
| Inventory reserve                                 |       | 225,000            |       | 237,000            |       |
| Net foreign deferred tax asset                    |       | 95,000             |       | 378,000            |       |
| Non-cash compensation                             |       | —             |       | 85,000             |       |
| Benefit of state tax items                        |       | —             |       | 69,000             |       |
| Tax credits                                       |       | 28,000             |       | 4,000              |       |
| Gross deferred tax assets                         |       | 1,278,000          |       | 1,542,000          |       |
| Deferred tax liabilities:                         |       |               |       |               |       |
| Depreciation and amortization                     |       | (226,000           | )          | (233,000           | )          |
| Benefit of state tax items                        |       | (79,000            | )          | —             |       |
| Net deferred tax asset before valuation allowance |       | 973,000            |       | 1,309,000          |       |
| Valuation allowance                               |       | (95,000            | )          | (378,000           | )          |
| Net deferred tax asset                            |       | $                  | 878,000    |               | $          | 931,000 |   |

 

F-19

----

 

The reconciliation of computed “expected” income taxes to effectiveincome tax expense by applying the federal statutory rate of 34% is as follows:

 
| ** **                                | ** ** | **2002**** ** | ** ** | **2003**** ** | ** ** | **2004**** ** | ** ** |
|-------------------------------------------|------------|--------------------|------------|--------------------|------------|--------------------|------------|
| Computed “expected” tax expense |       | $                  | 537,000    |               | $          | 404,000            |       | $ | 592,000 |   |
| State taxes, net of federal benefit       |       | 46,000             |       | 69,000             |       | 102,000            |       |
| Foreign tax expense                       |       | 413,000            |       | 149,000            |       | 164,000            |       |
| Foreign subsidiary (income) loss          |       | (337,000           | )          | 4,000              |       | 106,000            |       |
|                                      |       |               |       |               |       |               |       |
| Foreign permanent differences             |       | —             |       | 33,000             |       | —             |       |
| Meals and entertainment                   |       | 9,000              |       | 8,000              |       | 16,000             |       |
| Other, net                                |       | (1,000             | )          | 22,000             |       | (46,430            | )          |
|                                      |       | $                  | 667,000    |               | $          | 689,000            |       | $ | 933,570 |   |

 

The change in the valuation allowance for the years endedDecember 31, 2002, 2003 and 2004 was an increase of $216,653, a decreaseof $180,000 and an increase of $283,000, respectively. In assessing therealization of deferred tax assets, management considers whether it is morelikely than not that some portion or all of the deferred tax assets will not berealized. The ultimate realization of deferred tax assets is dependent upon thegeneration of future taxable income during the periods in which those temporarydifferences become deductible. Management considers the scheduled reversal ofdeferred tax liabilities, projected future taxable income, and tax planningstrategies in making this assessment. Based on the level of historicaloperating results and projections for the taxable income for the future,management has determined that it is more likely than not that the deferred taxassets, net of the valuation allowance, will be realized. Accordingly, theCompany has recorded no valuation allowance for its U.S. operations atDecember 31, 2003. The Company has recorded a $95,000 and $378,000valuation allowance for its wholly owned subsidiary, Spy Optic, S.r.l. atDecember 31, 2003 and 2004, respectively. At December 31, 2004, theCompany had no remaining net operating loss carryforwards for federal or stateincome tax purposes.

** **

**11.          EmployeeBenefit Plans**

 

In 1998, the Company adopted the Spy Optic 401(k) Plan (the “Plan”). ThePlan covers all employees who meet the eligibility requirements of a minimum of270 hours of service and 18 years of age. The Plan is subject to theprovisions of the Employee Retirement Income Security Act of 1974. Under theprovisions of the Plan, eligible participants may contribute up to 15% of theirannual compensation, not to exceed the maximum legal deferral. The Company isnot required to contribute to the Plan and made no contributions to the Planduring the years ended December 31, 2002, 2003 and 2004.

 

F-20

----

 

**12.          RelatedParty Transactions**

* *

*Vendor Purchases*

 

The Company purchases point-of-purchase displays and other materialsfrom a business controlled or owned by a stockholder. The total amountspurchased in 2002, 2003 and 2004 were approximately $980,000, $861,000, and $952,000,respectively.

* *

*Customer Sales*

 

No Fear, Inc., a stockholder, owns retail stores that purchase productsfrom the Company. Aggregated sales to these stores during 2002, 2003, and 2004were approximately $447,000, $660,000, and $927,000, respectively. Accountsreceivable due from these stores amounted to $845,000 and $243,000 atDecember 31, 2003 and 2004, respectively. At December 31, 2003, thereceivable was included in “Due from related party” balance.  At December 31, 2004, the receivable isincluded in accounts receivable.  In July2004, the Company converted the entire balance of amounts due from No Fear,Inc. along with a $400,000 loan into an interest bearing note receivable ofapproximately $1,605,000.  The note had amaturity date of December 31, 2005, and was personally guaranteed by three of theCompany’s stockholders, one of which is one of the Company’s directors.  As part of the Company’s initial publicoffering, No Fear sold shares in the Company and used the proceeds to repay thenote plus accrued interest.  The noteplus accrued interest was repaid upon the close of our initial public offering.

 

Stockholders of the Company, other than No Fear, own retail stores anddistribution companies that purchase products from the Company. Aggregated salesto these stores during the year ended December 31, 2002, 2003 and 2004 wereapproximately $305,000, $487,000, and $910,000, respectively. Accountsreceivable due from these entities amounted to approximately $318,000 and $423,000at December 31, 2003 and 2004, respectively.

* *

*Royalty Agreement*

 

The Company has a royalty agreement with an athlete who is also astockholder. The total royalty expense for this athlete amounted to $124,000,$161,000 and $159,000 in the years ended December 31, 2002, 2003 and 2004,respectively.

* *

*Loan*

 

During May and June 2004, the Company loaned $400,000 to No Fear,which was recorded as “Due from related party.” Effective July 1, 2004,the Company converted the entire balance of the loan into a promissory notethat was personally guaranteed by three of the Company’s stockholders, one ofwhich is one of the Company’s directors. The note was paid in full on December14, 2004. See a description of the note under “Customer Sales” above.

* *

*Contract Services*

 

During the year ended December 31, 2002, the Company incurredapproximately $103,000 in sales commission expense for an independentcontractor that is also a stockholder of the Company. There was no expense forthe years ended December 31, 2003 and 2004.

 

The Company has purchased T-shirts and hats from No Fear. Totalpurchases amounted to approximately $233,000 in 2002. There were no purchases forthe years ended December 31, 2003 and 2004.

 

In August 2004, the Company began operating No Fear’s web site on itsbehalf.  In December 2004, the Companysigned an agreement with No Fear to development and maintain their web site.  Products sold on the site include No Fear andSpy Optic branded products.  Under theagreement, the Company will be responsible for products purchased from No Fearto fulfill orders including shipping and insurance costs, and all web sitedevelopment, hosting, and maintenance costs. The Company must also pay No Fear a royalty of 5% on net sales.  For the year ended December 31, 2004, theCompany purchased approximately $28,000 of products from No Fear to fulfill website orders.  At December 31, 2004, theloss on this agreement was approximately $32,000 excluding other accounting andadministrative costs incurred by the Company in managing the website.

 

In January 2004, the Company and No Fear signed an agreement with CrownAthlete Management Group, Inc. (“Crown”) to provide athlete managementservices. As part of the agreement, the Company and No Fear each purchased a26% interest in Crown. In addition, the Company and No Fear each agreed to loanCrown $125,000 to be advanced in increments of $7,500 per month ($15,000total), until the aggregate loan equaled $250,000. The loan was non-interestbearing up to the note’s maturity date of December 31, 2006 but was convertibleinto equity of Crown at a

 

F-21

----

 

10% discount. In August 2004, the Companyand No Fear executed a buy-out agreement with Crown. As part of the agreement,the Company assigned its rights to receive payment of amounts previously loanedof $67,500 to No Fear plus a gain on the transaction of approximately $20,000.In addition the Company loaned No Fear $10,500 which represented the firstinstallment on the remaining debt outstanding that No Fear had with Crown.Separately, No Fear signed a note receivable for the rights assigned of$87,500, plus the amount loaned of $10,500, totaling $98,000. The interest rateon the note was at prime plus 2%.  The noteplus accrued interest was repaid upon the close of our initial public offering.

** **

**13.          Commitments and Contingencies**

* *

*Operating Leases*

 

The Company leases its principal administrative and distributionfacilities under an operating lease that expires in May 2005. The Company hasentered an agreement to extend the lease through December 31, 2005, with anoption to extend for one year beyond that period.  The lease provides for periodic rentadjustments. The Company also leases an administrative and distributionfacility in Italy under an agreement that expires in September 2009, butmay be terminated by the Company prior to such time with six-months notice.Rent expense was approximately $200,000, $239,000 and $267,000 for the yearsended December 31, 2002, 2003 and 2004, respectively.

 

Future minimum rental payments required under operating leases that haveinitial or remaining non-cancelable lease terms in excess of one year are asfollows: 

 
| **Year  Ending December 31,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
| 2005                               |       | $          | 291,872    |   |
| 2006                               |       | 45,933     |       |
| 2007                               |       | 35,727     |       |
| 2008                               |       | 15,012     |       |
| 2009                               |       | 11,259     |       |
| Total                              |       | $          | 399,803    |   |

* *

*Capital Leases*

 

Future minimum lease payments under capital leases are as follows: 

 
| **Year  Ending December 31,**      | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|
| 2005                                    |       | $          | 44,264     |   |
| 2006                                    |       | 22,187     |       |
| 2007                                    |       | 13,801     |       |
| 2008                                    |       | 2,029      |       |
| Total minimum lease payments            |       | 82,281     |       |
| Amount representing interest            |       | (13,542    | )          |
| Present value of minimum lease payments |       | 68,739     |       |
| Less current portion                    |       | (37,370    | )          |
| Long-term portion                       |       | $          | 31,369     |   |

 

The cost of equipment under capital lease obligations totaledapproximately $175,000 and $142,000 at December 31, 2003 and 2004,respectively. Amortization of assets held under capital leases is included indepreciation expense.

 

*Athlete EndorsementContracts*

 

The Company has entered into endorsement contracts with athletes toactively wear and endorse the Company’s products. These contracts are based onminimum annual payments and may include additional performance-based incentivesand/or product-specific sales incentives.

 

F-22

----

 

The minimum annual contracted payments are as follows: 

 
| **Year  Ending December 31,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
| 2005                               |       | $          | 452,337    |   |
| 2006                               |       | 248,300    |       |
| 2007                               |       | 110,254    |       |
| 2008                               |       | 85,000     |       |
| 2009                               |       | 85,000     |       |
| Thereafter                         |       | 255,000    |       |
|                               |       | $          | 1,235,891  |   |

* *

*Litigation*

 

From time to time, the Company may be party to lawsuits in the ordinarycourse of business.  Some of these claimsmay lead to litigation.

 

On March 7, 2005, Oakley, Inc, a major competitor ofthe Company, filed a lawsuit alleging patent, trade dress and trademarkinfringement, unfair competition, and false designation of origin.  The lawsuit specifically identifies three ofthe Company’s product styles which accounted for less than 4% of the Company’stotal sales for 2004.  While the Companybelieves that the lawsuit is without merit and that the ultimate outcome ofthis proceeding will not have a material adverse effect on the Company’sconsolidated balance sheet and statements of income and cash flows, litigationis subject to inherent uncertainties. The Company will seek coverage under its insurance policies with respectto these claims, although there can be no guarantee as to the extent that suchcoverage will be available, if at all.  TheCompany presently has no estimate of any potential loss or range of loss withrespect to the lawsuit or any estimate as to the potential costs of defendingagainst the lawsuit.

 

The Company, its directors and certain of its officers have recentlybeen named as defendants in a stockholder class action lawsuit filed in theUnited States District Court for the Southern District of California. Thecomplaint purports to seek unspecified damages on behalf of an alleged class ofpersons who purchased the Company's common stock pursuant to the registrationstatement filed in connection with the Company's public offering of stock onDecember 14, 2004.  The complaint allegesthat the Company and its officers and directors violated federal securitieslaws by failing to disclose material information about the status of ourEuropean operations and whether certain of the Company's products infringe onthe intellectual property rights of Oakley, Inc. in that registrationstatement.  The Company has not yetformally responded to this action and no discovery has been conducted. However,based on the facts presently known, management believes it has meritoriousdefenses to this action and intends to vigorously defend the action.  Based on the Company's insurance coverages, itscosts related to this action could range from $0 to $250,000.

** **

**14.          Concentrations**

* *

*Credit Risk*

 

Financial instruments that potentially subject the Company toconcentrations of credit risk consist principally of cash and accountsreceivable. The Company grants unsecured credit to substantially all of itscustomers. Management does not believe that it is exposed to any extraordinarycredit risk as a result of this policy.

 

The Company maintains cash balances at various financial institutionsprimarily located in San Diego and in Italy. Accounts at the U.S. institutionsare secured by the Federal Deposit Insurance Corporation up to $100,000. As of December31, 2004, the Company had approximately $11.1 million of uninsured cash basedon actual U.S. bank balances. The Company has not experienced any losses insuch accounts. Management believes that the Company is not exposed to anysignificant credit risk with respect to its cash and cash equivalents.

* *

*Customer*

 

For the year ended December 31, 2002, one customer individuallyaccounted for 10% of total net sales. For the years ended December 31,2003 and 2004, the Company had no customers that comprised 7% or more of totalnet sales.

 

F-23

----

 

*Supplier*

 

The Company relies primarily on a single source for the supply of itseyewear products. Total purchases from this supplier amounted to approximately$5,528,000, $9,099,000 and $11,989,000 for the years ended December 31,2002, 2003 and 2004, respectively, and represented approximately 89%, 78% and 64%,respectively, of the total eyewear related purchases. Accounts payable due tothis vendor totaled $699,000 and $289,000 at December 31, 2003 and 2004,respectively. To mitigate the impact of a potential loss of this source ofsupply, the Company has identified and has been transitioning a portion of itseyewear product requirements to an alternate supplier, which represents asubstantial portion of the Company’s remaining eyewear purchases for the yearsended December 31, 2002, 2003 and 2004. Accounts payable due to thisalternate supplier totaled $312,000 and $343,000 at December 31, 2003 and2004, respectively.  In addition, in2004, the Company purchased a substantial portion of its goggle products froman alternate supplier.  Accounts payabledue to this alternate supplier at December 31, 2004 totaled $502,000.

** **

**15.          Geographic Information**

 

The Company operated principally in two geographic areas, the UnitedStates and Italy, during the years ended December 31, 2002, 2003 and 2004.Net sales are attributed to countries based on shipping point, and thereforethe U.S. column includes U.S. sales to foreign customers. There were nosignificant transfers between geographic areas during the period.

 
| ** **          | ** ** | **2002**** **                            | ** ** |
|---------------------|------------|-----------------------------------------------|------------|
| ** **          | ** ** | **U.S.  (includes US  and Canada)**** ** | ** ** | **Foreign** | ** ** | **Consolidated** | ** ** |
| ** **          | ** ** | **(in thousands)**                            | ** ** |
|                |       |                                          |       |   |   |   |   |
| Net sales           |       | $                                             | 18,493     |   | $ | 3,801 |   | $ | 22,294 |   |
| Operating income    |       | 377                                           |       | 1,238 |   | 1,615 |   |
| Net income          |       | 333                                           |       | 578 |   | 911 |   |
| Identifiable assets |       | 14,577                                        |       | 2,996 |   | 17,573 |   |
|                     |            |                                               |            |  |  |  |  |  |  |  |

 
| ** **          | ** ** | **2003**** ** | ** ** |
|---------------------|------------|--------------------|------------|
| ** **          | ** ** | **U.S.**           | ** ** | **Foreign** | ** ** | **Consolidated** | ** ** |
| ** **          | ** ** | **(in thousands)** | ** ** |
|                | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales           |       | $                  | 22,904     |   | $ | 4,500 |   | $ | 27,404 |   |
| Operating income    |       | 1,274              |       | 59 |   | 1,333 |   |
| Net income (loss)   |       | 662                |       | (162 | ) | 500 |   |
| Identifiable assets |       | 17,404             |       | 3,637 |   | 21,041 |   |
|                     |            |                    |            |  |  |  |  |  |  |  |

 
| ** **              | ** ** | **2004**** ** | ** ** |
|-------------------------|------------|--------------------|------------|
| ** **              | ** ** | **U.S.**           | ** ** | **Foreign** | ** ** | **Consolidated** | ** ** |
| ** **              | ** ** | **(in thousands)** | ** ** |
|                    | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales               |       | $                  | 28,262     |   | $ | 5,301 |   | $ | 33,563 |   |
| Operating income (loss) |       | 2,354              |       | (778 | ) | 1,576 |   |
| Net income (loss)       |       | 1,238              |       | (431 | ) | 807 |   |
| Identifiable assets     |       | 32,650             |       | 4,874 |   | 37,524 |   |
|                         |            |                    |            |  |  |  |  |  |  |  |

 

F-24

----

 

**16.          Quarterly Financial Data (unaudited)**

 
| ** **                                       | ** ** | **First  Quarter**                        | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| ** **                                       | ** ** | **(in thousands, except per share data)** | ** ** |
| Year ended  December 31, 2004:              |       |                                      |       |                |       |               |       |                |       |
| Net sales                                        |       | $                                         | 6,403      |                | $          | 7,648              |       | $                   | 9,977      |   | $ | 9,535 |   |
| Gross profit                                     |       | 3,239                                     |       | 4,501               |       | 5,358              |       | 4,935               |       |
| Income (loss)  before provision for income taxes |       | (315                                      | )          | 133                 |       | 1,029              |       | 894                 |       |
| Net income  (loss)                               |       | (194                                      | )          | (238                | )          | 517                |       | 722                 |       |
| Basic net income  (loss) per share               |       | $                                         | (0.04      | )                   | $          | (0.05              | )          | $                   | 0.11       |   | $ | 0.13 |   |
| Diluted net  income (loss) per share             |       | $                                         | (0.04      | )                   | $          | (0.05              | )          | $                   | 0.10       |   | $ | 0.13 |   |
|                                             |       |                                      |       |                |       |               |       |                |       |
| Year ended  December 31, 2003:              |       |                                      |       |                |       |               |       |                |       |
| Net sales                                        |       | $                                         | 4,905      |                | $          | 5,909              |       | $                   | 8,938      |   | $ | 7,652 |   |
| Gross profit                                     |       | 2,466                                     |       | 3,740               |       | 4,408              |       | 3,604               |       |
| Income (loss)  before provision for income taxes |       | (504                                      | )          | 619                 |       | 726                |       | 348                 |       |
| Net income  (loss)                               |       | (289                                      | )          | 213                 |       | 686                |       | (110                | )          |
| Basic net income  (loss) per share               |       | $                                         | (0.07      | )                   | $          | 0.05               |       | $                   | 0.15       |   | $ | (0.02 | ) |
| Diluted net  income (loss) per share             |       | $                                         | (0.07      | )                   | $          | 0.05               |       | $                   | 0.15       |   | $ | (0.02 | ) |

 

**17.          Subsequent Event**

 

In January 2005, the Company sold 520,000 shares of common stock to ourunderwriters to cover their over-allotments as a result of our initial publicoffering.  The total net proceeds afteroffering costs of $353,000 and expenses of $16,000 amounted to approximately$4.2 million.

 

See Note 13 — Litigation.

 

**Orange 21and Subsidiaries**

 

**ScheduleII—Valuation and Qualifying Accounts**

**Forthe Years Ended December 31, 2002, 2003, and 2004**

 
| ** **                       | ** ** | **Balance at  Beginning  of Year** | ** ** | **Charges to  Expense/Against  Revenue** | ** ** | **Write-Offs,  Disposal, costs  and other** | ** ** | **Balance at  End of Year** | ** ** |
|----------------------------------|------------|------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|-----------------------------|------------|
| ** **                       | ** ** | ** **                         | ** ** | ** **                               | ** ** | ** **                                  | ** ** | ** **                  | ** ** |
| Allowance for  doubtful accounts |       |                               |       |                                     |       |                                        |       |                        |       |
| Year ended  December 31, 2002    |       | $                                  | 281,986    |                                     | $          | 350,978                                     |       | $                           | (312,702   | ) | $ | 320,262 |   |
| Year ended  December 31, 2003    |       | $                                  | 320,262    |                                     | $          | 349,111                                     |       | $                           | (170,662   | ) | $ | 498,711 |   |
| Year ended  December 31, 2004    |       | $                                  | 498,711    |                                     | $          | 300,470                                     |       | $                           | (231,640   | ) | $ | 567,541 |   |
|                             |       |                               |       |                                     |       |                                        |       |                        |       |
| Allowance for  sales returns     |       |                               |       |                                     |       |                                        |       |                        |       |
| Year ended  December 31, 2002    |       | $                                  | 313,051    |                                     | $          | 2,440,701                                   |       | $                           | (2,228,232 | ) | $ | 525,520 |   |
| Year ended  December 31, 2003    |       | $                                  | 525,520    |                                     | $          | 2,857,797                                   |       | $                           | (2,624,540 | ) | $ | 758,777 |   |
| Year ended  December 31, 2004    |       | $                                  | 758,777    |                                     | $          | 3,524,132                                   |       | $                           | (3,092,583 | ) | $ | 1,190,326 |   |
|                             |       |                               |       |                                     |       |                                        |       |                        |       |
| Allowance for  inventory reserve |       |                               |       |                                     |       |                                        |       |                        |       |
| Year ended  December 31, 2002    |       | $                                  | 317,274    |                                     | $          | 593,171                                     |       | $                           | (445,053   | ) | $ | 465,392 |   |
| Year ended  December 31, 2003    |       | $                                  | 465,392    |                                     | $          | 615,091                                     |       | $                           | (375,471   | ) | $ | 705,012 |   |
| Year ended  December 31, 2004    |       | $                                  | 705,012    |                                     | $          | 973,029                                     |       | $                           | (569,504   | ) | $ | 1,108,537 |   |

 

Note:                   Additions tothe allowance for doubtful accounts are charged to bad debt expense. Additionsto the allowance for sales returns are charged against revenues. Additions tothe allowance for inventory reserve is charged against cost of goods sold.

 

All other schedules havebeen omitted because they are either inapplicable or the required informationhas been provided in the Consolidated Financial Statements or the Notesthereto.

 

F-25

----

 

## **Item 9**.    Changes In and Disagreements WithAccountants on Accounting and Financial Disclosure

## ** **

## **None**.

## ** **

## **Item 9A**.Controls and Procedures

 

Based on their evaluation asof the end of the period covered by this Annual Report, under the supervisionand with the participation of our management, including our Chief ExecutiveOfficer (“CEO”) and Chief Financial Officer (“CFO”), our CEO and CFO haveconcluded that, as of the end of such period, our disclosure controls andprocedures as defined in Rule 13a-15(e) under the Securities Exchange Act of1934 (“Exchange Act”) were effective in timely making known to themmaterial information relating to the Company required to be disclosed in theCompany’s reports filed or submitted under the Exchange Act.

 

During the fourth fiscalquarter ended December 31, 2004, there was no change in our internal controlsover financial reporting identified in connection with the evaluation describedabove that has materially affected, or is reasonably likely to materiallyaffect, our internal controls over financial reporting.

 

We are beginning theevaluation of our internal controls over financial reporting in order to complywith Section 404 of the Sarbanes-Oxley Act of 2002. Section 404 requires us toevaluate annually the effectiveness of our internal controls over financialreporting as of the end of each fiscal year and to include a management reportassessing the effectiveness of our internal controls over financial reportingin all annual reports.  However, in March2005, the Securities Exchange Commission postponed the Section 404 requirementfor one year for those companies not qualifying as accelerated filers as ofJune 30, 2005.  Inasmuch as we believe wewill not be an accelerated filer at that time, we will not have to comply withthe Section 404 requirement until our annual report on Form 10-K for the fiscalyear ending December 31, 2006.

 

**Item9B.  Other Information**

 

None.

 

37

----

 

# **PART III**

## ** **

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

 

The information required bythis item (with respect to our directors) will be contained in, and is hereby incorporatedby reference from, the information under the caption “Election of Directors”contained in our Proxy Statement to be filed with the SEC in connection withthe solicitation of proxies for our 2005 Annual Meeting of Stockholders (the “2005Proxy Statement”). Certain information required by this item concerningexecutive officers is set forth in Part I of this Annual Report under thecaption “Executive Officers of the Registrant.”

 

The information required bythis item regarding compliance with Section 16(a) of the Exchange Act will becontained in, and is hereby incorporated by reference to, our 2005 ProxyStatement under the caption “Other Information-Section 16(a) BeneficialOwnership Reporting Compliance.”

 

We have a separatelydesignated standing Audit Committee established in accordance with Section3(a)(58)(A) of the Exchange Act.  Themembers of the Audit Committee are Harry Casari, David Mitchell and Greg Theiss.  All of such members meet the independencestandards established by The Nasdaq Stock Market for serving on an auditcommittee and the requirements under Section 10A of the Exchange Act. Our Boardof Directors has determined that Mr. Casari qualifies as an “audit committeefinancial expert” within the meaning of such regulations.

 

We have adopted a Code ofEthics for Senior Officers that applies to our CEO, CFO and other key managementemployees (including other senior financial officers) who have been identifiedby the board of directors (the “Code of Ethics”).  We have also adopted a Code of BusinessConduct that applies to all of our employees, officers and directors (the “Codeof Business Conduct”).  A copy of each ofthe Code of Ethics for Senior Officers and the Code of Business Conduct areincluded as Exhibits 14.1 and 14.2 to this Annual Report.  The Code of Ethics and the Code of BusinessConduct are also available on our website at www.orangetwentyone.com.  We will post (i) any waiver, if and whengranted, to any provision of the Code of Ethics (for executive officers anddirectors) and (ii) any amendment to the Code of Ethics or the Code of BusinessConduct on our website.

 

## **Item 11**. Executive Compensation

 

The information required by this item will be contained in, and ishereby incorporated by reference from, our 2005 Proxy Statement under thecaptions “Election of Directors — Director Compensation,” “Executive Compensation,”and “Election of Directors —Compensation Committee Interlocks and InsiderParticipation.”

## ** **

## **Item 12**. Security Ownership of Certain Beneficial Ownersand Management and Related Stockholders Matters

 

Theinformation required by this item will be contained in, and is herebyincorporated by reference from, our 2005 Proxy Statement under the captions  “Security Ownership of Certain BeneficialOwners and Management” and “Equity Compensation Plan Information.”

 

38

----

 

**EQUITY COMPENSATION PLAN INFORMATION**

 

Set forth in the tablebelow is certain information regarding the number of shares of Common Stockthat were subject to outstanding stock options or other compensation plangrants and awards as of December 31, 2004. 

 
| **Plan Category**                                               | ** ** | **Number of Securities to be Issued Upon  Exercise of Outstanding Options,  Warrants and Rights** | ** ** | **Weighted-Average  Exercise Price of  Outstanding Options,  Warrants and Rights** | ** ** | **Number of Securities  Remaining Available  for Future Issuance  Under Equity  Compensation  Plans (Excluding  Securities Reflected   In Column (a))** | ** **  |
|-----------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|-------------|
| **Equity  compensation plans approved by security holders**     | ** ** | **889,971**                                                                                       | ** ** | **$**                                                                              | **6.58**   | ** **                                                                                                                                              | **325,000** | ** ** |
| **Equity  compensation plans not approved by security holders** | ** ** | **Not applicable**                                                                                | ** ** | **Not applicable**                                                                 | ** ** | **Not applicable**                                                                                                                                      | ** **  |
|                                                                 |            |                                                                                                   |            |                                                                                    |            |                                                                                                                                                         |             |  |

 

## **Item 13**. Certain Relationships and Related Transactions

 

Theinformation required by this item will be contained in, and is herebyincorporated by reference from, our 2005 Proxy Statement under the caption “CertainRelationships and Related Party Transactions.”

## ** **

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

 

Theinformation required by this item will be contained in, and is herebyincorporated by reference from, our 2005 Proxy Statement under the captions “Ratificationof Independent Auditors – Principal Accountant Fees and Services” and “Pre-ApprovalPolicies and Procedures.”

# ** **

# **PART IV**

 

## **Item 15**.  Exhibits, Financial Statement Schedules

 

(a)           Documentsfiled as part of this report:

 

(1)                                  FinancialStatements

 

Reference is madeto the Index to Consolidated Financial Statements of Orange 21 Inc., underItem 8 of Part II hereof.

 

(2)                                  FinancialStatement Schedules

 

The followingfinancial statement schedule of Orange 21 Inc. is filed as part of this Form 10-K(under Item 8 of Paragraph II hereof).

 

  Schedule II – Valuation and QualifyingAccounts

 

All other financial statement schedules have beenomitted because they are not applicable or not required or because theinformation is included elsewhere in the Consolidated Financial Statements orthe Notes thereto.

 

39

----

 

(3)                                  Exhibits

 

See Item 15(b)below.  Each management contract orcompensatory plan or arrangement required to be filed has been identified.

 

(b)           **Exhibits**

** **
| **Exhibit  Number** | ** ** | **Description  of Document**                                                                                                                |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2                 | *          | Restated Certificate of Incorporation of the Company                                                                                        |
|                |       |                                                                                                                                        |
| 3.4                 | *          | Amended and Restated Bylaws of the Company                                                                                                  |
|                |       |                                                                                                                                        |
| 4.1                 | *          | Form of Common Stock Certificate                                                                                                            |
|                |       |                                                                                                                                        |
| 10.1                | +*         | Form of Indemnification Agreement between the  Company and its officers and directors                                                       |
|                |       |                                                                                                                                        |
| 10.2                | +*         | 2004 Stock Incentive Plan of the Company                                                                                                    |
|                |       |                                                                                                                                        |
| 10.3                | *          | Corporate Services Agreement by and between the  Company and No Fear, Inc. dated as of October 1, 2004                                      |
|                |       |                                                                                                                                        |
| 10.4                | *          | Loan and Security Agreement by and between Comerica  Bank-California and Spy Optic, Inc. dated as of October 5, 2001                        |
|                |       |                                                                                                                                        |
| 10.5                | *          | First Amendment to Loan and Security Agreement by  and between Comerica Bank-California and Spy Optic, Inc. dated as of July 17,  2002      |
|                |       |                                                                                                                                        |
| 10.6                | *          | Second Amendment to Loan and Security Agreement by  and between Comerica Bank-California and Spy Optic, Inc. dated as of March  21, 2003    |
|                |       |                                                                                                                                        |
| 10.7                | *          | Third Amendment to Loan and Security Agreement by  and between Comerica Bank-California and Spy Optic, Inc. dated as of August  14, 2003    |
|                |       |                                                                                                                                        |
| 10.8                | *          | Fourth Amendment to Loan and Security Agreement by  and between Comerica Bank-California and Spy Optic, Inc. dated as of November  26, 2003 |
|                |       |                                                                                                                                        |
| 10.9                | *          | Fifth Amendment to Loan and Security Agreement by  and between Comerica Bank-California dated as of December 16, 2003                  |
|                |       |                                                                                                                                        |
| 10.10               | *          | Sixth Amendment to Loan and Security Agreement by  and between Comerica Bank dated as of August 5, 2004                                |
|                |       |                                                                                                                                        |
| 10.11               | *          | Sublease Agreement by and between Harris Corporation  and Spy Optic, Inc. dated as of September 18, 2002                                    |
|                |       |                                                                                                                                        |
| 10.12               | *          | Preliminary Commercial Lease Contract by and among  Giudici Stefano, Giudici Sandro and Spy Optic, S.r.l. dated as of March 4,  2003        |
|                |       |                                                                                                                                        |
| 10.13               | *          | Limited Exclusive Supply Agreement by and between  Spy Optic, Inc. and LEM S.R.L. dated as of November 19, 2004                             |
|                |       |                                                                                                                                        |
| 10.14               | +*         | Employment Agreement by and between Spy Optic, Inc.  and Barry Buchholtz dated as of January 1, 2002                                        |
|                |       |                                                                                                                                        |
| 10.15               | *          | Website Services Agreement by and between the  Company and No Fear, Inc. dated December 17, 2004                                            |
|                |       |                                                                                                                                        |
| 10.16               | *          | Premium Dealer Agreement by and between Spy Optic,  Inc. and No Fear, Inc. dated as of September 9, 2004                               |
|                |       |                                                                                                                                        |
| 14.1                |       | Code of Ethics for Senior Officers                                                                                                          |
|                |       |                                                                                                                                        |
| 14.2                |       | Code of Business Conduct                                                                                                                    |

 

40

----

 
| **Exhibit  Number** | ** ** | **Description  of Document**                                                                                    |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------|
| 21.1                |       | Subsidiaries of the Company.                                                                                    |
|                |       |                                                                                                            |
| 23.1                |       | Consent of Mayer Hoffman McCann P.C. Independent Registered  Certified Public Accountants.                      |
|                |       |                                                                                                            |
| 23.2                |       | Consent of Nation Smith Hermes Diamond, APC  Independent Registered Certified Public Accountants                |
|                |       |                                                                                                            |
| 24.1                |       | Power of Attorney (see signature page of this Annual  Report)                                                   |
|                |       |                                                                                                            |
| 31.1                |       | Rule 13a-14(a) certification of Chief Executive  Officer                                                        |
|                |       |                                                                                                            |
| 31.2                |       | Rule 13a-14(a) certification of Chief Financial  Officer                                                        |
|                |       |                                                                                                            |
| 32.1                |       | Statement of Chief Executive Officer under Section  906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.§1350) |
|                |       |                                                                                                            |
| 32.2                |       | Statement of Chief Financial Officer under Section  906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.§1350) |
|                     |            |                                                                                                                 |  |

 

----

*  Incorporated by reference to exhibits filedwith the Company’s Registration Statement on Form S-1 (File No. 333-119024)declared effective by the U.S. Securities and Exchange Commission on December13, 2004.

 

+  Management contract or compensatory plan orarrangement

 

41

----

 

**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Company has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

 
|                 | Orange 21 Inc. |
|----------------------|----------------|
|                 |           |
|                 |           |
| Date: March 30, 2005 |           |
|                 | By             | /s/ Barry  Buchholtz |   |
|                 |           | Barry Buchholtz |   |
|                 |           | Chief Executive  Officer |   |

 

**POWER OF ATTORNEY**

 

KNOWALL MEN BY THESE PRESENTS, that each person whose signature appears belowconstitutes and appoints Barry Buchholtz and Michael Brower, and each of them,his true and lawful attorneys-in-fact, each with full power of substitution,for him or her in any and all capacities, to sign any amendments to this reporton Form 10-K and to file the same, with exhibits thereto and otherdocuments in connection therewith, with the Securities and Exchange Commission,hereby ratifying and confirming all that each of said attorneys-in-fact ortheir substitute or substitutes may do or cause to be done by virtue hereof.

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this Annual Reporton Form 10-K has been signed below by the following persons on behalf of the Registrantand in the capacities and on the dates indicated.

 
| **Name**             | ** ** | **Title**                                     | ** ** | **Date**       |
|----------------------|------------|-----------------------------------------------|------------|----------------|
|                 |       |                                          |       |           |
| /s/ Barry  Buchholtz |       | Chief Executive  Officer (Principal           |       | March 30, 2005 |
| Barry Buchholtz      |       | Executive  Officer) and Director              |       |           |
|                 |       |                                          |       |           |
|                 |       |                                          |       |           |
| /s/ Michael  Brower  |       | Chief Financial  Officer (Principal Financial |       | March 30, 2005 |
| Michael Brower       |       | and Accounting  Officer), Secretary and       |       |           |
|                 |       | Treasurer                                     |       |           |
|                 |       |                                          |       |           |
|                 |       |                                          |       |           |
| /s/ Mark Simo        |       | Chairman of the  Board of Directors           |       | March 30, 2005 |
| Mark Simo            |       |                                          |       |           |

 

42

----

 
| /s/ Harry Casari         |   | Director |   | March 30, 2005 |
|--------------------------|--------|----------|--------|----------------|
| Harry Casari             |   |     |   |           |
|                     |   |     |   |           |
| /s/ David  Mitchell      |   | Director |   | March 30, 2005 |
| David Mitchell           |   |     |   |           |
|                     |   |     |   |           |
|                     |   | Director |   |           |
| Roger Penske,  Jr.       |   |     |   |           |
|                     |   |     |   |           |
| /s/ Greg Theiss          |   | Director |   | March 30, 2005 |
| Greg Theiss              |   |     |   |           |
|                     |   |     |   |           |
| /s/ Jeffrey  Theodosakis |   | Director |   | March 30, 2005 |
| Jeffrey  Theodosakis     |   |     |   |           |

 

43

----

 

**ExhibitIndex**

 
| **Exhibit  Number** | ** ** | **Description of Document**                                                                                                                 |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2                 | *          | Restated Certificate of Incorporation of the Company                                                                                        |
|                |       |                                                                                                                                        |
| 3.4                 | *          | Amended and Restated Bylaws of the Company                                                                                                  |
|                |       |                                                                                                                                        |
| 4.1                 | *          | Form of Common Stock Certificate                                                                                                            |
|                |       |                                                                                                                                        |
| 10.1                | +*         | Form of Indemnification Agreement between the Company  and its officers and directors                                                       |
|                |       |                                                                                                                                        |
| 10.2                | +*         | 2004 Stock Incentive Plan of the Company                                                                                                    |
|                |       |                                                                                                                                        |
| 10.3                | *          | Corporate Services Agreement by and between the  Company and No Fear, Inc. dated as of October 1, 2004                                      |
|                |       |                                                                                                                                        |
| 10.4                | *          | Loan and Security Agreement by and between Comerica  Bank-California and Spy Optic, Inc. dated as of October 5, 2001                        |
|                |       |                                                                                                                                        |
| 10.5                | *          | First Amendment to Loan and Security Agreement by  and between Comerica Bank-California and Spy Optic, Inc. dated as of July 17,  2002      |
|                |       |                                                                                                                                        |
| 10.6                | *          | Second Amendment to Loan and Security Agreement by  and between Comerica Bank-California and Spy Optic, Inc. dated as of March  21, 2003    |
|                |       |                                                                                                                                        |
| 10.7                | *          | Third Amendment to Loan and Security Agreement by  and between Comerica Bank-California and Spy Optic, Inc. dated as of August  14, 2003    |
|                |       |                                                                                                                                        |
| 10.8                | *          | Fourth Amendment to Loan and Security Agreement by  and between Comerica Bank-California and Spy Optic, Inc. dated as of November  26, 2003 |
|                |       |                                                                                                                                        |
| 10.9                | *          | Fifth Amendment to Loan and Security Agreement by  and between Comerica Bank-California dated as of December 16, 2003                  |
|                |       |                                                                                                                                        |
| 10.10               | *          | Sixth Amendment to Loan and Security Agreement by  and between Comerica Bank dated as of August 5, 2004                                |
|                |       |                                                                                                                                        |
| 10.11               | *          | Sublease Agreement by and between Harris Corporation  and Spy Optic, Inc. dated as of September 18, 2002                                    |
|                |       |                                                                                                                                        |
| 10.12               | *          | Preliminary Commercial Lease Contract by and among  Giudici Stefano, Giudici Sandro and Spy Optic, S.r.l. dated as of March 4,  2003        |
|                |       |                                                                                                                                        |
| 10.13               | *          | Limited Exclusive Supply Agreement by and between  Spy Optic, Inc. and LEM S.R.L. dated as of November 19, 2004                             |
|                |       |                                                                                                                                        |
| 10.14               | +*         | Employment Agreement by and between Spy Optic, Inc.  and Barry Buchholtz dated as of January 1, 2002                                        |
|                |       |                                                                                                                                        |
| 10.15               | *          | Website Services Agreement by and between the  Company and No Fear, Inc. dated December 17, 2004                                            |
|                |       |                                                                                                                                        |
| 10.16               | *          | Premium Dealer Agreement by and between Spy Optic,  Inc. and No Fear, Inc. dated as of September 9, 2004                               |
|                |       |                                                                                                                                        |
| 14.1                |       | Code of Ethics for Senior Officers                                                                                                          |
|                |       |                                                                                                                                        |
| 14.2                |       | Code of Business Conduct                                                                                                                    |
|                |       |                                                                                                                                        |
| 21.1                |       | Subsidiaries of the Company.                                                                                                                |
|                |       |                                                                                                                                        |
| 23.1                |       | Consent of Mayer Hoffman McCann P.C. Independent Registered  Certified Public Accountants.                                                  |
|                |       |                                                                                                                                        |
| 23.2                |       | Consent of Nation Smith Hermes Diamond, APC  Independent Registered Certified Public Accountants                                            |

 

44

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| **Exhibit  Number** | ** ** | **Description of Document**                                                                                     |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------|
| 24.1                |       | Power of Attorney (see signature page of this Annual  Report)                                                   |
|                |       |                                                                                                            |
| 31.1                |       | Rule 13a-14(a) certification of Chief Executive  Officer                                                        |
|                |       |                                                                                                            |
| 31.2                |       | Rule 13a-14(a) certification of Chief Financial  Officer                                                        |
|                |       |                                                                                                            |
| 32.1                |       | Statement of Chief Executive Officer under Section  906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.§1350) |
|                |       |                                                                                                            |
| 32.2                |       | Statement of Chief Financial Officer under Section  906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.§1350) |

 

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*  Incorporated by reference to exhibits filedwith the Company’s Registration Statement on Form S-1 (File No. 333-119024)declared effective by the U.S. Securities and Exchange Commission on December13, 2004.

 

+  Management contract or compensatory plan orarrangement

 

45

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