Summary of LUNA INNOVATIONS INC

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes to those statements included elsewhere in this report. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and timing of selected events may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under "Risk factors" and elsewhere in this report.

Overview

We research, develop and commercialize innovative technologies in two primary areas of focus: instrumentation and test & measurement, sensing, and instrumentation products and healthcare products. We have a disciplined and integrated business model that is designed to accelerate the process of bringing new and innovative products to market. We identify technologies that can fulfill large and unmet market needs and then take these technologies from the applied research stage through commercialization. Although revenues from product sales currently represent less than half of our total revenues, we continue to invest in product development and commercialization, which we anticipate will lead to increased product sales growth. In the future, we expect that revenues from product sales will represent a larger proportion of our total revenues. In addition, we anticipate that these revenues will reflect a broader and more diversified mix of products as we develop and commercialize new products.

We have developed a disciplined and integrated process to accelerate the development and commercialization of innovative technologies. Our business model employs a market-driven approach and provides the infrastructure, resources and know-how throughout the process of developing and commercializing new products. To manage a diverse set of products effectively across a range of development stages, we are organized into two main groups: our Technology Development Division and our Products Division. These groups work together through all product development stages, including:

• Searching for emerging technologies based on market needs;

• Conducting applied research;

• Developing and commercializing innovative products; and

• Applying proven technologies and products to new market opportunities.

Our revenues were $29.5 million and $23.7 million during the nine months ended September 30, 2008 and 2007, respectively, and we had net losses of $4.1 million and $6.7 million for the same periods, respectively. We generate revenues through technology development services provided under contractual arrangements, product sales and license fees. Historically, our technology development revenues have accounted for a large and growing proportion of our total revenues, and we expect that they will continue to represent a significant portion of our total revenues for the foreseeable future. Our technology development revenues grew from $17.1 million to $20.8 million for the nine month periods ended September 30, 2007 and 2008, respectively. We regularly have a backlog of contracts for which work has been scheduled, but for which a specified portion of work has not yet been completed. We define backlog as the dollar amount of obligations payable to us under negotiated contracts upon completion of a specified portion of work that has not yet been completed, exclusive of revenues previously recognized for work already performed under these contracts, if any. The approximate value of our backlog was $25.7 million as of September 30, 2008, an increase of $0.5 million from December 31, 2007.

Revenues from product sales currently represent a smaller proportion of our total revenues, and, historically, we have derived most of these revenues from the sales of our sensing systems and products that make use of light-transmitting optical fibers, or fiber optics. License revenues associated with our proprietary technologies have been significant in prior years. In the near term, we expect revenues from product sales to increase primarily in areas associated with our fiber optic instrumentation and test and measurement platforms. We also expect to increase our investments in product development and commercialization, which we anticipate will lead to increased product sales growth. In the future, we expect that revenues from product sales will represent a larger proportion of our total revenues and that as we develop and commercialize new products, these revenues will reflect a broader and more diversified mix of products.

We expect to continue to incur significant additional expenses as we expand our business, including increased expenses for research and development, sales and marketing, manufacturing, and finance and accounting personnel. Although we have no current plans in this regard, we may also grow our business in part through acquisitions of additional companies and complementary technologies which could cause us to incur transaction expenses, amortization or write-offs of intangible assets and other acquisition-related expenses. As a result, we expect that we will continue to incur losses in 2008 and that these losses could be substantial.

Our operating expenses include stock-based compensation charges. We recorded stock-based compensation charges of $2.2 million for the nine months ended September 30, 2008. We also expect to record an aggregate stock-based compensation charge for stock options granted through September 30, 2008 of $6.8 million, to be recognized in future periods through 2013.

Global economic and political conditions affect our customers' businesses and the markets they serve. With over 60% of our revenues derived from U.S. federal government contracting research, we have not detected a significant effect to our financial results resulting from an economic downturn. However, a severe and/or prolonged economic downturn or a negative or uncertain political climate could adversely affect our customers' financial condition and the levels of business

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activity of our customers and the industries we serve. This may reduce the demand for our products or depress pricing for our products and have a material adverse effect on our results of operations. Changes in global economic conditions could also shift demand to products or services for which we do not have competitive advantages, and this could negatively affect the amount of business that we are able to obtain.

Description of Our Revenues, Costs and Expenses

Revenues

We generate revenues from technology development (contract research), contract product development, and product sales. We derive technology development revenues from providing research and development services to third parties, including government entities, academic institutions and corporations, and from achieving milestones established by some of these contracts and in collaboration agreements. In general, we complete contracted research over periods ranging from six months to three years, and recognize these revenues over the life of the contract as costs are incurred or upon the achievement of certain milestones built into the contracts. Our product revenues reflect amounts that we receive from sales of our products or development of products for third parties and currently represent approximately 30% of our total revenues.

Cost of Revenues

Cost of revenues associated with technology development revenues consists of costs associated with performing the related research activities, including direct labor, amounts paid to subcontractors and overhead allocated to technology development activities.

Cost of revenues associated with product sales and license revenues consists of license fees for use of certain technologies; product manufacturing costs including all direct material and direct labor costs; amounts paid to our contract manufacturers; manufacturing, shipping and handling; provisions for product warranty; and inventory obsolescence, as well as overhead allocated to these activities.

Operating Expense

Operating expense consists of selling, general and administrative expenses, as well as expenses related to research and development, depreciation of fixed assets and amortization of intangible assets. These expenses also include:
compensation for employees in executive and operational functions including certain non-cash charges related to expenses from option grants; facilities costs; professional fees; salaries, commissions, travel expense and related benefits of personnel engaged in sales, product management and marketing activities; costs of marketing programs and promotional materials; salaries, bonuses and related benefits of personnel engaged in our own research and development beyond the scope and activities of our Technology Development Division; product development activities not provided under contracts with third parties; and overhead costs related to these activities.

Interest Income/Expense

On May 21, 2008, we canceled our senior secured revolving credit facility with First National Bank, and entered into a new $10 million debt facility with Silicon Valley Bank. At September 30, 2008, a $5 million term loan was outstanding under this new facility. Interest expense includes interest accrued on the outstanding aggregate principal of the senior convertible promissory notes issued to Carilion Clinic on December 30, 2005, and interest payable on the Silicon Valley Bank debt term loan.

Interest income includes amounts earned on our cash deposits with financial institutions. During 2007 and the nine month period ended September 30, 2008, we invested the proceeds of the Carilion financing transactions and the net proceeds from our initial public offering in a money market account, and we draw from that account as needed to fund ongoing operations. We have currently invested the proceeds from the Silicon Valley Bank debt facility in a money market account.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (US GAAP). The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the amounts reported in our financial statements and the accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or judgments. Our significant accounting policies are described in the Management Discussion and Analysis section and the notes to our audited consolidated financial statements previously included in our Annual Report on Form 10-K for the period ended December 31, 2007, as filed with the Securities and Exchange Commission on March 19, 2008.

Results of Operations

Three Months Ended September 30, 2008 Compared to Three Months Ended September 30, 2007

Revenues

Total revenues increased 21% to $10.7 million for the three months ended September 30, 2008, from $8.8 million for the three months ended September 30, 2007. The increase was due to increased product sales related to our Luna Technologies Division, as well as an increase in technology development revenue recognized. We incurred increased costs of labor and other direct costs which resulted in the increase in technology development revenue. Approximately 69% of the growth in revenues from the corresponding period in 2007 was due to increased revenues from our Technology Development Division, and approximately 31% of the increase was due to increased product sales and product development revenues. We generated approximately $3.5 million in product sales in the third quarter of 2008 as compared with $2.9 million in the third quarter of 2007, an increase of approximately 21%, due primarily to increases in product development revenue related to our shape sensing technology and increased sales of fiber optic test and measurement equipment by our Luna Technologies division.

Cost of Revenues

Cost of revenues increased 22% to $6.4 million for the three months ended September 30, 2008 from $5.3 million for the corresponding 2007 period. The main component of this overall increase was increased costs of labor and other direct costs related to increases in technology development revenue. New technology development cost of sales increases accounted for approximately $1.0 million, or 85%, and product sales cost increases accounted for approximately $0.2 million, or 15%, respectively, of the overall increase in costs of revenues.

Technology development costs increased 24% to $5.0 million for the three months ended September 30, 2008 from $4.0 million in the same period in 2007. This increase was consistent with the 22% increase in our technology development revenues, and was comprised primarily of additional direct labor, subcontracting costs, and other direct costs related to research and development activities.

Product and licensing costs increased 13% to $1.5 million for the three months ended September 30, 2008 from $1.3 million in the same period in 2007. This increase is due to an increase in the number of units sold.

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Our overall gross margin remained consistent as compared with the third quarter of 2007. Our overall gross margin during the three months ended September 30, 2008 and the same period in 2007 was 40%. During the three months ended September 30, 2008, technology development activity returned a gross margin of approximately 31% compared to 33% in the same period of 2007. Product sales activity returned a gross margin of 58% for the three months ended September 30, 2008, compared to 55% for the same period in 2007.

Operating Expense

Operating expense decreased 3% to $5.4 million for the three months ended September 30, 2008 from $5.5 million for the corresponding quarter in 2007, primarily as a result of decreased legal expenses related to the settlement of a dispute through mediation in July 2008. The decrease was primarily attributable to legal expenses of $0.3 million, which were netted against the proceeds of $1.0 million from a settlement of litigation at mediation, and recorded in other income.

Other Income (Expense)

On July 23, 2008, we settled litigation at mediation with our former auditing and accounting firm in connection with the firm's auditing and opining on the accuracy of several years of our consolidated financial statements in preparation for our registration with the Securities and Exchange Commission and our initial public offering of securities. The settlement of the litigation at mediation was without any admission of liability, or adjudication of fact or law, and the material terms included payment to us of $1.0 million. The $0.7 million in other income related to this settlement is comprised of the proceeds of $1.0 million, less related legal expenses of $0.3 million.

Net interest income decreased from approximately $94,000 for the three months ended September 30, 2007, to a net interest expense of $36,000 for the three months ended September 30, 2008. This decrease was attributable to a reduction in invested cash and lower interest rates, combined with an increase in interest payments due to the addition of a $5.0 million term loan from the Silicon Valley Bank debt facility.

We incurred approximately $77,000 in interest expense on the $5.0 million Silicon Valley Bank term loan. We also incurred approximately $76,000 in interest expense on our convertible promissory notes issued to Carilion Clinic on December 30, 2005. These notes have an aggregate outstanding principal of approximately $5.0 million and accrue simple interest at a rate of 6.0% per year. In addition, interest income earned on invested cash positions for the three months ended September 30, 2008, totaled approximately $103,000.

Nine Months Ended September 30, 2008 Compared to Nine Months Ended September 30, 2007

Revenues

Total revenues increased 24% to approximately $29.5 million for the nine months ended September 30, 2008, from $23.7 million for the nine months ended September 30, 2007. Approximately 64% of the growth in revenues from the corresponding period in 2007 was due to increased revenues from our Technology Development Division, and approximately 36% of the increase was due to increased product sales and product development revenues. Product sales and product development revenues increased 31%, to $8.7 million for the nine months ended September 30, 2008, as compared to $6.7 million for the nine months ended September 30, 2007. This increase was primarily a result of increased sensing product sales as well as an increase in product development activity principally related to our shape sensing technology.

Growth in our technology development revenues also contributed to our overall growth in revenues for the nine months ended September 30, 2008 as compared with the same period in 2007. Technology development revenues increased 22% to $20.8 million for the nine months ended September 30, 2008 from $17.1 million for the corresponding 2007 period. This increase was primarily a result of a continued strong success in obtaining research contracts, an increase in the size of certain awards, and the addition of direct contract personnel that permitted us to service more contracts.

During the period ending March 31, 2008, we identified certain product development contracts, which we account for using the percentage of completion method, where our estimated cost to complete increased significantly from our prior estimates. The resulting decrease in the overall percentage of completion resulted in an adjustment to reduce revenues previously recognized. Pursuant to the provisions of SOP 81-1, Accounting for the Performance of Construction-Type and Certain Production-Type Contracts, we reduced our product and licensing revenues for the period ending March 31, 2008 on a cumulative basis in the amount of $0.3 million.

Cost of Revenues

Cost of revenues increased 22% to $17.8 million for the nine months ended September 30, 2008 from $14.6 million for the corresponding 2007 period. The components of this overall increase were increased costs of labor and materials related to increases in technology development revenue, as well as increased costs related to product and licensing revenue. New technology development cost of sales increases accounted for approximately $1.63 million, or 51%, and product sales cost increases accounted for approximately $1.55 million, or 49%, respectively, of the overall increase in costs of revenues.

Technology development costs increased 14% to $13.6 million for the nine months ended September 30, 2008 from $11.9 million in the same period in 2007. This increase was comprised primarily of additional direct labor and the technology associated overhead related to research and development activities.

Product and licensing costs increased 58% to $4.2 million for the nine months ended September 30, 2008 from $2.3 million in the same period in 2007. This increase was incurred due to a 41% increase in the number of units sold for the nine months ended September 30, 2008 versus September 30, 2007.

Product sales activity returned a gross margin of 52% for the nine months ended September 30, 2008, compared to 60% for the same period in 2007. The decrease in gross margin associated with our product and license segment was primarily attributable to the cumulative adjustment in product and license revenue described above, relating to the effects of applying SOP 87-1 to certain contracts.

Our overall gross margin improved as compared with the first nine months of 2007. Our overall gross margin during the nine months ended September 30, 2008 was 40% compared to 39% during the same period in 2007. During the nine months ended September 30, 2008, technology development activity returned a gross margin of approximately 35% compared to 30% in the same period of 2007.

Operating Expense

Operating expense increased 2% to $16.4 million for the nine months ended September 30, 2008 from $16.2 million for the corresponding period in 2007. The primary driver of the increase in the first nine months of 2008 as compared to the same period in 2007 was an increase in legal expenses associated with on-going legal matters, offset with a decrease due to netting expenses associated with a legal settlement received during the three months ending September 30, 2008, with the settlement reflected in other income.

Other Income (Expense)

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offering of securities. The settlement of the litigation at mediation was without any admission of liability, or adjudication of fact or law, and the material terms included payment to us of $1.0 million. The $0.7 million in other income related to this settlement is comprised of the proceeds of $1.0 million, less related legal expenses of $0.3 million.

Net interest income decreased from $0.3 million in net interest income for the nine months ended September 30, 2007 to approximately $45,000 in net interest expense for the nine months ended September 30, 2008. This decrease was attributable to a reduction in invested cash and lower interest rates, and an increase in interest payments due to the addition of a $5.0 million term loan from the Silicon Valley Bank debt facility.

During the nine month period ended September 30, 2008, we incurred approximately $77,000 in interest expense on the $5.0 million Silicon Valley Bank term loan. We also incurred $0.2 million in interest expense on our convertible promissory notes issued to Carilion Clinic on December 30, 2005. These notes have an aggregate outstanding principal of approximately $5.0 million and accrue simple interest at a rate of 6.0% per year. Interest income for the nine months ended September 30, 2008 totaled $0.3 million.

Liquidity and Capital Resources

Until May 2008, we had a $3.0 million senior secured revolving credit facility with First National Bank that was collateralized by a security interest in substantially all of our assets. The interest rate on borrowings under our secured revolving credit facility was equal to the prime rate, limited to no less than 6.0% and no greater than 10.0% per annum, with interest payable monthly. This agreement also provided a $1.0 million sub-limit for letters of credit.

In May 2008, we canceled our $3.0 million senior secured revolving credit facility with First National Bank, and entered into a $10.0 million credit facility with Silicon Valley Bank, which includes a four year term debt of $5.0 million and a remaining facility of up to $5.0 million available under a four-year revolving line of credit, based on the balance of our term loan at September 30, 2008. As we repay the term debt principal, the revolving facility available increases, so that at any time, the term debt plus the revolving debt may be equal to up to $10 million. For the remainder of 2008, we will pay only the interest portion of the loan. The interest rate on borrowings under the secured revolving facility is a floating per annum rate of one half of one percentage point above the prime interest rate, or 5.5% as of September 30, 2008. Interest on the term loan is a floating per annum rate of one percentage point above the prime interest rate, or 6.0% as of September 30, 2008. Beginning in January, 2009, we will begin to pay interest and principal monthly, so that principal is paid back ratably over 42 months. This agreement also provided a $1.0 million sub-limit for letters of credit. The facility is secured by certain company assets and is subject to customary covenants, including covenants requiring us to meet EBITDA milestones and liquidity ratios. In connection with the credit facility with Silicon Valley Bank, Carilion Clinic agreed to extend the maturity date of the existing $5.0 million aggregate principal amount in notes payable to Carilion Clinic to December 31, 2012, from the original date of December 30, 2009, and to subordinate the Carilion Clinic debt to that of Silicon Valley Bank.

Discussion of Cash Flows

Recent Activity

We used approximately $1.3 million and $3.8 million of net cash from operations during the nine months ended September 30, 2008 and 2007, respectively. The decrease in cash used in operations resulted primarily from a decrease of $2.6 million in net loss. The decrease in net loss includes the net effect of $0.7 million relating to proceeds received from a settlement of litigation at mediation. A decrease in deferred credits related to certain product development contracts used $0.3 million in cash during the nine months ended September 30, 2008, compared to providing cash of $0.9 million for the same period ended 2007, resulting in a net decrease in cash between the two periods of $1.2 million. Additionally, changes in working capital accounts (other than deferred credits) used a net $0.5 million in cash from operating activities for the nine months ended September 30, 2008 compared to $1.0 million used for the nine months ended September 30, 2007.

Cash used in investing activities for the nine months ended September 30, 2008 related primarily to the purchase of property and equipment and legal fees associated with securing patent rights to certain technology. Our overall cash used in investing activities was $0.7 million in the nine months ended September 30, 2008, compared to $1.6 million in the corresponding September 30, 2007 period. In future months, we expect that our cash used in investing activities will remain consistent with the current level.

Cash flows provided by financing activities for the nine months ended September 30, 2008 was $5.1 million, representing an increase in cash flow from cash generated by financing activities for the nine months ended September 30, 2007. Cash generated by financing activities for the nine months ended September 30, 2008 predominantly consisted of proceeds from the Silicon Valley Bank debt facility of $5.0 million. We did not draw additional financing from our line of credit or other sources in the nine months ended September 30, 2008.

At September 30, 2008, total cash and cash equivalents were approximately $15.2 million. We believe that our current cash on hand and cash available under our line of credit agreement will be sufficient to fund operations for the next 12 months.

Summary of Contractual Obligations

We lease our facilities in Blacksburg, Charlottesville, Danville, Hampton, and Roanoke, Virginia under operating leases that expire on various dates through January 2014 or under a month-to-month arrangement. Upon expiration of the leases, we may exercise certain renewal options as specified in the leases.

We also lease certain computer equipment and software under capital lease agreements that expire through January 2010. The assets subject to these obligations are included in property and equipment on our consolidated balance sheet.

Our Luna Technologies Division has an agreement with a supplier to purchase tunable lasers and estimates its non-cancellable obligation to be approximately $1.9 million through 2010.

In March 2004, we received a grant of $0.9 million from the City of Danville, Virginia under a Grant Agreement to support the expansion of economic and commercial growth within the City of Danville. Under the Grant Agreement, we . . .