UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-K





(Mark
One)


x
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934 for the fiscal year ended December 31,
2009


OR


o
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934 for the transition period from ______ to
  ________




Commission
file number:000-23576





STRASBAUGH


(Exact
name of registrant as specified in its charter)





California
            77-0057484(State
      or other jurisdiction of incorporation or organization)
            (I.R.S.
      Employer Identification No.)825
      Buckley Road
              San
      Luis Obispo, CA
            93401(Address
      of principal executive offices)
            (Zip
      Code)




Registrant’s
telephone number, including area code:(805) 541-6424





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




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


Common
Stock, no par value


(Title of
class)








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




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




Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes  x No o




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files). Yes o No o




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




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




Large
      accelerated filer   ̈
            Accelerated
      filer   ̈Non-accelerated
      filer   ̈ (Do not check if
      a smaller reporting company)
            Smaller
      reporting company  x




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




The
aggregate market value of the voting common equity held by nonaffiliates of the
registrant computed by reference to the closing sale price of such stock, was
approximately $1,644,878 as of June 30, 2009, the last business day of the
registrant’s most recently completed second fiscal quarter. The registrant has
no non-voting common equity.




The
registrant had 14,705,587 shares of common stock, no par value, outstanding as
of March 15, 2010.




DOCUMENTS
INCORPORATED BY REFERENCE: None.











TABLE
OF CONTENTS






PagePART IItem 1.
            Business
            1Item 1A.
            Risk Factors
            13Item 1B.
            Unresolved Staff Comments
            23Item 2.
            Properties
            23Item 3.
            Legal Proceedings
            24Item 4.
            (Removed
      and Reserved)
            24PART IIItem 5.
            Market for Registrant’s Common Equity, Related
      Stockholder Matters and Issuer Purchases of Equity
      Securities
            24Item 6.
            Selected Financial Data
            25Item 7.
            Management’s Discussion and Analysis of Financial
      Condition and Results of Operations
            25Item 7A.
            Quantitative and Qualitative Disclosures About
      Market Risk
            35Item 8.
            Financial Statements and Supplementary
      Data
            35Item 9.
            Changes in and Disagreements with Accountants on
      Accounting and Financial Disclosure
            35Item 9A.
            Controls
      and Procedures
            36Item
9A(T).
            Controls
      and Procedures
            36Item 9B.
            Other Information
            37PART IIIItem 10.
            Directors, Executive Officers and Corporate
      Governance
            38Item 11.
            Executive Compensation
            45Item 12.
            Security Ownership of Certain Beneficial Owners
      and Management and Related Stockholder Matters
            52Item 13.
            Certain Relationships and Related Transactions,
      and Director Independence
            56Item 14.
            Principal Accounting Fees and
      Services
            58PART IVItem 15.
            Exhibits, Financial Statement
      Schedules
            59Index
      to Consolidated Financial Statements and Supplemental
Information
            F-1Index
      To ExhibitsSignaturesExhibits
      Filed with this Report




ii





PART
I




CAUTIONARY
STATEMENT




All
statements included or incorporated by reference in this Annual Report on Form
10-K, other than statements or characterizations of historical fact, are
“forward-looking statements.” Examples of forward-looking statements include,
but are not limited to, statements concerning projected net sales, costs and
expenses and gross margins; our accounting estimates, assumptions and judgments;
the demand for our products; the competitive nature of and anticipated growth in
our industry; and our prospective needs for additional capital. These
forward-looking statements are based on our current expectations, estimates,
approximations and projections about our industry and business, management’s
beliefs, and certain assumptions made by us, all of which are subject to change.
Forward-looking statements can often be identified by such words as
“anticipates,” “expects,” “intends,” “plans,” “predicts,” “believes,” “seeks,”
“estimates,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,”
“ongoing,” similar expressions and variations or negatives of these words. These
statements are not guarantees of future performance and are subject to risks,
uncertainties and assumptions that are difficult to predict. Therefore, our
actual results could differ materially and adversely from those expressed in any
forward-looking statements as a result of various factors, some of which are
listed under “Risk Factors” in Item 1A of this report. These
forward-looking statements speak only as of the date of this report. We
undertake no obligation to revise or update publicly any forward-looking
statement for any reason, except as otherwise required by law.




Item
1. Business.


Company
Overview




We
develop, manufacture, market and sell an extensive line of precision surfacing
products, including chemical-mechanical planarizing, or CMP, polishing, grinding
and precision optics systems, to customers in the semiconductor and
semiconductor equipment, silicon wafer and silicon wafer equipment, data
storage, micro-electromechanical system, or MEMS, light emitting diode, or LED,
and precision optics markets worldwide.




Many of
our products are used by our customers in the fabrication of integrated
circuits, commonly known as chips or semiconductors, and in the fabrication of
silicon wafers.  Most semiconductors are built on a silicon wafer base
and include a variety of circuit components that are connected by multiple
layers of wiring or interconnects.  To build a semiconductor, the
components of the semiconductor are first created on the surface of a silicon
wafer by performing a series of processes to deposit and selectively remove
successive film layers.  After a series of steps designed to build the
wiring portion of the semiconductor through deposition and removal, a CMP, step
polishes the silicon wafer to achieve a flat surface.  Additional
deposition, etch and CMP steps are then performed to build up the layers of
wiring needed to complete the interconnection of the circuit elements to form
the semiconductor.  Through the use of CMP polishing products,
semiconductor manufacturers can increase the number of layers thereby reducing
the overall size of the semiconductor.




Over
time, semiconductor manufacturers have migrated toward utilizing increasingly
larger wafers in chip production.  While the predominate wafer size
used for volume production today is 200mm, a substantial number of advanced fabs
now use 300mm wafers, and the current trend continues toward the use of 300mm
wafers.




Our
business and technologies have grown with this changing market.  Our
equipment is configurable, and incorporates proprietary technology that we
believe results in higher yields for our manufacturing customers.  Our
newest product, introduced in July 2009, STB P300TM is a next generation 300mm
wafer polisher and CMP system.   Our other new product, the
nVision IITM, is an endpoint detection system for CMP wafer
processes.  Our other legacy products include the nOvation®, a 300mm
hybrid grinding tool, and CMP EnhancementTM, an upgrade for older CMP
systems.




1




We
utilize our extensive patent portfolio and core technology platform in designing
and manufacturing each of our products for multiple market applications, thereby
expanding the market available for each product.  Our customers
include some of the most well-established market participants such as LG
Electronics, Cree, Inc., and Western Digital Corporation.  We have
developed our client base through a direct sales force in the United States,
distributors in Europe and an international network of sales representatives in
Japan, China, Taiwan, South Korea, Israel and the Philippines.




Company
History




We are a
California corporation that was incorporated on December 28, 1984 as AHJP
Corporation.  On January 8, 1985 we changed our name to Celeritek,
Inc. and on July 22, 2005, in connection with the approval of a plan of
dissolution described below, we changed our name to CTK Windup
Corporation.  On May 24, 2007, we completed a transaction with the
shareholders of a California corporation now known as  R. H.
Strasbaugh pursuant to which we issued an aggregate of 13,770,366 shares of our
common stock to the shareholders of R. H. Strasbaugh and, in exchange, we
acquired all of the issued and outstanding shares of capital stock of R. H.
Strasbaugh.  We refer to this transaction as the “Share Exchange
Transaction” in this report.  On May 24, 2007, in connection with the
Share Exchange Transaction, we changed our name to Strasbaugh.  Our
wholly-owned operating subsidiary, R. H. Strasbaugh, commenced operations
in 1948 as a sole proprietorship prior to its incorporation in
1964.  Our principal executive offices are located in San Luis Obispo,
California and our main telephone number is (805) 541-6424.




On March
10, 2005, our prior board of directors approved a plan of dissolution, or Plan
of Dissolution, of our company and approved the solicitation of shareholder
approval of the Plan.  Our shareholders approved the Plan of
Dissolution on June 3, 2005.  As a result of approval of the Plan of
Dissolution and commencement of the wind up of our company, (i)  effective
as of June 3, 2005 we completed the sale of substantially all of our assets
to Mimix Broadband, Inc., (ii) we voluntarily delisted our common stock
from NASDAQ effective July 11, 2005, (iii) our common stock began trading
on the Pink Sheets® on
July 11, 2005, and (iv) our transfer agent closed the transfer books for our
common stock on July 11, 2005.  Because of our inability to
liquidate our investment in NewGen Telcom Co., Ltd., our prior board of
directors decided on August 25, 2005 to postpone our Plan of
Dissolution.  See “Risk Factors—Risks Relating to Ownership of Our
Common Stock.”




During
the fourth quarter of 2006, representatives of R. H. Strasbaugh proposed
the Share Exchange Transaction to our prior board of directors and on
December 5, 2006 the parties entered into a letter of intent regarding the
Share Exchange Transaction.  On January 17, 2007, our prior board of
directors preliminarily authorized the Share Exchange Transaction and authorized
our officers to solicit from our shareholders their vote in favor of the Share
Exchange Transaction.  In doing so, we prepared and distributed to all
shareholders a proxy statement seeking proxies in connection with the special
shareholders meeting that was to be held on March 14, 2007.  On
that date, our shareholders approved the Share Exchange Transaction, thereby
revoking our Plan of Dissolution.  Thereafter, our prior board of
directors approved and ratified entering into and closing the Share Exchange
Transaction.  After receiving both board and shareholder approval to
enter into the Share Exchange Transaction, we formally revoked the Plan of
Dissolution pursuant to Section 1904(a) of the California Corporations Code and
consummated the Share Exchange Transaction.  See “Risk Factors—Risks
Relating to Ownership of our Common Stock.”




2




On
May 24, 2007, we completed the Share Exchange Transaction.  Upon
completion of the Share Exchange Transaction, we acquired all of the issued and
outstanding shares of capital stock of R. H. Strasbaugh.  The
Share Exchange Transaction has been accounted for as a recapitalization of
R. H. Strasbaugh with R. H. Strasbaugh being the acquiror for
accounting purposes.  Immediately prior to the consummation of the
Share Exchange Transaction, we amended and restated our articles of
incorporation to effect a 1-for-31 reverse split of our common stock, to change
our name from CTK Windup Corporation to Strasbaugh, to increase our authorized
common stock from 50,000,000 shares to 100,000,000 shares, to increase our
authorized preferred stock from 2,000,000 shares to 15,000,000 shares (of which
5,909,089 shares were designated Series A Cumulative Redeemable Convertible
Preferred Stock, or Series A Preferred Stock) and to eliminate our
Series A Participating Preferred Stock.  On May 17, 2007,
prior to the filing of our amended and restated articles of incorporation, our
subsidiary amended its articles of incorporation to change its name from
Strasbaugh to R. H. Strasbaugh.




On
May 24, 2007, immediately after the closing of the Share Exchange
Transaction, we issued an aggregate of 5,909,089 shares of our Series A
Preferred Stock at a purchase price of $2.20 per share and five-year investor
warrants, or Investor Warrants, to purchase an aggregate of 886,363 shares of
common stock at an exercise price of $2.42 per share.  We refer to
this offering of securities in this report as the “Series A Preferred Stock
Financing.”  We also issued five-year placement warrants, or Placement
Warrants, to purchase 385,434 shares of common stock at an exercise price of
$2.42 per share in connection with the offering to B. Riley and Co. LLC and its
designees.




Prior to
the sale of our assets to Mimix, we designed and manufactured GaAs semiconductor
components and GaAs-based subsystems used in the transmission of voice, video
and data over wireless communication networks and systems. Our current business
is comprised solely of the business of our wholly-owned subsidiary,
R. H. Strasbaugh.




Semiconductor
and Semiconductor Equipment Industries




Over the
past twenty years, the semiconductor industry has grown rapidly as a result of
increasing demand for personal computers, the expansion of the Internet and the
telecommunications industry, and the emergence of new applications in consumer
electronics.  Nonetheless, the semiconductor industry has historically
been cyclical, with periods of rapid expansion followed by periods of
over-capacity.




Several
technological trends currently characterize the semiconductor industry,
including the increasing density of the integrated circuit, transition from
aluminum wiring to copper wiring as the primary conductive material in
semiconductor devices, transition from traditional insulating films made of
silicon oxide to insulators with a low dielectric constant, or “low-k,” and the
move to larger 300mm wafer sizes due to the potential manufacturing cost
advantages of these larger wafers.




The
semiconductor equipment industry is highly competitive and characterized by
rapid technological advancements.  The pace of technological change in
the semiconductor fabrication equipment industry is rapid, with customers
continually moving to smaller critical dimensions and larger wafer sizes and
adopting new materials for fabricating semiconductors.  Existing
technology can sometimes be adapted to the new requirements, but some of these
requirements may create the need for an entirely different technical approach.
The rapid pace of technological change has created opportunities for existing
companies that can gain market acceptance of their next generation
products.




An
example of this is the emergence of “Through Silicon Via” (“TSV”) or 3D
integration as a mainstream manufacturing method for creating chips with a
higher density of semiconductor devices on the chips providing better
performance, at a lower cost.  TSV presents several manufacturing
challenges requiring new approaches to polishing and grinding, and therefore an
opportunity for equipment suppliers to develop solutions.  The
equipment supplier that is first to market with a solution can gain significant
market share.




3




An
equipment supplier’s  ability to compete in this industry is primarily
dependent upon the supplier’s ability to market its technology, continually
improve its products, processes and services, and maintain its ability to
develop new products that meet constantly evolving customer
requirements.  The significant indicators of potential success in this
industry include a product’s technical capability, productivity and
cost-effectiveness, and the level of technical service and support that
accompanies the product.




Semiconductor
CMP




A
semiconductor chip is built on a silicon wafer by the deposition and etch of
successive layers of materials to create the transistors, diodes, capacitors and
interconnect circuitry that make up a micro-electronic circuit.  CMP
is a chemical-mechanical polishing process used to make each successive layer of
materials flat (i.e., planar) and reduce it to the desired thickness before the
deposition of the next layer of material.  This process is critical to
ensure accurate and consistent dimensions in the circuitry being
created.  It greatly aids performance and reliability and is a key
enabling technology to allow the production of ever smaller chips.




CMP has
evolved into the technology of choice for planarizing among semiconductor
manufacturers since it was first developed in the mid-1980s.  It is
now a key enabling process for the manufacturing of semiconductor
devices.  We believe that demand for CMP equipment is driven by the
overall growth in chip consumption, the transition to 300mm wafers, and the
increasing number of CMP processing steps needed to produce ever smaller chip
geometries.




Semiconductor
Niche Markets




Within
the semiconductor industry, we focus on serving three small, although we believe
growing, niche markets and applications:  research and development,
failure analysis and backgrinding.




Research
and Development




The
research and development market consists of customers who need CMP and grinding
tools for the development of new semiconductor products.  This market
includes universities, research institutes, device manufacturers and early
development technology companies that are working on the next generation
products and technologies.




Failure
Analysis




Failure
analysis is a process that is integral to the success and profitability of any
semiconductor manufacturing company.  The number of “good” computer
chips produced from a single wafer can be anywhere from 50% to over 90% of the
total number of chips produced.  Failure analysis equipment helps to
determine what causes this yield loss, and is utilized to quickly find a
solution.  The main process in failure analysis for which we provide
products “wafer de-construction.”  The de-construction process
utilizes a polishing process to remove the various conducting and insulating
layers on the front side of a wafer to expose underlying faults.




Backgrinding




Backgrinding
is the accepted method for reducing wafers from their original thickness at the
end of chip fabrication to a reduced  thickness suitable for final
packaging ready for assembly into an electronic product such as a television or
cell phone.  Backgrinding is important not only because it ultimately
allows for thinner chips, but also because it improves a chip’s ability to
dissipate heat by shortening the heat transfer path, thereby allowing the
semiconductor devices to operate at high power levels.   We
believe that the needs of chip fabricators for backgrinding equipment will
increase in the near future due to the move within the industry toward thinner
chips, as well as the fact that backgrinding is now finding a new application in
the manufacturing of 3-D stacked chips using TSV.  These 3-D stacked
chips increase the density and performance of semiconductor devices by extending
the area available for chip structure to more than one level of
silicon.  These new chips will require the development of advanced
wafer grinding and polishing tools, which we are currently working to
develop.




4




Silicon
Wafer and Silicon Wafer Equipment Industry




Silicon
wafers are the prime building blocks for almost all semiconductor integrated
circuits.  The quality of an integrated circuit is highly dependent
upon the quality of the silicon prime wafer it is built on.  All
silicon wafers must meet stringent specifications, including purity grade, high
dimensional accuracy and good surface integrity.  Manufacturing wafers
to conform to these high standards requires sophisticated equipment that is
constantly evolving and being replaced to meet the demands of the next
generation of wafers.




A typical
and simplified process for manufacturing a semiconductor chip wafer involves
generating a cylinder-shaped silicon ingot that is sliced into rough silicon
wafers.  The wafers undergo various process steps, including lapping,
edge-grinding and polishing steps to create the desired wafer flatness, surface
finish and edge profile characteristics.  Our products perform the
final polishing process step prior to the wafers being cleaned and
packaged.




The
silicon wafer equipment market is growing to keep pace with the increasing
number of chips required by the world’s markets.  We believe that
growth is being driven by the transition to 300mm wafers and the new
manufacturing methodologies needed to produce silicon wafers suitable for
ever-shrinking chip geometries.  Silicon wafers are produced in the
United States, Japan, Taiwan and Germany. The People’s Republic of China is also
contributing to growth in the industry as it equips itself to meet domestic
demands for silicon wafers.




Silicon
Wafer Niche Markets




In
addition to the overall silicon wafer industry, we also serve several niche
markets and applications, including silicon-on-insulator, or SOI, within this
broad industry.  SOI wafers are used to produce the most sophisticated
logic-integrated circuits, including microprocessors, high power devices and
micro-electromechanical systems, or MEMS, components for sensors and actuators.
SOI wafers are manufactured by bonding together two silicon wafers separated by
an insulating layer, usually silicon dioxide.  They are difficult to
produce and require more processing steps than typical silicon
wafers.




Data
Storage Industry




The
demand for increased data storage capacity is driven by the increasing quantity
and diversity of information that is created and managed digitally. As data
storage hardware, software, and transmission networks continue to deliver
improved cost/performance, new and expanded applications have emerged that more
efficiently support critical business processes.




Within
the data storage market, the growing demand for disc drives is focused on two
areas:




●
            Consumer
      Electronics.Increasingly,
      high-performance computing and communications functions and disc drives
      are being incorporated into consumer electronics devices.  For
      example, many of today’s digital video recorders, digital music players,
      video game consoles and advanced television set-top boxes now incorporate
      high performance computing functions and disk drives. In addition, faster
      connections to the Internet and increased broadband capacity have led to
      consumers downloading greater amounts of data than ever before, expanding
      the market for disc drives for use in new consumer and entertainment
      appliances. The adoption and rapid growth of the use of disc drives in
      these applications will be facilitated by the development of low-cost disc
      drives that meet the pricing requirements of the consumer electronics
      market.  5
  ●
              Mobile
      Computing.We believe
      that the mobile computing market will grow faster than any other personal
      computer segment, as price and performance continue to improve and
      notebook computers become an attractive alternative to desktop computers.
      Notebook systems are also becoming progressively more desirable to
      consumers as the need for mobility increases and wireless adoption
      continues to advance.




New
applications for hard disk storage technology have contributed to a strong
growth spurt in this industry.  These new applications require more
sophisticated manufacturing processes and methods than previously
existed.  As a consequence of this growth and demand for more
sophisticated products, older manufacturing methods are being phased out in
favor of more efficient and advanced technologies such as CMP.  CMP
polishing steps used in manufacturing of semiconductors are now used almost
universally for the production of the read-write heads used in these
drives.  Our products are used to perform these CMP polishing
steps.




LED
Industry




An LED is
a semiconductor device that emits incoherent narrow spectrum light and the
effect is considered a form of electroluminescence.  LEDs can emit
light in the infrared, visible or ultraviolet spectrums and are rapidly
replacing incandescent and fluorescent lamps in a multitude of applications and
as a result present a significant growth opportunity for sales of our grinding
products LEDs are fabricated on wafer substrates utilizing process steps similar
to semiconductor chip fabrication.  Rather than using a silicon wafer
as the substrate, harder wafer materials such as silicon carbide and sapphire
are used in the fabrication of LEDs.  Our products perform the
grinding step to reduce substrate thickness prior to the substrates being diced
into individual LED devices.  We believe that the lower cost of
manufacturing LEDs, their vastly extended life, and their energy efficiency will
fuel this trend toward LEDs into the foreseeable future.




Precision
Optics Industry




We
believe that the demand for optical-based components is growing
rapidly.  These components are utilized in a wide variety of products,
including DVD players, digital cameras, and night vision
equipment.  In addition, optical devices are currently being used in
many applications in the telecommunications industry.  We make a wide
variety of tools which grind and polish materials such as glass, crystals,
ceramics, compound semiconductor materials, metals, and plastics to make lenses,
prisms, displays, mirrors and other products.  Although it is
difficult to quantify total market size, optics has become, and will continue to
serve as, a source of stable and substantial revenue and growth for
us.  Growth drivers for the optics industry include the increased
demand for consumer electronics, the need for more sophisticated tools, the
introduction of semiconductor manufacturing technology to the field of optics,
and opportunities in the People’s Republic of China.




6




Our
Competitive Strengths




We
believe the following strengths serve as a foundation for our
strategy:




●
              Quality,
      Excellence and Reliability.  Over the years, we have
      manufactured what we believe to be high quality products that are robust,
      reliable and long-lasting.  For example, nTegrityTM,our first
      generation CMP tool developed in 1991, is still being sold today and
      maintains a large installed base.●
              Highly
      Configurable and Flexible Tools. We focus on
      developing tools that are flexible for our customers, rather than wafer
      size specific tools.  All of our tools are capable of processing
      multiple wafer sizes, in multiple configurations.  For example,
      our new STB P300TM
      CMP tool is unique in the semiconductor industry in its ability to convert
      from 200mm to 300mm wafer processing capability in a matter of
      hours.  In addition, the STB P300TMoffers
      unmatched process flexibility due to its independent turret
      design.  This flexibility and configurability has enabled us to
      serve a wider variety of markets and product applications with just a
      single tool.●
              Innovative
      Technology Applications and Product Options.  With a
      focus on building cutting edge tools, we have developed a host of advanced
      technologies that have allowed us to differentiate our products from those
      of our competitors.  These technologies include the nVision IITM, an in-pad
      optical endpoint detection system for CMP,and advanced
      carrier technologies such as ViPRRTM wafer carrier.
      All of these technologies are protected by multiple patents, pending
      patents and trade secrets belonging to Strasbaugh.●
              Next
      Generation Tools.We have developed
      next generation tools for over 50 years.  By utilizing our
      proprietary technology and working closely with customers, we have
      developed several new next generation tools that are just now being
      introduced into the market.  The STB P300TM, our next
      generation 300mm automatic CMP tool and wafer polisher, incorporates a
      host of new technologies and features a highly configurable and efficient
      design.  We believe that STB P300TMis a cost
      effective product given its low cost of ownership and a high throughput
      for its small footprint.  Our other next-generation tools
      include nVision IITMand a prototype 300mm wafer
grinder.


Our
Strategy




The
primary elements of our business strategy include:




Increase our
current market presence and selectively pursue new opportunities in mainstream
markets.  We intend to use our newly-developed products to
increase our current market share and selectively pursue new opportunities in
the mainstream semiconductor CMP and silicon wafer markets.  These
products include STB
P300TM, our advanced next-generation 300mm wafer polisher, and nVision IITM, our
newly-developed endpoint detection system.




While we
are targeting front-end-of-line, or FEOL, applications, including oxide,
tungsten, and shallow trench isolation, or STI, a recent shift in copper
CMP from a 3-step process to a 2-step CMP process may also give the STB P300TM a competitive
advantage for copper processing.  We believe that the CMP systems made
by the market leader, Applied Materials, Inc., are not well suited to a 2-step
copper process and the CMP systems of the other current market leader, Ebara
Corporation, are costly and have a very large footprint.  We further
believe that our STB
P300TM may offer an advantage with its compact, efficient design and
process flexibility that results in a lower cost of ownership and a better
throughput/footprint.




7




Continue to focus
on underserved semiconductor niche markets and offer high value
products.With a comprehensive product line, we intend to
continue to look for semiconductor niche markets and new product applications
where we can quickly use our competencies to become a market
leader.  We believe that many of our target customers seek high value
products that combine quality, excellence and reliability at prices competitive
with other leading products offered in the marketplace.  We intend to
continue to focus on high value product offerings by promoting and offering our
products that are affordable alternatives to the higher-priced products offered
by some of our competitors.




Expand our
presence in Taiwan.  We intend to expand our marketing and
sales efforts in Taiwan by setting up a direct sales and service office in this
key growing market.  Our strategy to expand our presence in Taiwan
involves leveraging our technological advantage for TSV, LED, FEOL and 2-step
copper CMP processes.All of these applications are expected to grow rapidly in
Taiwan.  For example, STB P300TM and our latest
grinding product have been well received by major Taiwanese manufacturers to
whom we have introducedthese products.




Continue to
develop next generation products.  We believe that our future
success is dependent on our ability to continue to develop next generation
products and technologies.  For example, we are in the process of
designing a new optical end-point detection system for CMP products that will
allow this key enabling technology to be implemented for the first time on the
large installed base of our competitors’ CMP tools. Another example of our
forward thinking is the patents and prototypes we have for an advanced wafer
grinding tool.




Pursue strategic
technology and/or product acquisitions.  We intend to
selectively pursue acquisitions of technology and/or products that enhance our
position in the markets in which we compete.  We believe that because
of our distribution capabilities, strong sales organization and relationships
with long-standing customers, we are well positioned to take advantage of
acquiring, licensing or distributing other products or technology.




Products
and Services




We have a
comprehensive product line of polishing, grinding and optics tools that serve a
wide range of markets and product applications.  We have built a core
competency designing innovative and quality manufacturing tools that provide
high-yield cost-effective solutions to our customers.  Our most recent
product offerings include the STB P300TM and the nVision IITM.




STB
P300TM




Introduced
in July 2009, the STB
P300TM is our newest product offering.  The STB P300TM is the industry’s
first CMP system to be designed to incorporate Next Generation Factory (“NGF”)
principles.  We believe that the STB P300TM combines the
greatest production and process flexibility of any CMP machine on the market
with the most advanced CMP technologies available.  With
industry-leading process performance, integrated state-of-the-art cleaning, low
cost of ownership and at a lower capital cost than its competition, we believe
the STB P300TM offers
device makers a new and better choice in CMP.  The STB P300TMis designed to meet
the needs of customers in several market segments, including semiconductor chip
manufacturing, silicon wafer fabrication, data storage and SOI.  We
believe this system has a much larger market potential than nTegrityTM,our previous
generation product.




8




STB P300TMtakes elements from
our previous generation300mm research and
development CMP system and earlier 300mm production technologies, and is the
culmination of CMP technologies developed at Strasbaugh over the past 15
years.  We shipped our first STB P300TM to a major Japanese
manufacturer in January 2010.   This sale represents a strategic
win for us and demonstrates the competitiveness of our next generation CMP
system internationally.




Another
strategic win is the booking of our first STB P300TM order to a major
data storage manufacturer, our primary target market for the introduction of the
STB P300TM.




nVision
IITM




nVision IITM is a newly
developed endpoint detection system designed to control semiconductor and SOI
CMP wafer processes for the newest generation integrated circuits. nVision IITM combines multiple
endpoint capabilities, optical signal, spindle motor current, table motor
current and pad temperature, into one system.  Using our proprietary
SmartPad®
technology, we believe nVision
IITM is a key technological breakthrough for endpoint detection systems
with the potential for use on most major brand CMP tools.




nTegrityTM




With over
300 tools in use by high-production semiconductor fabrication facilities
throughout the world, our nTegrityTM 200mm CMP system
has a proven record of adaptability and reliability.  We believe that
nTegrityTM is the
leading choice for the demanding data storage industry and for emerging
applications such as SOI, LED and MEMS. For applications not requiring an
integrated cleaner, we believe that nTegrityTM provides the
highest throughput per dollar of capital cost and the highest throughput per
square foot of clean room space of any CMP tool currently
available.  nTegrityTM was introduced in
1991.




Optics
Products




We offer
a full line of optical polishing (nFocusTM), ring lapping (nGaugeTM), continuous pitch
polishing (nSpecTM) and
curve generator (nLightenTM)
tools.  We have sold over 12,000 optical tools and we believe that we
have the world’s most comprehensive product line. Our optical products offer
greater precision, more reliable performance and long tool life than similar
products from our competitors.




Service,
Parts and Consumables




Our large
installed equipment base provides us with a source of recurring service, parts
and consumables revenues.  We have an international network of field
service engineers and we provide a variety of different service options, and
tailor service requirements to meet the needs of each customer.  A
one-year warranty covering parts and labor is included with each new tool. When
designing custom service plans, we can provide as much or as little as the
customer requires.  For example, service plans range from on-site
field service engineers to regularly scheduled maintenance with technical
support available 24 hours per day, 7 days a week.  Many customers
contract for regularly scheduled maintenance programs in which our service
engineers calibrate, adjust and clean their tools at regular
intervals.  Typically running between $20,000 and $100,000 per year,
service plans are negotiated with the customer depending upon the type of
machine and the level of service requested.  We also have a 24-hour
service line to field any emergency calls.




With a
large installed base of tools, we also enjoy a sizable parts and consumables
business.  Service, parts and consumables accounted for approximately
$5.5 million and $6.5 million in revenues for 2009 and 2008, respectively, or
42% and 68% of net revenues, respectively.  Parts include valves,
pulleys, belts, motors, joints, carriers and any of the thousands of parts used
in our tools.  Parts are purchased in three different ways: spare
parts kits that include the most commonly needed parts for each machine; single
parts as needed; and by consignment at customer
facilities.  Consumables include wafer retaining rings, wafer films,
shims, conditioning discs and other parts of the system that typically wear out
in conjunction with wafer processing.  Consumables sales are made on a
recurring basis and are generally more predictable than spare parts
sales.




9




Customers




We have a
large, active and diverse customer base and we maintain long-standing
relationships with our core customers.  Our main customers include
leading semiconductor device manufacturers, silicon wafer manufacturers, data
storage companies, and a multitude of smaller customers in multiple niche
markets.  Our top five customers accounted for 72% and 43% of net revenues
during 2009 and 2008, respectively. Three customers each accounted for more than
10% of net revenues during 2009 and two customers each accounted for more than
10% of net revenues during 2008. Our customers purchase our products by issuing
purchase orders from time to time.  We do not have long-term purchase
orders or commitments with our customers.  As a result, our customers may
terminate their relationship with us at any time.




Within
the semiconductor industry, we have a large installed base of tools at companies
representing the leaders in the industry, including Fortune 500 and Global 1000
companies.  In addition to these market leaders, we have a large number of
second and third-tier specialty customers that prefer lower prices, better
service and more customized solutions.  We also sell tools to testing
laboratories and research and development facilities at large device
manufacturers, as well as university research laboratories.




Within
the silicon industry, we sell to silicon wafer manufacturers that perform the
front-end polishing of the wafer before selling it to device
manufacturers. In the LED industry, we sell to the market leaders of
high-end devices who manufacture disk drives and memory applications. In
the optics industry, we have been manufacturing and selling machines to
thousands of customers since 1948.  Optics tools are sold to a wide variety
of customers and industries, including aerospace, defense, optical labs,
research institutions and medical applications.




Sales
and Marketing




Our sales
and marketing strategy focuses on establishing Strasbaugh as the premier
provider of polishing and grinding equipment by developing long-term
relationships with our active customer base. A key competitive advantage of our
sales process lies within our customer-focused approach. We frequently
collaborate with our leading customers to refine existing product lines and
design new innovations to meet their specific requirements.




With a
wide variety of markets served and product applications, we target markets where
we can be a market leader, such as data storage, LED and precision optics. In
mainstream markets, such as semiconductor CMP and silicon wafer, we target
applications where we can be the more customer-focused, low-cost alternative to
larger competitors with more expensive tools.




We are
currently re-developing our sales channels and are establishing a direct sales
and service office in Taiwan, based on feedback from customers who have stated a
preference working directly with Strasbaugh rather than through a
distributor.  We believe that establishing a direct sales and service
office will improve the communication and support available to our customers,
reduce costs, and result in greater savings to our customers and greater
profitability for Strasbaugh.




10




We use a
direct sales force in the United States who are all employees of Strasbaugh and
are paid a base salary plus commission.  In the United States, our
sales professionals sell equipment by geographic region.  We also have
a sales professional who focuses exclusively on the sale of our opticsproducts
worldwide.  With an average of eight years tenure at Strasbaugh, our
sales professionals are extremely knowledgeable about our products and the
markets in which we sell.  Our Vice President of Worldwide Sales is
responsible for managing our direct sales professionals and international
network of representatives.  Outside of the United States, and soon in
Taiwan, we rely on a sophisticated network of sales representatives to sell and
service our products.  Sales in Europe are handled
by distributors, one of whom has worked with us for ten
years.  Sales in China, South Korea and the rest of Asia are
handled by representatives who have also worked with us for many
years.  Both distributors and sales representatives offer our full
line of products.  Distributors purchase products directly from us at
our domestic retail price and then mark up their prices for sales in
Europe.  Our sales representatives are paid a commission of 10% – 15%
of the total amount of sales made by each such sales representative. Neither our
sales representatives, distributors nor the ultimate end users of our products
have return or exchange rights with respect to our products.  Also, we
do not offer any further sales incentives such as advertising or exclusivity
charges or a right of return.  Our sales representatives and
distributors may enter into maintenance contracts with their customers and the
particular distributor or sales representative will pay us directly for time and
material should our employees be used to provide maintenance
services.




Our sales
professionals, sales representatives and distributorsstrive to develop close
relationships with current and prospective customers.  We maintain
constant contact with customers to assess their needs and to update them on the
latest product developments.  In addition, our sales professionals
regularly attend national and international trade and technical shows to stay
abreast of industry trends and foster deeper relationships with
customers.  After contact has been initiated with a potential client,
we conduct a variety of meetings and presentations to introduce our products and
services.  Typically, customers will be provided with price
quotations, tool and process specifications, and product demonstrations before
an order is produced.




Competition




Substantial
competition exists for our products. Competitors range from small companies that
compete with us with a single product and/or in a single region to global
companies with multiple product lines.  We believe that our strong
competitive position is based on our ability to successfully provide products
and services that address customer requirements.




Semiconductor
CMP




The
number of CMP tool manufacturers has decreased in recent years leaving Applied
Materials and Ebara as our only competitors in the market for mainstream
semiconductor CMP products.  Within the mainstream semiconductor CMP
market we have traditionally focused on niche and specialty applications that
are not the main focus of Applied Materials.  However, we believe that
our most recent product offering, the STB P300TM,provides us with the
opportunity to compete on a technical basis in the significantly larger portion
of the mainstream semiconductor CMP market.




Semiconductor
Niche Market and Applications




Within
our small niche markets and applications, we face competition from a variety of
companies.  In failure analysis, we face competition from other
manufacturers of semi-automated CMP tools, including Logitech and MAT,
Inc.  Logitech and MAT, Inc. tools are designed to compete against
some of our legacy CMP tools adapted to this application.  Our
competitors offer less expensive products than us, but our products offer
greater precision and, we believe, performance.




Our main
competition in backgrinding is Disco Corporation, which we believe has the
largest market share, followed by Okamoto Industries.




11




Silicon
Wafer Fabrication and Niche Markets




In
silicon wafer fabrication and niche markets, our primary competition is from
Lapmaster and Peter Wolters (now owned by Novellus). We believe that our STB P300TM polisher is a
generation ahead of the tools offered by these competitors in terms of polishing
performance and that this enhanced level of performance may be required by the
industry as it migrates towards the sub-22nm technology node.




SOI/MEMS




We have
been successful in marketing our nTegrityTM product to smaller
customers in the SOI market, but have not been able to gain wide acceptance with
the larger companies that require newer technologies unavailable on nTegrityTM, such as integrated
cleaning, 300mm-capable wafer grinding and optical endpoint
detection.  The first installation of our new nVision IITMoptical endpoint
tool was to a major SOI producer and the launch of STB P300TMwill provide the
other technical innovations we believe required to compete in this
market.




MEMS are
mostly large feature size applications where there is less need for
sophisticated high volume production tools.  We face competition in
this market primarily from de-commissioned Integrated Process Equipment Corp CMP
tools.




LED




In the
LED market, our main competition comes from Disco Corporation for the sale of
grinders.




Data
Storage




Our main
competitors in the data storage market are Applied Materials and
Ebara.




Optics




Our
optics products face competition from more sophisticated automated machines in
the more sophisticated markets of the United States, Europe and
Japan.  In Asia we face competition from lower quality and lower
priced Asian made equipment.




Manufacturing




Our
headquarters are located approximately 185 miles south of San Jose in San Luis
Obispo, California. We lease a 135,000 square foot building owned by Alan
Strasbaugh, our Chairman of the Board and major shareholder.  The
facility is comprised of approximately 106,000 square feet of manufacturing
space, including 11,600 square feet of clean assembly space and 1,200 square
feet of clean rooms (60% Class 100, 40% Class 10).  All of our
manufacturing is completed at these facilities with full ability for design,
fabrication, assembly and distribution requiring a minimal amount of
outsourcing.  As a result of excess capacity, we are currently
subleasing approximately 40,000 square feet of the facility to third parties on
a short term basis. We estimate that current manufacturing capacity provides us
with the ability to substantially increase sales with only the addition of
personnel and relatively little capital equipment expenditures.  We
estimate that the facilities, machinery and equipment will support annual net
revenues of approximately $100 million.




Intellectual
Property




We
believe that we have a broad intellectual property portfolio.  We
primarily own intellectual property protecting the design features or operating
methods for tools manufactured by us for polishing or grinding semiconductor and
silicon wafers.  Our portfolio consists of 150 trade secrets and
processes, 89 issued patents, 12 licensed patents, and 31 patents
pending.  Our ten most important patents were issued between June 1995
and July 2007.  The duration of these patents runs until between June
2012 and August 2025.  The patents in our entire portfolio expire
between June 2012 and August 2024.  With customers worldwide, we have
received international patents covering Japan, China, Taiwan, Europe, Korea and
Singapore.




12




In 2000,
as part of a capital infusion by Lam Research Corporation, or Lam, into
R. H. Strasbaugh, we sold certain intellectual property to Lam, or Lam
Intellectual Property, for $4 million and concurrently entered into a License
Agreement with Lam.  Pursuant to the terms of the License Agreement,
for the duration of the License Agreement, which is perpetual unless terminated
as described below, Lam granted us a non-exclusive, royalty-free worldwide
license to use, upgrade, or modify the Lam Intellectual Property in industries
that develop, design, make, use, sell, repair or service semiconductor
processing equipment used in the fabrication of integrated
circuits.  These industries are collectively referred to in this
report as the Semiconductor Processing Equipment
Industry.  Additionally, pursuant to the License Agreement, Lam
granted to us an irrevocable, perpetual, exclusive, royalty-free worldwide
license to use the Lam Intellectual Property in any industry except the
Semiconductor Processing Equipment Industry.  The License Agreement
may be terminated upon either party breaching a material provision of the
License Agreement, ceasing to do business, ceasing to carry on as a going
concern or becoming insolvent.  The licensed intellectual property
originally consisted of 6 issued patents, 9 patent applications and 19 internal
disclosures related to CMP.  At this time, 12 patents have been issued
and licensed back to us.




Trademarks




Our
trademarks are filed and/or registered for a series of product names, all
beginning with the letter “n.”We currently have six
registered trademarks, five trademarks and one trademark with a filed
application for registration.




Employees




As of
March 26, 2010, we employed 82 full and part-time employees.  None of
our employees are represented by labor unions, and there have not been any
unplanned work stoppages at our facilities.  We generally consider our
relationships with our employees to be satisfactory.




Internet
Website




Our
Internet website is www.strasbaugh.com.  The
content of our Internet website does not constitute a part of this
report.




Item
1A. Risk
Factors.


An
investment in our common stock involves a high degree of risk. In addition to
the other information in this Annual Report on Form 10-K and in our other
filings with the Securities and Exchange Commission, or SEC, including our
subsequent reports on Forms 10-Q and 8-K, you should carefully consider the
following risk factors before deciding to invest in shares of our common stock
or to maintain or increase your investment in shares of our common stock. The
risks and uncertainties described below are not the only ones we face.
Additional risks and uncertainties not presently known to us or that we
currently deem immaterial may also affect our business, financial condition and
operating results. If any of the following risks, or any other risks not
described below, actually occur, it is likely that our business, financial
condition and operating results could be seriously harmed. As a result, the
trading price of our common stock could decline, and you could lose part or all
of your investment.




13




Risks
Relating to Our Business




The
industries within which we compete are cyclical and may experience periodic
downturns that may reduce customer demand for our products which, in turn, may
have an adverse impact on our results of operations, cash flows and financial
condition.




We
operate and compete within the semiconductor and semiconductor equipment,
silicon wafer and silicon wafer equipment, data storage, MEMS, LED and precision
optics industries.  These industries are cyclical and have
historically experienced periodic downturns, which have often resulted in a
decrease in demand for capital equipment.  Commencing in the third
quarter of 2007, we have seen a marked downturn in many of the industries within
which we operate and compete.  This current downturn has resulted in a
reduction in demand for our products which, in turn, has had an adverse impact
on our results of operations for 2008 and 2009.  A prolonged
continuation of the current downturn in these industries or any future downturn
may have an adverse impact on our future results of operations, cash flows and
financial condition.




We
have incurred losses in the past and we may incur losses in the
future.  If we incur losses in the future, we may experience negative
cash flow, which may hamper our operations, may prevent us from expanding our
business and may cause our stock price to decline.




We
incurred net losses of $680,000 and $4.5 million for the years ended
December 31, 2009 and 2008, respectively.  We also incurred net
losses in each of the years ended December 31, 2002 through 2005 and in
2007.  We may incur losses in future years due to, among other
factors, instability in the industries within which we operate, uncertain
economic conditions worldwide or lack of acceptance of our products in the
marketplace.  If we incur losses in the future, it may make it
difficult for us to raise additional capital to the extent needed for our
continued operations, particularly if we are unable to maintain profitable
operations in the future.  Consequently, future losses may result in
negative cash flow, which may hamper current operations and may prevent us from
expanding our business.  We may be unable to attain, sustain or
increase profitability on a quarterly or annual basis in the
future.  If we do not attain, sustain or increase profitability, our
stock price may decline.




The
current global financial crisis and uncertainty in global economic conditions
may have significant negative effects on our customers and our suppliers and may
therefore affect our business, results of operations, and financial
condition.




The
current global financial crisis—which has included, among other things,
significant reductions in available capital and liquidity from banks and other
providers of credit, substantial reductions and/or fluctuations in equity and
currency values worldwide, and concerns that the worldwide economy may enter
into a prolonged recessionary period—may have a significant negative effect on
our business and operating results.  The potential effects of the
current global financial crisis are difficult to forecast and mitigate. As a
consequence, our operating results for a particular period are difficult to
predict, and, therefore, prior results are not necessarily indicative of results
to be expected in future periods.




The
current economic crisis may affect our current and potential, direct and
indirect, customers’ access to capital or willingness to spend capital on our
products, and/or their levels of cash liquidity with which or willingness to pay
for products that they will order or have already ordered from
us.  The effect of the current economic conditions on our customers
may therefore lead to decreased demand, including order delays or cancellations,
which in turn may result in lower revenue and adversely affect our business,
results of operations and financial condition.




14




Likewise,
the current global financial crisis may negatively affect our suppliers’ access
to capital and liquidity with which to maintain their inventories, production
levels, and/or product quality, and could cause them to raise prices or lower
production levels, or result in their ceasing operations.  The
challenges that our suppliers’ may face in selling their products or otherwise
in operating their businesses may lead to our inability to obtain the materials
we use to manufacture our products. These actions could cause reductions in our
revenue, increased price competition and increased operating costs, which could
adversely affect our business, results of operations and financial
condition.




The
industries within which we compete are extremely competitive.  Many of
our competitors have greater financial and other resources and greater name
recognition than we do and one or more of these competitors could use their
greater financial and other resources or greater name recognition to gain market
share at our expense.




We
believe that to remain competitive, we will require significant financial
resources in order to offer a broad range of products, to maintain customer
service and support centers worldwide and to invest in research and development.
Many of our existing and potential competitors, including Applied Materials and
Ebara, have substantially greater financial resources, more extensive
engineering, manufacturing, marketing and customer service and support
capabilities, larger installed bases of current generation products, as well as
greater name recognition than we do. As a result, our competitors may be able to
compete more aggressively and sustain that competition over a larger period of
time than we could.  Our lack of resources relative to many of our
significant competitors may cause us to fail to anticipate or respond adequately
to new developments and other competitive pressures.  This failure
could reduce our competitiveness and cause a decline in our market share, sales
and profitability.




We
depend on a small number of customers for a significant portion of our total
sales.  A reduction in business from any of these customers could
cause a significant decline in our net revenues and profitability.




A
significant portion of our total net revenues are generated from a small number
of customers.  Our top five customers accounted for approximately 72%
and 43% of our net revenues during 2009 and 2008, respectively.  Three
customers each accounted for more than 10% of net revenues during 2009 and two
customers each accounted for more than 10% of net revenues during 2008. Although
the composition of the group comprising our largest customers may vary from year
to year, the loss of a significant customer or any reduction in orders by any
significant customer, including reductions due to market, economic or
competitive conditions in the industries in which we operate could cause a
significant decline in our net revenues and profitability.Our ability to increase
our net revenues in the future will depend, in part, upon our ability to obtain
orders from new customers, as well as the financial condition and success of our
existing customers and the general economy, which are largely beyond our ability
to control.




Our
potential customers may not purchase our products because of their significant
cost or because our potential customers are already using a competitor’s product
which, in turn, could cause a decline in our sales and
profitability.




A
substantial investment is required to install and integrate capital equipment
into a semiconductor or silicon wafer production line. We believe that once a
manufacturer has selected a particular vendor’s capital equipment, that
manufacturer generally relies upon that vendor’s equipment for that specific
production line application and, to the extent possible, subsequent generations
of that vendor’s systems. Accordingly, it may be extremely difficult to achieve
significant sales to a particular customer once that customer has selected
another vendor’s capital equipment unless there are compelling reasons to do so,
such as significant performance or cost advantages. Any failure to gain access
and achieve sales to new customers will adversely affect the successful
commercial adoption of our products and could cause a decline in our sales and
profitability.  Any significant order cancellations or order deferrals
could adversely affect our operating results.




15




Our
lack of long-term purchase orders and commitments could lead to a rapid decline
in our sales and profitability.




Our
customers issue purchase orders requesting products they desire to purchase from
us, and if we are able and willing to fill those orders, then we fill them under
the terms of the purchase orders.  Accordingly, we cannot rely on
long-term purchase orders or commitments to protect us from the negative
financial effects of reduced demand for our products that could result from a
general economic downturn, from changes in the industries within which we
operate, including the entry of new competitors into the market, from the
introduction by others of new or improved technology, from an unanticipated
shift in the needs of our customers, or from other causes.




Some
of our product sales cycles are lengthy, exposing us to the risks of inventory
obsolescence and fluctuations in operating results.




Sales of
our products depend, in significant part, upon the decision of a prospective
customer to add new manufacturing capacity or to expand existing manufacturing
capacity, both of which typically involve a significant capital
commitment.  Our products typically have a lengthy sales cycle, often
six to twelve months, during which time we may expend substantial funds and
management effort.  Lengthy sales cycles subject us to risks of
inventory obsolescence and fluctuations in operating results over which we have
little or no control.  Because technology changes rapidly, we may not
be able to introduce our products in a timely fashion.




Products
within the industries in which we operate are subject to rapid technological
changes.  If we fail to accurately anticipate and adapt to these
changes, the products we sell will become obsolete, causing a decline in our
sales and profitability.




The
industries within which we compete are subject to rapid technological change and
frequent new product introductions and enhancements which often cause product
obsolescence.  We believe that our future success depends on our
ability to continue to enhance our existing products and their process
capabilities, and to develop and manufacture in a timely manner new products
with improved process capabilities.  We may incur substantial
unanticipated costs to ensure product functionality and reliability early in its
products’ life cycles.  If we are not successful in the introduction
and manufacture of new products or in the development and introduction, in a
timely manner, of new products or enhancements to our existing products and
processes that satisfy customer needs and achieve market acceptance, our sales
and profitability will decline.




We
obtain some of the components and subassemblies included in our products from a
single source or limited group of suppliers, the partial or complete loss of
which could have an adverse effect on our sales and profitability.




We obtain
some of the components and subassemblies for our products from a single source
or a limited group of suppliers.  From time to time, we have
experienced temporary difficulties in receiving our orders from some of these
suppliers.  Although we seek to reduce dependence on these sole and
limited source suppliers, the partial or complete loss of these sources could
adversely affect our sales and profitability and damage customer relationships
by impeding our ability to fulfill our customers’ orders.  Further, a
significant increase in the price of one or more of these components or
subassemblies could adversely affect our profit margins and profitability if no
lower-priced alternative source is available.




16




We
manufacture all of our products at a single facility.  Any prolonged
disruption in the operations of that facility would result in a decline in our
sales and profitability.




We
manufacture all of our products in a facility located in San Luis Obispo,
California.  Our manufacturing processes are highly complex, require
sophisticated and costly equipment and a specially designed
facility.  As a result, any prolonged disruption in the operations of
our manufacturing facility, whether due to technical or labor difficulties,
termination of our month-to-month lease of this facility, destruction of or
damage to this facility as a result of an earthquake, fire or any other reason,
would result in a decline in our sales and profitability.




We
rely upon sales representatives and distributors for a significant portion of
our sales.  A disruption in our relationship with any sales
representative or distributor could cause our sales and profitability to
decline.




A
significant portion of our sales outside of the United States are made through
sales representatives and distributors.  The activities of these sales
representatives and distributors are not within our control, and they may sell
products manufactured by other manufacturers.  In addition, in some
locations our sales representatives and distributors also provide field service
and support to our customers.  A reduction in the sales efforts or
financial viability of these sales representatives and distributors, or a
termination of our relationship with these sales representatives and
distributors, could cause our sales and profitability to decline.




We
may not be able to protect our intellectual property or obtain licenses for
third parties’ intellectual property and, therefore, we may be subject to one or
more intellectual property infringement claims which may adversely affect our
sales, earnings and financial resources.




Although
we attempt to protect our intellectual property rights through patents,
copyrights, trade secrets and other measures, we may not be able to protect our
technology adequately, and competitors may be able to develop similar technology
independently.  Additionally, patent applications that we may file may
not be issued and foreign intellectual property laws may not protect our
intellectual property rights.  There is also a risk that patents
licensed by or issued to us will be challenged, invalidated or circumvented and
that the rights granted thereunder will not provide competitive advantages to
us.  Furthermore, others may independently develop similar products,
duplicate our products or design around the patents licensed by or issued to
us.




Litigation
could result in substantial cost and diversion of effort by us, which by itself
could adversely affect our sales, earnings and financial
resources.  Further, adverse determinations in such litigation could
result in our loss of proprietary rights, subject us to significant liabilities
to third parties, require us to seek licenses from third parties or prevent us
from manufacturing or selling our products.  In addition, licenses
under third parties’ intellectual property rights may not be available on
reasonable terms, if at all.




We
depend on the services of Alan Strasbaugh and Chuck Schillings, and the loss of
either of them could adversely affect our ability to achieve our business
objectives.




Our
continued success depends in part upon the continued service of Alan Strasbaugh,
who is our Chairman of the Board, and Chuck Schillings, who is our President and
Chief Executive Officer.  Each is critical to the overall management
of Strasbaugh as well as to the development of our technologies, our culture and
our strategic direction.  For example, Alan Strasbaugh is a member of
our technology committee and provides expertise on the development of our
products, and Chuck Schillings is instrumental in developing and maintaining
close ties with our customer base.  Although we have entered into
employment agreements with Messrs. Strasbaugh and Schillings, neither of
these agreements guarantees the service of the individual for a specified period
of time.  In addition, we do not maintain “key-person” life insurance
policies on Messrs. Strasbaugh or Schillings.  The loss of either Alan
Strasbaugh or Chuck Schillings could significantly delay or prevent the
achievement of our business objectives.




17




We
are exposed to additional risks associated with international sales and
operations.




International
sales accounted for approximately 17% and 29% of our net revenues during 2009
and 2008, respectively. Although we experienced a decline in international sales
during 2009 as compared to 2008, we expect that these sales will increase in
2010.  Our international sales are subject to certain risks, including
the following:


●
                tariffs
      and other trade barriers;●
                challenges
      in staffing and managing foreign operations and providing prompt and
      effective support to our customers outside the United
      States;●
                difficulties
      in managing foreign distributors;●
                governmental
      controls, either by the United States or other countries, that restrict
      our business overseas or the import or export of our products, or increase
      the cost of our operations;●
                longer
      payment cycles and difficulties in collecting amounts receivable outside
      of the United States;●
                inadequate
      protection or enforcement of our intellectual property and other legal
      rights in foreign jurisdictions;●
                global
      or regional economic downturns; and●
                geo-political
      instability, natural disasters, acts of war or
  terrorism.




There can
be no assurance that any of these factors will not have a material adverse
effect on our business, financial condition or results of
operations.  In addition, each region in the global markets within
which we operate exhibits unique market characteristics that can cause capital
equipment investment patterns to vary significantly from period to
period.




Risks
Relating to Ownership of our Common Stock




Because
certain actions taken by our prior board of directors may have been inconsistent
with the Plan of Dissolution approved by our shareholders and applicable
provisions of California law, we could be subject to significant liabilities
which would adversely affect our financial condition.




On
June 3, 2005, our shareholders approved the Plan of Dissolution and thereby
voluntarily elected to wind-up and dissolve Strasbaugh (formerly, CTK Windup
Corporation).  Under the terms of the Plan of Dissolution and
California law, after our shareholders approved the Plan of Dissolution and
thereby voluntarily elected to wind-up and dissolve Strasbaugh, our activities
were to be limited to conducting our business only insofar as necessary for the
winding up of our company.  Consequently, seeking shareholder approval
of, and entering into, the Share Exchange Transaction, may be viewed and
ultimately determined to be in conflict with the Plan of Dissolution and the
disclosures we made in our Proxy Statement filed with the SEC on May 5,
2005 relating to the special meeting of our shareholders at which we sought
approval of the Plan of Dissolution.  Additionally, the actions we
took in connection with declaring and paying certain dividends after our
shareholders approved the Plan of Dissolution may be viewed and ultimately
determined to be in violation of California law.  Although we believe
that the activities we conducted after our shareholders approved the Plan of
Dissolution were consistent with (i) the Plan of Dissolution, (ii) the
disclosures we made in our proxy statement, (iii) applicable provisions of
California law and (iv) our former board’s fiduciary duties to our
shareholders, it is possible that our shareholders, the SEC, the California
Commissioner of Corporations and/or the California Secretary of State may
disagree with us.  If that were to happen, we may be subject to an
action by our shareholders or by a regulatory agency for acting in a manner
inconsistent with the Plan of Dissolution and/or an action by the SEC and/or the
California Commissioner of Corporations for acting in a manner inconsistent with
California law and/or disseminating a proxy statement that contained material
misstatements.  If it is determined that disclosures contained in our
proxy statement seeking approval of the Plan of Dissolution were misleading and,
as a result, violated federal or state proxy rules, we may also be subject to
fines and other unspecified relief imposed by the SEC and/or the California
Commissioner of Corporations. The dollar amount of any damages and/or fines and
the costs associated with any potential shareholder lawsuit or action by the
SEC, the California Commissioner of Corporations and/or the California Secretary
of State is difficult for us to quantify, yet it could be significant. If it is
significant, our financial condition would be materially and adversely
affected.




18




After our
shareholders approved the Plan of Dissolution and before we obtained shareholder
approval for the Share Exchange Transaction, our former board of directors
declared and paid “extraordinary dividends” to our
shareholders.  Under California law, a corporation cannot revoke its
election to wind up and dissolve after distributing assets pursuant to the
corporation’s election to wind up and dissolve.  We believe that the
dividends that were declared and paid were “extraordinary dividends” and not
dividends made in connection with the distribution of assets pursuant to our
election to wind up and dissolve.  We also believe that the actions
taken by our former board of directors with respect to the declaration of
“extraordinary dividends” were consistent with California
law.  However, a contrary finding – namely, that the dividends were
made pursuant to our election to wind up and dissolve and/or our board of
directors did not have the power to declare any dividend, other than a dividend
in connection with our election to windup and dissolve – could mean that we did
not have the power to revoke our election to windup and dissolve, and
consequently that we did not have the power to enter into the Share Exchange
Transaction or to issue shares of our Series A Preferred Stock, or enter
into the Series A Preferred Stock Financing or to grant options under our 2007
Share Incentive Plan.  If this were the case, we could potentially
have violated the laws of the State of California and misrepresented to our
shareholders (including the former shareholders of R. H. Strasbaugh) and
holders of our issued and outstanding options and warrants that we had the power
to enter into the Share Exchange Transaction and the Series A Preferred Stock
Financing, to grant options under our 2007 Share Incentive Plan and to issue
warrants, as the case may be.  As a result, we could be subject to
actions by the California Secretary of State, the California Commissioner of
Corporations, our shareholders (including the former shareholders of R. H.
Strasbaugh) and/or holders of our issued and outstanding options and
warrants.  One possible outcome of such action or actions could be a
declaration that the securities we issued or may issue after our shareholders
approved the Plan of Dissolution, including the shares of common we may issue
upon conversion of our Series A Preferred Stock and exercise of warrants we
issued in connection with the Series A Preferred Stock Financing, a portion of
which shares of common stock are being offered and sold under this prospectus,
are void.  Additionally, the Share Exchange Transaction, the Series A
Preferred Stock Financing (including the issuance of the Series A Preferred
Stock and warrants to purchase common stock) and any option grants could be
rescinded and we may be required to pay significant damages to those who
received these securities.  The dollar amount of any damages and costs
associated with any of these potential actions is difficult for us to quantify,
yet it could be significant.  If it is significant, our financial
condition would be materially and adversely affected.




19




Because
of inaccuracies contained in a press release we issued in December 2005, certain
of our shareholders may have inaccurately reported certain tax benefits on their
federal income tax returns which could result in claims against us.




On
December 14, 2005, we issued a press release that contained an inaccurate
representation of the extraordinary cash dividend issued on December 22,
2005.  Contrary to our intention that both the dividends be treated as
extraordinary cash dividends, the press release stated that the dividend issued
on December 22, 2005 “will be treated for federal income tax purposes as a stock
redemption in partial liquidation” of our business. As a result of our
inaccurate and contradictory disclosures, some or all of  our
shareholders may have reported one or both of the distributions we made in 2005
to the Internal Revenue Service, or IRS, as liquidating dividends rather than as
extraordinary dividends.  Although, in either case, the applicable tax
rate would have been the same, if a shareholder characterized the dividend
payment as a liquidating dividend rather than as an extraordinary dividend, the
shareholder would have received an unintended benefit of being able to deduct
the cost basis of the shares in determining the total amount of taxable gain or
loss as a result of such distribution.  If such a shareholder’s tax
return were audited by the IRS, the IRS may conclude that the shareholder should
not have been able to utilize such benefit.  This conclusion by the
IRS could possibly result in an action by the shareholder against us to recover
the amount of the lost benefit and any potential penalties imposed on the
shareholder by the IRS as a result of the improper
characterization.




We
have not held an annual meeting of shareholders in several years, which could
result in a legal action being brought against us to compel an annual
meeting.




We have
not held an annual meeting of shareholders since October 21,
2004.  Under California law, if a we do not hold an annual meeting to
elect directors of Strasbaugh within fifteen months after the last annual
meeting of shareholders, a shareholder of Strasbaugh can apply to a court for an
order compelling us to hold a meeting of shareholders to elect
directors.  Because it has been more than fifteen months since our
last annual meeting where directors were elected, an action could be brought,
pursuant to California law, against Strasbaugh to compel us to hold an annual
meeting of shareholder and elect directors of Strasbaugh.




Our
common stock price has been volatile, which could result in substantial losses
for investors purchasing shares of our common stock.




The
market prices of securities of technology-based companies currently are highly
volatile.  The market price of our common stock has fluctuated
significantly in the past.  During 2009, the high and low closing bid
prices of a share of our common stock were $1.19 and $0.21,
respectively.  On March 11, 2010, the last reported sale price of a
share of our common stock was $0.50.  The market price of our common
stock may continue to fluctuate in response to the following factors, in
addition to others, many of which are beyond our control:


●
                  conversion
      of our Series A Preferred Stock and exercise of our warrants and the
      sale of their underlying common
stock;●
                  changes
      in market valuations of similar companies and stock market price and
      volume fluctuations generally;●
                  economic
      conditions specific to the industries within which we
      operate;●
                  the
      timing of introduction of new systems and technology announcements and
      releases and ability to transition between product
      versions;  20
  ●
                    changes
      in the timing of product orders due to unexpected delays in the
      introduction of our products due to lifecycles of our products ending
      earlier than expected or due to declines in market acceptance of our
      products;●
                    delays
      in our introduction of new products or technological innovations or
      problems in the functioning of our current or new products or
      innovations;●
                    third
      parties’ infringement of our intellectual property
      rights;●
                    changes
      in our pricing policies or the pricing policies of our
      competitors;●
                    regulatory
      developments;●
                    fluctuations
      in our quarterly or annual operating results;●
                    additions
      or departures of key personnel; and●
                    future
      sales of our common stock or other
securities.


Voting
power of a significant portion of our common stock is held by two of our
shareholders, the Chairman of our board of directors, Alan Strasbaugh, and his
brother Larry Strasbaugh, who, as a result, are able to control or exercise
significant influence over the outcome of matters to be voted on by our
shareholders.




Alan
Strasbaugh, our Chairman of the Board, and Larry Strasbaugh, the brother of Alan
Strasbaugh, have voting power equal to approximately 49.6% of all votes eligible
to be cast at a meeting of our shareholders.  As a result of their
significant ownership interest, these two shareholders will be able to control
or exercise significant influence with respect to the election of directors,
offers to acquire Strasbaugh and other matters submitted to a vote of all of our
shareholders.




Shares
of our common stock eligible, or to become eligible, for public sale could
adversely affect our stock price and make it difficult for us to raise
additional capital through sales of equity securities.




We cannot
predict the effect, if any, that market sales of shares of our common stock or
the availability of shares of common stock for sale will have on the market
price prevailing from time to time.  As of March 19, 2010, we had
outstanding 14,705,587 shares of common stock, a substantial number of which
were restricted under the Securities Act of 1933, as amended, or Securities
Act.  As of March 19, 2010, we also had outstanding options, warrants,
and Series A Preferred Stock that were exercisable for or convertible into
approximately 7,334,325shares of common
stock.  Sales of shares of our common stock in the public market, or
the perception that sales could occur, could adversely affect the market price
of our common stock. Any adverse effect on the market price of our common stock
could make it difficult for us to raise additional capital through sales of
equity securities at a time and at a price that we deem
appropriate.




The
conversion of our Series A Preferred Stock and the exercise of outstanding
options and warrants to purchase our common stock could substantially dilute
your investment, impede our ability to obtain additional financing, and cause us
to incur additional expenses.




Under the
terms of our Series A Preferred Stock and existing warrants to purchase our
common stock, and outstanding options to acquire our common stock issued to
employees and others, the holders of these instruments are given an opportunity
to profit from a rise in the market price of our common stock that, upon the
conversion of our Series A Preferred Stock and the exercise of the warrants
and/or options, could result in dilution in the interests of our other
shareholders.  The terms on which we may obtain additional financing
may be adversely affected by the existence and potentially dilutive impact of
our Series A Preferred Stock, options and warrants.  In addition,
holders of the Series A Preferred Stock and warrants have registration
rights with respect to the common stock underlying such Series A Preferred
Stock and warrants, the registration of which will cause us to incur a
substantial expense.




21




The
voting power and value of outstanding shares of our common stock could decline
if our Series A Preferred Stock and warrants issued to our investors are
converted or exercised at a reduced price due to our issuance of lower-priced
shares which trigger rights of the holders of our Series A Preferred Stock and
warrants to receive additional shares of our stock.




As part
of our Series A Preferred Stock Financing, we issued a significant amount
of Series A Preferred Stock and Investor Warrants, the conversion or
exercise of which could have a substantial negative impact on the price of our
common stock  The initial conversion price of our Series A
Preferred Stock and the initial exercise price of our Investor Warrants will be
subject to downward anti-dilution adjustments in most cases, from time to time,
where we issue securities at a purchase, exercise or conversion price that is
less than the then-applicable conversion price of our Series A Preferred
Stock or exercise price of our Investor Warrants.  Consequently, the
voting power and value of our common stock  in each such event would
decline if our Series A Preferred Stock or the Investor Warrants are
converted or exercised for shares of our common stock at the new lower price as
a result of sales of our securities made below the then applicable conversion
price of the Series A Preferred Stock and/or the exercise price of the Investor
Warrants.




The
market price of our common stock and the value of your investment could
substantially decline if our Series A Preferred Stock, warrants or options
are converted or exercised into shares of our common stock and resold into the
market, or if a perception exists that a substantial number of shares will be
issued upon conversion or exercise of our Series A Preferred Stock,
warrants or options and then resold into the market.




If the
conversion or exercise prices at which our Series A Preferred Stock,
warrants and options are converted or exercised are lower than the price at
which you made your investment, immediate dilution of the value of your
investment will occur.  In addition, sales of a substantial number of
shares of common stock issued upon conversion or exercise of our Series A
Preferred Stock, warrants and options, or even the perception that such sales
could occur, could adversely affect the market price of our common
stock.  You could, therefore, experience a substantial decline in the
value of your investment as a result of both the actual and potential conversion
or exercise of our Series A Preferred Stock, warrants or
options.




Because
we are subject to the “Penny Stock” rules, the level of trading activity in our
common stock may be reduced.




Our stock
constitutes “Penny Stock.” Under applicable SEC rules, Penny Stocks are
generally equity securities with a price per share of less than $5.00 (other
than securities registered on certain national
exchanges).  Broker-dealer practices in connection with transactions
in Penny Stocks are regulated by rules adopted by the SEC.  The Penny
Stock rules require a broker-dealer, prior to a transaction in Penny Stocks not
exempt from the rules, to deliver a standardized risk disclosure document that
provides information about Penny Stocks and the nature and level of risks in the
Penny Stock market.  The broker-dealer must also provide the customer
with current bid and offer quotations for the Penny Stock, the compensation of
the broker-dealer and the salesperson in the transaction, and monthly accounting
statements showing the market value of each Penny Stock held in the customer’s
account. In addition, the broker-dealer must make a special written
determination that the Penny Stock is a suitable investment for the purchaser
and receive the purchaser’s written agreement to the
transaction.  These requirements may have the effect of reducing the
level of trading activity in a Penny Stock, such as our common stock, and
investors in our common stock may find it difficult to sell their
shares.




22




Because
our common stock is not listed on a national securities exchange, you may find
it difficult to dispose of or obtain quotations for our common
stock.




Our
common stock is traded on the OTC Bulletin Board under the symbol
“STRB.OB.”  Because our stock is quoted on other than a national
securities exchange, you may find it difficult to either dispose of, or to
obtain quotations as to the price of, our common stock.




Failure
to maintain effective internal controls in accordance with Section 404 of the
Sarbanes-Oxley Act of 2002 could result in a restatement of our financial
statements, cause investors to lose confidence in our financial statements and
our company and have a material adverse effect on our business and stock
price.




We
produce our financial statements in accordance with accounting principles
generally accepted in the United States. Effective internal controls are
necessary for us to provide reliable financial reports to help mitigate the risk
of fraud and to operate successfully as a publicly traded company. As a public
company, we are required to document and test our internal control procedures in
order to satisfy the requirements of the Sarbanes-Oxley Act of 2002, which
requires annual management assessments of the effectiveness of our internal
controls over financial reporting and in future years will require a report by
our independent registered public accounting firm that addresses our internal
controls.




Testing
and maintaining internal controls can divert our management’s attention from
other matters that are important to our business. We may not be able to conclude
on an ongoing basis that we have effective internal controls over financial
reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002, or
our independent registered public accounting firm may not be able or willing, if
required, to issue a favorable assessment if we conclude that our internal
controls over financial reporting are effective. If in the future, either we are
unable to conclude that we have effective internal controls over financial
reporting or our independent registered public accounting firm is unable to
provide us with an unqualified report as required by Section 404, investors
could lose confidence in our reported financial information and our company,
which could result in a decline in the market price of our common stock, and
cause us to fail to meet our reporting obligations in the future, which in turn
could impact our ability to raise additional financing if needed in the future.




Item
1B. Unresolved
Staff Comments.




None.




Item
2. Properties.




Our
corporate headquarters is located approximately 185 miles south of San Jose in
San Luis Obispo, California.  We operate out of a 135,000 square foot
building located in a small industrial park. The facility is made up of
approximately 106,000 square feet of manufacturing space, including 11,600
square feet of clean assembly space and 1,200 square feet of cleanroom space
(60% Class 100, 40% Class 10).  The building is owned by Alan
Strasbaugh and is currently leased to our wholly-owned subsidiary, R. H.
Strasbaugh, for a term of one year expiring January 4, 2011, at $84,000 per
month.  During each of the years ended December 31, 2009 and
2008, our facility lease costs were approximately $1,000,000.  In
addition, as a result of excess capacity, we are currently subleasing
approximately 40,000 square feet of the facility to third partiesunder short term
agreements.  We believe that our existing facilities are sufficient to
meet our present needs and anticipated needs for the foreseeable
future.




23




Item
3. Legal
Proceedings.




On
December 1, 2006, a complaint on joinder for declaratory relief was filed
by April Paletsas requesting that our wholly-owned subsidiary, R. H. Strasbaugh,
be joined to a matter in the San Luis Obispo Superior Court involving Alan
Strasbaugh, and his former wife, April Paletsas with regards to the San Luis
Obispo facilities we occupy.  Until January 8, 2010, Mr.
Strasbaugh and Ms. Paletsas were co-landlords under the lease covering our
corporate facilities.  Ms. Paletsas is requesting a declaration
by the court that R. H. Strasbaugh is required to install a new roof on the
leased facilities in San Luis Obispo and make certain other capital repairs
under the repair and maintenance covenants of the lease covering our corporate
facilities at the time she filed the complaint.  The total costs of
such installation repairs are estimated to be $750,000.  The court
issued an order allowing R. H. Strasbaugh to be joined, but stayed the case
against R. H. Strasbaugh pending resolution of ownership issues between the
co-landlords.  The issues between Mr. Strasbaugh and
Ms. Paletsas have been resolved and the premises now belong solely to Alan
Strasbaugh as a result of Mr. Strasbaugh’s purchase of Ms. Paletsas’ interest in
the property on January 8, 2010.  With regard to the claims
asserted against R. H. Strasbaugh by Ms. Paletsas, we continue to monitor
the case and intend to vigorously defend the case on the merits, should the
court reactivate the case.  We believe that all of our defenses are
meritorious, and consider it unlikely that we will suffer an adverse result
should the court reactivate the case against R. H. Strasbaugh.




Item
4. (Removed
and Reserved).




PART
II




Item
5. Market
for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases
of Equity Securities.




Market
Information




Our
common stock has been quoted on the OTC Bulletin Board under the
symbol “STRB.OTCBB” since January 5, 2009.  Prior to
January 5, 2009 and since July 11, 2005, our common stock was quoted
on the Pink OTC Markets.  The table below sets forth for the quarters
indicated, the reported high and low bid prices of our common stock as
reported on the OTC Bulletin Board and the Pink OTC Markets.  The
prices shown reflect inter-dealer quotations without retail markups, markdowns
or commissions, and may not necessarily represent actual transactions.





High
            
            
            LowYear
      Ended December 31, 2008First
      Quarter
            
            $2.25
            
            
            $1.55Second
      Quarter
            
            $2.00
            
            
            $1.10Third
      Quarter
            
            $1.38
            
            
            $1.20Fourth
      Quarter
            
            $1.20
            
            
            $0.50Year
      Ended December 31, 2009First
      Quarter
            
            $0.70
            
            
            $0.20Second
      Quarter
            
            $0.60
            
            
            $0.18Third
      Quarter
            
            $1.10
            
            
            $0.25Fourth
      Quarter
            
            $0.65
            
            
            $0.25




As of
February 28, 2010, we had 14,705,587 shares of common stock outstanding held of
record by approximately 154shareholders.  These
holders of record include depositories that hold shares of stock for brokerage
firms which, in turn, hold shares of stock for numerous beneficial
owners.  On March 8, 2010, the closing sale price of our common stock
on the OTC Bulletin Board was $0.50 per share.




24




Dividends




Although
we have declared cash dividends on our common stock in the past, we currently
anticipate that we will not declare or pay cash dividends on our common stock in
the foreseeable future.  We will pay dividends on our common stock
only if and when declared by our board of directors.  Our board of
directors’ ability to declare a dividend is subject to restrictions imposed by
California law.  In determining whether to declare dividends, the
board of directors will consider these restrictions as well as our financial
condition, results of operations, working capital requirements, future prospects
and other factors it considers relevant.  In addition, the terms of
our Series A Preferred Stock restrict our ability to pay dividends to
holders of our common stock.  Under the terms of our Series A
Preferred Stock, we cannot pay dividends on shares of our common stock until all
dividends that have accrued on our Series A Preferred Stock have been
paid.  As of March 15, 2010, $2,288,000in dividends have
accrued on the outstanding shares of our Series A Preferred Stock and remain
unpaid.




Equity
Compensation Plan




The
information provided in Part III-Item 12 of this Annual Report under the heading
“Equity Compensation Plan Information” is incorporated herein by
reference.




Item
6. Selected
Financial Data.




Not
applicable.




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




The
following discussion and analysis should be read in conjunction with our
consolidated financial statements and notes to consolidated financial statements
included elsewhere in this report. This report and our financial statements and
notes to financial statements contain forward-looking statements, which
generally include the plans and objectives of management for future operations,
including plans and objectives relating to our future economic performance and
our current beliefs regarding revenues we might generate and profits we might
earn if we are successful in implementing our business strategies. The
forward-looking statements and associated risks may include, relate to or be
qualified by other important factors, including, without
limitation:


●
              the
      projected growth or contraction in the industries within which we
      operate;●
              our
      business strategy for expanding, maintaining or contracting our presence
      in these markets;●
              anticipated
      trends in our financial condition and results of operations;
      and●
              our
      ability to distinguish ourselves from our current and future
      competitors.
  We do not
undertake to update, revise or correct any forward-looking
statements.




Any of
the factors described above or in the “Risk Factors” section could cause our
financial results, including our net income or loss or growth in net income or
loss to differ materially from prior results, which in turn could, among other
things, cause the price of our common stock to fluctuate
substantially.




25




Overview




We
develop, manufacture, market and sell an extensive line of precision surfacing
products, including polishing, grinding and precision optics tools and systems,
to customers in the semiconductor and semiconductor equipment, silicon wafer and
silicon wafer equipment, data storage, MEMS, LED and precision optics markets
worldwide.  Many of our products are used by our customers in the
fabrication of semiconductors and silicon wafers.




For the
year ended December 31, 2009, we reported revenues of $12,873,000 as
compared to $9,554,000 for the year ended December 31, 2008, or an increase
of 35%.  We reported a net loss of $680,000 in 2009 as compared to a
net loss of $4,508,000 in 2008.  The improved performance for 2009
over 2008 is a result of improvement within the semiconductor industry,
stabilizing global economies as well as cost-cutting efforts launched by our
management in 2007 and extended into 2009.  We recognized an upturn in
our business by the fourth quarter of 2009 and presently anticipate some level
of continued growth into and potentially beyond 2010.  The growth and
percentage increases in revenues in 2009 over 2008 are also a result of the
inordinately poor performance in 2008 which we believe resulted from the impact
on our industry from the economic downturn.




Critical
Accounting Policies




Our
consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of these financial statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenues and expenses, and
related disclosure of contingent assets and liabilities. We base our estimates
on historical experience and on various other assumptions that are believed to
be reasonable under the circumstances, the results of which form the basis of
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.




We
believe that the following critical accounting policies, among others, affect
our more significant judgments and estimates used in the preparation of our
financial statements:




Revenue
Recognition.  We derive revenues principally from the sale of
tools, parts and services.  We recognize revenue pursuant to SEC staff
guidance covering revenue recognition.  Revenue is recognized when
there is persuasive evidence an arrangement exists, delivery has occurred or
services have been rendered, our price to the customer is fixed or determinable,
and collection of the related receivable is reasonably
assured.  Selling arrangements may include contractual customer
acceptance provisions and installation of the product occurs after shipment and
transfer of title.  We recognize revenue upon shipment of products or
performance of services and defer recognition of revenue for any amounts subject
to acceptance until such acceptance occurs.  Provisions for the
estimated future cost of warranty are recorded at the time the products are
shipped.




Generally,
we obtain a non-refundable down-payment from the customer.  These fees
are deferred and recognized as the tool is shipped.  All sales
contract fees are payable no later than 60 days after delivery and payment is
not contingent upon installation.  In addition, our tool sales have no
right of return, or cancellation rights.  Tools are typically modified
to some degree to fit the needs of the customer and, therefore, once a purchase
order has been accepted by us and the manufacturing process has begun, there is
no right to cancel, return or refuse the order.




We have
evaluated our arrangements with customers and revenue recognition policies under
the Financial Accounting Standards Board (“FASB”) Accounting Standards
Codification (“ASC”) 605-25, “Revenue Recognition-Multiple-Element
Arrangements,” and determined that its components of revenue are separate units
of accounting.  Each unit has value to the customer on a standalone
basis, there is objective and reliable evidence of the fair value of each unit,
and there is no right to cancel, return or refuse an order.  Our
revenue recognition policies for our specific units of accounting are as
follows:




26




●
              Tools
      – We recognize revenue once a customer has visited the plant and signed
      off on the tool or it has met the required specifications and the tool is
      completed and shipped.●
              Parts
      – We recognize revenue when the parts are
      shipped.●
              Service
      – Revenue from maintenance contracts is deferred and recognized over the
      life of the contract, which is generally one to three
      years.  Maintenance contracts are separate components of revenue
      and not bundled with our tools.  If a customer does not have a
      maintenance contract, then the customer is billed for time and material
      and we recognize the revenue after the service has been
      completed.●
              Upgrades
      – We offer a suite of products known as “enhancements” which are generally
      comprised of one-time parts and/or software upgrades to existing
      Strasbaugh and non-Strasbaugh tools.  These enhancements are not
      required for the tools to function, are not part of the original contract
      and do not include any obligation to provide any future
      upgrades.  We recognize revenue once these upgrades and
      enhancements are complete. Revenue is recognized on equipment upgrades
      when we complete the installation of the upgrade parts and/or software on
      the customer’s equipment and the equipment is accepted by the customer.
      The upgrade contracts cover a one-time upgrade of a customer’s equipment
      with new or modified parts and/or software. After installation of the
      upgrade, we have no further obligation on the contracts, other than
      standard warranty
provisions.


We
include software in our tools.  Software is considered an incidental
element of the tooling contracts and only minor modifications which are
incidental to the production effort may be necessary to meet customer
requirements. The software is used solely in connection with operating the tools
and is not sold, licensed or marketed separately.  The tools and
software are fully functional when the tool is completed, and after shipment,
the software is not updated for new versions that may be subsequently developed
and, we have no additional obligations relative to the
software.  However, software modifications may be included in tool
upgrade contracts. Our software is incidental to the tool contracts as a
whole.  The software and physical tool modifications occur and are
completed concurrently.  The completed tool is tested by either the
customer or us to ensure it has met all required specifications and then
accepted by the customer prior to shipment, at which point revenue is
recognized.  The revenue recognition requirements of FASB ASC 985-605,
“Software-Revenue Recognition,” are met when there is persuasive evidence an
arrangement exists, the fee is fixed or determinable, collection is probable and
delivery and acceptance of the equipment has occurred, including upgrade
contracts for parts and/or software, to the customer.




Installation
of a tool occurs after the tool is completed, tested, formally accepted by the
customer and shipped.  We do not charge the customer for installation
nor recognize revenue for installation as it is an inconsequential or
perfunctory obligation and it is not considered a separate element of the sales
contract or unit of accounting. If we do not perform the installation service
there is no effect on the price or payment terms, there are no refunds, and the
tool may not be rejected by the customer. In addition, installation is not
essential to the functionality of the equipment because the equipment is a
standard product, installation does not significantly alter the equipment’s
capabilities, and other companies are available to perform the installation.
Also, the fair value of the installation service has historically been
insignificant relative to our tools.




27




Derivative Income.In
accordance with FASB ASC 815-40-15 “Derivatives and Hedging-Contracts in
Entity’s Own Equity-Scope and Scope Exceptions,” we are required to account for
the preferred stock related embedded derivative and investor warrants as
derivative liabilities (see Implementation of FASB ASC 815-40-15 “Derivatives
and Hedging-Contracts in Entity’s Own Equity-Scope and Scope
Exceptions”).  We are required to mark to market in each reporting
quarter the value of the embedded derivative and investor warrants. We revalue
these derivative liabilities at the end of each reporting period.  The
periodic change in value of the derivative liabilities is recorded as either
non-cash derivative income (if the value of the embedded derivative and investor
warrants decrease) or as non-cash derivative expense (if the value of the
embedded derivative and investor warrants increase).  Although the
values of the embedded derivative and warrants are affected by interest rates,
the remaining contractual conversion period and the volatility of our common
stock, the primary cause of the change in the values will be the value of our
common stock.  If the stock price goes up, the value of these
derivatives will generally increase and if the stock price goes down the value
of these derivatives will generally decrease.




Stock-Based
Compensation.  We account for share-based payments in
accordance with FASB ASC 718-10, “Compensation-Stock
Compensation.”   As such, all share-based payments to employees,
including grants of employee stock options and restricted shares, are recognized
based on their fair values at the date of grant.  Stock-based
compensation cost is estimated at the grant date based on the fair value of the
award and is recognized as expense ratably over the requisite service period of
the award. Determining the appropriate fair value model and calculating the fair
value of stock-based awards, which includes estimates of stock price volatility,
forfeiture rates and expected lives, requires judgment that could materially
impact our operating results.  See Note 7 in our consolidated
financial statements for the significant estimates used to calculate our
stock-based compensation expense.




Warranty
Costs.  Warranty reserves are provided by management based on
historical experience and expected future claims.  Management believes
that the current reserves are adequate to meet any foreseeable contingencies
with respect to warranty claims.




Allowance for Doubtful
Accounts. We maintain allowances for doubtful accounts for estimated
losses resulting from the inability of our customers to make required payments.
The allowance for doubtful accounts is based on specific identification of
customer accounts and our best estimate of the likelihood of potential loss,
taking into account such factors as the financial condition and payment history
of major customers. We evaluate the collectability of our receivables at least
quarterly. If the financial condition of our customers were to deteriorate,
resulting in an impairment of their ability to make payments, additional
allowances may be required.  Management believes that our current
allowances for doubtful accounts are adequate to meet any foreseeable
contingencies.




Inventory. We write down our
inventory for estimated obsolescence or unmarketable inventory equal to the
difference between the cost of inventory and the estimated market value-based
upon assumptions about future demand, future pricing and market conditions. If
actual future-demand, future pricing or market conditions are less favorable
than those projected by management, additional inventory write-downs may be
required and the differences could be material. Once established, write-downs
are considered permanent adjustments to the cost basis of the obsolete or
unmarketable inventories.




Valuation of Intangibles.
From time to time, we acquire intangible assets that are beneficial to our
product development processes. We use our best judgment based on the current
facts and circumstances relating to our business when determining whether any
significant impairment factors exist.




Deferred Taxes.  We
record a valuation allowance to reduce the deferred tax assets to the amount
that is more likely than not to be realized. We have considered estimated future
taxable income and ongoing tax planning strategies in assessing the amount
needed for the valuation allowance. Based on these estimates, all of our
deferred tax assets have been reserved. If actual results differ favorably from
those estimates used, we may be able to realize all or part of our net deferred
tax assets.




28




Litigation.  We
account for litigation losses in accordance with FASB ASC 450-20,
“Contingencies-Loss Contingencies,” loss contingency provisions are recorded for
probable losses at management’s best estimate of a loss, or when a best estimate
cannot be made, a minimum loss contingency amount is recorded. These estimates
are often initially developed substantially earlier than the ultimate loss is
known, and the estimates are refined each accounting period, as additional
information is known. Accordingly, we are often initially unable to develop a
best estimate of loss; therefore, the minimum amount, which could be zero, is
recorded. As information becomes known, either the minimum loss amount is
increased or a best estimate can be made, resulting in additional loss
provisions. Occasionally, a best estimate amount is changed to a lower amount
when events result in an expectation of a more favorable outcome than previously
expected. Due to the nature of current litigation matters, the factors that
could lead to changes in loss reserves might change quickly and the range of
actual losses could be significant, which could adversely affect our results of
operations and cash flows from operating activities.




Series A Preferred Stock and
Warrants. We evaluate our Series A Preferred Stock and warrants on
an ongoing basis considering the provisions of FASB ASC Topic 480,
“Distinguishing Liabilities from Equity” which establishes standards for issuers
of financial instruments with characteristics of both liabilities and equity
related to the classification and measurement of those
instruments.  The Series A Preferred Stock conversion feature and
Warrants are evaluated considering the provisions of FASB ASC Topic 815,
“Derivatives and Hedging,” which establishes accounting and reporting standards
for derivative instruments, including certain derivative instruments embedded in
other contracts, and for hedging activities, considering FASB ASC 815-40,
“Derivatives and Hedging-Contracts in Entity’s Own Equity.”




Results
of Operations




The
tables presented below, which compare our results of operations from one period
to another, present the results for each period, the change in those results
from one period to another in both dollars and percentage change, and the
results for each period as a percentage of net revenues. The columns present the
following:


●
                The
      first two data columns in each table show the absolute results for each
      period presented.●
                The
      columns entitled “Dollar Variance” and “Percentage Variance” show the
      change in results, both in dollars and percentages. These two columns show
      favorable changes as a positive and unfavorable changes as a negative. For
      example, when our net revenues increase from one period to the next, that
      change is shown as a positive number in both columns. Conversely, when
      expenses increase from one period to the next, that change is shown as a
      negative in both columns.●
                The
      last two columns in each table show the results for each period as a
      percentage of net
  revenues.
  29
  Year
Ended December 31, 2009 Compared to the Year Ended December 31,
2008




Results
      as a PercentageDollar
            
            
            Percentage
            
            
            of
      Net Revenues for theYear
      Ended
            
            
            Variance
            
            
            Variance
            
            
            Year
      EndedDecember
      31,
            
            
            Favorable
            
            
            Favorable
            
            
            December
      31,2009
            
            
            2008
            
            
            (Unfavorable)
            
            
            (Unfavorable)
            
            
            2009
            
            
            2008(In
      thousands)Net
      revenues
            
            $
            12,873
            
            
            $
            9,554
            
            
            $
            3,319
            
            
            
            35
            %
            
            
            100
            %
            
            
            100
            %Cost
      of sales
            
            
            8,450
            
            
            
            7,108
            
            
            
            (1,342
            )
            
            
            (19
            )%
            
            
            66
            %
            
            
            74
            %Gross
      profit
            
            
            4,423
            
            
            
            2,446
            
            
            
            1,977
            
            
            
            81
            %
            
            
            34
            %
            
            
            26
            %Selling,
      general and administrative expenses
            
            
            3,855
            
            
            
            4,429
            
            
            
            574
            
            
            
            13
            %
            
            
            29
            %
            
            
            46
            %Research
      and development expenses
            
            
            3,593
            
            
            
            2,954
            
            
            
            (639
            )
            
            
            (22
            )%
            
            
            28
            %
            
            
            31
            %Loss
      from operations
            
            
            (3,025
            )
            
            
            (4,937
            )
            
            
            1,912
            
            
            
            39
            %
            
            
            (23
            )%
            
            
            (51
            )%Total
      other income
            
            
            2,333
            
            
            
            429
            
            
            
            1,904
            
            
            
            444
            %
            
            
            18
            %
            
            
            4
            %Loss
      from operations before income taxes
            
            
            (692
            )
            
            
            (4,508
            )
            
            
            3,816
            
            
            
            85
            %
            
            
            (5
            )%
            
            
            (47
            )%Benefit
      from income taxes
            
            
            12
            
            
            
            -
            
            
            
            12
            
            
            
            100
            %
            
            
            0
            %
            
            
            0
            %Net
      loss
            
            $
            (680
            )
            
            $
            (4,508
            )
            
            $
            3,828
            
            
            
            85
            %
            
            
            (5
            )%
            
            
            (47
            )%




Net revenues.The
increase in net revenues for 2009 was primarily due to an increase in tool
system shipments partially offset by lower parts and service revenue as compared
to 2008.  Sales of tool systems increased by $4,369,000 to $7,410,000
in 2009, compared to $3,041,000 in 2008.  Revenue from parts sales and
services declined by $1,050,000 to $5,463,000 in 2009, compared to $6,513,000 in
2008.  Management believes the decline in parts sales and services is
attributable to the poor economic conditions affecting the periods, during which
customers simply did not run their equipment in full production in an effort to
cut their own costs and overhead during these times.




Gross Profit.The
increase in gross profit, both in terms of dollar amount and as a percentage of
net revenues,  was primarily due to the higher sales volume for 2009
coupled with better utilization of our factory capacity.  We believe
that while the gross margin percentage of 34% was a marked improvement over the
gross margin we reported for 2008, it does not reflect the gross margin
attainable or sought by us. We offered a number of discounted sales in 2009
which eroded the margin from what we believe a more normal level of slightly
more than 40%.  Management does not anticipate offering such discounts
in 2010 and beyond.




Selling, General and Administrative
Expenses.The decrease in selling, general and administrative
expenses for 2009 as compared to 2008 is primarily a result of lower required
provisions for bad debts, lower professional fees and continued cost-cutting
measures.




Research and Development
Expenses. The increase in research and development expenses in 2009 over
2008 was primarily due to the development of new technology (primarily the STB P300TM) which we
released in late 2009 and continue to sell in 2010.




Other Income
(Expense).  The increase in other income in 2009 compared to
2008 was primarily due to non-cash gains totaling $1,688,000 resulting from the
decrease in the fair value of our preferred stock related embedded derivative
and warrant liabilities during 2009, and a $260,000 increase in income from
subleasing part of our corporate headquarters facility to unaffiliated third
parties.




30




Liquidity
and Capital Resources




During
2009, we funded our operations primarily from cash from operating
activities.  As of December 31, 2009, we had working capital of
$2,334,000 as compared to $4,009,000 at December 31, 2008.  At
December 31, 2009 and 2008 we had an accumulated deficit of $30,229,000 and
$32,186,000, respectively, and cash and cash equivalents of $1,240,000 and
$49,000, respectively, as well as accounts receivable of $3,298,000 and
$1,309,000, respectively.




Our
available capital resources at December 31, 2009 consist primarily of
approximately $1,240,000 in cash and $3,298,000 in accounts
receivable.  We expect that our future available capital resources
will consist primarily of cash on hand, cash generated from our business, and
future debt and/or equity financings, if any.




Cash
generated from operating activities for 2009 was $1,149,000 and cash used by
operating activities in 2008 was $1,207,000, including net losses of $680,000
and $4,508,000 for 2009 and 2008, respectively.  Non-cash gains
totaling $1,688,000 resulting from the decrease in the fair value of our
Series A Preferred Stock related embedded derivative and warrant
liabilities during the year are included in the 2009 net loss as well as
non-cash expenses for costs such as depreciation and amortization, stock-based
compensation expense, and reserve provisions for inventory totaling
$1,003,000.  Material changes in assets and liabilities at December
31, 2009 as compared to December 31, 2008 that affected these results
include:


●
                an
      increase in accounts receivable (before reserves) of
      $1,778,000;●
                an
      increase in customer deposits of $3,850,000;
      and●
                a
      net increase in accounts payable and accrued expenses of
      $486,000.


Cash
provided by investing activities for 2009 and 2008 was $42,000 and $546,000,
respectively.  For 2009 and 2008, the primary activity related to the
sale and maturity of investments in securities totaling $294,000 and $823,000,
respectively.




There
were no cash flows from financing activities in 2009.  Cash used in
financing activities for 2008 was $1,154,000 as a result of dividends and costs
associated with the Series A Preferred Stock Financing.




We
believe that current and future available capital resources, revenues generated
from operations, and other existing sources of liquidity, will be adequate to
meet our anticipated working capital and capital expenditure requirements for at
least the next twelve months. If, however, our capital requirements or cash flow
vary materially from our current projections or if unforeseen circumstances
occur, we may require additional financing.  Our failure to raise
capital, if needed, could restrict our growth, limit our development of new
products or hinder our ability to compete.




Backlog




As of
March 12, 2010, we had a backlog of approximately $5.2 million.  Our
backlog includes firm non-cancelable customer commitments for 7 tools and
approximately $670,000 in parts and upgrades.  Management believes
that products in our backlog will be shipped by the end of May
2010.




31




Effects
of Inflation




The
impact of inflation and changing prices has not been significant on the
financial condition or results of operations of either our company or our
operating subsidiary.




Impacts
of New Accounting Pronouncements




In
October 2009, the FASB issued ASU 2009-13, “Multiple-Deliverable Revenue
Arrangements, (amendments to FASB ASC Topic 605, Revenue Recognition)” and ASU
2009-14, “Certain Arrangements That Include Software Elements (amendments to
FASB ASC Topic 985, Software).”  ASU 2009-13 requires entities to
allocate revenue in an arrangement using estimated selling prices of the
delivered goods and services based on a selling price hierarchy. The amendments
eliminate the residual method of revenue allocation and require revenue to be
allocated using the relative selling price method. ASU 2009-14 removes
tangible products from the scope of software revenue guidance and provides
guidance on determining whether software deliverables in an arrangement that
includes a tangible product are covered by the scope of the software revenue
guidance. ASU 2009-13 and ASU 2009-14 should be applied on a prospective
basis for revenue arrangements entered into or materially modified in fiscal
years beginning on or after June 15, 2010, with early adoption permitted.
We do not expect adoption of ASU 2009-13 or ASU 2009-14 to have a material
impact on our consolidated results of operations or financial
condition.




In June
2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification
and the Hierarchy of Generally Accepted Accounting Principles,” which was
primarily codified into Topic 105 “Generally Accepted Accounting Standards” in
the ASC. This standard will become the single source of authoritative
nongovernmental U.S. generally accepted accounting principles (“GAAP”),
superseding existing FASB, American Institute of Certified Public Accountants
(“AICPA”), Emerging Issues Task Force (“EITF”), and related accounting
literature. This standard reorganizes the thousands of GAAP pronouncements into
roughly 90 accounting topics and displays them using a consistent structure.
Also included is relevant SEC guidance organized using the same topical
structure in separate sections. The FASB will not issue new standards in the
form of Statements, FASB Staff Positions or EITF Abstracts. Instead, it will
issue Accounting Standards Updates (“ASUs”). The FASB will not consider ASUs as
authoritative in their own right. ASUs will serve only to update the
Codification, provide background information about the guidance and provide the
bases for conclusions on the change(s) in the Codification. This guidance is
effective for financial statements issued for reporting periods that end after
September 15, 2009.  This guidance was adopted in the third quarter of
2009 and impacts our financial statements and related disclosures as all
references to authoritative accounting literature reflect the newly adopted
codification.




In June
2009, the FASB issued SFAS No. 167, “Amendments to FASB Interpretation No.
46(R),” which has not yet been codified in the ASC. This guidance is a revision
to pre-existing guidance pertaining to the consolidation and disclosures of
variable interest entities. Specifically, it changes how a reporting entity
determines when an entity that is insufficiently capitalized or is not
controlled through voting (or similar rights) should be consolidated. The
determination of whether a reporting entity is required to consolidate another
entity is based on, among other things, the other entity’s purpose and design
and the reporting entity’s ability to direct the activities of the other entity
that most significantly impact the other entity’s economic
performance. This guidance will require a reporting entity to provide
additional disclosures about its involvement with variable interest entities and
any significant changes in risk exposure due to that involvement. A reporting
entity will be required to disclose how its involvement with a variable interest
entity affects the reporting entity’s financial statements. This guidance will
be effective at the start of a reporting entity’s first fiscal year beginning
after November 15, 2009. Early application is not permitted. We do not
expect the adoption of this guidance to have a material impact on our
consolidated results of operations or financial condition.




32




In May
2009, the FASB issued SFAS No. 165, “Subsequent Events,” which was primarily
codified into Topic 855 “Subsequent Events” in the ASC. This guidance
establishes general standards of accounting for and disclosure of events that
occur after the balance sheet date but before the financial statements are
issued or are available to be issued. We adopted this guidance in the third
quarter of 2009 and it had no impact on our consolidated results of operations
or financial position.




In
April 2009, the FASB issued Staff Position (“FSP”) Financial Accounting
Standard (“FAS”) 157-4 “Determining Fair Value When the Volume and Level of
Activity for the Asset or Liability Have Significantly Decreased and Identifying
Transactions That Are Not Orderly” which was primarily codified into Topic 820
“Fair Value Measurements and Disclosures” in the ASC. Based on the guidance, if
an entity determines that the level of activity for an asset or liability has
significantly decreased and that a transaction is not orderly, further analysis
of transactions or quoted prices is needed, and a significant adjustment to the
transaction or quoted prices may be necessary to estimate fair value in
accordance with this guidance. This guidance is to be applied prospectively and
is effective for interim and annual periods ending after June 15, 2009 with
early adoption permitted for periods ending after March 15, 2009.
Implementation of this standard on April 1, 2009 had no impact on our financial
condition or results of operations.




In
April 2009, the FASB issued FSP FAS 115-2 and FAS 124-2 “Recognition and
Presentation of Other-Than-Temporary Impairments,” which was primarily codified
into Topic 320, “Investments — Debt and Equity Securities” and Topic 325
“Investments — Other” in the ASC. The guidance applies to investments in debt
securities for which other-than-temporary impairments may be recorded. If an
entity’s management asserts that it does not have the intent to sell a debt
security and it is more likely than not that it will not have to sell the
security before recovery of its cost basis, then an entity may separate
other-than-temporary impairments into two components: (i) the amount related to
credit losses (recorded in earnings), and (ii) all other amounts (recorded in
other comprehensive income). This guidance is to be applied prospectively and is
effective for interim and annual periods ending after June 15, 2009.
Implementation of this guidance on April 1, 2009 had no impact on our financial
condition or results of operations.




In
April 2009, the FASB issued FSP FAS 107-1 and Accounting Principles Board
(“APB”) 28-1 “Interim Disclosures about Fair Value of Financial Instruments,”
which was primarily codified into Topic 825 “Financial Instruments” in the ASC.
This standard extends the disclosure requirements concerning the fair value of
financial instruments to interim financial statements of publicly traded
companies.  This standard is to be applied prospectively and is
effective for interim and annual periods ending after June 15, 2009 with
early adoption permitted for periods ending after March 15, 2009. We have
included the required disclosures in these consolidated financial
statements.




In June
2008, the FASB ratified EITF Issue No. 07-5, “Determining Whether an Instrument
(Or an Embedded Feature) is Indexed to an Entity’s Own Stock,” which was
primarily codified into FASB ASC 815-40, “Derivatives and Hedging-Contracts in
Entity’s Own Equity.”  The guidance provides that an entity should use
a two-step approach to evaluate whether an equity-linked financial instrument
(or embedded feature) is indexed to its own stock, including evaluating the
instrument’s contingent exercise and settlement provisions. This guidance was
effective for financial statements issued for fiscal years beginning after
December 15, 2008. Early application was not permitted. Implementation of this
guidance has had a significant impact on our financial condition and results of
operations (See Implementation of FASBASC 815-40-15
“Derivatives and Hedging-Contracts in Entity’s Own Equity-Scope and Scope
Exceptions,” below).




In April
2008, the FASB issued FSP FAS No. 142-3 “Determination of the Useful Life
of Intangible Assets,” which was primarily codified into Topic 350 “Intangibles
– Goodwill and Other” in the ASC.This guidance amends
the factors that should be considered in developing renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
and requires enhanced related disclosures. This guidance must be applied
prospectively to all intangible assets acquired as of and subsequent to fiscal
years beginning after December 15, 2008.  This guidance is
effective for financial statements issued for fiscal years beginning after
December 15, 2008.  Although future transactions involving intangible
assets may be impacted by this guidance, it did not impact our financial
statements as we did not acquire any intangible assets during the year ended
December 31, 2009.




33




Implementation of FASBASC 815-40-15 “Derivatives and Hedging-Contracts in Entity’s Own
Equity-Scope and Scope Exceptions”




In June
2008, the FASB ratified guidance included in ASC 815-40-15 “Derivatives and
Hedging-Contracts in Entity’s Own Equity-Scope and Scope Exceptions,” which
provides that an entity should use a two-step approach to evaluate whether an
equity-linked financial instrument (or embedded feature) is indexed to its own
stock, including evaluating the instrument’s contingent exercise and settlement
provisions.  ASC 815-40-15 contains provisions describing conditions
when an instrument or embedded feature would be considered indexed to an
entity’s own stock for purposes of evaluating the instrument or embedded feature
under FASB ASC Topic 815 “Derivatives and Hedging,” which establishes accounting
and reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts.




Prior to
the implementation of ASC 815-40-15, our Series A Preferred Stock was classified
as “temporary equity,” or outside of permanent equity and liabilities, and the
Investor Warrants were classified as permanent equity because they met the
criteria in the FASB guidance covering the accounting for derivative financial
instruments indexed to, and potentially settled in, a company’s own
stock.  However, both the Series A Preferred Stock conversion feature
and Investor Warrants contain settlement provisions such that if we undertake
certain equity offerings in the future at a price lower than the conversion or
exercise prices of the instruments, the conversion ratio and exercise price
would be adjusted.  As such, under the provisions of ASC 815-40-15 the
embedded conversion feature in our Series A Preferred Stock, or Series A
Conversion Feature, and the Investor Warrants are not considered indexed to our
stock. As a result of the settlement provisions in our Series A Conversion
Feature and the application of ASC 815-40-15, effective January 1, 2009, the
Series A Conversion Feature was required to be bifurcated from its host and
accounted for as a derivative instrument.  Also, as a result of the
settlement provision in the Investor Warrants and the application of ASC
815-40-15, effective January 1, 2009, the Investor Warrants were required to be
accounted for as derivative instruments.  Accordingly, effective
January 1, 2009, our Series A Conversion Feature and Investor Warrants are
recognized as liabilities in our consolidated balance sheet.




As
described more fully in Note 2 to our consolidated financial statements, the
cumulative effect of this change in accounting principle is recognized as an
adjustment to the opening balance of our equity on January 1,
2009.  The Series A Preferred Stock host will remain classified in
temporary equity and stated at its fair value and the fair value of the Series A
Conversion Feature is bifurcated from the host instrument and recognized as a
liability on our consolidated balance sheet.  In addition, the
Investor Warrants are recognized at fair value as a liability on our
consolidated balance sheet.  The fair value of the conversion feature,
the warrants and other issuance costs of the Series A Preferred Stock financing
transaction, are recognized as a discount to the Series A Preferred Stock
host.  The discount will be accreted to the Series A Preferred Stock
host from our paid in capital, over the period from the issuance date through
the earliest redemption date of the Series A Preferred Stock.




34




The
following table illustrates the changes to our consolidated balance sheet
resulting from the implementation of ASC 815-40-15 effective January 1,
2009:





Balance
                December
      31,
                2008
            
            
            Cumulative
                Effect
                Adjustment
            
            
            Balance
                January
      1,
                2009Preferred
      stock related embedded derivative
            
            $
            —
            
            
            $
            1,493,000
            
            
            $
            1,493,000Warrants
            
            $
            —
            
            
            $
            199,000
            
            
            $
            199,000Series
      A preferred stock
            
            $
            11,964,000
            
            
            $
            (3,191,000
            )
            
            $
            8,733,000Additional
      paid-in capital
            
            $
            26,803,000
            
            
            $
            (1,138,000
            )
            
            $
            25,665,000Accumulated
      deficit
            
            $
            (32,186,000
            )
            
            $
            2,637,000
            
            
            $
            (29,549,000
            )




The fair
values of the Series A Conversion Feature, included in the “Preferred stock
related embedded derivative” liability and the Investor Warrants included in the
“Warrants” liability, on our consolidated balance sheet at January 1, 2009, were
estimated using the Black-Scholes model to be $1,493,000 and $199,000,
respectively.




As of
December 31, 2009, we determined that, using the Black-Scholes model, the fair
value of the Series A Preferred Stock related embedded derivative and the
Investor Warrants had declined since January 1, 2009.  Accordingly, we
have recorded a gain on the change in fair value of the embedded derivative and
warrants and recorded a corresponding reduction in the “Preferred stock related
embedded derivative” and “Warrant” liability of $1,489,000, and $199,000,
respectively, for the period from January 1, 2009 to December 31,
2009.  The effect of the income from these derivatives on the loss
from continuing operations and net loss for the year ended December 31, 2009 was
to reduce the net loss of $2,342,000 to a net loss of $654,000, and to reduce
the net loss per common share from $0.33 to a net loss per common share of
$0.22.




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




Not
applicable.




Item
      8.
            Financial
      Statements and Supplementary Data.




Reference
is made to the consolidated financial statements and accompanying notes included
in this report, which begin on page F-1.




Item
      9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure.




Effective
December 9, 2008, we dismissed Windes & McClaughry Accountancy Corporation
(“Windes”) as our independent registered public accounting
firm.  Effective the same date, we appointed Farber Hass Hurley LLP
(“FHH”), as our independent registered public accounting firm.  We had
not consulted with FHH in the past regarding either: (i) the application of
accounting principles to a specific transaction, either completed or proposed,
or the type of audit opinion that might be rendered on our financial statements;
or (ii) any matter that was the subject of a disagreement or event identified in
response to Item 304(a)(1)(iv) of Regulation S-K and the related instructions to
that Item.The
decision to change our independent registered public accounting firm was
approved by our Audit Committee.




The
reports issued by Windes on our financial statements as of and for the fiscal
years ended December 31, 2006 and 2007 did not contain an adverse opinion or a
disclaimer of opinion and were not qualified or modified as to uncertainty,
audit scope, or accounting principles.




35




In
connection with its audits of our financial statements for the years ended
December 31, 2007 and 2006, Windes advised management of the following matter
that Windes considered to be a material weakness in the area of accounting and
financial reporting: the current organization of our accounting department does
not provide management with the appropriate resources and adequate technical
skills to accurately account for and disclose our activities.  Windes
stated that this matter is evidenced by the following issues: (i) a number of
material adjusting entries were proposed by Windes and recorded by us for the
years ended December 31, 2007 and 2006, (ii) our closing procedures for the
years ended December 31, 2007 and 2006 were not adequate and resulted in
significant accounting adjustments for both years, and (iii) we were unable to
adequately perform the financial reporting process as evidenced by a significant
number of suggested revisions and comments by Windes to our financial statements
and related disclosures for the years ended December 31, 2007 and 2006. As
additional evidence of this material weakness, we restated our 2006 financial
statements and restated our financial statements for the three months ended
September 30, 2007.




During
the fiscal years ended December 31, 2006 and 2007, and through December 9, 2008,
there were no disagreements with Windes on any matter of accounting principles
or practices, financial statement disclosure, or auditing scope or procedures,
which disagreements, if not resolved to Windes’ satisfaction, would have caused
Windes to make reference thereto in its reports on the financial statements for
the years ended December 31, 2007 and 2006. During the period described in the
first sentence of this paragraph, there were no “reportable events” (as defined
in the SEC Regulation S-K, Item 304(a)(1)(v).




We
provided Windes with a copy of the above disclosures and requested Windes to
furnish a letter addressed to the SEC stating whether or not Windes agrees with
the above statements.




Item
      9A.
            Controls
      and Procedures.




Not
applicable.




Item
      9A(T).
            Controls
      and Procedures.




Evaluation
of Disclosure Controls and Procedures




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




Based on
their evaluation as of the end of the period covered by this Annual Report on
Form 10-K, our Chief Executive Officer and Chief Financial Officer have
concluded that our disclosure controls and procedures were effective at the
reasonable assurance level.




36




Management’s
Report on Internal Control over Financial Reporting




Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Exchange Act
Rules 13a-15(f) and 15d-15(f). Because of its inherent limitations,
internal control over financial reporting may not prevent or detect
misstatements. Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become inadequate because of
changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.




Under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, we conducted an evaluation of the
effectiveness of our internal control over financial reporting as of
December 31, 2009 based on the guidelines established in Internal Control — Integrated
Frameworkissued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). Based on the results of our evaluation, our
management concluded that our internal control over financial reporting was
effective as of December 31, 2009 to provide reasonable assurance regarding
the reliability of financial reporting and the preparation of financial
statements for external reporting purposes in accordance with GAAP applied in
the United States.




This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by our
registered public accounting firm pursuant to temporary rules of the SEC that
permit us to provide only management’s report in this annual
report.




Changes
in Internal Control Over Financial Reporting




There
have been no changes in internal controls over the financial reporting that
occurred during the most recent fiscal quarter that have materially affected, or
are reasonably likely to materially affect our internal controls over financial
reporting.




Item
      9B.
            Other
      Information.




None.




37




PART
III




Item
      10.
            Directors,
      Executive Officers and Corporate
Governance.




Directors
and Executive Officers




Our
directors and executive officers as of March 12, 2010 are as
follows:





Name
            Age
            Positions
      HeldAlan
      Strasbaugh
            61
            Chairman
      of the BoardChuck
      Schillings
            50
            President
      and Chief Executive OfficerRichard
      Nance
            61
            Executive
      Vice President and Chief Financial OfficerMichael
      Kirkpatrick
            54
            Director
      of Sales and MarketingAllan
      Paterson
            60
            Vice
      President of Business DevelopmentWesley
      Cummins
            32
            DirectorTom
      Walsh
      (1)
            68
            DirectorMartin
      Kulawski
      (1)
            39
            DirectorDan
      O’Hare
      (1)
            46
            Director





(1)
            Member
      of our Audit Committee, Compensation Committee and Nominating and
      Corporate Governance Committee.




Alan Strasbaugh  has
served as Chairman of our board of directors since May 2007 and as Chairman of
the Board of our operating subsidiary, R. H. Strasbaugh, since 1978.  Mr.
Strasbaugh started employment at R.H. Strasbaugh in 1961.  For the first
ten years he worked in most phases of manufacturing and engineering, followed by
eight years of manufacturing management, then ten years as General Manager and
Director of Operations. He was CEO from 1990 to 1998, growing annual sales from
$8 million to $80 million.  Mr. Strasbaugh currently is employed at the
company as an advisor.  He has a B.S. Degree in Mechanical Engineering from
California State Polytechnic University, Pomona.  He has been awarded nine
U.S. patents related to semiconductor manufacturing.  Mr. Strasbaugh
is uniquely qualified to serve on our board of directors given his long tenure
with Strasbaugh and the critical capacities in which he has
served.  Mr. Strasbaugh’s in depth knowledge of our operations,
products, and industry provides our board of directors with unique insights into
our operations and provides our board of directors with a broad perspective of
the operational challenges, opportunities and risks facing
Strasbaugh.




Chuck Schillings has served
as our President and Chief Executive Officer since May 2007 and as President and
Chief Executive Officer of our operating subsidiary, R. H. Strasbaugh,
since 2005.  Mr. Schillings also served as a member of the board
of directors of R. H. Strasbaugh between February 2003 and May
2007.  From 2001 to 2004, Mr. Schillings was engaged in real estate
development and was President and director of a not-for-profit organization he
co-founded. From 1995 to 2001, he held several sales and marketing management
positions at R. H. Strasbaugh.  Mr. Schillings holds an M.S.B.A.
degree in International Business from San Francisco State University and a B.S.
degree in Business Finance with an Economics minor from San Diego State
University.




Richard Nancehas served as
our Executive Vice President and Chief Financial Officer since May 2007 and as
Chief Financial Officer and Vice President - Finance of R. H. Strasbaugh
since 2002.  He has worked as a chief financial officer for both
public and private companies involved in software technology, manufacturing and
international sales and distribution. Mr. Nance is a licensed Certified Public
Accountant with prior experience as a National Bank Examiner with the United
States Comptroller of the Currency, a commercial banker, and has over 14 years
of experience in business consulting, strategic planning and advisory services.
Mr. Nance holds a B.B.A. degree in Banking and Finance from North Texas State
University, a B.S. degree in Accounting from Central State University of
Oklahoma and memberships in the American Institute of Certified Public
Accountants and the California Society of CPAs.




38




Michael A. Kirkpatrick has
served as Director of Sales and Marketing of R. H. Strasbaugh since 2004
and of Strasbaugh since May 2007.  Mr. Kirkpatrick is responsible for
the worldwide sales and marketing of all of our products.  During his
15 years of employment at R. H. Strasbaugh, Mr. Kirkpatrick has served as
United States Sales Manager and General Manager for R. H. Strasbaugh’s data
storage business and has been actively involved in its CMP
program.  Mr. Kirkpatrick helped pioneer the application of
CMP to the read/write head fabrication process.  During his
career at R. H. Strasbaugh, Mr. Kirkpatrick has been personally responsible
for over $100 million in semiconductor equipment sales.  He holds a
B.S. degree in Business Administration and Marketing from California Polytechnic
State University, San Luis Obispo, California.




Allan Paterson has served as
Vice President of Business Development of R. H. Strasbaugh since 1995 and
of Strasbaugh since May 2007 and is responsible for new product identification
and the development of marketing and business development
strategies.  Mr. Paterson has over 25 years of experience in
domestic and international business, marketing and sales
development.  His experience includes being responsible for sales,
marketing and customer support for high technology companies in Europe, Israel
and in the United States.  Mr. Patterson has been awarded two United
States patents related to semiconductor
manufacturing.  Mr. Paterson holds a Higher National Diploma in
Electrical Technology from Cleveland College in the United Kingdom.




Wesley Cummins has served as
a member of our board of directors since May 2007.  Mr. Cummins
is President of B. Riley and Co. LLC, a FINRA member firm, where he
oversees the firm’s investment banking, sales and trading and
research.  From July of 2006 through September 10, 2007, Mr.
Cummins spearheaded the firm’s initiative to grow the financial advisory and
capital raising services to middle publicly traded companies as Director of
Capital Markets of B. Riley and Co. LLC.  Mr. Cummins joined
B. Riley’s Research Department in February 2002 and was promoted to
Director of Research in January 2003. During his tenure, he grew B. Riley’s
research coverage to more than 100 companies in the following sectors: retail,
semiconductors, technology hardware, software, IT services, communications,
media and healthcare. While Director of Research, Mr. Cummins was ranked
No. 1 in the 2004 Forbes.com/StarMine-North American Analyst Survey in the
Best Stock Picker category for the Communications Equipment sector. Prior to
joining B. Riley, Mr. Cummins worked at Needham & Company and at
Kennedy Capital Management. He holds a B.S.B.A. degree from Washington
University in St. Louis. Mr. Cummins also currently serves as a Director for
Flight Safety Technologies (AMEX: FLT), Applied Technologies, Inc. and
Davidson Optronics.  Mr. Cummins’ extensive knowledge of the capital
markets and all aspects of finance is invaluable in discussions by our board of
directors surrounding our capital and liquidity needs, as well as strategic
planning in these areas. His extensive experience serving other public and
private company boards results in familiarity with corporate and board
functions.




Dr. Martin Kulawski has
served as a member of our board of directors since August
2009.  Currently, Dr. Kulawski is president of his own firm, Advaplan,
a CMP foundry and consulting service, and has held that position since September
2007.  From 2000 to 2007 he was Project Manager at the Government
Technical Institute of Finland.  From 1998 to 2000 he was a team
leader for CMP tool installation and process integration at customer sites for
Peter Wolters Company.  Dr. Kulawski is a member of CMP user groups in
the United States and Europe and has been a speaker and lecturer at
semiconductor conferences in the United States, Europe and Asia.  He
has authored more than 15 papers published in scientific
journals.  Dr. Kulawski was awarded a Master of Science Degree in
Electrical Engineering with a Solid State Electronics minor in 1998 from
Christian Albrecht University and a Ph.D. with a CMP thesis from the Technical
University of Helsinki.  Dr. Kulawski’s qualifications to serve on our
board of directors include his extensive knowledge of the semiconductor industry
and the technologies, as well as his experience with tool systems and processes,
which provide him with a deep technological expertise about our products and
current technologies.  Dr. Kulawski provides our board of directors
with unique insights regarding our anticipated future technological needs and
those of the industries within which we compete, as well as the related
challenges, opportunities and risks.




39




Dan O’Hare has served as a
member of our board of directors since August 2009.  Mr. O’Hare has
been with the accounting firm of Glenn, Burdette, Phillips and Bryson since 1989
specializing in tax planning and business consulting.  He has been the
President and managing partner since 1999.  Prior to that he held
positions at Arthur Young and Ernst and Whinney.  He has served board
and officer positions at the California Society of Certified Public
Accountants.  He currently serves on the board of Heritage Oaks
Bancorp and serves on Heritage Oaks Bancorp’s compensation committee and as the
financial expert on its audit committee.  He has testified as an
expert witness at Civil, Probate and Domestic Superior Courts.  Mr.
O’Hare earned a Bachelor of Business Administration Degree in 1985 from Notre
Dame University. Mr. O’Hare’s qualifications to serve on our board of directors
include his extensive background in accounting, tax and business consulting, as
well as his leadership experience and experience serving on boards and board
committees of other companies. Mr. O’Hare provides our board of directors with
extensive expertise in the areas of finance, financial risk assessment and
corporate governance.




Tom Walsh has been a member
of our board of directors  since August 2009.  Mr. Walsh, a
former long-standing employee of Strasbaugh, began his employment with R.H.
Strasbaugh in 1959.  After a short period in manufacturing, he moved
into engineering.  He quickly rose to be chief designer and Vice
President, Engineering.  Mr. Walsh is responsible for the design and
engineering direction of over one hundred products and over twelve thousand
machine tools manufactured during the past forty years.  Mr. Walsh’s
designs have been copied and propagated worldwide by countless other companies
in the optics and semiconductor industries.   While directing the
Engineering Department at Strasbaugh, Mr. Walsh studied mechanical engineering
at California State University at Long Beach but stopped a few units short of a
Bachelor of Science degree.  Mr. Walsh is the third largest holder of
Strasbaugh common stock.   His employment with Strasbaugh ended
in 2005 but he has remained an advisor to the Engineering
Department.  Mr. Walsh’s qualifications to serve on our board of
directors include his extensive experience with Strasbaugh which includes
intimate knowledge of our operations and products.  Mr. Walsh provides
our board of directors with unique insights into the challenges, opportunities
and risks associated with our product development and overall strategic
decisions.




Section
16(a) Beneficial Ownership Reporting Compliance




Section
16(a) of the Exchange Act requires our executive officers, directors and persons
who beneficially own more than 10% of a registered class of our equity
securities, or reporting persons, to file initial reports of ownership and
reports of changes in ownership of our common stock and other equity securities
with the SEC. The reporting persons are required by the SEC regulations to
furnish us with copies of all reports that they file.
  Based
solely upon a review of Forms 3 and 4 and amendments thereto furnished to us
during the year ended December 31, 2009 and Forms 5 and amendments thereto
furnished us with respect to the year ended December 31, 2009, our knowledge of
and written representations that no Form 5 is required, no person that was a
reporting person during the year ended December 31, 2009, except for Daniel
O’Hare, Martin Kulawski and Lloyd I. Miller, III, failed to file on a timely
basis, as disclosed in the above Forms, reports required by Section 16(a) of the
Exchange Act during the year ended December 31, 2009 or prior fiscal
years.  Daniel O’Hare and Martin Kulawski  each filed one late Form 3
during 2009.  In addition, Lloyd I. Miller, III did not file a Form 5 for
the fiscal year ended December 31, 2009, and we have not received a written
representation from Lloyd I. Miller, III  stating that no Form 5 is
required.  Further, based solely on our knowledge, Daniel O’Hare, Martin
Kulawski, Tom Walsh, Wes Cummins and Alan Strasbaugh each failed to file one
Form 4 to report one transaction during the fiscal year ended December 31,
2009.




40




Composition
of the Board of Directors




Our board
of directors has responsibility for our overall corporate governance and meets
regularly throughout the year.  Our bylaws provide that our board of
directors may fix the exact number of directors between four and
seven.  Our board of directors has fixed the number of directors at
five.




Our
directors are elected annually and hold office until the next annual meeting of
shareholders, until their successors are elected or until their earlier death,
resignation or removal.  Our directors are kept informed of our
business through discussions with our executive officers, by reviewing materials
provided to them and by participating in meetings of our board of directors and
its committees.




For so
long as our shares of Series A Preferred Stock remain outstanding, the holders
of at least a majority of our issued and outstanding shares of Series A
Preferred Stock are entitled to nominate one member of our board of
directors.  In addition, the holders of at least a majority of our
issued and outstanding shares of Series A Preferred Stock are entitled to
nominate a second member of our board of directors for successive one-year-terms
upon the accumulation of accrued and unpaid dividends for three or more
six-month periods or our failure to comply with the covenants or agreements set
forth in our articles of incorporation.  The holders of our
Series A Preferred Stock have nominated Wesley Cummins as a member of our
board of directors and currently have the right to nominate a second member of
our board of directors.  The right to nominate a second director will
terminate upon the cure of the defaults creating the right to nominate a second
director.




Our
executive officers are appointed by and serve at the discretion of our board of
directors. There are no family relationships among our executive officers and
directors.




As
discussed below, we have adopted procedures by which shareholders may elect
nominees to our board of directors.




Corporate
Governance




Our board
of directors believes that good corporate governance is paramount to ensure that
Strasbaugh is managed for the long-term benefit of our
shareholders.  Our board of directors has adopted corporate governance
guidelines that guide its actions with respect to, among other things, the
composition of the board of directors and its decision making processes, board
of directors meetings and involvement of management, the board of directors’
standing committees and procedures for appointing members of the committees, and
its performance evaluation for our Chief Executive Officer.




Our board
of directors has adopted a Code of Ethics and Corporate Conduct that applies to
all of our directors, officers and employees and an additional Code of Business
Ethics that applies to our Chief Executive Officer and senior financial
officers.  The Codes of Ethics, as applied to our principal executive
officer, principal financial officer and principal accounting officer
constitutes our “code of ethics” within the meaning of Section 406 of the
Sarbanes-Oxley Act of 2002.  Our Code of Ethics and Corporate Conduct
and our Code of Business Ethics that applies to our Chief Executive Officer and
Senior Corporate Financial Officer is posted on our Internet website, located at
http://www.strasbaugh.com.  We
will provide to any person, without charge, upon written request, a copy of our
Codes of Ethics.  Written requests should be made to Dan O’Hare, the
Board of Directors, Strasbaugh, 825 Buckley Road, San Luis Obispo, California
93401.




We intend
to satisfy the disclosure requirements of the federal securities laws relating
to amendments to or waivers from provisions of these codes, by describing on our
Internet website, located at http://www.strasbaugh.com,
within four business days following the date of a waiver or a substantive
amendment, the date of the waiver or amendment, the nature of the amendment or
waiver, and the name of the person to whom the waiver was granted.




41




Information
on our Internet website is not, and shall not be deemed to be, a part of this
report or incorporated into any other filings we make with the SEC.




Director
Independence




Our
corporate governance guidelines provide that a majority of the board of
directors and all members of the Audit, Compensation and Nominating and
Corporate Governance Committees of the board of directors must be
independent.




On an
annual basis, each director and executive officer is obligated to complete a
Director and Officer Questionnaire that requires disclosure of any transactions
with Strasbaugh in which a director or executive officer, or any member of his
or her immediate family, have a direct or indirect material
interest.  Following completion of these questionnaires, the board of
directors, with the assistance of the Nominating and Corporate Governance
Committee, makes an annual determination as to the independence of each director
using the current standards for “independence” established by the SEC and NASDAQ
Market Place Rules, additional criteria set forth in our corporate governance
guidelines and consideration of any other material relationship a director may
have with Strasbaugh.




Our board
of directors has determined that each of our directors who served on our board
during the year ended December 31, 2009 is independent under these standards,
except for Mr. Strasbaugh, who serves as our Chairman of the Board, and
Mr. Cummins, who is employed by B. Riley and Co. LLC and was nominated
to serve on our board by the holders of our Series A Preferred
Stock.




Shareholder
Communications with our Board of Directors




Our board
of directors has implemented a process by which shareholders may send written
communications directly to the attention of our board of directors or any
individual member of our board of directors.  Dan O’Hare, the Chairman
of our Audit Committee, is responsible for monitoring communications from
shareholders and providing copies of such communications to the other directors
as he considers appropriate.  Communications will be forwarded to all
directors if they relate to substantive matters and include suggestions or
comments that Mr. O’Hare considers to be important for the directors to
consider.  Shareholders who wish to communicate with our board of
directors can write to Dan O’Hare, The Board of Directors, Strasbaugh, 825
Buckley Road, San Luis Obispo, California 93401.




Committees
of the Board of Directors




Our board
of directors has established standing Audit, Compensation and Nominating and
Corporate Governance Committees.  Each committee has a written charter
that is reviewed annually and revised as appropriate.  A copy of each
committee’s charter is available on our Internet website, located at http://www.strasbaugh.com.




Audit
Committee




Our Audit
Committee selects our independent auditors, reviews the results and scope of the
audit and other services provided by our independent auditors, and reviews our
financial statements for each interim period and for our year end.




42




Our Audit
Committee operates pursuant to a charter approved by our board of directors and
our Audit Committee, according to the rules and regulations of the SEC. Our
Audit Committee consists of Messrs. O’Hare, Walsh and
Kulawski.  Mr. O’Hare serves as the Chairman of our Audit
Committee.  Our board of directors has determined that each of
Messrs. O’Hare, Walsh and Kulawski is “independent” under our Corporate
Governance Guidelines and the Nasdaq Marketplace Rules and that each satisfies
the other requirements under SEC rules regarding audit committee membership.
Mr. O’Hare qualifies as an “audit committee financial expert” under
applicable SEC rules and regulations governing the composition of the Audit
Committee, and satisfies the “financial sophistication” requirements of the
NASDAQ Marketplace Rules.




Compensation
Committee




Our
Compensation Committee is responsible for establishing and administering our
overall policies on compensation and the compensation to be provided to our
executive officers, including, among other things, annual salaries and bonuses,
stock options, stock grants, other stock-based awards, and other incentive
compensation arrangements.  In addition, the Compensation Committee
reviews the philosophy and policies behind the salary, bonus and stock
compensation arrangements for all other employees.  Although our
Compensation Committee makes all compensation decisions as to our executive
officers, our Chief Executive Officer makes recommendations to our Compensation
Committee regarding compensation for the other named executive
officers.  Our Compensation Committee has the authority to administer
our 2007 Share Incentive Plan with respect to grants to executive officers and
directors, and also has authority to make equity awards under our 2007 Share
Incentive Plan to all other eligible individuals.  However, our board
of directors may retain, reassume or exercise from time to time the power to
administer our 2007 Share Incentive Plan.  Equity awards made to
members of the Compensation Committee must be authorized and approved by a
disinterested majority of our board of directors.




The
Compensation Committee evaluates both performance and compensation to ensure
that the total compensation paid to our executive officers is fair, reasonable
and competitive so that we can attract and retain superior employees in key
positions.  The Compensation Committee believes that compensation
packages offered to our executives, including the named executive officers,
should include both cash and equity-based compensation that reward performance
as measured against established goals.  The Compensation Committee has
the authority to retain consultants, and other advisors and in furtherance of
the foregoing objectives.




Our
Compensation Committee operates pursuant to a charter approved by our board of
directors and our Compensation Committee.  Our Compensation Committee
consists of Messrs. Walsh, Kulawski and O’Hare.  Mr. Walsh acts as
Chairman of our Compensation Committee.  Our board of directors has
determined that each of Messrs. Walsh, Kulawski and O’Hare is “independent”
under the current NASDAQ Marketplace Rules.




Nominating
and Corporate Governance Committee




Our
Nominating and Corporate Governance Committee selects nominees for our board of
directors.  The Nominating and Corporate Governance Committee will
consider candidates for director recommended by any shareholder that is the
beneficial owner of shares representing more than 1% of the then-outstanding
shares of our common stock and who has beneficially owned those shares for at
least one year.  The Nominating and Corporate Governance Committee
will evaluate those recommendations by applying its regular nominee criteria and
considering the additional information described in the Nominating and Corporate
Governance Committee’s below-referenced charter.  Shareholders that
desire to recommend candidates for the board of directors for evaluation may do
so by contacting Strasbaugh in writing, identifying the potential candidate and
providing background and other relevant information.  Our Nominating
and Corporate Governance Committee utilizes a variety of methods for identifying
and evaluating nominees for director.  Candidates may also come to the
attention of the Nominating and Corporate Governance Committee through current
members of our board of directors, professional search firms and other
persons.  In evaluating potential candidates, our Nominating and
Corporate Governance Committee will take into account a number of factors,
including, among others, the following:




43




●
                the
      candidate’s independence from
  management;●
                whether
      the candidate has relevant business
  experience;●
                judgment,
      skill, integrity and reputation;●
                existing
      commitments to other businesses;●
                corporate
      governance background;●
                financial
      and accounting background, to enable the committee to determine whether
      the candidate would be suitable for Audit Committee membership;
      and●
                the
      size and composition of our board of
  directors.


While our
board of directors has not adopted a formal policy with respect to diversity,
our board of directors seeks directors who have a diversity of experience,
expertise, viewpoints, skills, and specialized knowledge.




Our
Nominating and Corporate Governance Committee operates pursuant to a charter
approved by our board of directors and our Nominating and Corporate Governance
Committee.  Our Nominating and Corporate Governance Committee consists
of Messrs. Kulawski, O’Hare and Walsh.  Mr. Kulawski acts as chairman
of our Nominating and Corporate Governance Committee.  Our board of
directors has determined that each of Messrs. Kulawski, O’Hare and Walsh is
“independent” under the NASDAQ Marketplace Rules.




Board
Leadership Structure




We
currently utilize a board leadership structure under which our most tenured
employee, and former Chief Executive Officer, serves as the Chairman of our
board of directors. The board of directors believes that Mr. Strasbaugh is the
one director who is the most familiar with our business and industry, and most
capable of effectively identifying strategic priorities and leading the
discussion and execution of our overall business strategy.




Mr.
Strasbaugh began his employment at R.H. Strasbaugh in 1961.  For the first
ten years he worked in most phases of manufacturing and engineering, followed by
eight years of manufacturing management, then ten years as General Manager and
Director of Operations. He was Chief Executive Officer from 1990 to 1998,
growing annual sales from $8 million to $80 million. We believe Mr. Strasbaugh
is uniquely qualified as the chairman based on his in-depth familiarity with our
operations, our products and the industry within which we operate.  We
believe the close working relationship between Mr. Strasbaugh and our Chief
Executive Officer enhances the unified leadership and direction of our board of
directors and executive management.




Our board
of directors is comprised of active and engaged directors. The board of
directors and its various committees closely oversee the effectiveness of
management policies and decisions. Each committee of the board of directors is
comprised entirely of independent directors. As a result, independent directors
directly oversee such critical matters as the integrity of our financial
statements, the compensation of our executive management, the selection and
evaluation of our directors, and the development and implementation of our
corporate programs.




44




Board
Role in Risk Oversight




Our board
of directors oversees an enterprise−wide approach to risk management, designed
to support the achievement of organizational objectives, including strategic
objectives, to improve long−term organizational performance and enhance
shareholder value. A fundamental part of risk management is not only
understanding the risks a company faces and what steps management is taking to
manage those risks, but also understanding what level of risk is appropriate for
the company. The involvement of the full board of directors in setting our
business strategy is a key part of its assessment of management’s appetite for
risk and also a determination of what constitutes an appropriate level of risk
for Strasbaugh. Risk is assessed throughout the business, focusing on three
primary areas of risk: financial risk, legal/compliance risk and
operational/strategic risk.




While the
board of directors has the ultimate oversight responsibility for the risk
management process, various committees of our board of directors also have
responsibility for risk management. The Audit Committee focuses on financial
risk, including internal controls. In addition, in setting compensation, the
Compensation Committee strives to create incentives that encourage a level of
risk−taking behavior consistent with our overall business strategy.




Compensation
Committee Interlocks and Insider Participation




No member
of our board of directors has a relationship that would constitute an
interlocking relationship with executive officers and directors of another
entity.




Item
      11.
            Executive
      Compensation.




Summary
Compensation Table




The
following table provides information concerning the compensation for the
individual who served as our principal executive officer during the year ended
December 31, 2009 and our two highest paid executive officers who were serving
as an executive officer on December 31, 2009.  These three individuals
are collectively referred to in this report as the “named executive
officers.”





Name and Principal Position
            
            Year
                ($)
            
            Salary
                ($)(4)
            
            
            Bonus
                ($)
            
            
            Stock
      Awards
                ($)(1)
            
            
            All
      other Compensation
                ($)
            
            
            Total
                ($)Chuck
      Schillings
            
            2008
            
            
            217,046
            
            
            
            —
            
            
            
            —
            
            
            
            3,958
            (3)
            
            
            221,004President
      and Chief Executive Officer
              of  Strasbaugh
      and R. H. Strasbaugh(2)
            
            2009
            
            
            221,944
            
            
            
            —
            
            
            
            22,000
            
            
            
            2,827
            (3)
            
            
            246,771Richard
      Nance
            
            2008
            
            
            178,111
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            178,111Chief
      Financial Officer of Strasbaugh
              and
      R. H. Strasbaugh(2)
            
            2009
            
            
            182,003
            
            
            
            —
            
            
            
            29,260
            
            
            
            —
            
            
            
            211,263Allan
      Paterson
            
            2008
            
            
            167,992
            
            
            
            —
            
            
            
            —
            
            
            
            3,346
            (3)
            
            
            171,338Vice
      President of Business Development
              of
      Strasbaugh and R. H. Strasbaugh(2)
            
            2009
            
            
            182,003
            
            
            
            —
            
            
            
            22,000
            
            
            
            538
            (3)
            
            
            204,541




45





(1)
            The
      amount reflected in this column is the aggregate grant date incremental
      fair value of the restricted shares of common stock issued in the Option
      Exchange Program during 2009, computed in accordance with FASB ASC Topic
      718.  The incremental fair value of the modified awards is
      estimated based on the closing price of our common stock on
      September 24, 2009, the date the exchange offer was terminate, using
      the Black-Scholes option-pricing model based on assumptions described in
      Note 7 to our consolidated financial
statements.


(2)
            Amounts
      for 2008 and 2009 represent compensation received for services provided as
      an executive officer of Strasbaugh and R. H.
    Strasbaugh.


(3)
            Represents
      our contributions to the employee’s 401(k)
plan.


(4)
            Amounts
      reported as earned may be less than base salaries contained in an
      employee’s applicable employment agreement as a result of plant shut-down
      periods implemented as cost savings
measures.




Employment
Agreements




Executive
Employment Agreements dated May 24, 2007 with each of Chuck Schillings and
Richard Nance




The
Executive Employment Agreements with Mr. Schillings and Mr. Nance provide for a
three-year term and automatic one-year renewals thereafter, unless either the
employee or Strasbaugh provides written notice to the other at least 90 days
prior to the expiration of the then-current term.




Mr.
Schillings is employed as our President and Chief Executive Officer and receives
an annual base salary of $245,000 during the first 12-month period that his
agreement is in effect, after which our Compensation Committee may, in its sole
discretion, increase Mr. Schillings’ annual base salary.  Further, Mr.
Schillings is eligible for an annual cash bonus, based upon performance criteria
to be established by the board, of up to 40% of his annual base
salary.  On May 24, 2007, Mr. Schillings was issued options to
purchase an aggregate of 200,000 shares of our common stock pursuant to our 2007
Share Incentive Plan.




Mr. Nance
is  employed as our Executive Vice President and Chief Financial
Officer and  receives an annual base salary of $200,000 during the
first 12-month period that his agreement is in effect, after which our
Compensation Committee may, in its sole discretion, increase Mr. Nance’s annual
base salary.  Further, Mr. Nance is eligible for an annual cash bonus,
based upon performance criteria to be established by the Board, of up to 35% of
his annual base salary.  On May 24, 2007, Mr. Nance was issued options
to purchase an aggregate of 266,000 shares of our common stock pursuant to our
2007 Share Incentive Plan.




We are
required to provide each of Messrs. Schillings and Nance certain benefits,
to the extent we offer them, including the right to participate in our employee
medical, dental, life and disability insurance plans, and any additional
compensation, benefit, pension, stock option, stock purchase, and 401(k) plans.
We are also required to provide Mr. Schillings with five weeks of paid vacation
per year and Mr. Nance with three weeks of paid vacation per year.




Each of
Messrs. Schillings and Nance are also entitled to reimbursement for all
reasonable business expenses incurred in the performance of their services under
the Executive Employment Agreements, including expenditures for entertainment,
gifts, cellular telephone expenses, and travel.




If the
employment relationship with Mr. Schillings or Mr. Nance is terminated (a) by us
or the employee upon 90 days’ written notice, (b) by us for due cause, or (c) by
the employee upon 30 days’ written notice or by the employee breaching his
employment agreement by refusing to continue his employment and failing to give
the requisite 90 days’ written notice, all compensation and benefits shall cease
as of the date of termination, other than: (i) those benefits that are provided
by retirement and benefit plans and programs specifically adopted and approved
by us for the employee that are earned and vested by the date of termination;
(ii) employee’s pro rata annual salary through the date of termination; (iii)
any restricted stock awards which have vested as of the date of termination
pursuant to the terms of the agreement granting the awards; and (iv) accrued
vacation as required by California law.




46




If the
employment relationship is terminated due to incapacity or death of the
employee, the employee or his estate or legal representative, will be entitled
to (i) those benefits that are provided by retirement and benefits plans and
programs specifically adopted and approved by us for his benefit that are earned
and vested at the date of termination, (ii) a prorated incentive bonus for the
fiscal year in which incapacity or death occurs, and, (iii) even though no
longer employed by us, the employee shall continue to receive the annual salary
compensation for six months following the date of termination, offset, however,
by any payments received by the employee as a result of any disability insurance
maintained by us for his benefit.




If the
employment relationship is terminated by the employee for good reason or by us
upon written notice, then the employee shall be entitled to (i) his salary in
effect as of the date of termination through the end of the month during which
the termination occurs plus credit for any vacation earned but not taken, (ii)
six months of base salary, (iii) a prorated incentive bonus for the fiscal year
during which termination occurs and (iv) maintain, at our expense, all medical
and life insurance to which he was entitled immediately prior to the date of
termination for a period not to exceed 12 months.




The term
“good reason” is defined in each of the Executive Employment Agreements as (i) a
general assignment by us for the benefit of creditors or filing by us of a
voluntary bankruptcy petition or the filing against us of any involuntary
bankruptcy which remains undismissed for 30 days or more or if a trustee,
receiver or liquidator is appointed, (ii) any material changes in the employee’s
titles, duties or responsibilities without his express written consent, or (iii)
the employee is not paid the compensation and benefits required under the
Executive Employment Agreement.




The term
“due cause” is defined in each of the Executive Employment Agreements as
(i) any intentional misapplication by the employee of Strasbaugh funds or
other material assets, or any other act of dishonesty injurious to Strasbaugh
committed by the employee; or (ii) the employee’s conviction of (a) a
felony or (b) a crime involving moral turpitude; or (iii) the employee’s use or
possession of any controlled substance or chronic abuse of alcoholic beverages,
which use or possession the board reasonably determines renders the employee
unfit to serve in his capacity as a senior executive of Strasbaugh; or (iv) the
employee’s breach, nonperformance or nonobservance of any of the terms of his
employment agreement with us, including but not limited to the employee’s
failure to adequately perform his duties or comply with the reasonable
directions of the board; but notwithstanding anything in the foregoing
subsections (iii) or (iv) to the contrary, we may not terminate the employee
unless our board of directors first provides the employee with a written
memorandum describing in detail how his performance thereunder is not
satisfactory and the employee is given a reasonable period of time (not less
than 30 days) to remedy the unsatisfactory performance related by the board of
directors to the employee in that memorandum. A determination of whether the
employee has satisfactorily remedied the unsatisfactory performance shall be
promptly made by a majority of the disinterested directors of the board (or the
entire board, but not including the employee, if there are no disinterested
directors) at the end of the period provided to the employee for remedy, and the
board’s determination shall be final.




47




Option
Exchange Program




On
October 12, 2009, we issued 504,000 shares of restricted common stock to holders
of options to purchase 1,008,000 shares of our common stock who tendered such
options to us for cancellation in exchange for the issuance of the shares of
restricted common stock.  The issuance was pursuant to an option
exchange program, or the Option Exchange Program, in which employees were
entitled to exchange outstanding options to purchase shares of our common stock
for shares of restricted common stock at the rate of two options for one share
of restricted common stock. The restricted shares were issued pursuant to our
2007 Share Incentive Plan and are subject to vesting, such that any of the
restricted shares issued to an employee who ceases to be employed on or before
March 31, 2010 will be cancelled. In connection with the
Option Exchange Program, Mr. Shillings tendered options to purchase 200,000
shares of our common stock for cancellation in exchange for 100,000 shares of
restricted common stock and Mr. Nance tendered options to purchase 266,000
shares of common stock for cancellation in exchange for 133,000 shares of
restricted common stock.




Outstanding
Equity Awards At Fiscal Year-End – 2009





Stock
      AwardsName and Principal Position
            
            Number of shares or Units
      of
                stock that have not
      vested
                (#)(1)
            
            
            Market
      value of shares or
                Units
      that have not vested
                ($)(2)Chuck
      Schillings
              President and Chief
      Executive Officer of  Strasbaugh and R. H.
      Strasbaugh
            
            100,000
            
            
            25,000Richard
      Nance
              Chief Financial
      Officer of Strasbaugh and R. H. Strasbaugh
            
            133,000
            
            
            33,250Allan
      Paterson
              Vice President of
      Business Development of Strasbaugh and R. H.
    Strasbaugh
            
            100,000
            
            
            25,000





(1)
            The
      amount reflected in this column is the number of restricted shares of our
      common stock issued in exchange for outstanding options during 2009 under
      the Option Exchange Program.  There was no other consideration
      given.  The options surrendered for shares reflected in this
      column were exercisable at a price of $1.71 per share.  The
      restricted shares will vest on March 31,
2010.


(2)
            The
      market value of the shares of restricted stock that have not vested is
      computed by reference to the closing sale price of our common stock on
      December 31, 2009.




Compensation
of Directors




Director
Compensation Table – 2009




The
following table summarizes for the twelve months ended December 31, 2009, the
compensation awarded to or paid to, or earned by, those who served on our board
of directors during 2009.




48




Name
            
            Fees
      Earned or
                Paid
      in Cash
                ($)
            
            
            Option
                Awards
                ($)(1)
            
            
            All
      Other
                Compensation
                ($)
            
            
            Total
                ($)Alan
      Strasbaugh
            
            
            —
            
            
            
            4,770
            (2)
            
            
            90,923
            (3)
            
            
            95,693Wesley
      Cummins
            
            
            12,000
            
            
            
            4,770
            (2)
            
            
            —
            
            
            
            16,770Daniel
      O’Hare
            
            
            7,500
            
            
            
            9,540
            (5)
            
            
            —
            
            
            
            17,040Tom
      Walsh
            
            
            6,332
            
            
            
            9,540
            (5)
            
            
            32,288
            (4)
            
            
            48,160Martin
      Kulawski
            
            
            6,168
            
            
            
            9,540
            (5)
            
            
            31,350
            (4)
            
            
            47,058John
      Givens(6)
            
            
            10,500
            
            
            
            —
            
            
            
            5,400
            (7)
            
            
            15,900Danilo
      Cacciamatta(6)
            
            
            15,750
            
            
            
            —
            
            
            
            5,400
            (7)
            
            
            21,150David
      Porter(6)
            
            
            12,250
            
            
            
            —
            
            
            
            5,400
            (7)
            
            
            17,650





(1)
            The
      amount reflected in this column is the aggregate grant date fair value of
      options granted during 2009 computed in accordance with FASB ASC Topic
      718.  The fair value of the option award is estimated on the
      option grant date based on the closing price of our common stock on the
      grant date using the Black-Scholes option-pricing model based on
      assumptions described in Note 7 to our consolidated financial
      statements.


(2)
            The
      director was granted options to purchase 18,000, 10,673 and 9,000 shares
      of our common stock on May 24, 2007, August 1, 2008, and August 1, 2009,
      respectively, which options remained outstanding on December 31, 2009. The
      stock options vest pursuant to a three year vesting schedule, whereby 33%
      of each option becomes exercisable on the first annual anniversary of its
      grant date, 33% of each option becomes exercisable on the second annual
      anniversary of its grant date and 34% becomes exercisable on the third
      annual anniversary of its grant date.  The options expire ten
      years from the date of grant.


(3)
            Includes
      $90,385 of base salary paid to Mr. Alan Strasbaugh pursuant to the terms
      of his Employment Agreement, dated May 24, 2007, and $538 of our
      contributions to his 401(k) plan.  The base salary earned is
      less than the base salary under Mr. Strasbaugh’s employment agreement as a
      result of plant shut-down periods implemented as cost savings measures
      during 2009.


(4)
            Represents
      payments made for consulting services during the year ended December 31,
      2009.


(5)
            The
      director was granted options to purchase 18,000 shares of our common stock
      on August 7, 2009, which options remained outstanding on December 31,
      2009. The stock options vest pursuant to a three year vesting schedule,
      whereby 33% of each option becomes exercisable on the first annual
      anniversary of its grant date, 33% of each option becomes exercisable on
      the second annual anniversary of its grant date and 34% becomes
      exercisable on the third annual anniversary of its grant
    date.


(6)
            On
      August 7, 2009, directors Cacciamatta, Givens and Porter resigned from the
      board of directors. All options issued to Messrs. Givens, Porter and
      Cacciamatta expired 90 days after their respective
      resignations.


(7)
            Represents
      one-time payment in connection with such person’s resignation as a
      director on August 7, 2009.




We use a
combination of cash and stock-based incentive compensation to attract and retain
qualified candidates to serve on our board of directors.  In setting
the compensation of directors, we consider the significant amount of time that
members of the board of directors spend in fulfilling their duties to Strasbaugh
as well as the experience level we require to serve on our board of
directors.  Our board of directors, through its Compensation
Committee, annually reviews the compensation and compensation policies for
members of the board of directors.  In recommending director
compensation, the Compensation Committee is guided by three goals:


●
                  compensation
      should fairly pay directors for work required in a company of our size and
      scope;●
                  compensation
      should align directors’ interests with the long-term interests of our
      shareholders; and●
                  the
      structure of the compensation should be clearly disclosed to our
      shareholders.
  49


Each of
our directors is paid $12,000 per year for serving on the board of
directors.  The Chairman of the Audit Committee, Compensation
Committee and Nominating and Corporate Governance Committee is paid an
additional $12,000, $4,000 and $2,000 per year, respectively, for serving in
such capacity.  Directors who serve (but do not chair) on the Audit
Committee, Compensation Committee and Nominating and Corporate Governance
Committee are paid an additional $3,000, $2,000 and $1,000 per year,
respectively, for serving in such capacity.  In addition, directors
are reimbursed for certain reasonable documented expenses in connection with
attendance at meetings of our board of directors and its
committees.  Employee directors do not receive compensation in
connection with their service as directors.




On August
1, 2009, each of Messrs. Cummins and Strasbaugh was issued options to purchase
9,000 shares of our common stock pursuant to our 2007 Share Incentive
Plan.  On August 7, 2009, each of Messrs. O’Hare, Walsh and Kulawski
was issued options to purchase 18,000 shares of our common stock pursuant to our
2007 Share Incentive Plan.




Employment
Agreement dated May 24, 2007 with Alan Strasbaugh




The
Employment Agreement with Mr. Strasbaugh provides for a five-year term and
renewal based upon mutual agreement.  For providing services to
Strasbaugh as a technical advisor, Mr. Strasbaugh is to receive an annual
base salary of $100,000.




We are
required to provide Mr. Strasbaugh with certain benefits, to the extent we
offer them, including the right to participate in our employee medical, dental,
life and disability insurance plans. Additionally, Mr. Strasbaugh is
eligible for holiday and vacation pay in accordance with our employment
policies.  Mr. Strasbaugh is also entitled to reimbursement for
all reasonable business expenses incurred on behalf of Strasbaugh, including
expenditures for travel.




The
Employment Agreement with Mr. Strasbaugh may only be terminated for
“cause,” or upon disability or death.  Upon termination on death, Mr.
Strasbaugh’s estate will be entitled to receive a payment equal to 60 days of
Mr. Strasbaugh’s base salary.




The term
“cause” is defined in the Employment Agreement as (i) any act of personal
dishonesty, including, but not limited to, any intentional misapplication of
Strasbaugh’s funds or other property, or action resulting in personal gain to
the employee at the expense of Strasbaugh; or (ii) employee’s regular neglect of
his duties or Employee’s gross negligence or willful misconduct in the
performance of his duties; or (iii) disobedience of a lawful and reasonable
order or directive given to employee by our board of directors and within the
scope of employee’s duties that is not cured within ten (10) days after
receiving written notice from us; or (iv) employee’s participation in a criminal
activity or in an activity involving moral turpitude that has a material adverse
effect (the report in the public media of conduct described in this subparagraph
(iv), above, shall be deemed to cause a material adverse effect on Strasbaugh);
or (v) employee’s misappropriation or disclosure to others in competition with
us any of our confidential information, including investment prospects, analysis
or advice, customer lists, plans or other property interests of
Strasbaugh.




Indemnification
of Directors and Officers




Our
articles of incorporation provide that the liability of our directors for
monetary damages shall be eliminated to the fullest extent permissible under
California law. This is intended to eliminate the personal liability of a
director for monetary damages in an action brought by or in the right of
Strasbaugh for breach of a director’s duties to Strasbaugh or our shareholders
except for liability:


50
  ●
                  for
      acts or omissions that involve intentional misconduct or a knowing and
      culpable violation of law;●
                  for
      acts or omissions that a director believes to be contrary to the best
      interests of Strasbaugh or our shareholders or that involve the absence of
      good faith on the part of the
  director;●
                  for
      any transaction for which a director derived an improper personal
      benefit;●
                  for
      acts or omissions that show a reckless disregard for the director’s duty
      to Strasbaugh or our shareholders in circumstances in which the director
      was aware, or should have been aware, in the ordinary course of performing
      a director’s duties, of a risk of serious injury to Strasbaugh or our
      shareholders;●
                  for
      acts or omissions that constitute an unexcused pattern of inattention that
      amounts to an abdication of the director’s duty to Strasbaugh or our
      shareholders; and●
                  for
      engaging in transactions described in the California Corporations Code or
      California case law that result in liability, or approving the same kinds
      of
transactions.


Our
articles of incorporation also provide that we are authorized to provide
indemnification to our agents, as defined in Section 317 of the California
Corporations Code, through our bylaws or through agreements with such agents or
both, for breach of duty to us and our shareholders, in excess of the
indemnification otherwise permitted by Section 317 of the California
Corporations Code, subject to the limits on such excess indemnification set
forth in Section 204 of the California Corporations Code.  Our bylaws
also authorize us to purchase and maintain insurance on behalf of any of our
directors or officers against any liability asserted against that person in that
capacity, whether or not we would have the power to indemnify that person under
the provisions of the California Corporations Code.  We have entered
and expect to continue to enter into agreements to indemnify our directors and
officers as determined by our board of directors.These agreements
provide for indemnification of related expenses including attorneys’ fees,
judgments, fines and settlement amounts incurred by any of these individuals in
any action or proceeding.  We believe that these bylaw provisions and
indemnification agreements are necessary to attract and retain qualified persons
as directors and officers.  We also maintain directors’ and officers’
liability insurance.




Our
bylaws provide for indemnification of our officers, directors, employees, and
other agents to the extent and under the circumstances permitted by California
law. In all cases where indemnification is permitted by the bylaws, a
determination to indemnify such person must be made when ordered by a court and
must be made in a specific case upon a determination that indemnification is
required or proper in the circumstances. Such determination must be
made:


●
                  by
      our board of directors by a majority vote of a quorum consisting of
      directors who were not parties to the action, suit or proceeding which is
      the subject of the request for indemnification;
      or●
                  if
      such a quorum is not obtainable, or, even if obtainable, a majority vote
      of a quorum of disinterested directors so directs, by independent legal
      counsel in a written opinion;
or●
                  by
      a majority of our
  shareholders.




The
limitation of liability and indemnification provisions in our articles of
incorporation and bylaws may discourage shareholders from bringing a lawsuit
against our directors for breach of their fiduciary duty.  They may
also reduce the likelihood of derivative litigation against our directors and
officers, even though an action, if successful, might benefit us and other
shareholders.  Furthermore, a shareholder’s investment may be
adversely affected to the extent that we pay the costs of settlement and damage
awards against directors and officers as required by these indemnification
provisions.  At present, there is no pending litigation or proceeding
involving any of our directors, officers or employees regarding which
indemnification is sought, and we are not aware of any threatened litigation
that may result in claims for indemnification.




51




Insofar
as indemnification for liabilities under the Securities Act may be permitted to
our directors, officers and controlling persons pursuant to the foregoing
provisions, or otherwise, we have been informed that in the opinion of the SEC
such indemnification is against public policy as expressed in the Securities Act
and is, therefore, unenforceable.




Item
      12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters.




The
following table sets forth information with respect to the beneficial ownership
of our voting stock as of March 15, 2010, the date of the table,
by:


●
                    each
      person known by us to beneficially own more than 5% of the outstanding
      shares any class of our voting
      stock;●
                    each
      of our directors;●
                    each
      of our current executive officers identified at the beginning of the
      “Management” section of this;
      and●
                    all
      of our directors and executive officers as a
  group.


Beneficial
ownership is determined in accordance with the rules of the SEC, and includes
voting or investment power with respect to the securities.  To our
knowledge, except as indicated by footnote, and subject to community property
laws where applicable, the persons named in the table below have sole voting and
investment power with respect to all shares of voting stock shown as
beneficially owned by them.  Except as indicated in the discussion of
the beneficial ownership limitations on the Series A Preferred Stock below
and except as indicated by footnote, all shares of common stock underlying
derivative securities, if any, that are currently exercisable or convertible or
are scheduled to become exercisable or convertible for or into shares of common
stock within 60 days after the date of the table are deemed to be outstanding
for the purpose of calculating the percentage ownership of each listed person or
group but are not deemed to be outstanding as to any other person or
group.  Percentage of beneficial ownership of our common stock is
based on 14,705,587 shares of common stock outstanding as of the date of the
table.  Percentage of beneficial ownership of our Series A
Preferred Stock is based on 5,909,089 shares of Series A Preferred Stock
outstanding as of the date of the table.




The
address of each of the following shareholders, unless otherwise indicated below,
is c/o Strasbaugh, 825 Buckley Road, San Luis Obispo, California
93401.  Messrs. Schillings, Nance, Kirkpatrick and Paterson are
executive officers of Strasbaugh.   Messrs. Alan Strasbaugh,
Cummins, O’Hare, Walsh and Kulawski are directors of
Strasbaugh.  Larry Strasbaugh is the brother of Alan
Strasbaugh.




52




Name
      of Beneficial Owner
              
              Title
      of Class
              
              Amount
      and Nature of Beneficial Ownership
              
              
              Percent
                  of
      ClassAlan
      Strasbaugh
              
              Common
              
              
              7,543,048
              (1)
              
              
              51.18%Chuck
      Schillings
              
              Common
              
              
              1,148,508
              (2)
              
              
              7.81%Richard
      Nance
              
              Common
              
              
              133,000
              (3)
              
              
              *Wesley
      Cummins
              
              Common
              
              
              142,535
              (4)
              
              
              *Thomas
      A.
      Walsh
              
              Common
              
              
              1,272,783
              
              
              
              8.66%Martin
      Kulawski
              
              Common
              
              
              —
              
              
              
              —Dan
      O’Hare
              
              Common
              
              
              —
              
              
              
              —Allan
      Paterson
              
              Common
              
              
              100,000
              (3)
              
              
              *Michael
      A.
      Kirkpatrick
              
              Common
              
              
              848,508
              
              
              
              5.77%Larry
      Strasbaugh
              
              Common
              
              
              2,616,712
              
              
              
              17.79%Lloyd
      I. Miller,
      III
              
              Common#
              
              
              2,314,603
              (5)
              
              
              13.61%Series
      A Preferred
              
              
              2,000,000
              (6)
              
              
              33.85%Milfam
      II
      L.P.
              
              Common#
              
              
              1,155,629
              (7)
              
              
              7.29%Series
      A Preferred
              
              
              1,000,000
              
              
              
              16.92%Harvey
      SMidCap Fund
      LP
              
              Common#
              
              
              745,878
              (8)
              
              
              4.99%Series
      A Preferred
              
              
              1,186,363
              
              
              
              20.08%James
      Schwartz
              
              Common#
              
              
              745,878
              (9)
              
              
              4.99%Series
      A Preferred
              
              
              1,363,636
              (10)
              
              
              23.08%Jeffrey
      Moskowitz
              
              Common#
              
              
              745,878
              (9)
              
              
              4.99%Series
      A Preferred
              
              
              1,363,636
              (10)
              
              
              23.08%Bryant
      Riley
              
              Common#
              
              
              743,497
              (11)
              
              
              4.99%Series
      A Preferred
              
              
              772,727
              
              
              
              13.08%The
      Robert A Lichtenstein & Annette Lichtenstein Revocable
      Trust
              
              Common#
              
              
              522,727
              (12)
              
              
              3.43%Series
      A Preferred
              
              
              454,545
              
              
              
              7.69%Kayne
      Anderson Capital Income Partners(QP),
      LP
              
              Common#
              
              
              418,183
              (13)
              
              
              2.77%Series
      A Preferred
              
              
              363,637
              
              
              
              6.15%Richard
      A.
      Kayne
              
              Common#
              
              
              627,274
              (14)
              
              
              4.09%Series
      A Preferred
              
              
              545,455
              (15)
              
              
              9.23%John
      P.
      Francis
              
              Common#
              
              
              365,910
              (16)
              
              
              2.43%Series
      A Preferred
              
              
              318,182
              (17)
              
              
              5.38%All
      directors and executive officersas
      a group (9 persons)
              
              Common#
              
              
              11,179,382
              (18)
              
              
              75.61%


*
            Less
      than 1%.


#
            The
      terms of the Series A Preferred Stock and the Investor Warrants held by
      the stockholder prohibits conversion of the Series A Preferred Stock or
      exercise of the Investor Warrants to the extent that such conversion or
      exercise would result in a holder, together with its affiliates,
      beneficially owning in excess of 4.99% of our outstanding shares of common
      stock. A holder may waive these 4.99% beneficial ownership limitations
      upon 61-days’ prior written notice to us. Also, these beneficial ownership
      limitations do not preclude a holder from exercising an Investor Warrant,
      converting Series A Preferred Stock or selling the shares underlying
      Investor Warrants or Series A Preferred Stock in stages over time where
      each stage does not cause the holder and its affiliates to beneficially
      own shares in excess of the 4.99% limitation amount.  The 4.99%
      limitation can be waived by a
stockholder.




53




(1)
            Includes
      15,557 shares underlying options.  Also includes 196 shares of
      common stock held by Mr. Strasbaugh’s
wife.


(2)
            Includes
      100,000 shares underlying restricted
stock.


(3)
            Represents
      shares underlying restricted stock.


(4)
            Includes
      48,198 shares underlying a Placement Warrant and 15,557  shares
      underlying options.  Also includes 78,780 shares of common stock
      reported as beneficially owned by Mr. Cummins on a Form 4 filed
      with the SEC on June 16, 2009.


(5)
            Includes1,000,000 shares
      underlying Series A Preferred Stock and 150,000 shares underlying Investor
      Warrants held directly by Lloyd I. Miller, III.  Also includes
      1,155,629 shares of common stock represented in this table as beneficially
      owned by Milfam II L.P.  Further includes 3,230 shares of outstanding
      common stock over which Lloyd I. Miller, III has sole dispositive and
      voting power as (i) a manager of a limited liability company,
      (ii) the trustee to a certain grantor retained annuity trust,
      (iii) the custodian to accounts set up under Florida Uniform Gift to
      Minors Act, (iv) trustee of certain generation-skipping trusts, and
      (vi) an individual.  Further, includes 5,744 shares of
      common stock over which Lloyd I. Miller, III has shared dispositive and
      voting power as (i) an investment advisor to the trustee of a certain
      family trust and (ii) co-trustee of a certain generation-skipping
      trust.  On May 30, 2007, Mr. Miller waived the 4.99% beneficial
      ownership limitation applicable to the Series A Preferred Stock and
      Investor Warrants held by himself and Milfam II L.P.  The address for
      Lloyd I. Miller, III is 4550 Gordon Drive, Naples, Florida
      34102.


(6)
            Includes
      1,000,000 shares of Series A Preferred Stock owned by Mr. Miller and
      1,000,000 shares of Series A Preferred stock represented in this table as
      held by Milfam II L.P.


(7)
            Represents
      5,629 shares of outstanding common stock, 1,000,000 shares underlying
      Series A Preferred Stock and 150,000 shares underlying Investor
      Warrants.  Mr. Lloyd I. Miller, III has the power to vote
      or dispose of the shares beneficially held by Milfam II
      L.P.  Milfam LLC is the general partner of Milfam II L.P. and
      Lloyd I. Miller, III is the manager of Milfam LLC.  On May 30,
      2007, Mr. Miller waived the 4.99% beneficial ownership limitation
      applicable to the Series A Preferred Stock and Investor Warrants held by
      Milfam II LP.  The address for Milfam II L.P. is c/o
      Lloyd I. Miller, III, 4550 Gordon Drive, Naples, Florida
      34102.


(8)
            Represents
      745,878 shares underlying Series A Preferred Stock and Investor
      Warrants.  The number of shares beneficially owned is limited to
      4.99% of our outstanding common stock pursuant to the terms of the Series
      A Preferred Stock and Investor Warrants.  If beneficial
      ownership limitations had not been in effect, the Harvey SMidCap Fund LP
      would have beneficially owned a total of 1,364,317 shares of common stock,
      or 8.49% of our outstanding common stock, representing 1,186,363 shares
      underlying Series A Preferred Stock and 177,954 shares underlying Investor
      Warrants.  Power to vote or dispose of the shares beneficially
      owned by Harvey SMidCap Fund LP is held by Harvey Partners LLC. The
      individuals authorized to act on behalf of Harvey Partners LLC in the
      voting and disposition of the shares are James Schwartz and Jeffrey
      Moskowitz.  The address for Harvey SMidCap Fund LP is 350
      Madison Avenue, 8th Floor, New York, New York
  10017.


(9)
            Represents
      shares underlying Series A Preferred Stock and Investor Warrants held by
      Harvey SMidCap Fund LP and Harvey SMidCap Offshore Fund
      LTD.  The number of shares beneficially owned is limited to
      4.99% of our outstanding common stock pursuant to the terms of the Series
      A Preferred Stock and Investor warrants.  If beneficial
      ownership limitations had not been in effect, Mr. Schwartz and Mr.
      Moskowitz would each have beneficially owned a total of 1,568,181 shares
      underlying the Series A Preferred Stock and Investor Warrants held by
      Harvey SMidcap Fund LP and Harvey SMidcap Offshore Fund LTD, or 9.64% of
      our outstanding common stock, representing 1,186,363 shares underlying
      Series A Preferred Stock and 177,954 shares underlying Investor Warrants
      held by Harvey SMidCap Fund LP and 177,273 shares underlying Series A
      Preferred Stock and 26,591 shares underlying Investor Warrants held by
      Harvey SMidCap Offshore Fund LTD.  Harvey Partners LLC holds the
      power to vote or dispose of the shares beneficially owned by Harvey
      SMidCap Fund LP and Harvey SMidCap Offshore Fund LTD.  Mr.
      Schwartz and Mr. Moskowitz are each authorized to act alone on behalf of
      Harvey Partners LLC.  The address for Mr. Schwartz and Mr.
      Moskowitz is 350 Madison Avenue, 8th Floor, New York, New York
      10017.


(10)
            Represents
      1,186,363 shares of Series A Preferred Stock held by Harvey SMidCap Fund
      LP and 177,273 shares of Series A Preferred Stock held Harvey SMidCap
      Offshore Fund LTD.  Harvey Partners LLC holds the power to vote
      or dispose of the shares beneficially owned by Harvey SMidCap Fund LP and
      Harvey SMidCap Offshore Fund LTD. Mr. Schwartz and Mr. Moskowitz are each
      authorized to act alone on behalf of Harvey Partners
  LLC.




54




(11)
            Includes
      2,045 shares of outstanding common stock held by Bryan and Carleen Riley
      JTWROS, 18,345 shares underlying Placement Warrants and 532,802 shares
      underlying both Series A Preferred Stock and Investor Warrants held by Mr.
      Riley.  Also includes 21,761 shares of common stock and 138,756
      shares underlying Placement Warrants held by B. Riley and Co.
      LLC.  Mr. Riley has shared power to vote or dispose of the
      shares held by B. Riley and Co. LLC.  Additionally includes the
      following shares of common stock over which Mr. Riley has the sole power
      to vote or dispose of: 322 shares held by BR Investco, LLC; 112 shares
      held by B. Riley and Co. Retirement Trust; 738 shares held by Investment
      Advisory Client; and 20,365 shares held by Riley Investment Partners
      Master Fund, L.P.  The number of shares beneficially owned is
      limited to 4.99% of the outstanding common stock of the Company pursuant
      to the terms of the Series A Preferred Stock and Investor
      warrants.  If beneficial ownership limitations had not been in
      effect, the selling security holder would have beneficially owned a total
      of 1,229,836 shares of common stock, or 6.93% of our outstanding common
      stock, which includes 772,727 shares underlying the Series A Preferred
      Stock and 115,909 shares underlying Investor Warrants.  The
      address for Mr. Riley is c/o Riley Investment Management LLC,
      11100 Santa Monica Boulevard, Suite 800, Los Angeles, California
      90025.


(12)
            Represents
      454,545 shares underlying Series A Preferred Stock and 68,182 shares
      underlying Investor Warrants. The individuals authorized to act on behalf
      of The Robert A Lichtenstein & Annette Lichtenstein Revocable Trust in
      the voting and disposition of the shares are Robert A Lichtenstein and
      Annette Lichtenstein,  trustees of The Robert A Lichtenstein
      & Annette Lichtenstein Revocable Trust. The address for The Robert A
      Lichtenstein & Annette Lichtenstein Revocable Trust is 4573 Tara
      Drive, Encino, California 91316.


(13)
            Represents
      363,637 shares underlying Series A Preferred Stock and 54,546 shares
      underlying Investor Warrants.  Power to vote or dispose of the
      shares is held by Kayne Anderson Capital Advisors, LP, the General Partner
      of Kayne Anderson Capital Income Partners (QP), LP and Kayne Anderson
      Investment Management, Inc., the investment advisor to Kayne Anderson
      Capital Income Partners (QP), LP.  Richard A. Kayne is
      authorized to act on behalf of Kayne Anderson Capital Advisors, LP as its
      chief executive officer and on behalf of Kayne Anderson Investment
      Management, Inc. as its chief executive officer.  The address
      for Kayne Anderson Capital Income Partners (QP), LP is 350 Madison Avenue,
      8th Floor, New York, New York
10017.


(14)
            Includes
      136,364 shares underlying Series A Preferred Stock and 45,454 shares
      underlying Investor Warrants held by Kayne Anderson Income Partners, LP
      and 20,455 shares underlying Series A Preferred Stock and 6,818 shares
      underlying Investor Warrants held by Kayne Anderson Capital Income Fund,
      Ltd.  Also includes the 418,183 shares of common stock
      represented in this table as beneficially owned by Kayne Anderson Capital
      Income Partners (QP), LP.  Power to vote or dispose of the
      shares is held by Kayne Anderson Capital Advisors, LP, the General Partner
      of the three affiliated entities and Kayne Anderson Investment Management,
      Inc., the investment advisor to the three affiliated
      entities.  Mr. Kayne is authorized to act on behalf of Kayne
      Anderson Capital Advisors, LP as its chief executive officer and on behalf
      of Kayne Anderson Capital Advisors, LP as its chief executive
      officer.  The address for Mr. Kayne is c/o Kayne Anderson
      Capital Advisors, LP, 1800 Avenue of the Stars, 2nd Floor, Los Angeles,
      California 90067.


(15)
            Represents
      136,364 shares underlying Series A Preferred Stock held by Kayne Anderson
      Income Partners, LP, 20,455 shares underlying Series A Preferred Stock
      held by Kayne Anderson Capital Income Fund, Ltd. and 363,637 shares
      underlying Series A Preferred Stock held by Kayne Anderson Capital Income
      Partners (QP), LP.


(16)
            Represents
      159,091 shares underlying Series A Preferred Stock and 23,864 shares
      underlying Investor Warrants held by Catalysis Offshore, Ltd. and 159,091
      shares underlying Series A Preferred Stock and 23,864 shares underlying
      Investor Warrants held by Catalysis Partners, LLC.  Power to
      vote or dispose of the shares is held by Francis Capital Management, LLC.
      Mr. Francis is authorized to act on behalf of Francis Capital Management,
      LLC in the voting and disposition of the shares. The address for Mr.
      Francis is 429 Santa Monica Boulevard, Suite 320, Santa Monica, California
      90401.


(17)
            Represents
      159,091 shares underlying Series A Preferred Stock held by Catalysis
      Offshore, Ltd. and 159,091 shares underlying Series A Preferred Stock and
      held by Catalysis Partners, LLC.


(18)
            Includes
      31,114 shares underlying options, 333,000 shares underlying restricted
      stock, and 48,198 shares underlying a Placement Warrant held by Mr.
      Cummins. Also includes 196 shares of common stock held by
      Mr. Strasbaugh’s wife.




Equity
Compensation Plan Information




The
following table gives information about our common stock that may be issued upon
the exercise of options, warrants and rights under all of our existing equity
compensation plans as of December 31, 2009.




55




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))(a)
              
              
              (b)
              
              
              (c)Equity
      compensation plans approved by security holders
              
              
              434,646
              (1)
              
              $
              1.24
              
              
              
              1,061,354
              (2)Equity
      compensation plans not approved by security holders
              
              
              —
              
              
              
              —
              
              
              
              —Total
              
              
              434,646
              
              
              
              
              
              
              
              1,061,354


(1)
            Represents
      shares of common stock underlying options that are outstanding under our
      2007 Share Incentive Plan.  The material features of our 2007
      Share Incentive Plan are described in Note 7 to our consolidated
      financial statements for the year ended December 31,
      2009.


(2)
            Represents
      shares of common stock available for issuance under our 2007 Share
      Incentive Plan.




Item
      13.
            Certain
      Relationships and Related Transactions, and Director
      Independence.




Policy
Regarding Related Party Transactions




We
recognize that related party transactions present a heightened risk of conflicts
of interest and in connection with this offering, have adopted a policy to which
all related party transactions shall be subject.  Pursuant to the
policy, the Audit Committee of our board of directors will review the relevant
facts and circumstances of all related party transactions, including, but not
limited to, whether the transaction is on terms comparable to those that could
be obtained in arm’s-length dealings with an unrelated third party and the
extent of the related party’s interest in the transaction.  Pursuant
to the policy, no director may participate in any approval of a related party
transaction to which he or she is a related party.




The Audit
Committee will then, in its sole discretion, either approve or disapprove the
transaction.  If advance Audit Committee approval of a transaction is
not feasible, the transaction may be preliminarily entered into by management,
subject to ratification of the transaction by the Audit Committee at the Audit
Committee’s next regularly scheduled meeting.  If at that meeting the
Audit Committee does not ratify the transaction, management shall make all
reasonable efforts to cancel or annul such transaction.




Certain
types of transactions, which would otherwise require individual review, have
been preapproved by the Audit Committee.  These types of transactions
include, for example, (i) compensation to an officer or director where such
compensation is required to be disclosed in our proxy statement,
(ii) transactions where the interest of the related party arises only by
way of a directorship or minority stake in another organization that is a party
to the transaction and (iii) transactions involving competitive bids or
fixed rates.




Employment
Agreements




We are or
have been a party to employment and compensation arrangements with related
parties, as more particularly described above under the headings “Compensation
of Executive Officers,” “Employment Agreements” and “Compensation of
Directors.”




56




Indemnification
Agreements




We have
entered into an indemnification agreement with each of our directors and
executive officers.The
indemnification agreements and our certificate of incorporation and bylaws
require us to indemnify our directors and officers to the fullest extent
permitted by California law.




Facilities
Lease




Our
corporate headquarters, in San Luis Obispo, is owned by Alan Strasbaugh and
leased to R. H. Strasbaugh, the term of the lease is one year, at $84,000
per month.  During the years ended December 31, 2009 and 2008 our
total lease costs were approximately $1,000,000 each year.  Alan
Strasbaugh is the chairman of our board of directors, the chairman of the board
of directors of R. H. Strasbaugh and an employee of
Strasbaugh.




Option
Exchange Program




In
connection with the Option Exchange Program described above, we issued 100,000
shares of restricted stock to Mr. Chuck Shillings in exchange for options
to purchase 200,000 shares of our common stock that he tendered to us for
cancellation.  We also issued to Mr. Richard Nance 133,000 shares
of restricted stock in exchange for options to purchase shares 266,000 shares of
our common stock that he tendered to us for cancellation.




Director
Independence




Our
corporate governance guidelines provide that a majority of the board of
directors and all members of the Audit, Compensation and Nominating and
Corporate Governance Committees of the board of directors must be
independent.




On an
annual basis, each director and executive officer is obligated to complete a
Director and Officer Questionnaire that requires disclosure of any transactions
with Strasbaugh in which a director or executive officer, or any member of his
or her immediate family, have a direct or indirect material
interest.  Following completion of these questionnaires, the board of
directors, with the assistance of the Nominating and Corporate Governance
Committee, makes an annual determination as to the independence of each director
using the current standards for “independence” established by the SEC and NASDAQ
Market Place Rules, additional criteria set forth in our corporate governance
guidelines and consideration of any other material relationship a director may
have with Strasbaugh.




Our board
of directors has determined that each of our directors who served
on our board during the year ended December 31, 2009 is independent under
these standards, except for Mr. Strasbaugh, who serves as our Chairman of
the Board, and Mr. Cummins, who is employed by B. Riley and Co. LLC
and was nominated to serve on our board by the holders of our Series A
Preferred Stock.




57




Item
      14.
            Principal
      Accounting Fees and Services.




The
following table presents the aggregate fees billed to us for professional audit
services rendered by Farber Hass Hurley LLP (“FHH”), for the years ended
December 31, 2009 and 2008.  We appointed FHH as our independent
registered public accounting firm on December 9, 2008.





2009
            
            
            2008Audit
      Fees
            
            $
            105,150
            
            
            $
            5,100Audit-Related
      Fees
            
            
            -0-
            
            
            
            -0-Tax
      Fees
            
            
            -0-
            
            
            
            -0-All
      Other Fees
            
            
            -0-
            
            
            
            -0-Total
            
            $
            105,150
            
            
            $
            5,100




Audit
Fees.  Consist of amounts billed for professional services
rendered for the audit of our annual consolidated financial statements included
in our Annual Report on Form 10-K, and reviews of our interim consolidated
financial statements included in our Quarterly Reports on Form
10-Q.




Audit-Related
Fees.  Audit-Related Fees consist of fees billed for
professional services that are reasonably related to the performance of the
audit or review of our consolidated financial statements but are not reported
under “Audit Fees.”




Tax Fees.Tax Fees
consist of fees for professional services for tax compliance activities,
including the preparation of federal and state tax returns and related
compliance matters.




All Other
Fees.  Consists of amounts billed for services other than those
noted above.




Our Audit
Committee has determined that all non-audit services provided by FHH and Windes
are and were compatible with maintaining audit independence.




Our Audit
Committee is responsible for approving all audit, audit-related, tax and other
services.  The Audit Committee pre-approves all auditing services and
permitted non-audit services, including all fees and terms to be performed for
us by our independent registered public accounting firm at the beginning of the
fiscal year.  Non-audit services are reviewed and pre-approved by
project at the beginning of the fiscal year.  Any additional non-audit
services contemplated by us after the beginning of the fiscal year are submitted
to the Audit Committee chairman for pre-approval prior to engaging the
independent auditor for such services.  These interim pre-approvals
are reviewed with the full Audit Committee at its next meeting for
ratification.  During 2009 and 2008, all services performed by FHH
were pre-approved by our Audit Committee in accordance with these policies and
applicable SEC regulations. During 2008, all services performed by Windes were
pre-approved by our Audit Committee in accordance with these policies and
applicable SEC regulations.




58





PART
IV




Item
      15.
            Exhibits,
      Financial Statement Schedules.




(a)(1),
(a)(2) and (c) Financial Statements and
Financial Statement Schedules




Reference
is made to the financial statements and financial statement schedule listed on
and attached following the Index to Consolidated Financial Statements contained
on page F-1 of this report.




(a)(3)
and (b) Exhibits




Reference
is made to the exhibits listed on the Index to Exhibits that follows the
financial statements and financial statement schedule.




59





STRASBAUGH
AND SUBSIDIARY





INDEX
TO FINANCIAL STATEMENTS







PageReport
      of Independent Registered Public Accounting Firm
            F-2Consolidated
      Balance Sheets as of December 31, 2009 and 2008
            F-3Consolidated
      Statements of Operations for the Years Ended December 31, 2009 and
      2008
            F-4Consolidated
      Statements of Redeemable Convertible Preferred Stock and Shareholders’
      Deficitfor
      the Years Ended December 31, 2009 and 2008
            F-5Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2009 and
      2008
            F-7Notes
      to Consolidated Financial Statements for the Years Ended December 31, 2009
      and 2008
            F-8




F-1




REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM








To the
Board of Directors and


Shareholders
of Strasbaugh








We have
audited the accompanying consolidated balance sheets of Strasbaugh (a California
corporation) and subsidiary as of December 31, 2009 and 2008, and the related
statements of operations, redeemable convertible preferred stock and
shareholders’ deficit, and cash flows for each of the two years in the period
ended December 31, 2009.  Strasbaugh’s management is responsible
for these financial statements.  Our responsibility is to express an
opinion on these financial statements based on our audit.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  The
company is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting.  Our audit included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the company’s
internal control over financial reporting.  Accordingly, we express no
such opinion.  An audit also includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.





In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Strasbaugh and subsidiary as of
December 31, 2009 and 2008, and the results of its operations and its cash flows
for each of the two years in the period ended December 31, 2009 in
conformity with accounting principles generally accepted in the United States of
America.








Farber
Hass Hurley LLP





Granada
Hills, California


March 30,
2010




F-2





STRASBAUGH
AND SUBSIDIARY


CONSOLIDATED BALANCE SHEETS


(In
thousands, except share data)




ASSETS




December
      31,2009
            
            
            2008CURRENT
      ASSETSCash
      and cash equivalents
            
            $
            1,240
            
            
            $
            49Accounts
      receivable, net of allowance for doubtful accountsof
      $13 and $224 in 2009 and 2008, respectively
            
            
            3,298
            
            
            
            1,309Investments
      in securities
            
            
            —
            
            
            
            239Inventories
            
            
            5,256
            
            
            
            5,659Prepaid
      expenses
            
            
            287
            
            
            
            26410,081
            
            
            
            7,520PROPERTY
      AND EQUIPMENT, NET
            
            
            2,046
            
            
            
            2,150OTHER
      ASSETSCapitalized
      intellectual property, net of accumulated amortization of$82
      and $54 at December 31, 2009 and 2008, respectively
            
            
            402
            
            
            
            381Deposits
      and other assets
            
            
            28
            
            
            
            36430
            
            
            
            417TOTAL
      ASSETS
            
            $
            12,557
            
            
            $
            10,087LIABILITIES,
      REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS’
      DEFICITCURRENT
      LIABILITIESNotes
      payable, current portion
            
            $
            —
            
            
            $
            100Accounts
      payable
            
            
            1,323
            
            
            
            1,231Accrued
      expenses
            
            
            2,379
            
            
            
            1,963Customer
      deposits
            
            
            3,997
            
            
            
            147Deferred
      revenue
            
            
            48
            
            
            
            707,747
            
            
            
            3,511OTHER
      LIABILITIESPreferred
      stock related embedded derivative and warrants
            
            
            4
            
            
            
            —7,751
            
            
            
            —COMMITMENTS AND
      CONTINGENCIES (Notes 6, 7 and 8)REDEEMABLE
      CONVERTIBLE PREFERRED STOCKRedeemable convertible preferred
      stock (“Series A”), no par value, aggregate preference in liquidation
      $15,077, 15,000,000 shares authorized, 5,909,089 shares issued and
      outstanding
            
            
            11,203
            
            
            
            11,964SHAREHOLDERS’
      DEFICITPreferred
      stock, no par value, 5,769,736 shares authorized,zero
      shares issued and outstanding
            
            
            —
            
            
            
            —Common
      stock, no par value, 100,000,000 shares authorized 14,705,587 and
      14,201,587 issued and outstanding at December 31, 2009 and 2008,
      respectively
            
            
            56
            
            
            
            56Additional
      paid-in capital
            
            
            23,776
            
            
            
            26,803Accumulated
      other comprehensive loss
            
            
            —
            
            
            
            (61
            )Accumulated
      deficit
            
            
            (30,229
            )
            
            
            (32,186
            )(6,397
            )
            
            
            (5,388
            )TOTAL
      LIABILITIES AND SHAREHOLDERS’ DEFICIT
            
            $
            12,557
            
            
            $
            10,087





F-3





STRASBAUGH
AND SUBSIDIARY


CONSOLIDATED
STATEMENTS OF OPERATIONS


(In
thousands, except per share data)





Years
      EndedDecember
      31,2009
            
            
            2008REVENUESTools
            
            $
            7,410
            
            
            $
            3,041Parts
      and service
            
            
            5,463
            
            
            
            6,513NET
      REVENUES
            
            
            12,873
            
            
            
            9,554COST
      OF SALESTools
            
            
            5,774
            
            
            
            2,777Parts
      and service
            
            
            2,676
            
            
            
            4,331TOTAL
      COST OF SALES
            
            
            8,450
            
            
            
            7,108GROSS
      PROFIT
            
            
            4,423
            
            
            
            2,446OPERATING
      EXPENSESSelling,
      general and administrative expenses
            
            
            3,855
            
            
            
            4,429Research
      and development
            
            
            3,593
            
            
            
            2,9547,448
            
            
            
            7,383LOSS
      FROM OPERATIONS
            
            
            (3,025
            )
            
            
            (4,937
            )OTHER
      INCOME (EXPENSE)Rental
      income
            
            
            581
            
            
            
            321Interest
      income
            
            
            9
            
            
            
            35Interest
      expense
            
            
            (22
            )
            
            
            (14
            )Gain
      on change in value of embedded derivative and warrants (Note
      2)
            
            
            1,688
            
            
            
            —Other
      income, net
            
            
            77
            
            
            
            872,333
            
            
            
            429LOSS
      BEFORE INCOME TAXES
            
            
            (692
            )
            
            
            (4,508
            )BENEFIT
      FROM INCOME TAXES
            
            
            12
            
            
            
            —NET
      LOSS
            
            $
            (680
            )
            
            $
            (4,508
            )NET
      LOSS PER COMMON SHAREBasic
            
            $
            (0.22
            )
            
            $
            (0.43
            )Diluted
            
            $
            (0.22
            )
            
            $
            (0.43
            )WEIGHTED
      AVERAGE COMMON SHARES OUTSTANDINGBasic
            
            
            14,312
            
            
            
            14,202Diluted
            
            
            14,312
            
            
            
            14,202




F-4





STRASBAUGH
AND SUBSIDIARY


CONSOLIDATED
STATEMENT OF REDEEMABLE CONVERTIBLE PREFERRED STOCK


AND
SHAREHOLDERS’ DEFICIT


(In
thousands, except share data)





Accumulated
            
            
            
            
            
            Total
              Shareholders’
      Equity andOther
            
            
            
            
            
            RedeemableRedeemable
      Convertible
            
            
            
            
            
            
            
            
            Additional
            
            
            Comprehensive
            
            
            
            
            
            ConvertiblePreferred
      Stock
            
            
            Preferred
      Stock
            
            
            Common
      Stock
            
            
            Paid-In
            
            
            Income
            
            
            Accumulated
            
            
            PreferredShares
            
            
            Amount
            
            
            Shares
            
            
            Amount
            
            
            Shares
            
            
            Amount
            
            
            Capital
            
            
            (Loss)
            
            
            Deficit
            
            
            StockBALANCE,
      JANUARY 1, 2008
            
            
            5,909,089
            
            
            $
            11,542
            
            
            
            —
            
            
            $
            —
            
            
            
            14,201,587
            
            
            $
            56
            
            
            $
            27,926
            
            
            $
            —
            
            
            $
            (27,678
            )
            
            $
            11,846Comprehensive
      loss:Net
      loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,508
            )
            
            
            (4,508
            )Other
      comprehensive loss:Unrealized
      loss on investments,net
      of tax of $0
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (61
            )
            
            
            
            
            
            
            (61
            )Total
      comprehensive loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,569
            )Series
      A issuance costs
            
            
            —
            
            
            
            (521
            )
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (521
            )Stock-based
      compensation expense
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            453
            
            
            
            —
            
            
            
            —
            
            
            
            453Accretion
      of redeemable convertible preferred stock
            
            
            —
            
            
            
            505
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (505
            )
            
            
            —
            
            
            
            —
            
            
            
            —Preferred
      stock dividend accumulated
            
            
            —
            
            
            
            1,071
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (1,071
            )
            
            
            —
            
            
            
            —
            
            
            
            —Preferred
      stock dividend paid
            
            
            —
            
            
            
            (633
            )
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (633
            )BALANCE,
      DECEMBER 31, 2008
            
            
            5,909,089
            
            
            $
            11,964
            
            
            
            —
            
            
            $
            —
            
            
            
            14,201,587
            
            
            $
            56
            
            
            $
            26,803
            
            
            $
            (61
            )
            
            $
            (32,186
            )
            
            $
            6,576




F-5


STRASBAUGH AND
SUBSIDIARY


CONSOLIDATED
STATEMENT OF REDEEMABLE CONVERTIBLE PREFERRED STOCK


AND
SHAREHOLDERS’ DEFICIT (Continued)


(In
thousands, except share data)





Accumulated
            
            
            
            
            
            Total
              Shareholders’
              Equity
      andOther
            
            
            
            
            
            RedeemableRedeemable
      Convertible
            
            
            
            
            
            
            
            
            Additional
            
            
            Comprehensive
            
            
            
            
            
            ConvertiblePreferred
      Stock
            
            
            Preferred
      Stock
            
            
            Common
      Stock
            
            
            Paid-In
            
            
            Income
            
            
            Accumulated
            
            
            PreferredShares
            
            
            Amount
            
            
            Shares
            
            
            Amount
            
            
            Shares
            
            
            Amount
            
            
            Capital
            
            
            (Loss)
            
            
            Deficit
            
            
            StockBALANCE,
      JANUARY 1, 2009
            
            
            5,909,089
            
            
            $
            11,964
            
            
            
            —
            
            
            $
            —
            
            
            
            14,201,587
            
            
            $
            56
            
            
            $
            26,803
            
            
            $
            (61
            )
            
            $
            (32,186
            )
            
            $
            6,576Cumulative
      effect of change in accounting principle (Note 2)
            
            
            —
            
            
            
            (3,191
            )
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (1,138
            )
            
            
            —
            
            
            
            2,637
            
            
            
            (1,692
            )Comprehensive
      loss:Net
      loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (680
            )
            
            
            (680
            )Other
      comprehensive loss:Unrealized
      gain, net of tax of $0
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            61
            
            
            
            —
            
            
            
            61Total
      comprehensive loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (619
            )Stock
      option expense
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            483
            
            
            
            —
            
            
            
            —
            
            
            
            483Issuance
      of restricted stock, less amortization
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            504,000
            
            
            
            —
            
            
            
            58
            
            
            
            —
            
            
            
            —
            
            
            
            58Accretion
      of redeemable convertible preferred stock
            
            
            —
            
            
            
            1,275
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (1,275
            )
            
            
            —
            
            
            
            —
            
            
            
            —Preferred
      stock dividend accumulated
            
            
            —
            
            
            
            1,155
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (1,155
            )
            
            
            —
            
            
            
            —
            
            
            
            —BALANCE,
      DECEMBER 31, 2009
            
            
            5,909,089
            
            
            $
            11,203
            
            
            
            —
            
            
            $
            —
            
            
            
            14,705,587
            
            
            $
            56
            
            
            $
            23,776
            
            
            $
            —
            
            
            $
            (30,229
            )
            
            $
            4,806





F-6





STRASBAUGH
AND SUBSIDIARY


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(In
thousands)





For
      the Year EndedDecember
      31,2009
            
            
            2008CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      loss
            
            $
            (680
            )
            
            $
            (4,508
            )Adjustments
      to reconcile net loss to net cash provided by (used in) operating
      activities:Depreciation
      and amortization
            
            
            362
            
            
            
            358Allowance
      for doubtful accounts
            
            
            (211
            )
            
            
            169Inventory
      reserves
            
            
            100
            
            
            
            1,629Noncash
      interest expense
            
            
            22
            
            
            
            14Stock-based
      compensation
            
            
            541
            
            
            
            453Gain
      on embedded derivative (Note 2)
            
            
            (1,489
            )
            
            
            —Gain
      on warrants (Note 2)
            
            
            (199
            )
            
            
            —Gain
      on extinguishment of debt
            
            
            (100
            )
            
            
            —Losses
      on sales of investment securities
            
            
            6
            
            
            
            6Changes
      in assets and liabilities:Accounts
      receivable
            
            
            (1,778
            )
            
            
            1,507Inventories
            
            
            284
            
            
            
            (1,037
            )Prepaid
      expenses
            
            
            (23
            )
            
            
            18Deposits
      and other assets
            
            
            —
            
            
            
            29Accounts
      payable
            
            
            92
            
            
            
            714Accrued
      expenses
            
            
            394
            
            
            
            (657
            )Deferred
      revenue
            
            
            (22
            )
            
            
            98Customer
      deposits
            
            
            3,850
            
            
            
            —Net
      Cash Provided by (Used in) Operating Activities
            
            
            1,149
            
            
            
            (1,207
            )CASH
      FLOWS FROM INVESTING ACTIVITIESProceeds
      from the sale of investment securities
            
            
            294
            
            
            
            590Proceeds
      from the maturity of investment securities
            
            
            —
            
            
            
            233Purchase
      of property and equipment
            
            
            (203
            )
            
            
            (177
            )Capitalized
      cost of intellectual property
            
            
            (49
            )
            
            
            (100
            )Net
      Cash Provided by Investing Activities
            
            
            42
            
            
            
            546CASH
      FLOWS FROM FINANCING ACTIVITIESIssuance
      cost of redeemable convertible preferred stock
            
            
            —
            
            
            
            (521
            )Preferred
      dividends paid
            
            
            —
            
            
            
            (633
            )Net
      Cash Used in Financing Activities
            
            
            —
            
            
            
            (1,154
            )NET
      CHANGE IN CASH AND CASH EQUIVALENTS
            
            
            1,191
            
            
            
            (1,815
            )CASH
      AND CASH EQUIVALENTS, BEGINNING OF YEAR
            
            
            49
            
            
            
            1,864CASH
      AND CASH EQUIVALENTS, END OF YEAR
            
            $
            1,240
            
            
            $
            49




F-7


STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




NOTE
1 – Summary of Significant Accounting Policies




The
following significant accounting policies are in conformity with accounting
principles generally accepted in the United States of America.  Such
policies are consistently followed by Strasbaugh, a California corporation and
subsidiary (the “Company”), in preparation of its consolidated financial
statements.




Organization
and Description of Business




The
consolidated financial statements include the accounts of Strasbaugh, a
California corporation formerly known as CTK Windup Corporation (“Strasbaugh”),
and its wholly-owned subsidiary, R. H. Strasbaugh, a California corporation (“R.
H. Strasbaugh,” and together with Strasbaugh, the “Company”). All material
inter-company accounts and transactions have been eliminated in the
consolidation.




The
Company designs, manufactures, markets and sells precision surfacing systems and
solutions for the global semiconductor and semiconductor equipment, silicon
wafer and silicon wafer equipment, data storage, micro-electromechanical system,
light emitting diode, and precision optics markets. Products are sold to
customers throughout the United States, Europe, and Asia and Pacific Rim
countries.




Share
Exchange Transaction




On May
24, 2007, Strasbaugh completed a share exchange transaction (the “Share Exchange
Transaction”) with R. H. Strasbaugh, a California corporation formerly known as
Strasbaugh. Upon completion of the Share Exchange Transaction, Strasbaugh
acquired all of the issued and outstanding shares of R. H. Strasbaugh’s capital
stock. In connection with the Share Exchange Transaction, Strasbaugh issued an
aggregate of 13,770,366 shares of its common stock to R. H. Strasbaugh’s
shareholders. The Share Exchange Transaction has been accounted for as a
recapitalization of R. H. Strasbaugh with R. H. Strasbaugh being the accounting
acquiror. As a result, the historical financial statements of R. H. Strasbaugh
are the financial statements of the legal acquiror, Strasbaugh (formerly known
as CTK Windup Corporation).




Immediately
prior to the consummation of the Share Exchange Transaction, CTK Windup
Corporation amended and restated its articles of incorporation to effectuate a
1-for-31 reverse split of its common stock, to change its name from CTK Windup
Corporation to Strasbaugh, to increase its authorized common stock from
50,000,000 shares to 100,000,000 shares, to increase its authorized preferred
stock from 2,000,000 shares to 15,000,000 shares (of which 5,909,089 shares have
been designated Series A Cumulative Redeemable Convertible Preferred Stock (the
“Series A Preferred Stock”)) and to eliminate its Series A Participating
Preferred Stock. On May 17, 2007, prior to the filing of CTK Windup
Corporation’s amended and restated articles of incorporation, the Company’s
subsidiary, R. H. Strasbaugh (then known as Strasbaugh), amended its articles of
incorporation to change its name from Strasbaugh to R. H.
Strasbaugh.




F-8




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
1 – Summary of Significant Accounting Policies (continued)




Estimates
and Assumptions




The
preparation of financial statements in accordance with accounting principles
generally accepted in the United States of America, or US GAAP, requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, the disclosure of contingent assets and liabilities at
the date of the financial statements, and the reported amounts of revenues and
expenses during the reporting periods. Actual results could differ from those
estimates and those differences could be material. Significant estimates include
the fair value of the Company’s common stock and the fair value of options and
warrants to purchase common stock, provision for doubtful accounts receivable,
inventory obsolescence, and depreciation and amortization.Certain
prior year amounts in the accompanying consolidated financial statements have
been reclassified to conform to the current year’s presentation.




Supplemental
Disclosure of Cash Flow Information





Year
      EndedDecember
      31,2009
            
            
            2008Cash
      paid for:Interest
            
            $
            —
            
            
            $
            —Income taxes
            
            $
            1,000
            
            
            $
            —Noncash
      investing and financing activities:Fair
      value accretion on redeemableconvertible
      preferred stock
            
            $
            1,275,000
            
            
            $
            505,000Preferred
      stock dividend
            
            $
            1,155,000
            
            
            $
            1,071,000Restricted
      common stock for employees and directors
            
            $
            58,000
            
            
            $
            —Unrealized
      gain (loss) on investments in securities
            
            $
            61,000
            
            
            $
            (61,000
            )Property
      and equipment transferred to/from inventory, net
            
            $
            19,000
            
            
            $
            71,000




Additional
information to the statements of cash flows with regard to certain noncash
investing and financing transactions includes inventory transferred from
property and equipment and inventory transferred to property and
equipment.  Inventory is transferred at the lower of cost, market or
net book value and is depreciated over its useful life once transferred to
property, plant and equipment.  These items are typically tools used
for testing, demonstrations and on-going engineering and are sometimes sold as
used tools to customers in the future as needed.




F-9




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




NOTE
1 – Summary of Significant Accounting Policies (continued)




Concentrations
of Credit Risk




Financial
instruments that subject the Company to credit risk consist primarily of cash,
cash equivalents and trade accounts receivable.  Throughout most of
2009 and 2008, the Company maintained cash balances in excess of federally
insured limits.  With regard to cash and cash equivalents, the Company
maintains its excess cash balances in checking and money market accounts at
high-credit quality financial institutions.  The Company has not
experienced any significant losses in any of the short-term investment
instruments we have used for excess cash balances.  The Company does
not require collateral on its trade receivables.  Historically, the
Company has not suffered significant losses with respect to trade accounts
receivable. However, recent developments in the global economy and credit
markets have caused unusual fluctuations in the values of various investment
instruments. Additionally, these developments have, in some cases, limited the
availability of credit funds that borrowers such as the Company normally utilize
in day-to-day operations which could impact the timing or ultimate recovery of
trade accounts. No assurances can be given that these recent developments will
not negatively impact the Company’s operations as a result of concentrations of
these investments.




The
Company sells its products on credit terms, performs ongoing credit evaluations
of its customers, and maintains an allowance for potential credit
losses.  During the years ended December 31, 2009 and 2008, the
Company’s top 10 customers accounted for 85% and 57% of net revenues,
respectively.  Sales to major customers (over 10%) as a percentage of
net revenues were 58% and 26% for the years ended December 31, 2009 and
2008, respectively.




A
decision by a significant customer to substantially decrease or delay purchases
from the Company, or the Company’s inability to collect receivables from these
customers, could have a material adverse effect on the Company’s financial
condition and results of operations.  As of December 31, 2009 and
2008, the amount due from the major customers (over 10%) discussed above
represented 80% and 5% of total accounts receivable, respectively.




Product
Warranties




The
Company provides limited warranty for the replacement or repair of defective
products at no cost to its customers within a specified time period after the
sale.  The Company makes no other guarantees or warranties, expressed
or implied, of any nature whatsoever as to the goods including without
limitation, warranties to merchantability, fit for a particular purpose or
non-infringement of patent or the like unless agreed upon in
writing.  The Company estimates the costs that may be incurred under
its limited warranty and reserve based on actual historical warranty claims
coupled with an analysis of unfulfilled claims at the balance sheet
date.  Warranty claims costs are not material given the nature of the
Company’s products and services which normally result in repairs and returns in
the same accounting period.




Fair
Value of Financial Instruments




The
carrying values of financial instruments approximate their fair
values.  The carrying values of cash and cash equivalents, accounts
receivable, accounts payable and accrued expenses approximate fair value because
of the short-term maturity of these instruments.  The carrying values
of the notes payable approximate fair value because the interest rates on these
instruments approximate market interest rates currently available to the
Company.




F-10




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




NOTE
1 – Summary of Significant Accounting Policies (continued)




Fair
Value of Financial Instruments (continued)




The
Company’s assets (liabilities) measured at fair value on a recurring basis were
determined using the following inputs:





Fair
      Value Measurements at December 31, 2009Quoted
                Prices
      in
                Active
                Markets
      for
                Identical
                Assets
            
            
            Significant
                Other
                Observable
                Inputs
            
            
            Significant
                Unobservable
                InputsTotal
            
            
            (Level
      1)
            
            
            (Level
      2)
            
            
            (Level
      3)Preferred
      stock related embedded derivative
            
            $
            (4,000
            )
            
            $
            —
            
            
            $
            —
            
            
            $
            (4,000
            )Warrants
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Total
            
            $
            (4,000
            )
            
            $
            —
            
            
            $
            —
            
            
            $
            (4,000
            )








Fair
      Value Measurements at December 31, 2008Quoted
                Prices
      in
                Active
                Markets
      for
                Identical
                Assets
            
            
            Significant
                Other
                Observable
                Inputs
            
            
            Significant
                Unobservable
                InputsTotal
            
            
            (Level
      1)
            
            
            (Level
      2)
            
            
            (Level
      3)Fixed
      income available-for-sale securities
            
            $
            239,000
            
            
            
            —
            
            
            $
            239,000
            
            
            
            —Total
            
            $
            239,000
            
            
            $
            —
            
            
            $
            239,000
            
            
            $
            —




The
Company’s investments were comprised of available-for-sale securities with
carrying amounts totaling $239,000 at December 31, 2008.  The Company
has no assets measured at fair value on a recurring basis at December 31,
2009.  The Company’s financial assets that were measured at fair value
on a recurring basis were comprised of fixed income available for sale
securities at December 31, 2008.




At
December 31, 2008, fixed income available-for-sale securities generally included
U.S. government agency securities, state and municipal bonds, and corporate
bonds and notes.  Valuations were based on observable inputs other
than Level 1 prices, such as quoted prices for similar assets or liabilities;
quoted prices for securities that were traded less frequently than
exchange-traded instruments or quoted prices in markets that were not active; or
other inputs that were observable or could have been corroborated by observable
market data.




F-11




STRASBAUGH
AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




NOTE
1 – Summary of Significant Accounting Policies (continued)




Fair
Value of Financial Instruments (continued)




Beginning
January 1, 2009, the Company carried its preferred stock related embedded
derivative and Investor Warrants (as defined in Note 8) . on its balance sheet
as liabilities (see Note 2) carried at fair value determined by using the Black
Scholes valuation model.  As of December 31, 2009, the assumptions
used in the valuation of the preferred stock related embedded derivative
included the Company’s Series A Cumulative Redeemable Convertible Preferred
Stock (the “Series A Preferred Stock”) conversion price of $2.20 and in the
valuation of the Investor Warrants with an exercise price of $2.42, as well as
the Company’s stock price of $0.25, discount rate of 1.1%, and volatility of
51%.




A
reconciliation of the Company’s liabilities measured at fair value on a
recurring basis using significant unobservable inputs (Level 3) is as
follows:


Fair
      Value
                Measurements
                Using
                Significant
                Unobservable
      Inputs
                (Level
      3)Preferred
      Stock
                Related
      Embedded
                Derivative
      and
                Warrant
      LiabilitiesBalance
      January 1, 2009
            
            $
            1,692,000Total
      unrealized gainsIncluded
      in earnings
            
            
            1,688,000Included
      in other comprehensive income
            
            
            —Settlements
            
            
            —Transfers
      in and/or out of Level 3
            
            
            —Balance
      December 31, 2009
            
            $
            4,000The
      amount of total gains during 2009 included in earnings attributable to the
      change in unrealized gains relating to liabilities still held at December
      31, 2009
            
            $
            1,688,000




There are
no assets or liabilities measured at fair value on a nonrecurring
basis.




Segment
Information




The
Company’s results of operations for the years ended December 31, 2009 and 2008
represent a single segment referred to as global semiconductor, and
semiconductor equipment, silicon wafer and silicon wafer equipment, LED, data
storage and precision optics industries.  Export sales represent
approximately 17% and 29% of sales for the years ended December 31, 2009 and
2008, respectively.




F-12


STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
1 – Summary of Significant Accounting Policies (continued)




Segment
Information (continued)




The
geographic breakdown of the Company’s sales was as follows:




For
      the Year EndedDecember
      31,2009
            
            
            2008United
      States
            
            
            83%
            
            
            
            71%Europe
            
            
            3%
            
            
            
            19%Asia
      and Pacific Rim countries
            
            
            14%
            
            
            
            10%





The
geographic breakdown of the Company’s accounts receivable was as
follows:





December
      31,2009
            
            
            2008United
      States
            
            
            49%
            
            
            
            43%Europe
            
            
            3%
            
            
            
            21%Asia
      and Pacific Rim countries
            
            
            48%
            
            
            
            36%




Cash
and Cash Equivalents




For
purposes of the statements of cash flows, the Company considers all highly
liquid debt instruments purchased with a maturity of three months or less to be
cash equivalents.




Accounts
Receivable




Accounts
receivable are due from companies operating primarily in the global
semiconductor, electronics, precision optics, and aerospace industries located
throughout the United States, Europe, and Asia and Pacific Rim
countries.  Credit is extended to both domestic and international
customers based on an evaluation of the customer’s financial condition and,
generally collateral is usually not required.  For international
customers, additional evaluation steps are performed, where required, and more
stringent terms, such as letters of credit, are used as necessary.




The
Company estimates an allowance for uncollectible accounts
receivable.  The allowance for probable uncollectible receivables is
based on a combination of historical data, cash payment trends, specific
customer issues, write-off trends, general economic conditions and other
factors.  These factors are continuously monitored by management to
arrive at the estimate for the amount of accounts receivable that may be
ultimately uncollectible.  In circumstances where the Company is aware
of a specific customer’s inability to meet its financial obligations, the
Company records a specific allowance for doubtful accounts against amounts due,
to reduce the net recognized receivable to the amount it reasonably believes
will be collected.  Management believes that the allowance for
doubtful accounts at December 31, 2009 and 2008 are reasonably
stated.




F-13




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
1 – Summary of Significant Accounting Policies (continued)




Investments
in Securities




The
Company considers all highly liquid debt instruments purchased with a maturity
of three months or less to be cash equivalents. The Company determines the
appropriate classification of its investments in debt and equity securities at
the time of purchase and reevaluates such determinations at each balance sheet
date. Debt securities are classified as held-to-maturity when the Company has
the positive intent and ability to hold the securities to maturity. Debt
securities for which the Company does not have the intent or ability to hold to
maturity are classified as available-for-sale. Held-to-maturity securities are
recorded as either short term or long term on the balance sheet based on the
contractual maturity date and are stated at amortized cost. Marketable
securities that are bought and held principally for the purpose of selling them
in the near term are classified as trading securities and are reported at fair
value, with unrealized gains and losses recognized in earnings (loss). Debt and
marketable equity securities not classified as held-to-maturity or as trading,
are classified as available-for-sale, and are carried at fair market value, with
the unrealized gains and losses, net of tax, included in the determination of
comprehensive income (loss) and reported in shareholders’ equity
(deficit).




At
December 31, 2008, the Company’s investments were classified as
available-for-sale and were included in current assets because the investments
were likely to be sold prior to maturity and within one year from the balance
sheet date. The Company’s investments in corporate debt securities had maturity
dates ranging from 2 to 10 years at December 31, 2008.  The Company
had realized losses on the sales of securities of $6,000, for the year ended
December 31, 2009 and 2008.  Total other than temporary impairment
recognized in accumulated other comprehensive income was $0, at December 31,
2009 and 2008. Total gains for securities with net gains in accumulated other
comprehensive income were $0, at December 31, 2009 and 2008.




There
were no investments in securities at December 31, 2009.  Investments
in securities at December 31, 2008 were as follows:




Aggregate
                Fair
      Value
            
            
            Amortized
      Cost Basis
            
            
            Unrealized
      Gain
                (Loss)Corporate
      debt securities
            
            $
            118,000
            
            
            $
            125,000
            
            
            $
            (7,000
            )Municipal
      and State debt securities
            
            
            121,000
            
            
            
            175,000
            
            
            
            (54,000
            )$
            239,000
            
            
            $
            300,000
            
            
            $
            (61,000
            )




At
December 31, 2008 all investments with unrealized losses were in loss positions
for less than 12 months.  The breakdown of investments with unrealized
losses at December 31, 2008 was as follows:




Aggregate
      Fair Value of Investments with Unrealized Losses
            
            
            Aggregate
      Amount of Unrealized LossesCorporate
      debt securities
            
            $
            118,000
            
            
            $
            (7,000
            )Municipal
      and State debt securities
            
            
            121,000
            
            
            
            (54,000
            )$
            239,000
            
            
            $
            (61,000
            )




F-14





STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
1 – Summary of Significant Accounting Policies (continued)




Inventories




Inventories
are maintained on the first-in, first-out method and are stated at the lower of
cost or market based on the lower of replacement cost or net realizable
value.  Costs include material, labor and overhead required in the
warehousing and production of the Company’s products.  Inventory
reserves are maintained for the estimated value of the inventory that may have a
lower value than stated or quantities in excess of estimated future production
needs.




Property,
Plant, and Equipment




Property,
plant, and equipment items are stated at cost, less accumulated
depreciation.  Additions, improvements, and major renewals are
capitalized, while maintenance, repairs, and minor renewals are expensed as
incurred.  When assets are retired or disposed of, the assets and
related accumulated depreciation are removed from the accounts and the resulting
gain or loss is reflected in operations.  Depreciation is computed
principally using the straight-line method over their estimated useful lives of
three to thirty years.  Amortization of leasehold improvements is
computed using the straight-line method over the shorter of the terms of
the leases or their estimated useful lives.  Periodically, the Company
may transfer a completed tool from inventory to property, plant and equipment
for use as a laboratory tool, or for customer demonstration
purposes.  The tools are transferred at the lower of cost or market
and then depreciated over its estimated useful life.  If the tool is
subsequently sold to an end user, it may be transferred back to inventory at net
book value and shipped to that customer.




Intellectual
Property




The
Company capitalizes the direct legal costs associated with the application and
successful defense of patents as incurred, and amortizes these costs over the
life of the patents, not to exceed 15 years.  Approximately $49,000
and $100,000 of such costs were capitalized during the years ended December 31,
2009 and 2008, respectively. Amortization expense for these patent costs totaled
$28,000 and $25,000 during the years ended December 31, 2009 and 2008,
respectively.  The estimated aggregate amortization expense for each
of the five succeeding fiscal years is as follows:





Year
      Ending
                December
      31,2010
            
            $
            32,0002011
            
            
            32,0002012
            
            
            32,0002013
            
            
            32,0002014
            
            
            32,000




Impairment
of Long-Lived Assets




Long-lived
assets, such as property, plant, and equipment, are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable.  Recoverability of assets to be held
and used is measured by a comparison of the carrying amount of an asset to
estimated undiscounted future cash flows expected to be generated by the
asset.  If the carrying amount of an asset exceeds its estimated
future cash flows, an impairment charge is recognized by the amount by which the
carrying amount of the asset exceeds the fair value of the
asset.  Management has evaluated its long-lived assets and has not
identified any impairment at December 31, 2009 and 2008.




F-15




STRASBAUGH
AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




NOTE
1 – Summary of Significant Accounting Policies (continued)




Deferred
Revenue


Deferred
revenue represents service contract revenue which is deferred and recognized
ratably over the life of the service contract, which is generally one
year.




Other
Comprehensive Income (Loss)




Comprehensive
income (loss) consists of net income (loss) and other gains and losses affecting
shareholders’ equity (deficit) that, under generally accepted accounting
principles, are excluded from net income (loss).  The Company’s other
comprehensive gains and losses (net of taxes of $0) consisted of unrealized
gains on investments of $61,000 for the year ended December 31, 2009, and
unrealized losses on investments of $61,000 for the year ended December 31,
2008.




Revenue
Recognition




The
Company derives revenues principally from the sale of tools, parts and
services.  The Company recognizes revenue pursuant to SEC staff
guidance covering revenue recognition.  Revenue is recognized when
there is persuasive evidence an arrangement exists, delivery has occurred or
services have been rendered, the Company’s price to the customer is fixed or
determinable, and collection of the related receivable is reasonably
assured.  Selling arrangements may include contractual customer
acceptance provisions and installation of the product occurs after shipment and
transfer of title.  The Company recognizes revenue upon shipment of
products or performance of services and defers recognition of revenue for any
amounts subject to acceptance until such acceptance
occurs.  Provisions for the estimated future cost of warranty are
recorded at the time the products are shipped.




Generally,
the Company obtains a non-refundable down-payment from the
customer.  These fees are deferred and recognized as the tool is
shipped.  All sales contract fees are payable no later than 60 days
after delivery and payment is not contingent upon installation.  In
addition, the Company’s tool sales have no right of return, or cancellation
rights.  Tools are typically modified to some degree to fit the needs
of the customer and, therefore, once a purchase order has been accepted by the
Company and the manufacturing process has begun, there is no right to cancel,
return or refuse the order.




F-16




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
1 – Summary of Significant Accounting Policies (continued)




Revenue
Recognition (continued)




The
Company has evaluated its arrangements with customers and revenue recognition
policies under the Financial Accounting Standards Board (“FASB”) Accounting
Standards Codification (“ASC”) 605-25, “Revenue Recognition-Multiple-Element
Arrangements,” and determined that its components of revenue are separate units
of accounting.  Each unit has value to the customer on a standalone
basis, there is objective and reliable evidence of the fair value of each unit,
and there is no right to cancel, return or refuse an order.  The
Company’s revenue recognition policies for its specific units of accounting are
as follows:




Tools –
The Company recognizes revenue once a customer has visited the plant and signed
off on the tool or it has met the required specifications and the tool is
completed and shipped.




Parts –
The Company recognizes revenue when the parts are shipped.




Service –
Revenue from maintenance contracts is deferred and recognized over the life of
the contract, which is generally one to three years.  Maintenance
contracts are separate components of revenue and not bundled with our
tools.  If a customer does not have a maintenance contract, then the
customer is billed for time and material and the Company recognizes revenue
after the service has been completed.




Upgrades
– The Company offers a suite of products known as “enhancements” which are
generally comprised of one-time parts and/or software upgrades to existing
Strasbaugh and non-Strasbaugh tools.  These enhancements are not
required for the tools to function, are not part of the original contract and do
not include any obligation to provide any future upgrades.  The
Company recognizes revenue once these upgrades and enhancements are complete.
Revenue is recognized on equipment upgrades when the Company completes the
installation of the upgrade parts and/or software on the customer’s equipment
and the equipment is accepted by the customer. The upgrade contracts cover a
one-time upgrade of a customer’s equipment with new or modified parts and/or
software. After installation of the upgrade, the Company has no further
obligation on the contracts, other than standard warranty
provisions.




The
Company includes software in its tools.  Software is considered an
incidental element of the tooling contracts and only minor modifications which
are incidental to the production effort may be necessary to meet customer
requirements. The software is used solely in connection with operating the tools
and is not sold, licensed or marketed separately.  The tools and
software are fully functional when the tool is completed, and after shipment,
the software is not updated for new versions that may be subsequently developed
and, the Company has no additional obligations relative to the
software.  However, software modifications may be included in tool
upgrade contracts. The Company’s software is incidental to the tool contracts as
a whole.  The software and physical tool modifications occur and are
completed concurrently. The completed tool is tested by either the customer or
the Company to ensure it has met all required specifications and then accepted
by the customer prior to shipment, at which point revenue is
recognized.  The revenue recognition requirements of FASB ASC 985-605,
“Software-Revenue Recognition,” are met when there is persuasive evidence an
arrangement exists, the fee is fixed or determinable, collectability is probable
and delivery and acceptance of the equipment has occurred, including upgrade
contracts for parts and/or software, to the customer.




F-17




STRASBAUGH
AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




NOTE
1 – Summary of Significant Accounting Policies (continued)




Revenue
Recognition (continued)




Installation
of a tool occurs after the tool is completed, tested, formally accepted by the
customer and shipped.  The Company does not charge the customer for
installation nor recognize revenue for installation as it is an inconsequential
or perfunctory obligation and it is not considered a separate element of the
sales contract or unit of accounting. If the Company does not perform the
installation service there is no effect on the price or payment terms, there are
no refunds, and the tool may not be rejected by the customer. In addition,
installation is not essential to the functionality of the equipment because the
equipment is a standard product, installation does not significantly alter the
equipment’s capabilities, and other companies are available to perform the
installation. Also, the fair value of the installation service has historically
been insignificant relative to the Company’s tools.





Derivative
Income




In
accordance with FASB ASC 815-40-15 “Derivatives and Hedging-Contracts in
Entity’s Own Equity-Scope and Scope Exceptions” (see Note 2), the Company is
required to account for the preferred stock related embedded derivative and
investor warrants as derivative liabilities.  The Company is required
to mark to market in each reporting quarter the value of the embedded derivative
and investor warrants. The Company revalues these derivative liabilities at the
end of each reporting period.  The periodic change in value of the
derivative liabilities is recorded as either non-cash derivative income (if the
value of the embedded derivative and investor warrants decrease) or as non-cash
derivative expense (if the value of the embedded derivative and investor
warrants increase).  Although the values of the embedded derivative
and warrants are affected by interest rates, the remaining contractual
conversion period and the Company’s stock volatility, the primary cause of the
change in the values will be the value of the Company’s Common
Stock.  If the stock price goes up, the value of these derivatives
will generally increase and if the stock price goes down the value of these
derivatives will generally decrease.




Research
and Development




Costs
related to designing and developing new products are expensed as research and
product development expenses as incurred.  Research and development
expenses totaled approximately $3,593,000 and $2,954,000 for the years ended
December 31, 2009 and 2008, respectively.




Shipping
Costs




During
the years ended December 31, 2009 and 2008, freight and handling amounts
incurred by the Company totaled approximately $46,000 and $63,000, respectively,
and are included in the cost of sales.  Freight and handling fees
billed to customers of approximately $8,000 and $7,000 are included in revenues
for the years ended December 31, 2009 and 2008, respectively.




F-18


STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
1 – Summary of Significant Accounting Policies (continued)




Stock-Based
Compensation




The
Company accounts for share-based payments in accordance with FASB ASC 718-10,
“Compensation-Stock Compensation.”As such, all
share-based payments to employees, including grants of employee stock options
and restricted shares, are recognized based on their fair values at the date of
grant.  Stock-based compensation cost is estimated at the grant date
based on the fair value of the award and is recognized as expense ratably over
the requisite service period of the award. Determining the appropriate fair
value model and calculating the fair value of stock-based awards, which includes
estimates of stock price volatility, forfeiture rates and expected lives,
requires judgment that could materially impact our operating
results.  See Note 7 for the significant estimates used to calculate
our stock-based compensation expense.




Foreign
Currency Transactions




The
accounts of the Company are maintained in U.S. dollars.  Transactions
denominated in foreign currencies are recorded at the rate of exchange in effect
on the dates of the transactions.  Balances payable in foreign
currencies are translated at the current rate of exchange when
settled.




Earnings
Per Share




Basic net
income (loss) per share is computed by dividing net income (loss) available to
common stockholders by the weighted-average number of outstanding common shares
for the period.  Diluted net income per share is computed by using the
treasury stock method and dividing net income available to common stockholders,
plus the effect of assumed conversions (if applicable), by the weighted-average
number of outstanding common shares after giving effect to all potential
dilutive common stock, including options, warrants, common stock subject to
repurchase, and convertible preferred stock, if any.




F-19





STRASBAUGH
AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




NOTE
1 – Summary of Significant Accounting Policies (continued)




Earnings
Per Share (continued)




Reconciliations
of the numerator and denominator used in the calculation of basic and diluted
net (loss) income per common share are as follows:





For
      the Year EndedDecember
      31,2009
            
            
            2008Numerator:Net
      loss
            
            $
            (680,000
            )
            
            $
            (4,508,000
            )Preferred
      stock accretion
            
            
            (1,275,000
            )
            
            
            (505,000
            )Preferred
      stock dividend
            
            
            (1,155,000
            )
            
            
            (1,071,000
            )Net
      loss available to common shareholders – basic
            
            
            (3,110,000
            )
            
            
            (6,084,000
            )Adjustment
      to net loss for assumed conversions
            
            
            —
            
            
            
            —Net
      loss available to common shareholders – diluted
            
            $
            (3,110,000
            )
            
            $
            (6,084,000
            )Denominator:Shares
      outstanding, beginning
            
            
            14,201,587
            
            
            
            14,201,587Weighted-average
      shares issued
            
            
            110,466
            
            
            
            —Weighted-average
      shares outstanding – basic
            
            
            14,312,053
            
            
            
            14,201,587Effect
      of dilutive securities
            
            
            —
            
            
            
            —Weighted-average
      shares outstanding—diluted
            
            
            14,312,053
            
            
            
            14,201,587




Shares
issuable pursuant to the Series A Preferred Stock totaling 5,909,089 and
1,271,797 shares issuable pursuant to outstanding warrants for the year ended
December 31, 2009 and 2008 and shares issuable upon exercise of outstanding
stock options totaling 434,646 and 1,327,416 as of December 31, 2009 and 2008,
respectively are excluded from the computation of diluted loss per common share
because the Company had a loss from continuing operations for the periods and to
include the representative share increments would be anti-dilutive. Accordingly,
for the year ended December 31, 2009 and 2008, basic and diluted net loss per
common share is computed based solely on the weighted average number of shares
of common stock outstanding during the period.




Income
Taxes and Deferred Income Taxes




Income
taxes are provided for the effects of transactions reported in the financial
statements and consist of taxes currently due plus deferred taxes related
primarily to differences between the basis of certain assets and liabilities for
financial and income tax reporting.  Deferred taxes are classified as
current or noncurrent depending on the classification of the assets and
liabilities to which they relate.  Deferred taxes arising from
temporary differences that are not related to an asset or liability are
classified as current or noncurrent, depending on the periods in which the
temporary differences are expected to reverse.  A valuation allowance
is established when necessary to reduce deferred tax assets if it is more likely
than not that all, or some portion of, such deferred tax assets will not be
realized.





F-20





STRASBAUGH
AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008





NOTE
1 – Summary of Significant Accounting Policies (continued)




Series
A Preferred Stock and Warrants





The
Company evaluates its Series A Preferred Stock and Warrants (as defined in
Note 8) on an ongoing basis considering the provisions of FASB ASC Topic
480, “Distinguishing Liabilities from Equity” which establishes standards for
issuers of financial instruments with characteristics of both liabilities and
equity related to the classification and measurement of those
instruments  The Series A Preferred Stock conversion feature and
Warrants are evaluated considering the provisions of FASB ASC Topic 815,
“Derivatives and Hedging,” which establishes accounting and reporting standards
for derivative instruments, including certain derivative instruments embedded in
other contracts, and for hedging activities, considering FASB ASC 815-40,
“Derivatives and Hedging-Contracts in Entity’s Own Equity.”





New
Accounting Pronouncements




In
October 2009, the FASB issued ASU 2009-13, “Multiple-Deliverable Revenue
Arrangements, (amendments to FASB ASC Topic 605, Revenue Recognition)” and ASU
2009-14, “Certain Arrangements
That Include Software Elements, (amendments to FASB ASC Topic 985, Software).” ASU 2009-13
requires entities to allocate revenue in an arrangement using estimated selling
prices of the delivered goods and services based on a selling price hierarchy.
The amendments eliminate the residual method of revenue allocation and require
revenue to be allocated using the relative selling price method. ASU
2009-14 removes tangible products from the scope of software revenue guidance
and provides guidance on determining whether software deliverables in an
arrangement that includes a tangible product are covered by the scope of the
software revenue guidance. ASU 2009-13 and ASU 2009-14 should be applied on
a prospective basis for revenue arrangements entered into or materially modified
in fiscal years beginning on or after June 15, 2010, with early adoption
permitted. The Company does not expect adoption of ASU 2009-13 or ASU 2009-14 to
have a material impact on the Company’s consolidated results of operations or
financial condition.




In June
2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting
Principles,” which was primarily codified into Topic 105 “Generally Accepted Accounting
Standards” in the ASC. This standard will become the single source of
authoritative nongovernmental U.S. generally accepted accounting principles
(“GAAP”), superseding existing FASB, American Institute of Certified Public
Accountants (“AICPA”), Emerging Issues Task Force (“EITF”), and related
accounting literature. This standard reorganizes the thousands of GAAP
pronouncements into roughly 90 accounting topics and displays them using a
consistent structure. Also included is relevant SEC guidance organized using the
same topical structure in separate sections. The FASB will not issue new
standards in the form of Statements, FASB Staff Positions or EITF Abstracts.
Instead, it will issue Accounting Standards Updates (“ASUs”). The FASB will not
consider ASUs as authoritative in their own right. ASUs will serve only to
update the Codification, provide background information about the guidance and
provide the bases for conclusions on the change(s) in the Codification. This
guidance is effective for financial statements issued for reporting periods that
end after September 15, 2009.  This guidance was adopted in the third
quarter of 2009 and impacts the Company’s financial statements and related
disclosures as all references to authoritative accounting literature reflect the
newly adopted codification.




F-21




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
1 – Summary of Significant Accounting Policies (continued)




New
Accounting Pronouncements (continued)




In June
2009, the FASB issued SFAS No. 167, “Amendments to FASB Interpretation
No. 46(R),” which has not yet been codified in the ASC. This guidance is
a revision to pre-existing guidance pertaining to the consolidation and
disclosures of variable interest entities. Specifically, it changes how a
reporting entity determines when an entity that is insufficiently capitalized or
is not controlled through voting (or similar rights) should be consolidated. The
determination of whether a reporting entity is required to consolidate another
entity is based on, among other things, the other entity’s purpose and design
and the reporting entity’s ability to direct the activities of the other entity
that most significantly impact the other entity’s economic
performance. This guidance will require a reporting entity to provide
additional disclosures about its involvement with variable interest entities and
any significant changes in risk exposure due to that involvement. A reporting
entity will be required to disclose how its involvement with a variable interest
entity affects the reporting entity’s financial statements. This guidance will
be effective at the start of a reporting entity’s first fiscal year beginning
after November 15, 2009. Early application is not permitted. The Company
does not expect the adoption of this guidance to have a material impact on the
Company’s consolidated results of operations or financial
condition.




In May
2009, the FASB issued SFAS No. 165, “Subsequent Events,” which was
primarily codified into Topic 855 “Subsequent Events” in the
ASC. This guidance establishes general standards of accounting for and
disclosure of events that occur after the balance sheet date but before the
financial statements are issued or are available to be issued. This guidance was
adopted in the third quarter of 2009 and it had no impact on the Company’s
results of operations or financial position.





In
April 2009, the FASB issued Staff Position (“FSP”) Financial Accounting
Standard (“FAS”) 157-4 “Determining Fair Value When the Volume and Level of
Activity for the Asset or Liability Have Significantly Decreased and Identifying
Transactions That Are Not Orderly” which was primarily codified into Topic 820,
“Fair Value Measurements and Disclosures” In the ASC. Based on the guidance, if
an entity determines that the level of activity for an asset or liability has
significantly decreased and that a transaction is not orderly, further analysis
of transactions or quoted prices is needed, and a significant adjustment to the
transaction or quoted prices may be necessary to estimate fair value in
accordance with this guidance. This guidance is to be applied prospectively and
is effective for interim and annual periods ending after June 15, 2009 with
early adoption permitted for periods ending after March 15, 2009.
Implementation of this standard on April 1, 2009 had no impact on the Company’s
financial condition or results of operations.





In
April 2009, the FASB issued FSP FAS 115-2 and FAS 124-2 “Recognition and
Presentation of Other-Than-Temporary Impairments,” which was primarily codified
into Topic 320, “Investments — Debt and Equity Securities” and Topic 325
“Investments — Other” in the ASC.  The guidance applies to investments
in debt securities for which other-than-temporary impairments may be recorded.
If an entity’s management asserts that it does not have the intent to sell a
debt security and it is more likely than not that it will not have to sell the
security before recovery of its cost basis, then an entity may separate
other-than-temporary impairments into two components: 1) the amount related to
credit losses (recorded in earnings), and 2) all other amounts (recorded in
other comprehensive income). This guidance is to be applied prospectively and is
effective for interim and annual periods ending after June 15, 2009.
Implementation of this guidance on April 1, 2009 had no impact on the Company’s
financial condition or results of operations.




F-22




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
1 – Summary of Significant Accounting Policies (continued)




New
Accounting Pronouncements (continued)





In
April 2009, the FASB issued FSP FAS 107-1 and Accounting Principles Board
(“APB”) 28-1 “Interim Disclosures about Fair Value of Financial Instruments,”
which was primarily codified into Topic 825 “Financial Instruments” in the ASC.
This standard extends the disclosure requirements concerning the fair value of
financial instruments to interim financial statements of publicly traded
companies.  This standard is to be applied prospectively and is
effective for interim and annual periods ending after June 15, 2009 with
early adoption permitted for periods ending after March 15, 2009. The
Company has included the required disclosures in these consolidated financial
statements.





In June
2008, the FASB ratified EITF Issue No. 07-5, “Determining Whether an Instrument
(Or an Embedded Feature) is Indexed to an Entity’s Own Stock,” which was
primarily codified into FASB ASC 815-40, “Derivatives and Hedging-Contracts in
Entity’s Own Equity.”  The guidance provides that an entity should use
a two-step approach to evaluate whether an equity-linked financial instrument
(or embedded feature) is indexed to its own stock, including evaluating the
instrument’s contingent exercise and settlement provisions. This guidance was
effective for financial statements issued for fiscal years beginning after
December 15, 2008. Early application was not permitted. Implementation of this
guidance has had a significant impact on the Company’s financial condition and
results of operations (See Note 2).




In April
2008, the FASB issued FSP FAS No. 142-3 “Determination of the Useful Life
of Intangible Assets,” which was primarily codified into Topic 350 “Intangibles – Goodwill and
Other” in the ASC.This guidance amends
the factors that should be considered in developing renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
and requires enhanced related disclosures. This guidance must be applied
prospectively to all intangible assets acquired as of and subsequent to fiscal
years beginning after December 15, 2008.  This guidance is
effective for financial statements issued for fiscal years beginning after
December 15, 2008.  Although future transactions involving intangible
assets may be impacted by this guidance, it did not impact the Company’s
financial statements as the Company did not acquire any intangible assets during
the year ended December 31, 2009.





NOTE 2 –Implementation of FASBASC 815-40-15 “Derivatives and Hedging-Contracts in Entity’s Own
Equity-Scope and Scope Exceptions”





In June
2008, the FASB ratified guidance included in ASC 815-40-15 “Derivatives and
Hedging-Contracts in Entity’s Own Equity-Scope and Scope Exceptions,” which
provides that an entity should use a two-step approach to evaluate whether an
equity-linked financial instrument (or embedded feature) is indexed to its own
stock, including evaluating the instrument’s contingent exercise and settlement
provisions.  ASC 815-40-15 contains provisions describing conditions
when an instrument or embedded feature would be considered indexed to an
entity’s own stock for purposes of evaluating the instrument or embedded feature
under FASB ASC Topic 815, “Derivatives and Hedging,” which establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts.  FASB ASC
815-10-15-74(a) indicates that “contracts issued or held by that reporting
entity that are both (1) indexed to its own stock and (2) classified in
stockholders’ equity in its statement of financial position” should not be
considered derivative instruments (“Topic 815 Scope Exception”).





F-23




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




NOTE 2 – Implementation of FASBASC 815-40-15 “Derivatives and Hedging-Contracts in Entity’s Own
Equity-Scope and Scope Exceptions” (continued)




The
Company’s convertible Series A Preferred Stock (Note 8) has been recognized as
“temporary equity,” or outside of permanent equity and liabilities, in the
Company’s consolidated balance sheet.  The Series A Preferred Stock
does not meet the definition of mandatorily redeemable under FASB ASC Topic 480,
“Distinguishing Liabilities from Equity” because redemption is contingent upon
the holders not exercising their conversion option and the host contract is
classified as temporary equity in accordance with SEC guidance.  The
two embedded features in the Series A Preferred Stock did not require
bifurcation under ASC Topic 815 since, prior to the implementation of ASC
815-40-15, the conversion feature met the Topic 815 Scope Exception and the
applicable criteria in the FASB guidance covering the accounting for derivative
financial instruments indexed to, and potentially settled in, a company’s own
stock, and the redemption feature was determined to be clearly and closely
related to the host contract, therefore, failing the FASB criteria requiring
bifurcation.  Since there was no bifurcation of the embedded features
there was no separate accounting for those features.




The
Investor Warrants (Note 8) have previously been recognized as permanent equity
in the Company’s statement of financial position.  Prior to the
implementation of ASC 815-40-15, the Investor Warrants were classified as
permanent equity because they met the Topic 815 Scope Exception and all of the
criteria in the FASB guidance covering the accounting for derivative financial
instruments indexed to, and potentially settled in, a company’s own
stock.  However, both the convertible Series A Preferred Stock
conversion feature and Investor Warrants contain settlement provisions such that
if the Company makes certain equity offerings in the future at a price lower
than the conversion prices of the instruments, the conversion ratio would be
adjusted.




FASB ASC
815-40-15 provides that an instrument’s strike price or the number of shares
used to calculate the settlement amount are not fixed if its terms provide for
any potential adjustment, regardless of the probability of such
adjustment(s)or whether
such adjustments are in the entity’s control. If the instrument’s strike price
or the number of shares used to calculate the settlement amount are not fixed,
the instrument (or embedded feature) would still be considered indexed to an
entity’s own stock if the only variables that could affect the settlement amount
would be inputs to the fair value of a “fixed-for-fixed” forward or option on
equity shares.




Accordingly,
under the provisions of ASC 815-40-15 the embedded conversion feature in the
Company’s Series A Preferred Stock (the “Series A Conversion Feature”) and the
Investor Warrants are not considered indexed to the Company’s stock because
future equity offerings (or sales) of the Company’s stock are not an input to
the fair value of a “fixed-for-fixed” option on equity shares.  As a
result of the settlement provisions in the Company’s Series A Conversion Feature
and the application of ASC 815-40-15, effective January 1, 2009, the Series A
Conversion Feature no longer qualified for the Topic 815 Scope Exception, and
was required to be bifurcated from its host, in accordance with FASB guidance
covering the recognition of embedded derivatives in ASC Topic 815, and accounted
for as a derivative instrument.  Also, as a result of the settlement
provision in the Investor Warrants and the application of ASC 815-40-15,
effective January 1, 2009, the Investor Warrants no longer qualified for the
Topic 815 Scope Exception, and were required to be accounted for as
derivatives.  In determining the classification of the Series A
Conversion Feature and the Investor Warrants the Company considered guidance in
ASC 815-40-15 indicating that an instrument considered indexed to its own stock
is evaluated under the applicable FASB guidance to determine whether it should
be classified as equity, or as an asset or a liability, however, if the terms
are such that it is not considered to be indexed to the entity’s own stock then
equity classification is precluded.  Accordingly, effective January 1,
2009 the Company’s Series A Conversion Feature and Investor Warrants are
recognized as liabilities in the Company’s consolidated balance
sheet.




F-24




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE 2 – Implementation of FASBASC 815-40-15 “Derivatives and Hedging-Contracts in Entity’s Own
Equity-Scope and Scope Exceptions” (continued)




In
accordance with FASB ASC 815-10-65-3 “Derivatives and Hedging-Overall-Transition
and Open Effective Date Information-Transition Related to EITF Issue No. 07-5,
“Determining Whether an Instrument (or Embedded Feature) Is Indexed to an
Entity’s Own Stock,” the cumulative effect of this change in accounting
principle is recognized as an adjustment to the opening balance of the Company’s
equity on January 1, 2009.  The Series A Preferred Stock host, the
Series A Conversion Feature, the Investor Warrant and the cumulative effect
adjustment are determined based on amounts that would have been recognized if
the guidance in ASC 815-40-15 had been applied from the date the preferred stock
and warrants were issued.  The Series A Preferred Stock host will
remain classified in temporary equity and stated at its fair value as the
accounting for the instrument, excluding the Series A Conversion Feature,
follows the applicable SEC guidance.  In accordance with FASB guidance
covering the recognition of embedded derivatives in ASC Topic 815, the fair
value of the Series A Conversion Feature is bifurcated from the host instrument
and recognized as a liability on the Company’s consolidated balance
sheet.  The Investor Warrants are recognized at fair value as a
liability on the Company’s consolidated balance sheet.  The fair value
of the conversion feature, the warrants and other issuance costs of the Series A
Preferred Stock financing transaction, are recognized as a discount to the
Series A Preferred Stock host.  The discount will be accreted to the
Series A Preferred Stock host from the Company’s paid in capital, treated as a
deemed dividend, over the period from the issuance date through the earliest
redemption date of the Series A Preferred Stock.




The
following table illustrates the changes to the Company’s consolidated balance
sheet resulting from the implementation of ASC 815-40-15 effective January 1,
2009:





Balance
                December
      31, 2008
            
            
            Cumulative
      Effect Adjustment
            
            
            Balance
                January
      1, 2009Preferred
      stock related embedded derivative
            
            $
            —
            
            
            $
            1,493,000
            
            
            $
            1,493,000Warrants
            
            $
            —
            
            
            $
            199,000
            
            
            $
            199,000Series
      A preferred stock
            
            $
            11,964,000
            
            
            $
            (3,191,000
            )
            
            $
            8,733,000Additional
      paid-in capital
            
            $
            26,803,000
            
            
            $
            (1,138,000
            )
            
            $
            25,665,000Accumulated
      deficit
            
            $
            (32,186,000
            )
            
            $
            2,637,000
            
            
            $
            (29,549,000
            )





The fair
value of the Series A Conversion Feature at the issuance date of the Series A
Preferred Stock (May 24, 2007) was estimated to be $4,085,000 using the Black
Scholes model.  The assumptions used in the model included the Series
A Preferred Stock conversion price of $2.20, the Company’s stock price of $1.71,
discount rate of 4.8%, and volatility of 48%.  The accretion of the
additional discount to the preferred stock resulting from bifurcating the Series
A Conversion Feature totaled $894,000 through January 1, 2009.  The
cumulative effect of these adjustments on January 1, 2009 was a reduction of the
Series A Preferred Stock balance of $3,191,000.





The fair
value of the Investor Warrants of $244,000 was included in additional paid in
capital on the issuance date of the Investor Warrants (May 24,
2007).  As a result of reclassifying these warrants from equity to
liabilities, and the additional preferred stock accretion noted above, the
cumulative effect of these adjustments on January 1, 2009 was a reduction of
additional paid in capital of $1,138,000.




F-25




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE 2 – Implementation of FASBASC 815-40-15 “Derivatives and Hedging-Contracts in Entity’s Own
Equity-Scope and Scope Exceptions” (continued)




The fair
value of the Series A Conversion Feature, included in the “Preferred stock
related embedded derivative” liability on the Company’s consolidated balance
sheet, on January 1, 2009 was estimated to be $1,493,000 using the Black Scholes
model.  The assumptions used in the model included the Series A
Preferred Stock conversion price of $2.20, the Company’s stock price on January
1, 2009 of $1.19, discount rate of 1.12%, and volatility of 53%.  The
fair value of the Investor Warrants, included in the “Warrants” liability on the
Company’s consolidated balance sheet, on January 1, 2009 was estimated to be
$199,000 using the Black Scholes model.  The assumptions used in the
model included the Investor Warrants conversion prices of $2.42, the Company’s
stock price on January 1, 2009 of $1.19, discount rate of 1.12%, and volatility
of 53%.




The
Company determined that, using the Black Scholes model, the fair value of the
preferred stock related embedded derivative and Investor Warrants had declined
as of January 1, 2009.  Accordingly, the Company recorded as a
cumulative effect adjustment, the reduction of the fair value of these
derivative liabilities totaling $2,637,000 as a reduction of the Company’s
accumulated deficit.





As of
December 31, 2009, the Company determined that, using the Black Scholes model,
the fair value of the preferred stock related embedded derivative and the
investor warrants had declined since January 1, 2009.  Accordingly,
the Company has recorded a gain on the change in fair value of the embedded
derivative and warrants and recorded a corresponding reduction in the “Preferred
stock related embedded derivative” and “Warrant” liability of $1,489,000, and
$199,000, respectively, for the period from January 1, 2009 to December 31,
2009.  The effect of the income from these derivatives on the loss
from continuing operations and net loss for the year ended December 31, 2009 was
to reduce the net loss of $2,368,000 to a net loss of $680,000, and to reduce
the net loss per common share from $0.34 to a net loss per common share of
$0.22.





NOTE
3 – Management’s Plans




For the
year ended December 31, 2009, the Company had a net loss of approximately
$680,000; however, excluding the non-cash gains from the preferred stock related
embedded derivative and warrants, the loss from operations was approximately
$2,368,000, and as of December 31, 2009, the Company had an accumulated deficit
of approximately $30,229,000.  The Company has invested substantial
resources in product development, which has negatively impacted its cost
structure and contributed to a significant portion of its recent
losses.  Additionally, the decline in the semiconductor industry since
2007 has added to those losses as revenues declined.




Management’s
plans with respect to these matters include efforts to increase revenues through
the sale of existing products and new technology and continuing to closely
monitor and control certain operating expenses.  Management is also
optimistic about the semiconductor industry’s near term business recovery as
well as improvement in the global economy.  Management believes that
the Company’s current backlog and working capital is sufficient to maintain
operations in the near term and that product development can be reduced or
curtailed in the future to further manage cash expenditures.  There
are no current plans to seek additional outside capital at this time. There are
no assurances that the Company will achieve profitable operations in the future
or that additional capital will be raised or obtained by the Company if cash
generated from operations is insufficient to pay current
liabilities.




F-26




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
4 – Inventories




Inventories
consist of the following:




December
      31,2009
            
            
            2008Raw
      materials
            
            $
            5,593,000
            
            
            $
            5,562,000Work-in-process
            
            
            1,655,000
            
            
            
            2,156,000Finished
      goods
            
            
            1,704,000
            
            
            
            1,537,0008,952,000
            
            
            
            9,255,000Inventory
      Reserves
            
            
            (3,696,000
            )
            
            
            (3,596,000
            )$
            5,256,000
            
            
            $
            5,659,000




NOTE
5 – Property, Plant, and Equipment




Property,
plant, and equipment consist of the following:




December
      31,2009
            
            
            2008Buildings
      and improvements
            
            $
            2,283,000
            
            
            $
            2,283,000Shop
      and lab equipment
            
            
            6,184,000
            
            
            
            6,012,000Transportation
      equipment
            
            
            170,000
            
            
            
            166,000Furniture
      and fixtures
            
            
            1,113,000
            
            
            
            1,113,000Computer
      equipment
            
            
            2,326,000
            
            
            
            2,326,00012,076,000
            
            
            
            11,900,000Less:  accumulated
      depreciation and amortization
            
            
            (10,030,000
            )
            
            
            (9,750,000
            )$
            2,046,000
            
            
            $
            2,150,000




Depreciation
expense totaled approximately $326,000 and $335,000 for the years ended December
31, 2009 and 2008, respectively.




NOTE
6 –Commitments and Contingencies




Lease
Commitments




During
2008 and 2009, the Company leased its manufacturing and sales facility from the
chairman of the Company, who is a significant shareholder of the Company, and
his former spouse.  The original term of the lease was 15 years and
ended on April 30, 2005.  Under the original terms of the
lease, the Company paid monthly lease payments and was liable for all property
taxes, insurance, repairs, and maintenance.  Effective May 1, 2005,
the Company exercised the holdover provision within the lease agreement which
allowed the Company to remain the tenant on a month-to-month basis under the
terms that existed at the end of the original lease term, as
defined.  The holdover provision remained valid as long as the Company
remained in possession and made timely monthly rent payments.  The
monthly rent was $84,000 during 2008 and 2009.




Effective
January 4, 2010, the Company entered into a new lease agreement for its
manufacturing and sales facility with the chairman and significant shareholder
of the Company.  The term of the lease agreement is one year
commencing January 4, 2010 and ending January 4, 2011.  Under the
terms of the lease, the Company pays monthly lease payments and is liable for
all property taxes, insurance, repairs, and maintenance.  The monthly
rent is currently $84,000.




F-27




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
6 –Commitments and Contingencies (continued)




Lease
Commitments (continued)




Rent
expense under the Company’s operating leases totaled approximately $1,007,000
and $1,014,000 for the years ended December 31, 2009 and 2008, respectively, of
which approximately $1,000,000 was related to the shareholder lease for each
year.




Sublease
Agreement




The
Company entered into two sublease agreements with unaffiliated third parties
during 2008.  The first sublease agreement provides for monthly rent
of approximately $24,000 and expires on February 28, 2010, this sublease has
been renewed and extended effective February 1, 2010 for an initial period of
two years, and providing for monthly rent of approximately
$21,000.  The second agreement provides for monthly rent of
approximately $11,000 and expires July 31, 2011.  Rental income
totaled approximately $581,000 and $321,000 for years ended December 31, 2009
and 2008, respectively.




Litigation




On
December 1, 2006, a complaint on joinder for declaratory relief was filed
by April Paletsas requesting that our wholly-owned subsidiary, R. H. Strasbaugh,
be joined to a matter in the San Luis Obispo Superior Court involving Alan
Strasbaugh, Chairman and a significant shareholder of the Company, and his
former wife, April Paletsas with regards to the San Luis Obispo facilities the
Company occupies.  Until January 8, 2010, Mr. Strasbaugh and
Ms. Paletsas were co-landlords under the lease covering the Company’s
corporate facilities.  Ms. Paletsas is requesting a declaration
by the court that R. H. Strasbaugh is required to install a new roof on the
leased facilities in San Luis Obispo and make certain other capital repairs
under the repair and maintenance covenants of the lease covering the Company’s
corporate facilities at the time she filed the complaint.  The total
costs of such installation repairs are estimated to be $750,000.  The
court issued an order allowing R. H. Strasbaugh to be joined, but stayed
the case against R. H. Strasbaugh pending resolution of ownership issues
between the co-landlords.  The issues between Mr. Strasbaugh and
Ms. Paletsas have been resolved and the premises now belong solely to Alan
Strasbaugh as a result of Mr. Strasbaugh’s purchase of Ms. Paletsas’ interest in
the property on January 8, 2010.  With regard to the claims
asserted against R. H. Strasbaugh by Ms. Paletsas, Company management
continues to monitor the case and intends to vigorously defend the case on the
merits, should the court reactivate the case.  Management believes
that all of the Company’s defenses are meritorious, and consider it unlikely
that it will suffer an adverse result should the court reactivate the case
against R. H. Strasbaugh.





The
Company is subject to various lawsuits and claims with respect to such matters
as product liabilities, employment matters and other actions arising out of the
normal course of business. While the effect on future financial results is not
subject to reasonable estimation because considerable uncertainty exists, in the
opinion of Company management, the ultimate liabilities resulting from such
lawsuits and claims will not materially affect the financial condition or
results of operations.




F-28




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
7 – Stock Compensation Plan




Litigation
(continued)




In
February 2007, the Company established the 2007 Share Incentive Plan (the “2007
Plan”), under which 2,000,000 shares of the Company’s common stock are available
for issuance.  The 2007 Plan provides for the grant to employees,
consultants and outside directors, of equity based awards including stock
options and restricted shares of the Company’s common stock.  On July
22, 2009, the Company issued an offer to holders of outstanding stock options
issued under the 2007 Plan (“Eligible Options”), to exchange their Eligible
Options for shares of common stock of the Company on a 2 for 1 basis (the
“Option Exchange Program”).  The offer expired on September 25,
2009.  As result of this offer, the Company accepted 1,008,000 stock
options for exchange and cancellation, and issued 504,000 restricted shares of
common stock.




Stock
Options




Under the
2007 Plan, stock options have an exercise price per share determined by the plan
administrator, provided that the exercise price will not be less than 85% or
100% of the fair market value of a share on the grant date in the case of
non-statutory or incentive options, respectively. No granted option will have a
term in excess of ten years. Options generally will become exercisable in one or
more installments over a specified period of service measured from the grant
date. However, options may be structured so that they will be immediately
exercisable for any or all of the option shares.




Stock
option grants to Company employees during 2009 and 2008 included options to
purchase 57,800 shares of common stock with an exercise price of $0.26 per share
on November 17, 2009, 65,000 shares of common stock with an exercise price of
$0.65 per share on November 4, 2009, and 5,000 shares of common stock with an
exercise price of $1.20 per share on October 10, 2008.  Stock option
grants to certain members of the Company’s board of directors during 2009 and
2008 included options to purchase 54,000 shares of common stock with an exercise
price of $1.10 on August 7, 2009, 18,000 shares of common stock with an exercise
price of $1.10 on August 1, 2009, 40,836 shares of common stock with an exercise
price of $1.38 per share on August 1, 2008, and 36,000 shares of common stock
with an exercise price of $1.50 per share on April 25, 2008.  All
options granted by the Company expire ten years from the date of issuance and
vest over a period of three years. The fair values of options granted were
calculated using the Black-Scholes option pricing model and the
following:





December
      31,2009
            
            
            2008Options
      granted
            
            
            194,800
            
            
            
            81,836Weighted-average
      stock price
            
            $
            0.70
            
            
            $
            1.42Weighted-average
      exercise prices of stock options
            
            $
            0.70
            
            
            $
            1.42Assumptions:Weighted-average
      expected volatility
            
            
            53%
            
            
            
            49%Weighted-average
      expected term (in years)
            
            4.5
      years
            
            
            4.4
      yearsRisk-free
      interest rate
            
            
            2.25%
            
            
            
            3.51%Expected
      dividend yield 0%
            
            
            0%
            
            
            
            0%




F-29


STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
7 – Stock Compensation Plans (continued)




Stock
Options (continued)




The
exercise prices of the options granted were determined based on the market price
of the Company’s stock on the date of the grant. The fair value per share of the
common stock on the date of grant was deemed to be equal to the closing selling
price per share of the Company’s common stock at the close of regular hours
trading on the OTC Bulletin Board on that date, as the price was reported by the
National Association of Securities Dealers (currently, FINRA). The volatility
and expected life for the options have been determined based on an analysis of
reported data for a peer group of companies that issued options with
substantially similar terms. The expected volatility of options granted has been
determined using an average of the historical volatility measures of this peer
group of companies for a period equal to the expected life of the option. The
risk-free interest rate is based on United States treasury instruments whose
terms are consistent with the expected life of the stock options. The Company
does not anticipate paying cash dividends on its shares of common stock;
therefore, the expected dividend yield is assumed to be zero. In addition, FASB
ASC Topic 718, “Compensation-Stock Compensation” requires companies to utilize
an estimated forfeiture rate when calculating the expense for the
period.  As a result, the Company uses estimated annual forfeiture
rates based on classifications such as director grants and grants to different
categories of employees.  Those estimates are revised using our
judgment and based on actual results taking into account cancellations related
to terminations, as applicable to each classification.




The
status of the options under the 2007 Plan is summarized below:





Shares
            
            
            Weighted-Average
      Price
            
            
            Weighted-Average
      Contractual Term
                (in
      Years)
            
            
            Aggregate
                Intrinsic
      ValueOutstanding
      at January 1, 2008
            
            
            1,338,000
            
            
            $
            1.71
            
            
            
            8.5
            
            
            $
            —Granted
            
            
            81,836
            
            
            $
            1.42Forfeited
            
            
            (92,420
            )
            
            $
            1.71Outstanding
      at December 31, 2008
            
            
            1,327,416
            
            
            $
            1.69
            
            
            
            8.6
            
            
            $
            —Granted
            
            
            194,800
            
            
            $
            0.70Cancelled
      (see “Restricted Stock” below)
            
            
            (1,008,000
            )
            
            $
            1.71Forfeited
            
            
            (79,570
            )
            
            $
            1.58Outstanding
      at December 31, 2009
            
            
            434,646
            
            
            $
            1.24
            
            
            
            8.5
            
            
            $
            —Exercisable
      at December 31, 2009
            
            
            153,439
            
            
            $
            1.69
            
            
            
            7.5
            
            
            $
            —Vested
      and expected to vest after December 31, 2009
            
            
            364,517
            
            
            $
            $1.27
            
            
            
            8.4
            
            
            $
            —




F-30




STRASBAUGH
AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




NOTE
7 – Stock Compensation Plans (continued)




Restricted
Stock





As a
result of the Option Exchange Program, the Company accepted and cancelled
1,008,000 Eligible Options in exchange for 504,000 shares of its restricted
common stock, which were issued on October 12, 2009.  Fair value of
this award on the grant date was $.25 per share.  The grant date fair
value of the restricted stock award was determined by using the closing price of
the Company’s common stock on September 24, 2009.




The
excess of the aggregate grant date fair value of the Company’s restricted common
stock of $126,000 over the fair value of the stock options canceled of $15,000
was added to the unamortized value of the options canceled on September 25,
2009, which amounted to $205,000.  The total of the unamortized value
of the canceled options and the modification charge are being amortized over the
vesting period of the restricted common stock.  The restricted shares
vest on March 31, 2010.  At December 31, 2009, none of the 504,000
restricted shares had been forfeited and remained outstanding as of that
date.





At
December 31, 2009, the unamortized value of the restricted share award was
approximately $53,000. The unamortized portion will be expensed over a weighted
average period of three months.  For the year ended December 31, 2009,
a cost of $58,000 was recognized in connection with the vesting of the
restricted share award.





The
Company’s executive officers were entitled to participate in the exchange offer,
and as a group accounted for approximately 66% of the stock options exchanged
and cancelled and 66% of the shares of restricted common stock issued in the
offer.




The weighted average
grant-date fair value of options granted during the year ended December 31, 2009
and 2008 was $0.33 and $0.63, respectively. As of December 31, 2009, a total of
1,061,354 common shares were available for future grants under the Company’s
2007 Plan.




Share
based compensation expense is measured at grant date, based on the fair value of
the award, and is recognized over the employee’s requisite service
period.  The share based compensation expense for the year ended
December 31, 2009 and 2008 was $541,000 and $453,000,
respectively.  The share based compensation capitalized as part of
inventory was insignificant at December 31, 2009 and 2008.  The
breakdown of share-based compensation charges by category of expense was as
follows:




December
      31,2009
            
            
            2008Selling,
      general and administrative
            
            $
            374,000
            
            
            $
            342,000Research
      and development
            
            $
            86,000
            
            
            $
            64,000Cost
      of goods sold
            
            $
            81,000
            
            
            $
            47,000




F-31




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008





NOTE
7 – Stock Compensation Plans (continued)




Restricted
Stock (continued)




At
December 31, 2009, there were 153,439 shares vested under the 2007
Plan.  Compensation cost on non-vested awards of stock options and
restricted stock that has not yet been recognized through December 31, 2009 and
is expected to be recognized is as follows:





Year
      Ending
                December
      31,2010
            
            $
            204,0002011
            
            
            24,0002012
            
            
            16,000$
            244,000


NOTE
8 – Redeemable Convertible Series A Preferred Stock




Series
A Preferred Stock Financing




On May
24, 2007, immediately after the closing of the Share Exchange Transaction, the
Company entered into an agreement with 21 accredited investors for the sale by
it in a private offering of 5,909,089 shares of its Series A Preferred Stock at
a purchase price of $2.20 per share for gross proceeds of $13
million.   This transaction is referred to as the “Series A
Preferred Stock Financing.” The Series A Preferred Stock ranks senior in
liquidation and dividend preferences to the Company’s common stock. Holders of
the Series A Preferred Stock are entitled to semi-annual cumulative dividends
payable in arrears in cash in an amount equal to 8% of the purchase price per
share of the Series A Preferred Stock.  Each share of Series A
Preferred Stock is convertible by the holder at any time after its initial
issuance at an initial conversion price of $2.20 per share such that one share
of common stock would be issued for each share of Series A Preferred Stock.
Subject to certain exceptions, the conversion ratio is subject to customary
antidilution adjustments and antidilution adjustments if the Company
subsequently issues certain equity securities at a price equivalent of less than
$2.20 per share. The Company has no present intention to issue equity securities
at a price equivalent of less than $2.20 per share. The shares of Series A
Preferred Stock are also subject to forced conversion, at a conversion price as
last adjusted, anytime after May 24, 2008, if the closing price of our common
stock exceeds 200% of the conversion price then in effect for 20 consecutive
trading days. As of December 31, 2009, the shares of Series A Preferred Stock
have not been subject to forced conversion.  The holders of Series A
Preferred Stock vote together as a single class with the holders of the
Company’s other classes and series of voting stock on all actions to be taken by
its shareholders. Each share of Series A Preferred Stock entitles the holder to
the number of votes equal to the number of shares of our common stock into which
each share of Series A Preferred Stock is convertible. In addition, the holders
of Series A Preferred Stock are afforded numerous customary protective
provisions with respect to certain actions that may only be approved by holders
of a majority of the shares of Series A Preferred Stock. The Company is also
required at all times to reserve and keep available out of its authorized but
unissued shares of Common Stock, such number of shares of Common Stock
sufficient to effect the conversion of all outstanding shares of Series A
Preferred Stock. On or after May 24, 2012 the holders of then outstanding shares
of our Series A Preferred Stock will be entitled to redemption rights. The
redemption price is equal to the per-share purchase price of the Series A
Preferred Stock, which is subject to adjustment as discussed above and in our
articles of incorporation, plus any accrued but unpaid dividends. The Series A
Preferred Stock contain provisions prohibiting certain conversions of the Series
A Preferred Stock.




F-32




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
8 - Redeemable Convertible Series A Preferred Stock (continued)




Series
A Preferred Stock Financing (continued)




Prior to
the implementation of FASB ASC 815-40-15 “Derivatives and Hedging-Contracts in
Entity’s Own Equity-Scope and Scope Exception,” effective January 1, 2009 (as
described in Note 2) , the Series A Preferred Stock was carried at its fair
value based on the gross proceeds from the sale less issuance costs, plus
changes in the redemption value.  Changes in the redemption value of
the Series A Preferred Stock are accreted over the period from the date of
issuance to the earliest redemption date (May 24, 2012) using the interest
method. The accretion of unpaid dividends and issuance costs for the year ended
December 31, 2009 and 2008 was approximately $2,430,000 and $1,576,000,
respectively.




The
Series A Preferred Stock contains standard antidilution provisions and
provisions that are solely within the control of the
Company.  Standard antidilution provisions are those that result in
adjustments to the conversion ratio in the event of an equity restructuring
transaction (as defined) that are designed to maintain the value of the
conversion option. The Series A Preferred Stock also contains a provision that
if the Company makes certain equity offerings in the future at a price lower
than the conversion price, the conversion ratio would also be adjusted for
dilution. However, the Company is required at all times to maintain adequate
authorized and unissued common shares to effect conversion of its convertible
securities and warrants and must control the number of shares issuable on
conversion, additionally, the Company has no plans to make such future equity
offerings. The Series A Preferred also contains a buy-in provision that in the
event the Company fails to deliver to the holder the required number of shares
upon exercise the Company may be required to pay the difference between the
market value of the shares at the exercise date and the conversion price. This
provision is similar to giving the Company the option to settle in shares or in
cash, as the Company may settle the conversion shares at any time with
authorized and unregistered shares and delivery is solely in the control of the
Company.




Warrants




In
connection with the Series A Preferred Stock Financing, the Company issued to
the investors five-year warrants (“Investor Warrants”) to purchase an aggregate
of 886,363 shares of common stock and issued to its placement agent, B. Riley
and Co. LLC and its assignees, five-year warrants (“Placement Warrants”) to
purchase an aggregate of 385,434 shares of common stock. The Investor Warrants
and the Placement Warrants are collectively referred to as the “Warrants.” The
shares underlying the warrants are referred to as the “Warrant Shares.” The
Investor Warrants and the Placement Warrants have an exercise price of $2.42 per
share. The Investor Warrants are exercisable beginning 180 days after May 24,
2007 and the Placement Warrants became immediately exercisable upon issuance on
May 24, 2007. The Company recorded the $350,000 fair value of the warrants as
issuance costs of the Series A preferred Stock Financing.




The
Warrants contain cashless exercise features which could require the Company to
issue fewer shares to the holder, but without cash payment, under a net-share
settlement formula. The number of shares issuable under the cashless exercise
feature is based on a formula that considers the excess of the market value of
the Company’s common stock on the exercise date over the stated exercise price,
as defined in the Warrant.




F-33


STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
8 - Redeemable Convertible Series A Preferred Stock (continued)




Warrants
(continued)




The
exercise price and number of Warrant Shares issuable upon exercise of the
Warrants are subject to adjustment from time to time for (i) stock dividends and
splits, and (ii) “fundamental transactions” including a merger or consolidation,
any sale of all or substantially all of the Company’s assets, any tender offer
or exchange offer is completed pursuant to which holders of the Company’s common
stock are permitted to tender or exchange their shares for other securities,
cash or property, or any reclassification of the Company’s common stock or any
compulsory share exchange pursuant to which the Company’s common stock is
effectively converted into or exchanged for other securities, cash or property.
In the case of a fundamental transaction, the Warrant holders will be entitled
to rights equivalent to the common shareholders as if the Warrant Shares were
issued immediately prior to the fundamental transaction. The Investor Warrants
also provide that if the Company offers or sells stock in subsequent equity
sales at a price below the Warrant exercise price then in effect, then the
number of Warrant Shares issuable will be increased such that the aggregate
exercise price of the Warrants, after taking into account an equivalent price
decrease, shall be equal to the aggregate exercise price prior to such
adjustment (the “Reset Provisions”).




The
Placement Warrants include “piggyback” registration rights. In addition, each
holder of the Placement Warrants is either an “accredited investor” as defined
in Rule 501(a) under the Securities Act or a “qualified institutional buyer” as
defined in Rule 144A(a) under the Securities Act. The Warrants may be
transferred by the original holder to any other Person provided such Person is
an “accredited investor” as defined in Rule 501(a).




Prior to
exercise of the Warrants, the holders are not entitled to any rights of a
shareholder with respect to the Warrant Shares. In addition, under the terms of
the Warrants, the Company is required at all times to reserve and keep available
out of the aggregate of its authorized but unissued and otherwise unreserved
common stock, adequate shares for the purpose of enabling it to issue Warrant
Shares upon exercise of the Warrants.




NOTE
9 - Stockholders’ Equity




Issuance
of Restricted Shares




On
October 12, 2009, the Company issued 504,000 shares of restricted common stock
to holders of its employee stock options, in exchange for cancellation of
options to purchase 1,008,000 shares of common stock (Note 7). The issuance was
pursuant to the Company’s Option Exchange Program, in which employees were
entitled to exchange options for Common Stock at the rate of two options for one
share of common stock. The shares issued are subject to vesting, so that any of
the shares issued to an employee who ceases to be employed on or before March
31, 2010 will be cancelled.  The options surrendered were exercisable
at prices ranging from $1.20 to $1.71 per share. There was no other
consideration given.




F-34




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008


NOTE
9 - Stockholders’ Equity (continued)




Registration
Rights Agreement




The
Company is obligated under a registration rights agreement related to the Series
A Preferred Stock Financing to file a registration statement with the
Commission, registering for resale shares of common stock underlying the Series
A Preferred Stock and shares of common stock underlying Investor Warrants,
issued in connection with the Series A Preferred Stock Financing. The
registration obligations required, among other things, that a registration
statement be declared effective by the Commission on or before October 6, 2007.
As the Company was unable to meet this obligation in accordance with the
requirements contained in the registration rights agreement the Company entered
into with the investors, the Company is required to pay to each investor
liquidated damages equal to 1% per month of the amount paid by the investor for
the common shares still owned by the investor on the date of the default and 1%
of the amount paid by the investor for the common shares still owned by the
investor on each monthly anniversary of the date of the default that occurs
prior to the cure of the default. The maximum aggregate liquidated damages
payable to any investor will be equal to 10% of the aggregate amount paid by the
investor for the shares of the Company’s Series A Preferred Stock. Accordingly,
the maximum aggregate liquidation damages that we would be required to pay under
this provision is $1.3 million.  However, the Company is not obligated
to pay any liquidated damages with respect to any shares of common stock not
included on the registration statement as a result of limitations imposed by the
SEC relating to Rule 415 under the Securities Act.




The
Company’s registration statement was declared effective by the SEC on November
6, 2008.  Included in accrued expenses on the accompanying balance
sheet are penalties calculated based on the number of shares registered and the
length of the default period as well as interest accrued at a rate of 10% per
annum on the unpaid amount of liquidated damages under the
agreement.  Total penalties and interest are estimated to be $244,000
and $223,000, at December 31, 2009 and 2008, respectively.




NOTE
10 – Income Taxes




The
provision for income taxes consists of the following:




For
      the Year EndedDecember
      31,2009
            
            
            2008Current:Federal
            
            $
            (11,000
            )
            
            $
            —State
            
            
            (1,000
            )
            
            
            —Foreign
            
            
            —
            
            
            
            —Deferred:
            
            
            (12,000
            )
            
            
            —Federal
            
            
            —
            
            
            
            —State
            
            
            —
            
            
            
            —Foreign
            
            
            —
            
            
            
            —$
            (12,000
            )
            
            $
            —




F-35




STRASBAUGH
AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008





NOTE
10 – Income Taxes (continued)




The
reconciliation of the Company’s expected tax rate to the effective tax rate is
as follows:





For
      the Year EndedDecember
      31,2009
            
            
            2008Statutory
      federal rate
            
            $
            (235,000
            )
            
            $
            (1,533,000
            )State
      income taxes, net of federal benefit
            
            
            (36,000
            )
            
            
            (179,000
            )Nondeductible
      expenses
            
            
            4,000
            
            
            
            5,000Change
      in valuation allowance
            
            
            116,000
            
            
            
            1,869,000Other
            
            
            139,000
            
            
            
            (163,000
            )$
            (12,000
            )
            
            $
            —




Deferred
taxes consist of the following:




December
      31,2009
            
            
            2008Deferred
      tax assetsAccrued
      vacation
            
            $
            142,000
            
            
            $
            112,000Allowance
      for doubtful accounts
            
            
            5,000
            
            
            
            86,000Accrued
      warranty
            
            
            117,000
            
            
            
            52,000Inventory
      reserve
            
            
            1,620,000
            
            
            
            1,361,000Additional
      inventory costs
            
            
            99,000
            
            
            
            129,000Other
      accruals
            
            
            202,000
            
            
            
            84,000Stock
      based compensation
            
            
            387,000
            
            
            
            221,000Federal
      net operating losses
            
            
            9,696,000
            
            
            
            9,458,000State
      deferred income taxes
            
            
            152,000
            
            
            
            152,000State
      net operating losses
            
            
            880,000
            
            
            
            858,000Federal
      tax credits
            
            
            311,000
            
            
            
            311,000Total deferred tax
      assets
            
            
            13,611,000
            
            
            
            12,824,000Deferred
      tax liabilitiesDerivative
      liabilities
            
            
            (662,000
            )Patent
      costs
            
            
            (158,000
            )
            
            
            (149,000
            )Total deferred tax
      liabilities
            
            
            (820,000
            )
            
            
            (149,000
            )Net deferred tax assets before
      valuation allowance
            
            
            12,791,000
            
            
            
            12,675,000Valuation
    allowance
            
            $
            (12,791,000
            )
            
            $
            (12,675,000
            )None
            
            
            None




The
Company had federal and state net operating losses of approximately $27,686,000
and $10,303,000, respectively, at December 31, 2009, which begin to expire in
2019 for federal purposes.  Annual utilization of the federal net
operating loss may be limited for federal tax purposes as a result of Internal
Revenue Code Section 382 change of ownership rules.  The state net
operating losses expire at various dates through 2029.




The
Company has foreign tax credit, general business credit, and alternative minimum
tax credit carryforwards of approximately $311,000 as of December 31,
2009.  The valuation allowance increased by approximately $116,000
during the year ended December 31, 2009.




F-36




STRASBAUGH
AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




NOTE
10 – Income Taxes (continued)




Since
January 1, 2007, the Company has accounted for its uncertain tax positions
in accordance with FASB ASC 740-10, “Income Taxes.”  The Company
recognizes any interest and penalties related to unrecognized tax benefits in
income tax expense.  The Company made no adjustment to its amount of
unrecognized tax benefits during 2009 or 2008.  The amount of
unrecognized tax benefits was $0 as of December 31, 2009 and
2008.  The Company had no amount accrued for the payment of interest
and penalties at December 31, 2009.




Included
in the balance at December 31, 2009 are $0 of tax positions for which the
ultimate deductibility is highly certain but for which there is uncertainty
about the timing of such deductibility.  Also included in the balance
at December 31, 2009 is $0 of unrecognized tax benefits that, if
recognized, would impact the effective tax rate.




The
Company files income tax returns in the U.S. and various state
jurisdictions. The Company is generally subject to examinations by
U.S. federal and state tax authorities from 1999 to the present as the
U.S. Company has historically generated federal and state tax losses and
tax credits since 1999 which, if utilized in future periods, may subject some or
all periods to examination.





F-37




INDEX
TO EXHIBITS





Exhibit
                Number
            Description2.1
            Share
      Exchange Agreement by and between the Registrant and R. H. Strasbaugh
      dated January 31, 2007 (1)2.2
            Amendment
      No. 1 to Share Exchange Agreement between the Registrant and R. H.
      Strasbaugh dated April 30, 2007 (1)3.1
            Amended
      and Restated Articles of Incorporation of the Registrant
    (1)3.2
            Amended
      and Restated Bylaws of the Registrant (1)4.1
            Securities
      Purchase Agreement dated May 24, 2007 by and among the Registrant and
      the investors who are parties thereto (1)4.2
            Registration
      Rights Agreement dated May 24, 2007 by and among the Registrant and
      the investors who are parties thereto (1)4.3
            Specimen
      Common Stock Certificate (1)4.4
            Specimen
      Preferred Stock Certificate (1)4.5
            Form
      of Warrant dated May 24, 2007 issued by the Registrant to certain
      investors pursuant to the Securities Purchase Agreement filed as Exhibit
      4.1 hereto (1)4.6
            Form
      of Placement Agent Warrant dated effective May 24, 2007 issued by the
      Registrant to B. Riley and Co. Inc. Inc. and its assignees
      (1)4.7
            Article
      IV of Amended and Restated Articles of Incorporation of Registrant
      (contained in Exhibit 3.1 to this Registration Statement)
      (1)4.8
            Form
      of Warrant Clarification Agreement by and among the Registrant and the
      investors who are parties thereto (2)10.1
            Strasbaugh
      2007 Share Incentive Plan (#)(1)10.2
            Form
      of the Strasbaugh 2007 Share Incentive Plan Stock Option Grant Notice and
      Stock Option Agreement (#)(1)10.3
            Form
      of Indemnification Agreement for officers and directors
    (#)(1)10.4
            Executive
      Employment Agreement by and between the Registrant and Chuck
      Schillings (#)(1)10.5
            Executive
      Employment Agreement by and between the Registrant and Richard Nance
      (#)(1)10.6
            Employment
      Agreement by and between the Registrant and Alan Strasbaugh
      (#)(1)10.7
            License
      Agreement by and between Lam Research Corporation and R. H.
      Strasbaugh dated December 20, 2000 (1)10.8
            Loan
      and Security Agreement by and between Silicon Valley Bank and R. H.
      Strasbaugh dated August 23, 2004 (1)10.9
            Amendment
      to Loan Documents by and between Silicon Valley Bank and R. H.
      Strasbaugh dated February 28, 2007 (1)10.10
            Amendment
      to Loan and Security Agreement by and between Silicon Valley Bank and
      R. H. Strasbaugh dated May 22, 2007 (1)10.11
            Amendment
      to Loan and Security Agreement by and between Silicon Valley Bank and
      R. H. Strasbaugh dated September 6, 2007 (3)10.12
            Standard
      Industrial Lease by and between Larry and Alan Strasbaugh and R. H.
      Strasbaugh dated as of May 1, 1990 (1)10.13
            Assignment
      dated April 14, 1995 by Larry Strasbaugh of his interest in the Standard
      Industrial Lease by and between Larry and Alan Strasbaugh and R. H.
      Strasbaugh dated as of May 1, 1990 to Alan and April Strasbaugh
      (1)10.14
            Agreement
      dated October 18, 2007 by and between B. Riley and Co. Inc. and R. H.
      Strasbaugh (3)10.15
            Assignment
      and Assumption Agreement dated May 24, 2007 by and among the Registrant,
      R. H. Strasbaugh and B. Riley and Co. Inc. (3)10.16
            Loan
      and Security Agreement dated December 3, 2007 by and among Silicon
      Valley Bank, the Registrant and R. H. Strasbaugh
  (4)10.17
            Loan
      and Security Agreement (EXIM Facility) dated December 3, 2007 by and
      among Silicon Valley Bank, the Registrant and R. H. Strasbaugh
      (4)10.18
            Memorandum
      of Understanding dated December 1, 2006 by and between the Registrant
      and the45th
      Research Institute the People’s Republic of China Electronic Technology
      Corporation (4)14.1
            Code
      of Ethics (1)16.1
            Letter
      on Change in Certifying Accountant (6)21
            Subsidiaries
      of the Registrant (1)31.1
            Certification
      Required by Rule 13a-14(a) of the Securities and Exchange Act of 1934, as
      amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act
      of 2002 (*)31.2
            Certification
      Required by Rule 13a-14(a) of the Securities and Exchange Act of 1934, as
      amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act
      of 2002 (*)32.1
            Certification
      of Chief Executive Officer and Chief Financial Officer Pursuant to
      18U.S.C. Section 350, as Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002 (*)





*
            Filed
      herewith.


(#)
            This
      exhibit is a management contract or a compensatory plan or
      arrangement.


(1)
            Incorporated
      by reference to Registrant’s registration statement on Form SB-2
      (Registration Statement No.:
333-144787).


(2)
            Filed
      as an exhibit to Registrant’s registration statement on Form S-1/A
      (Amendment No. 8 to Form SB-2) (Registration Statement No. 333-144787)
      filed on October 1, 2008 and incorporated herein by
      reference.]


(3)
            Incorporated
      by reference to Registrant’s registration statement on Form SB-2/A
      (Registration Statement No.: 333-144787) filed on September 17,
      2007.


(4)
            Incorporated
      by reference to Registrant’s registration statement on Form SB-2/A
      (Registration Statement No.: 333-144787) filed on December 14,
      2007.


(5)
            Incorporated
      by reference to Registrant’s registration statement on Form S-1/A
      (Amendment No. 4 to Form SB-2) (Registration Statement No. 333-144787)
      filed on March 25, 2008.


(6)
            Incorporated
      by reference to Registrant’s current report on Form 8-K filed on December
      16, 2008.





60




SIGNATURES




Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this Report to be signed on its behalf by
the undersigned, thereunto duly authorized on this 31st day of March,
2010.






STRASBAUGHBy:
              /s/ CHUCK SHILLINGSChuck
      ShillingsPresident
      and Chief Executive Officer





Pursuant
to the requirements of the Securities Exchange Act of 1934, this Report has been
signed below by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.





Name
            
            Title
            
            Date/s/ CHUCK SCHILLINGS
            
            President
      and Chief Executive Officer
            
            March 31,
      2010Chuck
      Schillings
            
            (principal
      executive officer)/s/ RICHARD NANCE
            
            Chief
      Financial Officer (principal financial officer
            
            March 31,
      2010Richard
      Nance
            
            and
      principal accounting officer)/s/ ALAN STRASBAUGH
            
            Chairman
      of the Board and Director
            
            March 29,
      2010Alan
      Strasbaugh/s/ WESLEY CUMMINGS
            
            Director
            
            March 30,
      2010Wesley
      Cummings/s/ DANIEL O’HARE
            
            Director
            
            March 29,
      2010Daniel
      O’Hare/s/ TOM WALSH
            
            Director
            
            March 31,
      2010Tom
      Walsh/s/ MARTIN KULAWSKI
            
            Director
            
            March 31,
      2010Martin
      Kulawski





61





EXHIBITS
FILED WITH THIS REPORT





Exhibit
              Number
            Description31.1
            Certification
      Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as
      amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
      200231.2
            Certification
      Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as
      amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
      200232.1
            Certification
      of Chief Executive Officer and Chief Financial Officer Pursuant to 18
      U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002





62