**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
                1934****For
                the quarterly period ended September 30, 2006****or**£
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934****For
                the transition period from
                to**





**Commission
      file number 001-15751**





**eMAGIN
      CORPORATION**


*(Exact
      name of registrant as specified in its charter* *)*





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





**10500
      NE 8** **th** **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 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, 2006 was
      10,180,841.

















**EXPLANATORY
      NOTE**





All
      common share amounts and per share amounts in the accompanying financial
      statements and in this Quarterly Report on Form 10-Q for the three and nine
      months ended September 30, 2006 reflect the one-for-ten reverse stock split
      of
      the issued and outstanding shares of common stock of the Company, effective
      on
      November 3, 2006 (See Notes 1 and 8 to the accompanying Condensed Consolidated
      Financial Statements). ****






2


**eMagin
      Corporation**


**Form
      10-Q**


**For
      the Quarter ended September 30, 2006**





**Table
      of Contents**


**Page****PART
                I FINANCIAL INFORMATION**Item
                1
            Condensed
                Consolidated Financial StatementsCondensed
                Consolidated Balance Sheets as of September 30, 2006 (unaudited)
                and
                December 31, 2005
            4Condensed
                Consolidated Statements of Operations for the Three and Nine Months
                ended
                September 30, 2006 and 2005 (unaudited)
            5Condensed
                Consolidated Statements of Changes in Shareholders’ Equity (Capital
                Deficit) for the Nine Months ended September 30, 2006 (unaudited)
            6Condensed
                Consolidated Statements of Cash Flows for the Nine Months ended September
                30, 2006 and 2005 (unaudited)
            7Notes
                to Condensed Consolidated Financial Statements (unaudited)
            8Item
                2
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            17Item
                3
            Quantitative
                and Qualitative Disclosures About Market Risk
            21Item
                4
            Controls
                and Procedures
            22**PART
                II OTHER INFORMATION**Item
                1
            Legal
                Proceedings
            23Item
                1A
            Risk
                Factors
            23Item
                2
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            29Item
                3
            Defaults
                Upon Senior Securities
            29Item
                4
            Submission
                of Matters to a Vote of Security Holders
            29Item
                5
            Other
                Information
            29Item
                6
            Exhibits
            29**SIGNATURES**
            30**CERTIFICATIONS**








3





**ITEM
      1. Condensed Consolidated Financial Statements**





**eMAGIN
      CORPORATION**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


**(In
      thousands, except share data)**





**September
                30,****2006**
              **(unaudited)**
            
            **December
                  31,****2005****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            1,407
            
            $
            6,727Investments
                - held to maturity
            
            
            124
            
            
            120Accounts
                receivable, net
            
            
            1,119
            
            
            762Inventory
            
            
            2,940
            
            
            3,839Prepaid
                expenses and other current assets
            
            
            1,053
            
            
            1,045Total
                current assets
            
            
            6,643
            
            
            12,493Equipment,
                furniture and leasehold improvements, net
            
            
            802
            
            
            1,299Intangible
                assets, net
            
            
            56
            
            
            57Other
                assets
            
            
            390
            
            
            233Deferred
                costs
            
            
            549
            
            
            —Total
                assets
            
            $
            8,440
            
            $
            14,082**LIABILITIES
                AND SHAREHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            272
            
            $
            562Accrued
                compensation
            
            
            791
            
            
            1,010Other
                accrued expenses
            
            
            1,361
            
            
            1,894Deferred
                revenue
            
            
            116
            
            
            96Current
                portion of capitalized lease obligations
            
            
            10
            
            
            16Current
                portion of debt
            
            
            2,963
            
            
            —Derivative
                liability- warrants
            
            
            2,107
            
            
            —Other
                current liabilities
            
            
            49
            
            
            47Total
                current liabilities
            
            
            7,669
            
            
            3,625Capitalized
                lease obligations
            
            
            —
            
            
            6Long-term
                debt
            
            
            1,311
            
            
            50Total
                liabilities
            
            
            8,980
            
            
            3,681Commitments
                and contingenciesShareholders’
                equity  (capital deficit) :Preferred
                stock, $.001 par value: authorized 10,000,000 shares; no shares issued
                and
                outstanding
            
            
            —
            
            
            —Common
                stock, $.001 par value: authorized 200,000,000 shares, issued and
                outstanding, 10,136,789 shares as of September 30, 2006 and 9,997,247
                shares as of December 31, 2005
            
            
            10
            
            
            10Additional
                paid-in capital
            
            
            178,701
            
            
            175,950Accumulated
                deficit
            
            
            (179,251
            )
            
            (165,559
            )Total
                shareholders’ equity (capital deficit)
            
            
            (540
            )
            
            10,401Total
                liabilities and shareholders’ equity (capital deficit)
            
            $
            8,440
            
            $
            14,082








See
      notes
      to Condensed Consolidated Financial Statements .


4


**eMAGIN
      CORPORATION**


**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


**(In
      thousands, except share data)**


**(unaudited)**





**Three
                Months Ended September 30,**
            
            **Nine
                Months Ended****September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Revenue:Product
                revenue
            
            $
            2,242
            
            $
            1,131
            
            $
            5,487
            
            $
            2,437Contract
                revenue
            
            
            50
            
            
            —
            
            
            120
            
            
            36Total
                revenue, net
            
            
            2,292
            
            
            1,131
            
            
            5,607
            
            
            2,473Cost
                of goods sold
            
            
            2,940
            
            
            2,686
            
            
            8,934
            
            
            7,031Gross
                loss
            
            
            (648
            )
            
            (1,555
            )
            
            (3,327
            )
            
            (4,558
            )Operating
                expenses:Research
                and development
            
            
            965
            
            
            1,022
            
            
            3,507
            
            
            3,038Selling,
                general and administrative
            
            
            1,838
            
            
            1,220
            
            
            6,674
            
            
            4,315Total
                operating expenses
            
            
            2,803
            
            
            2,242
            
            
            10,181
            
            
            7,353Loss
                from operations
            
            
            (3,451
            )
            
            (3,797
            )
            
            (13,508
            )
            
            (11,911
            )Other
                income (expense):Interest
                expense
            
            
            (354
            )
            
            (1
            )
            
            (354
            )
            
            (3
            )Gain
                on warrant derivative liability
            
            
            97
            
            
            —
            
            
            97
            
            
            —Other
                income, net
            
            
            14
            
            
            35
            
            
            73
            
            
            184Total
                other income (expense)
            
            
            (243
            )
            
            34
            
            
            (184
            )
            
            181Net
                loss
            
            $
            (3,694
            )
            $
            (3,763
            )
            $
            (13,692
            )
            $
            (11,730
            )Loss
                per share, basic and diluted
            
            $
            (0.37
            )
            $
            (0.45
            )
            $
            (1.36
            )
            $
            (1.42
            )Weighted
                average number of shares outstanding:Basic
                and diluted
            
            
            10,077,260
            
            
            8,303,647
            
            
            10,030,988
            
            
            8,232,010










See
      notes
      to Condensed Consolidated Financial Statements .






5





**eMAGIN
      CORPORATION**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**


**(In
      thousands)**








**Additional**
            
            
            
            **Total****Common
                Stock**
            
            **Paid-In**
            
            **Accumulated**
            
            **Shareholders’****Shares**
            
            **Amount**
            
            **Capital**
            
            **Deficit**
            
            **Equity**Balance,
                December 31, 2005
            
            
            9,997
            
            $
            10
            
            $
            175,950
            
            $
            (165,559
            )
            $
            10,401Stock-based
                compensation
            
            
            —
            
            
            —
            
            
            2,270
            
            
            —
            
            
            2,270Debt
                conversion to equity
            
            
            27
            
            
            —
            
            
            70
            
            
            —
            
            
            70Exercise
                of options
            
            
            5
            
            
            —
            
            
            10
            
            
            —
            
            
            10Issuance
                of common stock for services
            
            
            108
            
            
            —
            
            
            401
            
            
            —
            
            
            401Net
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            (13,692
            )
            
            (13,692
            )Balance,
                September 30, 2006, (unaudited)
            
            
            10,137
            
            $
            10
            
            $
            178,701
            
            $
            (179,251
            )
            $
            (540
            )





(1)
              The
                  number of shares outstanding per share amounts, common stock and
                  additional paid-in capital for all periods has been adjusted to
                  reflect a
                  one-for-ten reverse stock split effective in November
                  2006.


See
        notes
        to Condensed Consolidated Financial Statements .


6








**eMAGIN
      CORPORATION**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(In
      thousands)**







**Nine
                months ended****September
                30,****2006**
            
            **2005****(unaudited)**Cash
                flows from operating activities:Net
                loss
            
            $
            (13,692
            )
            $
            (11,730
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            792
            
            
            630Reduction
                in provision for sales returns and doubtful accounts
            
            
            (18
            )
            
            (419
            )Stock-based
                compensation
            
            
            2,270
            
            
            —Issuance
                of common stock for services, net
            
            
            375
            
            
            397Amortization
                of discount on notes payable
            
            
            227
            
            
            —Gain on
              warrant derivative liabilty
            
            
            (97
            )
            
            —Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            (339
            )
            
            179Inventory
            
            
            899
            
            
            (1,574
            )Prepaid
                expenses and other current assets
            
            
            (8
            )
            
            (382
            )Deferred
                revenue
            
            
            20
            
            
            ---Accounts
                payable, accrued compensation, and other accrued expenses
            
            
            (899
            )
            
            586Other
                current liabilities
            
            
            101
            
            
            68Net
                cash used in operating activities
            
            
            (10,369
            )
            
            (12,245
            )Cash
                flows from investing activities:Purchase
                of equipment
            
            
            (204
            )
            
            (665
            )Purchase
                of investments - held to maturity
            
            
            (4
            )
            
            —Purchase
                of intangibles and other assets
            
            
            (2
            )
            
            (46
            )Net
                cash used by investing activities
            
            
            (210
            )
            
            (711
            )Cash
                flows from financing activities:Proceeds
                from exercise of stock options and warrants
            
            
            10
            
            
            1,594Net
                proceeds from issuance of debt
            
            
            5,379
            
            
            —Payments
                of long-term debt and capital leases
            
            
            (130
            )
            
            (10
            )Net
                cash provided by financing activities
            
            
            5,259
            
            
            1,584Net
                (decrease) in cash and cash equivalents
            
            
            (5,320
            )
            
            (11,372
            )Cash
                and cash equivalents beginning of period
            
            
            6,727
            
            
            13,457Cash
                and cash equivalents end of period
            
            $
            1,407
            
            $
            2,085Cash
                paid for interest
            
            $
            127
            
            $
            8Cash
                paid for taxes
            
            $
            35
            
            $
            ---




Supplemental
      non-cash information:


During
      the nine months ended September 30, 2006, the Company




§
            entered
                into several Note Purchase Agreements with investors and issued warrants
                that are exercisable at $3.60 per share into approximately 1.6 million
                shares of common stock valued at $2
                million; §
            issued
                10,000 shares of common stock in lieu of cash payments of $26,000
                as
                compensation for services performed and recorded as deferred
                costs; §
            issued
                approximately 27,000 shares for the conversion of Notes totaling
                $70,000;
                and §
            issued
                warrants that are exercisable at $2.60 per share into approximately
                190,000 shares of common stock valued at approximately
                $158,000.








See
      notes
      to Condensed Consolidated Financial Statements .






7








**eMAGIN
      CORPORATION**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**(Unaudited)**





**Note
      1: Description of the Business and Summary of Significant Account Policies**





***The
      Business***





eMagin
      Corporation is a developer and manufacturer of optical systems and microdisplays
      for use in the electronics industry. eMagin also develops and markets
      microdisplay systems and optics technology for commercial, industrial and
      military applications.





***Basis
      of Presentation***





In
      the
      opinion of management, the accompanying unaudited condensed consolidated
      financial statements of eMagin Corporation and its subsidiary reflects 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 instruction, 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, 2005.





Certain
      prior-period balances have been reclassified to conform to the current period
      presentation. These reclassifications had no impact on revenue, net loss, assets
      or liabilities in either period presented. The results of operations for the
      period ended September 30, 2006 are not necessarily indicative of the results
      to
      be expected for the full year.




On
      November 3, 2006, the Company effected a one-for-ten (1-for-10) reverse stock
      split of its issued and outstanding common stock - see Note 8. All common share
      amounts and per share amounts in the accompanying financial statements and
      this
      Form 10-Q have been adjusted to reflect the 1-for-10 reverse stock split. The
      Company has adjusted its shareholders’ equity accounts by reducing its stated
      capital and increasing its additional paid-in capital by approximately $91,000
      as of September 30, 2006 and December 31, 2005, to reflect the reduction in
      outstanding shares as a result of the reverse stock split.





The
      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 2006 and
      2007.  The Company’s cash requirements over the next 12 months are greater
      than our current cash on hand. 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 6 months, the
      Company will further reduce the size of its organization and/or curtail
      operations which will have a material adverse impact on our business prospects.
      The 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,
      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.








8





***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 and revenues are considered to be earned when the Company
      has completed the process by which it is entitled to such revenues. Revenue
      is
      recognized when persuasive evidence of an arrangement exists, delivery has
      occurred, the selling price is fixed or determinable and collection is
      reasonably assured. The Company defers revenue recognition on products sold
      directly to the consumer with a fifteen day right of return. Revenue is
      recognized upon the expiration of the right of return.





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 relating to firm fixed-price contracts are generally
      recognized on the percentage-of-completion method of accounting 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.





***Stock-based
      Compensation***





The
      Company maintains several stock equity incentive plans. The 2005 Employee Stock
      Purchase Plan (the “ESPP”) provides the Company’s 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, 2006, the number of shares of common
      stock available for issuance was 150,000. As of September 30, 2006, 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 the Company’s 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 at the date of grant. These options have a term of up to 10 years and
      vest
      over a schedule determined by the Board of Directors, generally five years.
      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 nine (9) years which
      commenced January 1, 2005.





On
      January 1, 2006, the Company adopted the provisions of Financial Accounting
      Standards Board (“FASB”) Statement No. 123(R), “ *Share-Based
      Payment”* ,
      (“SFAS
      No. 123R”), which requires the Company to recognize expense related to the fair
      value of the Company’s share-based compensation. Prior to January 1, 2006, the
      Company accounted for share-based compensation under the recognition and
      measurement provisions of Accounting Principles Board Opinion No. 25
      ("APB No. 25"), “ *Accounting for Stock Issued
      to Employees”,* and
      related interpretations, as permitted by FASB Statement No. 123, "Accounting
      for
      Stock-Based Compensation" (“SFAS No. 123”). In accordance with APB No. 25, no
      compensation cost was required to be recognized for options granted that had
      an
      exercise price equal to the market value of the underlying common stock on
      the
      date of grant.





The
      Company adopted SFAS No. 123R using the modified prospective transition method
      and consequently has not retroactively adjusted results for prior periods.
      Under
      this transition method, compensation cost associated with stock options
      includes: a) compensation cost for all share-based compensation granted prior
      to, but not vested as of January 1, 2006, based on the grant-date fair value
      estimated in accordance with the original provisions of SFAS No.123 and b)
      compensation cost for all share-based compensation granted beginning January
      1,
      2006, based on the grant-date fair value estimated in accordance with the
      provisions of SFAS No.123R. The Company uses the straight-line method for
      recognizing compensation expense. Compensation expense for awards under SFAS
      123R includes an estimate for forfeitures.





See
      Note
      7 for further information regarding the Company’s stock-based compensation
      assumptions and expenses, including the impact of adoption on the Company’s
      condensed Consolidated Financial Statements and pro forma disclosures for prior
      periods as if we had recorded stock-based compensation expense.





**Note
      2: 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.







9


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,****2006**
              **(unaudited)**
            
            **December
                31, 2005**Accounts
                receivable
            
            $
            1,588
            
            $
            1,249Less
                allowance for doubtful accounts
            
            
            (469
            )
            
            (487
            )Net
                receivables
            
            $
            1,119
            
            $
            762





**Note
      3: Research and Development Costs**





Research
      and development costs are expensed as incurred.





**Note
      4: Net Loss per Common Share**





In
      accordance with SFAS No. 128, net loss per common share amounts ("basic EPS")
      was 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") was computed by reflecting potential dilution from the
      exercise of stock options and warrants.  Common stock equivalent
      shares are excluded from the computation if their effect is antidilutive. As
      of
      September 30, 2006 and 2005, there were stock options and warrants outstanding
      to acquire 4,893,921 and 3,519,393 shares of our common stock, respectively.
      These shares were excluded from the computation of diluted loss per share
      because their effect would be antidilutive.





**Note
      5: Inventories**





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, 2006**
              **(unaudited)**
            
            **December
                31, 2005**Raw
                materials
            
            $
            1,396
            
            $
            2,353Work
                in process
            
            
            266
            
            
            107Finished
                goods
            
            
            1,278
            
            
            1,379Total
                Inventory
            
            $
            2,940
            
            $
            3,839





10


**Note
      6: Debt**





Debt
      is
      as follows (in thousands):


**September
                30, 2006**
              **(unaudited)**
            
            **December
                31, 2005**Current
                portion of capitalized lease obligations
            
            $
            10
            
            $
            16Current
                portion of debt
            
            
            2,963Long-term
                capitalized lease obligations
            
            
            —
            
            
            6Long-term
                debt
            
            
            3,131
            
            
            —Less:
                Unamortized discount on notes payable - long term
            
            
            1,820
            
            
            —Long-term
                debt, net
            
            
            1,311
            
            
            50Total
                debt
            
            $
            4,284
            
            $
            72





On
      July
      21, 2006, the Company entered into several Note Purchase Agreements for the
      sale
      of approximately $5.99 million of senior secured debentures (the “Notes”)
      together with warrants to purchase approximately 1.8 million shares of common
      stock, par value $.0001 per share. 50% of the aggregate principal amount matures
      on July 21, 2007 and the remaining 50% matures on January 21, 2008. The Notes
      pay 6% interest quarterly beginning September 1, 2006. Approximately $37,000
      of
      interest was paid to investors on September 1, 2006.





The
      Company accounted for the net proceeds from the issuance of the Notes as two
      separate components: a detachable warrant component and a debt component.
 The Company determined the relative fair value of warrants to be $2.0
      million which was recorded as debt discount, a reduction of the carrying value
      of the Notes. The following assumptions were used to determine the fair value
      of
      the warrants:





Dividend
                yield
            
            0%Risk
                free interest rates
            
            5.14%Expected
                volatility
            
            122%Expected
                term (in years)
            
            1.5
                years




The
      discount is being amortized to interest expense over the term of the Note.
      For
      the three and nine months ended September 30, 2006, debt discount of $227,000
      was amortized to interest expense - see Note
      8: Shareholders’ Equity for additional information on the Notes.




**Note
      7: Stock-based Compensation**





On
      January 1, 2006, the Company adopted the provisions of SFAS No. 123R, which
      requires the Company to recognize expense related to the fair value of the
      Company’s share-based compensation issued to employees and directors. Prior to
      January 1, 2006, the Company accounted for share-based compensation under the
      recognition and measurement provisions of APB No. 25 and related
      interpretations, as permitted by SFAS No. 123. We adopted SFAS No. 123R using
      the modified prospective transition method. Accordingly, periods prior to
      adoption have not been restated. Compensation cost recognized for the three
      and
      nine months ended September 30, 2006 includes a) compensation cost for all
      share-based compensation granted prior to, but not vested as of January 1,
      2006,
      based on the grant-date fair value estimated in accordance with the original
      provisions of SFAS No.123 and b) compensation cost for all share-based
      compensation granted beginning January 1, 2006, based on the grant-date fair
      value estimated in accordance with the provisions of SFAS No.123R. The
      compensation cost was recognized using the straight-line attribution method.





11


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, 2006 (in thousands):





**Three
                Months Ended**
              **September
                30, 2006**
            
            **Nine
                Months Ended**
              **September
                30, 2006**Cost
                of revenue
            
            $
            112
            
            $
            370Research
                and development
            
            
            119
            
            
            378Selling,
                general and administrative
            
            
            459
            
            
            1,522Total
                stock compensation expense
            
            $
            690
            
            $
            2,270





For
      the
      three and nine months ended September 30, 2006, stock compensation was
      approximately $0.7 million and $2.3 million, respectively. At September 30,
      2006, total unrecognized non-cash compensation costs related to stock options
      was approximately $4.8 million, net of estimated 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
      5.4 years.





The
      Company recognizes compensation expense for options granted to non-employees
      in
      accordance with the provision 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.





In
      determining the fair value of stock options granted during the nine month
      periods ended September 30, 2006 and 2005, the following key assumptions were
      used in the Black-Scholes option pricing model:




**For
                the Nine Months Ended September 30,****2006**
            
            **2005**Dividend
                yield
            
            
            0
                %
            
            
            0%Risk
                free interest rates
            
            
            4.59%
            
            
            4.39%Expected
                volatility
            
            
            126%
            
            
            52%Expected
                term (in years)
            
            
            5
                years
            
            
            10
                years





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 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.







12





**Three
                Months Ended**
              **September
                30, 2005**
            
            **Nine
                Months Ended**
              **September
                30, 2005**Net
                loss, as reported
            
            $
            (3,763
            )
            $
            (11,730
            )Deduct: 
                Stock-based employee compensation expense determined under fair value
                method
            
            
            (465
            )
            
            (2,809
            )Pro
                forma net loss
            
            $
            (4,228
            )
            $
            (14,539
            )Net
                loss per share:Basic
                and diluted, as reported
            
            $
            (0.45
            )
            $
            (1.42
            )Basic
                and diluted, pro forma
            
            $
            (0.51
            )
            $
            (1.77
            )





A
      summary
      of the Company’s stock option activity for the nine months ended September 30,
      2006 is presented in the following tables:




**Number
                of Shares**
            
            **Weighted
                Average Exercise Price**
            
            **Weighted
                Average Remaining Contractual Life (In Years)**
            
            **Aggregate
                Intrinsic Value**Outstanding
                at January 1, 2006
            
            
            1,805,264
            
            $
            10.90Options
                granted
            
            
            185,744
            
            
            4.30Options
                exercised
            
            
            (5,000
            )
            
            2.10
            
            
            
            
            $
            2,000Options
                forfeited
            
            
            (365,420
            )
            
            8.74Options
                cancelled
            
            
            (467,148
            )
            
            11.97Outstanding
                at September 30, 2006
            
            
            1,153,440
            
            $
            2.88
            
            
            3.96
            
            $
            47,681Vested
                or expected to vest at September 30, 2006 (1)
            
            
            1,072,699
            
            $
            2.88
            
            
            3.96
            
            $
            47,681Exercisable
                at September 30, 2006
            
            
            684,342
            
            $
            2.78
            
            
            2.81
            
            $
            47,681





**Options
                Outstanding**
            
            **Options
                Exercisable****Number
                Outstanding**
            
            **Weighted
                Average Remaining Contractual Life (In Years)**
            
            **Weighted
                Average Exercise Price**
            
            **Number
                Exercisable**
            
            **Weighted
                Average Exercisable Price**$2.10
                - $2.70
            
            
            1,140,034
            
            
            4.21
            
            $
            2.25
            
            
            581,269
            
            $
            2.50$3.40
                - $5.80
            
            
            109,424
            
            
            1.49
            
            
            3.76
            
            
            94,924
            
            
            3.45$6.60
                - $22.5
            
            
            29,982
            
            
            4.71
            
            
            10.82
            
            
            8,149
            
            
            14.811,153,440
            
            
            3.96
            
            $
            2.88
            
            
            684,342
            
            $
            2.78


(1)
      The
      expected to vest options are the result of applying the pre-vesting forfeiture
      rate assumptions to total outstanding 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 for the 125,202 options that were in-the-money at


September
      30, 2006. The Company’s closing stock price was $2.50 as of September 30, 2006.
      The Company issues new shares of common stock upon exercise of stock
      options.





On
      July
      21, 2006, certain employees and Directors of the Company agreed to forfeit
      approximately 467,000 shares underlying existing stock options in return for
      the
      re-pricing of approximately 869,000 existing options at $2.60 per share having
      a
      weighted average original exercise price of $11.97. Option grants that have
      not
      been re-priced will remain unchanged. The unvested options which were re-priced
      will continue to vest on original vesting schedules, but in no event prior
      to
      January 19, 2007. Previously vested options which were re-priced will now vest
      on January 19, 2007. Re-priced grants will be forfeited if the individual leaves
      voluntarily. The Company has accounted for the re-pricing and cancellation
      transactions as a modification under SFAS No. 123R. The Company will recognize
      the additional compensation charges over the four months ended January 19,
      2007
      for previously vested options and over the remaining vesting period for unvested
      options.









13


**Note
      8: Shareholders’ Equity**




At
      the
      Company’s 2006 Annual Meeting of Shareholders in October 2006, the Company’s
      shareholders approved an amendment to the Company’s certificate of incorporation
      to effect a reverse stock split of the issued and outstanding common stock
      on a
      ratio of 1-for-10. On November 3, 2006, the reverse stock split became
      effective. The Company has adjusted its shareholders’ equity accounts by
      reducing its stated capital and increasing its additional paid-in capital by
      approximately $91,000 as of September 30, 2006 and December 31, 2005, to reflect
      the reduction in outstanding shares as a result of the reverse stock split.





On
      July
      21, 2006, the Company entered into several Note Purchase Agreements for the
      sale
      of approximately $5.99 million of senior secured debentures (the “Notes”) and
      warrants to purchase approximately 1.8 million shares of common stock, par
      value
      $.001 per share. The investors purchased $5.99 million principal amount of
      Notes
      with conversion prices of $2.60 per share that may convert into approximately
      2.3 million shares of common stock and 5 year warrants exercisable at $3.60
      per
      share into approximately 1.6 million shares of common stock. If the Notes are
      not converted, 50% of the principal amount will be due on July 21, 2007 and
      the
      remaining 50% will be due on January 21, 2008. Commencing September 1, 2006,
      6%
      interest is payable in quarterly installments on outstanding notes. On September
      1, 2006, the Company paid approximately $37,000 to investors for the first
      installment of quarterly interest. In the quarter ended September 30, 2006,
      two
      note holders partially converted their promissory note valued at approximately
      $70,000 and were issued an aggregate of approximately 27,000 shares. The Company
      received approximately $5.4 million, net of deferred costs of approximately
      $0.6
      million which are amortized over the life of the Notes.




The
      Company accounted for the net proceeds from the issuance of the Notes as two
      separate components: a detachable warrant component and a debt component.
 The Company determined the relative fair value of the warrants to be
      approximately $2.0 million which was recorded as debt discount, a reduction
      of
      the carrying value of the Notes. The following assumptions were used to
      determine the fair value of the warrants:





Dividend
                yield
            
            0%Risk
                free interest rates
            
            5.14%Expected
                volatility
            
            122%Expected
                term (in years)
            
            1.5
                years


The
      discount is being amortized to interest expense over the term of the Note.
      For
      the three and nine months ended September 30, 2006, debt discount of
      approximately $227,000 was amortized to interest expense.





An
      additional $0.5 million will be invested through the exercise of a warrant
      to
      purchase approximately 192,000 shares of common stock at $2.60 per share on
      or
      prior to December 14, 2006, or at the election of the Company, by the purchase
      of additional Notes and warrants. The Company determined the relative fair
      value
      of the warrants to be approximately $158,000 which was recorded as an other
      asset. The following assumptions were used to determine the fair value of the
      warrant:




Dividend
                yield
            
            0%Risk
                free interest rates
            
            5.25%Expected
                volatility
            
            122%Expected
                term (in years)
            
            0.4
                years





Under
        EITF 00-19,  “Accounting for Derivative Financial Instruments Indexed to
        and Potentially Settled in, a Company’s Own Stock”, the fair value of the
        warrants, $2.2 million, have been recorded as a liability since the warrant
        agreement requires a potential net-cash settlement in the first year of the
        warrant agreement if the registration statement is not effective. As of
        September 30, 2006,  the registration statement is effective. The liability
        will be adjusted to fair value at each reporting period. The change in the
        fair
        value of the warrants will be recorded in the Consolidated Statement of
        Operations as other income (expense). For the three and nine months ended
        September 30, 2006, the Company recorded approximately $97,000 of gain from
        the
        change in the fair value of the derivative liability.




As
      a
      result of the issuance of the Notes, the outstanding 116,576 Series A Common
      Stock Purchase Warrants, that were issued to certain accredited and/or
      institutional investors pursuant to the Securities Purchase Agreement dated
      January 9, 2004, were re-priced from $5.50 to $2.60 and the outstanding 650,001
      Series F Common Stock Purchase Warrants, that were issued to certain accredited
      and/or institutional investors pursuant to the Securities Purchase Agreement
      dated October 25, 2004, were re-priced from $10.90 to $8.60.





14


A
      registration rights agreement was entered into in connection with the Notes
      which requires the Company to file a registration statement for the resale
      of
      the common stock underlying the Notes and the warrants. The Company must use
      its
      best efforts to have the registration statement declared effective by the end
      of
      a specified grace period and also maintain the effectiveness of the registration
      statement until all shares of common stock underlying the Notes and the warrants
      have been sold or may be sold without volume restrictions pursuant to Rule
      144(k) of the Securities Act. If the Company fails to have the registration
      statement declared effective within the grace period or fails to maintain the
      effectiveness as set forth in the preceding sentence, the Company is required
      to
      pay each investor cash payments equal to 1.0% of the aggregate purchase price
      monthly until the failure is cured. If the Company fails to pay the liquidated
      damages, interest at 16.0% will accrue until the liquidated damages are paid
      in
      full. The registration statement was filed and declared effective by the
      Securities and Exchange Commission within the specified grace period. As of
      September 30, 2006, the registration statement remains effective.





The
      Company accounts for the registration rights agreement as a separate
      freestanding instrument and accounts for the liquidated damages provision as
      a
      derivative liability subject to SFAS 133. The estimated fair value of the
      liability is based on an estimate of the probability and costs of cash penalties
      being incurred. The Company determined that the fair value of the liability
      was
      immaterial and it is not recorded in accrued liabilities. The Company will
      revalue the potential liability at each balance sheet date.





For
      the
      three and nine months ended September 30, 2006, the Company received
      approximately $10,000 for the exercise of 5,000 options and there were no
      warrants exercised. For the three and nine months ended September 30, 2005,
      the
      Company received approximately $30,000 and $35,000, respectively, for the
      exercise of 9,600 and 10,400 options, respectively. For the three and nine
      months ended September 30, 2005, the Company received approximately $1.6 million
      for the exercise of approximately 300,000 warrants.





For
      the
      three and nine months ended September 30, 2006, the Company also issued
      approximately 63,000 and 108,000 shares of common stock, respectively, in lieu
      of cash payments in the amount of approximately $209,000 and $401,000,
      respectively, as compensation for services rendered and to be rendered in
      the future.  For the three and nine months ended September 30, 2005, the
      Company also issued approximately 12,000 and 41,000 shares of common stock,
      respectively, in lieu of cash payments in the amount of approximately $121,000
      and $378,000, respectively, as compensation for services rendered and to be
      rendered in the future.





**Note
      9: Commitments and Contingencies**





***Royalty
      Payments***





The Company, in accordance with
      a royalty agreement with Eastman Kodak, is obligated to make
      minimum annual royalty payments of $125,000 which commenced on January 1,
      2001. Under this agreement, the Company 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.





The
      Company paid $125,000 for the minimum amount due for 2006 and 2005. The amount
      was recorded in prepaid expenses and will be amortized as the
      Company records the royalty expense as defined in the agreement. Royalty
      expense was approximately $149,000 and $340,000, respectively, for the three
      and
      nine months ended September 30, 2006 and approximately $65,000 and $130,000,
      respectively, for the three and nine months ended September 30, 2005.





***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 $332,000 and $1.0 million for the three and nine months ended
      September 30, 2006, respectively, and approximately $267,000 and $742,000 for
      the three and nine months ended September 30, 2005, respectively.





15


**Note
      10: Legal Proceedings** ******





On
      December 6, 2005, New York State Urban Development Corporation commenced action
      in the Supreme Court of the State of New York, County of New York against the
      Company, asserting breach of contract and seeking to recover a $150,000 grant
      which was made to the Company based on goals set forth in the agreement for
      recruitment of employees. On July 13, 2006, the Company agreed to a settlement
      with the New York State Urban Development Corporation to repay $112,200. The
      settlement requires that repayments be made on a monthly basis in the amount
      of
      $3,116.67 per month commencing August 1, 2006 and ending on July 1,
      2009.




**Note
      11: Subsequent Events**




At
      the
      Company’s 2006 Annual Meeting of Shareholders held on October 20, 2006, the
      Company’s shareholders approved an amendment to the Company’s Certificate of
      Incorporation to effect a reverse stock split of the Company’s outstanding
      common stock at an exchange ratio of one-for-ten. On November 3, 2006, the
      reverse stock split became effective. Each holder of ten shares of the Company’s
      common stock will become the holder of one share of the Company’s common stock.
      In addition, all outstanding options, warrants, and convertible notes will
      be
      adjusted in accordance with their terms and pursuant to the ratio of the reverse
      split. All fractional shares shall be rounded up to the next whole number of
      shares.





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 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).





In
      January 2005, we announced the world's first personal display system to combine
      OLED technology with head-tracking and 3D stereovision, the Z800 3DVisor(tm),
      which was first shipped in mid-2005. This product received a CES Design and
      Innovations Award for the electronic gaming category and also received the
      coveted Best of Innovation Awards for the entire display category. The product
      was also recognized as a Digital Living Class of 2005 Innovators.





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**





From
      inception through January 1, 2003, we were a developmental stage company. We
      have transitioned to manufacturing our products and intend to significantly
      increase our marketing, sales, and research and development
      efforts, and expand our operating infrastructure. Most of our operating
      expenses are fixed in the near term. 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 on product sales is
      recognized when persuasive evidence of an
      arrangement exists, such as when a purchase order or contract is
      received from the customer, the selling price is fixed, title to the goods
      has changed and there is a reasonable assurance of collection of the
      sales proceeds.  We obtain written purchase authorizations from
      our customers for a specified amount of product at a specified price
      and consider delivery to have occurred at the time
      of shipment.  Revenue is recognized at shipment and we
      record a reserve for estimated sales returns, which
      is reflected as a reduction of revenue at the time of revenue recognition.
      We defer revenue on products sold directly to the consumer with a fifteen day
      right of return. Revenue is recognized upon the expiration of the right of
      return.





Revenues
      from research and development activities relating to firm fixed-price
      contracts are generally recognized on the percentage-of-completion
      method of accounting as costs are incurred (cost-to-cost basis). 
Revenues from research and development activities relating to
      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,
      management utilizes estimates and assumptions that affect the reported amounts
      of assets and liabilities and the disclosure of contingent assets and
      liabilities at the date of the financial statements as well as the reported
      amounts of revenues and expenses during the reporting period. Actual results
      could differ from those estimates. These estimates and assumptions relate to
      recording net revenue, collectibility of accounts receivable, useful lives
      and
      impairment of tangible and intangible assets, accruals, income taxes, inventory
      realization, stock-based compensation expense and other factors. Management
      believes it has exercised reasonable judgment in deriving these estimates.
      Consequently, a change in conditions could affect these estimates.





**Fair
      Value of Financial Instruments**





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





**Stock-based
      Compensation**





We
      maintain several stock equity incentive plans. The 2005 Employee Stock Purchase
      Plan (the “ESPP”) 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, 2006, the number of shares of common stock available for issuance
      was 150,000. As of September 30, 2006, the plan had not been
      implemented.





18


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.





On
      January 1, 2006, we adopted the provisions of Financial Accounting Standards
      Board (“FASB”) Statement No. 123(R), “ *Share-Based
      Payment”* ,
      and
      (“SFAS No. 123R”), which requires us to recognize expense related to the fair
      value of our share-based compensation issued to employees and directors. Prior
      to the January 1, 2006, we accounted for share-based compensation under the
      recognition and measurement provisions of Accounting Principles
      Board Opinion No. 25 ("APB No. 25"), “ *Accounting for Stock Issued
      to Employees”,* and
      related interpretations, as permitted by FASB Statement No. 123, "Accounting
      for
      Stock-Based Compensation" (“SFAS No. 123”). In accordance with APB No. 25, no
      compensation cost was required to be recognized for options granted that had
      an
      exercise price equal to the market value of the underlying common stock on
      the
      date of grant.





We
      adopted SFAS No. 123R using the modified prospective transition method and
      consequently have not retroactively adjusted results for prior periods. Under
      this transition method, compensation cost associated with stock options
      includes: a) compensation cost for all share-based compensation granted prior
      to, but not vested as of January 1, 2006, based on the grant-date fair value
      estimated in accordance with the provisions of SFAS No.123 and b) compensation
      cost for all share-based compensation granted beginning January 1, 2006, based
      on the grant-date fair value estimated in accordance with the original
      provisions of SFAS No.123R. We use the straight-line method for recognizing
      compensation expense. Compensation expense for awards under SFAS 123R includes
      an estimate for forfeitures.





**NEW
      ACCOUNTING PRONOUNCEMENTS**





The
      Financial Accounting Standards Board (“FASB”) has issued interpretation No. 48,
“Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement
      No. 109” (“FIN 48”), regarding accounting for, and disclosure of, uncertain tax
      positions. FIN 48 clarifies the accounting for uncertainty in income taxes
      recognized in an enterprise’s financial statements in accordance with FASB
      Statement No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a
      recognition threshold and measurement attribute for the financial statement
      recognition and measurement of a tax position taken or expected to be taken
      in a
      tax return. FIN 48 also provides guidance on derecognition, classification,
      interest and penalties, accounting in interim periods, disclosure, and
      transition. FIN 48 is effective for fiscal years beginning after December 15,
      2006. We do not anticipate that the adoption of this statement will have a
      material effect on our financial position or results of operation.





In
      September 2006, the FASB issued SFAS 157, “Fair Value
      Measurements”.  SFAS 157 defines fair value, establishes a framework for
      measuring fair value in GAAP and expands disclosures about fair value
      measurements.  SFAS 157 is effective for fiscal years beginning after
      November 15, 2007 and interim periods within those fiscal years.  We
      will be evaluating the effect that the adoption of SFAS 157 may have on our
      financial position and results of operations.




**RESULTS
      OF OPERATIONS**





**THREE
      AND NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO THREE AND NINE MONTHS
      ENDED
      SEPTEMBER 30, 2005**





**Revenues**





Revenues
      for the three and nine months ended September 30, 2006 were approximately
      $2.3 million and $5.6 million, respectively, as compared to approximately $1.1
      million and $2.5 million, respectively, for the three and nine months ended
      September 30, 2005, an increase of approximately 103% and 127%, respectively.
      Higher revenue for the three and nine month periods was primarily due to
      increased microdisplay demand and increased availability of finished displays
      due to manufacturing improvements.





19


**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, 2006 was approximately $2.9 million and $8.9 million,
      respectively, as compared to approximately $2.7 million and $7.0 million,
      respectively, for the three and nine months ended September 30, 2005, an
      increase of approximately $0.2 million and $1.9 million, respectively.  The
      gross loss for the three and nine months ended September 30, 2006 was
      approximately ($0.6) million and ($3.3) million, respectively, as compared
      to
      approximately ($1.6) million and $(4.6) million, respectively, for the three
      and
      nine months ended September 30, 2005. This translates to a gross loss of (28%)
      and (59%), respectively, for the three and nine months ended September 30,
      2006
      as compared to a gross loss of (137%) and (184%), respectively, for the three
      and nine months ended September 30, 2005. The increase in cost of goods sold
      for
      the three and nine months 2006 was attributed to higher materials usage to
      support increased production as well as approximately $112,000 and $370,000
      for
      the three and nine month periods, respectively, of non cash stock compensation
      expense reflected in accordance with SFAS No. 123R in 2006.





**Operating
      Expenses**





*Research
      and Development* . 
      Research and development expenses included 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, 2006 were approximately $1.0 million and $3.5 million, respectively, a
      decrease of approximately $57,000 and an increase of $469,000, as compared
      to
      approximately $1.0 million and $3.0 million, respectively, for the three and
      nine months ended September 30, 2005.  The decrease in the
      quarter was due to reductions in research and development expenditures and
      personnel costs and offset in part by the stock-based compensation of $119,000
      reflected in accordance with SFAS No. 123R in 2006. The increase in the nine
      months ended September 30, 2006 was primarily due to the stock-based
      compensation expense of $378,000 and slightly higher headcount for the first
      6
      months of the year. Options were not expensed during 2005.





*Selling,
      General and Administrative* .
      Selling, general and administrative expenses consist principally of
      salaries and fees for professional services, legal fees incurred in
      connection with patent filings and related matters, as well as other
      marketing and administrative expenses.  Selling, general and
      administrative expenses for the three and nine months ended September
      30, 2006 were approximately $1.8 million and $6.7 million, respectively, as
      compared to approximately $1.2 million and $4.3 million, respectively, for
      the
      three and nine months ended September 30, 2005.  The increase of
      approximately $0.6 million for the quarter ended September 30, 2006 was
      primarily related to the stock-based compensation expense of approximately
      $458,000. The increase of approximately $2.4 million for the nine months ended
      September 30, 2006 was primarily due to stock-based compensation expense of
      approximately $1.5 million and an increase in advertising and trade show
      expenses related to the marketing of our Z800 3DVisor.





*Other
      Income, net* .
      Other
      income, net consists primarily of interest income earned on
      investments, interest expense related to the secured debentures, and gain
      from the change in the derivative liability. For the three and nine months
      ended
      September 30, 2006, interest income was $14,000 and $73,000, respectively,
      as
      compared to $34,000 and $157,000, respectively, for the three and nine
      months ended September 30, 2005. The decrease in interest income was
      primarily a result of lower cash balances available for investment. For the
      three and nine months ended September 30, 2006, interest expense was $354,000
      as
      compared to $1,000 and $3,000, respectively, for the three and nine
      months ended September 30, 2005. The increase in the interest expense was a
      result of interest associated with our notes payable of $37,000, the
      amortization of the deferred costs associated with the notes payable of $88,000,
      and the amortization of the debt discount of $227,000. For the three and nine
      months ended September 30, 2006, income from the change in the derivative
      liability was $97,000 as compared to $0 for the three and nine months ended
      September 30, 2006.





**Liquidity
      and Capital Resources**





As
      of
      September 30, 2006, we had approximately $1.4 million of cash and cash
      equivalents as compared to $6.7 million as of December 31, 2005. The decrease
      of
      approximately $5.3 million was due primarily to $10.4 million of cash used
      for
      operating activities offset by $5.3 million of cash provided by financing
      activities.





Cash
      flow
      used in operating activities during the nine months of 2006 was approximately
      $10.4 million as compared to cash used of approximately $12.2 million during
      the
      nine months of 2005. This decrease of approximately $1.8 million was primarily
      attributable to an increased inventory and prepaid expenses during the first
      nine months of 2005 and not repeated in 2006 as well as a reduction of
      approximately $400,000 in net losses before stock option expenses. In June
      of
      2006, we took steps to reduce our use of cash for operating activities by
      approximately $4 million annually by reducing our headcount by 28 employees
      and
      lowering discretionary spending.





20


Cash
      used
      in investing activities during the nine months ended September 30, 2006 was
      approximately $0.2 million as compared to approximately $0.7 million during
      the
      nine months ended September 30, 2005. The reduction of cash used in investing
      activities was primarily due to lower purchases of equipment.





Cash
      provided from financing activities during the nine months ended September 30,
      2006 was approximately $5.3 million as compared approximately $1.6 million
      during the nine months ended September 30, 2005. We received approximately
      $5.4
      million, net, from the sale of senior secured debentures for the nine months
      ended September 30, 2006 and approximately $1.6 million of proceeds from the
      exercise of employee stock options and warrants during the same period in 2005.





Our
      condensed consolidated financial statements as of September 30, 2006 have been
      prepared under the assumption that we will continue as a going concern for
      the
      year ending December 31, 2006. Our independent registered public accounting
      firm
      have issued their report dated March 15 , 2006
      that included an explanatory paragraph expressing substantial doubt in our
      ability to continue as a going concern without additional capital becoming
      available. Our
      ability to continue as a going concern ultimately is dependent on our ability
      to
      generate a profit which is 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.





As
      we
      have reported our business is currently experiencing significant revenue growth
      during the first nine months of 2006. This trend, if it continues, may result
      in
      higher accounts receivable levels and may require increased production and/or
      higher inventory levels. We anticipate that our cash requirements to fund these
      requirements as well as other operating or investing cash requirements over
      the
      next 6 months will be greater than our current cash on hand. While we received
      approximately $5.4 million, net, from the sale of senior secured debentures
      pursuant to the Note
      Purchase agreements that we entered into on July 21, 2006, and such agreements
      provide for the investors to purchase an additional $0.5 million prior to
      December 14, 2006, nevertheless we anticipate that we will still require
      additional funds over the next 6 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. If we
      are unable to obtain sufficient funds during the next 12 months we will 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.





In
      addition to the foregoing, as previously reported, we have retained CIBC World
      Markets Corporation and Larkspur Capital Corporation to assist us in
      investigating and evaluating various strategic alternatives, ranging from
      investment to acquisition, in response to inquiries that we have
      received.




**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**





***Market
      Rate Risk***





We
      are
      exposed to market risk related to changes in interest rates and foreign currency
      exchanges rates.





***Interest
      Rate Risk***





We
      hold
      our assets in cash and cash equivalents. We do not hold derivative financial
      instruments or equity securities.





***Foreign
      Currency Exchange Rate Risk***





Our
      revenue and expenses are denominated in U.S. dollars. We have conducted some
      transactions in foreign currencies and expect to continue to do so; we do not
      anticipate that foreign exchange gains or losses will be significant. We have
      not engaged in foreign currency hedging to date.





Our
      international business is subject to risks typical of international activity,
      including, but not limited to, differing economic conditions; change in
      political climates; differing tax structures; and other regulations and
      restrictions. Accordingly, our future results could be impacted by changes
      in
      these or other factors.


21


**ITEM
      4. 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 September 30, 2006, our Chief Executive Officer and
      Chief Financial Officer have concluded that our disclosure controls and
      procedures were 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 September 30, 2006, our disclosure
      controls and procedures were effective in ensuring that information required
      to
      be disclosed by us in the reports that we file or submit under the Exchange
      Act
      is accumulated and communicated to our management, including our Chief Executive
      Officer and Chief Financial Officer, to allow timely decisions regarding
      required disclosure..





(b) *Changes
      in Internal Controls.*  *.* During
      the quarter ended September 30, 2006, 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**




On
      December 6, 2005, New York State Urban Development Corporation commenced action
      in the Supreme Court of the State of New York, County of New York against
      eMagin, asserting breach of contract and seeking to recover a $150,000 grant
      which was made to eMagin based on goals set forth in the agreement for
      recruitment of employees *.* ****** On
      July
      13, 2006, the Company agreed to a settlement with the New York State Urban
      Development Corporation to repay $112,200 of a $150,000 grant made to the
      Company based on goals set forth in an agreement for recruitment of employees.
      The settlement requires that repayments be made on a monthly-basis in the amount
      of $3,116.67 per month commencing August 1, 2006 and ending on July 1, 2009.





**ITEM
      1A. Risk Factors**





In evaluating our
      business, prospective investors and shareholders should
      carefully consider the risks factors, any of which could have a material adverse
      impact on our business, operating results and financial condition and
      result in a complete loss of your investment.





**RISKS
      RELATED TO OUR FINANCIAL RESULTS**





***We
      have a history of losses since our inception and may incur losses for the
      foreseeable future*** **.**





Accumulated
      losses excluding non-cash transactions as of September 30, 2006 were $77 million
      and acquisition related non-cash transactions were $102 million, which resulted
      in an accumulated net loss of $179 million. We have not yet achieved
      profitability and we can give no assurances that we will achieve profitability
      within the foreseeable future as we fund operating and capital expenditures
      in
      areas such as establishment and expansion of markets, sales and marketing,
      operating equipment and research and development. We cannot assure investors
      that we will ever achieve or sustain profitability or that our operating losses
      will not increase in the future.





***We
      may not be able to execute our business plan and may not generate cash from
      operations.***





As
      we
      have reported, our business is currently experiencing significant revenue growth
      during the first nine months of 2006. We anticipate that our cash requirements
      to fund these requirements as well as other operating or investing cash
      requirements over the next 6 months will be greater than our current cash on
      hand. While we received approximately $5.4 million, net, from the sale of senior
      secured debentures pursuant to the Note
      Purchase agreements that we entered into on July 21, 2006, and such agreements
      provide for the investors to purchase an additional $0.5 million prior to
      December 14, 2006, we will nevertheless still require additional funds. We
      do
      not currently have any financing commitments and no assurance can be given
      that
      additional financing will be available, or if available, will be on acceptable
      terms. If we
      are unable to obtain sufficient funds during the next 6 months we will 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.





***Our
      independent registered public accounting firm has expressed substantial doubt
      about our ability to continue as a going concern, which may hinder our ability
      to obtain future financing.***




Our
      consolidated financial statements as of September 30, 2006 have been prepared
      under the assumption that we will continue as a going concern for the year
      ending December 31, 2006. Our independent registered public accounting firm
      have
      issued their report dated March 15, 2006 that included an explanatory paragraph
      expressing substantial doubt in our ability to continue as a going concern
      without additional capital becoming available. Our
      ability to continue as a going concern ultimately is dependent on our ability
      to
      generate a profit which is likely dependant 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.








23





***The
      manufacture of*** **OLED** ***-on-silicon
      is new and*** **OLED** ***microdisplays have not been produced in significant quantities.***





If
      we are
      unable to produce our products in sufficient quantity, we will be unable to
      maintain and attract new customers. In addition, we cannot assure you that
      once
      we commence volume production we will attain yields at high throughput that
      will
      result in profitable gross margins or that we will not experience manufacturing
      problems which could result in delays in delivery of orders or product
      introductions.





***We
      are dependent on a single manufacturing line.***





We
      currently manufacture our products on a single manufacturing line. If we
      experience any significant disruption in the operation of our manufacturing
      facility or a serious failure of a critical piece of equipment, we may be unable
      to supply microdisplays to our customers. For this reason, some OEMs may also
      be
      reluctant to commit a broad line of products to our microdisplays without a
      second production facility in place. However, we try to maintain product
      inventory to fill the requirements under such circumstances. Interruptions
      in
      our manufacturing could be caused by manufacturing equipment problems, the
      introduction of new equipment into the manufacturing process or delays in the
      delivery of new manufacturing equipment. Lead-time for delivery of manufacturing
      equipment can be extensive. No assurance can be given that we will not lose
      potential sales or be unable to meet production orders due to production
      interruptions in our manufacturing line. In order to meet the requirements
      of
      certain OEMs for multiple manufacturing sites, we will have to expend capital
      to
      secure additional sites and may not be able to manage multiple sites
      successfully.





***We
      could experience manufacturing interruptions, delays, or inefficiencies if
      we
      are unable to timely and reliably procure components from single-sourced
      suppliers.***





We
      maintain several single-source supplier relationships, either because
      alternative sources are not available or the relationship is advantageous due
      to
      performance, quality, support, delivery, capacity, or price considerations.
      If
      the supply of a critical single-source material or component is delayed or
      curtailed, we may not be able to produce our products in desired quantities
      and
      in a timely manner. Even where alternative sources of supply are available,
      qualification of the alternative suppliers and establishment of reliable
      supplies could result in delays and a possible loss of sales, which could harm
      operating results.





***We
      expect to depend on semiconductor contract manufacturers to supply our silicon
      integrated circuits and other suppliers of key components, materials and
      services.***





We
      do not
      manufacture the silicon integrated circuits on which we incorporate our OLED
      technology. Instead, we expect to provide the design layouts to semiconductor
      contract manufacturers who will manufacture the integrated circuits on silicon
      wafers. We also expect to depend on suppliers of a variety of other components
      and services, including circuit boards, graphic integrated circuits, passive
      components, materials and chemicals, and equipment support. Our inability to
      obtain sufficient quantities of high quality silicon integrated circuits or
      other necessary components, materials or services on a timely basis could result
      in manufacturing delays, increased costs and ultimately in reduced or delayed
      sales or lost orders which could materially and adversely affect our operating
      results.





**RISKS
      RELATED TO OUR INTELLECTUAL PROPERTY**





***We
      rely on our license agreement with Eastman Kodak for the development of our
      products.***





We
      rely
      on our license agreement with Eastman Kodak for the development of our products,
      and the termination of this license, Eastman Kodak's licensing of its OLED
      technology to others for microdisplay applications, or the sublicensing by
      Eastman Kodak of our OLED technology to third parties, could have a material
      adverse impact on our business.





Our
      principal products and those under development utilize OLED technology that
      we
      license from Eastman Kodak. We rely upon Eastman Kodak to protect and enforce
      key patents, relating to OLED display technology. Eastman Kodak's patents expire
      at various times in the future. Our license with Eastman Kodak could terminate
      if we fail to perform any material term or covenant under the license agreement.
      Since our license is non-exclusive, Eastman Kodak could also elect to become
      a
      competitor itself or to license OLED technology for microdisplay applications
      to
      others who have the potential to compete with us. The occurrence of any of
      these
      events could have a material adverse impact on our business.





***We
      may not be successful in protecting our intellectual property and proprietary
      rights.***





We
      rely
      on a combination of patents, trade secret protection, licensing agreements
      and
      other arrangements to establish and protect our proprietary technologies. If
      we
      fail to successfully enforce our intellectual property rights, our competitive
      position could suffer, which could harm our operating results. Patents may
      not
      be issued for our current patent applications, third parties may challenge,
      invalidate or circumvent any patent issued to us, unauthorized parties could
      obtain and use information that we regard as proprietary despite our efforts
      to
      protect our proprietary rights, rights granted under patents issued to us may
      not afford us any competitive advantage, others may independently develop
      similar technology or design around our patents, our technology may be available
      to licensees of Eastman Kodak, and protection of our intellectual property
      rights may be limited in certain foreign countries. We may be required to expend
      significant resources to monitor and police our intellectual property rights.
      Any future infringement or other claims or prosecutions related to our
      intellectual property could have a material adverse effect on our business.
      Any
      such claims, with or without merit, could be time consuming to defend, result
      in
      costly litigation, divert management's attention and resources, or require
      us to
      enter into royalty or licensing agreements. Such royalty or licensing
      agreements, if required, may not be available on terms acceptable to us, if
      at
      all. Protection of intellectual property has historically been a large yearly
      expense for eMagin. We have not been in a financial position to properly protect
      all of our intellectual property, and may not be in a position to properly
      protect our position or stay ahead of competition in new research and the
      protecting of the resulting intellectual property.






24




**RISKS
      RELATED TO THE MICRODISPLAY INDUSTRY**




***The
      commercial success of the microdisplay industry depends on the widespread market
      acceptance of microdisplay systems products.***





The
      market for microdisplays is emerging. Our success will depend on consumer
      acceptance of microdisplays as well as the success of the commercialization
      of
      the microdisplay market. As an OEM supplier, our customer's products must also
      be well accepted. At present, it is difficult to assess or predict with any
      assurance the potential size, timing and viability of market opportunities
      for
      our technology in this market. The viewfinder microdisplay market sector is
      well
      established with entrenched competitors with whom we must compete.





***The
      microdisplay systems business is intensely competitive.***





We
      do
      business in intensely competitive markets that are characterized by rapid
      technological change, changes in market requirements and competition from both
      other suppliers and our potential OEM customers. Such markets are typically
      characterized by price erosion. This intense competition could result in pricing
      pressures, lower sales, reduced margins, and lower market share. Our ability
      to
      compete successfully will depend on a number of factors, both within and outside
      our control. We expect these factors to include the following:





·
            our
                success in designing, manufacturing and delivering expected new products,
                including those implementing new technologies on a timely basis;





·
            our
                ability to address the needs of our customers and the quality of
                our
                customer services;





·
            the
                quality, performance, reliability, features, ease of use and pricing
                of
                our products;





·
            successful
                expansion of our manufacturing capabilities;





·
            our
                efficiency of production, and ability to manufacture and ship products
                on
                time;





·
            the
                rate at which original equipment manufacturing customers incorporate
                our
                product solutions into their own products;





·
            the
                market acceptance of our customers' products; and





·
            product
                or technology introductions by our competitors.





Our
      competitive position could be damaged if one or more potential OEM customers
      decide to manufacture their own microdisplays, using OLED or alternate
      technologies. In addition, our customers may be reluctant to rely on a
      relatively small company such as eMagin for a critical component. We cannot
      assure you that we will be able to compete successfully against current and
      future competition, and the failure to do so would have a materially adverse
      effect upon our business, operating results and financial condition.





25


***The
      display industry is cyclical*** *.*





The
      display industry is characterized by fabrication facilities that require large
      capital expenditures and long lead times for supplies and the subsequent
      processing time, leading to frequent mismatches between supply and demand.
      The
      OLED microdisplay sector may experience overcapacity if and when all of the
      facilities presently in the planning stage come on line leading to a difficult
      market in which to sell our products.





***Competing
      products may get to market sooner than ours.***





Our
      competitors are investing substantial resources in the development and
      manufacture of microdisplay systems using alternative technologies such as
      reflective liquid crystal displays (LCDs), LCD-on-Silicon ("LCOS")
      microdisplays, active matrix electroluminescence and scanning image systems,
      and
      transmissive active matrix LCDs. Our competitive position could be damaged
      if
      one or more of our competitors’ products get to the market sooner than our
      products. We cannot assure you that our product will get to market ahead of
      our
      competitors or that we will be able to compete successfully against current
      and
      future competition. The failure to do so would have a materially adverse effect
      upon our business, operating results and financial condition.





***Our
      competitors have many advantages over us.***





As
      the
      microdisplay market develops, we expect to experience intense competition from
      numerous domestic and foreign companies including well-established corporations
      possessing worldwide manufacturing and production facilities, greater name
      recognition, larger retail bases and significantly greater financial, technical,
      and marketing resources than us, as well as from emerging companies attempting
      to obtain a share of the various markets in which our microdisplay products
      have
      the potential to compete. We cannot assure you that we will be able to compete
      successfully against current and future competition, and the failure to do
      so
      would have a materially adverse effect upon our business, operating results
      and
      financial condition.





***Our
      products are subject to lengthy OEM development periods.***





We
      plan
      to sell most of our microdisplays to OEMs who will incorporate them into
      products they sell. OEMs determine during their product development phase
      whether they will incorporate our products. The time elapsed between initial
      sampling of our products by OEMs, the custom design of our products to meet
      specific OEM product requirements, and the ultimate incorporation of our
      products into OEM consumer products is significant. If our products fail to
      meet
      our OEM customers' cost, performance or technical requirements or if unexpected
      technical challenges arise in the integration of our products into OEM consumer
      products, our operating results could be significantly and adversely affected.
      Long delays in achieving customer qualification and incorporation of our
      products could adversely affect our business.





***Our
      products will likely experience rapidly declining unit prices.***





In
      the
      markets in which we expect to compete, prices of established products tend
      to
      decline significantly over time. In order to maintain our profit margins over
      the long term, we believe that we will need to continuously develop product
      enhancements and new technologies that will either slow price declines of our
      products or reduce the cost of producing and delivering our products. While
      we
      anticipate many opportunities to reduce production costs over time, there can
      be
      no assurance that these cost reduction plans will be successful nor is there
      any
      assurance that our costs can be reduced as quickly as any reduction in unit
      prices. We may also attempt to offset the anticipated decrease in our average
      selling price by introducing new products, increasing our sales volumes or
      adjusting our product mix. If we fail to do so, our results of operations would
      be materially and adversely affected.


26





**RISKS
      RELATED TO OUR BUSINESS**





***Our
      success depends on attracting and retaining highly skilled and qualified
      technical and consulting personnel.***





We
      must
      hire highly skilled technical personnel as employees and as independent
      contractors in order to develop our products. The competition for skilled
      technical employees is intense and we may not be able to retain or recruit
      such
      personnel. We must compete with companies that possess greater financial and
      other resources than we do, and that may be more attractive to potential
      employees and contractors. To be competitive, we may have to increase the
      compensation, bonuses, stock options and other fringe benefits offered to
      employees in order to attract and retain such personnel. The costs of retaining
      or attracting new personnel may have a materially adverse affect on our business
      and our operating results. In addition, difficulties in hiring and retaining
      technical personnel could delay the implementation of our business plan.





***Our
      success depends in a large part on the continuing service of key personnel.***





Changes
      in management could have an adverse effect on our business. We are dependent
      upon the active participation of several key management personnel, including
      Gary W. Jones, our chief executive officer. We will also need to recruit
      additional management in order to expand according to our business plan. The
      failure to attract and retain additional management or personnel could have
      a
      material adverse effect on our operating results and financial performance.





***Our
      business depends on new products and technologies.***





The
      market for our products is characterized by rapid changes in product, design
      and
      manufacturing process technologies. Our success depends to a large extent on
      our
      ability to develop and manufacture new products and technologies to match the
      varying requirements of different customers in order to establish a competitive
      position and become profitable. Furthermore, we must adopt our products and
      processes to technological changes and emerging industry standards and practices
      on a cost-effective and timely basis. Our failure to accomplish any of the
      above
      could harm our business and operating results.





***We
      generally do not have long-term contracts with our customers.***





Our
      business has primarily operated on the basis of short-term purchase orders.
      We
      are now receiving longer term purchase agreements and procurement contracts,
      but
      we cannot guarantee that we will continue to do so. Our current purchase
      agreements can be cancelled or revised without penalty, depending on the
      circumstances. We plan production on the basis of internally generated forecasts
      of demand, which makes it difficult to accurately forecast revenues. If we
      fail
      to accurately forecast operating results, our business may suffer and the value
      of your investment in our company may decline.





***Our
      business strategy may fail if we cannot continue to form strategic relationships
      with companies that manufacture and use products that could incorporate our
      OLED-on-silicon technology.***





Our
      prospects will be significantly affected by our ability to develop strategic
      alliances with OEMs for incorporation of our OLED-on-silicon technology into
      their products. While we intend to continue to establish strategic relationships
      with manufacturers of electronic consumer products, personal computers,
      chipmakers, lens makers, equipment makers, material suppliers and/or systems
      assemblers, there is no assurance that we will be able to continue to establish
      and maintain strategic relationships on commercially acceptable terms, or that
      the alliances we do enter in to will realize their objectives. Failure to do
      so
      would have a material adverse effect on our business.





***Our
      business depends to some extent on international transactions.***





We
      purchase needed materials from companies located abroad and may be adversely
      affected by political and currency risk, as well as the additional costs of
      doing business with a foreign entity. Some customers in other countries have
      longer receivable periods or warranty periods. In addition, many of the OEMs
      that are the most likely long-term purchasers of our microdisplays are located
      abroad exposing us to additional political and currency risk. We may find it
      necessary to locate manufacturing facilities abroad to be closer to our
      customers which could expose us to various risks, including management of a
      multi-national organization, the complexities of complying with foreign laws
      and
      customs, political instability and the complexities of taxation in multiple
      jurisdictions.




***Our
        business may expose us to product liability claims.***
 
 Our
        business may expose us to potential product liability claims. Although no
        such
        claims have been brought against us to date, and to our knowledge no such
        claim
        is threatened or likely, we may face liability to product users for damages
        resulting from the faulty design or manufacture of our products. While we
        plan
        to maintain product liability insurance coverage, there can be no assurance
        that
        product liability claims will not exceed coverage limits, fall outside the
        scope
        of such coverage, or that such insurance will continue to be available at
        commercially reasonable rates, if at all.


27





***Our
      business is subject to environmental regulations and possible liability arising
      from potential employee claims of exposure to harmful substances used in the
      development and manufacture of our products.***





We
      are
      subject to various governmental regulations related to toxic, volatile,
      experimental and other hazardous chemicals used in our design and manufacturing
      process. Our failure to comply with these regulations could result in the
      imposition of fines or in the suspension or cessation of our operations.
      Compliance with these regulations could require us to acquire costly equipment
      or to incur other significant expenses. We develop, evaluate and utilize new
      chemical compounds in the manufacture of our products. While we attempt to
      ensure that our employees are protected from exposure to hazardous materials,
      we
      cannot assure you that potentially harmful exposure will not occur or that
      we
      will not be liable to employees as a result.




**RISKS
      RELATED TO OUR STOCK**




***The
      substantial number of shares that are or will be eligible for sale could cause
      our common stock price to decline even if the company is successful.***





Sales
      of
      significant amounts of common stock in the public market, or the perception
      that
      such sales may occur, could materially affect the market price of our common
      stock. These sales might also make it more difficult for us to sell equity
      or
      equity-related securities in the future at a time and price that we deem
      appropriate. As of September 30, 2006, we have outstanding (i) options to
      purchase 1,153,440 shares and (ii) warrants to purchase 3,740,481 shares of
      common stock.





***We
      have a staggered board of directors and other anti-takeover provisions, which
      could inhibit potential investors or delay or prevent a change of control that
      may favor you.***





Our
      Board
      of Directors is divided into three classes and our Board members are elected
      for
      terms that are staggered. This could discourage the efforts by others to obtain
      control of the company. Some of the provisions of our certificate of
      incorporation, our bylaws and Delaware law could, together or separately,
      discourage potential acquisition proposals or delay or prevent a change in
      control. In particular, our board of directors is authorized to issue up to
      10,000,000 shares of preferred stock (less any outstanding shares of preferred
      stock) with rights and privileges that might be senior to our common stock,
      without the consent of the holders of the common stock.




***Our
        common stock may be delisted from the American Stock Exchange (the “Exchange”),
        which may have a material adverse impact on the pricing and trading of our
        common stock, and which would be deemed an event of default under our 6%
        senior
        secured convertible notes.***
 
 To
        maintain the listing of our common stock on the Exchange, we are required
        to
        meet certain continued listing requirements, including, but not limited to,
        the
        requirement that we maintain a minimum amount in shareholder’s equity. On
        October 9, 2006, we received notice from the Exchange stating that we do
        not
        meet certain of the Exchange’s continued listing standards as set forth in Part
        10 of the Exchange Company Guide (the “Company Guide”) and that we have become
        subject to the continued listing evaluation and follow-up procedures and
        requirements of Section 1009 of the Company Guide.
 
 Pursuant
        to a review by the Exchange of our 10-Q for the three and six months ended
        June
        30, 2006, the Exchange has determined that we are not in compliance with
        Sections 1003(a)(ii) and 1003(a)(iii) of the Company Guide, respectively,
        which
        state, in relevant part, that the Exchange will normally consider suspending
        dealings in, or removing from the list, securities of a company which (a)
        has
        stockholders' equity of less than $4,000,000 if such company has sustained
        losses from continuing operations and/or net losses in three of its four
        most
        recent fiscal years; or (b) has stockholders' equity of less than $6,000,000
        if
        such company has sustained losses from continuing operations and/or net losses
        in its five most recent fiscal years, respectively.
 
 We
        submitted a plan on November 6, 2006 advising the Exchange of actions that
        we
        will take, which may bring us into compliance with Sections 1003 (a)(ii)
        and
        1003(a)(iii) of the Company Guide within a maximum of 18 months of receipt
        of
        the notice letter. The plan included specific milestones, quarterly financial
        projections, and details relating to any strategic initiatives we plan to
        complete. The Exchange will evaluate the plan, including supporting
        documentation which we submitted, and will make a determination as to whether
        we
        have made a reasonable demonstration in the plan of an ability to regain
        compliance with Sections 1003 (a)(ii) and 1003(a)(iii) of the Company Guide
        within a maximum of 18 months of receipt of the notice letter, in which case
        the
        plan will be accepted. If the plan is accepted, we may be able to continue
        listing during the plan of up to 18 months, during which time we will be
        subject
        to periodic review to determine if it is making progress consistent with
        the
        plan. As of the date hereof, we have not received a response from the Exchange
        with respect to our plan.
 
 If
        our
        common stock were delisted from the Exchange, we would trade on the
        Over-the-Counter Bulletin Board and the market price for shares or our common
        stock could decline. In addition, it may become more difficult for us to
        raise
        funds through the sale of our common stock or securities convertible into
        our
        common stock. Further, if our common stock were delisted from the Exchange,
        we
        would be in default of our 6% Senior Secured Convertible Notes in the principal
        amount of $5,970,000 and unless a waiver was granted, we would be required
        to
        repay such principal amount, including a default interest rate of 12% on
        the
        outstanding principal balance. If we were required to repay the secured
        convertible notes, we would be required to use our limited working capital
        and
        raise additional funds. If we were unable to repay the notes when required,
        the
        note holders could commence legal action against us to recover the amounts
        due. Any such action would require us to curtail or cease
        operations.
  28


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





For
      the
      three months ended September 30, 2006, the Company issued 71,700 options
      exercisable into shares of common stock at a price equal to $2.70 per share
      to
      employees as compensation for services performed on behalf of the
      Company.





*All
      of
      the above issuances and sales were deemed to be exempt under Rule 506 of
      Regulation D and Section (2) of the Securities Act of 1933, as amended. No
      advertising or general solicitation was employed in offering the securities.
      The
      offerings and sales were made to a limited number of persons, all of whom were
      accredited investors, business associates of eMagin or executive officers of
      eMagin, and transfer was restricted by eMagin in accordance with the requirement
      of the Securities Act of 1933. In addition to representations by the
      above-referenced persons, we have made independent determinations that the
      above-referenced persons were accredited or sophisticated investors, and that
      they were capable of analyzing the merits and risks of their investment, and
      that they understood the speculative nature of their investment. Furthermore,
      all of the above-referenced persons were provided with access to our Securities
      and Exchange Commission filings.




**ITEM
      3. Defaults Upon Senior Securities**




None.





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





None.





**ITEM
      5. Other Information**





None.




**ITEM
      6. Exhibits**




**EXHIBIT
                NUMBER**
              
              **DESCRIPTION**31.1
              
              Certification
                  by Chief Executive Officer pursuant to Sarbanes Oxley Section 302*31.2
              
              Certification
                  by Chief Financial Officer pursuant to Sarbanes Oxley Section 302*32.1
              
              Certification
                  by Chief Executive Officer pursuant to 18 U.S.C. Section 1350*32.2
              
              Certification
                  by Chief Financial Officer pursuant to 18 U.S.C. Section
                  1350*


*Filed
      herewith.


29


**SIGNATURES**





In
      accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused
      this report to be signed on its behalf by the undersigned, thereunto duly
      authorized on this 20th day of November, 2006.




**eMAGIN
              CORPORATION**By:
            /s/ Gary
              W.
              JonesGary
              W. Jones*Chief
                Executive Officer*
              *Principal
                Executive Officer*





By:
            /s/ John
              AtherlyJohn
              Atherly*Chief
                Financial Officer*
              *Principal
                Accounting and Financial
                Officer*





30