Critical Accounting Policies

The following accounting policies are important to understanding our financial condition and results of operations and should be read as an integral part of the discussion and analysis of the results of our operations and financial position. For additional accounting policies, see note 2 to our consolidated financial statements, "Summary of Significant Accounting Policies."

The Company has entered into a number of license agreements covering potential products using the Company's SPD technology. The Company receives fees and minimum annual royalties under certain license agreements and records fee income on a ratable basis each quarter. In instances when sales of licensed products by its licensees exceed minimum annual royalties, the Company recognizes fee income as the amounts have been earned. Certain of the fees are accrued by, or paid to, the Company in advance of the period in which they are earned resulting in deferred revenue.

The Company expenses costs relating to the development or acquisition of patents due to the uncertainty of the recoverability of these items.

All of our research and development costs are charged to operations as incurred. Our research and development expenses consist of costs incurred for internal and external research and development. These costs include direct and indirect overhead expenses.

The Company has historically used the Black-Scholes option-pricing model to determine the estimated fair value of each option grant. The Black-Scholes model includes assumptions regarding dividend yields, expected volatility, expected lives, and risk-free interest rates. These assumptions reflect our best estimates, but these items involve uncertainties based on market conditions generally outside of our control. As a result, if other assumptions had been used in the current period, stock-based compensation expense could have been materially impacted. Furthermore, if management uses different assumptions in future periods, stock-based compensation expense could be materially impacted in future years.

On occasion, the Company may issue to consultants either options or warrants to purchase shares of common stock of the Company at specified share prices. These options or warrants may vest based upon specific services being performed or performance criteria being met. In accordance with Emerging Issues Task Force Issue 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, the Company would be required to record consulting expenses based upon the fair value of such options or warrants on the date that such options or warrants vest as determined using a Black-Scholes option pricing model.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make 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, and reported amounts of revenues and expenses during the reporting periods. Actual results could differ from these estimates. An example of a critical estimate is the full valuation allowance for deferred taxes that was recorded based on the uncertainty that such tax benefits will be realized in future periods.

Results of Operations

Year ended December 31, 2008 Compared to the Year ended December 31, 2007

The Company's fee income from licensing activities for 2008 was $1,679,919, as compared to $402,359 for 2007. This difference in fee income was primarily the result of the receipt of a one-time payment from a former licensee in full settlement of past due minimum annual royalties for several years and the Company entering into a new agreement with Hitachi Chemical regarding payments made by Hitachi Chemical to the Company for guaranteed access to future improvements in the Company's technology, the timing and amount of minimum annual royalties paid, and the date of receipt of such payment on certain license agreements, by end-product licensees. Certain license fees, which are paid to the Company in advance of the accounting period in which they are earned can result in the recognition of deferred revenue for the current accounting period, which will be recognized as fee income in future periods. Also, licensees may offset some or all of their royalty payments on sales of licensed products for a given period by applying these advance payments towards such earned royalty payments. Because the Company's license agreements typically provide for the payment of royalties by a licensee on product sales within 45 days after the end of the quarter in which a sale of a licensed product occurs (with some of the Company's more recent license agreements providing for payments on a monthly basis), and because of the time period which typically will elapse between a customer order and the sale of the licensed product and installation in a home, office building, automobile, aircraft, boat, or any other product, there could be a delay between when economic activity between a licensee and its customer occurs and when the Company gets paid its royalty resulting from such activity.

Operating expenses decreased by $2,814,451 for 2008 to $2,959,576 from $5,774,027 for 2007. This decrease was principally the result of non-cash charges of $2,790,656 in 2007 relating to primarily fully vested stock options granted by the Company. Additional factors causing this decrease were lower payroll costs ($41,000), marketing costs ($81,000), and patent costs ($13,000) partially offset by increased reserves for uncollectable accounts ($40,000) and higher insurance costs ($29,000).

Research and development expenditures decreased by $1,059,816 to $1,469,760 for 2008 from $2,529,576 for 2007. This decrease was principally the result of non-cash charges of $1,236,199 in 2007 relating to fully vested stock options granted by the Company. Offsetting this decrease were higher payroll costs ($132,000), and insurance costs ($29,000).

Investment income for 2008 was $154,574 as compared to $336,026 for 2007. The difference was primarily due to lower cash balances available to invest, as well as lower interest rates during 2008.

As a consequence of the factors discussed above, the Company's net loss was $2,594,843 ($0.17 per share) for 2008 as compared to $7,565,218 ($0.50 per share) for 2007. The difference is primarily due to non-cash accounting charges of $4,026,855 ($0.26 per share) in 2007 relating to the issuance of common stock options as well as $1,277,560 ($0.08 per share) in higher fee income in 2008.

Year ended December 31, 2007 Compared to the Year ended December 31, 2006

The Company's fee income from licensing activities for 2007 was $402,359, as compared to $162,639 for 2006. This difference in fee income was primarily the result of the Company entering into a new agreement with Hitachi Chemical regarding payments made by Hitachi Chemical to the Company for guaranteed access to future improvements in the Company's technology, the timing and amount of minimum annual royalties paid, and the date of receipt of such payment on certain license agreements, by end-product licensees, and an amendment to an existing license agreement with American Glass Products ("AGP"), which, among other things, increased the percentage royalty due from AGP from 5% to 15%. Certain license fees, which are paid to the Company in advance of the accounting period in which they are earned resulting in the recognition of deferred revenue for the current accounting period, will be recognized as fee income in future periods. Also, licensees may offset some or all of their royalty payments on sales of licensed products for a given period by applying these advance payments towards such earned royalty payments. Because the Company's license agreements typically provide for the payment of royalties by a licensee on product sales within 45 days after the end of the quarter in which a sale of a licensed product occurs (with some of the Company's more recent license agreements providing for payments on a monthly basis), and because of the time period which typically will elapse between a customer order and the sale of the licensed product and installation in a home, office building, automobile, aircraft, boat or any other product, there could be a delay between when economic activity between a licensee and its customer occurs and when the Company gets paid its royalty resulting from such activity.

Operating expenses increased by $3,390,171 for 2007 to $5,774,027 from $2,383,856 for 2006. This increase was primarily the result of non-cash charges of $2,790,656 relating to primarily fully vested stock options granted by the Company during the year. Additional factors causing this increase were higher payroll costs ($151,000), and marketing costs ($158,000), patent costs ($113,000) and insurance costs ($59,000).

Research and development expenditures increased by $1,359,073 to $2,529,576 for 2007 from $1,170,503 for 2006. This increase was primarily the result of non-cash charges of $1,236,199 relating to fully vested stock options granted by the Company during the year. Additional factors causing this increase were higher payroll costs ($52,000), insurance ($55,000) and consulting costs ($25,000).

Investment income for 2007 was $336,026 as compared to $88,087 for 2006. The difference was primarily due to higher cash balances available to invest, partially offset by lower interest rates during 2007.

As a consequence of the factors discussed above, the Company's net loss was $7,565,218 ($0.50 per share) for 2007 as compared to $3,303,633 ($0.24 per share) for 2006. The difference is primarily due to non-cash accounting charges of $4,026,855 ($0.26 per common share) resulting from the issuance of stock options during 2007.

Financial Condition, Liquidity and Capital Resources

During 2008, the Company's cash and cash equivalents balance decreased $4,892,680 principally as a result of cash used to fund operations of $2,414,276 as well as net purchases of US Treasury Securities ($2,259,496), fixed assets ($76,220) and $112,500 invested in SPD Control Systems. At December 31, 2008, the Company had working capital of $4,525,836 and shareholders' equity of $4,872,185.

During 2007, the Company's cash and cash equivalent balance increased by $4,259,671 principally as a result of net proceeds received from the issuance of common stock and on the exercise of options and warrants of $7,876,550 partially offset by cash used to fund operations of $3,517,185.

During 2006, the Company's cash and cash equivalent balance decreased by $644,164 principally as a result of cash used to fund the Company's operating activities of $3,265,358 partially offset by $2,650,000 of net proceeds received from the issuance of common stock.

The Company occupies premises under an operating lease agreement which expires on January 31, 2014 and requires minimum annual rent which rises over the term of the lease to approximately $176,669, plus tenant's share of applicable taxes. These lease obligations are summarized over time as of

December 31, 2008:

                                                        Payments due by period
                                  <1 year         1-3 years     4-5 years       >5 years        Total
Operating lease obligations       $167,000       $513,000        $192,000        $     --   $872,000

The Company expects to use its cash to fund its research and development of SPD light valves and for other working capital purposes. The Company's working capital and capital requirements depend upon numerous factors, including the results of research and development activities, competitive and technological developments, the timing and cost of patent filings, the development of new licensees and changes in the Company's relationships with its existing licensees. The degree of dependence of the Company's working capital requirements on each of the foregoing factors cannot be quantified; increased research and development activities and related costs would increase such requirements; the addition of new licensees may provide additional working capital or working capital requirements, and changes in relationships with existing licensees would have a favorable or negative impact depending upon the nature of such changes. Based upon existing levels of cash expenditures, existing cash reserves and budgeted revenues, the Company believes that it would not require additional funding until the first quarter of 2010. There can be no assurance that expenditures will not exceed the anticipated amounts or that additional financing, if required, will be available when needed or, if available, that its terms will be favorable or acceptable to the Company. Eventual success of the Company and generation of positive cash flow will be dependent upon the extent of commercialization of products using the Company's technology by the Company's licensees and payments of continuing royalties on account thereof.

Inflation

The Company does not believe that inflation has a significant impact on its business.

Related Party Transactions

None.

Forward Looking Statements

The information set forth in this Report and in all publicly disseminated information about the Company, including the narrative contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations" above, includes "forward-looking statements" within the meaning of
Section 21E of the Securities Exchange Act of 1934, as amended, and is subject to the safe harbor created by that section. Readers are cautioned not to place undue reliance on these forward-looking statements as they speak only as of the date hereof and are not guaranteed.