Summary of IRVINE SENSORS CORP/DE/

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operatis.

This report contains forward-looking statements regarding Irvine Sensors which include, but are not limited to, statements concerning our projected revenues, expenses, gross profit and income, mix of revenue, the need for additional capital, our ability to regain and maintain compliance with Nasdaq listing requirements, demand for our products, the benefits and potential applications for our products and technologies, the effect of the Patent Sale and License and our ability to develop and sell new patents in the future, the effect of the sale of the assets of Optex Systems, Inc., our ability to obtain and successfully perform additional new contract awards and the related funding and profitability of such awards, market acceptance of our products and technologies, the competitive nature of our business and markets, the success and timing of new product introductions and commercialization of our technologies, product qualification requirements of our customers, our significant accounting policies and estimates, and the outcome of expense audits. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management's beliefs, and certain assumptions made by us. Words such as "anticipates," "expects," "intends," "plans," "predicts," "potential," "believes," "seeks," "hopes," "estimates," "should," "may," "will," "with a view to" and variations of these words or similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Such factors include, but are not limited to the following:
• our ability to obtain additional financing for working capital on acceptable terms in a timely manner;

• our ability to regain and maintain compliance with Nasdaq's listing requirements, including our ability to increase our net income from continuing operations;

• the outcome of existing litigation;

• our ability to continue as a going concern;

• our ability to obtain critical and timely product and service deliveries from key vendors due to our working capital limitations, competitive pressures or other factors;

• our ability to successfully execute our business plan and control costs and expenses;

• our ability to obtain expected and timely bookings and orders resulting from existing contracts;

• our ability to secure and successfully perform additional research and development contracts, and achieve greater contracts backlog;

• governmental agendas, budget issues and constraints and funding or approval delays;

• our ability to maintain adequate internal controls and disclosure procedures, and achieve compliance with Section 404 of the Sarbanes-Oxley Act;

• our ability to introduce new products, gain broad market acceptance for such products and ramp up manufacturing in a timely manner;

• new products or technologies introduced by our competitors, many of whom are bigger and better financed than us;

• the pace at which new markets develop;

• our ability to establish strategic partnerships to develop our business;

• our limited market capitalization;

• general economic and political instability; and

• those additional factors which are listed under the section "Risk Factors" in Part II, Item 1A of this report.

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We do not undertake any obligation to revise or update publicly any forward-looking statements for any reason, except as required by law. Additional information on the various risks and uncertainties potentially affecting our operating results are discussed below and are contained in our publicly filed documents available through the SEC's website (www.sec.gov) or upon written request to our Investor Relations Department at 3001 Red Hill Avenue, Costa Mesa, California 92626.
Overview
We are a vision systems company enabled by technology for three-dimensional packaging of electronics and manufacturing of electro-optical products. We design, develop, manufacture and sell vision systems and miniaturized electronic products for defense, security and commercial applications. We also perform customer-funded contract research and development related to these products, mostly for U.S. government customers or prime contractors. Most of our historical business relates to application of our technologies for stacking either packaged or unpackaged semiconductors into more compact three-dimensional forms, which we believe offer volume, power, weight and operational advantages over competing packaging approaches, and which we believe allows us to offer higher level products with unique operational features.
In December 2005, we completed the Initial Acquisition of Optex, a privately held manufacturer of telescopes, periscopes, lenses and other optical systems and instruments whose customers were primarily agencies of and prime contractors to the U.S. Government. In consideration for the Initial Acquisition, we made an initial cash payment to the sole shareholder of Optex, Timothy Looney, in the amount of $14.0 million and made an additional cash payment of $64,200 to Mr. Looney in July 2006 upon completion of the audit of Optex's financial statements for the year ended December 31, 2005. As additional consideration, we were initially required to pay to Mr. Looney cash earnout payments in the aggregate amount up to $4.0 million based upon the net cash generated from the Optex business, after debt service, for fiscal 2006 and the next two subsequent fiscal years. Mr. Looney was not entitled to any earnout payments for fiscal 2006, for fiscal 2007 or for fiscal 2008. In January 2007, we negotiated an amendment to our earnout agreement with Mr. Looney that extended his earnout period to December 2009 and reduced the aggregate maximum potential earnout by $100,000 to $3.9 million in consideration for a secured subordinated term loan providing for advances from an entity owned by Mr. Looney to Optex of up to $2 million. This term loan bears interest at 10% per annum and matures on the earlier of February 2009 or 60 days after repayment of our senior debt. As of June 28, 2009, this term loan was fully advanced to Optex. Mr. Looney has brought a lawsuit against the Company alleging that the Company is obligated to pay him the full earnout as a result of the Optex Asset Sale. (See Part II, Item 1, Legal Proceedings).
In connection with the Initial Acquisition, we entered into the Buyer Option with Mr. Looney, pursuant to which we agreed to purchase the remaining 30% of the capital stock of Optex held by Mr. Looney. On December 29, 2006, we amended certain of our agreements with Mr. Looney regarding the Buyer Option. In consideration for such amendments, we issued a one-year unsecured subordinated promissory note to Mr. Looney in the principal amount of $400,000, bearing interest at a rate of 11% per annum. We exercised the Buyer Option on December 29, 2006 and issued Mr. Looney approximately 269,231 shares of our common stock as consideration for our purchase of the remaining 30% of the outstanding common stock of Optex held by him. As a result of the Initial Acquisition and exercise of the Buyer Option, Optex became our wholly-owned subsidiary.

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We financed the Initial Acquisition of Optex by a combination of $4.9 million of senior secured debt from Square 1 Bank under a term loan and $10.0 million of senior subordinated secured convertible notes from two private equity funds, which are sometimes referred to in this report collectively as "Pequot." In December 2006, both of these obligations were refinanced with two new senior Lenders, Longview and Alpha. These transactions resulted in approximately $4.4 million of non-recurring debt extinguishment expenses, which were largely non-cash, and approximately $12.4 million of future additional interest expense resulting from debt discounts and issuance costs. In November 2007, we restructured these obligations, as well as a short-term $2.1 million debt obligation to Longview, to extend the maturity date of all of such obligations, including the related interest, to December 30, 2009 in consideration for a restructuring fee of approximately $1.1 million, which fee was also initially payable December 30, 2009, but which was extended to September 30, 2010 in connection with partial repayment related to the Patent Sale and License. In September 2008, we entered into a binding Memorandum of Understanding for Settlement and Debt Conversion Agreement (the "MOU") with the Lenders with the intent to effect a global settlement and restructuring of our aggregate outstanding indebtedness payable to the Lenders, which was then approximately $18.4 million. In October 2008, pursuant to the MOU, an entity controlled by the Lenders delivered a notice to us and to Optex of the occurrence of an event of default and acceleration of the obligations due to the Lenders and their assignee and conducted the Optex Asset Sale, which was a public UCC foreclosure sale of the assets of Optex. The entity controlled by the Lenders credit bid $15 million in the Optex Asset Sale, which was the winning bid. As a result, $15 million of our aggregate indebtedness to the Lenders was extinguished. All financial statements and notes and schedules thereto give effect to this event and report Optex as a discontinued operation for both the current and prior fiscal periods. We recorded a loss on disposal of the Optex discontinued operations of approximately $7.6 million during the fiscal year ended September 28, 2008.
In March 2009, we sold most of our patent portfolio to a patent acquisition company for $9.5 million in cash, $8.5 million of which was paid in March 2009 and $1.0 million of which was paid in April 2009, and the patent acquisition company granted us a perpetual, worldwide, royalty-free, non-exclusive license to use the sold patents in our business (the "Patent Sale and License"). In order to secure the release of security interests to effectuate the Patent Sale and License, we agreed to pay $2.8 million of the aggregate principal and accrued interest owed to the Lenders from the proceeds of the Patent Sale and License. After such payment, our aggregate principal and accrued interest owed to the Lenders was approximately $1.2 million. Subject to satisfying certain conditions, including our consummation of a $1.0 million bridge debt financing, the Lenders had agreed to exchange Notes in the amount of $1.0 million of such residual principal for a new class of non-voting convertible preferred stock of the Company. We completed such a bridge financing in February 2009 and satisfied other conditions for such exchange in April 2009, and $1.0 million of principal under our obligations was cancelled in through the exchange of Notes for the issuance of 24,999 shares of our newly-created Series A-2 Stock on April 30, 2009. The conversion of the Series A-2 Stock into shares of our common stock is subject to the same conversion blocker as contained in our Series A-1 Preferred Stock.
Since 2002, and prior to our acquisition of Optex, we historically derived a substantial majority of our total revenues from government-funded research and development rather than from product sales. Optex also historically derived most of its revenues from product sales to government agencies or prime contractors. We anticipate that a substantial majority of our total revenues will continue to be derived from government-funded sources in the immediately foreseeable future. Prior to fiscal 2005, with a few exceptions, our government-funded research and development contracts were largely early-stage in nature and relatively modest in size. As a result, our revenues from this source during that period were not significantly affected by changes in the U.S. defense budget. In fiscal 2008, our contract research and development revenues were adversely affected by

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procurement delays, as well as diversion of management and financial resources to address supply chain and margin issues at Optex. Our current marketing efforts are focused on government programs that we believe have the potential to transition to government production contracts. If we are successful in this transition, our future revenues may become more dependent upon U.S. defense budgets, funding approvals and political agendas. We are also attempting to increase our revenues from product sales by introducing new products with commercial applications, in particular, miniaturized cameras and stacked computer memory chips. We cannot assure you that we will be able to complete development, successfully launch or profitably manufacture and sell any such products on a timely basis, if at all. We generally use contract manufacturers to produce these products, and all of our other current operations occur at a single, leased facility in Costa Mesa, California. Prior to the Optex Asset Sale, Optex manufactured its products at its leased facility in Richardson, Texas.
We have a history of unprofitable operations due in part to our investment in Optex and due to discretionary investments that we have made to commercialize our technologies and to maintain our technical staff and corporate infrastructure at levels that we believed were required for future growth. These investments have yet to produce profitable operating results, except for the current 39-week period ended June 28, 2009 as a result of the Patent Sale and License. With respect to our investments in staff and infrastructure, the advanced technical and multi-disciplinary content of our technologies places a premium on a stable and well-trained work force. As a result, we generally maintain the size of our work force even when anticipated government contracts are delayed, a circumstance that has occurred with some frequency in the past and that has resulted in under-utilization of our labor force for revenue generation from time to time. Delays in receipt of research and development contracts are unpredictable, but we believe such delays represent a recurring characteristic of our research and development contract business. We anticipate that the impact on our business of future delays can be mitigated by the achievement of greater contract backlog and are seeking growth in our research and development contract revenue to that end. We are also seeking to expand the contribution to our total revenues from product sales, which have not historically experienced the same types of delays that can occur in research and development contracts. We have not yet demonstrated the level of sustained research and development contract revenue or product sales that we believe is required to achieve profitable operations. Our ability to recover our investments through the cost-reimbursement features of our government contracts is constrained due to both regulatory and competitive pricing considerations. To offset the adverse working capital effect of our net losses, we have historically financed our operations through issuance of various equity and debt instruments. To finance the acquisition of Optex, we also incurred material long-term debt, and we have exchanged a significant portion of that debt into preferred stock that is convertible into our common stock. Since the beginning of fiscal 2006 through June 28, 2009, we have issued approximately 6.2 million shares of our common stock, an increase of approximately 330% over the approximately 1.9 million shares of our common stock outstanding at the beginning of that period, and a substantial dilution of stockholder interests. At June 28, 2009, our fully diluted common stock position was approximately 21.4 million shares, which assumes the conversion into common stock of all preferred stock outstanding as of June 28, 2009 and the exercise for cash of all outstanding warrants and options to purchase the Company's securities. At June 28, 2009, we had approximately $588,400 of debt, exclusive of debt discounts and exclusive of the $2.0 million of debt owed by Optex. None of our subsidiaries accounted for more than 10% of our total assets at June 28, 2009 or have separate employees or facilities. We currently report our operating results and financial condition in two operating segments, our research and development business and our product business.

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Critical Accounting Estimates
Our consolidated financial statements have been prepared in conformity with GAAP. As such, management is required to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The significant accounting policies that are most critical to aid in fully understanding and evaluating reported financial results include the following:
Revenue Recognition. Our consolidated total revenues during the 39 weeks ended June 28, 2009 were primarily derived from contracts to develop prototypes and provide research, development, design, testing and evaluation of complex detection and control defense systems. Our research and development contracts are usually cost reimbursement plus a fixed fee, fixed price with billing entitlements based on the level of effort we expended or occasionally firm fixed price. Our cost reimbursement plus fixed fee research and development contracts require our good faith performance of a statement of work within overall budgetary constraints, but with latitude as to resources utilized. Our fixed price level of effort research and development contracts require us to deliver a specified number of labor hours in the performance of a statement of work. Our firm fixed price research and development contracts require us to deliver specified items of work independent of resources utilized to achieve the required deliverables. For all types of research and development contracts, we recognize revenues as we incur costs and include applicable fees or profits primarily in the proportion that costs incurred bear to estimated final costs. Costs and estimated earnings in excess of billings under government research and development contracts are accounted for as unbilled revenues on uncompleted contracts, stated at estimated realizable value and are expected to be realized in cash within one year.
Upon the initiation of each research and development contract, a detailed cost budget is established for direct labor, material, subcontract support and allowable indirect costs based on our proposal and the required scope of the contract as may have been modified by negotiation with the customer, usually a U.S. government agency or prime contractor. A program manager is assigned to secure the needed labor, material and subcontract in the program budget to achieve the stated goals of the contract and to manage the deployment of those resources against the program plan. Our accounting department collects the direct labor, material and subcontract charges for each contract on a weekly basis and provides such information to the respective program managers and senior management.
The program managers review and report the performance of their contracts against the respective program plans with our senior management on a monthly basis. These reviews are summarized in the form of estimates of costs to complete the contracts ("ETCs"). If an ETC indicates a potential overrun against budgeted program resources, it is the responsibility of the program manager to revise the program plan in a manner consistent with the customer's objectives to eliminate such overrun and achieve planned contract profitability, and to seek necessary customer agreement to such revision. To mitigate the financial risk of such re-planning, we attempt to negotiate the deliverable requirements of our research and development contracts to allow as much flexibility as possible in technical outcomes. Given the inherent technical uncertainty involved in research and development contracts, in which new technology is being invented, explored or enhanced, such flexibility in terms is frequently achievable. When re-planning does not appear possible within program budgets, senior management makes a judgment as to whether the program statement of work will require additional resources to be expended to meet contractual obligations or whether it is in our interest to supplement the customer's budget with our own funds. If either determination is made, we record an accrual for the anticipated contract overrun based on the most recent ETC of the particular contract.

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We provide for anticipated losses on contracts by recording a charge to earnings during the period in which a potential for loss is first identified. We adjust the accrual for contract losses quarterly based on the review of outstanding contracts. Upon completion of a contract, we reduce any associated accrual of anticipated loss on such contract as the previously recorded obligations are satisfied. Costs and estimated earnings in excess of billings under government contracts are accounted for as unbilled revenues on uncompleted contracts and are stated at estimated realizable value.
We consider many factors when applying GAAP related to revenue recognition. These factors generally include, but are not limited to:
• The actual contractual terms, such as payment terms, delivery dates, and pricing terms of the various product and service elements of a contract;

• Time period over which services are to be performed;

• Costs incurred to date;

• Total estimated costs of the project;

• Anticipated losses on contracts; and

• Collectibility of the revenues.

We analyze each of the relevant factors to determine its impact, individually and collectively with other factors, on the revenue to be recognized for any particular contract with a customer. Our management is required to make judgments regarding the significance of each factor in applying the revenue recognition standards, as well as whether or not each factor complies with such standards. Any misjudgment or error by our management in evaluation of the factors and the application of the standards could have a material adverse effect on our future operating results.
We recognize revenue from product sales upon shipment, provided that the following conditions are met:
• There are no unfulfilled contingencies associated with the sale;

• We have a sales contract or purchase order with the customer; and

• We are reasonably assured that the sales price can be collected.

The absence of any of these conditions, including the lack of shipment, would cause revenue recognition to be deferred. Our terms are FOB shipping point. Historically, our products have not been sold under formal warranty terms. We do not offer contractual price protection on any of our products. Accordingly, we do not presently maintain any reserves for returns under warranty or post-shipment price adjustments although we do record product support expenses incurred and accrue such expenses expected to be incurred in relation to shipped products. However, we anticipate future shipments of products that may include formal warranty terms and may therefore include reserves for returns under warranty in future periods.
We do not utilize distributors for the sale of our products nor do we enter into revenue transactions in which the customer has the right to return product, other than pursuant to a warranty. Accordingly, we do not make any provisions for sales returns, contractual price protection or adjustments in the recognition of revenue.
Inventory. Inventories are stated at the lower of cost or market value. Each quarter, we evaluate our inventories for excess quantities and obsolescence. We write off inventories that are considered obsolete and adjust remaining inventory balances to approximate the lower of cost or market value. The valuation of inventories at the lower of cost or market requires us to estimate the amounts of current inventories that will be sold. These estimates are dependent on our assessment of current and expected orders from our customers.

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Costs on long-term contracts and programs in progress generally represent recoverable costs incurred. The marketing of our research and development contracts involves the identification and pursuit of contracts under specific government budgets and programs. We are frequently involved in the pursuit of a specific anticipated contract that is a follow-on or related to an existing contract. We often determine that it is probable that a subsequent award will be successfully received, particularly if continued progress can be demonstrated against anticipated technical goals of the projected new program while the government goes through its lengthy approval process required to allocate funds and award contracts. When such a determination occurs, we capitalize material, labor and overhead costs that we expect to recover from a follow-on or new contract. Due to the uncertainties associated with new or follow-on research and development contracts, we maintain significant reserves for this inventory to avoid overstating its value. We have adopted this practice because we believe that we are typically able to more fully recover such costs under the provisions of government contracts by direct billing of inventory rather than by seeking recovery of such costs through permitted indirect rates, which may be more vulnerable to competitive market pressures.
Cost of our product inventory includes direct material and labor costs, as well as manufacturing overhead costs allocated based on direct labor dollars. Inventory cost is determined using the average cost method. Pursuant to contract provisions, agencies of the U.S. Government and certain other customers may have title to, or a security interest in, inventories related to certain contracts as a result of advances and progress payments. In such instances, we reflect those advances and payments as an offset against the related inventory balances. Inventories are reviewed quarterly to determine salability and obsolescence. A reserve is established for slow moving and obsolete product inventory items. Valuation Allowances. We maintain allowances for doubtful accounts for estimated losses resulting from a deterioration of a customer's ability to make required payments to the point where we believe it is likely there has been an impairment of its ability to make payments. Such allowances are established, maintained or modified at each reporting date based on the most current available information. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance.
Goodwill and Other Intangible Assets. Goodwill represents the cost of acquired businesses in excess of fair value of the related net assets at acquisition. (See also Note 1 to the Condensed Notes to Consolidated Financial Statements). Valuation of intangible assets such as goodwill requires us to make significant estimates and assumptions including, but not limited to, estimating future cash flows from product sales, developing appropriate discount rates, continuation of customer relationships and renewal of customer contracts, and approximating the . . .