EMAN eMagin Corporation

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  

 ( u naudited)  

Note 1:   Summary of Significant Accounting Policies 

The Business 

eMagin Corporation (the “Company”) designs, develops, manufactures, and markets OLED (organic light emitting diode)–on-silicon microdisplays and virtual imaging products which utilize OLED microdisplays. The Company’s products are sold mainly in North America, Asia, and Europe. 

Basis of Presentation 

In the opinion of management , the accompanying unaudited condensed consolidated financial statements of eMagin Corporation and its subsidiary reflect all adjustments, including normal recurring accruals, necessary for a fair presentation.  All significant intercompany balances and transactions have been eliminated in consolidation.  Certain information and footnote disclosure normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to instructions, rules and regulations prescribed by the Securities and Exchange Commission.  The Company believes that the disclosures provided herein are adequate to make the information presented not misleading when these unaudited condensed consolidated financial statements are read in conjunction with the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.  The results of operations for the period ended September 30, 2016 are not necessarily indicative of the results to be expected for the full year.  The consolidated condensed financial statements as of December 31, 2015 are derived from audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015. 

Use of estimates 



In accordance with accounting principles generally accepted in the United States of America, management utilizes certain estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments related to, among others, allowance for doubtful accounts, warranty reserves, inventory reserves, stock-based compensation expense, deferred tax asset valuation allowances, litigation and other loss contingencies. 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. 



Reclassifications



Certain immaterial prior period amounts have been reclassified to conform to current period presentatio n with no impact on previously reported net income , assets or shareholders’ equity.



Revenues and Cost Recognition  

Revenues from product sales are recognized when persuasive evidence of an arrangement exists, such as when a purchase order or contract is received from the customer, the price is fixed, title and risk of loss 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.

Revenues from research and development activities relating to firm fixed-price contracts and cost-type contracts are generally recognized on the percentage-of-completion method of accounting as costs are incurred (cost-to-cost basis). Progress is generally based on a cost-to-cost approach; however, an alternative method may be used such as physical progress, labor hours or others depending on the type of contract.  Physical progress is determined as a combination of input and output measures as deemed appropriate by the circumstances.  Contract costs include all direct material, labor and subcontractor 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.



Revenues from sales or licenses of intellectual property are recognized when transferred to the customer, provided the license has stand-alone value and the contract provides the right to use the intellectual property as it exists at the point the license is granted, without further obligations of the Company to update the intellectual property after the license is transferred.  If the license does not have standalone value, then the license is combined with other deliverables, such as Research and Development (“ R&D ”) or manufacturing services into a single unit of account.  Revenue from the single unit of account is recognized when earned, typically as the R&D or manufacturing services are performed over the life of the contract.



Recently issued accounting standards



In March 2016, the Financial Accounting Standards Board ( “ FASB ” ) issued guidance which changes the accounting for share-based payment transactions including the income tax consequences, classification of awards as either equity or liabilities, and classification in the Consolidated Statement of Cash Flows. The guidance is effective January 1, 2017 and early adoption is permitted.  The Company is currently evaluating the impact of the new guidance.



In February 2016, the FASB issued guidance which changes the accounting for leases. The guidance requires lessees to recognize a right-of-use asset, which is an asset that represents the lessee’s   right to use, or control the use of, a specified asset for the lease term and, a lease liability, which is a lessee’s obligation to make lease payments arising from a   lease, measured on a discounted basis for all leases (with the exception of short-term leases).   The guidance is effective January 1, 2019 and early adoption is permitted. The Company is currently evaluating the impact of the new guidance and the date of adoption . The Company’s operating lease commitments were $3.2   million at December 31, 2015. 



In November 2015, the FASB issued guidance which requires deferred tax liabilities and assets be classified as noncurrent in the statement of financial position. This guidance requires entities with a classified balance sheet to present all deferred tax assets and liabilities as non-current. The guidance is effective for annual and interim periods beginning after December 15, 2016 and can be applied prospectively or retrospectively to adjustments with early adoption permitted at the beginning of an interim or annual reporting period. The Company does not expect the adoption of the new accounting guidance to have a material impact on its financial statements.



In July 2015, the FASB issued guidance on the measurement of inventory, which requires that inventory be measured at the lower of cost or net realizable value.   The updated standard should be adopted prospectively and is effective for annual reporting periods (including interim periods therein) beginning after December 15, 2016 with early adoption permitted. The Company does not expect the adoption of the new accounting guidance to have a material impact on its financial statements.



In April 2015, the FASB issued guidance about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a services contract. All software licenses recognized under this guidance will be accounted for consistent with other licenses of intangible assets. The guidance was effective January 1, 2016 and the Company adopted it on a prospective basis. The guidance did not have a material impact on the Company’s financial statements.



In November 2014, the FASB issued guidance to eliminate the diversity in practice for the accounting for hybrid financial instruments issued in the form of a share.  The guidance requires management to consider all terms and features, whether stated or implied, of a hybrid instrument when determining whether the nature of the instrument is more akin to a debt instrument or an equity instrument. Embedded derivative features, which are accounted for separately from host contracts, should also be considered in the analysis of the hybrid instrument. The Company adopted the guidance effective January 1, 2016 and it did not have an impact on its financial statements.



In May 2014, the FASB issued guidance on the recognition of revenue from contracts with customers, which will require an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The updated standard will replace most existing revenue recognition guidance in U.S. Generally A ccepted Accounting Principles ( GAAP) when it becomes effective and permits the use of either the retrospective or cumulative effect transition method. In July 2015, the FASB voted to defer the effective date for annual reporting periods beginning after December 15, 2017 (including interim reporting periods within those periods) and permitted early adoption of the standard, but not before the original effective date of December 15, 2016.  The Company expects the updated standard to become effective for it in the first quarter of fiscal 2018. The Company has not yet selected a transition method and is currently evaluating the effect that the updated standard will have on its financial statements.



Unbilled Accounts Receivable



Unbilled accounts receivable represents contract revenue recognized but not yet invoiced due to contract terms or the timing of the accounting invoicing cycle.



Intangible Assets – Patents



Acquired patents are recorded at purchase price as of the date acquired and amortized over the expected useful life which is generally the remaining life of the patent.   



The total intangible amortization expense was approximately $1 4 thousand and $ 41 thousand for the three and n ine m onths ended   September 30, 2016 and 2015 , respectively.  Estimated future amortization expense as of September 30, 2016 is as follows (in thousands):







Product warranty

The Company generally offers a one - year product replacement warranty. T he standard policy is to repair or replace the defective products. The Company accrues for estimated returns of defective products at the time revenue is recognized based on historical activity as well as for specific known product issues. The determination of these accruals requires the Company to make estimates of the frequency and extent of warranty activity and estimate future costs to replace the products under warranty. If the actual warranty activity and/or repair and replacement costs differ significantly from these estimates, adjustments to cost of revenue may be required in future periods.



The following table provides a summary of the activity related to the Company's warranty liability included in other current liabilities, (in thousands):  

















Net Income per Common Share   

Basic income (loss) per share is computed using the weighted average number of common shares outstanding during the period, and excludes any dilutive effects of common stock equivalent shares such as stock options, warrants, and convertible preferred stock. Diluted income (loss) per share is computed using the weighted average number of common shares outstanding and potentially dilutive common stock equivalent shares outstanding during the period. Common stock equivalent shares are excluded from the

computation if their effect is anti-dilutive. 



The Company’s Series B Convertible Preferred stock (“Preferred Stock – Series B”) is considered a participating security as the preferred stock participates in dividends with the common stock, which requires the use of the two-class method when computing basic and diluted earnings per share.  The Preferred Stock – Series B is not required to absorb any net loss. Although the Company paid a one-time special dividend in 2012, the Company does not expect to pay dividends on its common or preferred stock in the near future.   



The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share and share data) for the three and nine months ended   September 30, 2016 and 2015:











The following table sets forth the potentially dilutive common stock equivalents for the three and nine month periods ended September 30, 2016 and 2015 that were not included in diluted EPS as their effect would be anti-dilutive:



























Note 2:  Accounts Receivable, net  

The majority of the Company’s commercial accounts receivable are due from Original Equipment Manufacturers ( “ OEM’s”). Credit is extended based on an evaluation of a customer’s financial condition and, generally, collateral is not required.  

Accounts receivable consisted of the following (in thousands):





Note 3:  Inventories, net  

The components of inventories are as follows (in thousands):  



Note 4:  Line of Credit 

The Company had a credit facility with a lender that expired on August 31, 2016 and was not renewed, The facility provided for up to a maximum of $3 million in borrowings based on 75% of eligible accounts receivable , as defined in the agreement.  The interest on the credit facility was equal to the prime rate plus 4% but could not be less than 7.25% with a minimum monthly interest payment of $1 thousand.  The credit facility contained the customary representations and warranties as well as affirmative and negative covenants.  The Company was in compliance with all debt covenants throughout the term of the credit facility .  The Company did not draw on the credit facility during the nine months ended September 30, 2016 or at any time since its inception in September 2010 and there is no outstanding balance.



The Company is in discussions with the former lender and with other parties about a new credit facility.  No facility was in place at September 30, 2016.







Note 5:  Stock-based Compensation 

The Company uses the fair value method of accounting for share-based compensation arrangements. The fair value of stock options is estimated at the date of grant using the Black-Scholes option valuation model.  Stock-based compensation expense is reduced for estimated forfeitures and is amortized over the vesting period using the straight-line method. 



The following table summarizes the allocation of non-cash stock-based compensation to our expense categories for the three and nine month periods ended September 30, 2016 and 201 5 (in thousands): 





At September 30, 2016 , total unrecognized compensation costs related to stock options was approxima tel y   $1.1   m illion, 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 3.1  y ears.    

The following key assumptions were used in the Black-Scholes option pricing model to determine the fair value of stock options granted: 









The Company does not expect to pay dividends in the near future .  T herefore , the Company used an expected dividend yield of 0% .  The risk-free interest rate used in the Black-Scholes option pricing model is based on yield available at dates of option grant, 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 equivalent term.  The expected term of the options represents the period that the Company’s stock-based awards are expected to be outstanding and was determined based on historical experience and vesting schedules of similar awards. 



A summary of the Company’s stock option activity for the nine months ended   September 30, 2016 is presented in the following table (unaudited):     



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 nine months ended   September 30, 2016 the aggregate intrinsic value of options exercised was $7,484 .    The Company issues new shares of common stock upon exercise of stock options.  





Note 6:  Shareholders’ Equity 



Preferred Stock - Series B Convertible Preferred Stock



As of September 30, 2016 and December 31, 201 5 , there were 5,659 shares of Preferred Stock – Series B issued and outstanding . 



Common Stock 



During the three-month period ended September 30 , 2016 , options to purchase 18,06 1 shares were exercised for proceeds of $37,880 ,  and warrants to purchase 2,216,500 shares were exercised for net proceeds of $4,294,000 .



Warrants



On August 18, 2016, the Company entered into letter agreements with certain warrant   holders pursuant to which such w arrant h olders agreed to   exercise warrants to purchase a total of 2,216,500 of the Company’s c ommon s tock, at an exercise price of $2.05 per share, which they acquired in December 201 5 .



On August 24, 2016, in consideration for the exercise of the 2,216,500   w arrant s hares, the Company issued new c ommon s tock p urchase w arrants (the “New Warrants”) to purchase 2,947,949 shares of the   Company’s c ommon s tock   which is equal to 133% of the 2,216,500 w arrant s hares exercised . The  N ew   W arrants have an exe rcise price of $2.60 per share and are substantially similar to the warrants issued in December 201 5 , except that they are:   (a) restricted; (b) not exercisable for six months from the date of issuance; and (c) have a term of five and a half years from the issuance date.



The Company   raised approximately $4.5 million in gross proceeds f r om the t ransaction, which will be used for general c orporate purposes.



The issuance of the New Warrants was exempt from   f ederal and s tate registration requirements.  T he Company expects to file a resale   registration statement to register the shares of the Company ’s   c ommon Stock issuable upon the exercise of the New Warrants.

At September 30, 2016 there were New Warrants outstanding to purchase 2,947,949 shares of Company ’s   c ommon s tock at an exercise price of $2.60 , which expire in February 2023 .  In addition, warrants to purchase 383, 500 shares remaining from the December 2015 issuance were outstanding at September 30, 2016 at an exercise price of $2.05 , which expire in June 2021 .



Note 7:   Income Taxes    

The Company’s effective tax rate is calculated quarterly based upon current assumptions relating to the full year’s estimated operating results and various tax-related items. The Company’s effective tax rate for the   three   month periods ended September 30, 2016   and 201 5   was 0% .   The difference between the effective tax rate of 0% and the U.S. federal statutory rate of 34% for the three and nine month periods ended September 30, 2016 and 201 5 was primarily due to recognizing a full valuation allowance on deferred tax assets .  



As of September 30, 2016 , the Company determined that based on all available eviden ce, both positive and negative , including the Company’s latest   forecasts and cumulative losses in recent years , it was more likely than not that none of its deferred tax assets would be realized and therefore it continued to rec ord a full valuation allowance .    



The Company’s net operating loss carry forward amounts e xpire through   203 7 and are subject to certain limitation s that may occur due to change in ownership provisions   under Section 382 of the Internal Revenue Code and similar state provisions.



Due to the Company’s operating loss carryforwards, all tax years remain open to examination by the major taxing jurisdictions to which the Company is subject. In the event that the Company is assessed interest or penalties at some point in the future, it will be classified in the financial statements as tax expense.  

Note 8:  Commitments and Contingencies 

Equipment Purchase Commitments 

The Company has committed to equipment purchases of approximately $0. 6 million at September 30, 2016 .



Future Sales Concessions



I n the first quarter of 2014, the Company received a notification to stop shipments to three of its customers regarding a possible wire bonding problem in some of the microdisplays shipped to these customers. Shipments to two of the three customers resumed in 2014.   As the third customer (“this Customer”) was not interested in continuing to use the Company ’s standard commercial microdisplay which was originally shipped, the Company has been working, at this Customer’s request, on a more mechanically robust display configuration.  This Customer provided a proposal to the Company which the Company countered that included concessions to this Customer predicated on future business.  On June 16, 2016, the Company obtained a formal release from this Customer for any future concessions and from any liabilities or obligations arising from the matter.



Litigation



From time to time, the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. The Company accrues for losses related to li ti gation when a potential loss is probable and the loss can be reasonably estimated. Significant judgment is required to determine the probability that a liability has been incurred and whether such liability is reasonably estimable. All estimates are based on the best information available at the time which can be highly subjective.



On May 5, 2015, Kimchuk, Inc. (“Kimchuk”), a former supplier , commenced action against the Company in the U.S. District Court, District of Connecticut, asserting breach of contract and seeking to recover approximately $389,000 in alleged damages. The Company filed its response and counter-complaint on August 11, 2015 wherein the Company denied the material allegations asserted by Kimchuk and sought approximately $3.5 million in damages from Kimchuk.  On June 1, 2016, the Company entered into a settlement agreement with Kimchuk whereby, for consideration of approximately $227 ,000 , Kimchuk agreed to dismiss the matter, provide parts and material to eMagin and settle outstanding accounts payable.  The Company recorded an accrual for the litigation in the quarter ended September 30, 2015, and did not incur any additional settlement expense during the quarter ended September 30, 2016 associated with the matter .



During 2015, the Company received a letter from an attorney representing a former employee claiming damages for age discrimination and wrongful termination.  In September 2016, this former employee commenced action against the Company in Superior Court for the State of Washington, The Company believes the assertions contained in this action are baseless and without merit and will defend its position vigorously. 













Note 9:  Concentrations    

The following is a schedule of revenue s by geographic location (in thousands):  











The following table represents the domestic and international revenues as a percentage of total net revenues:









The Company purchases principally all of its silicon wafers from two   suppliers located in Taiwan and Korea.   



For the three months ended September 30, 2016 ,   two   customer s accounted for 1 0 % and 9 %   of net revenue s.     F or the nine months ended   September 30, 201 6 ,   there were no customers accounting for over 10 %   of net revenue s .     For the three months ended September 30, 2015 ,   four customer s accounted for 51 % of net revenue s.  For the nine months ended   September 30, 201 5 ,   two customers accounted for 25%   of n et revenue s.       As of September 30, 2016 ,   one customer accounted for 1 6 %   of the Company’s consolidated accounts receivable balance.