UNITED
STATES SECURITIES AND EXCHANGE COMMISSION







Washington,
D.C. 20549








Form
10-Q








(Mark
      One)R
            QUARTERLY
      REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the quarterly period ended September 30, 2008or£
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the transition period
      from           to





Commission
file number 001-15751





eMAGIN
CORPORATION


(Exact
name of registrant as specified in its charter)





Delaware
            56-1764501(State
      or other jurisdiction of
            (I.R.S.
      Employerincorporation
      or organization)
            Identification
      No.)





10500
NE 8th Street,
Suite 1400, Bellevue, Washington 98004


(Address
of principal executive offices)





(425)
749-3600


(Registrant’s
telephone number, including area code)





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





Securities
registered pursuant to Section 12(g) of the Act: Common Stock, $.001 Par Value
Per Share








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 R     No
£





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 £         Smaller
reporting company R





Indicate
by check mark whether the registrant is a shell company (as defined by Rule
12b-2 of the Exchange Act) Yes £    No
R


The
number of shares of common stock outstanding as of October 31, 2008 was
15,018,839.
  1


eMagin
Corporation


Form
10-Q


For
the Quarter ended September 30, 2008





Table
of Contents


PagePART
      I   FINANCIAL INFORMATIONItem
      1
              Condensed
      Consolidated Financial StatementsCondensed
      Consolidated Balance Sheets as of September 30, 2008 (unaudited) and
      December 31, 2007
              3Condensed
      Consolidated Statements of Operations for the Three and Nine Months ended
      September 30, 2008 and 2007 (unaudited)
              4Condensed
      Consolidated Statements of Changes in Capital Deficit for the Nine Months
      ended September 30, 2008 (unaudited)
              5Condensed
      Consolidated Statements of Cash Flows for the Nine Months ended September
      30, 2008 and 2007 (unaudited)
              6Notes
      to Condensed Consolidated Financial Statements (unaudited)
              7Item
      2
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
              17Item
      3
              Quantitative
      and Qualitative Disclosures About Market
      Risk
              21Item
      4T
              Controls
      and
      Procedures
              21PART
      II OTHER INFORMATIONItem
      1
              Legal
      Proceedings
              23Item
      1A
              Risk
      Factors
              23Item
      2
              Unregistered
      Sales of Equity Securities and Use of
      Proceeds
              23Item
      3
              Defaults
      Upon Senior
      Securities
              23Item
      4
              Submission
      of Matters to a Vote of Security
      Holders
              23Item
      5
              Other
      Information
              23Item
      6
              Exhibits
              23SIGNATURESCERTIFICATIONS







2





ITEM
1.  Condensed Consolidated Financial Statements





eMAGIN
CORPORATION


CONDENSED
CONSOLIDATED BALANCE SHEETS


(In
thousands, except share data)




September
      30,
                  
                  
                  December
    31,2008
                    (unaudited)
                  
                  
                  2007
                    (as restated,
      see Note 10)ASSETSCurrent
      assets:Cash
      and cash equivalents
                  
                  $
                  1,272
                  
                  
                  $
                  713Investments
      – held to maturity
                  
                  
                  94
                  
                  
                  
                  94Accounts
      receivable, net
                  
                  
                  4,002
                  
                  
                  
                  2,383Inventory
                  
                  
                  1,978
                  
                  
                  
                  1,815Prepaid
      expenses and other current assets
                  
                  
                  711
                  
                  
                  
                  850Total
      current assets
                  
                  
                  8,057
                  
                  
                  
                  5,855Equipment,
      furniture and leasehold improvements, net
                  
                  
                  348
                  
                  
                  
                  292Intangible
      assets, net
                  
                  
                  48
                  
                  
                  
                  51Other
      assets
                  
                  
                  231
                  
                  
                  
                  232Deferred
      financing costs, net
                  
                  
                  507
                  
                  
                  
                  218Total
      assets
                  
                  $
                  9,191
                  
                  
                  $
                  6,648LIABILITIES
      AND CAPITAL DEFICITCurrent
      liabilities:Accounts
      payable
                  
                  $
                  746
                  
                  
                  $
                  620Accrued
      compensation
                  
                  
                  886
                  
                  
                  
                  891Other
      accrued expenses
                  
                  
                  737
                  
                  
                  
                  729Advance
      payments
                  
                  
                  —
                  
                  
                  
                  35Deferred
      revenue
                  
                  
                  125
                  
                  
                  
                  179Current
      portion of  debt
                  
                  
                  8,375
                  
                  
                  
                  7,089Other
      current liabilities
                  
                  
                  743
                  
                  
                  
                  1,020Total
      current liabilities
                  
                  
                  11,612
                  
                  
                  
                  10,563Long-term
      debt
                  
                  
                  38
                  
                  
                  
                  60Total
      liabilities
                  
                  
                  11,650
                  
                  
                  
                  10,623Commitments
      and contingenciesRedeemable
      common stock:  525,500 shares redeemable as of September 30,
      2008
                    and 162,500 shares redeemable as of December 31,
    2007
                  
                  
                  429
                  
                  
                  
                  195Capital
      deficit:Preferred
      stock, $.001 par value: authorized 10,000,000 shares; no shares issued and
      outstanding
                  
                  
                  —
                  
                  
                  
                  —Series
      A Senior Secured Convertible Preferred stock, stated value $1,000 per
      share, $.001 par value:  3,198 shares designated and none
      issued
                  
                  
                  —
                  
                  
                  
                  —Common
      stock, $.001 par value: authorized 200,000,000 shares, issued and
      outstanding, 14,496,339 shares as of September 30, 2008 and 12,458,400
      shares as of December 31, 2007, net of redeemable common
    stock
                  
                  
                  14
                  
                  
                  
                  12Additional
      paid-in capital
                  
                  
                  198,846
                  
                  
                  
                  195,131Accumulated
      deficit
                  
                  
                  (201,748
                  )
                  
                  
                  (199,313
                  )Total
      capital deficit
                  
                  
                  (2,888
                  )
                  
                  
                  (4,170
                  )Total
      liabilities and capital deficit
                  
                  $
                  9,191
                  
                  
                  $
                  6,648




See notes
to Condensed Consolidated Financial Statements.


3


eMAGIN
CORPORATION


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


(In
thousands, except share and per share data)


(unaudited)





Three
      Months Ended
                      September
      30,
                    
                    
                    Nine
      Months Ended
                      September
      30,2008
                    
                    
                    2007
                    
                    
                    2008
                    
                    
                    2007Revenue:Product
      revenue
                    
                    $
                    4,181
                    
                    
                    $
                    4,318
                    
                    
                    $
                    11,139
                    
                    
                    $
                    11,985Contract
      revenue
                    
                    
                    1,004
                    
                    
                    
                    753
                    
                    
                    
                    2,330
                    
                    
                    
                    927Total
      revenue, net
                    
                    
                    5,185
                    
                    
                    
                    5,071
                    
                    
                    
                    13,469
                    
                    
                    
                    12,912Cost
      of goods sold
                    
                    
                    2,801
                    
                    
                    
                    3,059
                    
                    
                    
                    8,110
                    
                    
                    
                    9,120Gross
      profit
                    
                    
                    2,384
                    
                    
                    
                    2,012
                    
                    
                    
                    5,359
                    
                    
                    
                    3,792Operating
      expenses:Research
      and development
                    
                    
                    306
                    
                    
                    
                    564
                    
                    
                    
                    1,614
                    
                    
                    
                    2,304Selling,
      general and administrative
                    
                    
                    1,293
                    
                    
                    
                    1,434
                    
                    
                    
                    4,797
                    
                    
                    
                    5,198Total
      operating expenses
                    
                    
                    1,599
                    
                    
                    
                    1,998
                    
                    
                    
                    6,411
                    
                    
                    
                    7,502Income
      (loss) from operations
                    
                    
                    785
                    
                    
                    
                    14
                    
                    
                    
                    (1,052
                    )
                    
                    
                    (3,710
                    )Other
      income (expense):Interest
      expense
                    
                    
                    (508
                    )
                    
                    
                    (592
                    )
                    
                    
                    (1,677
                    )
                    
                    
                    (2,766
                    )Loss
      on extinguishment of debt
                    
                    
                    —
                    
                    
                    
                    (10,749
                    )
                    
                    
                    —
                    
                    
                    
                    (10,749
                    )Loss
      on warrant derivative liability
                    
                    
                    —
                    
                    
                    
                    (1,496
                    )
                    
                    
                    —
                    
                    
                    
                    (853
                    )Other
      income, net
                    
                    
                    84
                    
                    
                    
                    172
                    
                    
                    
                    294
                    
                    
                    
                    762Total
      other expense
                    
                    
                    (424
                    )
                    
                    
                    (12,665
                    )
                    
                    
                    (1,383
                    )
                    
                    
                    (13,606
                    )Net
      income (loss)
                    
                    $
                    361
                    
                    
                    $
                    (12,651
                    )
                    
                    $
                    (2,435
                    )
                    
                    $
                    (17,316
                    )Income
      (loss) per share, basic
                    
                    $
                    0.02
                    
                    
                    $
                    (1.06
                    )
                    
                    $
                    (0.18
                    )
                    
                    $
                    (1.53
                    )Income
      (loss) per share, diluted
                    
                    $
                    0.02
                    
                    
                    $
                    (1.06
                    )
                    
                    $
                    (0.18
                    )
                    
                    $
                    (1.53
                    )Weighted
      average number of shares outstanding:Basic
                    
                    
                    14,617,235
                    
                    
                    
                    11,934,705
                    
                    
                    
                    13,854,860
                    
                    
                    
                    11,300,757Diluted
                    
                    
                    23,430,416
                    
                    
                    
                    11,934,705
                    
                    
                    
                    13,854,860
                    
                    
                    
                    11,300,757




See notes
to Condensed Consolidated Financial Statements.


4


eMAGIN
CORPORATION


CONDENSED
CONSOLIDATED STATEMENT OF CHANGES IN CAPITAL DEFICIT


(In
thousands)


(unaudited)








Additional
                
                
                
                
                
                TotalCommon
      Stock
                
                
                Paid-In
                
                
                Accumulated
                
                
                Shareholders’Shares
                
                
                Amount
                
                
                Capital
                
                
                Deficit
                
                
                DeficitBalance,
      December 31, 2007 as reported
                
                
                12,621
                
                
                $
                12
                
                
                $
                195,326
                
                
                $
                (199,313
                )
                
                $
                (3,975
                )Adjustments
                
                
                (163
                )
                
                
                -
                
                
                
                (195
                )
                
                
                —
                
                
                
                (195
                )Adjusted
      balance
                
                
                12,458
                
                
                
                12
                
                
                
                195,131
                
                
                
                (199,313
                )
                
                
                (4,170
                )Sale
      of common stock, net of issuance costs
                
                
                1,587
                
                
                
                2
                
                
                
                1,578
                
                
                
                —
                
                
                
                1,580Expiration
      of put option
                
                
                125
                
                
                
                —
                
                
                
                150
                
                
                
                —
                
                
                
                150Issuance
      of common stock for services
                
                
                326
                
                
                
                —
                
                
                
                303
                
                
                
                —
                
                
                
                303Stock-based
      compensation
                
                
                —
                
                
                
                —
                
                
                
                845
                
                
                
                —
                
                
                
                845Fair
      value of warrants issued
                
                
                —
                
                
                
                —
                
                
                
                883
                
                
                
                —
                
                
                
                883Deemed
      dividend, put option
                
                
                —
                
                
                
                —
                
                
                
                (44
                )
                
                
                —
                
                
                
                (44
                )Net
      loss
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (2,435
                )
                
                
                (2,435
                )Balance,
      September 30, 2008
                
                
                14,496
                
                
                $
                14
                
                
                $
                198,846
                
                
                $
                (201,748
                )
                
                $
                (2,888
                )








See notes to Condensed
Consolidated Financial Statements.





5


eMAGIN
CORPORATION


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(In
thousands)





Nine
      months EndedSeptember
      30,2008
                      
                      
                      2007(unaudited)Cash
      flows from operating activities:Net
      loss
                      
                      $
                      (2,435
                      )
                      
                      $
                      (17,316
                      )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
                      
                      
                      183
                      
                      
                      
                      313Amortization
      of deferred financing and waiver fees
                      
                      
                      1,152
                      
                      
                      
                      266Increase
      in (reduction of) provision for sales returns and doubtful
      accounts
                      
                      
                      241
                      
                      
                      
                      (35
                      )Stock-based
      compensation
                      
                      
                      845
                      
                      
                      
                      1,172Amortization
      of common stock issued for services
                      
                      
                      88
                      
                      
                      
                      953Amortization
      of discount on notes payable
                      
                      
                      25
                      
                      
                      
                      1,848Loss
      on warrant derivative liability
                      
                      
                      —
                      
                      
                      
                      853Loss
      on extinguishment of debt
                      
                      
                      —
                      
                      
                      
                      10,749Changes
      in operating assets and liabilities:Accounts
      receivable
                      
                      
                      (1,860
                      )
                      
                      
                      (1,755
                      )Inventory
                      
                      
                      (163
                      )
                      
                      
                      534Prepaid
      expenses and other current assets
                      
                      
                      254
                      
                      
                      
                      (145
                      )Deferred
      revenue
                      
                      
                      (54
                      )
                      
                      
                      128Accounts
      payable, accrued compensation, other accrued expenses, and advance
      payments
                      
                      
                      94
                      
                      
                      
                      750Other
      current liabilities
                      
                      
                      (277
                      )
                      
                      
                      15Net
      cash used in operating activities
                      
                      
                      (1,908
                      )
                      
                      
                      (1,670
                      )Cash
      flows from investing activities:Purchase
      of equipment
                      
                      
                      (236
                      )
                      
                      
                      (9
                      )Proceeds
      from investments – held to maturity
                      
                      
                      —
                      
                      
                      
                      33Net
      cash (used in) provided by investing activities
                      
                      
                      (236
                      )
                      
                      
                      24Cash
      flows from financing activities:Proceeds
      from sale of common stock, net of issuance costs
                      
                      
                      1,580
                      
                      
                      
                      —Proceeds
      from exercise of warrants
                      
                      
                      —
                      
                      
                      
                      3Proceeds
      from debt
                      
                      
                      1,934
                      
                      
                      
                      1,108Payments
      related to deferred financing costs
                      
                      
                      (117
                      )
                      
                      
                      (40
                      )Payments
      of debt and capital leases
                      
                      
                      (694
                      )
                      
                      
                      (48
                      )Net
      cash provided by financing activities
                      
                      
                      2,703
                      
                      
                      
                      1,023Net
      increase (decrease) in cash and cash equivalents
                      
                      
                      559
                      
                      
                      
                      (623
                      )Cash
      and cash equivalents beginning of period
                      
                      
                      713
                      
                      
                      
                      1,415Cash
      and cash equivalents end of period
                      
                      $
                      1,272
                      
                      
                      $
                      792Cash
      paid for interest
                      
                      $
                      524
                      
                      
                      $
                      281Cash
      paid for taxes
                      
                      $
                      31
                      
                      
                      $
                      67
  Non-cash
      financing and investing activities:
                      
                      During
      the nine months ended September 30, 2008, the Company:·Entered
      into an amended Loan and Security Agreement and issued warrants that are
      exercisable at $1.50 per share into 1.0 million shares of common stock
      valued at approximately $0.7 million.·Entered
      into an amended Loan and Security Agreement and issued warrants that are
      exercisable at $1.30 per share into 370,000 shares of common stock valued
      at approximately $154,000.





See notes
to Condensed Consolidated Financial Statements.


6





eMAGIN
CORPORATION


NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS


(Unaudited)





Note
1:  Description of the Business and Summary of Significant Accounting
Policies





The
Business





eMagin
Corporation (the “Company”) designs, develops, manufactures, and markets virtual
imaging products for consumer, commercial, industrial and military
applications.  The Company’s products are sold mainly in North
America, Asia, and Europe.





Basis
of Presentation





In the
opinion of management, the accompanying unaudited condensed consolidated
financial statements of eMagin Corporation and its subsidiary reflect all
adjustments, including normal recurring accruals, necessary for a fair
presentation.  Certain information and footnote disclosure normally
included in annual financial statements prepared in accordance with accounting
principles generally accepted in the United States have been condensed or
omitted pursuant to instructions, rules and regulations prescribed by the
Securities and Exchange Commission.  The Company believes that the
disclosures provided herein are adequate to make the information presented not
misleading when these unaudited condensed consolidated financial statements are
read in conjunction with the audited consolidated financial statements contained
in the Company’s Annual Report on Form 10-K for the year ended December 31,
2007.  The results of operations for the period ended September 30,
2008 are not necessarily indicative of the results to be expected for the full
year.





The
unaudited condensed consolidated financial statements have been prepared
assuming that the Company will continue as a going concern.  The Company
has had recurring losses from operations, which it believes will continue
through the foreseeable future.  The Company’s cash requirements over the
next twelve months are greater than the Company’s current cash, cash
equivalents, and investments at September 30, 2008.  The Company has
working capital and capital deficits as of September 30, 2008. These factors
raise substantial doubt regarding the Company’s ability to continue as a going
concern without continuing to obtain additional funding.  The Company does
not have commitments for such financing and no assurance can be given that
additional financing will be available, or if available, will be on acceptable
terms.If the Company
is unable to obtain sufficient funds during the next twelve months, the Company
will further reduce the size of its organization and/or curtail operations which
will have a material adverse impact on the Company’s business prospects. The
Company is reviewing its cost structures for cost efficiencies and is taking
measures to reduce costs. The unaudited condensed consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.




Use
of Estimates





In
accordance with accounting principles generally accepted in the United States of
America, management utilizes certain estimates and assumptions that affect the
reported amounts of assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. On an on-going basis, management evaluates its estimates and
judgments. Management bases its estimates and judgments on historical experience
and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results could differ from those estimates.





Revenue
Recognition





Revenue
is recognized when products are shipped to customers, net of allowances for
anticipated returns.  The Company’s revenue-earning
activities generally involve delivering products.
Revenue is recognized when persuasive evidence of
an arrangement exists, delivery has occurred, selling price is
fixed or determinable and collection is reasonably
assured.





The
Company also earns revenues from certain R&D activities under
both firm fixed-price contracts and cost-type
contracts, including some cost-plus-fee contracts.  Revenues on
cost-plus-fee contracts include costs incurred plus a portion of
estimated fees or profits based on the relationship of costs incurred to total
estimated costs. Contract costs include all direct material and labor costs
and an allocation of allowable indirect costs as defined by each
contract, as periodically adjusted to reflect revised agreed upon
rates. These rates are subject to audit by the other party.




7





Note
2:  Recently Issued Accounting Pronouncements




In
September 2006, the FASB issued Statement of Financial Accounting Standards
No. 157, “Fair Value Measurements,” (“SFAS 157”), which defines fair value,
establishes a framework for measuring fair value under generally accepted
accounting principles and expands disclosures about fair value measurements.
SFAS 157 does not require any new fair value measurements, but provides guidance
on how to measure fair value by providing a fair value hierarchy used to
classify the source of the information. In February 2008, the FASB issued
FASB Staff Position No. FSP 157-2, “Effective Date of FASB Statement
No. 157”, which provides a one year deferral of the effective date of SFAS
157 for non-financial assets and non-financial liabilities, except those that
are recognized or disclosed in the financial statements at fair value on a
recurring basis. The Company adopted SFAS 157 as of January 1, 2008, with
the exception of the application of the statement to non-recurring non-financial
assets and non-financial liabilities for which it will defer the adoption until
January 1, 2009. In October 2008, the FASB issued FASP FAS 157-3,
“Determining the Fair Value of a Financial Asset When the Market for That Asset
Is Not Active” (“FSP 157-3”). FSP 157-3 clarified the application of
FAS 157 in situations where the market for that financial asset is not
active.  FSP 157-3 was effective upon issuance, including prior
periods for which financial statements had not been issued. The adoption of SFAS
157 did not have a material impact on the Company’s consolidated results of
operations, financial condition or cash flows.





In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option
for Financial Assets and Financial Liabilities — including an amendment of FASB
Statement No. 115,” (“SFAS 159”) which is effective for fiscal years
beginning after November 15, 2007. This statement permits entities to
choose to measure many financial instruments and certain other items at fair
value. This statement also establishes presentation and disclosure requirements
designed to facilitate comparisons between entities that choose different
measurement attributes for similar types of assets and liabilities. Unrealized
gains and losses on items for which the fair value option is elected would be
reported in earnings. The Company has adopted SFAS 159 and has elected not to
measure any additional financial instruments and other items at fair value and
therefore the adoption of SFAS 159 did not have a material impact on the
Company’s condensed consolidated results of operations, financial condition or
cash flows.





In March 2008, the FASB
issued Statement of Financial Accounting Standards No. 161, Disclosures
about Derivative Instruments and Hedging Activities, an amendment of FASB
Statement No. 133 (“SFAS 161”). SFAS 161 requires entities to provide
greater transparency about (a) how and why an entity uses derivative
instruments, (b) how derivative instruments and related hedged items are
accounted for under Statement 133 and its related interpretations and
(c) how derivative instruments and related hedged items affect an entity’s
financial position, results of operations, and cash flows. SFAS 161 is effective
prospectively for financial statements issued for fiscal years and interim
periods beginning after November 15, 2008, with early application
permitted. The Company is currently evaluating the disclosure implications of
this statement.




In May
2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles, (“SFAS 162”), which identifies the sources of
accounting principles and the framework for selecting principles to be used in
the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles in the
United States. This statement shall be effective 60 days following the
SEC's approval of the Public Company Accounting Oversight Board's amendments to
AU section 411, The Meaning of Present Fairly in Conformity with Generally
Accepted Accounting Principles. The Company is currently evaluating the impact
of SFAS 162, but does not expect the adoption of this pronouncement will
have a material impact on the Company's financial statements.





Note
3:  Receivables




The
majority of the Company’s commercial accounts receivable are due from Original
Equipment Manufacturers ("OEM’s”). Credit is extended based on evaluation of a
customer’s financial condition and, generally, collateral is not required.
Accounts receivable are payable in U.S. dollars, are due within 30-90 days and
are stated at amounts due from customers, net of an allowance for doubtful
accounts. Any account outstanding longer than the contractual payment terms is
considered past due.




8





The
Company determines the allowance for doubtful accounts
by considering a number of factors, including the length of time the
trade accounts receivable are past due, eMagin's previous loss history, the
customer's current ability to pay its obligation, and the condition of
the general economy and the industry as a whole.   The Company will
record a specific reserve for individual accounts when the Company becomes aware
of a customer's inability to meet its financial obligations, such as in the case
of bankruptcy filings or deterioration in the customer's operating results or
financial position.  If circumstances related to customers change, the
Company would further adjust estimates of the recoverability of
receivables.





Receivables
consisted of the following (in thousands):





September
      30,
                      2008
                      (unaudited)
                    
                    
                    December
      31, 2007Accounts
      receivable
                    
                    $
                    4,600
                    
                    
                    $
                    2,741Less
      allowance for doubtful accounts
                    
                    
                    (598
                    )
                    
                    
                    (358
                    )Net
      receivables
                    
                    $
                    4,002
                    
                    
                    $
                    2,383





Note
4:  Research and Development Costs





Research
and development costs are expensed as incurred.





Note
5:  Net Loss per Common Share





In
accordance with SFAS No. 128, net loss per common share amounts ("basic EPS")
is computed by dividing net loss by the weighted average number
of common shares outstanding and excluding any
potential dilution.  Net loss per common share assuming dilution
("diluted EPS") is computed by reflecting potential dilution from the
exercise of stock options, warrants, convertible notes and
redeemable stock.




The
following table presents a reconciliation of the numerator and denominators of
the basic and diluted EPS calculations (in thousands, except share and per share
data):





Three
      Months Ended September 30,
                        
                        
                        Nine
      Months Ended September 30,2008
                        
                        
                        2007
                        
                        
                        2008
                        
                        
                        2007Numerator:Net
      earnings
                        
                        $
                        361
                        
                        
                        $
                        (12,651
                        )
                        
                        $
                        (2,435
                        )
                        
                        $
                        (17,316
                        )Adjustment
      for interest expense on convertible notes, net of taxes
                        
                        
                        121Net
      earnings (loss), adjusted
                        
                        $
                        482
                        
                        
                        $
                        (12,651
                        )
                        
                        $
                        (2,435
                        )
                        
                        $
                        (17,316
                        )Denominator:Weighted
      average shares
      outstanding for basic earning per share
                        
                        
                        14,617,235
                        
                        
                        
                        11,934,705
                        
                        
                        
                        13,854,860
                        
                        
                        
                        11,300,757Effective
      of dilutive shares:Dilution
      from stock options and warrants
                        
                        
                        365,216
                        
                        
                        
                        —
                        
                        
                        
                        —
                        
                        
                        
                        —Redeemable
      stock
                        
                        
                        117,277
                        
                        
                        
                        —
                        
                        
                        
                        —
                        
                        
                        
                        —Convertible
      notes
                        
                        
                        8,330,688
                        
                        
                        
                        —
                        
                        
                        
                        —
                        
                        
                        
                        —Dilutive
      potential common shares
                        
                        
                        8,813,181
                        
                        
                        
                        —
                        
                        
                        
                        —
                        
                        
                        
                        —Weighted
      –average shares outstanding for diluted earnings per share
                        
                        
                        23,430,416
                        
                        
                        
                        11,934,705
                        
                        
                        
                        13,854,860
                        
                        
                        
                        11,300,757





The
Company excludes options and warrants with exercise prices that are greater than
the average market price from the calculation of diluted EPS whose effect would
be anti-dilutive.  For the three months ended September 30, 2008, the
Company excluded 11,680,679 from its diluted EPS calculation as their
effect would be anit-dilutive.




For the
nine months ended September 30, 2008 and the three and nine months ended
September 30, 2007, the Company has excluded options, warrants, and convertible
notes outstanding to acquire 10,901,343 and 17,440,096 shares of our common
stock, respectively, since their effect would be anti-dilutive.




9





The
Company issued 522,500 shares of common stock which were
redeemable.  Of the 522,500 shares, 360,000 shares were excluded as
the shares have a redemption price below the average market price and would be
anti-dilutive. Of the remaining 162,500 shares which were “in the money”, only
the incremental shares, 117,277, were included.





The
convertible notes are convertible at the option of the holders at any time prior
to maturity.  For purposes of calculating diluted earnings per share,
the interest expense associated with the notes was added back to net earnings
and the shares issuable upon conversion of the notes were included.





Note
6:  Inventory





Inventory
is stated at the lower of cost or market. Cost is determined using the first-in
first-out method.  The Company reviews the value of its inventory and
reduces the inventory value to its net realizable value based upon current
market prices and contracts for future sales. The components of inventories are
as follows (in thousands):





September
      30,
                    2008
                    (unaudited)
                  
                  
                  December
      31, 2007Raw
      materials
                  
                  $
                  1,175
                  
                  
                  $
                  1,069Work
      in process
                  
                  
                  157
                  
                  
                  
                  370Finished
      goods
                  
                  
                  646
                  
                  
                  
                  376Total
      inventory
                  
                  $
                  1,978
                  
                  
                  $
                  1,815





Note
7:  Prepaid Expenses and Other Current Assets:





Prepaid
expenses and other current assets consist of the following (in
thousands):




September
      30,
                    2008
                    (unaudited)
                  
                  
                  December
      31, 2007Vendor
      prepayments
                  
                  $
                  344
                  
                  
                  $
                  537Other
      prepaid expenses
                  
                  
                  364
                  
                  
                  
                  310Other
      assets
                  
                  
                  3
                  
                  
                  
                  3Total
      prepaid expenses and other current assets
                  
                  $
                  711
                  
                  
                  $
                  850




Note
8:  Debt





Debt is
as follows (in thousands):




September
      30,2008
                      (unaudited)
                    
                    
                    December
      31,
                      2007Current
      portion of long-term debt:Other
      debt
                    
                    $
                    31
                    
                    
                    $
                    44Line
      of credit with Moriah
                    
                    
                    2,382
                    
                    
                    
                    1,1088%
      Senior Secured Convertible Notes
                    
                    
                    5,962
                    
                    
                    
                    5,962Less:  Unamortized
      discount on notes payable
                    
                    
                    —
                    
                    
                    
                    (25
                    )Current
      portion of long-term debt, net
                    
                    
                    8,375
                    
                    
                    
                    7,089Long-term
      debt:Other
      debt
                    
                    
                    38
                    
                    
                    
                    60Long-term
      debt, net
                    
                    
                    38
                    
                    
                    
                    60Total
      debt, net
                    
                    $
                    8,413
                    
                    
                    $
                    7,149





On August
7, 2007, the Company enteredinto
a loan agreement with Moriah Capital, L.P. (“Moriah”)and
established a revolving line of credit (the “Loan”) of $2.5
million.  The Company is permitted to borrow an amount not to exceed
90% of its domestic eligible accounts receivable and 50% of its eligible
inventory capped at $600 thousand.  As part of the transaction, the
Company issued 162,500 shares of unregistered common stock valued at $195
thousand and paid a servicing fee of $82.5 thousand to Moriah which are
amortized to interest expense over the life of the agreement. In conjunction
with entering into this loan and issuing unregistered common stock, the Company
granted Moriah registration rights.  The Loan is convertible into
shares of the Company’s common stock pursuant to the terms of the Loan
Conversion Agreement.  The Loan was to mature on August 7, 2008,
however Moriah extended the maturity date to August 20, 2008 when the loan
agreement was further amended as explained below.




10





On
January 30, 2008, the Company amended and restated its Loan agreement (“Amended
Loan Agreement”) with Moriah.  The Amended Loan Agreement’s borrowing
base calculation was modified to include 70% of eligible foreign
accounts.  The Amended Loan Agreement eliminated the optional
conversion of principal up to $2.0 million into common stock.  In
connection with the amendment, the Company issued a Warrant to purchase 750,000
shares of its common stock at a price of $1.50 per share with an expiration date
of January 29, 2013.





The
Amended Loan Agreement has specific terms to which the Company must comply
including (a) maintaining a lockbox account into which payments from related
accounts receivable must be deposited, (b) periodic certifications as to
borrowing base amounts equaling or exceeding net balances outstanding under the
Line of Credit, and (c) a requirement that a registration statement with respect
to shares held or to be issued to the lender be filed within thirty days of
January 30, 2008.  A delay in establishing the required lockbox
account created a technical default under the Line of Credit
agreement.  Similarly, the production and subsequent discovery of
defective displays resulted in an inadvertent overstatement of inventory during
December, January and early February that created a technical default under the
agreement.  Finally, the Company was not able to complete the
registration of shares within the thirty day timeframe mandated in the amended
agreement.  On March 25, 2008 the Company received a waiver from the
lender (a) waiving compliance with the lockbox account requirement through March
14, 2008, (b) waiving compliance with the borrowing base requirement in so far
as it related exclusively to the defective displays inadvertently included in
inventory, and (c) extending the period for filing a registration statement for
certain shares held or to be issued to the lender until April 29,
2008.  The Company established a lockbox account by March 14, 2008 and
filed a registration statement with the SEC on April 29, 2008.





Effective March 25, 2008, the Company
amended the Warrant Issuance Agreement (“Amended Warrant Agreement”) with
Moriah. In connection with such amendment, the Company issued a waiver fee in
the form of a Warrant to purchase an additional 250,000 shares of its common
stock at a price of $1.50 expiring March 25, 2013.





The
Company determined the fair value of the 1,000,000 warrants to be $729 thousand
of which $168 thousand was expensed immediately and $561 thousand will be
amortized to interest expense over the life of the loan.  The
following assumptions were used to determine the fair value of the
warrants:  dividend yield of 0%; risk free interest rates of 2.61 %
and 2.96%; expected volatility of 90.9% and 92.3%; and expected contractual term
of 5 years.





The
Company and Moriah entered into Amendment No. 3 to the Loan and Security
Agreement dated August 20, 2008 (the “Amendment No. 3”).  Pursuant to
Amendment No. 3, the Company issued Moriah an Amended and Restated Revolving
Loan Note (the “Amended Note”) and the maturity date has been extended to August
7, 2009. The Company will pay Moriah $85 thousand in servicing fees by December
1, 2008 and as of September 30, 2008, the Company has paid $34
thousand.  The servicing fees will be amortized to interest expense
over the life of the agreement.





Pursuant
to Amendment No. 3, the following changes were made to the Loan:  the
maximum amount the Company can borrow has been increased to $3 million; the
borrowing base calculation was modified to increase eligible foreign accounts
receivable to 80% and increased the eligible inventory to the lesser of 70% or
$800 thousand; and financial covenants have been added.





The
Company issued Moriah a warrant, which terminates on August 7, 2013, to purchase
up to 370,000 shares of the Company’s common stock at an exercise price of $1.30
per share.  The Company determined the fair value of the warrants to
be approximately $154 thousand which was recorded as a deferred debt issuance
cost. The following assumptions were used to determine the fair value of the
warrants:  dividend yield of 0%; risk free interest rates of 3.16 %;
expected volatility of 87.7%; and expected contractual term of 5
years.  The deferred debt issuance costs are being amortized to
interest expense over the life of the loan.




11





Pursuant
to Amendment No. 3, the Company and Moriah, also, entered into an Amended and
Restated Securities Issuance Agreement.  The Company issued 485,000
shares of unregistered common stock valued at approximately $340 thousand which
was recorded as a deferred debt issuance cost.  It will be amortized
to interest expense over the life of the agreement. In addition, the holders of
the Amended 8% Notes and the investors in the Purchase Agreement (See Note 10)
consented to the Amended Note and received a total of 144,000 shares of
unregistered common stock valued at approximately $101 thousand which was
recorded as waiver fees and expensed to interest expense.





Pursuant
to Amendment No. 3, the Company and Moriah entered into an Amendment to
Registration Rights Agreement (the “Amended Registration Rights
Agreement”).   Pursuant to the Amended Registration Rights
Agreement, the Company agreed to use its best efforts to file a registration
statement  to register the shares 485,000 shares of the company’s common
stock issued pursuant to the Amended and Restated Securities Issuance Agreement
and the shares of common stock issuable upon exercise of the Warrant, provided
that the Company is permitted to under applicable securities rules and
regulations and after the certain other registration statements that the Company
was obligated to file on behalf of selling shareholders have
been  declared effective.





In the
three and nine months ended September 30, 2008, approximately $331 thousand and
$1.2 million, respectively, of deferred debt issuance costs and waiver fees were
amortized to interest expense.  For the three and nine months ended
September 30, 2008, interest expense includes interest paid or accrued on
outstanding debt of approximately $178 thousand and $501 thousand,
respectively.





The 8%
Senior Secured Convertible Notes can also convert into the Company’s Series A
Convertible Preferred Stock (the “Preferred Stock”).  See Note
10:  Shareholders’ Equity for additional information.





Note
9:  Stock-based Compensation





The
Company accounts for the measurement and recognition of compensation expense for
all share-based payment awards made to employees and directors under Statement
of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, (SFAS
123(R)). Under SFAS 123(R), the fair value of stock awards is estimated at the
date of grant using the Black-Scholes option valuation
model.  Stock-based compensation expense is reduced for estimated
forfeitures and is amortized over the vesting period using the straight-line
method.





The
following table summarizes the allocation of non-cash stock-based compensation
to our expense categories for the three and nine-month periods ended September
30, 2008 and 2007 (in thousands):





Three
      Months Ended September 30,
                  
                  
                  Nine
      Months Ended September 30,2008
                  
                  
                  2007
                  
                  
                  2008
                  
                  
                  2007Cost
      of revenue
                  
                  $
                  31
                  
                  
                  $
                  43
                  
                  
                  $
                  106
                  
                  
                  $
                  173Research
      and development
                  
                  
                  58
                  
                  
                  
                  82
                  
                  
                  
                  192
                  
                  
                  
                  282Selling,
      general and administrative
                  
                  
                  149
                  
                  
                  
                  148
                  
                  
                  
                  547
                  
                  
                  
                  717Total
      stock compensation expense
                  
                  $
                  238
                  
                  
                  $
                  273
                  
                  
                  $
                  845
                  
                  
                  $
                  1,172





At
September 30, 2008, total unrecognized non-cash compensation cost related to
stock options was approximately $964 thousand, net of
forfeitures.  Total unrecognized compensation cost will be adjusted
for future changes in estimated forfeitures and is expected to be recognized
over a weighted average period of approximately 1.7 years.





The
Company recognizes compensation expense for options granted to non-employees in
accordance with the provisions of Emerging Issues Task Force (“EITF”) consensus
Issue 96-18, “Accounting for
Equity Instruments that are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling Goods or Services,” which requires using a fair
value options pricing model and re-measuring such stock options to the current
fair market value at each reporting period as the underlying options vest and
services are rendered.





There
were approximately 171,000 and 919,000 options granted to employees and
directors during the three and nine months ended September 30, 2008. The
following key assumptions were used in the Black-Scholes option pricing model to
determine the fair value of stock options granted:




For
      the Nine Months Ended
                              September
      302008
                            
                            
                            2007Dividend
      yield
                            
                            
                            0
                            %
                            
                            
                            0
                            %Risk
      free interest rates
                            
                            2.46
      to 3.37%
                            
                            
                            
                            4.23
                            %Expected  volatility
                            
                            88.4
      to 92.3%
                            
                            
                            
                            106
                            %Expected
      term (in years)
                            
                            
                            5
                            
                            
                            
                            5





12





There
were no stock options granted during the three and nine-month period ended
September 30, 2007.  We have not declared or paid any dividends and do
not currently expect to do so in the near future.  The risk-free
interest rate used in the Black-Scholes option pricing model is based on the
implied yield currently available on U.S. Treasury securities with an equivalent
term.   Expected volatility is based on the weighted average
historical volatility of the Company’s common stock for the most recent five
year period.  The expected term of options represents the period that
our stock-based awards are expected to be outstanding and was determined based
on historical experience and vesting schedules of similar awards.





The Board
of Directors authorized the establishment of the 2008 Incentive Stock Plan with
2,000,000 options available for grant.  The 2008 Incentive Stock Plan
is intended to provide long-term performance incentives to directors,
executives, selected employees and consultants and reward them for making major
contributions to the success and well being of the Company.  No
options were granted from this plan as of September 30, 2008.





A summary
of the Company’s stock option activity for the nine months ended September 30,
2008 is presented in the following tables:




Number
      of Shares
                    
                    
                    Weighted
      Average Exercise Price
                    
                    
                    Weighted
      Average Remaining Contractual Life (In Years)
                    
                    
                    Aggregate
      Intrinsic ValueOutstanding
      at January 1, 2008
                    
                    
                    894,323
                    
                    
                    $
                    2.62Options
      granted
                    
                    
                    919,253
                    
                    
                    
                    0.89Options
      exercised
                    
                    
                    —Options
      forfeited
                    
                    
                    (205,903
                    )
                    
                    
                    2.29Options
      cancelled
                    
                    
                    —Outstanding
      at September 30, 2008
                    
                    
                    1,607,673
                    
                    
                    $
                    1.63
                    
                    
                    
                    6.67
                    
                    
                    $
                    —Vested
      or expected to vest at September 30, 2008 (1)
                    
                    
                    1,569,232
                    
                    
                    $
                    1.55
                    
                    
                    
                    6.67
                    
                    
                    $
                    —Exercisable
      at September 30, 2008
                    
                    
                    1,127,170
                    
                    
                    $
                    1.76
                    
                    
                    
                    6.91
                    
                    
                    $
                    —





Options
      Outstanding
                      
                      
                      Options
      ExercisableNumber
      Outstanding
                      
                      
                      Weighted
      Average Remaining Contractual Life (In Years)
                      
                      
                      Weighted
      Average Exercise Price
                      
                      
                      Number
      Exercisable
                      
                      
                      Weighted
      Average Exercisable Price$
                      0.81
      - $1.51
                      
                      
                      
                      1,140,130
                      
                      
                      
                      8.09
                      
                      
                      $
                      1.00
                      
                      
                      
                      763,017
                      
                      
                      $
                      1.08$
                      2.60
      - $2.70
                      
                      
                      
                      430,343
                      
                      
                      
                      3.23
                      
                      
                      
                      2.61
                      
                      
                      
                      333,153
                      
                      
                      
                      2.60$
                      3.50
      - $5.80
                      
                      
                      
                      8,000
                      
                      
                      
                      3.81
                      
                      
                      
                      5.51
                      
                      
                      
                      8,000
                      
                      
                      
                      5.51$
                      6.60
      - $22.50
                      
                      
                      
                      29,200
                      
                      
                      
                      2.82
                      
                      
                      
                      10.91
                      
                      
                      
                      23,000
                      
                      
                      
                      10.821,607,673
                      
                      
                      
                      6.67
                      
                      
                      $
                      1.63
                      
                      
                      
                      1,127,170
                      
                      
                      $
                      1.76





(1) The
expected to vest options are the result of applying the pre-vesting forfeiture
rate assumptions to total unvested options.





The
aggregate intrinsic value in the table above represents the difference between
the exercise price of the underlying options and the quoted price of the
Company’s common stock.  There were no options in-the-money at
September 30, 2008.   The Company’s closing stock price was $0.54
as of September 30, 2008. The Company issues new shares of common stock upon
exercise of stock options.


13




Note
10:  Shareholders’ Equity





Preferred
Stock





The
Company has designated but not issued 3,198 shares of the Company’s Preferred
Stock at a stated value of $1,000 per share.  The Preferred Stock is
entitled to cumulative dividends which accrue at a rate of 8% per annum, payable
on December 21, 2008.  Each share of the Preferred Stock has voting
rights equal to (1)  in any case in which the Preferred Stock votes
together with the Company's Common Stock or any other class or series of stock
of the Company, the number of shares of Common Stock issuable upon conversion of
such shares of Preferred Stock at such time (determined without regard to the
shares of Common Stock so issuable upon such conversion in respect of accrued
and unpaid dividends on such share of Preferred Stock) and (2) in any case not
covered by the immediately preceding clause one vote per share of Preferred
Stock.  The Preferred Stock, if issued, has a mandatory redemption at
December 21, 2008.





Common
Stock





On
January 30, 2008, the Company amended and restated its Loan and Security
Agreement (“Amended Loan Agreement”) with Moriah.   As part of the
amended agreement, the Loan Conversion agreement was terminated which eliminated
the optional conversion of principal up to $2.0 million into common stock at
$1.50.  In connection with the Amended Loan agreement, the Company
issued a Warrant to purchase 750,000 shares of its common stock at a price of
$1.50 per share with an expiration date of January 29, 2013.





Effective March 25, 2008, the Company
amended the Warrant Issuance Agreement (“Amended Warrant Agreement”) with
Moriah. In connection with such amendment, the Company issued a Warrant to
purchase an additional 250,000 shares of its common stock at a price of $1.50
expiring March 25, 2013.





On April
2, 2008, the Company entered into a Securities Purchase Agreement (“Purchase
Agreement”), pursuant to which the Company sold and issued 1,586,539 shares of
common stock, par value of $0.001 per share, at a price of $1.04 per share and
warrants to purchase an additional 793,273 shares of common stock for an
aggregate purchase price of approximately $1.65 million.  The net
proceeds received after expenses were approximately $1.58
million.  The warrants are exercisable at a price of $1.30 per share
and expire on April 2, 2013.





As a
result of the Purchase Agreement, the outstanding 650,000 Series F Common Stock
Purchase Warrants that were issued to participants of the Securities Purchase
Agreement dated October 25, 2004, were repriced from $4.09 to
$3.45.





A
registration rights agreement was entered into on April 2, 2008 in connection
with the private placement which required the Company to file a registration
statement for the resale of the common stock and the shares underlying the
warrants within 45 days of the signing of the agreement.  The Company
must use its best efforts to have the registration statement declared effective
within 90 days of the signing of the agreement or if a SEC review occurs, 120
days.  In addition, the Company must use its best efforts to maintain
the effectiveness of the registration statement until all common stock has been
sold or may be sold without volume restrictions pursuant to Rule 144(k) of the
Securities Act.





If the
registration statement is not effective within the grace periods (“Event Date”)
or the Company cannot maintain its effectiveness (“Event Date”), the Company
must pay partial liquidated damages (“damages”) in cash to each investor equal
to 2% of the aggregate purchase price paid by each investor under the Purchase
Agreement on the Event Date and each monthly anniversary of the Event Date (or
on a pro-rata basis for any portion of a month) until the registration statement
is effective.  The Company is not liable for any damages with respect
to the warrants or warrant shares.  The maximum damages payable to
each investor is 36% of the aggregate purchase price.  If the Company
fails to pay the damages to the investors within 7 days after the date payable,
the Company must pay interest at a rate of 15% per annum to each investor which
accrues daily from the date payable until damages are paid in full.





The
Company filed the registration statement within the 45 day period however the
Company was notified that the registration statement was under review by the
SEC.  The amended registration statement was not filed by August 2,
2008 which was the 120th day from the signing of the purchase agreement and
therefore the registration statement is not effective. As of September 30, 2008,
the registration statement is not effective.





The
Company accounted for the registration payment arrangement under the guidance of
EITF 00-19-2, “Accounting for Registration Payment Arrangements”, (“EITF
00-19-2”) which requires the contingent obligation to make future payments be
recognized and measured in accordance with FASB Statement No. 5, “Accounting for
Contingencies”, (“Statement 5”) and FASB Interpretation No. 14, “Reasonable
Estimation of the Amount of a Loss”, (“Interpretation 14”). The Company
estimated $399 thousand to be the maximum potential damages that the Company may
be required to pay the investors if the registration statement is not effective
within three years of the signing of the agreement. The Company estimated $126
thousand to be a reasonable estimate of the potential damages that may be due to
the investors.  As a result, the Company recorded a liability of $126
thousand in the condensed consolidated balance sheets and the associated expense
in other income (expense) in the condensed consolidated statements of operations
of approximately $60 thousand and $126 thousand for the three and nine months
ended September 30, 2008, respectively.




14





On August
20, 2008, the Company and Moriah Capital entered into Amendment No. 3 to the
Loan and Security Agreement (“Amendment No. 3”) effective August 7, 2008. The
Company issued Moriah a warrant, which terminates on August 7, 2013, to purchase
up to 370,000 shares of the Company’s common stock at an exercise price of $1.30
per share.





In
addition, the Company and Moriah entered into an Amended and Restated
Securities Issuance agreement (the “Amended and Restated Securities Issuance
Agreement”) on August 20, 2008. On August 7, 2007, in connection with the
Securities Issuance Agreement, (the “Original Securities Issuance Agreement”),
the Company issued Moriah 162,500 shares of the Company’s common stock (the
“2007 Shares”). With respect to the Amended and Restated Securities
Issuance Agreement, Moriah agreed to waive the Company’s obligation to buy
back the 2007 Shares with respect to 125,000 of such shares and to defer the
Company’s obligation to buy back 37,500 of such 2007
Shares  (collectively, the “Put Waiver”). The Company issued Moriah
485,000 shares of its Common Stock (of which 125,000 shares were issued in
consideration for the Put Waiver from Moriah and 360,000 shares were
issued in lieu of the issuance to Moriah of the Contingent Issued Shares
(as described in the Original Securities Issuance Agreement)). Additionally, the
Company has granted Moriah a put option pursuant to which Moriah can sell to the
Company 162,500 shares of its common stock for $195,000, pro-rated for any
portion thereof (the “2007 Put Price”) and a second put option pursuant to which
Moriah can sell 360,000 of the shares issued to Moriah to the Company for
$234,000 (the “2008 Put Option”).  The 2007 and 2008 Put Option shall
automatically be deemed exercised by Moriah unless Moriah delivers written
notice to the Company at any time between July 1, 2009 and August 1, 2009 that
Moriah does not wish to exercise the 2008 Put option in whole or in part.




The shares
underlying the put options are presented as redeemable common stock
and presented separately from permanent equity. As of September 30,
2008, an aggregate  of 522,500 shares related to the 2007 and 2008 put
options are presented on the balance sheet as redeemable common stock in
the amount of $429,000, representing the amount for which the shares may be
redeemed at the option of the holders at such date.




We
have restated the December 31, 2007 balance sheet with respect to 162,500
shares of common stock underlying the 2007 put option, in the amount of
$195,000, representing the amount for which the shares may be redeemed at the
option of the holders at such date. Such shares, which were previously reported
as permanent equity, (“capital deficit”) are presented as redeemable common
stock on the accompanying balance sheet.




The
Company and Moriah entered into an Amendment to Registration Rights Agreement
(the “Amended Registration Rights Agreement”) and the Company agreed to use its
best efforts to file a registration statement to register the 485,000
shares of the Company’s common stock issued and the shares of common stock
issuable upon exercise of the Warrant.




On August
19, 2008, the Holders of the Amended Notes and the Investors in
the Purchase Agreement consented to the Company’s execution of the Amended
Note, Amendment No. 3, Amended and Restated Securities Issuance Agreement, and
the Amended Registration Rights Agreement.  In consideration for the
consent, a total of 144,000 shares of common stock were issued to the Holders
and Investors based on individual participation in the Amended Notes and
Purchase Agreement on September 4, 2008.




For the
three and nine months ended September 30, 2008 and 2007, there were no stock
options exercised.  For the three and nine months ended September 30,
2008, there were no warrants exercised and for the three months ended September
30, 2007, there were no warrants exercised and for the nine months ended
September 30, 2007, the Company received approximately $3 thousand in proceeds
for warrants exercised.




For the
three and nine months ended September 30, 2008, the Company issued approximately
629,000 and 811,000 shares of common stock, respectively, for payment of
approximately $441 thousand  and $643 thousand, respectively, for
services rendered or to be rendered in the future.  For the three and
nine months ended September 30, 2007, the Company issued approximately 163
thousand and 1.1 million shares of common stock, respectively, for payment of
approximately $195 thousand and $953 thousand, respectively, for services
rendered and to be rendered in the future.  As such, the Company
recorded the fair value of the services to be rendered in prepaid expenses and
rendered in selling, general and administrative expenses in the accompanying
unaudited condensed consolidated statement of operations for the three and nine
months ended September 30, 2008 and 2007, respectively.




Note
11:  Income Taxes




The
Company adopted the provisions of Financial Standards Accounting Board
Interpretation No. 48 Accounting for Uncertainty in Income Taxes (“FIN 48”) an
interpretation of FASB Statement No. 109 (“SFAS 109”) on January 1, 2007. As a
result of the implementation of FIN 48, we did not recognize any adjustment in
the liability for unrecognized income tax benefits. The tax years 2004-2007
remain open to examination by the major taxing jurisdictions to which we are
subject. In the event that the Company is assessed interest or penalties at some
point in the future, they will be classified in the financial statements as
general and administrative expense.  The Company has not provided for
income taxes in the three and nine months ended September 30, 2008 as the
Company expects its effective tax rate to be zero due to continuing
losses.




15




Note
12:  Commitments and Contingencies





Royalty
Payments





The Company, in accordance with
a royalty agreement with Eastman Kodak, must pay to Eastman Kodak a
certain percentage of net sales with respect to certain
products, which percentages are defined in the agreement. The percentages
are on a sliding scale depending on the amount of sales generated. Any
minimum royalties paid will be credited against the amounts due based on
the percentage of sales. The royalty agreement terminates upon the
expiration of the issued patent which is the last to expire.





Effective
May 30, 2007, Kodak and eMagin entered into an intellectual property agreement
where eMagin has assigned Kodak the rights, title, and interest to a Company
owned patent currently not being used by the Company and in consideration, Kodak
waived the royalties due under the existing licensing agreements for the first
six months of 2007, and reduced the royalty payments by 50% for the second half
of 2007 and for the entire calendar year of 2008. In addition, the minimum
royalty payment is delayed until December 1st for the
years 2007 and 2008.  The Company recorded approximately $142 thousand
and $396 thousand for the three and nine months ended September 30, 2008,
respectively, and approximately $163 thousand and $723 thousand for the three
and nine months ended September 30, 2007 as income from the license of
intangible assets and included this amount as other income in the condensed
consolidated statements of operations.  The income from the license of
intangible assets is equivalent to the royalty payments that have been waived by
Kodak.





Royalty
expense (including amounts imputed – see above) was approximately $284 thousand
and $792 thousand, respectively, for the three and nine months ended
September 30, 2008 and approximately $327 thousand and $887 thousand,
respectively, for the three and nine months ended September 30,
2007.





Contractual
Obligations





The Company leases
office facilities and office, lab and factory equipment under operating leases
expiring through 2009.  Certain leases provide for payments of monthly
operating expenses. The Company currently has lease commitments for space in
Hopewell Junction, New York and Bellevue, Washington.  Rent expense
was approximately $332 thousand and $996 thousand, respectively, for the three
and nine months ended September 30, 2008 and 2007.





Note
13:  Legal Proceedings





A former
employee (“plaintiff”) of the Company commenced legal action in the United
States District Court for the Southern District of New York, on or about October
12, 2007, alleging that the plaintiff was subject to gender based discrimination
and retaliation in violation of Title VII of the Civil Rights Act of 1964 (Case
No. 07-CV-8827 (KMK)). The plaintiff seeks unspecified compensatory damages,
punitive damages and attorneys’ fees.  On November 26, 2007, the
Company served and filed its Answer, in which it denied the material allegations
of the Complaint and asserted numerous affirmative defenses.  This
action is presently in the discovery stage.  The Company disputes the
allegations of the Complaint and intends on vigorously defending this
action.


16


Item 2. Management’s Discussion and Analysis of
Financial Condition and Results of Operations





Statement
of Forward-Looking Information





In this
quarterly report, references to "eMagin Corporation," "eMagin," "Virtual
Vision," "the Company," "we," "us," and "our" refer to eMagin Corporation and
its wholly owned subsidiary, Virtual Vision, Inc. Except
for the historical information contained herein, some of the statements in this
Report contain forward-looking statements that involve risks and
uncertainties.  These statements are found in the sections entitled
"Management's Discussion and Analysis or Plan of Operations" and "Risk
Factors."  They include statements concerning: our business strategy;
expectations of market and customer response; liquidity and capital
expenditures; future sources of revenues; expansion of our proposed product
line; and trends in industry activity generally.  In some cases, you
can identify forward-looking statements by words such as "may," "will,"
"should," "expect," "plan," "could," "anticipate," "intend," "believe,"
"estimate," "predict," "potential," "goal," or "continue" or similar
terminology.  These statements are only predictions and involve known
and unknown risks, uncertainties and other factors, including, but not limited
to, the risks outlined under "Risk Factors," that may cause our or our
industry's actual results, levels of activity, performance or achievements to be
materially different from any future results, levels of activity, performance or
achievements expressed or implied by such forward-looking
statements.  For example, assumptions that could cause actual results
to vary materially from future results include, but are not limited to: our
ability to successfully develop and market our products to customers; our
ability to generate customer demand for our products in our target markets; the
development of our target markets and market opportunities; our ability to
manufacture suitable products at competitive cost; market pricing for our
products and for competing products; the extent of increasing competition;
technological developments in our target markets and the development of
alternate, competing technologies in them; and sales of shares by existing
shareholders.  Although we believe that the expectations reflected in
the forward looking statements are reasonable, we cannot guarantee future
results, levels of activity, performance or achievements.  Unless we
are required to do so under federal securities laws or other applicable laws, we
do not intend to update or revise any forward-looking statements.





Overview





We design, develop, manufacture, and
market virtual imaging products which utilize OLEDs, or organic light emitting
diodes, OLED-on-silicon microdisplays and related information technology
solutions.  We integrate OLED technology with silicon chips to produce
high-resolution microdisplays smaller than one-inch diagonally which, when
viewed through a magnifier, create virtual images that appear comparable in size
to that of a computer monitor or a large-screen television.  Our
products enable our original equipment manufacturer, or OEM, customers to
develop and market improved or new electronic products.  We believe
that virtual imaging will become an important way for increasingly mobile people
to have quick access to high-resolution data, work, and experience new more
immersive forms of communications and entertainment.





Our first
commercial product, the SVGA+ (Super Video Graphics Array of 800x600 plus 52
added columns of data) OLED microdisplay, was initially offered for sampling in
2001, and our first SVGA-3D (Super Video Graphics Array plus built-in
stereovision capability) OLED microdisplay was shipped in early
2002.  We are in the process of completing development of 2 additional
OLED microdisplays, namely the SVGA 3DS (SVGA 3D shrink, a smaller format SVGA
display with a new cell architecture with embedded features) and an SXGA (1280 x
1024).





We
license our core OLED technology from Eastman Kodak and we have developed our
own technology to create high performance OLED-on-silicon microdisplays and
related optical systems.  We believe our technology licensing
agreement with Eastman Kodak, coupled with our own intellectual property
portfolio, gives us a leadership position in OLED and OLED-on-silicon
microdisplay technology.  We believe we are the only company to sell
full-color active matrix small molecule OLED-on-silicon
microdisplays.





Company
History





Historically,
we have been a developmental stage company. As of January 1, 2003, we were no
longer classified as a development stage company. We have transitioned to
manufacturing our product and intend to significantly increase our marketing,
sales, and research and development efforts, and expand our operating
infrastructure. Currently, most of our operating expenses are fixed. If we are
unable to generate significant revenues, our net losses in any given period
could be greater than expected.




17





CRITICAL
ACCOUNTING POLICIES





The
Securities and
Exchange Commission ("SEC") defines "critical accounting
policies" as those that require application of management's most
difficult, subjective or complex judgments, often as a result of the need to
make estimates about the effect of matters that
are inherently uncertain and may change in subsequent periods.
Not all of the accounting policies require
management to make difficult, subjective or complex judgments or
estimates.  However, the following policies could be deemed to be
critical within the SEC definition.





Revenue
Recognition





Revenue
is recognized when products are shipped to customers, net of allowances for
anticipated returns.  The Company’s revenue-earning
activities generally involve delivering products.
Revenue is recognized when persuasive evidence of
an arrangement exists, delivery has occurred, selling price is
fixed or determinable and collection is reasonably assured.





The
Company also earns revenues from certain R&D activities under
both firm fixed-price contracts and cost-type
contracts, including some cost-plus-fee contracts. 
Revenues on firm fixed-price contracts are recognized as costs
are incurred (cost-to-cost basis).  Revenues on
cost-plus-fee contracts include costs incurred plus a portion of
estimated fees or profits based on the relationship of costs incurred to total
estimated costs. Contract costs include all direct material and labor costs
and an allocation of allowable indirect costs as defined by each
contract, as periodically adjusted to reflect revised agreed upon
rates. These rates are subject to audit by the other party.





Use
of Estimates





In
accordance with accounting principles generally accepted in the United States of
America, management utilizes certain estimates and assumptions that affect the
reported amounts of assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. On an on-going basis, management evaluates its estimates and
judgments. Management bases its estimates and judgments on historical experience
and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results could differ from those estimates.





Fair
Value of Financial Instruments





The
Company's cash, cash equivalents, accounts receivable, short-term investments,
accounts payable and debt are shown at cost which approximates fair value due to
the short-term nature of these instruments.





Stock-based
Compensation





We
maintain several stock incentive plans.  The 2005 Employee Stock
Purchase Plan provides our employees with the opportunity to purchase common
stock through payroll deductions. Employees purchase stock semi-annually at a
price that is 85% of the fair market value at certain plan-defined dates. As of
September 30, 2008, the plan had not been implemented.





The 2003
Stock Option Plan (the”2003 Plan”) provides for grants of shares of common stock
and options to purchase shares of common stock to employees, officers, directors
and consultants.   Under the 2003 Plan, an ISO grant is granted
at the market value of our common stock at the date of the grant and a non-ISO
is granted at a price not to be less than 85% of the market value of the common
stock.  These options have a term of up to 10 years and vest over a
schedule determined by the Board of Directors, generally over a five year
period.  The amended 2003 Plan provides for an annual increase of 3%
of the diluted shares outstanding on January 1 of each year for a period of 9
years which commenced January 1, 2005.





The Board
of Directors authorized the establishment of the 2008 Incentive Stock Plan with
2,000,000 options available for grant.  The 2008 Incentive Stock Plan
is intended to provide long-term performance incentives to directors,
executives, selected employees and consultants and reward them for making major
contributions to the success and well being of the Company.  As of
September 30, 2008, no options have been issued from this plan.




18





The
Company accounts for its stock based compensation in accordance with the
provisions of SFAS No. 123R, “Share-Based Payment”, which requires the Company
to recognize expense related to the fair value of the Company’s share-based
compensation issued to employees and directors. SFAS 123R requires companies to
estimate the fair value of share-based payment awards on the date of grant using
an option-pricing model. The value of the portion of the award that is
ultimately expected to vest is recognized as expense over the requisite service
periods in the Company’s condensed consolidated statement of operations. The
Company uses the straight-line method for recognizing compensation expense. An
estimate for forfeitures is included in compensation expense for awards under
SFAS 123R.  See Note 9 to the Condensed Consolidated Financial
Statements for a further discussion on stock-based compensation.





NEW
ACCOUNTING PRONOUNCEMENTS





See Note
2 of the Condensed Consolidated Financial Statements in Item 1 for a description
of recent accounting pronouncements, including the expected dates of adoption
and estimated effects on results of operations and financial
condition.





RESULTS
OF OPERATIONS





THREE
MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2008 COMPARED TO THREE MONTHS AND
NINE MONTHS ENDED SEPTEMBER 30, 2007





Revenues




Revenues
for the three and nine months ended September 30, 2008 were approximately
$5.2 million and $13.5 million, respectively, as compared to approximately $5.1
million and $12.9 million for the three and nine months ended September 30,
2007, respectively, an increase of approximately 2% and 5%,
respectively.  There was relatively no change in revenues for the
three month period as compared to the same period of the prior
year.  The higher revenues of $0.6 million for the nine month period
as compared to the same period in the prior year was due to an increase in the
contract revenues of $1.4 million as a result of additional contracts the
Company has obtained offset by a slight decrease in product revenue of $0.8
million.  The decrease in the product revenue was due to
a production issue the Company experienced in the first quarter of 2008
which resulted in a shortage of displays.  The Company has rectified
the production issue and has seen improvement in its production volume and
yield.





Cost
of Goods Sold





Cost of
goods sold includes direct and indirect costs associated with
production.  Cost of goods sold for the three and nine months ended
September 30, 2008 were approximately $2.8 million and $8.1 million,
respectively, as compared to approximately $3.1 million and $9.1 million,
respectively, for the three and nine months ended September 30,
2007.  For the three and nine month periods as compared to the same
periods of the prior year there was a decrease of approximately $0.3 million and
$1.0 million, respectively. The gross margin for the three and nine months
ended September 30, 2008 was approximately $2.4 million and $5.4 million,
respectively, as compared to approximately $2.0 million and $3.8 million,
respectively, for the three and nine months ended September 30, 2007. As a
percentage of revenue this translates to a gross margin for the three and nine
months ended September 30, 2008 of 46% and 40%, respectively, as compared to 40%
and 29%, respectively, for the three and nine months ended September 30,
2007.  The increase in the gross margin was attributed to fuller
utilization of our fixed production overhead due to higher unit production
volume, improved yields, and a decrease in the third party rebillable R&D
costs.





Operating
Expenses





Research and
Development.  Research and development expenses include salaries,
development materials and other costs specifically allocated to the development
of new microdisplay products, OLED materials and subsystems.  Research
and development expenses for the three and nine months ended September
30, 2008 were approximately $0.3 million and $1.6 million, respectively, as
compared to $0.6 million and $2.3 million for the three and nine months
ended September 30, 2007, a decrease of approximately $0.3 million and $0.7
million, respectively.  The decrease was due to the re-deployment of
research and development personnel to production contract services which are
included in cost of goods sold.





Selling, General and
Administrative.  Selling, general and administrative
expenses consist principally of salaries, fees for professional services
including legal fees, as well as other marketing and administrative
expenses.  Selling, general and administrative expenses for the three
and nine months ended September 30, 2008 were approximately $1.3 million and
$4.8 million, respectively, as compared to approximately $1.4 million and
$5.2 million for the three and nine months ended September 30, 2007, a decrease
of $0.1 million and $0.4 million, respectively. The decrease of approximately
$0.1 million for the three months ended September 30, 2008 was primarily related
to a decrease in professional services offset by an increase in the reserve for
allowance for bad debts.  The decrease of approximately $0.4 million
for the nine months ended September 30, 2008 was primarily related to decreases
in personnel costs and professional services offset by an increase in reserve
for allowance for bad debts.




19





Other Income (Expense), net.
Other income (expense), net consists primarily of interest income earned on
investments, interest expense related to the secured debt, gain from the change
in the derivative liability, and income from the licensing of intangible
assets.





For the
three and nine months ended September 30, 2008, interest income was
approximately $2 thousand and $6 thousand as compared to approximately $9
thousand and $32 thousand for the three and nine months ended September 30,
2007.   The decrease in interest income was primarily a result of
lower interest rates on investments.





For the
three and nine months ended September 30, 2008, interest expense was
approximately $0.5 million and $1.7 million, respectively, as compared to
approximately $0.6 million and $2.8 million, respectively, for the three and
nine months ended September 30, 2007.   The breakdown of the
interest expense for the three and nine month period in 2008 is as
follows:  interest expense associated with debt of approximately $178
thousand and $501 thousand, respectively; the amortization of the deferred costs
and waiver fees associated with the debt of approximately $331 thousand and $1.2
million, respectively; and the amortization of the debt discount associated with
the debt of approximately $0 and $25 thousand, respectively.  The
breakdown of the interest expense for the three and nine month period in 2007 is
as follows:  interest expense associated with debt of approximately
$195 and $652 thousand, respectively; the amortization of the deferred costs
associated with the notes payable of approximately $0 and $265 thousand,
respectively; and the amortization of the debt discount of approximately $397
thousand and $1.96 million, respectively.





The gain
from the change in the derivative liability was $0 for the three and nine months
ended September 30, 2008 as compared to approximately $1.5 million and $0.9
million, respectively, for the three and nine months ended September 30, 2007
related to an extinguishment of debt.





Other
income, net (excluding interest income), for the three and nine months ended
September 30, 2008 was approximately $82 thousand and $288 thousand,
respectively,  as compared to approximately $172 thousand and $762
thousand, respectively, for the three and nine months ended September 30,
2007.  Other income, net (excluding interest income)  for
the three and nine months ended September 30, 2008 consists of approximately $18
thousand of income from equipment salvage; approximately $142 thousand and $396
thousand, respectively, of  income from the licensing of intangible
assets; and is offset by approximately $60 thousand and $126 thousand,
respectively, of expense from registration payment arrangements.  See
Note 12:  Commitments and Contingencies – Royalty Payments for
additional information on the income from licensing of intangible
assets.





Liquidity
and Capital Resources





As of
September 30, 2008, we had approximately $1.4 million of cash and investments as
compared to $0.8 million as of December 31, 2007.  The change in cash
and investments was primarily due to cash provided by financing activities of
$2.7 million offset by cash used for operating activities and investing
activities of $2.1 million.





Cash flow
used in operating activities during the nine months ended September 30, 2008 was
approximately $1.9 million primarily attributable to our net loss of
approximately $2.4 million and an increase in accounts receivable of $1.9
million offset by non-cash expenses of $2.5 million. During the nine months
ended September 30, 2007, operating activities used cash of approximately $1.7
million attributable to our net loss of approximately $17.3 million and
primarily offset by non-cash expenses of $16.1 million.





Cash used
in investing activities during the nine months ended September 30, 2008 was
approximately $236 thousand used for equipment purchases.  During the
nine months ended September 30, 2007, the net cash provided by investing
activities was approximately $24 thousand.   There was
approximately $33 thousand provided from maturing investments offset by
approximately $9 thousand used for equipment purchase.





Cash
provided by financing activities during the nine months ended September 30, 2008
was approximately $2.7 million and was comprised of approximately $1.6 million
from the sale of common stock, approximately $1.8 million from the line of
credit, net of debt financing costs and offset by payments on debt of
approximately $0.7 million.  The cash provided by financing activities
during the nine months ended September 30, 2007 was approximately $1.0 million
and was comprised of proceeds from exercise of warrants of $3 thousand, proceeds
from debt of approximately $1.1 million, net of debt financing costs and offset
by payments against debt of approximately $48 thousand.




20





Our
condensed consolidated financial statements as of September 30, 2008 have been
prepared under the assumption that we will continue as a going concern. Our
independent registered public accounting firm had issued a report dated April 9,
2008 that included an explanatory paragraph expressing substantial doubt in our
ability to continue as a going concern. Our ability to continue as a going
concern. Our ability to generate a profit which is likely dependent
upon our ability to obtain additional equity or debt financing, attain
further operating efficiencies and, ultimately, to achieve profitable
operations. The financial statements do not include any adjustments that might
result from the outcome of this uncertainty.





We
anticipate our business will experience revenue growth during the year ending
December 31, 2008. This trend may result in higher accounts receivable levels
and may require increased production and/or higher inventory levels.  
In addition, in December 2008, we will be obligated to repay approximately $6.0
million to the note holders.  If the funds are not available, we will
negotiate with the note holders to defer the payment but no assurances can be
made that they will agree to this. We anticipate that our cash requirements to
fund these requirements as well as other operating or investing cash
requirements over the next twelve months will be greater than our current cash
on hand.  We anticipate that we will still require additional funds
over the next twelve months.  We do not currently have commitments for
these funds and no assurance can be given that additional financing will be
available, or if available, will be on acceptable terms.





The
Company’s ability to obtain additional funding is impacted by its present
indebtedness.  The Company’s notes payable have covenants which the
Company currently is in compliance with and the covenants contain certain
restrictive components that materially limit our ability to raise additional
secured debt which is presently limited to a maximum of $3.0 million. The
Company has a line of credit with a maximum of $3.0 million which is secured by
accounts receivable and inventory which effectively eliminates any additional
secured indebtedness under the note covenants.   In addition, pursuant to
the notes payable agreement, the Company cannot enter into a consolidation,
merger, or acquisition under certain conditions without consent of the note
holders.  The Company may raise additional unsecured debt under the
note covenants given certain restrictions.  In addition, the notes
payable allow for additional equity financing.





If we are
unable to obtain sufficient funds during the next twelve months, we may further
reduce the size of our organization and may be forced to reduce and/or curtail
our production and operations, all of which could have a material adverse impact
on our business prospects. The Company is continually reviewing its cost
structures for cost efficiencies and is taking measures to reduce non-production
costs.





In 2007,
we retained CIBC World Markets Corporation and Larkspur Capital Corporation to
assist us in investigating and evaluating various strategic alternatives,
ranging from investment to acquisition.




Off-Balance Sheet
Arrangements





We do not
have any off balance sheet arrangements that are reasonably likely to have a
current or future effect on our financial condition, revenues, results of
operations, liquidity or capital expenditures.





ITEM
3.  Quantitative and Qualitative Disclosures About Market
Risk





Not
Applicable.





ITEM
4T.  Controls and Procedures





(a)  Evaluation of Disclosure Controls
and Procedures. Based on an evaluation of our disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the
Securities Exchange Act of 1934, as amended) required by paragraph (b) of
Rule 13a-15 or Rule 15d-15, as of the end of the period covered by
this Report, our Chief Executive Officer and Chief Financial Officer have
concluded that our disclosure controls and procedures were not effective in
ensuring that information required to be disclosed by us in the reports that we
file or submit under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in the Commission’s rules and
forms. Our Chief Executive Officer and Chief Financial Officer also concluded
that, as of the end of the period covered by this Report, there were material
weaknesses in both the design and effectiveness of our internal control over
financial reporting.  Management has assessed these deficiencies and
has determined that there were four general categories of material weaknesses in
eMagin’s internal control over financial reporting.  As a result of
our assessment that material weaknesses in our internal control over financial
reporting existed as of September 30, 2008, management has concluded that our
internal control over financial reporting was not effective as of September 30,
2008.  A material weakness is a deficiency, or a combination of
deficiencies, in internal control over financial reporting such that there is a
reasonable possibility that a material misstatement of our annual or interim
financial statements will not be prevented or detected on a timely
basis.




21





In
management’s opinion, our assessment as of September 30, 2008 regarding the
existence of material weaknesses in our internal control over financial
reporting relates to (1) the absence of adequate staffing, proper role
descriptions, inadequate training and excessive employee turnover, (2) the lack
of controls or ineffectively designed controls, (3) the failure in design and
operating effectiveness of information technology controls over financial
reporting, and (4) failures in operating control effectiveness identified during
the testing of the internal control over financial
reporting.  Management and our audit committee have assigned a high
priority to the short-term and long-term improvement of our internal control
over financial reporting.





The
material weaknesses we have identified include:





Deficiencies pertaining to a lack of
human resources within our finance and accounting
functions.  During the latter part of 2007 we experienced
significant turnover of personnel in our finance and accounting department,
including the positions of Chief Financial Officer and Staff
Accountant.  The reduced staffing resulted in instances of altered
responsibilities and improper role definition leading to lapses in proper
segregation of duties.  The lack of appropriately skilled personnel
and less effective monitoring activities related to employee turnover could
result in material misstatements to financial statements not being detected in a
timely manner.





Deficiencies pertaining to the lack
of controls or ineffectively designed controls.  Our control
design analysis and process walk-throughs disclosed a number of instances where
review approvals were undocumented, where established policies and procedures
were not defined, and controls were not in place.





Deficiencies related to information
technology control design and operating effectiveness
weaknesses.  This material weakness resulted from the absence
of key formalized information technology policies and procedures and could
result in (1) unauthorized system access, (2) application changes being
implemented without adequate reliability testing, (3) inconsistent investigation
of system errors and the absence of timely or properly considered remedial
actions, and (4) over reliance on spreadsheet applications without quality
control assurances.  These factors could lead to material errors and
misstatements to financial statements occurring without timely
detection.





Deficiencies related to failures in
operating effectiveness of the internal control over financial
reporting.  Certain internal control procedures were developed
during the latter part of 2007.  When testing occurred to confirm the
effectiveness of the internal control over financial reporting, controls were
not operating effectively.





(b)  Changes in Internal
Controls.  During the quarter ended September 30, 2008, there
were no changes in our internal control over financial reporting identified in
connection with the evaluation required by paragraph (d) of Rule 13a-15 or Rule
15d-15 that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.





22


PART
II - OTHER INFORMATION





ITEM
1.  Legal Proceedings




Other
than the legal proceeding pending against the Company as described in the
Company’s Annual Report on Form 10-K for the year ended December 31, 2007,
through September 30, 2008, the Company is not a party to any legal proceedings
and there have been no material developments in any legal proceedings reported
in such Annual Report.





ITEM
1A.  Risk Factors





In
addition to other information set forth in this Report, you should carefully
consider the risk factors previously disclosed in “Item 1A to Part 1” of our
Annual Report on Form 10-KSB for the year ended December 31,
2007.  There were no material changes from the risk factors during the
three and nine months ended September 30, 2008.





ITEM
2.  Unregistered Sales of Equity Securities and Use of
Proceeds.





On August
26, 2008, the Company and Moriah Capital, L.P. (“Moriah”) entered into Amendment
No. 3 to the Loan and Security Agreement dated as of August 20, 2008 (the
“Amendment No. 3”). Pursuant to Amendment No. 3, the Company issued Moriah
a warrant, which terminates on August 7, 2013, to purchase up to 370,000 shares
of the Company’s common stock at an exercise price of $1.30 per
share.





Pursuant
to Amendment No. 3, the Company and Moriah entered into an Amended and
Restated Securities Issuance agreement (the “Amended and Restated Securities
Issuance Agreement”).  Pursuant to the Amended and Restated Securities
Agreement, the Company is issued Moriah 485,000 shares of its Common
Stock.




On August
19, 2008, the Holders of the Amended Notes and the Investors in
the Purchase Agreement consented to the Company’s execution of the Amended
Note, Amendment No. 3, Amended and Restated Securities Issuance Agreement, and
the Amended Registration Rights Agreement.  In consideration for the
consent, a total of 144,000 shares of common stock were issued to the Holders
and Investors based on individual participation in the Amended Notes and
Securities Purchase Agreement on September 4, 2008.





We claim
an exemption from the registration requirements of the Securities  Act of
1933, amended (the "Act") for the private placement of the
above-referenced securities pursuant to Section 4(2) of the Act since,
among other things, these transactions did not involve a public offering and we
took appropriate measures to restrict the transfer of the
securities.





ITEM
3.  Defaults Upon Senior Securities





None.





ITEM
4.  Submission of Matters to a Vote of Security Holders





None.





ITEM
5.  Other Information





None.




23





ITEM
6.  Exhibits


EXHIBIT


NUMBER                                DESCRIPTION





4.1
              Form
      of Common Stock Purchase Warrant, dated August 7, 2008
  (2)





4.2
              Form
      of Amended and Restated Secured Revolving Loan Note, dated August 20, 2008
      (2)





10.1
              Amendment
      No. 3 to Loan and Security Agreement, dated as of August 20, 2008 to the
      Loan and Security Agreement dated August 7, 2007
  (2)





10.2
              Warrant
      Issuance Agreement No. 2, dated August 20, 2008
  (2)





10.3
              Amended
      and Restated Securities Issuance Agreement, dated as of August 20, 2008
      (2)





10.4
              Amendment,
      dated August 20, 2008, to Registration Rights Agreement, dated as of
      August 7, 2007 (2)31.1
              Certification
      by Chief Executive Officer pursuant to Sarbanes Oxley Section 302 (1)31.2
              Certification
      by Chief Financial Officer pursuant to Sarbanes Oxley Section 302 (1)32.1
              Certification
      by Chief Executive Officer pursuant to 18 U.S.C. Section 1350 (1)32.2
              Certification
      by Chief Financial Officer pursuant to 18 U.S.C. Section 1350 (1)


(1)
              Filed
      herewith.(2)
              Incorporated
      by reference to the Current Report on Form 8-K, as filed by the Company
      with the SEC on August 26,
2008.





24




SIGNATURES





Pursuant
to the requirements 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 13th day of
November 14, 2008.






eMAGIN
      CORPORATIONBy:
            /s/ Andrew
      G. SculleyAndrew
      G. SculleyChief Executive
      OfficerPrincipal Executive
      Officer




By:
                /s/ Paul
      CampbellPaul
      CampbellInterim Chief Financial
      OfficerPrincipal
      Accounting and Financial Officer














25