10-K

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

þ	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the fiscal year ended December 31, 2006
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from          to

Commission file number: 001-31783

RAE Systems Inc.

(Exact name of registrant as specified in its charter)

Delaware	77-0280662
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
3775 North First Street San Jose, California (Address of principal executive offices)	95134 (Zip Code)

408-952-8200

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class	Name of Each Exchange on Which Registered
Common Stock, $0.001 par value per share	The American Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:
None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes o     No þ

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes o     No þ

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

As of June 30, 2006, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $155,560,324, based upon the closing sale price of $4.00 on the American Stock Exchange on June 30, 2006, the last business day of the registrant’s most recently completed second fiscal quarter. As of the close of business on February 28, 2007, the number of shares of registrant’s Common Stock outstanding was 59,301,054.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s proxy statement for its 2007 Annual Meeting of Stockholders are incorporated by reference into Part III of this Annual Report on Form 10-K.

RAE SYSTEMS INC.

INDEX TO
ANNUAL REPORT ON FORM 10-K
FOR YEAR ENDED DECEMBER 31, 2006

TABLE OF CONTENTS

			Page
PART I				3
	ITEM 1.	BUSINESS		3
	ITEM 1A.	RISK FACTORS		14
	ITEM 1B.	UNRESOLVED STAFF COMMENTS		21
	ITEM 2.	PROPERTIES		21
	ITEM 3.	LEGAL PROCEEDINGS		21
	ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS		22
PART II				23
	ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES		23
	ITEM 6.	SELECTED FINANCIAL DATA		25
	ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		26
	ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		40
	ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA		41
	ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE		41
	ITEM 9A.	CONTROLS AND PROCEDURES		41
	ITEM 9B.	OTHER INFORMATION		46
PART III				46
	ITEM 10.	DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE		46
	ITEM 11.	EXECUTIVE COMPENSATION		46
	ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS		46
	ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE		46
	ITEM 14.	PRINCIPAL ACCOUNTING FEES AND SERVICES		46
PART IV				47
	ITEM 15.	EXHIBITS, FINANCIAL STATEMENT SCHEDULES		47
SIGNATURES				48
EXHIBIT 10.13
EXHIBIT 10.14
EXHIBIT 21.1
EXHIBIT 23.1
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

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PART I

In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements. These statements typically are preceded or accompanied by words like “believe,” “anticipate,” “expect,” “may,” “will,” “should,” “intend,” “plan,” “estimate,” “potential,” or “continue,” and other words of similar meaning. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in these forward-looking statements. Readers are cautioned not to place undue reliance on those forward-looking statements, which reflect management’s opinions only as of the date hereof. We undertake no obligation to revise or update or publicly release the results of any revisions or update to these forward-looking statements. Readers should carefully review the risk factors described herein and in other documents that we file from time to time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q that we file for the fiscal year 2007.

ITEM 1.   BUSINESS.

General

We are a leading global developer and manufacturer of rapidly-deployable, multi-sensor chemical and radiation detection monitors and networks for application in industrial and environmental safety and public and government first responder security applications. We provide rapidly-deployable sensor networks that enable our customers to identify safety and security threats in real-time.

We offer a full line of portable single-sensor chemical and radiation detection products, multi-sensor portable products and wireless integrated sensor systems. In addition, we offer a line of fixed and mobile digital video recorders that are used by the military, transportation agencies and public venues for safety and security applications. Our technologically advanced products are based on proprietary patented technology, and include portable, wireless and fixed chemical detection monitors and gamma and neutron detectors and dosimeters. Industrial applications include the detection of toxic industrial chemicals, volatile organic compounds and petrochemicals. Our products are deployed in oil, gas, petrochemical plants and in other types of manufacturing facilities. Our products enable the military and first responders such as firefighters, law enforcement and other emergency management personnel to detect and provide early warning of weapons of mass destruction and other hazardous materials.

We were founded in 1991 to develop technologies for the detection of hazardous materials in environmental remediation and chemical spill clean-ups. We have a broad patent portfolio consisting of 18 issued and pending patents in gas and radiation detection technology and two in video compression and stabilization that are the basis for many of our products. For example, our patented photoionization detector technology allows our products to rapidly and reliably indicate many toxic chemicals and vapors in the part-per-billion range of readings. In 1995, we expanded our operations into Shanghai, China, giving us access to high-quality, cost-efficient manufacturing and world-class research capabilities. In April 2002, we completed a reverse merger by which we became a publicly-traded Delaware corporation. In May 2004, we acquired a 64% interest in “KLH”, now known as RAE-KLH (Beijing) Co., Limited, or RAE Beijing, a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment. With the acquisition of KLH, we expanded our presence in the personal security and safety market in China and gained access to an established distribution channel. In July 2006, we acquired Aegison, a manufacturer of portable and fixed digital video recorders and increased our ownership of RAE Beijing to 96 %. In December 2006, we announced the formation of a joint venture in Fushun, China and created RAE Coal Mine Safety Instruments (Fushun) Co., Ltd., hereafter referred to as RAE Fushun. RAE Fushun is owned 70% by a wholly owned subsidiary of RAE Systems and 30% by the Liaoning Coal Industry Group Co., Ltd., a Chinese state enterprise management group. RAE Fushun offers a wide range of mine safety products for both personal and permanently fixed use in the Chinese coal mining industry.

The end users of our products include many of the world’s leading corporations in the airline, automotive, computer and oil industries. Our products are used in civilian and government atmospheric monitoring programs in over 65 countries. Several government agencies and departments have standardized their programs based on our products for hazardous materials incident response. A number of United States government agencies, including the

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Department of Homeland Security, the Department of Justice, the Department of State, as well as all branches of the United States military, and by city and state agencies use RAE Systems products.

Additional information about RAE Systems Inc. (referred to herein as the “Company”, “we”, or “our”) is available on our web site atwww.raesystems.com. We make available, free of charge on our web site, access to our Annual Report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we file them electronically with or furnish them to the Securities and Exchange Commission (“SEC”). Information contained on or accessible through our web site is not part of this Annual Report or our other filings with the SEC.

The public may also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Rooms by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet website that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The SEC’s Internet website is located at http://www.sec.gov.

Industry Background

The market for our products has evolved from being strictly focused on environmental and industrial monitoring to encompassing public safety, including the threat of terrorism and coal mine safety in China. The market demand for our products has grown in the fields of environmental remediation, confined space entry, OSHA Regulation 1910 compliance and industrial safety monitoring. The application of our products in these established markets stems from the dependence of numerous key industries on sensors that provide vital information that can affect worker safety, products, processes and systems. A few examples of these market sectors that use monitoring include:

•  chemicals and manufacturing (process control);

•  municipal and volunteer fire departments (arson investigations, hazardous fumes detection);

•  petroleum (leaks, explosive vapors, records of worker exposure);

•  transportation (airplane wing tank entry); and

•  hazardous materials clean-up (environmental remediation).

The increasing concerns about domestic terrorist attacks in the United States as well as the increasing risks of unconventional asymmetric methods of attack using chemical or radiological agents has created the need for technologically advanced hazardous material detection devices to protect vulnerable public venues to such attacks. In response to such risks, the United States Congress authorized $40.3 billion for fiscal 2006 and $46.4 billion for fiscal 2007 for the Department of Homeland Security. The part of the budget that our products address is designated for Chemical, Biological, Radiation, Nuclear and Explosive (CBRNE) threat detection. For 2006 the CBRNE designation was $421 million. We expect a 20% reduction in that amount for 2007.

The need for sophisticated monitoring has been most apparent for emergency response personnel, who are typically the first to arrive on the scene. To date, many first responders have not been trained for and have not carried chemical and radiological detection equipment to detect harmful agents, preventing them from recognizing unseen threats that could create a potentially lethal situation. We believe first responders need a suite of products that provide a practical, comprehensive solution to protect them from this danger. The following features are important to this solution:

•  protection through detection;

•  portability for easy transport;

•  rapid deployment for emergency response;

•  fast and reliable detection of a broad array of chemicals;

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•  an open system architecture that allows networking among multiple detectors;

•  wireless on-ramp to the Internet, allowing the data to be shared and acted upon;

•  wireless networking for monitoring from remote locations; and

•  information to make time and life critical decision.

Many of the same equipment capabilities that are necessary to support first responders are also necessary to address other areas where there are increasing demands for chemical and radiation detection. For example, many of the world’s major spectator events are considered potential targets for terrorist attacks. As a result, wireless detection systems have been deployed at these events for public venue protection. The potential for accidents or terrorist attacks in the world-wide chemical infrastructure may also present a hazardous chemical threat to the communities that surround the world’s pharmaceutical, petroleum and chemical plants.

Currently, the majority of electricity that is produced in China is generated by coal fired power plants. In 2006, China produced 2.2 billion metric tons of coal. The government of China has levied a two dollar per metric ton coal tax to be utilized for improving coal mine safety. In time, based on our analysis of the market, we believe this represents a potential addressable market opportunity of up to $500 million per year for RAE Fushun’s products.

Our Strengths

We have a comprehensive product portfolio.  Our broad portfolio of portable, rapidly-deployable and rugged products consists of atmospheric monitors, photoionization detectors, radiation detectors, gas detection tubes, sampling pumps, security monitoring devices, mobile digital video recorders and fixed digital video recorders. Our products incorporate a broad array of sensors, with the ability to detect over 600 chemicals. Based upon our familiarity with the market and our competition, we believe that we offer a competitive suite of products with multiple sensors that can be interfaced to a wireless network and monitored from a base location or command center.

We are a technological leader in the industry.  We have a history of being the first to market in the industry. For example, in 1994, we introduced the world’s smallest portable photoionization detection monitor; in 1996, we were the first to introduce a multi-sensor chemical detection product; and in 2002, we were the first to introduce a wireless network of chemical sensors. In addition, in 2004 we were the first to introduce a monitor with a combination of radiological and chemical sensors in a single unit and a wireless mesh network sensor system with a range of applications in cargo container security, transportation security and indoor air security. In 2006, we were the first to introduce a wireless sensor system that meets the radio and packaging standards for the European, ATEX certified market. We believe our expertise and knowledge of current and future standards for monitoring sensors through wired and wireless delivery platforms will allow us to continue to be an industry leader in developing the most appropriate design architecture for modular systems that can be quickly and efficiently reconfigured as the mission requirements dictate.

We have an established customer base.  We have a substantial customer list consisting of governmental entities and industries that we support with our array of products and solutions. Our products and systems have been used extensively in high-profile events such as the Salt Lake City Olympics, the Torino Winter Games, the Athens Olympics, the Super Bowl, the United States Open golf tournament, the Republican and Democratic National Conventions, the Presidential Inauguration, the Rose Bowl, the World Series, the Major League Baseball All-Star game, the Kentucky Derby, and the Fifa World Cup of Soccer. In addition, our equipment has been utilized to monitor the indoor air quality and security of venues such as Soldier’s Field in Chicago and the HSBC Arena in Buffalo. In 2006, our AreaRAE wireless sensor system was selected by the United States National guard for deployment with the National Guard Weapons of Mass Destruction Civil Support Teams in all 50 states.

We have modern, cost-efficient manufacturing.  We lease a modern, cost-efficient manufacturing facility in Shanghai, China that is currently producing the majority of our products. With the acquisition of a majority interest in RAE Beijing, we have expanded our manufacturing capabilities in Beijing, China. With the formation of RAE Fushun we have heavy machining and additional manufacturing capability. We believe that our facilities will allow a significant scaling of production to meet the requirements for our future sales growth.

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We have strong research, development and engineering capabilities.  We have assembled a team of research, development and engineering scientists in China and the United States. In addition, we are engaged in a collaborative effort with Shanghai University, which is known for its research depth in the electronics engineering, telecommunications and material science fields.

Our Strategy

Since our inception, we have focused on becoming a leader in the development of sensor systems for hazardous materials detection. We intend to maintain this focus by pursuing the following strategies:

Pursue the shifts in global industrial growth.  According to the National Bureau of Statistics, industrial spending growth in China expanded by over 27 percent in 2006. Our products have been certified for use in the production of steel and other iron alloys. They are well suited for deployment in oil and gas refining, chemical production and power generation.

Pursue the Homeland Security Market.  The heightened concerns about domestic terrorist attacks in the United States led to the creation of the Department of Homeland Security as well as the allocation of billions of dollars of the federal budget to counter these threats. In addition, many state and local government agencies also have committed resources to combat this threat. As our products already address many of the needs of these governmental agencies, we intend to capitalize and sustain our leadership as a leading provider to first responders.

Aggressively Pursue the Rapidly Expanding Network Detection Market.  We believe the market for fixed and wireless networked sensor systems is growing rapidly, driven by reduced costs, increased safety and greater advanced warning that remote detection over a wide coverage area can offer. Our unique combination of the wireless systems and sensor technology is well positioned to satisfy this growing market. Our current network products enable data to be transmitted from remote locations in the field to a base station located up to two miles from the site of the detector, and can also be hosted via the Internet.

Develop New Products and Solutions.  We intend to continue to develop products and solutions based on our patented technology and ongoing research and development that provide a compelling value proposition. A number of our hazardous material detection devices have been first to the market, and we continue to demonstrate our ability to innovate by being the first to combine radiation and chemical detection in a wireless network device.

Leverage Our Cost-Efficient Infrastructure.  We have significant additional manufacturing capacity in Shanghai and Beijing. As we continue to grow our business, we expect to realize manufacturing efficiencies, thereby reducing per unit costs. In addition, we expect to benefit from significant savings by complementing our research and development cost capabilities at our headquarters in California with more cost-efficient intellectual capital available in China.

Selectively Pursue Acquisitions, Joint Ventures and Licensing Agreements.  We will continue to selectively pursue acquisitions, joint ventures and licensing agreements in order to more rapidly and effectively develop new technology. We are confident in our ability to continue to develop state-of-the-art technology; however, we also believe that the industry is very fragmented and there exists a considerable opportunity to acquire new technologies and processes to further broaden and complement our product offerings.

Technology

Our strength is in the development of sensors, measurement technology and the integration of wireless technology. As an instrument manufacturer, we have differentiated ourselves from our competition by developing a broad array of specific chemical sensors, including an array of gas sensors and photoionization detectors.

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Sensor and Measurement Technology

Our products are based on a broad array of proprietary and patented gas and chemical sensors. We design and manufacture the following sensors:

•  photoionization detectors for the measurement of volatile organic compounds, highly toxic chemical warfare agents and toxic industrial chemicals;

•  catalytic bead pellistors for the detection and measurement of combustible gas;

•  non-dispersive infrared sensors for the measurement of carbon dioxide and hydrocarbons; and

•  electro-chemical sensors for the measurement oxygen and toxic gases such as carbon monoxide.

We believe that our main competitive advantage is our proprietary photoionization technology. Photoionization detectors use ultraviolet light to ionize the molecules of the gas into charged particles. This produces a flow of electrical current proportional to the concentration of the charge. Our patented photoionization detector technology enables dependable, linear, part-per-billion range readings for many toxic gases and vapors. Photoionization detection is particularly suited to the detection of the highly toxic, long-chain, low vapor pressure volatile organic compounds associated with many toxic industrial chemicals and chemical warfare agents.

Integrated Wireless Technology

In 1999, anticipating the emergence of robust wireless networks, we began to develop wireless capabilities for our gas monitoring instruments that enable them to detect from remote locations. In 2002, we introduced the AreaRAE, a wireless-enabled gas detector, which provides real-time transmission of monitoring information to a base station located up to two miles away from the detectors. The AreaRAE enables industrial workers, hazardous materials, or “HazMat”, teams, firefighters, law enforcement officials and other emergency management personnel to remain a safe distance away from toxins, flames and explosives. The AreaRAE incorporates technologies such as global positioning system (GPS) receivers and geographic information system (GIS) capabilities to create awareness of hazardous conditions for decision makers located remotely in a central command and control location. In addition, the AreaRAE can be made to interface with the Internet, making measurements available from virtually any location with Internet access. AreaRAE has also found an application in industrial monitoring due to the low installation and infrastructure costs compared with direct-wired fixed systems.

In 2004, we introduced the AreaRAE Gamma, the first combined multi-gas and radiation detector equipped with a wireless radio frequency modem that allows the unit to communicate and transmit sensor and other information on a real-time basis with a remotely located base controller. The AreaRAE Gamma is currently being used in applications such as homeland security, venue protection, and HazMat and emergency protection. We also partnered with Safer Systems to introduce PlumeRAE the first plume measurement system to use remote wireless sensors. In 2006, we introduced the AreaRAE Steel, a stainless steel version of the AreaRAE that met the intrinsic safety requirements of the European Union (ATEX). In addition, we partnered with Vivometrics to integrate Lifeshirt, a personal monitoring system for first responders and industrial workers that can be displayed on the same screen as the AreaRAE Monitors.

Radiation Technology

We have developed technology for alpha, gamma and neutron particle detection. These technologies are incorporated into highly sensitive instruments capable of detecting low levels of radiation on a real-time basis which makes them ideal for border control applications. This is in contrast to dosimeters, which are used in nuclear plants to protect personnel from long-term radiation exposure.

Our scintillating crystal-based sensors detect low levels of radiation and are ideal for detecting illicit trafficking of radiological material. Our cost-efficient, low-power consumption devices enable us to address low-maintenance, long-term stability requirements in the law enforcement and first responder markets.

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Products

Product	Description	Application
Integrated Systems
AreaRAE	Wireless, multi-channel, integrated five-gas detection systems	• HazMat and emergency response • Confined space entry • Plant turnarounds • Venue protection • Oil platform protection
AreaRAEGamma	Wireless, combined multi-gas and radiation detector	• HazMat and emergency response • Homeland defense • Venue protection
RAEGuard PID	Permanently mounted photoionization	• Waste water treatment plants
RAEGuard EC	Detector (PID) equipped with digital display of the gas concentration, unit of measurement and functional keys for performing calibration	• Marine and off-shore oil wells • Refineries • Petrochemical plants • Power plants • Pulp and paper
		• Solvent recovery systems
Photoionization Detection
MiniRAE 2000	Versatile handheld volatile organic compound monitor with sensitivity range of 0 – 10,000 parts-per-million	• Confined space entry • Emergency response to hazardous spills • Environmental remediation • Soil remediation • Military
UltraRAE	Combines vapor separation tubes and photoionization detection into compound-specific monitor for Benzene	• Crude oil production, pipelines • Transportation of hazardous materials • Refineries • Plant turn-arounds
ppbRAE Plus	Hand-held photoionization detection monitor to detect volatile organic compounds down to one part-per-billion	• Emergency response to hazardous spills • Indoor air quality in new, sick and mixed usage buildings
		• Personal monitoring
		• Drug detection
EntryRAE	4-gas monitor plus photoionization (PID) detection	• Refineries • Chemical processing • Water & wastewater facilities • Semiconductor manufacturing
Radiation Detection
GammaRAE II	Rapid detector of gamma sources, includes cesium iodide (CsI) scintillator that provides low level detection in a compact unit	• Emergency response • Customs and border patrols • Law enforcement • Military
GammaRAE II R	Combination Gamma Detector and Gamma Dosimeter	• Emergency response • Customs and border patrols
		• Law enforcement • Military

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Product	Description	Application
NeutronRAE II	Rapid detector of gamma and neutron sources, includes both cesium iodide (CsI) and lithium iodide (LiI) scintillators that provide low level detection in a compact unit	• Emergency response • Customs and border patrols • Law enforcement • Military
Multi-Sensor
MultiRAE IR	One-to-five gas surveyor with CO2 and photoionization detection	• Indoor air quality • Beverage and brewery • Food industry
MultiRAE PLUS	Hand-held, 1-to-5 gas monitor with lower explosive limit measurement capability, O2, two toxic sensors, and photoionization detector for toxic volatile organic compound detection	• Confined space entry • Wing tank entry • HazMat
VRAE	Hand-held 5-gas confined space monitor and sniffer	• Refineries and petrochemical plants • Confined space entry, hot work permits
		• Utilities — Cable vaults, transformer stations
		• Waste water treatment plants
QRAE / QRAE PLUS	Economical, robust 4-gas confined space monitor	• Confined space entry • Refineries and petrochemicals plants
		• Power plants
IAQRAE	Indoor air quality monitor with CO2, photoionization detection, relative humidity, temperature and toxic gas sensors	• Indoor air quality • Beverage and brewery • Food industry
Single-Sensor
BadgeRAE	Single gas H2S and CO disposable two year personal monitor	• Oil fields and refineries • Utilities and power plants • Chemical plants
ToxiRAE Plus PID	Pocket-sized, single-gas PID monitor	• Oil fields and refineries
		• Mining and metals
		• Pulp and paper mills
ToxiRAE II	Full-featured gas monitor providing continuous, digital display of gas concentration, available with ten different sensors	• Refineries and chemical plants • Oil production • Contractors • Industrial safety • Power plants
AutoRAE	A bench-top calibration and charging station that currently supports EntryRAE, MultiRAE Plus, ppbRAE, MiniRAE 2000 and QRAE Plus	• All existing and future users of these instruments
Tubes
Gas Detection Tubes	Single-use, single-sensor for the detection of specific chemicals	• Refineries • Petrochemical plants • Compressed gas distribution facilities

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Product	Description	Application
Other
HazRAE	Hazardous materials decision support facilities application for chemical, biological and WMD assessment that runs on handheld wireless devices	• Emergency first responders • HazMat teams • EMS and emergency rooms
PlumeRAE	Plume measurement for chemical plants and first responders	• Law enforcement and forensics personnel
		• Intelligence community

Sales, Marketing and Distribution

Most of our products are sold through a worldwide organization that includes direct sales personnel and distributors managed through our San Jose, California; Beijing, China and Copenhagen, Denmark offices. We have sales and distribution worldwide, including locations in the United States, Canada, Western Europe, United Arab Emirates, Mexico, Latin America, Japan, China, Hong Kong and Singapore.

Currently, our predominant distribution channel is value added business-to-business and business-to-government distribution services companies that focus on the health, safety and security product markets. Many of our distributors are international companies with distribution rights in specific territories. We seek those distributors that have the greatest reach and broadest array of end-user customers. Currently, we benchmark our distributors’ performance according to pricing policy, volume, payment schedule, training, services and other support programs.

Our suite of wireless detection products, specifically the AreaRAE suite of products and its peripherals, are largely sold directly in the United States and Europe, with customers identified through external manufacturers’ representatives. This channel was established because of the technical expertise required to advise and sell these complex monitoring systems. Commissions are paid to the representatives based on the amount of effort extended in consummating the sale and the amount of training provided to customers after the product is sold.

Our products are distributed globally, with approximately 49% of our revenues derived from sales in Americas, approximately 38% of revenues derived from sales in Asia and approximately 13% of revenues derived from sales in Europe for the year ended December 31, 2006.

Our marketing efforts are focused on increasing brand awareness through advertising, direct mail, web sites, trade shows and focused sales strategies. We hired product specific managers whose primary responsibilities are to develop marketing programs targeted towards specific audiences in the areas of integrated systems, portable products, and consumable products and accessories. We also formed an applications group whose primary task is to develop and identify new applications for our products and to provide training of our installed customer base. We have established a number of alliances, partnerships and collaboration agreements, some of which have been identified in the strategic relationships section.

Customers

Our end-user customers include many United States government agencies in the intelligence and law enforcement community as well as all branches of the armed forces, and numerous local, state and federal agencies and departments. We also have significant numbers of instruments currently in service with many of the world’s leading corporations in the airline, automotive, oil, energy, metals, computer and telecommunications industries. Our products are used in confined space entry monitoring programs throughout the world, and are used in civilian and government atmospheric monitoring programs in over 65 countries. Several government agencies and departments have standardized their programs based on our products for hazardous materials incident response. For fiscal years 2006, 2005 and 2004, approximately 49%, 56% and 66% of our revenues, respectively, were derived from sales in the Americas. During the same three periods, 38%, 33% and 24% of our revenues, respectively, were derived from our sales to Asia.

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Research, Development and Engineering

We are expanding our product offerings through advances in sensor, wireless and networking technologies, including:

•  the introduction of PlumeRAE, in a Rapid Deployment Kit, which provides first responders with powerful decision support capabilities when determining the best course of action for a population near an incident;

•  the introduction of the AreaRAE Gamma, which provides wireless delivery of remotely sensed gas vapors and gamma radiation, an industry first; and

•  networking advances, which allow RAE sensor to be connected to industrial command and control system via mesh networking of Ethernet.

The adoption with modular product design and flexible rapid manufacturing have resulted in improved system performance as well as advanced scalability thereby allowing rapid development of new products. New portable products have been introduced for use in confined space/hazardous materials applications, including the GammaRAE II and QRAE 2. We expect to continue to receive governmental and industry certifications for our products in various jurisdictions.

Our research and development process is done in collaboration with our manufacturing department. Such collaboration is designed to ensure the manufacturability of the product and to expedite the transition from the conceptual design phase to the actual production phase. For 2006, 2005 and 2004, we spent $6.2 million, $5.4 million and $4.4 million, respectively, on research and development activities.

Manufacturing

We have been ISO 9001 certified since 1998 and were upgraded to ISO 9001:2000 in December 2001. Our international manufacturing subsidiary, RAE Systems Shanghai Inc., was certified to ISO 9002 and was upgraded to ISO 9001 in 2001.

We lease a modern 61,000 square foot manufacturing facility and laboratory space in Shanghai, China where the majority of our components and products are manufactured. Our manufacturing capabilities in Shanghai include:

•  material planning and production scheduling;

•  procurement;

•  incoming quality assurance;

•  manufacturing process design;

•  production, including precision machining, plastic injection, colorimetric tube production, electrochemical sensor manufacturing and printed circuit board assembly using surface mount technology;

•  final assembly and test; and

•  quality control and assurance.

We also own a 67,000 square foot office and manufacturing, integration and test site in San Jose, California, where we manufacture some of our more complex and sensitive sensors.

At our manufacturing facility in San Jose, our capabilities include:

•  material planning and production scheduling;

•  procurement;

•  sensor manufacturing;

•  photoionization detection lamp manufacturing;

•  prototyping for engineering;

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•  process design;

•  final assembly and test;

•  calibration; and

•  final quality control and assurance.

Through our investment in RAE Beijing, we have added manufacturing capabilities in our facility in Beijing, China, which include:

•  material planning and production scheduling;

•  procurement;

•  sensor manufacturing;

•  photoionization detection lamp manufacturing;

•  prototyping for engineering;

•  process design;

•  final assembly and test;

•  calibration; and

•  final quality control and assurance.

The facility in Beijing consists of 106,000 square feet, of which 41,000 is dedicated to the manufacturing of RAE Beijing’s products and the storage of the inventory and the balance of the space is used for sales, marketing and administrative functions.

Competition

The market for gas detection monitoring devices is highly competitive and we expect the emerging wireless gas monitoring system market to be equally competitive. Our primary competitors include Industrial Scientific Corporation, Mine Safety Appliances Company, Honeywell (BW Technologies), Ion Science, Draeger Safety Inc., Gastec Corporation and Bacou-Dalloz.

Competitors in the gas monitoring industry differentiate themselves on the basis of their technology, quality of product, service offerings, sales capabilities, cost and time to market. We believe we compete strongly in these areas, and thus consider ourselves one of the industry leaders in the design, development, marketing and manufacture of gas monitoring devices. In particular, we believe our ability to develop products that integrate different chemical detection techniques, such as photoionization detectors, electrochemical sensors for specific toxic chemicals and combustible gas detectors, along with communication technologies that allow wireless data transfer, provide us with a competitive advantage versus our competitors. In addition, we believe our training support materials are a valuable resource for our distributors and end-users, which make our products more attractive to customers.

Many of our competitors, however, have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial and marketing resources than us. In addition, some of our competitors may be able to devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing policies and/or devote more resources to technology and systems development.

Employees

As of December 31, 2006, we employed 791 individuals. Our employees are not covered by a collective bargaining agreement. We have never experienced an employee-related work stoppage and consider our employee relations to be good.

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Executive Officers of the Registrant

The following table sets forth the names, ages and positions held by our executive officers and other key employees.

Name	Age	Position
Robert I. Chen	59	President, Chief Executive Officer and Chairman of the Board
Randall Gausman	57	Vice President and Chief Financial Officer
Peter C. Hsi	56	Chief Technology Officer and Vice President of Emerging Technologies Development
Rudy Mui	46	Executive Vice President and Chief Operating Officer
Christopher Hameister	52	Vice President of Asia-Pacific, Europe, Middle East Business and Operations
Fei-Zhou Shen	44	Vice President of China Business Worldwide Manufacturing
Gregory J. Vervais	59	Vice President and Chief Human Resources Officer

Robert I. Chen co-founded RAE Systems in 1991 and has served as President, Chief Executive Officer, and as a member of the board of directors since our inception. From 1981 to 1990, Mr. Chen served as President and Chief Executive Officer of Applied Optoelectronic Technology Corporation, a manufacturer of computer-aided test systems, a company he founded and subsequently sold to Hewlett-Packard. Mr. Chen currently serves on the board of directors for the Shanghai Ericsson Simtek Electronics Company, Limited, a telecommunications and electronics company. Mr. Chen received a B.S.E.E. from Taiwan National Cheng Kung University, an M.S.E.E. from South Dakota School of Mines and Technology, an advanced engineering degree from Syracuse University and graduated from the Harvard Owner/President program.

Randall Gausman joined RAE Systems in October 2006 as Chief Financial Officer. Since May 2006, Mr. Gausman has worked as an independent financial consultant. From April 2002 to May 2006, Mr. Gausman served as Chief Financial Officer of Tut Systems, Inc. (NASDAQ:TUTS), which delivers industry leading content processing and distribution products for deploying next-generation video and IP services over broadband networks. His previous work experience also included assignments in finance with Zantaz, Inc. and American President Companies. Mr. Gausman holds both a bachelor of science and masters in business administration from the University of Southern California, as well as a certificate in corporate finance from the University of Michigan School of Business Administration.

Dr. Peter C. Hsi co-founded RAE Systems in 1991 and has served as our Vice President, Chief Technology Officer, and as a member of the board of directors since our inception. Prior to co-founding RAE Systems, Dr. Hsi worked at Applied Optoelectronic Technology Corporation as the chief architect for semiconductor test systems. He was also the general manager for Shanghai Simax Technology Co. Ltd. Dr. Hsi has filed 21 patent applications, of which 11 have been granted and 10 are pending. Dr. Hsi received a B.S.E.E. from the National Chiao-Tung University, and a M.S. and Ph.D. in Electrical Engineering from Syracuse University.

Rudy Mui has served as our Chief Operating Officer since January 13, 2006. Mr. Mui joined RAE Systems in December 2003 as Vice President of Marketing and has been instrumental in the strategic planning and marketing of our products. Prior to joining RAE Systems, Mr. Mui was Vice President of Marketing for Metara Incorporated from 2001 to 2003. From 1999 to 2001, Mr. Mui was Vice President of Marketing for Crossbow Technology and from 1995 to 1999, Director of Strategic Marketing for LAM Research Corporation. Mr. Mui received his B.S. in Computer Engineering and B.A. in Economics from the University of Michigan. Mr. Mui also received an M.B.A. and M.S. in Electrical Engineering from the University of Santa Clara.

Christopher Hameister serves as our Vice President of Asia-Pacific, Europe, Middle East Business and Operations since January 2007. Previously, Mr. Hameister served as Vice President of Worldwide Sales with RAE Systems from July 2006 to January 2007. In the last 25 years, Mr. Hameister’s experiences have all been with

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instrumentation companies, including seven years, prior to rejoining the company in July 2005, as Director of Marketing and Sales with RAE Systems and six years with Thermo Instruments as Business Operation Manager. Mr. Hameister holds a BS from the University of Adelaide, South Australia and certificate in marketing from University of New South Wales.

Fei-Zhou Shen joined RAE Systems in May 2001 and has served in various key roles including Vice President of Worldwide Manufacturing and his current position is Vice President of China Business Operations & Worldwide Manufacturing. Mr. Shen has over 20 years of business experience serving in key business and strategic management roles. Prior to joining the Company Mr. Shen worked with Solectron. Mr. Shen has a BS in Mechanical Engineering from Shanghai Jiao-Tong University and a MS in Mechanical Engineering from the University of Idaho.

Gregory J. Vervais joined RAE Systems in March 2006 as our Vice President and Chief Human Resources Officer. Previously, Mr. Vervais served as an independent Consultant, from July 2005 until joining RAE Systems in March 2006. From March 2004 to July 2005, Mr. Vervais worked for Varian, Inc. as Director, Human Resources, Scientific Instruments and from February 2001 to March 2004, he worked as Director, Human Resources, Analytical Instruments, Varian, Inc. Prior to February 2001, Mr. Vervais held various top human resources positions for Nummi, Nippendenso and Western Company of North America. Mr. Vervais received his BS in Industrial Relations/Economics and MS in Human Relations and Organizational Development from the University of San Francisco.

ITEM 1A.   RISK FACTORS.

You should carefully consider the risks described below before making a decision regarding an investment in our common stock. If any of the following risks actually occur, our business could be harmed, the trading price of our common stock could decline and you may lose all or part of your investment. You should also refer to the other information contained in this report, including our financial statements and the related notes.

Our future revenues are unpredictable, our operating results are likely to fluctuate from quarter-to-quarter, and if we fail to meet the expectations of securities analysts or investors, our stock price could decline significantly.

Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a variety of factors, some of which are outside of our control. Accordingly, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indications of future performance. Some of the factors that could cause our quarterly or annual operating results to fluctuate include significant shortfalls in revenue relative to our planned expenditures, changes in budget allocations by the federal government for homeland security purposes, changes in world-wide energy production and refining, market acceptance of our products, ongoing product development and production, competitive pressures and customer retention. It is likely that in some future quarters our operating results may fall below the expectations of investors. In this event, the trading price of our common stock could significantly decline.

We may have difficulty sustaining profitability and may experience additional losses in the future. If we continue to report losses or are marginally profitable, the financial impact of future events may be magnified and may lead to a disproportionate impact on the trading price of our stock.

We recorded a net loss of $1.5 million for fiscal year 2006 and a net loss of $0.8 million for fiscal year 2005. In order to improve our profitability, we will need to continue to generate new sales while controlling our costs. As we plan on continuing the growth of our business while implementing cost control measures, we may not be able to successfully generate enough revenues to return to profitability with this growth. Any failure to increase our revenues and control costs as we pursue our planned growth would harm our profitability and would likely result in a negative affect on the market price of our stock. In addition, our financial results have historically bordered at or near profitability, and if we continue to perform at this level, the financial impact may be magnified and we may experience a disproportionate impact on our trading price as a result.

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We may require additional capital in the future, which may not be available or may only be available on unfavorable terms.

Our future capital requirements depend on many factors, including potential future acquisitions and our ability to generate revenue and control costs. Should we have the need to raise additional capital, there can be no assurance we will be able to do so at all or on favorable terms. In the case of any future equity financings, dilution to our shareholders could result and, in any case, such securities may have rights, preferences and privileges that are senior to those of our common stock. If we are unable to obtain needed capital on favorable terms, or at all, our business and results of operations could be harmed and our liquidity could be adversely affected.

As a result of our failure to timely file with the SEC two current reports on Form 8-K during fiscal year 2006 (related to our acquisitions of Aegison Corporation and Tianjin Securay Technology Co., Ltd.), we will be ineligible to register our securities on Form S-3 for sale by us or resale by others until we have timely filed all periodic reports under the Securities and Exchange Act of 1934 for a period of twelve months. We may use Form S-1 to raise capital or complete acquisitions, but doing so could increase transaction costs and adversely impact our ability to raise capital or complete acquisitions of other companies in a timely manner.

The market for gas and radiation detection monitoring devices is highly competitive, and if we cannot compete effectively, our business may be harmed.

The market for gas and radiation detection monitoring devices is highly competitive. Competitors in the gas and radiation monitoring industry differentiate themselves on the basis of their technology, quality of product and service offerings, cost and time to market. Our primary competitors in the gas detection market include Industrial Scientific Corporation, Mine Safety Appliances Company, Honeywell (BW Technologies), Ion Science, Draeger Safety Inc., Gastec Corporation and Bacou-Dalloz Group. Our competitors in the radiation market include TSA Limited, Polimaster, Exporanium and Santa Barbara Systems. Several of our competitors such as Mine Safety Appliances Company and Draeger Safety Inc. have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial and marketing resources than we do. In addition, some of our competitors may be able to:

•  devote greater resources to marketing and promotional campaigns;

•  adopt more aggressive pricing policies; or

•  devote more resources to technology and systems development.

In light of these factors, we may be unable to compete successfully.

We may not be successful in the development or introduction of new products and services in a timely and effective manner and, consequently, we may not be able to remain competitive and the results of operations may suffer.

Our revenue growth is dependent on the timely introduction of new products to market. We may be unsuccessful in identifying new product and service opportunities or in developing or marketing new products and services in a timely or cost-effective manner. In developing new products, we may be required to make significant investments before we can determine the commercial viability of the new product. If we fail to accurately foresee our customers’ needs and future activities, we may invest heavily in research and development of products that do not lead to significant sales.

We have expanded our current business of providing gas detection instruments to include radiation detection and wireless systems for local and remote security monitoring. While we perceive a large market for such products, the radiation detection and wireless systems markets are still evolving, and we have little basis to assess the demand for these products and services or to evaluate whether our products and services will be accepted by the market. If our radiation detection products and wireless products and services do not gain broad market acceptance or if we do not continue to maintain the necessary technology, our business and results of operations will be harmed.

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In addition, compliance with safety regulations, specifically the need to obtain regulatory approvals in certain jurisdictions, could delay the introduction of new products by us. As a result, we may experience delays in realizing revenues from our new products.

Recently enacted changes in the securities laws and regulations have and are likely to continue to increase our costs.

The Sarbanes-Oxley Act of 2002 (the “Act”) has required changes in some of our corporate governance, securities disclosure and compliance practices. In response to the requirements of the Act, the SEC and American Stock Exchange (“AMEX”) have promulgated new rules. Compliance with these new rules has increased our legal, financial and accounting costs, and we expect these increased costs to continue indefinitely.

In the event we are unable to satisfy regulatory requirements relating to internal control over financial reporting or, if these controls are not effective, our business and financial results may suffer.

In designing and evaluating our internal control over financial reporting, we recognize that any internal control or procedure, no matter how well designed and operated, can provide only reasonable assurance of achieving desired control objectives. For example, a company’s operations may change over time as the result of new or discontinued lines of business and management must periodically modify a company’s internal controls and procedures to timely match these changes in its business. In addition, management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures and company personnel are required to use judgment in their application. While we continue to improve upon our internal control over financial reporting so that it can provide reasonable assurance of achieving its control objectives, no system of internal controls can be designed to provide absolute assurance of effectiveness.

In our fiscal year 2005 annual report on Form 10-K, management identified three material weaknesses. The weaknesses were related to our calculation of share-based compensation and diluted shares in accordance with SFAS 123, “Accounting for Stock-Based Compensation,” inadequate control over our accounting and reporting of certain non-routine transactions occurring at two of our foreign operations and an inadequate number of accounting and finance personnel or consultants sufficiently trained to address some of the complex accounting and financial reporting matters that arise from time-to-time. In connection with year-end work on our fiscal year 2006 Form 10-K, management identified a material weakness in the Company’s internal control relating to assurance that information from its Chinese subsidiaries has been properly adjusted to generally accepted accounting principles in the United States of America for inclusion in its annual or interim financial statements. A discussion of the material weaknesses in our internal control over financial reporting and management’s remediation efforts is available herein under the subheading “Management’s Report on Internal Control over Financial Reporting.”

Material weaknesses in internal control over financial reporting may materially impact our reported financial results and the market price of our stock could significantly decline. Additionally, adverse publicity related to a material failure of internal control over financial reporting could have a negative impact on our reputation and business.

We are subject to risks and uncertainties of the government marketplace, including the risk that the government may not fund projects that our products are designed to address and that certain terms of our contracts with government agencies may subject us to adverse government actions or penalties.

Our business is increasingly dependent upon government funded projects. Decisions on what types of projects are to be funded by local, state and federal government agencies will have a material impact on our business. The current Federal budget for the Department of Homeland Security, which we refer to as “Homeland Security” herein, is a source for funding for many of our customers either directly or through grants to state and local agencies. The current Homeland Security budget increased by approximately 15% from $40.3 billion in fiscal year 2006 to $46.4 billion for fiscal 2007. However, if the government does not fund projects that our products are designed to address, or funds such projects at levels lower than we expect, our business and results of operations will be harmed.

Government contracts also contain provisions and are subject to laws and regulations that provide government clients with rights and remedies not typically found in commercial contracts. For example, a portion of our federal

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contracting is done through the Federal Supply Schedules from the United States General Services Administration (GSA). Our GSA Schedule contract, like all others, includes a clause known as the “Price Reductions” clause; the terms of that clause are similar but not identical to a “most favored customer” clause in commercial contracts. Under that clause, we have agreed that the prices to the government under the GSA Schedules contract will maintain a constant relationship to the prices charged to certain commercial customers, i.e., when prices to those benchmark customers drop, our prices on our GSA Schedules contract must be adjusted accordingly. Although we have undertaken extensive efforts to comply with the Price Reductions clause, it is possible that we may have an unreported discount offered to a “Basis of Award” customer and may have failed to honor the obligations of the Price Reductions clause. If that occurred, we could, under certain circumstances, be subject to an audit, an action in fraud, or other adverse government actions or penalties.

We may not be successful in promoting and developing our brand, which could prevent us from remaining competitive.

We believe that our future success will depend on our ability to maintain and strengthen the RAE brand, which will depend, in turn, largely on the success of our marketing efforts and ability to provide our customers with high-quality products. If we fail to successfully promote and maintain our brand, or incur excessive expenses in attempting to promote and maintain our brand, our business will be harmed.

We may face risks from our substantial international operations and sales.

We have significant operations in foreign countries, including manufacturing facilities, sales personnel and customer support operations. For the fiscal years ended December 31, 2006 and 2005, approximately 38% and 33% of our revenues, respectively, were from sales to customers located in Asia and approximately 13% and 11% of our revenues, respectively, were from sales to customers located in Europe. We have manufacturing facilities in China and in the United States. A significant portion of our products and components are manufactured at our facility in Shanghai, China.

Our international operations are subject to economic and other risks inherent in doing business in foreign countries, including the following:

•  difficulties with staffing and managing international operations;

•  transportation and supply chain disruptions and increased transportation expense as a result of epidemics, terrorist activity, acts of war or hostility, generally higher oil prices, increased security and less developed infrastructure;

•  economic slowdown and/or downturn in foreign markets;

•  international currency fluctuations;

•  political and economic uncertainty caused by epidemics, terrorism or acts of war or hostility;

•  legislative and regulatory responses to terrorist activity such as increased restrictions on cross-border movement of products and technology;

•  legislative, regulatory, police, or civil responses to epidemics or other outbreaks of infectious diseases such as quarantines, factory closures, or increased restrictions on transportation or travel;

•  increased costs and complexities associated with complying with Section 404 of the Sarbanes-Oxley Act of 2002;

•  general strikes or other disruptions in working conditions;

•  labor shortages;

•  political instability;

•  changes in tariffs;

•  generally longer periods to collect receivables;

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•  unexpected legislative or regulatory requirements;

•  reduced protection for intellectual property rights in some countries;

•  significant unexpected duties or taxes or other adverse tax consequences;

•  difficulty in obtaining export licenses and other trade barriers; and

•  ability to obtain credit and access to capital issues faced by our international customers.

The specific economic conditions in each country will impact our future international sales. For example, approximately half of our recognized revenue has been denominated in U.S. dollars. Significant downward fluctuations in currency exchange rates against the U.S. dollar could result in higher product prices and/or declining margins and increased manufacturing costs. If we do not effectively manage the risks associated with international operations and sales, our business, financial condition and operating results could suffer. In addition, to date we have experienced lower gross margins on sales in Asia. To the extent that the percentage of our total net sales from Asia increases and our gross margins do not improve, our business financial condition and operating results could suffer.

The loss of “Normal Trade Relation” status for China, changes in current tariff structures or adoption of other trade policies adverse to China could have an adverse effect on our business.

Our ability to import products from China at current tariff levels could be materially and adversely affected if the “normal trade relations” (“NTR”, formerly “most favored nation”) status the United States government has granted to China for trade and tariff purposes is terminated. As a result of its NTR status, China receives the same favorable tariff treatment that the United States extends to its other “normal” trading partners. China’s NTR status, coupled with its membership in the World Trade Organization, could eventually reduce barriers to manufacturing products in and exporting products from China. However, we cannot provide any assurance that China’s membership in the World Trade Organization or NTR status will not change. As a result of opposition to certain policies of the Chinese government and China’s growing trade surpluses with the United States, there has been, and in the future may be, opposition to NTR status for China. Also, the imposition of trade sanctions by the United States or the European Union against a class of products imported by us from, or the loss of NTR status with, China, could significantly increase our cost of products imported into the United States or Europe and harm our business. Because of the importance of our international sales and international sourcing of manufacturing to our business, our financial condition and results of operations could be significantly and adversely affected if any of the risks described above were to occur.

The government of China may change or even reverse its policies of promoting private industry and foreign investment, in which case our assets and operations may be at risk.

We currently manufacture and sell a significant portion of our components and products in China. Our existing and planned operations in China are subject to the general risks of doing business internationally and the specific risks related to the business, economic and political conditions in China, which include the possibility that the central government of China will change or even reverse its policies of promoting private industry and foreign investment in China. Many of the current reforms which support private business in China are unprecedented or experimental. Other political, economic and social factors, such as political changes, changes in the rates of economic growth, unemployment or inflation, or in the disparities of per capita wealth among citizens of China and between regions within China, could also lead to further readjustment of the government’s reform measures. It is not possible to predict whether the Chinese government will continue to be as supportive of private business in China, nor is it possible to predict how future reforms will affect our business.

Any failure to adequately protect and enforce our intellectual property rights could harm our business.

We regard our intellectual property as critical to our success. We rely on a combination of patent, trademark, copyright, trade secret laws and non-disclosure agreements and confidentiality procedures to protect our proprietary rights. Notwithstanding these laws, we may be unsuccessful in protecting our intellectual property rights or in obtaining patents or registered trademarks for which we apply. Although processes are in place to protect our

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intellectual property rights, we cannot guarantee that these procedures are adequate to prevent misappropriation of our current technology or that our competitors will not develop technology that is similar to our own.

While there is no single patent or license to technology of material significance to the Company, our ability to compete is affected by our ability to protect our intellectual property rights in general. For example, we have a collection of patents related to our photoionization detector technology of which the first of such patents expires in 2012, and our ability to compete may be affected by any competing similar or new technology. In addition, if we lose the licensing rights to a patented or other proprietary technology, we may need to stop selling products incorporating that technology and possibly other products, redesign our products or lose a competitive advantage. We cannot ensure that our future patent applications will be approved or that our current patents will not be challenged by third parties. Furthermore, we cannot ensure that, if challenged, our patents will be found to be valid and enforceable.

Any litigation relating to our intellectual property rights could, regardless of the outcome, have a material adverse impact on our business and results of operations.

We may face intellectual property infringement claims that might be costly to resolve and affect our results of operations.

In connection with the enforcement of our own intellectual property rights, the acquisition of third-party intellectual property rights or disputes relating to the validity or alleged infringement of third-party rights, including patent rights, we have been, are currently and may in the future be subject to claims, negotiations or complex, protracted litigation. Intellectual property disputes and litigation are typically very costly and can be disruptive to our business operations by diverting the attention and energies of management and key technical personnel. Although we have successfully defended or resolved past litigation and disputes, we may not prevail in any ongoing or future litigation and disputes. We may incur significant costs in acquiring the necessary third party intellectual property rights for use in our products. Third party intellectual property disputes could subject us to significant liabilities, require us to enter into royalty and licensing arrangements on less favorable terms, prevent us from manufacturing or licensing certain of our products, cause severe disruptions to our operations or the markets in which we compete, or require us to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements any one of which could seriously harm our business.

For example, Polimaster Ltd. filed a complaint against us on May 9, 2005 in the United States District Court for the Northern District of California in a case styled Polimaster Ltd. v. RAE Systems Inc. (Case No. 05-CV-01887-JF). The complaint alleges, among other things, that we breached our contract with Polimaster and infringed upon Polimaster’s intellectual property rights. Polimaster moved for a preliminary injunction on June 17, 2005. The Court denied Polimaster’s request on September 6, 2005. The dispute is subject to a contractual arbitration agreement, although the federal court has retained jurisdiction over the matter pending arbitration by the parties.

An arbitration was formally commenced in June 2006 for the Polimaster Ltd. matter. The arbitration will be conducted under the auspices of Judicial Arbitration and Mediation Services, Inc. (JAMS) in California. A ten-day arbitration preceding has been scheduled for March 2007. Polimaster’s Demand for Arbitration asserts damages totaling $13.2 million and seeks an injunction against sales of the Company’s Gamma Rae II and Neutron RAE II radiation detection products. We have asserted counterclaims against Polimaster for breach of contract and tortious interference with contract, among other things, and seek monetary damages of its own. We believe the claim by Polimaster is without merit and we expect to vigorously defend our position. Were Polimaster to prevail in this arbitration, it would have a material adverse effect upon the business.

However, claims of this type, regardless of merit, can be time-consuming to defend, result in costly litigation, divert management’s attention and resources or require us to enter into royalty or license agreements. The terms of any such license agreements may not be available on reasonable terms, if at all, and the assertion or prosecution of any infringement claims could significantly harm our business.

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Some of our products may be subject to product liability claims which could be costly to resolve and affect our results of operations.

There can be no assurance that we will not be subject to third-party claims in connection with our products or that any indemnification or insurance available to us will be adequate to protect us from liability. A product liability claim, product recall or other claim, as well as any claims for uninsured liabilities or in excess of insured liabilities, could have a material adverse effect on our business and results of operations.

We sell a majority of our products through distributors, and if our distributors stop selling our products, our revenues would suffer.

We distribute our products in the Americas primarily through distributors. We are dependent upon these distributors to sell our products and to assist us in promoting and creating a demand for our products. For example, we derived approximately 55% of our Americas’ revenues from our sales distribution channels in fiscal year 2006. We also believe our future growth depends materially on the efforts of distributors. In addition, the contractual obligations of our distributors to continue carrying our products are subject to a sixty-day termination notice by either party for convenience. If one or more of our distributors were to experience financial difficulties or become unwilling to promote and sell our products for any reason, including any refusal to renew their commitment as our distributor, we might not be able to replace such lost revenue, and our business and results of operations could be materially harmed.

Because we purchase a significant portion of our component parts from a limited number of third party suppliers, we are subject to the risk that we may be unable to acquire quality components in a timely manner, which could result in delays of product shipments and damage our business and operating results.

We currently purchase component parts used in the manufacture of our products from a limited number of third party suppliers. We depend on these suppliers to meet our needs for various sensors, microprocessors and other material components. Moreover, we depend on the quality of the products supplied to us over which we have limited control. Should we encounter shortages and delays in obtaining components, we might not be able to supply products in a timely manner due to a lack of components, and our business could be adversely affected.

Future acquisitions that we undertake could be difficult to integrate, disrupt our business, dilute stockholder value or harm our results of operations.

In 2006, we acquired Aegison Corporation, formed RAE Coal Mine Safety Instruments (Fushun) Co., Ltd. and acquired an additional 32% of ownership of RAE-KLH (Beijing) Co., Ltd. In addition, during January 2007, we completed the acquisition of Tianjin Securay Technology Co., Ltd. We may acquire or make additional investments in complementary businesses, technologies, services or products if appropriate opportunities arise. The process of integrating any acquired business, technology, service or product into our business and operations may result in unforeseen operating difficulties and expenditures. Integration of an acquired company also may consume much of our management’s time and attention that would otherwise be available for ongoing development of our business. Moreover, the anticipated benefits of any acquisition may not be realized. Future acquisitions could result in dilutive issuances of equity securities or the incurrence of debt, contingent liabilities or expenses related to goodwill recognition and other intangible assets, any of which could harm our business.

Our ownership interest in Renex will cause us to incur losses that we would not otherwise incur.

We currently own approximately 40% of Renex Technology Ltd., a wireless systems company still in the research and development stage. We are required to incorporate our share of its expenses as losses in our Consolidated Statements of Operations. If Renex does not begin to generate revenues at the level we anticipate or otherwise incurs greater losses, we could incur greater losses than we anticipate and our results of operations will suffer.

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Our business could suffer if we lose the services of any of our executive officers.

Our future success depends to a significant extent on the continued service of our executive officers. We have no formal employment agreements with any of our executive other than their initial offer letter, if applicable. The loss of the services of any of our executive officers could harm our business.

Our officers, directors and principal stockholders beneficially own approximately 34% of our common stock and, accordingly, may exert substantial influence over the Company.

Our executive officers and directors and principal stockholders, in the aggregate, beneficially own approximately 34% of our common stock as of February 28, 2007. These stockholders acting together have the ability to substantially influence all matters requiring approval by our stockholders. These matters include the election and removal of the directors, amendment of our certificate of incorporation, and any merger, consolidation or sale of all or substantially all of our assets. In addition, they may dictate the management of our business and affairs. Furthermore, this concentration of ownership could have the effect of delaying, deferring or preventing a change in control, or impeding a merger or consolidation, takeover or other business combination and may substantially reduce the marketability of our common stock.

ITEM 1B.   UNRESOLVED STAFF COMMENTS.

None.

ITEM 2.   PROPERTIES.

Our corporate headquarters and principal offices are located in a facility we own in San Jose, California. The San Jose facility consists of approximately 67,000 square feet, which we purchased in December 2004, and, which includes research and development, sales and marketing, general and administrative and manufacturing operations. We abandoned a leased facility of approximately 25,000 square feet in May 2005 that served as our former corporate headquarters and United States manufacturing facility. The abandoned facility is currently available for sublease. The lease for the abandoned facility expires in October 2009.

We lease a manufacturing facility in Shanghai, China consisting of approximately 44,000 square feet, a research and development facility consisting of approximately 17,000 square feet and a sensor laboratory/manufacturing facility consisting of 17,000 square feet. The lease on the research and development facility will expire in phases for portions of the property through February 2010. The lease on the manufacturing facility expires in September 2011 and contains an option, subject to local government approval, to purchase the property. The lease on the sensor laboratory expires in October 2009. In addition, through our acquisition of RAE Beijing, China, we own 96% of a manufacturing facility consisting of approximately 106,000 square feet, of which 41,000 square feet is dedicated to the manufacturing of RAE Beijing’s products and the storage of the inventory.

We maintain a sales office in Fan Ling, Hong Kong, from which we sell our products to Asia. The lease of the Fan Ling office has been extended for a period of two years commencing in January 2007. We also maintain sales and service centers in Copenhagen, Denmark, the United Kingdom, France and United Arab Emirates, from which we sell our products to Europe, Australia and New Zealand, the Middle East and Africa. The new lease of the Copenhagen facility expires in September 2014.

ITEM 3.   LEGAL PROCEEDINGS.

Polimaster Ltd. v. RAE Systems Inc., United States District Court for the Northern District of California, Case No. 05-CV-01887-JF

Polimaster Ltd. filed a complaint against RAE Systems Inc. on May 9, 2005 in the United States District Court for the Northern District of California in a case styled Polimaster Ltd. v. RAE Systems Inc. (Case No. 05-CV-01887-JF). The complaint alleges, among other things, that RAE Systems Inc. breached its contract with Polimaster and infringed upon Polimaster’s intellectual property rights. Polimaster moved for a preliminary injunction on June 17, 2005. The Court denied Polimaster’s request on September 6, 2005. The dispute is subject to a contractual arbitration agreement, although the federal court has retained jurisdiction over the matter pending arbitration by the parties.

An arbitration was formally commenced on June 12, 2006 for the Polimaster Ltd. matter. The arbitration will be conducted under the auspices of Judicial Arbitration and Mediation Services, Inc. (JAMS) in California. A

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ten-day arbitration preceding has been scheduled for March 2007. Polimaster’s Demand for Arbitration asserts damages totaling $13.2 million and seeks an injunction against sales of the Company’s Gamma Rae II and Neutron RAE II radiation detection products. The Company has asserted counterclaims against Polimaster for breach of contract and tortious interference with contract, among other things, and seeks monetary damages of its own. At this time, due to the preliminary and speculative nature of these proceedings, we do not believe an amount of loss, if any, can be reasonably estimated for this matter. We also believe the claim by Polimaster is without merit and we expect to vigorously defend our position.

Notwithstanding the Polimaster proceeding described above, from time to time, the Company is engaged in various legal proceedings incidental to its normal business activities. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations or cash flows.

ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None.

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PART II

ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS. AND ISSUER PURCHASES OF EQUITY SECURITIES.

Our common stock has been trading on the AMEX under the trading symbol “RAE” since August 29, 2003. The following table sets forth, for the periods indicated, the high and low sales prices for our common stock as derived from publicly reported AMEX daily trading data. The quotations do not reflect adjustments for retail mark-ups, mark-downs, or commissions and may not necessarily represent actual transactions.

	2006				2005
	High		Low		High		Low
First Quarter	$	3.93	$	3.26	$	7.50	$	2.90
Second Quarter	$	4.54	$	3.27	$	3.87	$	2.35
Third Quarter	$	4.14	$	2.40	$	4.33	$	3.03
Fourth Quarter	$	4.05	$	2.81	$	4.09	$	3.19

As of December 31, 2006, there were 301 shareholders of record who held shares of our common stock.

We have never declared or paid dividends on our common stock and currently do not intend to pay dividends in the foreseeable future so that we may reinvest our earnings in the development of our business. The payment of dividends in the future will be at the discretion of the Board of Directors.

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PERFORMANCE GRAPH

The following chart presents a comparative analysis of the stock performance of our common stock (“RAE”) relative to AMEX Composite and AMEX stock for SIC codes 3800-3899 Measuring Instruments indexes. This analysis assumes a $100 investment in the underlying common stock of RAE and these indexes on April 9, 2002, the date of our initial public offering, through December 31, 2006. This analysis does not purport to be a representation of the actual market performance of our stock or these indexes. This chart has been provided for informational purposes to assist the reader in evaluating the market performance of our common stock compared to other market participants.

Notwithstanding anything to the contrary set forth in our previous filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, which might incorporate future filings made by us under those statutes, the following Stock Performance Graph will not be deemed incorporated by reference into any future filings made by us under those statutes.

COMPARISON OF 57 MONTH CUMULATIVE TOTAL RETURN*
Among RAE Systems, Inc., The AMEX Composite Index
And AMEX stocks for SIC codes 3800 - 3899 Measuring Instruments

* $100 invested on 4/9/02 in stock or on 3/31/02 in index-including reinvestment of dividends.

Fiscal year ending December 31.

	4/02		12/02		12/03		12/04		12/05		12/06
RAE Systems, Inc.		100.00		18.31		148.21		318.22		153.01		139.49
AMEX Composite		100.00		91.97		132.86		163.99		202.49		240.92
AMEX stocks for SIC codes 3800 - 3899 Measuring Instruments		100.00		80.78		130.23		137.73		126.72		143.07

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ITEM 6.   SELECTED FINANCIAL DATA.

SUMMARY FINANCIAL DATA

The selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the Consolidated Financial Statements of RAE Systems Inc. and Notes thereto, and other financial information included elsewhere in this Form 10-K. Historical results are not necessarily indicative of results that may be expected for future periods.

	2006			2005			2004
	(1)(2)(3)(4)			(5)			(6)(7)		2003		2002
Operating Data:
Net sales	$	67,986,000		$	60,293,000		$	45,540,000	$	31,361,000	$	21,828,000
Gross profit	$	35,735,000		$	35,603,000		$	27,023,000	$	19,256,000	$	13,071,000
Operating (loss) income	$	(3,114,000	)	$	(1,588,000	)	$	3,514,000	$	3,759,000	$	(8,982,000	)
Net (loss) income	$	(1,529,000	)	$	(759,000	)	$	2,335,000	$	2,738,000	$	(9,462,000	)
Basic (loss) income per share	$	(0.03	)	$	(0.01	)	$	0.04	$	0.06	$	(0.24	)
Diluted (loss) income per share	$	(0.03	)	$	(0.01	)	$	0.04	$	0.06	$	(0.24	)
Weighted-average common shares:
Basic outstanding shares		58,424,970			57,687,714			55,809,638		46,179,770		39,902,169
Diluted outstanding shares		58,424,970			57,687,714			60,135,692		49,225,169		39,902,169
Balance Sheet Data:
Working capital	$	36,641,000		$	41,366,000		$	38,857,000	$	12,423,000	$	8,263,000
Total assets	$	89,753,000		$	76,264,000		$	69,115,000	$	20,765,000	$	16,865,000
Long-term liabilities	$	5,441,000		$	2,962,000		$	1,645,000	$	200,000	$	411,000
Total shareholders’ equity	$	56,179,000		$	54,573,000		$	52,189,000	$	14,807,000	$	10,747,000

	The following information summarizes events that affect comparability of the information reflected in selected financial data:
(1)	RAE Fushun joint venture was formed in December 2006. The fair value of assets acquired and liabilities assumed were included in the balance sheet as of December 31, 2006. There were no operating activities recorded in 2006.
(2)	The Company purchased an additional 32% ownership in RAE Beijing in July 2006. The Company has consolidated RAE Beijing since 2004. With the purchase in July 2006, minority shareholder’s interest was reduced to 4%.
(3)	In July 2006, the Company purchased Aegison Corporation. The fair value of assets acquired and liabilities assumed were included in the balance sheet as of December 31, 2006.
(4)	As of December 31, 2006, the Company was in the process of acquiring Securay. The Company recorded $820,000 of acquisition in progress as of December 31, 2006.
(5)	During the second quarter of 2005, the Company abandoned its leased facility in Sunnyvale California and moved to a new headquarters and U.S. manufacturing facility. As a result, the Company took a before-tax charge of approximately $2.0 million for abandonment of its lease in the second quarter of 2005.
(6)	The Company purchased 64% of ownership in RAE Beijing in May 2004. The fair value of assets acquired and liabilities assumed were included in the balance sheet at December 31, 2004. Seven months of operating activities were recorded in statement of operations in 2004.
(7)	In January 2004, the Company closed its public offering of 8,050,000 shares of its common stock at $4.25 share, less the applicable underwriting discount. The net proceeds was approximately $31.8 million.

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Additional information regarding the 2006 acquisition is included in Note 2 Mergers and Acquisition of the Notes to Consolidated Financial Statements.

ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements. In some cases, readers can identify forward-looking statements by terminology such as “may,” “will,” “should,” “could,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue.” These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from those stated herein. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in Item 1A, “Risk Factors” as well as in Item 1, “Business” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K. You should carefully review these risks and also review the risks described in other documents we file from time to time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q that we will file in fiscal year 2007. You are cautioned not to place undue reliance on these forward-looking statements, and we expressly assume no obligations to update the forward-looking statements in this report that occur after the date hereof.

Overview

We are a leading global developer and manufacturer of rapidly-deployable, multi-sensor chemical and radiation detection monitors and networks for industrial applications and homeland security. In addition, we offer a full line of portable single-sensor chemical and radiation detection products. We were founded in 1991 to develop technologies for the detection and early warning of hazardous materials. The market for our products has evolved from being strictly focused on environmental and industrial monitoring to now encompassing public safety and the threat of terrorism. In conjunction with our acquisition of Aegison Corporation and formation of RAE Coal Mine Safety Instruments (Fushun) Co., Ltd., we expect to expand our presence to include the mobile in the mobile digital video security market in the United States and broader energy exploration and refining safety equipment market, especially as it applies to the coal mine safety equipment market in China.

In 2006, we leveraged our expertise and experience to make two key investments in China to pursue opportunities in one of the world’s largest and fastest growing economies. First in July 2006, we increased our ownership in RAE Beijing to 96 percent to benefit from our efforts to drive higher revenue and operating profit at the consolidated subsidiary. RAE Beijing produces, sells and distributes safety and security solutions for the chemical, oil, gas, metals and energy sectors in China. Second, in December 2006, we formed RAE Fushun, a joint venture to capitalize on China’s growing reliance on coal based energy resources. RAE Fushun manufactures and sells coal mine safety equipment. RAE Systems retains 70 percent ownership and the joint venture combines our skill and expertise with Fushun Anyi, a former state owned company that we have had as a distribution partner for a number of years. RAE Fushun offers a wide and well balanced range of safety products from personal safety equipment like headlamps, respiratory protection and portable gas detection to fixed, mine based safety systems such as permanently mounted mine-wide gas detection systems and methane pump systems to “degasify” potentially explosive mines.

In July 2006, we also invested in next generation mobile and wireless digital video technology by acquiring Aegison Corporation. This transaction added two more patents to our intellectual property portfolio and creates the opportunity to offer new solutions to our law enforcement and other mobile video customers.

We have had a number of successful product deployments. The AreaRAE has been adopted as a standard for continuous monitoring of worker safety in the petrochemical industry during plant turnarounds. We believe AreaRAE provides a significant cost savings and productivity advantage for bringing facilities back on-line more quickly. National Guard Civil Support Teams have deployed over fifty-seven AreaRAE platforms — at least one system for each State. The GammaRAE II R portable radiation detector/dosimeter was selected and is being evaluated by the State of Illinois as part of their large multi-year radiation equipment procurement.

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Several chemical manufacturers, throughout Europe, have selected the MiniRAE 2000 and ppbRAE Plus PID instruments for industrial hygiene applications. In China, we received a large order for RAEGuard fixed sensor systems from PetroChina, Dushanzi Project. We also received orders from several state operated oil fields including Da-Gang, Liao-He, and the Chang-Qing.

In early 2007, we have strengthened and expanded our sales and distribution channels in each of our three geographic sales regions. We continue to augment our sales model with the introduction of a value-added reseller program, additional regional sales management and inside sales resources. We have also added a direct sales component for key national and government accounts. To accelerate transactions with our channel partners we are deploying a web portal for our value added resellers. We are expanding our training programs to offer product and service training, and American Industrial Hygiene certification classes. We expect to launch a number of additional new products for various global markets in 2007.

In 2006, our oil and gas customers have experienced success in deploying our wireless gas detection solutions in plant turnarounds. One of our industrial targets for 2007 is to extend that success to the 260 chemical plants in the gulf coast region of the U.S.

In India and the Middle East we added additional regional sales managers to grow our presence in these two emerging markets. In China, our focus is on the growing environmental protection market and the industrial sector, including oil and gas, petro-chemicals, certain telecom applications and coal mining. A major priority will be to introduce new products for the coal mine safety market through RAE Fushun. We believe this market will provide us a number of exciting new business opportunities in 2007 and beyond, as China continues to modernize its coal mining industry.

In all of our markets we will continue to explore and develop strategic value added partnerships, to leverage our product and market expertise.

Critical Accounting Policies

The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, we evaluate the estimates, including those related to our allowance for doubtful accounts, valuation of goodwill and intangible assets, investments, valuation of deferred tax assets, restructuring costs, contingencies, inventory valuation, warranty accrual and stock-based compensation expense. In conjunction with acquisitions, we allocate investment costs based on the fair value of the assets acquired and liabilities assumed. We base our estimates 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 may differ significantly from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments or estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. A provision for estimated product returns is established at the time of sale based upon historical return rates adjusted for current economic conditions. Historically, the Company has experienced an insignificant amount of sales returns. The Company generally recognizes revenue when goods are shipped to its distributors in accordance with standard contract terms that pass title of all goods upon delivery to a common carrier (FOB factory) and provides for sales returns under standard product warranty provisions. For non-standard contract terms where title to goods pass at time of delivery (FOB destination), revenue is recognized after the Company has established proof of delivery. Revenues relating to services performed under the Company’s extended warranty program represent less than 5% of net revenues in each

27

of 2006, 2005 and 2004 and are recognized as earned based upon contract terms, generally ratable over the term of service. We record project installation work in Asia using the percentage-of-completion method. Installation revenue represents less than 5% of net revenue in 2006, 2005 and 2004. Net revenues include amounts billed to customers in sales transactions for shipping and handling, as prescribed by the Emerging Issues Task Force Issue (“EITF”) No. 00-10, Accounting for Shipping and Handling Fees and Costs. Shipping fees represent less than 1% of net revenues in each of 2006, 2005 and 2004. Shipping costs are included in cost of goods sold.

Accounts Receivable, Trade Notes Receivable and Allowance for Doubtful Accounts

The Company grants credit to its customers after undertaking an investigation of credit risk for all significant amounts. An allowance for doubtful accounts is provided for estimated credit losses at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowance is based on reviews of loss, adjustments history, current economic conditions and other factors that deserve recognition in estimating potential losses. The Company generally does not require collateral for sales on credit. While management uses the best information available in making its determination, the ultimate recovery of recorded accounts receivable is also dependent upon future economic and other conditions that may be beyond management’s control. If there was a deterioration of a major customer’s credit-worthiness or if actual defaults were higher than what have been experienced historically, additional allowances would be required.

Trade notes receivables are presented to the Company from some of our customers in China as a payment against the outstanding trade receivables. These notes receivables are bank guarantee promissory notes which are non-interest bearing and generally mature within 6 months.

Inventories

Inventories are stated at the lower of cost, using the first-in, first-out method, or market. The Company is exposed to a number of economic and industry factors that could result in portions of its inventory becoming either obsolete or in excess of anticipated usage, or saleable only for amounts that are less than their carrying amounts. These factors include, but are not limited to, technological changes in the market, competitive pressures in products and prices, and the availability of key components from its suppliers. The Company has established inventory reserves when conditions exist that suggest that its inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for its products and market conditions. When recorded, reserves are intended to reduce the carrying value of the inventory to its net realizable value. If actual demand for specified products deteriorates, or market conditions are less favorable than those projected, additional reserves may be required.

  Investments

As a result of our 2006 investment commitments and in accordance with Financial Accounting Standard 115, “Accounting for Certain Investments in Debt and Equity,” the Company changed the classification of its investments from “held-to-maturity” to “available-for-sale.” The resulting fair-value calculation of the Company’s investments led to a nominal net decrease in carrying value of the investments in 2006.

Stock-Based Compensation Expense

Effective January 1, 2003, the Company adopted FAS 123, “Accounting for Stock-Based Compensation,” for the recognition of stock-based compensation cost in its statement of operations. The fair value of each option award was estimated on the date of the grant using the Black-Scholes-Merton valuation method. This fair value was amortized as compensation expense, on a straight line basis, over the requisite service periods of the awards, which was generally the vesting period.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of FAS 123 (Revised 2004), “Share-Based Payment,” where the fair value of each option is adjusted to reflect only those shares that are expected to vest. The Company’s implementation of FAS 123(R) uses the modified-prospective-transition method where the compensation cost related to each unvested option as of January 1, 2006, is recalculated and any necessary adjustment is reported in the first quarter of adoption.

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The Company made the following estimates and assumptions in determining fair value:

Valuation and amortization method — The Company estimates the fair value of stock options granted using the Black-Scholes-Merton option-pricing formula and a single option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period.

Expected Term — The Company’s expected term represents the period that the Company’s stock-based awards are expected to be outstanding and was determined using the “Simplified Method” as defined in the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107.

Expected Volatility — The Company’s expected volatilities are based on historical volatility of the Company’s stock, adjusted where determined by management for unusual and non-representative stock price activity not expected to recur.

Expected Dividend — The Black-Scholes-Merton valuation model calls for a single expected dividend yield as an input. The Company currently pays no dividends and does not expect to pay dividends in the foreseeable future.

Risk-Free Interest Rate — The Company bases the risk-free interest rate on the implied yield currently available on United States Treasury zero-coupon issues with an equivalent remaining term.

Estimated Forfeitures — When estimating forfeitures, the Company uses the average historical option forfeitures over a period of four years.

Business Combinations

In accordance with business combination accounting, we allocate the purchase price of acquired companies to the tangible and intangible assets acquired, liabilities assumed on their estimated fair values. We engage third-party appraisal firms to assist management in determining the fair values of certain assets acquired and liabilities assumed. Such a valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets.

Management makes estimates of fair value based upon assumptions believed to be reasonable. These estimates are based on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows from maintenance agreements, customer contracts, acquired developed technologies and pending patents; expected costs to develop the in-process research and development into commercially viable products and estimating cash flows from the projects when completed; the acquired Company’s brand awareness and market position, as well as assumptions about the period of time the acquired brand will continue to be used in the combined Company’s product portfolio; and discount rates. Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results.

Income Taxes

We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes.

Our effective tax rates differ from the statutory rate primarily due to foreign earnings taxed at lower rates, foreign losses not benefited, non-deductible stock compensation deductions under FAS 123(R) and change provisions for uncertain tax positions. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. We regularly assess the likelihood of adverse outcomes resulting from tax examinations to determine the adequacy of our provision for income taxes.

Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets. In assessing the need for a valuation allowance, we consider all available evidence including past operating

29

results, estimates of future taxable income, and the feasibility of tax planning strategies. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made.

RESULTS OF OPERATIONS

Comparison of Years Ended December 31, 2006 and 2005

Total Net Sales

	Years Ended December 31,
	2006		2005		Change		% change
Net sales	$	67,986,000	$	60,293,000	$	7,693,000		13	%

Net sales were $68.0 million for the year ended December 31, 2006, an increase of $7.7 million, or 13%, compared with $60.3 million for the year ended December 31, 2005. The increase was primarily the result of increases in net sales in Asia of $6.1 million and Europe of $2.4 million partially offset by a decrease in the Americas of $0.8 million. The increase in Asia was due to higher sales of third party products, RAE gas detector product sales and increased installation revenue. The increase in Europe was primarily driven by integrated wireless systems sales. The decrease in the Americas was primarily the result of slower spending in the first half of 2006 for homeland security products compared with 2005, as well as from increased competitive product pricing pressure in the industrial sector in 2006.

Cost of Sales & Gross Profit

	Years Ended December 31,
	2006			2005			Change		% change
Cost of sales	$	32,251,000		$	24,690,000		$	7,561,000		31	%
Gross profit	$	35,735,000		$	35,603,000		$	132,000		0	%
Gross profit as % of net sales		53	%		59	%

Cost of sales was $32.3 million for the year ended December 31, 2006, an increase of $7.6 million, or 31%, from $24.7 million for the year ended December 31, 2005. Gross profit for the year ended December 31, 2006 was $35.7 million, compared with $35.6 million for the year ended December 31, 2005. However, the ratio of gross profit to sales decreased to 53% in 2006 compared with 59% in 2005. The lower gross profit ratio in 2006 was primarily due to a shift in sales in the Americas towards lower-margin portable products, an increase in the United States manufacturing overhead associated with facility cost and more competitive product pricing pressure in the United States. In addition, lower gross margin installation revenue and third party product sales in Asia contributed to the year-over-year decline in gross margin.

Sales and Marketing Expense

	Years Ended December 31,
	2006			2005			Change		% change
Sales and marketing	$	19,277,000		$	16,835,000		$	2,442,000		15	%
As % of net sales		28	%		28	%

Sales and marketing expenses during the year ended December 31, 2006 increased by $2.4 million, or 15%, from $16.8 million for the year ended December 31, 2005. The increase was attributable to an increase in sales and marketing expenses related to increased revenue, payroll related expenses attributable to increased headcount, as well as from higher infrastructure costs across the Company to support sales growth.

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Research and Development Expense

	Years Ended December 31,
	2006			2005			Change		% change
Research and development	$	6,234,000		$	5,414,000		$	820,000		15	%
As % of net sales		9	%		9	%

Research and development expenses during the year ended December 31, 2006 increased by $0.8 million, or 15%, compared with the year ended December 31, 2005. The increased expenses were primarily the result of increased headcount and project expenses for the development of new portable and wireless products at our engineering center in Shanghai, China. Key product releases during 2006 included the GammaRAE Systems II R portable radiation detector and dosimeter as well as the Neutron RAE II, a combined gamma and neutron radiation detector. We also released the ChemRAE, a portable device for the detection of chemical warfare agents capable of integration into our wireless communications products.

General and Administrative Expense

	Years Ended December 31,
	2006			2005			Change		% change
General and administrative	$	13,338,000		$	12,915,000		$	423,000		3	%
As % of net sales		20	%		21	%

General and administrative expenses during the year ended December 31, 2006 increased by $0.4 million, or 3%, compared with the year ended December 31, 2005. The increased expenses were primarily the result of increases in Sarbanes-Oxley compliance related charges. The Company also experienced higher infrastructure costs such as increased communication and consulting expenses following implementation of the Oracle Enterprise Resource Planning system.

Loss on Abandonment of Lease

	Years Ended December 31,
	2006			2005			Change			% change
Loss on abandonment of lease	$	—		$	2,027,000		$	(2,027,000	)		(100	)%
As % of net sales		0	%		3	%

The loss on abandonment of lease cost of approximately $2.0 million in 2005 was associated with our abandonment of our former headquarters and manufacturing lease site in Sunnyvale, California. We completed our move to a larger headquarters and United States manufacturing facility during the second quarter of 2005 to support our sales growth.

Other Income (Expense)

	Years Ended December 31,
	2006			2005			Change			% change
Interest income	$	782,000		$	641,000		$	141,000			22	%
Interest expense		(249,000	)		(180,000	)		(69,000	)		38	%
Other, net		232,000			25,000			207,000			828	%
Equity in loss of unconsolidated affiliate		(194,000	)		(196,000	)		2,000			(1	)%
Total	$	571,000		$	290,000		$	281,000			97	%
As % of net sales		1	%		0	%

Total other income (expense) improved profits by $0.3 million for the year ended December 31, 2006, as compared with the year ended December 31, 2005. The increase was primarily the result of increased other income of $0.2 million in 2006, primarily resulting from a foreign exchange gain of $0.2 million in Eurodollar and Renminbi denominated balances and a litigation settlement gain of $0.2 million. The increase was partially offset

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by loss on fixed assets disposal of $0.2 million. We also experienced an increase in interest income of $0.1 million, which was largely attributed to higher interest rates on investments in 2006 compared with 2005.

Income Taxes

	Years Ended December 31,
	2006			2005			Change			% change
Income tax benefit	$	(965,000	)	$	(477,000	)	$	(488,000	)		102	%
As % of loss before income taxes, minority interest and cumulative effect on change in accounting principle		(38	%)		(37	%)

Income tax benefit increased by $0.5 million for the year ended December 31, 2006, as compared with the year ended December 31, 2005. Our effective tax rate was a 38% tax benefit in 2006 and 37% tax benefit in 2005. The tax rate for fiscal years 2006 and 2005 differed from the United States statutory rate due to foreign earnings taxed at lower rates, foreign losses not benefited, non-deductible stock compensation deductions under FAS 123 and FAS 123(R) and adjustments to our reserves for uncertain tax positions.

In 2006, the Internal Revenue Service completed its examination of our federal income tax returns for the years ended December 31, 2003 and 2004. Based on the results of the examination, the Company paid $391,000 to the IRS in April 2006, which was accrued at December 31, 2005. Based on a favorable outcome of the audit, the Company released $337,000 of additional reserves applicable to 2003 and 2004 during the year. Additionally, the Company reported $190,000 for the release of tax reserves and related interest upon the expiration of the statute of limitations for federal tax liabilities applicable to uncertain tax positions for the year ended December 31, 2002. In 2006, the tax authority in Denmark, Skat, has completed the audit of the Company’s subsidiary in Denmark for the year ended December 31, 2004 without any adjustment.

Minority interest in income of consolidated subsidiaries

	Years Ended December 31,
	2006			2005			Change			% change
Minority interest in loss of consolidated subsidiaries	$	49,000		$	62,000		$	(13,000	)		(21	)%
As % of net sales		0	%		0	%

Minority interest in loss of consolidated entities for the year ended December 31, 2006 decreased by approximately $13,000, or 21%, compared with the year ended December 31, 2005. Minority interest in loss of consolidated subsidiaries represented net loss allocated to minority shareholders’ interest in RAE Beijing and majority shareholders’ interest in RAE France. The reduction in minority interest in loss of consolidated entities was due to improved profitability at RAE Beijing and RAE France. Partially offsetting that reduction was the decrease in minority ownership that resulted from the Company’s increase in ownership of RAE Beijing from 64% to 96% in July 2006.

Comparison of Years Ended December 31, 2005 and 2004

Certain 2005 and 2004 numbers have been reclassified in order to comply with 2006 presentation. These reclassification adjustments do not have an impact on net income or loss for the year.

Total Net Sales

	Years Ended December 31,
	2005		2004		Change		% change
Net sales	$	60,293,000	$	45,540,000	$	14,753,000		32	%

Net sales increased by $14.8 million for the year ended December 31, 2005, from the year ended December 31, 2004. The increase was primarily due to higher sales reported by RAE Beijing of $10.1 million, which included twelve months of sales during 2005 as compared with seven months of sales for 2004, partially offset by a decrease

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in sales of $1.4 million, as other affiliates in China transferred sales responsibility to RAE Beijing for RAE products in China. Also, sales increased by $6.1 million in the Americas and Europe from sales of patented photoionization detection and wireless products. Overall non-Americas sales increased by $10.6 million in 2005 from 2004 to 44% of total revenue compared with 34% of the total revenue in 2004. The non-Americas sales growth was also impacted favorably as a result of RAE Beijing being included in the consolidated sales results for twelve months during the year ended December 31, 2005, as compared with seven months for the year ended December 31, 2004.

Cost of Sales & Gross Profit

	Years Ended December 31,
	2005			2004			Change		% change
Cost of sales	$	24,690,000		$	18,517,000		$	6,173,000		33	%
Gross profit	$	35,603,000		$	27,023,000		$	8,580,000		32	%
Gross profit as % of net sales		59	%		59	%

Cost of sales excluding RAE Beijing was $14.5 million for the year ended December 31, 2005, as compared with $13.9 million for the year ended December 31, 2004, an increase of $0.6 million. Cost of sales excluding the impact of RAE Beijing increased due to a 12% increase in the sales volume between the years 2005 and 2004 partially offset by cost improvements from the volume increases and manufacturing efficiencies. Cost of sales for RAE Beijing increased to $10.2 million for the year ended December 31, 2005, from $4.6 million for the year ended December 31, 2004, primarily as a result of sales volume increases, which were partially offset by improved costs as a result of increased volume. Gross profit, excluding RAE Beijing, was $27.8 million and $23.7 million for the years ended December 31, 2005 and 2004, respectively. Gross profit excluding RAE Beijing increased due to higher sales of our integrated systems and patented photoionization detection products and from improved costs as a result of higher volumes and manufacturing efficiencies. Gross profit as a percentage of sales for the year ended December 31, 2005, was the same 59% as for the year-ended December 31, 2004, as the increase in lower margin distribution and installation business at RAE Beijing was offset by the favorable impact of higher volumes and manufacturing efficiencies on our overall product costs.

Sales and Marketing Expense

	Years Ended December 31,
	2005			2004			Change		% change
Sales and marketing	$	16,835,000		$	10,583,000		$	6,252,000		59	%
As % of net sales		28	%		23	%

Sales and marketing expenses increased by $6.3 million during the year ended December 31, 2005, as compared with the year ended December 31, 2004. Approximately $3.9 million of the increase was attributable to an increase in RAE Beijing sales and marketing expenses, which included twelve months of expenses during 2005 as compared with seven months of expenses for 2004 as well as from higher infrastructure costs to support RAE Beijing’s growth. Sales and marketing expenses also increased by $1.9 million to support increased sales in the Americas and Europe, $0.3 million for external commissions paid primarily to support the sale of integrated systems products and approximately $0.2 million for severance expense.

Research and Development Expense

	Years Ended December 31,
	2005			2004			Change		% change
Research and development	$	5,414,000		$	4,383,000		$	1,031,000		24	%
As % of net sales		9	%		10	%

Research and development expenses increased by $1.0 million during the year ended December 31, 2005, as compared with the year ended December 31, 2004. The higher spending was largely the result of increased spending at RAE Beijing of $0.6 million for twelve months of expenses included in 2005 results compared with seven months of expenses in the 2004, as well as from increases to R&D personnel related expenses at RAE Beijing. The

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remaining $0.4 million increase was mainly the result of increases to R&D personnel in Shanghai to support new product development.

General and Administrative Expense

	Years Ended December 31,
	2005			2004			Change		% change
General and administrative	$	12,915,000		$	8,543,000		$	4,372,000		51	%
As % of net sales		21	%		19	%

General and administrative (G&A) expenses increased by $4.4 million during the year ended December 31, 2005, as compared with the year ended December 31, 2004. The increase was primarily the result of $1.3 million of additional expenses at RAE Beijing, primarily due to the inclusion of twelve months of expenses in 2005 compared with seven months for 2004, as well as increases in G&A personnel related expenses to support RAE Beijing’s growth. We also experienced increases across the Company in audit and Sarbanes-Oxley certification costs ($0.9 million), legal fees ($0.6 million), and amortization of stock options and warrants ($0.5 million). The remaining amount of $1.1 million was for additional infrastructure and personnel to support increased sales growth in all other units.

Loss on Abandonment of Lease

	Years Ended December 31,
	2005			2004			Change		% change
Loss on abandonment of lease	$	2,027,000		$	—		$	2,027,000		100	%
As % of net sales		3	%		0	%

The loss on abandonment of lease cost of approximately $2.0 million in 2005 was associated with our abandonment of our former United States headquarters and manufacturing lease site in Sunnyvale, California. We completed our move to a larger headquarters and United States manufacturing facility during the second quarter of 2005 to support our sales growth.

Other Income (Expense)

	Years Ended December 31,
	2005			2004			Change			% change
Interest income	$	641,000		$	333,000		$	308,000			92	%
Interest expense		(180,000	)		(17,000	)		(163,000	)		959	%
Other, net		25,000			194,000			(169,000	)		(87	)%
Equity in loss of unconsolidated affiliate		(196,000	)		(353,000	)		157,000			(44	)%
Total	$	290,000		$	157,000		$	133,000			85	%
As % of net sales		0	%		0	%

Total other income (expense) improved profits by $133,000 for the year ended December 31, 2005, as compared with the year ended December 31, 2004. The increase was the result of increased interest income of $308,000, largely from increased interest rates earned on our cash and investments. Equity in loss from an unconsolidated affiliate also improved by $157,000, compared with 2004, mainly as a result of lower operating losses at our Renex affiliate during the year ended December 31, 2005. Partially offsetting those items was a decline of $169,000 in other income as we received a consulting payment of $137,000 in 2004 from a sales affiliate in China that is no longer operating and an increase of interest expense of $163,000, primarily from $126,000 from the amortization of discount to interest expense related to RAE Beijing notes payable.

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Income Taxes

	Years Ended December 31,
	2005			2004			Change			% change
Income tax benefit (expense)	$	(477,000	)	$	983,000		$	(1,460,000	)		(149	)%
As % of (loss) income before income taxes, minority interest and cumulative effect on change in accounting principle		(37	%)		27	%

Income tax expense decreased by $1.5 million for the year ended December 31, 2005, compared with the year ended December 31, 2004. Our effective tax rate was a 37% benefit in 2005 and a 27% tax provision in 2004, respectively. The tax benefit is primarily from the operating losses which were largely the result of the abandonment of the lease on our former Sunnyvale headquarters and research and development tax credits.

Minority interest in income of consolidated subsidiaries

	Years Ended December 31,
	2005			2004			Change		% change
Minority interest in loss (income) of consolidated subsidiaries	$	62,000		$	(353,000	)	$	415,000		(118	)%
As % of net sales		0	%		(1	)%

For the year ended December 31, 2005, we recognized $62,000 in net loss of consolidated subsidiaries allocated to minority interest, which related mainly to the 36% minority interest’s share in RAE Beijing losses partially offset by the 51% owners share in income of our French subsidiary. During the year ended December 31, 2004, our minority partners share in profits was $353,000 representing the 36% minority interest’s share in profits at RAE Beijing and our 51% majority investors share in RAE France.

Liquidity and Capital Resources

To date, we have financed our operations primarily through bank borrowings, revenues from operations and proceeds from the issuance of equity securities. As of December 31, 2006, we had $21,367,000 in cash and investments compared with $29,488,000 on December 31, 2005. The $8,121,000 million year-over-year reduction in the Company’s cash and investments was primarily due to business acquisitions of $7,439,000 and investments in property and equipment of $2,235,000, which was partially offset by net cash provided by operating activities of $1,051,000 and cash provided by financing activities of $230,000. On December 31, 2006, we had $36,641,000 in working capital (current assets less current liabilities) and a current ratio (ratio of current assets to current liabilities) of 2.6 to 1.0 compared to working capital of $41,366,000 and a current ratio of 3.9 to 1.0 on December 31, 2005.

On March 14, 2007, the Company signed a one year $15 million revolving credit agreement, which is available to help fund future growth and expansion. The agreement provides for borrowings up to $7 million based on a blanket security interest in the Company’s assets. An additional $8 million of borrowing will be available based on a percentage of qualifying assets. The Company is required to comply with certain bank specific reporting requirements whenever borrowings against the line of credit exceed $3 million, in addition to the on-going requirement to submit quarterly financial statements. The Company is in full compliance with all of the borrowing requirements, including certain financial covenants, and as such, has the full line available. At present, there are no outstanding amounts under the line of credit agreement.

We believe our existing balances of cash and cash equivalents, together with cash generated from product sales, will be sufficient to meet our cash needs for working capital and capital expenditures for at least the next twelve months. Our future capital requirements will depend on many factors that are difficult to predict, including the size, timing and structure of any future acquisitions, future capital investments, and future results of operations. Any future financing we may require may be unavailable on favorable terms, if at all. Any difficulty in obtaining additional financial resources could force us to curtail our operations or could prevent us from pursuing our growth strategy. Any future funding may dilute the ownership of our stockholders.

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Summary of the Consolidated Statements of Cash Flows for the years 2006, 2005 and 2004 are as follows:

	Year Ended December 31,
	2006		2005			2004
Net cash provided by (used in):
Operating activities	$	1,051,000	$	1,368,000		$	3,207,000
Investing activities		3,025,000		(9,562,000	)		(21,009,000	)
Financing activities		230,000		108,000			31,816,000
Effect of exchange rate changes on cash and cash equivalents		289,000		44,000			40,000
Net increase (decrease) in cash and cash equivalents	$	4,595,000	$	(8,042,000	)	$	14,054,000

Operating Activities

For the year ended December 31, 2006, net cash provided by operating activities was $1,051,000 which exceeded our net loss of $(1,529,000) primarily for two reasons:

1. Non-cash charges to our net income were approximately $4,672,000. The non-cash adjustments to net income resulted primarily from depreciation and amortization of long-lived assets of $3,189,000, compensation expense of fair value accounting for stock options of $1,620,000, other reserve and non-cash adjustments to the Company’s net income of approximately $1,043,000, partially offset by an adjustment to the Company’s deferred income taxes of $1,180,000.

2. The positive effect of the non-cash adjustments described in item 1 above, for the year 2006, was offset by an increased investment in working capital of $2,092,000. The increase in working capital was primarily the result of increased sales in Asia, which has a longer average collection period for accounts receivable than sales in the United States, partially offset by higher payables related to the increased volume in December 2006.

For the year ended December 31, 2005, net cash provided by operating activities was $1,368,000 which exceeded our net loss of $(759,000) primarily for two reasons:

1. Non-cash charges to our net income were approximately $5,397,000. The non-cash adjustments to net income resulted primarily from depreciation and amortization of long-lived assets of $2,143,000, the reserve amounts to cover the anticipated payment to the landlord of the Sunnyvale, California, headquarters building of $2,027,000 which was abandoned when the Company purchased its headquarters building in San Jose, California, compensation expense of fair value accounting for stock options of $1,970,000, other reserve and non-cash adjustments to the Company’s net income of approximately $1,182,000, partially offset by an adjustment to the Company’s deferred income taxes of $1,925,000.

2. The positive effect of the non-cash adjustments described in item 1 above, for the year 2005, was partially offset by an increased investment in working capital of $3,270,000, which was comprised primarily of increases in accounts receivable and inventory related to increased sales levels and the continued growth of the business in Asia.

For the year ended December 31, 2004, net cash provided by operating activities was $3,207,000, which exceeded our net income of $2,335,000 for two reasons:

1. Non-cash charges to our net income was $4,414,000 of which $2,445,000 comprised of stock option expense and stock option income tax benefits; depreciation and amortization of $991,000 and other non-cash adjustments of $1,788,000, partially offset by deferred income taxes of $810,000.

2. There was an increase in working capital of $3,542,000 primarily as a result of the inclusion of RAE Beijing in our balance sheet in 2004.

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Investing Activities

Net cash provided (used) in investing activities during the years ended December 31, 2006, 2005 and 2004 amounted to $3,025,000, ($9,562,000) and ($21,009,000), respectively.

During 2006, the proceeds from investing activities contributed $3,025,000 to cash. The increase consisted primarily of $12,699,000 in net proceeds from the sale of investments and the maturity of investments. The net proceeds were partially offset by investments of $7,439,000 used for business acquisitions. Of the acquisitions approximately $4,850,000 was invested to increase our stake in RAE Beijing from 64% to 96%, $2,100,000 to acquire the assets of Aegison Corporation and $467,000 to acquire certain assets of Tianjin Securay Technology Co Ltd. In addition, $2,235,000 was used for the acquisition of property and equipment.

During 2005, there was an increase in investing activities that reduced cash available to business operations by $9,562,000. The cash reduction resulting from increased investing activities during 2005, which was primarily the result of $4,855,000 being used for acquisition of property and equipment related to existing businesses and a net increase of investments of surplus cash held by the Company of approximately $4,707,000.

During 2004, there was an increase in investing activities that reduced cash available to business operations by $21,009,000. The cash reduction resulting from increased investing activities during 2004 was primarily due to $9,273,000 that was invested in property, including $5,000,000 for a new headquarters and manufacturing facilities in the United States. In addition, the Company had a net increase of investments of $11,245,000 and other cash used in investing activities of $491,000.

Financing activities

Net cash provided by financing activities during the years ended December 31, 2006, 2005 and 2004 amounted to $230,000, $108,000 and $31,816,000, respectively.

The net cash provided by financing activities for 2006 and 2005 was mainly from the proceeds from the exercise of stock options and warrants.

The net cash of $31.8 million provided in 2004 was primarily the result of a public offering of 8,050,000 shares of common stock at $4.25 per share less the applicable discount.

Commitments and Contingencies

Operating leases

The Company and its subsidiaries lease certain manufacturing, warehousing and other facilities under operating leases. The leases generally provide for the lessee to pay taxes, maintenance, insurance and certain other operating costs of the leased property. Total rent expense for the years ended December 31, 2006, 2005 and 2004 was $654,000, $624,000 and $809,000, respectively. Future minimum lease payments for each of the next five years from 2007 through 2011 and thereafter, excluding the Sunnyvale, California abandoned building lease, as described below, are $947,000, $621,000, $426,000, $378,000, $349,000 and $801,000, respectively.

In December 2004, the Company purchased the property located at 3775 North First Street in San Jose, California. The lease related to our previous headquarters in Sunnyvale, California was written-off as of the second quarter of 2005. The total loss on abandonment of the lease was approximately $2 million. Future discounted lease payments related to the Sunnyvale building have been included in accrued expenses totaling $478,000 and other long term liabilities totaling $1,000,000 at December 31, 2006. Future minimum lease payments for each of the next three years from 2007 through 2009 are $528,000, $627,000 and $556,000, respectively. The discount rate used was 4.85% and the liability was not reduced for any anticipated future sublease income. Based upon broker estimates of current real estate market conditions and other factors, it was considered more likely than not that any potential sublease income would be offset by brokerage, refurbishment and other costs to make the facility ready for a sublease.

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Purchase obligations

The Company has agreements with suppliers and other parties to purchase inventories and other goods and services. The Company estimated its non-cancelable obligations under these agreements for the next three years from 2007 through 2009 to be approximately $3,844,000, $244,000 and $230,000, respectively. There are no non-cancelable obligations after 2009. All non-cancelable obligations related to inventories are expected to be delivered within the next 12 months. The Company periodically reviews the carrying value of its inventories and non-cancelable purchase commitments by evaluating material usage requirements and forecasts and estimates inventory obsolescence, excess quantities and any expected losses on purchase commitments. The Company may record charges to write-down inventory due to excess, obsolete and slow-moving inventory and lower-of-cost or market based on an analysis of the impact of changes in technology, estimates of future sales volumes and market value estimates. There was no loss accrued related to current purchase obligations. However, any additional future write-downs of inventories or loss accrued on inventory purchase commitments, if any, due to market conditions, may negatively affect gross margins in future periods.

In December 2006, RAE Fushun entered into an agreement with Fushun Economic Development Zone Administration to purchase a land use right for approximately $446,000. The land use right will be used to construct RAE Fushun’s new manufacturing and administrative facility. The construction is expected to begin prior to June 2007.

Guarantees

The Company is permitted under Delaware law and in accordance with its Bylaws to indemnify its officers and directors for certain events or occurrences, subject to certain limits, while the officer is or was serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has a Director and Officer Insurance Policy that limits its exposure and enables it to recover a portion of any future amounts paid. To date the Company has not incurred any losses under these agreements.

In the Company’s sales agreements, the Company typically agrees to indemnify its customers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date, the Company has not paid any amounts to settle claims or defend lawsuits.

Product Warranties

The Company sells the majority of its products with a 12 to 24 month repair or replacement warranty from the date of shipment. The Company provides an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to sales. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized. At December 31, 2006 and 2005, the warranty reserve recorded in accrued expenses was $553,000 and $377,000, respectively.

Summary of Obligations

The following table quantifies our known contractual obligations in tabular form as of December 31, 2006:

	Total		2007		2008		2009		2010		2011		Thereafter
Contractual obligations:
Operating lease obligations	$	5,233,000	$	1,475,000	$	1,248,000	$	982,000	$	378,000	$	349,000	$	801,000
Purchase obligations		4,764,000		4,290,000		244,000		230,000		—		—		—
Notes payable — related parties		4,779,000		859,000		257,000		1,756,000		967,000		940,000		—
Total	$	14,776,000	$	6,624,000	$	1,749,000	$	2,968,000	$	1,345,000	$	1,289,000	$	801,000

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Related Party Transactions

In conjunction with the original and subsequent additional investment in RAE Beijing, unsecured note payables were established for the previous RAE Beijing shareholders as part of the purchase price agreement in May 2004 and July 2006. As of December 31, 2006 and December 31, 2005, $822,000 and $759,000, respectively, was included in notes payable — related parties and $3,222,000 and $821,000, respectively, was included in long term notes payable — related parties.

The notes issued in conjunction with the original RAE Beijing purchase in May 2004 were non-interest bearing and were recorded at net present value using a discount rate of 5.5%. In conjunction with the additional investment in RAE Beijing in July 2006, 11.0 million shares of preferred stock were issued to four shareholders of RAE Beijing. In accordance with the Financial Accounting Standards Board Statements No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, (“FAS 150”), these preferred shares were classified as liabilities and were recorded as long-term notes payable — related parties. Although, these preferred shares bear a dividend yield rate of 3% per annum, the notes payable were discounted using a market interest rate of 6.48%.

Included in the current portion of notes payable is a sum of $448,000 due on demand after December 31, 2006. In addition, the future payment plan for each of the years from 2007 through 2011 is $411,000, $257,000, $1,756,000, $967,000 and $940,000, respectively.

The Company’s Director of Information Systems, Lien Chen, is the wife of our Chief Executive Officer, Robert Chen. Ms. Chen was paid a salary and bonus of $103,000 and $96,000 for 2006 and 2005, respectively. Ms. Chen also receives standard employee benefits offered to all other full-time U.S. employees. Ms. Chen does not report to Robert Chen and compensation decisions regarding Ms. Chen are performed in the same manner as other U.S. employees, with Robert Chen the final approval signatory on compensation recommendations.

On January 14, 2006, Lien Chen and Sandy Hsi, the wife of our Chief Technology Officer, Peter C. Hsi, signed a promissory note to lend $200,000 to Aegison Corporation at an interest rate of 10% per year. On July 11, 2006, the Company purchased the assets, including two pending patents, of Aegison Corporation for a total purchase price of $2 million in cash. At such time, the promissory note held by Lien Chen and Sandy Hsi was repaid by Aegison Corporation.

Recent Accounting Pronouncements

In July 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (FIN 48), which is a change in accounting for income taxes. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim-period guidance, among other provisions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and as a result, is effective for us on January 1, 2007. We are currently evaluating the impact of FIN 48 on our consolidated financial statements.

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework and gives guidance regarding the methods used in measuring fair value, and expands disclosures about fair value measurements. SFAS 157 is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. SFAS 157 does not expand or require any new fair value measures, however the application of this statement may change current practice. SFAS 157 is effective for fiscal years beginning after November 15, 2007 and as a result, is effective for our fiscal year beginning January 1, 2008. We are currently evaluating the impact of adopting SFAS 157 on our consolidated financial statements.

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ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The following discussion analyzes our disclosure to market risk related to concentration of credit risk, changes in interest rates and foreign currency exchange rates.

Concentration of Credit Risk

Currently, we have cash and cash equivalents deposited with one large United States financial institution, one large Hong Kong financial institution, three large Shanghai financial institutions, one local Beijing financial institutions, two large Beijing financial institutions and one large Danish financial institution. Our deposits may exceed the amount of insurance available to cover such deposits. To date, we have not experienced any losses of deposits of cash and cash equivalents. Management regularly reviews our deposit amounts and the credit worthiness of the financial institution which hold our deposits.

Interest Rate Risk

As of December 31, 2006, we had cash, cash equivalents and short term investments of $21.4 million consisting of cash and highly liquid short-term investments. As a result of our 2006 investment commitments and in accordance with Financial Accounting Standard 115, “Accounting for Certain Investments in Debt and Equity,” the Company changed the classification of its investments from “held-to-maturity” to “available-for-sale.” The resulting fair-value calculation of the Company’s investments led to a nominal net decrease in carrying value of the investments in 2006. In addition, changes to interest rates over time may reduce or increase our interest income from our short-term investments. If, for example, there is a hypothetical 150 (basis points, 1.5%) bps change in the interest rates in the United States, the approximate impact on our cash and short-term investments would be $97,000.

Foreign Currency Exchange Rate Risk

For the year ended December 31, 2006, a substantial portion of our recognized revenue was denominated in U.S. dollars generated primarily from customers in the Americas (49%). Revenue generated from our European operations (13%)was primarily in Euros, revenue generated by our Asia operations (38%)was primarily in the Renminbi (“RMB”). We manufacture a majority of our component parts at our manufacturing facility in Shanghai, China. Since January 2006, our operations in China have been affected by currency fluctuations due to an approximate 3.1% appreciation of the RMB relative to the U.S. dollar.

Our strategy has been and will continue to be to increase our overseas manufacturing and research and development activities to capitalize on low-cost intellectual property and efficiency in supply-chain management. In 2004 and 2006, we made a strategic investment in China with the acquisition of a 96% interest in RAE Bejing, a Beijing-based manufacturer and distributor of environmental safety and security equipment. We also formed RAE Coal Mine Safety Instruments (Fushun) Co., Ltd., in late 2006 to capitalize on increase in demand for safety equipment in the energy sector in China. There has been continued speculation in the financial press that China’s currency, the RMB, will be subject to a further market adjustment relative to the U.S. dollar and other currencies. If, for example, in 2006 there was a hypothetical 10% change in the RMB relative to the U.S. dollar, the approximate impact on our profits would have been approximately $536,000 for the 2006 fiscal year. Were the currencies in all other countries in Europe and Asia where we have operations to change in unison with the RMB by a hypothetical 10% against the U.S. dollar the approximate impact on our profits would be approximately $151,000 for the 2006 fiscal year. The reduction in the impact of the RMB is due to the offset of changes in reported net sales in our other units resulting from changes in those countries local currencies.

Furthermore, to the extent that we engage in international sales denominated in U.S. dollars in countries other than China, any fluctuation in the value of the U.S. dollar relative to foreign currencies could affect our competitive position in the international markets. Although we would continue to monitor our exposure to currency fluctuations and, when appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, we cannot be certain that exchange rate fluctuations will not adversely affect our financial results in the future.

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ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

Our consolidated financial statements included in this report beginning on page F-1 are incorporated herein by reference.

ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

None.

ITEM 9A.   CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures

RAE Systems, Inc. (the “Company”) maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports the Company files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required financial disclosure.

In connection with the preparation of this Annual Report on Form 10-K, the Company carried out an evaluation under the supervision and with the participation of the Company’s management, including the CEO and CFO, as of December 31, 2006 of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based upon this evaluation, the CEO and CFO concluded that as of December 31, 2006 the Company’s disclosure controls and procedures were not effective due to the discovery of a material weakness in the Company’s internal control over financial reporting, as described below under “Management’s Report on Internal Control over Financial Reporting.”

Management’s Report on Internal Control over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles in the United States.

Internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the consolidated financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management has conducted an assessment, including testing, of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006. In making its assessment of internal control over financial reporting, management used the criteria in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Our management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls

41

of RAE Coal Mine Safety Instruments (Fushun) Co., Ltd. (“RAE Fushun”), which was acquired on December 10, 2006, and which is included in our consolidated balance sheet as of December 31, 2006. RAE Fushun constituted 21% of total assets as of December 31, 2006. The operations of RAE Fushun are not being reflected in consolidated financial statements until January 2007. Our management did not assess the effectiveness of internal control over financial reporting of RAE Fushun because of the timing of the acquisition, which was completed in December 2006. Based on the results of this assessment, our management concluded that the Company’s internal control over financial reporting was not effective as of December 31, 2006 due to the discovery of a material weakness. In evaluating the Company’s internal control over financial reporting as of December 31, 2006, management concluded that the Company’s controls that ensure financial information from its Chinese subsidiaries has been properly adjusted from a local statutory basis to reflect Generally Accepted Accounting Principles in the United States of America (“US GAAP”) for inclusion in the worldwide consolidated financial statements, failed to detect certain adjustments arising out of an audit conducted by the Company’s independent registered public accounting firm. Principally, the Company failed to detect adjustments relating to: depreciation on property and equipment, inventory reserves and certain balance sheet reclassifications. As a result of these failures, management concluded that the controls that ensure information from its Chinese subsidiaries has been properly adjusted to US GAAP for inclusion in the consolidated financial statements were inadequate, and as a result, there existed as of December 31, 2006 a more than remote likelihood that a material misstatement of the Company’s annual or interim financial statements could occur and not be prevented or detected.

A material weakness is a control deficiency within the meaning of the Public Company Accounting Oversight Board (United States) Auditing Standard No. 2, or combination of control deficiencies, that results in there being more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis by employees in the normal course of their assigned functions.

Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31,2006 has been audited by BDO Seidman, LLP, an independent registered public accounting firm, as stated in their report which appears herein.

Remediation of Material Weakness Identified by Management as of December 31, 2006

As described above, management identified a material weakness in the Company’s internal control over financial reporting as of December 31, 2006 relating to assurance that information from its Chinese subsidiaries has been properly adjusted to US GAAP for inclusion in its annual or interim financial statements. As a consequence, beginning with the first quarter of 2007, management of the Company initiated steps to implement a number of compensating controls and remediation measures to improve the level of assurance to ensure that the information from its Chinese subsidiaries has been properly adjusted to US GAAP. These controls include:

•  Implement in China US GAAP accounting policies for depreciation, inventory reserves and balance sheet classification that are consistent with the Company’s US accounting policy.

•  Provide the Company’s Chinese accounting staff with extended training on the proper implementation of US GAAP accounting policies for depreciation on property and equipment, inventory and balance sheet classification of assets and liabilities.

•  Implementation of specific accounting procedures and templates for calculating and reporting depreciation, reserves and balance sheet classifications.

•  The corporate controller and chief financial officer shall conduct extensive quarterly reviews of financial records of the Company’s Chinese operations.

•  Assess the requirement to hire additional US GAAP trained accounting personnel in China.

42

Management believes the additional temporary reviews and monitoring procedures instituted by the Company in the first quarter of 2007 have mitigated the control deficiencies with respect to the preparation of this annual report on Form 10-K.

Remediation of Material Weaknesses Identified by Management as of December 31, 2005

As December 31, 2005, management identified three material weaknesses in the Company’s annual report on Form 10-K for the fiscal year ending December 31, 2005 under Part II, Item 9A, “Controls and Procedures.” Management disclosed its progress remediating the material weaknesses identified as of December 31, 2005, in the Company’s annual report on Form 10-K for the fiscal year ending December 31, 2005, plus updates were filed each quarter on the Form 10-Q under Item 4 Controls and Procedures. As of December 31, 2006, management of the Company concluded that these previously identified material weaknesses in the Company’s internal control over financial reporting had been remediated. However, as stated in the “Management’s Report on Internal Control over Financial Reporting,” which accompanies this annual report on Form 10-K for the fiscal year ended December 31, 2006, management concluded that the Company’s internal control over financial reporting was not effective as of December 31, 2006 due to the discovery of a material weakness relating to assurance that information from its Chinese subsidiaries has been properly adjusted to US GAAP for inclusion in its annual or interim financial statements.

Changes in Internal Control Over Financial Reporting

There was no change in our internal control over financial reporting during our fourth quarter of fiscal 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

43

Report of Independent Registered Public Accounting Firm

To The Board of Directors and
Stockholders of RAE Systems Inc.:

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that RAE Systems Inc. did not maintain effective internal control over financial reporting as of December 31, 2006, because of the effects of the material weakness identified in management’s assessment, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). RAE Systems Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States of America. A Company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

As indicated in the accompanying Management’s Annual Report on Internal Control over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of RAE Coal Mine Safety Instruments (Fushun) Co., Ltd. (“RAE Fushun”), which was acquired on December 10, 2006, and which is included in the consolidated balance sheet of the Company as of December 31, 2006. RAE Fushun constituted 21% of total assets as of December 31, 2006. The operations of RAE Fushun are not being reflected in consolidated financial statements until January 2007. Management did not assess the effectiveness of internal control over financial reporting of RAE Fushun because of the timing of the acquisition, which was completed in December 2006. Our audit of internal control over financial reporting of the Company also did not include an evaluation of the internal control over financial reporting of RAE Fushun.

44

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment:

The Company’s controls that ensure that financial information from its Chinese subsidiaries has been properly adjusted from a local statutory basis to reflect Accounting Principles Generally Accepted in the United States of America (“US GAAP”) for inclusion in the worldwide consolidated financial statements failed to detect certain adjustments arising out of the integrated audit principally relating to: depreciation on property and equipment, inventory reserves and certain balance sheet reclassifications. Due to these failures management has concluded that controls that ensure that information from its Chinese subsidiaries has been properly adjusted to US GAAP for inclusion in the consolidation are inadequate and as a result there existed as of December 31, 2006, a more than remote likelihood that a material misstatement of the Company’s annual or interim financial statements could occur and not be prevented or detected.

This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of RAE Systems Inc.’s consolidated financial statements as of and for the year ended December 31, 2006, and this report does not affect our report dated March 16, 2007 on those consolidated financial statements.

In our opinion, management’s assessment that RAE Systems Inc. did not maintain effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, because of the effects of the material weakness described above on the achievement of the objectives of the control criteria, RAE Systems Inc. has not maintained effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We do not express an opinion or any other form of assurance on management’s statements regarding corrective actions taken by the Company after December 31, 2006.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the accompanying consolidated balance sheets of RAE Systems Inc. as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006, and our report dated March 16, 2007 expressed an unqualified opinion thereon.

/s/  BDO Seidman, LLP

San Jose, California

March 16, 2007

45

ITEM 9B.   OTHER INFORMATION.

On March 14, 2007, the Company signed a one year $15 million revolving credit agreement, which is available to help fund future growth and expansion. The agreement provides for borrowings up to $7 million based on a blanket security interest in the Company’s assets. An additional $8 million of borrowing will be available based on a percentage of qualifying assets. The Company is required to comply with certain bank specific reporting requirements whenever borrowings against the line of credit exceed $3 million, in addition to the on-going requirement to submit quarterly financial statements. The Company is in full compliance with all of the borrowing requirements, including certain financial covenants, and as such, has the full line available. At present, there are no outstanding amounts under the line of credit agreement.

PART III

ITEM 10.   DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by this item with respect to the Company’s executive officers is incorporated herein by reference from the information contained in Item 1 of Part I of this Report under the caption “Executive Officers of the Registrant.”

The information required by this item regarding (a) the Company’s directors, (b) compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended and (c) the Company’s Code of Conduct and Ethics is incorporated herein by reference from the information provided under the headings “Proposal No. 1 — Election of Directors”, “Section 16(a) Beneficial Ownership Reporting Compliance” and “Code of Conduct and Ethics” of the Proxy Statement for our 2007 Annual Meeting of Stockholders.

ITEM 11.   EXECUTIVE COMPENSATION.

The information required by this item, which will be set forth in our Proxy Statement for our 2007 Annual Meeting of Stockholders under the caption “Executive Compensation and Other Matters”, is incorporated herein by reference.

ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.

The information required by this item, which will be set forth in our Proxy Statement for our 2007 Annual Meeting of Stockholders under the caption “Stock Ownership of Certain Beneficial Owners and Management”, is incorporated herein by reference.

ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE.

The information required by this item, which will be set forth in our Proxy Statement for our 2007 Annual Meeting of Stockholders under the caption “Certain Relationships and Related Transactions”, is incorporated herein by reference.

ITEM 14.   PRINCIPAL ACCOUNTING FEES AND SERVICES.

The information required by this item, which will be set forth in our Proxy Statement for our 2007 Annual Meeting of Stockholders under the heading “Proposal No. 2 — Ratification of Appointment of Independent Auditors”, is incorporated herein by reference.

46

PART IV.

ITEM 15.   EXHIBITS, FINANCIAL STATEMENT SCHEDULES.

(a) (1) Financial Statements

See the index of the Consolidated Financial Statements of this Form 10-K.

(2) Financial Statement Schedules

Schedules are not provided because of the absence of conditions under which they are required or because the required information is given in the financial statements or the notes thereto.

(3) Exhibits

See Index to Exhibits on page 49 herein.

47

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 16, 2007.

RAE SYSTEMS INC.

By:  /s/  Robert I. Chen

Robert I. Chen

President and Chief Executive Officer

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Robert I. Chen and Randall Gausman, and each of them, as such person’s true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for such person and in such person’s name, place and stead, in any and all capacities, to sign any and all amendments to this report on Form 10-K, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as such person might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his or her substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated:

Signature	Title	Date
/s/  Robert I. Chen Robert I. Chen	President, Chief Executive Officer and Chairman of the Board (Principal Executive Officer)	March 16, 2007
/s/  Randall Gausman Randall Gausman	Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)	March 16, 2007
/s/  Peter C. Hsi Peter C. Hsi	Chief Technology Officer, Vice President of Emerging Technologies Development and Director	March 16, 2007
/s/  Lyle D. Feisel Lyle D. Feisel	Director	March 16, 2007
/s/  Neil W. Flanzraich Neil W. Flanzraich	Director	March 16, 2007
/s/  Sigrun Hjelmquist Sigrun Hjelmquist	Director	March 16, 2007
/s/  A. Marvin Strait A. Marvin Strait	Director	March 16, 2007
/s/  James W. Power James W. Power	Director	March 16, 2007

48

INDEX TO EXHIBITS

Exhibit
Number			Description of Document
	3	.1	Certificate of Incorporation of Registrant(1)
	3	.2	Bylaws of Registrant(1)
	4	.1	Specimen certificate representing the common stock of Registrant(1)
	10	.0	Purchase and Sale Agreement dated November 1, 2004 by and between RAE Systems Inc. and CarrAmerica Realty Operating Partnership, L.P.(2)
	10	.1	Form of Indemnity Agreement between the Registrant and the Registrant’s directors and officers(1)
	10	.2	RAE Systems Inc. 2002 Stock Option Plan(1)
	10	.3	RAE Systems Inc. 1993 Stock Plan(1)
	10	.4	Form of Stock Option Agreement under the Registrant’s 2002 Stock option Plan(4)
	10	.5	Lease Agreement by and between Aetna Life Insurance Company and the Registrant dated June 1, 1999(1)
	10	.6	First Amendment to Lease by and between Moffett Office Park Investors LLC and the Registrant dated effective November 1, 2002 amending Lease Agreement between Aetna Life Insurance Company and the Registrant dated June 1, 1999(3)
	10	.7	Manufacturing Building Lease Agreement by and between Shanghai China Academic Science High Tech Industrial Park Development Co., Ltd. and RAE Systems(Asia), Ltd., incorporated in Hong Kong, dated September 15, 2001(1)
	10	.8	Lease Agreement by and between Shanghai Institute of Metallurgy Research, Chinese Academy of Sciences and WARAE Instrument(Shanghai) Incorporated, incorporated in Jiading, Shanghai, dated January 8, 1999(1)
	10	.9	Form of Share Transfer Agreement by and between RAE-KLH shareholders and RAE Systems Asia(Hong Kong) Ltd.(5)
	10	.10	Separation Agreement and General Release of Claims by and between Donald W. Morgan and the Registrant dated August 8, 2006(6)
	10	.11	RAE System’s Inc. Management Incentive Plan(7)
	10	.12	Employment Offer Letter by and between Randall Gausman and the Registrant dated October 17, 2006 (8)
	10	.13	Loan and Security Agreement dated as of March 14, 2007 between Silicon Valley Bank and the Registrant(9)
	10	.14	Joint Venture Agreement by and between Lioaning Coal Industry Group Co., Ltd. and RAE Systems (Asia), Ltd. dated December 10, 2006(9)
	21	.1	Subsidiaries of the Registrant(9)
	23	.1	Consent of BDO Seidman, LLP(9)
	24	.1	Power of Attorney(9) (included on signature page)
	31	.1	Certifications of Robert I. Chen, President and Chief Executive Officer of Registrant pursuant to Rule 13a-14 adopted under the Securities Exchange Act of 1934, as amended, and Section 302 of the Sarbanes-Oxley Act of 2002(9)
	31	.2	Certifications of Randall Gausman, Vice President and Chief Financial Officer of Registrant pursuant to Rule 13a-14 adopted under the Securities Exchange Act of 1934, as amended, and Section 302 of the Sarbanes-Oxley Act of 2002(9)
	32	.1	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(9)
	32	.2	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(9)

(1) Previously filed as an exhibit to the Registrant’s quarterly report on Form 10-Q, for the quarter ended March 31, 2002 and incorporated herein by reference.

49

(2)	Previously filed as an exhibit to the Registrant’s current report on Form 8-K on November 2, 2004 and incorporated herein by reference.
(3)	Previously filed on February 28, 2003 as an exhibit to the Registrant’s annual report on Form 10-K, for the year ended December 31, 2002 and incorporated herein by reference.
(4)	Previously filed on March 31, 2006 as an exhibit to the Registrant’s annual report on Form 10-K, for the year ended December 31, 2005 and incorporated herein by reference.
(5)	Previously filed on August 8, 2006 as an exhibit to the Registrant’s quarterly report on Form 10-Q, for the quarter ended June 30, 2006 and incorporated herein by reference.
(6)	Previously filed as an exhibit to the Registrant’s current report on Form 8-K on August 8, 2006 and incorporated herein by reference.
(7)	Previously filed as an exhibit to the Registrant’s current report on Form 8-K on August 16, 2006 and incorporated herein by reference.
(8)	Previously filed as an exhibit to the Registrant’s current report on Form 8-K on October 18, 2006 and incorporated herein by reference.
(9)	Filed herewith.

50

RAE Systems Inc.

Consolidated Financial Statements
As of December 31, 2006 and 2005

Report of Independent Registered Public Accounting Firm	F-1
Consolidated Financial Statements
Consolidated balance sheets	F-2
Consolidated statements of operations	F-3
Consolidated statements of shareholders’ equity	F-4
Consolidated statements of cash flows	F-5
Notes to consolidated financial statements	F-6 — F-31

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders

RAE Systems Inc.

We have audited the accompanying consolidated balance sheets of RAE Systems Inc. (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of RAE Systems Inc. as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 1, effective on January 1, 2006 the Company adopted Statement of Financial Accounting Standards No. 123(R) “Share-Based Payment”.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of RAE Systems, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of internal control over financial reporting and an adverse opinion on the effectiveness of internal control over financial reporting due to the existence of a material weakness.

/s/  BDO Seidman, LLP

San Jose, California

March 16, 2007

F-1

RAE SYSTEMS INC.

CONSOLIDATED BALANCE SHEETS

	December 31,			December 31,
	2006			2005
ASSETS
Current Assets:
Cash and cash equivalents	$	18,119,000		$	13,524,000
Short-term investments		3,248,000			14,348,000
Trade notes receivable		1,977,000			1,087,000
Accounts receivable, net of allowance for doubtful accounts of $843,000 and $963,000 at December 31, 2006 and 2005, respectively		16,966,000			11,707,000
Accounts receivable from affiliate		154,000			84,000
Inventories, net		15,382,000			9,477,000
Prepaid expenses and other current assets		3,498,000			2,773,000
Deferred tax assets		935,000			2,869,000
Total Current Assets		60,279,000			55,869,000
Property and Equipment, net		15,120,000			14,911,000
Long Term Investments		—			1,616,000
Intangible Assets, net		5,304,000			1,782,000
Goodwill		3,760,000			136,000
Long Term Deferred Tax Assets		3,402,000			634,000
Deposits and Other Assets		648,000			867,000
Acquisition in Progress		820,000			—
Investment in Unconsolidated Affiliate		420,000			449,000
Total Assets	$	89,753,000		$	76,264,000
LIABILITIES, MINORITY INTEREST IN CONSOLIDATED ENTITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$	7,187,000		$	3,979,000
Accounts payable to affiliate		360,000			—
Payable to Fushun shareholder		3,926,000			—
Accrued liabilities		8,793,000			7,329,000
Notes payable — related parties		822,000			759,000
Income taxes payable		520,000			407,000
Current portion of deferred revenue		2,030,000			2,029,000
Total Current Liabilities		23,638,000			14,503,000
Deferred Revenue, net of current portion		736,000			296,000
Deferred Tax Liabilities		438,000			379,000
Other Long Term Liabilities		1,045,000			1,466,000
Long Term Notes Payable — Related Parties		3,222,000			821,000
Total Liabilities		29,079,000			17,465,000
Commitments and Contingencies
Minority Interest in Consolidated Entities		4,495,000			4,226,000
Shareholders’ Equity:
Common stock, $0.001 par value; 200,000,000 shares authorized; 59,274,596 and 57,837,843 shares issued and outstanding at December 31, 2006 and 2005, respectively		59,000			58,000
Additional paid-in capital		58,828,000			56,629,000
Accumulated other comprehensive income		1,245,000			310,000
Accumulated deficit		(3,953,000	)		(2,424,000	)
Total Shareholders’ Equity		56,179,000			54,573,000
Total Liabilities, Minority Interest in Consolidated Entities and Shareholders’ Equity	$	89,753,000		$	76,264,000

See accompanying notes to consolidated financial statements.

F-2

RAE SYSTEMS INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

	Year Ended December 31,
	2006			2005			2004
Net Sales	$	67,986,000		$	60,293,000		$	45,540,000
Cost of Sales		32,251,000			24,690,000			18,517,000
Gross Profit		35,735,000			35,603,000			27,023,000
Operating Expenses:
Sales and marketing		19,277,000			16,835,000			10,583,000
Research and development		6,234,000			5,414,000			4,383,000
General and administrative		13,338,000			12,915,000			8,543,000
Loss on abandonment of lease		—			2,027,000			—
Total Operating Expenses		38,849,000			37,191,000			23,509,000
Operating (Loss) Income		(3,114,000	)		(1,588,000	)		3,514,000
Other Income (Expense):
Interest income		782,000			641,000			333,000
Interest expense		(249,000	)		(180,000	)		(17,000	)
Other, net		232,000			25,000			194,000
Equity in (loss) of unconsolidated affiliate		(194,000	)		(196,000	)		(353,000	)
Total Other Income		571,000			290,000			157,000
(Loss) Income Before Income Taxes and Minority Interest		(2,543,000	)		(1,298,000	)		3,671,000
Income tax (benefit) expense		(965,000	)		(477,000	)		983,000
(Loss) Income Before Minority Interest		(1,578,000	)		(821,000	)		2,688,000
Minority interest in loss (income) of consolidated subsidiaries		49,000			62,000			(353,000	)
Net (Loss) Income	$	(1,529,000	)	$	(759,000	)	$	2,335,000
Basic (Loss) Income Per Common Share	$	(0.03	)	$	(0.01	)	$	0.04
Diluted (Loss) Income Per Common Share	$	(0.03	)	$	(0.01	)	$	0.04
Weighted average common shares outstanding — Basic		58,424,970			57,687,714			55,809,638
Dilutive effect of employee stock plans		—			—			4,326,054
Weighted average common shares outstanding — Diluted		58,424,970			57,687,714			60,135,692

See accompanying notes to consolidated financial statements.

F-3

RAE SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

								Accumulated
					Additional			Other
	Common Stock				Paid-in			Comprehensive			Accumulated
	Shares		Amount		Capital			Income			Deficit			Total
Balances, December 31, 2003		46,824,626	$	47,000	$	18,753,000		$	7,000		$	(4,000,000	)	$	14,807,000
Components of comprehensive income:
Net income		—		—		—			—			2,335,000			2,335,000
Foreign currency translation adjustments		—		—		—			130,000			—			130,000
Total comprehensive income															2,465,000
Issuance of common stock due to exercise of stock options		1,338,471		1,000		618,000			—			—			619,000
Issuance of common stock due to net exercise of warrants		1,039,078		1,000		12,000			—			—			13,000
Proceeds from the sale of common stock, net of offering costs of $370,000		8,050,000		8,000		31,782,000			—			—			31,790,000
Compensation expense under fair value accounting of common stock options		—		—		1,404,000			—			—			1,404,000
Issuance of common stock due to exercise of restricted stock		63,000		—		50,000			—			—			50,000
Tax benefits from exercise of stock options		—		—		1,041,000			—			—			1,041,000
Balances, December 31, 2004		57,315,175	$	57,000	$	53,660,000		$	137,000		$	(1,665,000	)	$	52,189,000
Components of comprehensive (loss):
Net loss		—		—		—			—			(759,000	)		(759,000	)
Foreign currency translation adjustments		—		—		—			173,000			—			173,000
Total comprehensive loss															(586,000	)
Issuance of common stock due to exercise of stock options		522,668		1,000		324,000			—			—			325,000
Compensation expense under fair value accounting of common stock options		—		—		1,970,000			—			—			1,970,000
Adjustment to carrying value of investment in unconsolidated entity		—		—		489,000			—			—			489,000
Tax benefits from exercise of stock options		—		—		186,000			—			—			186,000
Balances, December 31, 2005		57,837,843	$	58,000	$	56,629,000		$	310,000		$	(2,424,000	)	$	54,573,000
Components of comprehensive (loss):
Net loss		—		—		—			—			(1,529,000	)		(1,529,000	)
Foreign currency translation adjustments		—		—		—			936,000			—			936,000
Unrealized loss on investment, net of tax		—		—		—			(1,000	)		—			(1,000	)
Total comprehensive loss															(594,000	)
Issuance of common stock due to exercise of stock options		1,115,497		1,000		632,000			—			—			633,000
Issuance of common stock due to net exercise of warrants		321,256		—		—			—			—			—
Compensation expense under fair value accounting of common stock options		—		—		1,620,000			—			—			1,620,000
Adjustment to carrying value of investment in unconsolidated entity		—		—		146,000			—			—			146,000
Deficient tax benefit from exercise of stock options		—		—		(199,000	)		—			—			(199,000	)
Balances, December 31, 2006		59,274,596	$	59,000	$	58,828,000		$	1,245,000		$	(3,953,000	)	$	56,179,000

See accompanying notes to consolidated financial statements.

F-4

RAE SYSTEMS INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Year End December 31,
	2006			2005			2004
Increase (Decrease) in Cash and Cash Equivalents
Cash Flows From Operating Activities:
Net (Loss) Income	$	(1,529,000	)	$	(759,000	)	$	2,335,000
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Depreciation and amortization		3,189,000			2,143,000			991,000
Provision for doubtful accounts		(123,000	)		313,000			489,000
Loss on disposal of fixed assets		245,000			41,000			—
Inventory reserve		589,000			439,000			428,000
Compensation expense under fair value accounting of common stock options		1,620,000			1,970,000			1,404,000
Common stock warrants granted for services		—			69,000			165,000
Equity in loss of unconsolidated affiliate		194,000			196,000			353,000
Minority interest in loss of consolidated subsidiary		(49,000	)		(62,000	)		353,000
Tax benefits from exercise of stock options		—			186,000			1,041,000
Deferred income taxes		(1,180,000	)		(1,925,000	)		(810,000	)
Loss on abandonment of lease		—			2,027,000			—
Amortization of discount on notes payable		187,000			—			—
Changes in operating assets and liabilities:		—			—			—
Trade notes receivable		(838,000	)		(535,000	)		(535,000	)
Accounts receivable		(2,729,000	)		(2,091,000	)		(2,784,000	)
Accounts receivable from affiliate		(49,000	)		35,000			(119,000	)
Inventories		(2,890,000	)		(2,026,000	)		(2,627,000	)
Prepaid expenses and other current assets		565,000			(1,248,000	)		(832,000	)
Deposit and other		231,000			301,000			5,000
Accounts payable		2,973,000			494,000			1,019,000
Accounts payable to affiliate		335,000			—			(594,000	)
Accrued liabilities		1,200,000			1,250,000			3,008,000
Income taxes payable		(823,000	)		(13,000	)		(580,000	)
Deferred revenue		384,000			939,000			439,000
Other long-term liabilities		(451,000	)		(376,000	)		58,000
Net Cash Provided By Operating Activities		1,051,000			1,368,000			3,207,000
Cash Flows From Investing Activities:
Purchase of investments		(12,615,000	)		(16,642,000	)		(15,729,000	)
Proceeds from maturities of investments		16,801,000			11,935,000			4,484,000
Proceeds from sales prior to maturity of investments		8,513,000			—			—
Purchase of property and equipment		(2,235,000	)		(4,855,000	)		(9,273,000	)
Payments for business acquisitions, net of cash acquired		(7,439,000	)		—			—
Proceeds from business acquisition		—			—			377,000
Purchased of intangibles		—			—			(77,000	)
Deposits and other		—			—			(791,000	)
Net Cash Provided By (Used In) Investing Activities		3,025,000			(9,562,000	)		(21,009,000	)
Cash Flows From Financing Activities:
Notes payable — related parties		(402,000	)		—			(435,000	)
Payment on capital lease obligation		—			(217,000	)		(122,000	)
Proceeds from the exercise of stock options and warrants		632,000			325,000			682,000
Proceeds from the sale of common stock		—			—			32,160,000
Bank borrowing		—			—			(120,000	)
Offering cost		—			—			(370,000	)
Proceeds from minority shareholder investment		—			—			21,000
Net Cash Provided By Financing Activities		230,000			108,000			31,816,000
Effect of exchange rate changes on cash and cash equivalents		289,000			44,000			40,000
Net Increase (Decrease) in Cash and Cash Equivalents		4,595,000			(8,042,000	)		14,054,000
Cash and Cash Equivalents, beginning of period		13,524,000			21,566,000			7,512,000
Cash and Cash Equivalents, end of period	$	18,119,000		$	13,524,000		$	21,566,000
Supplemental Disclosure of Cash Flow Information:
Cash Paid:
Income taxes	$	1,084,000		$	1,833,000		$	726,000
Interest	$	6,000		$	8,000		$	17,000
Noncash Investing and Financing Activities:
Exchange of warrants for common stock	$	—		$	—		$	1,532,000
Capital leases entered into for equipment	$	—		$	—		$	217,000
Notes payable issued in conjunction with RAE Beijing Acquisition	$	2,648,000		$	—		$	—
Acquisitions:
Fair value of assets acquired	$	27,352,000		$	243,000		$	7,890,000
Liabilities assumed	$	6,486,000		$	243,000		$	3,976,000

See accompanying notes to consolidated financial statements.

F-5

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.   Summary of Significant Accounting Policies

  (a)   The Company

RAE Systems Inc. (the “Company” or “RAE”), a Delaware company, develops and manufactures chemical and radiation detection monitors and networks for industrial applications and homeland security. The Company’s products are based on proprietary technology, and include portable, wireless and fixed chemical detection monitors and radiation detectors.

  (b)   Principles of Consolidation

The consolidated financial statements include the accounts of RAE Systems Inc. and its subsidiaries. The ownership of other interest holders of consolidated subsidiaries is reflected as minority interest. All significant intercompany balances and transactions have been eliminated in consolidation.

  (c)   Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, we evaluate the estimates, including those related to our allowance for doubtful accounts, valuation of goodwill and intangible assets, valuation of deferred tax assets, restructuring costs, contingencies, inventory valuation, warranty accrual and the stock compensation expense. We base our estimates 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 may differ significantly from these estimates under different assumptions or conditions.

  (d)   Revenue Recognition

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. A provision for estimated product returns is established at the time of sale based upon historical return rates adjusted for current economic conditions. Historically, the Company has experienced an insignificant amount of sales returns. The Company generally recognizes revenue upon shipment to its distributors in accordance with standard contract terms that pass title of all goods upon delivery to a common carrier (FOB factory) and provides for sales returns under standard product warranty provisions. For non-standard contract terms where title to goods pass at time of delivery (FOB destination), revenue is recognized after the Company has established proof of delivery. Revenues related to services performed under the Company’s extended warranty program represent less than 5% of net revenues in each of 2006, 2005 and 2004 and are recognized as earned based upon contract terms, generally ratable over the term of service. We record project installation work in Asia using the percentage-of-completion method. Installation revenue represents less than 5% of net revenue in 2006, 2005 and 2004. Net revenues include amounts billed to customers in sales transactions for shipping and handling, as prescribed by the Emerging Issues Task Force Issue (“EITF”) No. 00-10, Accounting for Shipping and Handling Fees and Costs. Shipping fees represent less than 1% of net revenues in each of 2006, 2005 and 2004. Shipping costs are included in cost of goods sold.

  (e)   Cash and Cash Equivalents

The Company considers all highly liquid investments having original maturities of 90 days or less to be cash equivalents.

F-6

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

  (f)   Accounts Receivable, Trade Notes Receivable and Allowance for Doubtful Accounts

The Company grants credit to its customers after undertaking an investigation of credit risk for all significant amounts. An allowance for doubtful accounts is provided for estimated credit losses at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowance is based on reviews of loss, adjustments history, current economic conditions and other factors that deserve recognition in estimating potential losses. The Company generally does not require collateral for sales on credit. While management uses the best information available in making its determination, the ultimate recovery of recorded accounts receivable is also dependent upon future economic and other conditions that may be beyond management’s control. If there was a deterioration of a major customer’s credit-worthiness, or if actual defaults were higher than what has been experienced historically, then additional allowances would be required.

Trade notes receivable are presented to the Company from some of our customers in China as a payment against the outstanding trade receivables. These notes receivable are bank guarantee promissory notes which are non-interest bearing and generally mature within six months.

  (g)   Inventories

Inventories are stated at the lower-of-cost, using the first-in, first-out method, or market. The Company is exposed to a number of economic and industry factors that could result in portions of its inventory becoming either obsolete or in excess of anticipated usage, or saleable only for amounts that are less than their carrying amounts. These factors include, but are not limited to, technological changes in the market, competitive pressures in products and prices, and the availability of key components from its suppliers. The Company has established inventory reserves when conditions exist that suggest that its inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for its products and market conditions. When recorded, reserves are intended to reduce the carrying value of the inventory to its net realizable value. If actual demand for specified products deteriorates, or market conditions are less favorable than those projected, additional reserves may be required.

  (h)   Property and Equipment

Property and equipment are stated at cost net of accumulated depreciation. Depreciation is provided using the straight — line method over the related estimated useful lives, as follows:

Buildings	20 to 25 years
Equipment	3 to 10 years
Furniture and fixtures	3 to 7 years
Computers and software	3 to 7 years
Automobiles	3 to 5 years
Building improvements	Lesser of useful life or remaining lease term

  (i)   Warranty Repairs

The Company sells the majority of its products with a 12 to 24 month repair or replacement warranty from the date of shipment. The Company provides an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to sales. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized. The estimated future warranty obligations are affected by the warranty periods, sales volumes, product failure rates, material usage, labor and replacement costs incurred in correcting a product failure. If actual product failure rates, material usage, labor or replacement costs differ from the Company’s estimates, revisions to the estimated warranty obligations would be required. The warranty accrual represents the best estimate of the amount necessary to settle future and existing claims on

F-7

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

products sold as of the balance sheet date. The Company periodically assesses the adequacy of its reported warranty reserve and adjusts the amounts in accordance with changes in these factors.

  (j)   Research and Development

Research and development costs incurred by the Company are expensed as incurred.

  (k)   Advertising Costs

The Company expenses the costs of advertising as incurred. During the years ended December 31, 2006, 2005 and 2004, advertising expense was $1,029,000, $1,086,000 and $1,026,000, respectively.

  (l)   Income Taxes

The Company reports income taxes in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, Accounting for Income Taxes, which requires an asset and liability approach. This approach results in the recognition of deferred tax assets (future tax benefits) and liabilities for the expected future tax consequences of temporary differences between the book carrying amounts and the tax basis of assets and liabilities. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be deductible or taxable when the assets and liabilities are recovered or settled. A valuation allowance is provided against the deferred tax assets to the extent that management is unable to conclude that it is more likely than not that the deferred tax assets will be realized.

We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes.

Our effective tax rates differ from the statutory rates primarily due to foreign earnings taxed at lower rates, foreign losses not benefited, non-deductible stock-based compensation deductions under “Share-Based Payment,” (“FAS 123(R)”) and additional provisions for uncertain tax positions. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. We regularly assess the likelihood of adverse outcomes resulting from tax examinations to determine the adequacy of our provision for income taxes.

Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets. In assessing the need for a valuation allowance, we consider all available evidence including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made.

  (m)   Goodwill and Other Intangible Assets

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations”, and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), goodwill and intangible assets deemed to have indefinite lives are no longer to be amortized, but instead are subject to annual impairment tests. The Company periodically evaluates purchased intangibles, including goodwill, for impairment. An assessment of goodwill is subjective by nature, and significant management judgment is required to forecast future operating results, projected cash flows and current period market capitalization levels. If our estimates or related assumptions change in the future, these changes in conditions could require material write-downs of net intangible assets, including impairment charges for goodwill. The valuation of intangible assets was based on management’s estimates. Intangible assets with finite useful lives are amortized over the estimated life of each asset.

F-8

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

  (n)   Long — Lived Assets

The Company evaluates the recoverability of long-lived assets with finite lives in accordance with SFAS No. 144, “Accounting for the Impairment of Long-Lived Assets” (“SFAS 144”). SFAS 144 requires recognition of impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company periodically reviews its long — lived assets for impairment. When events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable based on estimated undiscounted cash flows, the Company writes the asset down to its estimated fair value.

  (o)   Fair Values of Financial Instruments

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:

•  Cash and Cash Equivalents, Accounts Receivable, Trade Notes Receivables, Accounts Receivable from Affiliate, Accounts Payable, Accrued Expenses, Inventory Purchase Obligations:

The carrying amount reported in the balance sheet for these items approximates fair value because of the short maturity of these instruments. In addition, for inventory purchase obligations, the carrying value approximates fair value based on market rates for comparable products.

•  Investments:

The fair value of investments is determined using quoted market prices for those securities or similar financial instruments. Management accounts for its debt investments as available-for-sale.

•  Lines of Credits:

The Company has two lines of credit available for future growth, which in the aggregate total $10 million as of December 31, 2006. We are currently in compliance with the debt financial covenants such as a minimum quick ratio and tangible net worth and non-financial covenants. We have these lines available to us in full. At present, there are no amounts outstanding under these agreements. On March 14, 2007, the Company replaced these lines of credit; please refer to Note 15 Subsequent Events. At present, there are no outstanding amounts under the line of credit agreement.

•  Notes Payable — Related Parties:

Carrying value of notes payable — related parties approximates fair value as the Company has discounted these non interest bearing notes payables at an interest rate commensurate with commercial borrowing rates available to the Company in China.

As of December 31, 2006 and 2005, the fair values of the Company’s financial instruments approximate their historical carrying amounts.

  (p)   Translation of Foreign Currencies

Assets and liabilities of non-U.S. subsidiaries are translated to U.S. dollars at exchange rates in effect at the balance sheet date; with the resulting translation adjustments directly recorded to the accumulated other comprehensive income in shareholders’ equity. Income and expense accounts are translated at average exchange rates during each period. Foreign currency transaction gains and losses are recorded in other income (loss), net. The functional currency is the local currency for all non-U.S. subsidiaries.

F-9

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

  (q)   Stock-Based Compensation Expense

On January 1, 2003, the Company adopted Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”), for the recognition of stock-based compensation cost in its statement of operations. The fair value of each option award was estimated on the date of the grant using the Black-Scholes-Merton valuation method. This fair value was amortized as compensation expense, on a straight line basis, over the requisite service periods of the awards, which was generally the vesting period.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of FAS 123 (Revised 2004), “Share-Based Payment,” (“FAS 123(R)”) where the fair value of each option is adjusted to reflect only those shares that are expected to vest. The Company’s implementation of FAS 123(R) uses the modified-prospective-transition method where the compensation cost related to each unvested option as of January 1, 2006, is recalculated and any necessary adjustment is reported in the first quarter of adoption.

On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 123(R)-3 “Transition Election Related to Accounting for Tax Effects of Stock-based Payment Awards” that allows for a simplified method to establish the beginning balance of the additional paid-in capital pool (“APIC Pool”) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC Pool and consolidated statements of cash flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R). On January 1, 2006, the Company adopted the simplified method for the computation of the beginning balance of the APIC pool.

Determining Fair Value Valuation and Amortization Method — The Company estimates the fair value of stock options granted using the Black-Scholes-Merton option-pricing formula and a single option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period.

Expected Term — The Company’s expected term represents the period that the Company’s stock-based awards are expected to be outstanding and was determined using the “Simplified Method” as defined in the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107.

Expected Volatility — The Company’s expected volatilities are based on historical volatility of the Company’s stock, adjusted where determined by management for unusual and non-representative stock price activity not expected to recur.

Expected Dividend — The Black-Scholes-Merton valuation model calls for a single expected dividend yield as an input. The Company currently pays no dividends and does not expect to pay dividends in the foreseeable future.

Risk-Free Interest Rate — The Company bases the risk-free interest rate on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term.

Estimated Forfeitures — When estimating forfeitures, the Company uses the average historical option forfeitures over a period of four years.

Fair Value — The fair value of the Company’s stock options granted to employees for the years ended December 31, 2006, 2005 and 2004 was estimated using the following weighted- average assumptions:

December 31	2006			2005			2004
Expect term in years		6			5			5
Volatility		75-79	%		103-109	%		103-116	%
Expected dividend		—			—			—
Risk-free interest rate		5.00	%		4.00	%		3.25	%
Weighted-average fair value	$	2.62		$	2.80		$	4.34

F-10

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Total stock-based compensation for the year ended December 31, 2006, 2005 and 2004 was $1.6 million, $2.0 million and $1.4 million, respectively.

  (r)   Earnings Per Share

Basic earnings per share includes no dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of common stock equivalents such as options and warrants, to the extent the impact is dilutive. Anti-dilutive shares excluded from diluted earnings per share calculation for 2006, 2005 and 2004 were 2,953,204, 6,765,118 and 3,898,448, respectively.

  (s)   Retained Earnings

Included in retained earnings at December 31, 2006 and 2005 were $1.7 million and $1.5 million, respectively, of restricted retained earnings. The Company complies with the Chinese statutory rules regarding profit appropriation and the restricted funds are to be used for specific purposes as defined by the Ministry of Finance Department of China. These funds are not available to the Company for use in operations or distribution.

  (t)   Recent Accounting Pronouncements

In July 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), which is a change in accounting for income taxes. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim-period guidance, among other provisions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and as a result, is effective for us on January 1, 2007. We are currently evaluating the impact of FIN 48 on our consolidated financial statements.

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework and gives guidance regarding the methods used in measuring fair value, and expands disclosures about fair value measurements. SFAS 157 is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. SFAS 157 does not expand or require any new fair value measures, however the application of this statement may change current practice. SFAS 157 is effective for fiscal years beginning after November 15, 2007 and as a result, is effective for our fiscal year beginning January 1, 2008. We are currently evaluating the impact of adopting SFAS 157 on our consolidated financial statements.

  (u)   Segment Reporting

Our operating divisions consist of geographically based entities in the Americas, Asia and Europe. All such operating divisions have similar economic characteristics, as defined in SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, and accordingly, we operated in one reportable segment for the years ended December 31, 2006, 2005 and 2004.

  (v)   Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation. These reclassifications have no effect on previously reported results of operations.

F-11

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 2.   Mergers and Acquisitions

RAE Coal Mine Safety Instruments (Fushun) Co., Ltd.

On December 10, 2006, a wholly owned subsidiary of the Company, RAE Systems (Asia) Ltd., (“RAE Asia”) entered into an agreement to form a joint venture with Liaoning Coal Industry Group Co., Ltd. (“Liaoning Group”). The Company and Liaoning Group formed RAE Coal Mine Safety Instruments (Fushun) Co., Ltd., a limited liability company (“RAE Fushun”), under the laws of the People’s Republic of China, with a duration of 50 years. In forming the joint venture with Liaoning Group, the Company obtained control of Fushun Anyi, Ltd. (a wholly owned subsidiary of Liaoning Group) a manufacturer and distributor of coal-mining safety equipment. Fushun Anyi , Ltd., as a separate wholly-owned subsidiary and formerly a division of Liaoning Group has been in the coal mining safety business for over 50 years. The primary reason for the acquisition is to penetrate China’s coal mine safety equipment industry and to capitalize on growth and increases in demand for safety equipment in the coal mining industry.

The joint venture agreement provided that RAE Asia, for its 70% interest in RAE Fushun, would contribute $10.8 million in cash. $2.2 million was due immediately upon formation of RAE Fushun and the remainder payable in installments through December 2007. For its 30% interest in RAE Fushun and a note payable of $3.9 million, Liaoning Group contributed the operating assets of Fushun Anyi, Ltd. with a book value of $8.5 million. Total purchase price for RAE Asia’s 70% interest in RAE Fushun is as follows:

	Amount
Cash	$	2,151,000
Notes payable		8,606,000
Acquisition related cost		38,000
Total	$	10,795,000

RAE Asia’s purchase of 70% of the joint venture was allocated to the fair value of the assets acquired and liabilities assumed. The Company is in the process of completing the valuation of certain intangible assets; thus, the allocation of the purchase price is subject to refinement. The following table summarizes the purchase price allocation of RAE Asia’s 70% interest in RAE Fushun:

	Amount
Cash	$	1,506,000
Accounts receivable		1,375,000
Inventories		2,173,000
Receivables due from RAE(*)		6,024,000
Property & equipment, net		366,000
Intangible assets		2,099,000
Total assets		13,543,000
Payable to Liaoning Group		(2,748,000	)
Purchase price	$	10,795,000

* Balance eliminated in consolidation.

F-12

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following intangible assets were acquired as part of the acquisition:

			Weighted Average
	Amount		Useful Life (Years)
Customer list	$	1,478,000		9
Tradenames		366,000		10
Patents and technology		255,000		7
Total	$	2,099,000

The customer list is being amortized using accelerated method, which represents the estimated pattern of use. Other intangible assets are amortized on a straight line basis over their estimated useful lives.

The unaudited financial information in the table below summarizes the combined results of operations of the Company and RAE Fushun, on a pro forma basis, as though the companies had been combined as of the beginning of each of the fiscal years presented. The pro forma financial information is presented for information purpose only and is not indicative of what would have occurred had the acquisition been made as of such periods, nor is it indicative of future results of operations. The pro forma amounts give effect to appropriate adjustments for the fair value of the assets acquired, amortization of intangibles and income taxes.

	Years Ended December 31,
	2006			2005
	(Unaudited)			(Unaudited)
Net sales	$	76,141,000		$	64,293,000
Net loss	$	(1,632,000	)	$	(215,000	)
Net loss per share — basic	$	(0.03	)	$	(0.00	)
Ner loss per share — diluted	$	(0.03	)	$	(0.00	)

RAE Beijing Acquisition

On July 12, 2006, RAE Asia entered into four separate agreements to purchase an aggregate of thirty-two percent (32%) of the outstanding common stock of RAE KLH (Beijing) Co., Ltd (“RAE Beijing”) from four of the minority interest holders. This 32% combined with the 64% of RAE Beijing acquired in May 2004 raises the Company’s ownership to 96%. Management believes that the increase in the Company’s RAE Beijing ownership will strengthen the Company’s ability to benefit from the fast-growing industrial market in China. The purchase of these shares was accomplished via an initial cash payment to these minority shareholders of $4.8 million for 19% of the total 32% being purchased. For the remaining common shares, to effect the purchase, the Company converted those common shares to non-voting, redeemable, convertible preferred stock. The preferred stock is redeemable in accordance with the following schedule:

• July 2009 —	$1,499,000
• July 2010 —	$967,000
• July 2011 —	$940,000
Total	$3,406,000

The preferred shares are contingently convertible at the option of the holders in the event of an initial public offering in China of the RAE Beijing subsidiary. Management believes the likelihood of an initial public offering in China is remote and as a result, do not believe the conversion provision is substantive. Therefore in accordance with the guidance in Statement of Financial Accounting Standards No. 150 “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”, the Company has classified the preferred stock as a liability. The preferred stock also accrues dividends at a rate of 3% per year. Due to its classification as a liability, the

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RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Company has discounted the preferred stock and dividends at a market rate of 6.48% resulting in a discount of $0.8 million. Total purchase price for the 32% minority interest is summarized as follows:

	Amount
Cash	$	4,808,000
Long term notes payable (net of discount of 0.8 million)		2,648,000
Acquisition related cost		49,000
Total	$	7,505,000

Since May 2004, the Company has consolidated the results of RAE Beijing within its publicly reported financial statements. The RAE Beijing purchase price for the additional 32% ownership interest was allocated to the fair value of the assets acquired and liabilities assumed as follows (represents 32% of the total fair value):

	Amount
Current assets	$	5,760,000
Property and equipment, net		1,292,000
Intangible assets		1,197,000
Goodwill		2,754,000
Total Assets		11,003,000
Current liabilities		(3,146,000	)
Long-term liabilities		(352,000	)
Total Liabilities		(3,498,000	)
Purchase price	$	7,505,000

The following table represents details of the intangible assets acquired as part of the RAE Beijing acquisition:

			Weighted Average
	Cost		Useful Life (Years)
Customer list	$	817,000		6
Business name and trade name		216,000		7
Patents and technology		164,000		7
	$	1,197,000

The $2.8 million of goodwill recorded in conjunction with the RAE Beijing acquisition is not deductible for income tax purposes. The customer list is being amortized using accelerated method, which represents the estimated pattern of use. Other intangible assets are amortized on a straight line basis over their estimated useful lives.

Other Acquisitions

On July 11, 2006, the Company purchased the assets, including two pending patents, of Santa Clara, California based Aegison Corporation (“Aegison”), a supplier of fixed and mobile digital video surveillance systems for approximately $2 million in cash. We expect to expand our presence to include the mobile digital video security market in the United States.

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RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The acquisition constitutes a business combination in accordance with criteria defined in Emerging Issues Task Force 98-3 “Determining Whether a Non-monetary Transaction Involves Receipt of Productive Assets or of a Business”. The following table allocates the purchase price to fair value of assets acquired and liabilities assumed:

	Amount
Current assets	$	97,000
Property & equipment, net		36,000
Intangible assets		909,000
Goodwill		816,000
20% interest in Tianjin Securay Technology Ltd. Co.		353,000
Total assets		2,211,000
Current liabilities		(112,000	)
Purchase price	$	2,099,000

The following table presents details of the purchased intangible assets:

			Weighted Average
	Amount		Useful Life (Years)
Customer list	$	91,000		3
Business name and trade name		108,000		2
Trade secret		79,000		10
Patents and technology		631,000		10
Total	$	909,000

Goodwill of $816,000 recorded in conjunction with Aegison purchase is deductible for income tax purposes. The purchase of Aegison has been deemed by management to be an immaterial business combination and therefore no pro forma information is included.

Acquisition in progress

As of December 31, 2006, the Company was in the process of acquiring Tianjin Securay Technology Ltd. Co. (“Securay”). The Company owns 20% of Securay from the acquisition of Aegison in July 2006. As of December 31, 2006, the Company recorded $820,000 of acquisition in progress, of which $467,000 represented purchase of inventories and property and equipment, and the remaining $353,000 representing the 20% ownership interest that the Company had previously acquired in conjunction with Aegison acquisition discussed above. For additional information regarding the Securay acquisition, please refer to Note 15 Subsequent Events.

Note 3.   Investments

In accordance with Financial Accounting Standard 115, “Accounting for Certain Investments in Debt and Equity,” the Company changed the classification of its investments from “held-to-maturity” to “available-for-sale” in the second quarter of 2006. The resulting fair-value adjustment of the Company’s investments led to a net $23,000 reduction in carrying value of the investments as the date of change.

F-15

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The break down of the Company’s available-for-sale investments at December 31, 2006 was as follows:

			Unrealized			Fair
	Cost		Losses			Value
Certificates of Deposit	$	1,050,000	$	—		$	1,050,000
US Government Agencies		2,199,000		(1,000	)		2,198,000
Total	$	3,249,000	$	(1,000	)	$	3,248,000

The Company’s investments, classified as available-for-sale securities at December 31, 2006 and held-to-maturity securities at December 31, 2005, are broken down as follows:

	Current				Noncurrent
	December 31,				December 31,
	2006		2005		2006		2005
Certificates of Deposit	$	1,050,000	$	6,067,000	$	—	$	—
US Treasury Bonds & Notes		—		2,918,000		—		—
US Government Agencies		2,198,000		3,269,000		—		1,600,000
Mortgage Backed Securities		—		2,094,000		—		—
Other		—		—		—		16,000
	$	3,248,000	$	14,348,000	$	—	$	1,616,000

The Company’s unrealized losses on investments are of a temporary nature due to the Company’s intent and ability to hold the investments until maturity or until the par value is realized. Based on the review of these securities, including the assessment of the duration and severity of the related unrealized losses, the Company has not recorded any other-than-temporary impairments on these securities.

The following table summarizes the maturities of the Company’s fixed income securities at December 31, 2006 and 2005:

	2006				2005
	Cost		Fair Value		Amortized Cost
Years to Maturity
Less than one year	$	3,249,000	$	3,248,000	$	14,348,000
One to five years		—		—		1,616,000
	$	3,249,000	$	3,248,000	$	15,964,000

Note 4.   Inventories

Inventories consist of the following:

	December 31,
	2006		2005
Raw materials	$	4,675,000	$	2,862,000
Work-in-progress		1,858,000		2,286,000
Finished goods		8,849,000		4,329,000
	$	15,382,000	$	9,477,000

F-16

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 5.   Property and Equipment

A summary of property and equipment follows:

	December 31,
	2006		2005
Building and building improvements	$	8,150,000	$	7,824,000
Land		3,220,000		3,220,000
Equipment		4,043,000		2,757,000
Computer equipment		3,498,000		2,015,000
Automobiles		1,126,000		851,000
Furniture and fixtures		550,000		669,000
Construction in progress		53,000		993,000
		20,640,000		18,329,000
Less: accumulated depreciation		5,520,000		3,418,000
	$	15,120,000	$	14,911,000

Significant construction in progress in 2005 primarily represented cost to implement an Oracle ERP system. The ERP system was placed in service in 2006 and therefore, the costs has been transferred to the computer equipment account. Depreciation expense for the years ended December 31, 2006, 2005 and 2004, was $2.6 million, $1.6 million and $0.7 million, respectively.

Note 6.   Goodwill and Intangible Assets

Goodwill represents the excess of purchase price and related costs over the value assigned to the net tangible and identifiable intangible assets. The Company recorded goodwill as a result of the investments in RAE Beijing and Aegison in the amount of $3.0 million and $0.8 million, respectively. No goodwill was impaired at December 31, 2006, as a result of the required annual impairment review.

The majority of intangible assets, related to the RAE Beijing investment, and the components of the purchased intangible assets were as follows:

	December 31, 2006						December 31, 2005
	Gross Carrying		Accumulated		Net Carrying		Gross Carrying		Accumulated		Net Carrying
	Amount		Amortization		Amount		Amount		Amortization		Amount
Customer list	$	3,059,000	$	675,000	$	2,384,000	$	644,000	$	321,000	$	323,000
Patent and technology		1,966,000		381,000		1,585,000		915,000		207,000		708,000
Trade name		1,661,000		401,000		1,260,000		971,000		220,000		751,000
Trade secret		79,000		4,000		75,000		—		—		—
Total	$	6,765,000	$	1,461,000	$	5,304,000	$	2,530,000	$	748,000	$	1,782,000

All of the Company’s purchased intangible assets other than goodwill are subject to amortization. The weighted average life is 5.62 years. Amortization expense for years ended December 31, 2006, 2005 and 2004, was

F-17

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

$0.7 million, $0.5 million and $0.3 million, respectively. Estimated future amortization expense is shown in the following table:

	Expected Future
	Amortization Expense
2007	$	1,158,000
2008		953,000
2009		850,000
2010		819,000
2011		537,000
Thereafter		987,000
Total	$	5,304,000

Note 7.   Accrued Liabilities

Accrued liabilities as of December 31, 2006 and 2005 are summarized as follows:

December 31,	2006		2005
Compensation and related benefits	$	2,233,000	$	2,120,000
Accrued commissions		1,815,000		1,415,000
Professional fees		1,066,000		1,269,000
Warranty reserve		553,000		377,000
Marketing & advertising		933,000		177,000
Taxes other than income tax		500,000		616,000
Abandonment of lease (see note 9)		478,000		482,000
Accrued inventory receipts		242,000		—
Payable to Aegison shareholder		200,000		—
Other		773,000		873,000
Total	$	8,793,000	$	7,329,000

Note 8.   Income Taxes

(Loss) income before income taxes and minority interest comprises:

	Year Ended December 31,
	2006			2005			2004
U.S.	$	(3,456,000	)	$	(752,000	)	$	2,503,000
Foreign		913,000			(546,000	)		1,168,000
Total	$	(2,543,000	)	$	(1,298,000	)	$	3,671,000

F-18

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Income tax (benefit) expense comprises:

	Year Ended December 31,
	2006			2005			2004
Current:
Federal	$	(609,000	)	$	775,000		$	1,190,000
State		22,000			1,000			1,000
Foreign		792,000			672,000			604,000
		205,000			1,448,000			1,795,000
Deferred:
Federal		(880,000	)		(1,134,000	)		(839,000	)
State		(202,000	)		(472,000	)		58,000
Foreign		(88,000	)		(319,000	)		(31,000	)
		(1,170,000	)		(1,925,000	)		(812,000	)
Total income tax (benefit) expense	$	(965,000	)	$	(477,000	)	$	983,000

The following summarizes the differences between the income tax (benefit) expense and the amount computed by applying the Federal income tax rate in 2006, 2005, and 2004, to income before income taxes:

	Year Ended December 31,
	2006			2005			2004
Federal income tax (benefit) expense at statutory rate	$	(890,000	)	$	(441,000	)	$	1,115,000
State income tax (benefit) expense, net of federal benefit		(126,000	)		(141,000	)		39,000
Foreign tax (benefit) expense		(71,000	)		313,000			296,000
Nondeductible expenses		238,000			241,000			248,000
Other		(359,000	)		(73,000	)		(132,000	)
Change in valuation allowance		243,000			(376,000	)		(583,000	)
Total income tax (benefit) expense	$	(965,000	)	$	(477,000	)	$	983,000

F-19

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Deferred tax assets and liabilities as of December 31, 2006 and 2005, were comprised of the following:

	Year Ended December 31,
	2006			2005
Deferred tax assets:
Fixed assets	$	(102,000	)	$	13,000
Allowance for doubtful accounts		64,000			62,000
Inventories		300,000			265,000
Accrued vacation		240,000			198,000
Other accruals		1,348,000			1,071,000
Capitalized research and development		703,000			959,000
Unrealized foreign losses		1,450,000			995,000
Federal tax credits		287,000			—
Stock-based compensation		1,436,000			1,068,000
State income taxes and credits		(269,000	)		(251,000	)
Valuation allowance		(1,120,000	)		(877,000	)
Total deferred tax assets		4,337,000			3,503,000
Deferred tax liabilities:
Intangibles		(438,000	)		(379,000	)
Total deferred tax liabilities		(438,000	)		(379,000	)
Net deferred tax assets	$	3,899,000		$	3,124,000

In assessing the recoverability of its deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of the deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, historical and projected future taxable income, and tax planning strategies in making this assessment.

At December 31, 2006, a valuation allowance in the amount of approximately $1.1 million has been established against the deferred tax assets as management is unable to conclude at this time that it is more likely than not that the Company will realize the tax benefit of all of its deferred tax assets. During 2006, the valuation allowance was reduced by approximately $0.2 million to reflect the Company’s realization in 2006 of certain tax benefits attributable to its deferred tax assets. Management will continue to evaluate the appropriateness of its valuation allowance in light of current and anticipated future taxable income.

U.S. income taxes were provided for deferred taxes on undistributed earnings of non-U.S. subsidiaries that are not expected to be permanently reinvested in such companies. There has been no provision for U.S. income taxes for the remaining undistributed earnings of approximately $2.5 million as of December 31, 2006, because the Company intends to reinvest these earnings indefinitely in operations outside the United States.

In accordance with Statement of Financial Accounting Standards No. 5 (“SFAS 5”), “Accounting for Contingencies,” the Company maintains reserves for estimated income tax exposures for various tax jurisdictions when the exposure item becomes probable and estimable. Exposures are settled primarily through the settlement of audits within each individual tax jurisdiction or the closing of a statute of limitation. Exposures can also be affected by changes in applicable tax law or other factors, which may cause management to believe a revision of past estimates is appropriate. Management believes that an appropriate liability has been established for income tax exposure; however, actual amounts may differ materially from these estimates. As of December 31, 2006, the

F-20

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Company has recorded tax contingency reserves of approximately $0.6 million which are included within income taxes payable in the consolidated balance sheet.

In 2006, the Internal Revenue Service completed its examination of our federal income tax returns for the years ended December 31, 2003 and 2004. Based on the results of the examination, the Company paid $391,000 to the IRS in April 2006, which was accrued at December 31, 2005. Based on a favorable outcome of the audit, the Company released $337,000 of additional reserves applicable to 2003 and 2004 during the year. Additionally, the Company reported $190,000 for the release of tax reserves and related interest upon the expiration of the statute of limitations for federal tax liabilities applicable to uncertain tax positions for the year ended December 31, 2002. In 2006, the tax authority in Denmark, Skat, has completed the audit of the Company’s subsidiary in Denmark for the year ended December 31, 2004 without any adjustment.

As of December 31, 2006, the Company had research and development credit carryforwards of approximately $0.3 million for California income tax purposes. The California credits are not subject to expiration under current California tax law.

Note 9.   Commitments and Contingencies

(a)  Legal Proceedings

Polimaster Ltd. v. RAE Systems Inc., United States District Court for the Northern District of California, Case No. 05-CV-01887-JF

Polimaster Ltd. filed a complaint against RAE Systems Inc. on May 9, 2005 in the United States District Court for the Northern District of California in a case styled Polimaster Ltd. v. RAE Systems Inc. (Case No. 05-CV-01887-JF). The complaint alleges, among other things, that RAE Systems Inc. breached its contract with Polimaster and infringed upon Polimaster’s intellectual property rights. Polimaster moved for a preliminary injunction on June 17, 2005. The Court denied Polimaster’s request on September 6, 2005. The dispute is subject to a contractual arbitration agreement, although the federal court has retained jurisdiction over the matter pending arbitration by the parties.

An arbitration was formally commenced on June 12, 2006 for the Polimaster Ltd. matter. The arbitration will be conducted under the auspices of Judicial Arbitration and Mediation Services, Inc. (JAMS) in California. A ten-day arbitration preceding has been scheduled for March 5-16, 2007. Polimaster’s Demand for Arbitration asserts damages totaling $13.2 million and seeks an injunction against sales of the Company’s Gamma Rae II and Neutron RAE II radiation detection products. The Company has asserted counterclaims against Polimaster for breach of contract and tortious interference with contract, among other things, and seeks monetary damages of its own. At this time, due to the preliminary and speculative nature of these proceedings, we do not believe an amount of loss, if any, can be reasonably estimated for this matter. We also believe the claim by Polimaster is without merit and we expect to vigorously defend our position.

Notwithstanding the Polimaster proceeding described above, from time to time, the Company is engaged in various legal proceedings incidental to its normal business activities. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations or cash flows.

  (b)  Operating leases

The Company and its subsidiaries lease certain manufacturing, warehousing and other facilities under operating leases. The leases generally provide for the lessee to pay taxes, maintenance, insurance and certain other operating costs of the leased property. Total rent expense for the years ended December 31, 2006, 2005 and 2004 was $654,000, $624,000 and $809,000, respectively. Future minimum lease payments for each of the next five

F-21

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

years from 2007 through 2011 and thereafter, excluding the Sunnyvale, California abandoned building lease, as described below, are $947,000, $621,000, $426,000, $378,000, $349,000 and $801,000, respectively.

In December 2004, the Company purchased the property located at 3775 North First Street in San Jose, California. The lease related to our previous headquarters in Sunnyvale, California was written-off as of the second quarter of 2005. The total loss on abandonment of the lease was approximately $2 million. Future discounted lease payments related to the Sunnyvale building have been included in accrued expenses totaling $478,000 and other long term liabilities totaling $1,000,000 at December 31, 2006. Future minimum lease payments for each of the next three years from 2007 through 2009 are $528,000, $627,000 and $556,000, respectively. The discount rate used was 4.85% and the liability was not reduced for any anticipated future sublease income. Based upon broker estimates of current real estate market conditions and other factors, it was considered more likely than not that any potential sublease income would be offset by brokerage, refurbishment and other costs to make the facility ready for a sublease.

  (c)  Purchase obligations

The Company has agreements with suppliers and other parties to purchase inventories and other goods and services. The Company estimated its non-cancelable obligations under these agreements for the next three years from 2007 through 2009 to be approximately $3,844,000, $244,000 and $230,000, respectively. There are no non-cancelable obligations after 2009. All non-cancelable obligations related to inventories are expected to be delivered within the next 12 months. The Company periodically reviews the carrying value of its inventories and non-cancelable purchase commitments by evaluating material usage requirements and forecasts and estimates inventory obsolescence, excess quantities and any expected losses on purchase commitments. The Company may record charges to write-down inventory due to excess, obsolete and slow-moving inventory and lower-of-cost or market based on an analysis of the impact of changes in technology, estimates of future sales volumes and market value estimates. There was no loss accrued related to current purchase obligations. However, any additional future write-downs of inventories or loss accrued on inventory purchase commitments, if any, due to market conditions, may negatively affect gross margins in future periods.

In December 2006, RAE Fushun entered into an agreement with Fushun Economic Development Zone Administration to purchase a land use right for approximately $446,000. The land use right will be used to construct RAE Fushun’s new manufacturing and administrative facility. The construction is expected to begin prior to June 2007.

  (d)   Guarantees

The Company is permitted under Delaware law and in accordance with its Bylaws to indemnify its officers and directors for certain events or occurrences, subject to certain limits, while the officer is or was serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has a Director and Officer Insurance Policy that limits its exposure and enables it to recover a portion of any future amounts paid. To date the Company has not incurred any losses under these agreements.

In the Company’s sales agreements, the Company typically agrees to indemnify its customers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date, the Company has not paid any amounts to settle claims or defend lawsuits.

F-22

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

  (e)   Product Warranties

The Company sells the majority of its products with a 12 to 24 month repair or replacement warranty from the date of shipment. The Company provides an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to sales. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized. At December 31, 2006 and 2005, the warranty reserve recorded in accrued expenses was $553,000 and $377,000, respectively.

Summary of Obligations

The following table quantifies our known contractual obligations in tabular form as of December 31, 2006:

	Total		2007		2008		2009		2010		2011		Thereafter
Contractual obligations:
Operating lease obligations	$	5,233,000	$	1,475,000	$	1,248,000	$	982,000	$	378,000	$	349,000	$	801,000
Purchase obligations		4,764,000		4,290,000		244,000		230,000		—		—		—
Notes payable — related parties (Note 14)		4,779,000		859,000		257,000		1,756,000		967,000		940,000		—
Total	$	14,776,000	$	6,624,000	$	1,749,000	$	2,968,000	$	1,345,000	$	1,289,000	$	801,000

Note 10.   Employee Benefit Plans

The Company has a defined contribution 401(k) plan (the “Plan”) for its domestic employees. The Plan is available to all employees who have reached the age of 21 and who have completed three months of service with the Company. Under the Plan, eligible employees may contribute a portion of their salaries to the Plan. The Company’s contributions are determined based on matching 25% of the first 6% of the covered employee’s salary, subject to statutory maximum levels. Contributions to the Plan totaled $113,000, $108,000 and $92,000, for the years ended December 31, 2006, 2005 and 2004, respectively.

Note 11.   Concentrations

Financial instruments, which potentially subject the Company to concentration of credit risk, consist principally of cash and cash equivalents and trade receivables. The Company places its domestic and foreign cash and cash equivalents with large financial institutions. Domestic cash balances are insured by the Federal Deposit Insurance Company up to $100,000 per financial institution. As of December 31, 2006 and 2005, the Company had deposits in excess of insured limits of $7,859,000 and $5,906,000, respectively. The Company also had deposits at several foreign financial institutions, which are not insured, that aggregated $10,159,000 and $7,518,000 as of December 31, 2006 and 2005, respectively.

A significant portion of the Company’s revenues and accounts receivable are derived from sales made to distributors located primarily throughout Americas, as well as Asia and Europe. The following table presents certain data by geographic area:

Year Ended December 31,	2006		2005		2004
Net Sales to Customers:
Americas(1)	$	33,068,000	$	33,902,000	$	29,901,000
Asia		26,024,000		19,902,000		11,090,000
Europe		8,894,000		6,489,000		4,549,000
Total consolidated net sales to customers	$	67,986,000	$	60,293,000	$	45,540,000

F-23

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

December 31,	2006		2005		2004
Property and equipment, net:
Asia	$	8,105,000	$	7,134,000	$	5,433,000
Americas		6,941,000		7,724,000		5,805,000
Europe		74,000		53,000		49,000
Total property and equipment, net	$	15,120,000	$	14,911,000	$	11,287,000

(1) Americas revenue included sales to customers in the United States, Canada and Latin American countries. Sales to Canada and Latin American countries represent less than 8% of total Americas sales.

During fiscal 2006, 2005 and 2004, 38%, 33% and 24%, respectively, of our revenues were derived from our sales to Asia. No individual customer comprised more than 10% of consolidated net sales in 2006, 2005, and 2004. The Company believes any risk of loss is significantly reduced due to the diversity in customers, geographic sales areas and the Company’s credit policy of establishing payment terms and credit limits based on a risk analysis. The Company performs credit evaluations of its customers’ financial condition whenever necessary and generally does not require cash collateral.

In 2006 and 2005, approximately 46% and 52%, respectively, of the property and equipment is located in the Americas and 54% and 48%, respectively, is located in Asia.

Note 12.   Shareholders’ Equity

Warrants

Since 2002, the Company has warrants outstanding to purchase the Company’s common stock. A summary of the Company’s warrants as of December 31, 2006, 2005 and 2004 and changes during 2006 and 2005 are presented in the following tables:

								Warrants
	Warrants							Outstanding as of
	Outstanding as of		Expired		Exercised			December 31,		Expire
Exercise Price	December 31, 2005		2006		2006			2006		Date
$0.74		—		—		—			—		—
$1.07		450,000		—		(450,000	)		—		Jun-07
$1.19		—		—		—			—		—
$1.98		—		—		—			—		—
$8.51		—		—		—			—		—
$22.68		—		—		—			—		—
		450,000				(450,000	)

F-24

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

								Warrants
	Warrants							Outstanding as of
	Outstanding as of		Expired			Exercised		December 31,		Expire
Exercise Price	December 31, 2004		2005			2005		2005		Date
$0.74		264,551		(264,551	)		—		—		Apr-05
$1.07		450,000		—			—		450,000		Jun-07
$1.19		10,000		(10,000	)		—		—		Apr-05
$1.98		61,729		(61,729	)		—		—		Oct-05
$8.51		388,008		(388,008	)		—		—		Jun-05
$22.68		2,719,004		(2,719,004	)		—				Jan-05
		3,893,292		(3,443,292	)				450,000

Non-Plan Restricted Stock

In August 2006, the Company granted 536,000 shares of restricted stock to four individuals as an inducement to enter into employment with the Company. The restricted stock granted to these individuals will vest at a rate of 25% in July 2007 and the remainder will vest quarterly over the subsequent three-year period. The weighted-average fair value of awards granted during the period was $2.81.

Non-Plan Stock Options

In 2002, the Company granted certain of its Directors Non-Plan Options to purchase 400,000 shares of non-plan restricted stock at a weighted-average exercise price of $0.99. The options vest 25% after one year with the remainder vesting monthly over the following three years and are exercisable over ten years.

A summary of the status of the Directors Non-Plan Options as of December 31, 2006, 2005 and 2004 and changes during the years then ended is presented in the following table:

	Options Outstanding
	December 31, 2006					December 31, 2005				December 31, 2004
				Weighted-				Weighted-					Weighted-
				Average				Average					Average
				Exercise				Exercise					Exercise
	Shares			Price		Shares		Price		Shares			Price
Beginning		337,000		$	1.02		337,000	$	1.02		400,000		$	0.99
Granted		—		$	—		—	$	—		—		$	—
Exercised		(237,000	)	$	1.01		—	$	—		(63,000	)	$	0.80
Cancelled		—		$	—		—	$	—		—		$	—
Ending		100,000		$	1.06		337,000	$	1.02		337,000		$	1.02
Exercisable at year-end		100,000					293,249				193,249
Aggregate intrinsic value of options exercised during 2006:				$	588,525
Aggregate intrinsic value of options outstanding at December 31, 2006:				$	214,500

F-25

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following table summarizes information about stock options included in the Directors Non-Plan Options outstanding as of December 31, 2006:

	Options Outstanding						Options Exercisable
			Weighted-
			Average		Weighted-				Weighted-
			Remaining		Average				Average
	Number		Contractual		Exercise		Number		Exercise
Range of Exercise Prices	Outstanding		Life (Years)		Prices		Exercisable		Prices
$1.06		100,000		5.41	$	1.06		100,000	$	1.06
		100,000		5.41	$	1.06		100,000	$	1.06

Stock Option Plan

In August 1993, the Company’s Board of Directors adopted the 1993 Stock Option Plan and in May 2002, the Board of Directors adopted the 2002 Stock Option Plan (collectively the “Plans”). The Plans authorize the grant of options to purchase shares of common stock to employees, directors, and consultants of the Company and its affiliates. The Plans feature both incentive and non-statutory options.

Incentive options may be granted at not less than 100% of the fair market value per share, and non-statutory options may be granted at not less than 85% of the fair market value per share at the date of grant as determined by the Board of Directors or committee thereof, except for options granted to a person owning greater than 10% of the outstanding stock, for which the exercise price must not be less than 110% of the fair market value. Options granted under the Plans generally vest 25% after one year with the remainder vesting monthly over the following three years and are exercisable over ten years.

As of December 31, 2006, the Company has reserved 235,870 shares of common stock for issuance under the 1993 Stock Option Plan and 2,902,945 shares of common stock for issuance under the 2002 Stock Option Plan. As of December 31, 2006, the Company had 899,276 shares of common stock available for future grant under the 2002 Stock Option Plan.

F-26

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

A summary of the status of the Company’s stock option plan as of December 31, 2006, 2005 and 2004 and changes during the years then ended is presented in the following table:

	Options Outstanding
	December 31, 2006					December 31, 2005					December 31, 2004
				Weighted-					Weighted-					Weighted-
				Average					Average					Average
				Exercise					Exercise					Exercise
	Shares			Price		Shares			Price		Shares			Price
Beginning		2,701,554		$	2.92		3,105,494		$	2.57		4,046,683		$	1.18
Granted		1,141,500		$	3.69		514,500		$	3.63		1,004,000		$	5.40
Exercised		(342,497	)	$	1.15		(522,668	)	$	0.62		(1,338,471	)	$	0.46
Cancelled		(361,742	)	$	4.42		(395,772	)	$	4.07		(606,718	)	$	2.63
Ending		3,138,815		$	3.22	$	2,701,554		$	2.92		3,105,494		$	2.57
Exercisable at year-end		1,573,479					1,602,044					1,285,604
Weighted-average fair value of options granted during the period:				$	2.62				$	2.80				$	4.59
Aggregate intrinsic value of options exercised during 2006:				$	840,383
Aggregate intrinsic value of options outstanding at December 31, 2006:				$	2,051,448

The following table summarizes information about stock options included in the 1993 and 2002 plans outstanding as of December 31, 2006:

	Options Outstanding						Options Exercisable
			Weighted-
			Average		Weighted-				Weighted-
Range of			Remaining		Average				Average
Exercise	Number		Contractual		Exercise		Number		Exercise
Prices	Outstanding		Life (Years)		Prices		Exercisable		Prices
$0.01-0.50		235,870		4.63	$	0.08		235,870	$	0.08
$0.51-1.00		102,152		6.00	$	0.58		101,149	$	0.58
$1.01-1.50		461,240		5.48	$	1.07		454,864	$	1.07
$1.51-3.00		85,000		9.61	$	2.81		—	$	—
$3.01-3.50		565,991		7.50	$	3.20		349,872	$	3.22
$3.51-4.00		1,084,500		9.43	$	3.76		18,083	$	3.62
$4.01-5.00		217,500		7.37	$	4.80		148,644	$	4.84
$5.01-6.00		224,375		7.26	$	5.27		173,125	$	5.27
$6.01-7.00		62,187		7.87	$	6.43		41,872	$	6.43
$7.01-8.00		100,000		7.98	$	7.81		50,000	$	7.81
		3,138,815		7.66	$	3.22		1,573,479	$	3.10

As of December 31, 2006 the stock options outstanding in the 1993 and 2002 Plans, included 2,921,796 options which were either vested or are expected to vest, with a weighted-average exercise price of $3.18, an aggregate intrinsic value of $2.0 million and a remaining contractual term of 7.55 years.

F-27

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Information about stock options included in the 1993 and 2002 Plans outstanding at December 31, 2006, with exercise price less than or above the closing price at December 31, 2006, $3.20 per share, is as follows:

	Exercisable				Unexercisable				Total
			Weighted				Weighted				Weighted
			Average				Average				Average
	Number of		Exercise		Number of		Exercise		Number of		Exercise
	Shares		Price		Shares		Price		Shares		Price
Stock Options with exercise prices less than or equal to $3.20		951,090	$	1.11		214,663	$	2.90		1,165,753	$	1.44
Stock Options with exercise prices greater $3.20		622,389	$	4.81		1,350,673	$	4.02		1,973,062	$	4.27
		1,573,479				1,565,336				3,138,815

Stock-Based Compensation Expense

The Company recorded $1.6 million, $2.0 million and $1.4 million of stock-based compensation for the years ended December 31, 2006, 2005 and 2004, respectively.

As required by FAS 123(R), management made an estimate of expected forfeitures and is recognizing compensation costs only for those equity awards expected to vest.

At December 31, 2006, the total unearned compensation cost related to unvested options granted to employees under the Company’s stock option plans but not yet recognized was approximately $3.3 million, net of estimated forfeitures of approximately $1.1 million. The fair value of each grant will be amortized on a straight-line basis over a weighted-average period of approximately 3 years and will be adjusted for subsequent changes in estimated forfeitures.

At December 31, 2006, the total unearned compensation cost related to unvested restricted stock awards granted to employees was approximately $1.1 million, net of estimated forfeitures of approximately $0.3 million. The fair value of each award will be amortized on a straight-line basis over a weighted-average period of approximately 3.5 years and will be adjusted for subsequent changes in estimated forfeitures.

Note 13.   Investments in Other Entities

The Company accounts for its 40% ownership in Renex Technologies Ltd.(“Renex”), a Hong Kong company, using the equity method starting January 1, 2002. The Company’s total investment in Renex at December 31, 2006 and 2005, was $402,000 and $449,000, respectively. For the years ended December 31, 2006, 2005 and 2004, the Company recorded losses in Renex of $194,000, $196,000 and $353,000, respectively.

Renex Technologies, Ltd.’s financial information, derived from its unaudited financial statements, is as follows:

	December 31,
	2006		2005
Current assets	$	988,000	$	1,053,000
Noncurrent assets		285,000		328,000
Total Assets		1,273,000		1,381,000
Current liabilities		223,000		133,000
Total Liabilities	$	223,000	$	133,000

F-28

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	Year Ended December 31,
	2006			2005			2004
Net sales	$	595,000		$	444,000		$	216,000
Operating income (loss)	$	316,000		$	(600,000	)	$	(983,000	)
Net loss	$	(217,000	)	$	(542,000	)	$	(981,000	)

The Company paid a 7.5% royalty to Renex for using certain modems developed by Renex. In 2006 and 2005, the Company made royalty payments amounting to $91,000 and $70,000, respectively. In 2006, 2005 and 2004, the Company purchased $573,000, $408,000 and $98,000, respectively, of inventory items from Renex and sold $91,000, $48,000 and $108,000, respectively of inventory items to Renex. The Company also paid $254,000 and $139,000 to Renex for a research project in 2006 and 2005, respectively. Accounts receivable due from Renex at December 31, 2006 and 2005 were $154,000 and $84,000, respectively. Accounts payable due to Renex at December 31, 2006 and 2005 were $360,000 and $0, respectively.

The Company recorded $146,000 and $489,000 of investment and additional paid in capital in 2006 and 2005, respectively to adjust the prior year investment balance to properly reflect the carrying value of its investment and its prorated share of the net equity of Renex.

Note 14.   Related Party Transactions

In conjunction with the original and subsequent additional investment in RAE Beijing, unsecured note payables were established for the previous RAE Beijing shareholders as part of the purchase price agreement in May 2004 and July 2006. As of December 31, 2006 and December 31, 2005, $822,000 and $759,000, respectively, were included in notes payable — related parties and $3,222,000 and $821,000, respectively, were included in long term notes payable — related parties.

The notes issued in conjunction with the original RAE Beijing purchase in May 2004 were non-interest bearing and were recorded at net present value using a discount rate of 5.5%. In conjunction with the additional investment in RAE Beijing in July 2006, 11.0 million shares of preferred stock were issued to four shareholders of RAE Beijing. In accordance with FAS 150, these preferred shares were classified as liabilities and were recorded as long-term notes payable — related parties. Although, these preferred shares bear a dividend yield rate of 3% per annum, the notes payable was discounted using a market interest rate of 6.48%.

Included in the current portion of notes payable is a sum of $448,000 due on demand after December 31, 2006. In addition, the future payment plan for each of the years from 2007 through 2011 is $411,000, $257,000, $1,756,000, $967,000 and $940,000, respectively.

The Company’s Director of Information Systems, Lien Chen, is the wife of our Chief Executive Officer, Robert Chen. Ms. Chen was paid a salary and bonus of $103,000 and $96,000 for 2006 and 2005, respectively. Ms. Chen also receives standard employee benefits offered to all other full-time U.S. employees. Ms. Chen does not report to Robert Chen and compensation decisions regarding Ms. Chen are performed in the same manner as other U.S. employees, with Robert Chen the final approval signatory on compensation recommendations.

On January 14, 2006, Lien Chen and Sandy Hsi, the wife of our Chief Technology Officer, Peter C. Hsi, signed a promissory note to lend $200,000 to Aegison Corporation at an interest rate of 10% per year. On July 11, 2006, the Company purchased the assets, including two pending patents, of Aegison Corporation for a total purchase price of $2 million in cash. At such time, the promissory note held by Lien Chen and Sandy Hsi was repaid by Aegison Corporation.

Note 15.   Subsequent Events

On January 3, 2007, RAE Systems (Asia) Ltd. entered into an agreement to purchase intellectual properties of Tianjin Securay Technology Ltd. Co. for Renminbi 12 million (approximately $1.5 million). This transaction,

F-29

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

together with purchase agreements entered in 2006, completed our purchase of Tianjin Securay Technologies Ltd. Co. Including transactions entered in 2006, total purchase price was $2 million cash. Assets purchased in 2006 amounting to $820,000 was recorded to acquisition in progress. Please see Note 2 Mergers and Acquisitions for additional information.

On March 14, 2007, the Company signed a one year $15 million revolving credit agreement, which is available to help fund future growth and expansion. The agreement provides for borrowings up to $7 million based on a blanket security interest in the Company’s assets. An additional $8 million of borrowing will be available based on a percentage of qualifying assets. The Company is required to comply with certain bank specific reporting requirements whenever borrowings against the line of credit exceed $3 million, in addition to the on-going requirement to submit quarterly financial statements. The Company is in full compliance with all of the borrowing requirements, including certain financial covenants, and as such, has the full line available. At present, there are no outstanding amounts under the line of credit agreement.

Note 16.   Quarterly Information (Unaudited)

The summarized quarterly financial data presented below reflect all adjustments, which, in the opinion of management, are of a normal and recurring nature necessary to present fairly the results of operations for the periods presented.

	First			Second			Third		Fourth
	Quarter			Quarter			Quarter(1)		Quarter			2006
Net sales	$	12,426,000		$	15,901,000		$	18,564,000	$	21,095,000		$	67,986,000
Gross profit	$	6,710,000		$	8,462,000		$	9,967,000	$	10,596,000		$	35,735,000
Operating (loss) income	$	(1,603,000	)	$	(444,000	)	$	659,000	$	(1,726,000	)	$	(3,114,000	)
Net (loss) income	$	(1,033,000	)	$	(54,000	)	$	513,000	$	(955,000	)	$	(1,529,000	)
Loss (income) per common share:
Basic:	$	(0.02	)	$	(0.00	)	$	0.01	$	(0.02	)	$	(0.03	)
Diluted:	$	(0.02	)	$	(0.00	)	$	0.01	$	(0.02	)	$	(0.03	)

	First		Second			Third		Fourth
	Quarter		Quarter(2)			Quarter		Quarter		2005
Net sales	$	12,248,000	$	13,624,000		$	16,152,000	$	18,269,000	$	60,293,000
Gross profit(3)	$	7,170,000	$	8,344,000		$	9,647,000	$	10,442,000	$	35,603,000
Operating (loss) income	$	194,000	$	(2,847,000	)	$	842,000	$	223,000	$	(1,588,000	)
Net (loss) income	$	94,000	$	(1,341,000	)	$	397,000	$	91,000	$	(759,000	)
Loss (income) per common share:
Basic:	$	0.00	$	(0.02	)	$	0.01	$	0.00	$	(0.01	)
Diluted:	$	0.00	$	(0.02	)	$	0.01	$	0.00	$	(0.01	)

(1)	The Company purchased an additional 32% ownership in RAE Beijing in July 2006. The Company has consolidated RAE Beijing since 2004. With the purchase in July 2006, minority shareholder’s interest was reduced to 4%.
(2)	During the second quarter of 2005, the Company abandoned its leased facility in Sunnyvale California and moved to a new headquarters and U.S. manufacturing facility. As a result, the Company took a before-tax charge of approximately $2.0 million for abandonment of its lease in the second quarter of 2005.

F-30

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(3) Gross profit numbers in 2005 have been reclassified in order to comply with 2006 presentation. These reclassification adjustments do not have an impact on net income or loss for each quarter in 2005.

Note 17.   Supplemental Disclosures

The following are supplemental disclosures of valuation and qualifying accounts.

			Additions
	Balance as of		Charged to					Balance as of
Description	Beginning of Year		Expenses		Deductions			End of Year
2006:
Allowance for doubtful accounts	$	963,000	$	—	$	(120,000	)	$	843,000
2005:
Allowance for doubtful accounts	$	665,000	$	313,000	$	(15,000	)	$	963,000
2004:
Allowance for doubtful accounts	$	176,000	$	489,000	$	—		$	665,000

			Additions
	Balance as of		Charged to					Balance as of
Description	Beginning of Year		Expenses		Deductions			End of Year
2006:
Inventory reserve	$	1,015,000	$	592,000	$	(121,000	)	$	1,486,000
2005:
Inventory reserve	$	703,000	$	439,000	$	(127,000	)	$	1,015,000
2004:
Inventory reserve	$	275,000	$	428,000	$	—		$	703,000

			Additions
	Balance as of		Charged to					Balance as of
Description	Beginning of Year		Expenses		Deductions			End of Year
2006:
Warranty reserve	$	377,000	$	246,000	$	(70,000	)	$	553,000
2005:
Warranty reserve	$	490,000	$	218,000	$	(331,000	)	$	377,000
2004:
Warranty reserve	$	358,000	$	332,000	$	(200,000	)	$	490,000

F-31

EX-10.13

EXHIBIT 10.13

LOAN AND SECURITY AGREEMENT

     THIS LOAN AND SECURITY AGREEMENT (this “Agreement”) dated as of the Effective Date between SILICON VALLEY BANK, a California corporation (“Bank”), and RAE SYSTEMS INC., a Delaware corporation (“Borrower”), provides the terms on which Bank shall lend to Borrower and Borrower shall repay Bank. The parties agree as follows:

     1 ACCOUNTING AND OTHER TERMS

     Accounting terms not defined in this Agreement shall be construed following GAAP. Calculations and determinations must be made following GAAP. Capitalized terms not otherwise defined in this Agreement shall have the meanings set forth in Section 13. All other terms contained in this Agreement, unless otherwise indicated, shall have the meaning provided by the Code to the extent such terms are defined therein.

     2 LOAN AND TERMS OF PAYMENT

     2.1 Promise to Pay. Borrower hereby unconditionally promises to pay Bank the outstanding principal amount of all Credit Extensions and accrued and unpaid interest thereon as and when due in accordance with this Agreement.

     2.1.1 Revolving Advances.

          (a) Availability. Bank shall make Advances subject to the terms and conditions of this Agreement; provided however, the aggregate amount of all outstanding Advances shall not exceed (i) the lesser of (1) the Revolving Line or (2) the Borrowing Base minus (ii) the amount of all outstanding Letters of Credit (including drawn but unreimbursed Letters of Credit) plus an amount equal to the Letter of Credit Reserves, minus (iii) the FX Reserve, minus (iv) the outstanding amounts used for Cash Management Services. Amounts borrowed under the Revolving Line may be repaid and, so long as no Default has occurred and is continuing and prior to the Revolving Line Maturity Date, reborrowed, subject to the applicable terms and conditions precedent herein.

          (b) Termination; Repayment. The Revolving Line terminates on the Revolving Line Maturity Date, when the principal amount of all Advances, the unpaid interest thereon, and all other Obligations relating to the Revolving Line shall be immediately due and payable.

     2.1.2 Letters of Credit Sublimit.

          (a) As part of the Revolving Line, Bank shall issue or have issued Letters of Credit for Borrower’s account. The face amount of outstanding Letters of Credit (including drawn but unreimbursed Letters of Credit and any Letter of Credit Reserve) may not exceed the (i) the lesser of (1) the Revolving Line or (2) the Borrowing Base minus (ii) an amount equal to the Letter of Credit Reserves, minus (iii) the FX Reserve, minus (iv) the outstanding principal balance of any Advances (including any amounts used for Cash Management Services). Such aggregate amounts utilized hereunder shall at all times reduce the amount otherwise available for Advances under the Revolving Line. If, on the Revolving Maturity Date, there are any outstanding Letters of Credit, then on such date Borrower shall provide to Bank cash collateral in an amount equal to 105% of the face amount of all such Letters of Credit plus all interest, fees, and costs due or to become due in connection therewith (as estimated by Bank in its good faith business judgment), to secure all of the Obligations relating to said Letters of Credit. All Letters of Credit shall be in form and substance acceptable to Bank in its sole discretion and shall be subject to the terms and conditions of Bank’s standard Application and Letter of Credit Agreement (the “Letter of Credit Application”). Borrower agrees to execute any further documentation in connection with the Letters of Credit as Bank may reasonably request.

          (b) The obligation of Borrower to immediately reimburse Bank for drawings made under Letters of Credit shall be absolute, unconditional, and irrevocable, and shall be performed strictly in accordance with the terms of this Agreement, such Letters of Credit, and the Letter of Credit Application.

          (c) Borrower may request that Bank issue a Letter of Credit payable in a Foreign Currency. If a demand for payment is made under any such Letter of Credit, Bank shall treat such demand as an Advance to Borrower of the equivalent of the amount thereof (plus fees and charges in connection therewith such as wire, cable, SWIFT or similar charges) in Dollars at the then-prevailing rate of exchange in San Francisco, California, for sales of the Foreign Currency for transfer to the country issuing such Foreign Currency.

          (d) To guard against fluctuations in currency exchange rates, upon the issuance of any Letter of Credit payable in a Foreign Currency, Bank shall create a reserve (the “Letter of Credit Reserve”) under the Revolving Line in an amount equal to ten percent (10%) of the face amount of such Letter of Credit. The amount of the Letter of Credit Reserve may be adjusted by Bank from time to time to account for fluctuations in the exchange rate. The availability of funds under the Revolving Line shall be reduced by the amount of such Letter of Credit Reserve for as long as such Letter of Credit remains outstanding.

     2.1.3 Foreign Exchange Sublimit. As part of the Revolving Line, Borrower may enter into foreign exchange contracts with Bank under which Borrower commits to purchase from or sell to Bank a specific amount of Foreign Currency (each, a “FX Forward Contract”) on a specified date (the “Settlement Date”). FX Forward Contracts shall have a Settlement Date of at least one (1) FX Business Day after the contract date and shall be subject to a reserve of ten percent (10%) (in a maximum aggregate amount equal to $5,000,000) of each outstanding FX Forward Contract (the “FX Reserve”). The aggregate amount of FX Forward Contracts at any one time may not exceed ten (10) times the amount of the FX Reserve. The obligations of Borrower relating to this section may not exceed the lesser of $5,000,000 or the (i) the lesser of (1) the Revolving Line or (2) the Borrowing Base minus (ii) the amount of all outstanding Letters of Credit (including drawn but unreimbursed Letters of Credit) plus an amount equal to the Letter of Credit Reserves, minus (iii) the outstanding principal balance of any Advances (including any amounts used for Cash Management Services).

     2.1.4 Cash Management Services Sublimit. Borrower may use up to the (i) lesser of (1) the Revolving Line or (2) the Borrowing Base minus (ii) the amount of all outstanding Letters of Credit (including drawn but unreimbursed Letters of Credit) plus an amount equal to the Letter of Credit Reserves, minus (iii) the FX Reserve, and minus (iv) the outstanding principal balance of any Advances (the “Cash Management Services Sublimit”) of the Revolving Line for Bank’s cash management services which may include merchant services, direct deposit of payroll, business credit card, and check cashing services identified in Bank’s various cash management services agreements (collectively, the “Cash Management Services”). Any amounts Bank pays on behalf of Borrower or any amounts that are not paid by Borrower for any Cash Management Services will be treated as Advances under the Revolving Line and will accrue interest at the interest rate applicable to Advances.

     2.2 Overadvances. If, at any time, the Credit Extensions under Sections 2.1.1, 2.1.2, 2.1.3 and 2.1.4 exceed the lesser of either (a) the Revolving Line or (b) the Borrowing Base, Borrower shall immediately pay to Bank in cash such excess.

     2.3 Payment of Interest on the Credit Extensions.

          (a) Interest Rate. Subject to Section 2.3(b), the principal amount outstanding under the Revolving Line shall accrue interest at a floating per annum rate equal to the Prime Rate minus one half one percentage point (0.50%), which interest shall be payable monthly in accordance with Section 2.3(f) below.

          (b) Default Rate. Immediately upon the occurrence and during the continuance of an Event of Default, Obligations shall bear interest at a rate per annum which is five percentage points above the rate effective immediately before the Event of Default (the “Default Rate”). Payment or acceptance of the increased interest rate provided in this Section 2.3(b) is not a permitted alternative to timely payment and shall not constitute a waiver of any Event of Default or otherwise prejudice or limit any rights or remedies of Bank.

          (c) Adjustment to Interest Rate. Changes to the interest rate of any Credit Extension based on changes to the Prime Rate shall be effective on the effective date of any change to the Prime Rate and to the extent of any such change.

          (d) 360-Day Year. Interest shall be computed on the basis of a 360-day year for the actual number of days elapsed.

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          (e) Debit of Accounts. Bank may debit any of Borrower’s deposit accounts, including the Designated Deposit Account, for principal and interest payments or any other amounts Borrower owes Bank when due. These debits shall not constitute a set-off.

          (f) Payments. Unless otherwise provided, interest is payable monthly on the first calendar day of each month. Payments of principal and/or interest received after 12:00 p.m. Pacific time are considered received at the opening of business on the next Business Day. When a payment is due on a day that is not a Business Day, the payment is due the next Business Day and additional fees or interest, as applicable, shall continue to accrue.

     2.4 Fees. Borrower shall pay to Bank:

          (a) Commitment Fee. A fully earned, non-refundable commitment fee of $15,000, on the Effective Date;

          (b) Letter of Credit Fee. Bank’s customary fees and expenses for the issuance or renewal of Letters of Credit issued, upon the issuance, each anniversary of the issuance, and the renewal of such Letter of Credit;

          (c) Unused Revolving Line Facility Fee. A fee (the “Unused Revolving Line Facility Fee”), payable quarterly, in arrears, on a calendar year basis, in an amount equal to one quarter of one percent (0.25%) per annum of the average unused portion of the Revolving Line, as determined by Bank. Borrower shall not be entitled to any credit, rebate or repayment of any Unused Revolving Line Facility Fee previously earned by Bank pursuant to this Section notwithstanding any termination of the Agreement or the suspension or termination of Bank’s obligation to make loans and advances hereunder; and

          (d) Bank Expenses. All Bank Expenses (including reasonable attorneys’ fees and expenses), plus expenses, for documentation and negotiation of this Agreement) incurred through and after the Effective Date, when due. Bank shall notify Borrower when such expenses reach $5,000 and each multiple thereof.

     3 CONDITIONS OF LOANS

     3.1 Conditions Precedent to Initial Credit Extension. Bank’s obligation to make the initial Credit Extension is subject to the condition precedent that Bank shall have received, in form and substance satisfactory to Bank, such documents, and completion of such other matters, as Bank may reasonably deem necessary or appropriate, including, without limitation:

          (a) Borrower shall have delivered duly executed original signatures to the Loan Documents to which it is a party;

          (b) Borrower shall have delivered duly executed original signatures to the Control Agreement by and among Borrower, Bank and First Bank & Trust;

          (c) Borrower shall have delivered its Operating Documents and a good standing certificate of Borrower certified by the Secretary of State of the State of Delaware;

          (d) Borrower shall have delivered duly executed original signatures to the completed Borrowing Resolutions for Borrower;

          (e) Borrower shall have delivered a payoff letter from First Bank & Trust;

          (f) Borrower shall have delivered evidence that (i) the Liens securing Indebtedness owed by Borrower to First Bank & Trust will be terminated and (ii) the documents and/or filings evidencing the perfection of such Liens, including without limitation any financing statements and/or control agreements, have or will, concurrently with the initial Credit Extension, be terminated;

          (g) Bank shall have received certified copies, dated as of a recent date, of financing statement searches, as Bank shall request, accompanied by written evidence (including any UCC termination statements) that

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the Liens indicated in any such financing statements either constitute Permitted Liens or have been or, in connection with the initial Credit Extension, will be terminated or released;

          (h) Borrower shall have delivered the Perfection Certificate executed by Borrower;

          (i) Borrower shall have delivered a legal opinion of Borrower’s counsel dated as of the Effective Date together with the duly executed original signatures thereto;

          (j) Borrower shall have delivered evidence satisfactory to Bank that the insurance policies required by Section 6.5 hereof are in full force and effect, together with appropriate evidence showing loss payable and/or additional insured clauses or endorsements in favor of Bank; and

          (k) Borrower shall have delivered executed true and complete copies of the KLH selling shareholders notes; and

          (l) Borrower shall have paid the fees and Bank Expenses then due as specified in Section 2.4 hereof.

     3.2 Conditions Precedent to all Credit Extensions. Bank’s obligations to make each Credit Extension, including the initial Credit Extension, is subject to the following:

          (a) except as otherwise provided in Section 3.4, timely receipt of an executed Payment/Advance Form;

          (b) the representations and warranties in Section 5 shall be true in all material respects on the date of the Payment/Advance Form and on the Funding Date of each Credit Extension; provided, however, that such materiality qualifier shall not be applicable to any representations and warranties that already are qualified or modified by materiality in the text thereof; and provided, further that those representations and warranties expressly referring to a specific date shall be true, accurate and complete in all material respects as of such date, and no Default or Event of Default shall have occurred and be continuing or result from the Credit Extension. Each Credit Extension is Borrower’s representation and warranty on that date that the representations and warranties in Section 5 remain true in all material respects; provided, however, that such materiality qualifier shall not be applicable to any representations and warranties that already are qualified or modified by materiality in the text thereof; and provided, further that those representations and warranties expressly referring to a specific date shall be true, accurate and complete in all material respects as of such date; and

          (c) in Bank’s good faith judgment, there has not been a Material Adverse Change.

     3.3 Covenant to Deliver.

     Borrower agrees to deliver to Bank each item required to be delivered to Bank under this Agreement as a condition to any Credit Extension. Borrower expressly agrees that the extension of a Credit Extension prior to the receipt by Bank of any such item shall not constitute a waiver by Bank of Borrower’s obligation to deliver such item, and any such extension in the absence of a required item shall be in Bank’s sole discretion.

     3.4 Procedures for Borrowing.

     Subject to the prior satisfaction of all other applicable conditions to the making of an Advance set forth in this Agreement, to obtain an Advance (other than Advances under Sections 2.1.2 or 2.1.4), Borrower shall notify Bank (which notice shall be irrevocable) by electronic mail, facsimile, or telephone by 12:00 p.m. Pacific time on the Funding Date of the Advance. Together with any such electronic or facsimile notification, Borrower shall deliver to Bank by electronic mail or facsimile a completed Payment/Advance Form executed by a Responsible Officer or his or her designee. Bank may rely on any telephone notice given by a person whom Bank believes is a Responsible Officer or designee. Bank shall credit Advances to the Designated Deposit Account. Bank may make Advances under this Agreement based on instructions from a Responsible Officer or his or her designee or without instructions if the Advances are necessary to meet Obligations which have become due.

     4 CREATION OF SECURITY INTEREST

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     4.1 Grant of Security Interest. Borrower hereby grants Bank, to secure the payment and performance in full of all of the Obligations, a continuing security interest in, and pledges to Bank, the Collateral, wherever located, whether now owned or hereafter acquired or arising, and all proceeds and products thereof. Borrower represents, warrants, and covenants that the security interest granted herein is and shall at all times continue to be a first priority perfected security interest in the Collateral (subject only to Permitted Liens that may have superior priority to Bank’s Lien under this Agreement). If Borrower shall acquire a commercial tort claim, Borrower shall promptly notify Bank in a writing signed by Borrower of the general details thereof and grant to Bank in such writing a security interest therein and in the proceeds thereof, all upon the terms of this Agreement, with such writing to be in form and substance reasonably satisfactory to Bank.

     If this Agreement is terminated, Bank’s Lien in the Collateral shall continue until the Obligations (other than inchoate indemnity obligations) are repaid in full in cash. Upon payment in full in cash of the Obligations and at such time as Bank’s obligation to make Credit Extensions has terminated, Bank shall, at Borrower’s sole cost and expense, release its Liens in the Collateral and all rights therein shall revert to Borrower.

     4.2 Authorization to File Financing Statements. Borrower hereby authorizes Bank to file financing statements, without notice to Borrower, with all appropriate jurisdictions to perfect or protect Bank’s interest or rights hereunder, including a notice that any disposition of the Collateral, by either Borrower or any other Person, shall be deemed to violate the rights of Bank under the Code.

     5 REPRESENTATIONS AND WARRANTIES

     Borrower represents and warrants as follows:

     5.1 Due Organization and Authorization. Borrower and each of its Subsidiaries are duly existing and in good standing in their respective jurisdictions of formation and are qualified and licensed to do business and are in good standing in any jurisdiction in which the conduct of their business or their ownership of property requires that they be qualified except where the failure to do so could not reasonably be expected to have a material adverse effect on Borrower’s business. In connection with this Agreement, Borrower has delivered to Bank completed certificates in form satisfactory to Bank signed by Borrower entitled “Perfection Certificate”. Borrower represents and warrants to Bank that (a) Borrower’s exact legal name is that indicated on the Perfection Certificate and on the signature page hereof; (b) Borrower is an organization of the type and is organized in the jurisdiction set forth in the Perfection Certificate; (c) the Perfection Certificate accurately sets forth Borrower’s organizational identification number or accurately states that Borrower has none; (d) the Perfection Certificate accurately sets forth Borrower’s place of business, or, if more than one, its chief executive office as well as Borrower’s mailing address (if different than its chief executive office); (e) other than its merger with Nettaxi.com in 2002, Borrower (and each of its predecessors) has not, in the past five (5) years, changed its jurisdiction of formation, organizational structure or type, or any organizational number assigned by its jurisdiction; and (f) all other information set forth on the Perfection Certificate pertaining to Borrower and each of its Subsidiaries is accurate and complete. If Borrower is not now a Registered Organization but later becomes one, Borrower shall promptly notify Bank of such occurrence and provide Bank with Borrower’s organizational identification number.

     The execution, delivery and performance of the Loan Documents have been duly authorized, and do not conflict with Borrower’s organizational documents, nor constitute an event of default under any material agreement by which Borrower is bound. Borrower is not in default under any agreement to which it is a party or by which it is bound in which the default could reasonably be expected to have a material adverse effect on Borrower’s business.

     5.2 Collateral. Borrower has good title to, has rights in, and the power to transfer each item of the Collateral upon which it purports to grant a Lien hereunder, free and clear of any and all Liens except Permitted Liens. Except to the extent permitted in Section 6.6(a), Borrower has no deposit accounts other than the deposit accounts with Bank, the deposit accounts, if any, described in the Perfection Certificate delivered to Bank in connection herewith, or of which Borrower has given Bank notice and taken such actions as are necessary to give Bank a perfected security interest therein except as set forth in Section 6.6(b). The Eligible Accounts included in the Borrowing Base Certificate are bona fide, existing obligations of the Account Debtors.

     The Collateral consisting of tangible personal property is not in the possession of any third party bailee (such as a warehouse) except (i) as otherwise provided in the Perfection Certificate, or (ii) as disclosed to Bank in writing and in accordance with this Section 5.2 below. In the event that Borrower, after the date hereof, intends to

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store or otherwise deliver Collateral consisting of tangible personal property with a fair market value in excess of $250,000 to a bailee located in the United States (provided however, the aggregate fair market value of Collateral at all locations not subject to a bailee agreement shall not exceed $1,000,000), then Borrower will first receive from such bailee an executed bailee agreement in form and substance satisfactory to Bank in its reasonably discretion.

     Borrower is the sole owner of its intellectual property, except for non-exclusive licenses and similar arrangements granted to its customers in the ordinary course of business, other non-perpetual licenses that may be exclusive in some respects other than territory, but that do not result in a legal transfer of Borrower’s title in the licensed property and licenses of intellectual property from third parties. Each patent is valid and enforceable, and no part of the intellectual property has been judged invalid or unenforceable, in whole or in part, and to the best of Borrower’s knowledge, no claim has been made that any part of the intellectual property violates the rights of any third party except to the extent such claim could not reasonably be expected to have a material adverse effect on Borrower’s business. Except as noted on the Perfection Certificate, as of the Effective Date, Borrower is not a party to, nor is bound by, any material license or other agreement with respect to which Borrower is the licensee that prohibits or otherwise restricts Borrower from granting a security interest in Borrower’s interest in such license or agreement or any other property (where such prohibition or restriction is enforceable under applicable law, including Section 9408 of the Code).

     5.3 Accounts Receivable. For any Eligible Domestic Account and Eligible Foreign Account in any Borrowing Base Certificate, all statements made and all unpaid balances appearing in all invoices, instruments and other documents evidencing such Eligible Domestic Accounts and Eligible Foreign Accounts are and shall be true and correct and all such invoices, instruments and other documents, and all of Borrower’s Books are genuine and in all respects what they purport to be. All sales and other transactions underlying or giving rise to each Eligible Domestic Account and Eligible Foreign Account shall comply in all material respects with all applicable laws and governmental rules and regulations. Borrower has no knowledge of any actual or imminent Insolvency Proceeding of any Account Debtor whose accounts are an Eligible Domestic Account and Eligible Foreign Account in any Borrowing Base Certificate. To the best of Borrower’s knowledge, all signatures and endorsements on all documents, instruments, and agreements relating to all Eligible Domestic Accounts and Eligible Foreign Accounts are genuine, and all such documents, instruments and agreements are legally enforceable in accordance with their terms.

     5.4 Litigation. Except as disclosed to Bank from time to time pursuant to Section 6.2 and which are reasonably satisfactory to Bank, there are no actions or proceedings pending or, to the knowledge of the Responsible Officers, threatened in writing by or against Borrower or any of its Subsidiaries involving more than $500,000.

     5.5 No Material Deviation in Financial Statements. All consolidated financial statements for Borrower and any of its Subsidiaries delivered to Bank fairly present in all material respects Borrower’s consolidated financial condition and Borrower’s consolidated results of operations. There has not been any material deterioration in Borrower’s consolidated financial condition since the date of the most recent financial statements submitted to Bank.

     5.6 Solvency. The fair salable value of Borrower’s and each Guarantor’s assets (including goodwill minus disposition costs) exceeds the fair value of its respective liabilities; Neither Borrower nor any Guarantor is left with unreasonably small capital after the transactions in this Agreement; and Borrower and each Guarantor are able to pay their debts (including trade debts) as they mature.

     5.7 Regulatory Compliance. Borrower is not an “investment company” or a company “controlled” by an “investment company” under the Investment Company Act. Borrower is not engaged as one of its important activities in extending credit for margin stock (under Regulations T and U of the Federal Reserve Board of Governors). Borrower has complied in all material respects with the Federal Fair Labor Standards Act. Borrower has not violated any laws, ordinances or rules, the violation of which could reasonably be expected to have a material adverse effect on its business. None of Borrower’s or any of its Subsidiaries’ properties or assets has been used by Borrower or any Subsidiary or, to the best of Borrower’s knowledge, by previous Persons, in disposing, producing, storing, treating, or transporting any hazardous substance other than legally. Borrower and each of its Subsidiaries have obtained all consents, approvals and authorizations of, made all declarations or filings with, and given all notices to, all government authorities that are necessary to continue its business as currently conducted.

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     5.8 Subsidiaries; Investments. Borrower does not own any stock, partnership interest or other equity securities except for Permitted Investments.

     5.9 Tax Returns and Payments; Pension Contributions. Borrower has timely filed all required tax returns and reports, and Borrower has timely paid all foreign, federal, state and local taxes, assessments, deposits and contributions owed by Borrower. Borrower may defer payment of any contested taxes, provided that Borrower (a) in good faith contests its obligation to pay the taxes by appropriate proceedings promptly and diligently instituted and conducted, (b) notifies Bank in writing of the commencement of, and any material development in, the proceedings, (c) posts bonds or takes any other steps required to prevent the governmental authority levying such contested taxes from obtaining a Lien upon any of the Collateral that is other than a “Permitted Lien”. Borrower is unaware of any claims or adjustments proposed for any of Borrower’s prior tax years which could result in additional taxes becoming due and payable by Borrower. Borrower has paid all amounts necessary to fund all present pension, profit sharing and deferred compensation plans in accordance with their terms, and Borrower has not withdrawn from participation in, and has not permitted partial or complete termination of, or permitted the occurrence of any other event with respect to, any such plan which could reasonably be expected to result in any liability of Borrower, including any liability to the Pension Benefit Guaranty Corporation or its successors or any other governmental agency.

     5.10 Use of Proceeds. Borrower shall use the proceeds of the Credit Extensions solely as working capital and to fund its general business requirements, including acquisitions and capital expenditures, each to the extent permitted hereunder.

     5.11 Full Disclosure. No written representation, warranty or other statement of Borrower in any certificate or written statement given to Bank, as of the date such representations, warranties, or other statements were made, taken together with all such written certificates and written statements given to Bank, contains any untrue statement of a material fact or omits to state a material fact necessary to make the statements contained in the certificates or statements not misleading (it being recognized by Bank that the projections and forecasts provided by Borrower in good faith and based upon reasonable assumptions are not viewed as facts and that actual results during the period or periods covered by such projections and forecasts may differ from the projected or forecasted results).

     6 AFFIRMATIVE COVENANTS

     Borrower shall do all of the following:

     6.1 Government Compliance. Borrower shall, and shall cause each of its Subsidiaries to, maintain its legal existence and good standing in its jurisdiction of formation and each jurisdiction in which the nature of its business requires them to be so qualified, except where the failure to take such action would not reasonably be expected to have a material adverse effect on Borrower’s and its Subsidiaries’ business or operations, taken as a whole; provided, that (a) the legal existence of any Subsidiary that is not a Guarantor may be terminated or permitted to lapse, and any qualification of such Subsidiary to do business may be terminated or permitted to lapse, if, in the good faith judgment of Borrower, such termination or lapse is in the best interests of Borrower and its Subsidiaries, taken as a whole, and (b) Borrower may not permit its qualification to do business in the jurisdiction of its chief executive office to terminate or lapse; and provided, further, that this Section 6.1 shall not be construed to prohibit any other transaction that is otherwise permitted in Section 7 of this Agreement.

     Borrower shall comply, and shall have each Subsidiary comply, with all laws, ordinances and regulations to which it is subject, noncompliance with which could have a material adverse effect on Borrower’s business.

     6.2 Financial Statements, Reports, Certificates.

          (a) Deliver to Bank: (i) as soon as available, but no later than the earlier of (A) five (5) days after filing with the Securities Exchange Commission or (B) fifty (50) days after the end of each fiscal quarter, the Borrower’s 10Q; (ii) as soon as available, but no later than the earlier of (A) five (5) days after filing with the Securities Exchange Commission or (B) ninety (90) days after the end of each fiscal year, the Borrower’s 10K and an unqualified opinion of the financial statements prepared by an independent certified public accounting firm reasonably acceptable to Bank; (iii) as soon as available, but no later than five (5) days after filing with the Securities Exchange Commission, the Borrower’s 8K reports; (iv) within 45 days after the end of each fiscal year, annual financial projections (which shall include projected balance sheets, income statements and cash flow

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statements) for the following fiscal year (on a quarterly basis) as approved by Borrower’s board of directors, together with any related business forecasts used in the preparation of such annual financial projections; (v) a prompt report of any legal actions pending or threatened against Borrower or any Subsidiary that could result in damages or costs to Borrower or any Subsidiary of $1,000,000 or more; and (vi) budgets, sales projections, operating plans or other financial information Bank reasonably requests.

     Borrower’s 10K, 10Q, and 8K reports required to be delivered pursuant to Section 6.2(a) shall be deemed to have been delivered on the date on which Borrower posts such report or provides a link thereto on Borrower’s or another website on the Internet; provided, that Borrower shall provide paper copies to Bank of the Compliance Certificates required by Section 6.2(d).

     (b) Within 30 days after the last day of each month, Borrower will deliver to Bank a cash balance report detailing investment type and maturity dates.

     (c) When the outstanding Obligations under Section 2.1 are equal to or greater than $3,000,000 for longer than 3 consecutive Business Days during any calendar month, within thirty (30) days after the last day of such month, deliver to Bank a duly completed Borrowing Base Certificate signed by a Responsible Officer, with aged listings of accounts receivable and accounts payable (by invoice date).

     (d) Within five (5) days after filing the 10Q and 10K, as applicable, with the Securities Exchange Commission or (B) fifty (50) days after the end of each fiscal quarter, deliver to Bank with the quarterly financial statements, a duly completed Compliance Certificate signed by a Responsible Officer setting forth calculations showing compliance with the financial covenants set forth in this Agreement.

     (e) The initial field examination shall be completed within 60 days of the Effective Date. Thereafter, allow Bank to audit Borrower’s Collateral at Borrower’s expense. Such audits shall be conducted no more often than once every twelve (12) months unless a Default or an Event of Default has occurred and is continuing. Bank shall notify Borrower when such expenses reach $2,500 and each multiple thereof.

     6.4 Post closing item. Borrower shall obtain Comerica Bank’s authorization to file the executed Reassignment and Release of Security Interest of Security Interest dated as of January 23, 2007 with the Patent and Trademark Office or Bank shall have received evidence of such filing by Comerica Bank reasonably satisfactory to Bank, within 30 days of the Effective Date.

     6.5 Taxes; Pensions. Make, and cause each of its Subsidiaries to make, timely payment of all foreign, federal, state, and local taxes or assessments (other than taxes and assessments which Borrower is contesting pursuant to the terms of Section 5.9 hereof) and shall deliver to Bank, on demand, appropriate certificates attesting to such payments, and pay all amounts necessary to fund all present pension, profit sharing and deferred compensation plans in accordance with their terms.

     6.6 Insurance. Keep its business and the Collateral insured for risks and in amounts standard for companies in Borrower’s industry and location and as Bank may reasonably request. Insurance policies shall be in a form, with companies, and in amounts that are satisfactory to Bank. All property policies shall have a lender’s loss payable endorsement showing Bank as lender loss payee and waive subrogation against Bank, and all liability policies shall show, or have endorsements showing, Bank as an additional insured. All policies (or the loss payable and additional insured endorsements) shall provide that the insurer must give Bank at least twenty (20) days notice before canceling, amending, or declining to renew its policy. At Bank’s request, Borrower shall deliver certified copies of policies and evidence of all premium payments. Proceeds payable under any policy shall, at Bank’s option, be payable to Bank on account of the Obligations. Notwithstanding the foregoing, (a)(x) so long as no Event of Default has occurred and is continuing, Borrower shall have the option of applying the proceeds of any casualty policy up to $1,000,000, in the aggregate, toward the replacement or repair of destroyed or damaged property; provided that any such replaced or repaired property (i) shall be of equal or like value as the replaced or repaired Collateral and (ii) shall be deemed Collateral in which Bank has been granted a first priority security interest (subject to Permitted Liens), and (b)(y) after the occurrence and during the continuance of an Event of Default, all proceeds payable under such casualty policy shall, at the option of Bank, be payable to Bank on account of the Obligations. If Borrower fails to obtain insurance as required under this Section 6.5 or to pay any amount or furnish any required proof of payment to third persons and Bank, Bank may make all or part of such payment or obtain such insurance policies required in this Section 6.5, and take any action under the policies Bank deems prudent.

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     6.7 Operating Accounts.

     (a) Within 3 months of the Effective Date, maintain a significant portion of its and its Domestic Subsidiaries’ domestic depository and operating accounts and domestic securities accounts with Bank and Bank’s affiliates.

     (b) Provide Bank five (5) days prior written notice before establishing any Collateral Account at or with any bank or financial institution other than Bank or its Affiliates. In addition, for each Collateral Account that Borrower at any time maintains, Borrower shall cause the applicable bank or financial institution (other than Bank) at or with which any Collateral Account is maintained to execute and deliver a Control Agreement or other appropriate instrument with respect to such Collateral Account to perfect Bank’s Lien in such Collateral Account in accordance with the terms hereunder. The provisions of the previous sentence shall not apply to deposit accounts exclusively used for payroll, payroll taxes and other employee wage and benefit payments to or for the benefit of Borrower’s employees and identified to Bank by Borrower as such.

     6.8 Financial Covenants.

          Borrower shall maintain at all times, unless otherwise noted, on a consolidated basis with respect to Borrower and its Subsidiaries:

          (a) Quick Ratio. Tested as of the last day of each fiscal quarter, a ratio of Quick Assets to Current Liabilities of at least 1.0 to 1.0.

          (b) Tangible Net Worth. Tested as of the last day of each fiscal quarter, a Tangible Net Worth of at least $35,000,000, increasing by 50% of Net Income and 50% of net cash proceeds of equity issuances after the Effective Date.

     6.9 Protection of Intellectual Property Rights. Borrower shall: (a) protect, defend and maintain the validity and enforceability of its intellectual property material to its business consistent with reasonable business practices for companies similar to Borrower, in Borrower’s industry; (b) promptly advise Bank in writing of material infringements of its intellectual property; and (c) not allow any intellectual property material to Borrower’s business to be abandoned, forfeited or dedicated to the public unless Borrower’s Board of Directors determines that such abandonment, forefeiture or dedication is reasonable.

     6.10 Litigation Cooperation. From the date hereof and continuing through the termination of this Agreement, make available to Bank, without expense to Bank, Borrower and its officers, employees and agents and Borrower’s books and records, to the extent that Bank may deem them reasonably necessary to prosecute or defend any third-party suit or proceeding instituted by or against Bank with respect to any Collateral or relating to Borrower.

     6.11 Designated Senior Indebtedness. Borrower shall designate all principal of, interest (including all interest accruing after the commencement of any bankruptcy or similar proceeding, whether or not a claim for post-petition interest is allowable as a claim in any such proceeding), and all fees, costs, expenses and other amounts accrued or due under this Agreement as “Designated Senior Indebtedness”, or such similar term, in any future Subordinated Debt incurred by Borrower after the date hereof, if such Subordinated Debt contains such term or similar term and if the effect of such designation is to grant to Bank the same or similar rights as granted to Bank as a holder of “Designated Senior Indebtedness” under any indenture.

     6.12 Further Assurances. Borrower shall execute any further instruments and take further action as Bank reasonably requests to perfect or continue Bank’s Lien in the Collateral or to effect the purposes of this Agreement.

     7 NEGATIVE COVENANTS

     Borrower shall not do any of the following without Bank’s prior written consent:

     7.1 Dispositions. Convey, sell, lease, transfer or otherwise dispose of (collectively “Transfer”), or permit any of its Subsidiaries to Transfer, all or any part of its business or property, except for:

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          (a) Transfers in the ordinary course of business for reasonably equivalent consideration, including Transfers with Foreign Subsidiaries that are not prohibited by Section 7.8;

          (b) Transfers (i) to Borrower, (ii) to any Guarantor, (iii) between any Subsidiaries that are not Guarantors or (iv) from Borrower or any Guarantor to any of their Subsidiaries that are not Guarantors in an aggregate amount (when added together with Investments under item (m) of the definition of “Permitted Investments”), does not exceed $10,000,000 in the aggregate during fiscal year 2007 or $5,000,000 in the aggregate during fiscal year 2008;

          (c) Transfers of property for fair market value, including Transfers with Foreign Subsidiaries that are not prohibited by Section 7.8;

          (d) Transfers of property in connection with sale-leaseback transactions;

          (e) Transfers of property to the extent such property is exchanged for credit against, or proceeds are promptly applied to, the purchase price of other property used or useful in the business of Borrower or its Subsidiaries;

          (f) Transfers constituting non-exclusive licenses and similar arrangements for the use of the property of Borrower or its Subsidiaries in the ordinary course of business and other non-perpetual licenses that may be exclusive in some respects other than territory but that do not result in a legal transfer of Borrower’s title in the licensed property;

          (g) Transfers otherwise permitted by the Loan Documents;

          (h) sales or discounting of delinquent accounts in the ordinary course of business;

          (i) Transfers associated with the making or disposition of a Permitted Investment;

          (j) Transfers in connection with a permitted acquisition of a portion of the assets or rights acquired; and

          (k) Transfers not otherwise permitted in this Section 7.1, provided, that the aggregate book value of all such Transfers by Borrower and its Subsidiaries, together, shall not exceed (when added together with the amount of Investments pursuant to item (o) of the definition of “Permitted Investments”) in any fiscal year, $1,000,000.

     7.2 Changes in Business; Change in Control; Jurisdiction of Formation.

     Engage in any material line of business other than those lines of business conducted by Borrower and its Subsidiaries on the date hereof and any businesses reasonably related, complementary or incidental thereto or reasonable extensions thereof; permit or suffer any Change in Control. Borrower will not, without prior written notice, change its jurisdiction of formation.

     7.3 Mergers or Acquisitions.

          (a) Merge or consolidate, or permit any of its Subsidiaries to merge or consolidate, with any Person; provided however,

               (i) any Subsidiary that is not a Guarantor may merge or consolidate into Borrower or any Subsidiary,

               (ii) any Guarantor may merge or consolidate with another Guarantor or into the Borrower; and

               (iii) nothing in this clause (a) shall prohibit any merger or consolidation if (A) (1) no Event of Default has occurred and is continuing or would result from such action during the term of this Agreement,

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or (2) if Borrower or a Guarantor is a party to such transaction, Borrower or such Guarantor, as the case maybe, is the surviving or successor entity business or (B) such merger or consolidation is a Transfer otherwise permitted pursuant to Section 7.1 hereof; or

     (b) acquire, or permit any of its Subsidiaries to acquire, all or substantially all of the capital stock or property of a Person; provided however nothing in this clause (b) above shall prohibit any acquisition if (1) no Event of Default has occurred and is continuing or would result from such action during the term of this Agreement, or (2) such acquisition is a Transfer otherwise permitted pursuant to Section 7.1 hereof.

     7.4 Indebtedness. Create, incur, assume, or be liable for any Indebtedness, or permit any Subsidiary to do so, other than Permitted Indebtedness.

     7.5 Encumbrance. Create, incur, or allow any Lien on any of its property, or assign or convey any right to receive income, including the sale of any Accounts, or permit any of its Subsidiaries to do so, except for Permitted Liens, permit any Collateral not to be subject to the first priority security interest granted herein,or enter into any agreement, document, instrument or other arrangement (except with or in favor of Bank) with any Person which directly or indirectly prohibits or has the effect of prohibiting Borrower or any Subsidiary from assigning, mortgaging, pledging, granting a security interest in or upon, or encumbering any of Borrower’s or any Subsidiary’s intellectual property, except as is otherwise permitted in Section 7.1 hereof and the definition of “Permitted Lien” herein.

     7.6 Maintenance of Collateral Accounts. Maintain any Collateral Account except pursuant to the terms of Section 6.6.(b) hereof.

     7.7 Distributions; Investments. (a) Directly or indirectly acquire or own any Person, or make any Investment in any Person, other than Permitted Investments, or permit any of its Subsidiaries to do so; or (b) pay any dividends or make any distribution or payment or redeem, retire or purchase any capital stock other than Permitted Distributions.

     7.8 Transactions with Affiliates. Directly or indirectly enter into or permit to exist any material transaction with any Affiliate of Borrower except for transactions that are in the ordinary course of Borrower’s business, upon fair and reasonable terms (when viewed in the context of any series of transactions of which it may be a part, if applicable) that are no less favorable to Borrower than would be obtained in an arm’s length transaction with a non-affiliated Person.

     7.9 Subordinated Debt. Make or permit any payment on or amendments of any Subordinated Debt, except (a) payments pursuant to the terms of the applicable Subordination Agreement; (b) payments made with Borrower’s capital stock or other Subordinated Debt; or (c) amendments to Subordinated Debt so long as such Subordinated Debt remains subordinated in right of payment to this Agreement and any Liens securing such Subordinated Debt remain subordinate in priority to Bank’s Lien hereunder and such amendment is not adverse to the rights of Bank.

     7.10 Compliance. Become an “investment company” or a company controlled by an “investment company”, under the Investment Company Act of 1940 or undertake as one of its important activities extending credit to purchase or carry margin stock (as defined in Regulation U of the Board of Governors of the Federal Reserve System), or use the proceeds of any Credit Extension for that purpose; fail to meet the minimum funding requirements of ERISA, permit a Reportable Event or Prohibited Transaction, as defined in ERISA, to occur; fail to comply with the Federal Fair Labor Standards Act or violate any other law or regulation, if the violation could reasonably be expected to have a material adverse effect on Borrower’s business, or permit any of its Subsidiaries to do so; withdraw or permit any Subsidiary to withdraw from participation in, permit partial or complete termination of, or permit the occurrence of any other event with respect to, any present pension, profit sharing and deferred compensation plan which could reasonably be expected to result in any liability of Borrower, including any liability to the Pension Benefit Guaranty Corporation or its successors or any other governmental agency.

     8 EVENTS OF DEFAULT

     Any one of the following shall constitute an event of default (an “Event of Default”) under this Agreement:

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     8.1 Payment Default. Borrower fails to (a) make any payment of principal or interest on any Credit Extension on its due date, or (b) pay any other Obligations within five (5) Business Days after such Obligations are due and payable. During the cure period, the failure to cure the payment default is not an Event of Default (but no Credit Extension will be made during the cure period);

     8.2 Covenant Default.

          (a) Borrower fails or neglects to perform any obligation in Sections 6.2, 6.6, 6.7, 6.10, 6.11 or violates any covenant in Section 7; or

          (b) Borrower fails or neglects to perform, keep, or observe any other term, provision, condition, covenant or agreement contained in this Agreement, any Loan Documents, and as to any default (other than those specified in Section 8 below) under such other term, provision, condition, covenant or agreement that can be cured, has failed to cure the default within ten (10) days after the occurrence thereof; provided, however, that if the default cannot by its nature be cured within the ten (10) day period or cannot after diligent attempts by Borrower be cured within such ten (10) day period, and such default is likely to be cured within a reasonable time, then Borrower shall have an additional period (which shall not in any case exceed thirty (30) days) to attempt to cure such default, and within such reasonable time period the failure to cure the default shall not be deemed an Event of Default (but no Credit Extensions shall be made during such cure period). Grace periods provided under this section shall not apply, among other things, to financial covenants or any other covenants set forth in subsection (a) above;

     8.3 Material Adverse Change. A Material Adverse Change occurs;

     8.4 Attachment. (a) Any material portion of Borrower’s assets is attached, seized, levied on, or comes into possession of a trustee or receiver and the attachment, seizure or levy is not removed in ten (10) days; (b) the service of process upon Borrower seeking to attach, by trustee or similar process, any funds of Borrower on deposit with Bank, or any entity under control of Bank (including a subsidiary); (c) Borrower is enjoined, restrained, or prevented by court order from conducting a material part of its business; (d) a judgment or other claim in excess of $750,000 becomes a Lien on any of Borrower’s assets; or (e) a notice of lien, levy, or assessment is filed against any material portion of Borrower’s assets by any government agency and not paid within ten (10) days after Borrower receives notice. These are not Events of Default if stayed or if a bond is posted pending contest by Borrower (but no Credit Extensions shall be made during the cure period);

     8.5 Insolvency. Borrower is unable to pay its debts (including trade debts) as they become due or otherwise becomes insolvent; (b) Borrower begins an Insolvency Proceeding; or (c) an Insolvency Proceeding is begun against Borrower and not dismissed or stayed within thirty (30) days (but no Credit Extensions shall be made while of any of the conditions described in clause (a) exist and/or until any Insolvency Proceeding is dismissed);

     8.6 Other Agreements. If Borrower fails to (a) make any payment that is due and payable with respect to any Material Indebtedness and such failure continues after the applicable grace or notice period, if any, specified in the agreement or instrument relating thereto, or (b) perform or observe any other condition or covenant, or any other event shall occur or condition exist under any agreement or instrument relating to any Material Indebtedness, and such failure continues after the applicable grace or notice period, if any, specified in the agreement or instrument relating thereto and the effect of such failure, event or condition is to cause the holder or holders of such Material Indebtedness to accelerate the maturity of such Material Indebtedness or cause the mandatory repurchase of any Material Indebtedness;

     8.7 Judgments. A judgment or judgments for the payment of money in an amount, individually or in the aggregate, of at least $750,000 (not covered by independent third-party insurance) shall be rendered against Borrower and shall remain unsatisfied and unstayed for a period of ten (10) days after the entry thereof (provided that no Credit Extensions will be made prior to the satisfaction or stay of such judgment);

     8.8 Misrepresentations. Borrower or any Person acting for Borrower makes any representation, warranty, or other statement now or later in this Agreement, any Loan Document or in any writing delivered to Bank or to induce Bank to enter this Agreement or any Loan Document, and such representation, warranty, or other statement is incorrect in any material respect when made;

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     8.9 Subordinated Debt. A default or breach occurs under any agreement between Borrower and any creditor of Borrower that signed a subordination, intercreditor, or other similar agreement with Bank, or any creditor that has signed such an agreement with Bank breaches any terms of such agreement; or

     8.10 Guaranty. (a) Any guaranty of any Obligations terminates or ceases for any reason to be in full force and effect; (b) any Guarantor does not perform any obligation or covenant under any guaranty of the Obligations; (c) any circumstance described in Sections 8.4, 8.5, 8.7, or 8.8. occurs with respect to any Guarantor, or (d) the liquidation, winding up, or termination of existence of any Guarantor.

     9 BANK’S RIGHTS AND REMEDIES

     9.1 Rights and Remedies. While an Event of Default occurs and continues Bank may, without notice or demand, do any or all of the following:

          (a) declare all Obligations immediately due and payable (but if an Event of Default described in Section 8.5 occurs all Obligations are immediately due and payable without any action by Bank);

          (b) stop advancing money or extending credit for Borrower’s benefit under this Agreement or under any other agreement between Borrower and Bank;

          (c) demand that Borrower (i) deposits cash with Bank in an amount equal to the aggregate amount of any Letters of Credit remaining undrawn, as collateral security for the repayment of any future drawings under such Letters of Credit, and Borrower shall forthwith deposit and pay such amounts, and (ii) pay in advance all Letter of Credit fees scheduled to be paid or payable over the remaining term of any Letters of Credit;

          (d) terminate any FX Contracts;

          (e) settle or adjust disputes and claims directly with Account Debtors for amounts on terms and in any order that Bank considers advisable, notify any Person owing Borrower money of Bank’s security interest in such funds, and verify the amount of such account;

          (f) make any payments and do any acts it considers necessary or reasonable to protect the Collateral and/or its security interest in the Collateral. Borrower shall assemble the Collateral if Bank requests and make it available as Bank designates. Bank may enter premises where the Collateral is located, take and maintain possession of any part of the Collateral, and pay, purchase, contest, or compromise any Lien which appears to be prior or superior to its security interest and pay all expenses incurred. Borrower grants Bank a license to enter and occupy any of its premises, without charge, to exercise any of Bank’s rights or remedies;

          (g) apply to the Obligations any (i) balances and deposits of Borrower it holds, or (ii) any amount held by Bank owing to or for the credit or the account of Borrower;

          (h) ship, reclaim, recover, store, finish, maintain, repair, prepare for sale, advertise for sale, and sell the Collateral. Bank is hereby granted a non-exclusive, royalty-free license or other right to use, without charge, Borrower’s labels, patents, copyrights, mask works, rights of use of any name, trade secrets, trade names, trademarks, service marks, and advertising matter, or any similar property as it pertains to the Collateral, in completing production of, advertising for sale, and selling any Collateral and, in connection with Bank’s exercise of its rights under this Section, Borrower’s rights under all licenses and all franchise agreements inure to Bank’s benefit;

          (i) place a “hold” on any account maintained with Bank and/or deliver a notice of exclusive control, any entitlement order, or other directions or instructions pursuant to any Control Agreement or similar agreements providing control of any Collateral;

          (j) demand and receive possession of Borrower’s Books; and

          (k) exercise all rights and remedies available to Bank under the Loan Documents or at law or equity, including all remedies provided under the Code (including disposal of the Collateral pursuant to the terms thereof).

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     9.2 Power of Attorney. Borrower hereby irrevocably appoints Bank as its lawful attorney-in-fact, exercisable upon the occurrence and during the continuance of an Event of Default, to: (a) endorse Borrower’s name on any checks or other forms of payment or security; (b) sign Borrower’s name on any invoice or bill of lading for any Account or drafts against Account Debtors; (c) settle and adjust disputes and claims about the Accounts directly with Account Debtors, for amounts and on terms Bank determines reasonable; (d) make, settle, and adjust all claims under Borrower’s insurance policies; (e) pay, contest or settle any Lien, charge, encumbrance, security interest, and adverse claim in or to the Collateral, or any judgment based thereon, or otherwise take any action to terminate or discharge the same; and (f) transfer the Collateral into the name of Bank or a third party as the Code permits. Borrower hereby appoints Bank as its lawful attorney-in-fact to sign Borrower’s name on any documents necessary to perfect or continue the perfection of any security interest regardless of whether an Event of Default has occurred until all Obligations have been satisfied in full and Bank is under no further obligation to make Credit Extensions hereunder. Bank’s foregoing appointment as Borrower’s attorney in fact, and all of Bank’s rights and powers, coupled with an interest, are irrevocable until all Obligations have been fully repaid and performed and Bank’s obligation to provide Credit Extensions terminates.

     9.3 Accounts Verification; Collection. Whether or not an Event of Default has occurred and is continuing, Bank may notify any Person owing Borrower money of Bank’s security interest in such funds and verify the amount of such account. After the occurrence of an Event of Default, any amounts received by Borrower shall be held in trust by Borrower for Bank, and, if requested by Bank, Borrower shall immediately deliver such receipts to Bank in the form received from the Account Debtor, with proper endorsements for deposit.

     9.4 Protective Payments. If Borrower fails to obtain the insurance called for by Section 6.5 or fails to pay any premium thereon or fails to pay any other amount which Borrower is obligated to pay under this Agreement or any other Loan Document, Bank may obtain such insurance or make such payment, and all amounts so paid by Bank are Bank Expenses and immediately due and payable, bearing interest at the then highest applicable rate, and secured by the Collateral. Bank will make reasonable efforts to provide Borrower with notice of Bank obtaining such insurance at the time it is obtained or within a reasonable time thereafter. No payments by Bank are deemed an agreement to make similar payments in the future or Bank’s waiver of any Event of Default.

     9.5 Application of Payments and Proceeds. Unless an Event of Default has occurred and is continuing, Bank shall apply any funds in its possession, whether from Borrower account balances, payments, or proceeds realized as the result of any collection of Accounts or other disposition of the Collateral, first, to Bank Expenses, including without limitation, the reasonable costs, expenses, liabilities, obligations and attorneys’ fees incurred by Bank in the exercise of its rights under this Agreement; second, to the interest due upon any of the Obligations; and third, to the principal of the Obligations and any applicable fees and other charges, in such order as Bank shall determine in its sole discretion. Any surplus shall be paid to Borrower or other Persons legally entitled thereto; Borrower shall remain liable to Bank for any deficiency. If an Event of Default has occurred and is continuing, Bank may apply any funds in its possession, whether from Borrower account balances, payments, proceeds realized as the result of any collection of Accounts or other disposition of the Collateral, or otherwise, to the Obligations in such order as Bank shall determine in its sole discretion. Any surplus shall be paid to Borrower or other Persons legally entitled thereto; Borrower shall remain liable to Bank for any deficiency. If Bank, in its good faith business judgment, directly or indirectly enters into a deferred payment or other credit transaction with any purchaser at any sale of Collateral, Bank shall have the option, exercisable at any time, of either reducing the Obligations by the principal amount of the purchase price or deferring the reduction of the Obligations until the actual receipt by Bank of cash therefor.

     9.6 Bank’s Liability for Collateral. So long as Bank complies with reasonable banking practices regarding the safekeeping of the Collateral in the possession or under the control of Bank, Bank shall not be liable or responsible for: (a) the safekeeping of the Collateral; (b) any loss or damage to the Collateral; (c) any diminution in the value of the Collateral; or (d) any act or default of any carrier, warehouseman, bailee, or other Person. Borrower bears all risk of loss, damage or destruction of the Collateral.

     9.7 No Waiver; Remedies Cumulative. Bank’s failure, at any time or times, to require strict performance by Borrower of any provision of this Agreement or any other Loan Document shall not waive, affect, or diminish any right of Bank thereafter to demand strict performance and compliance herewith or therewith. No waiver hereunder shall be effective unless signed by Bank and then is only effective for the specific instance and purpose for which it is given. Bank’s rights and remedies under this Agreement and the other Loan Documents are cumulative. Bank has all rights and remedies provided under the Code, by law, or in equity. Bank’s exercise of one

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right or remedy is not an election, and Bank’s waiver of any Event of Default is not a continuing waiver. Bank’s delay in exercising any remedy is not a waiver, election, or acquiescence.

     9.8 Demand Waiver. Borrower waives demand, notice of default or dishonor, notice of payment and nonpayment, notice of any default, nonpayment at maturity, release, compromise, settlement, extension, or renewal of accounts, documents, instruments, chattel paper, and guarantees held by Bank on which Borrower is liable.

     10 NOTICES

     All notices, consents, requests, approvals, demands, or other communication (collectively, “Communication”) by any party to this Agreement or any other Loan Document must be in writing and shall be deemed to have been validly served, given, or delivered: (a) upon the earlier of actual receipt and three (3) Business Days after deposit in the U.S. mail, first class, registered or certified mail return receipt requested, with proper postage prepaid; (b) upon transmission, when sent by electronic mail or facsimile transmission; (c) one (1) Business Day after deposit with a reputable overnight courier with all charges prepaid; or (d) when delivered, if hand-delivered by messenger, all of which shall be addressed to the party to be notified and sent to the address, facsimile number, or email address indicated below. Bank or Borrower may change its address or facsimile number by giving the other party written notice thereof in accordance with the terms of this Section 10.

If to Borrower:	RAE Systems Inc.
	3775 North First Street
	San Jose, California 95134
	Attn: Chief Financial Officer
	Fax: (408) 952-8480
If to Bank:	Silicon Valley Bank
	3979 Freedom Circle, Suite 600
	Santa Clara, California 95054
	Attn: Tom Smith
	Fax: (408) 654-5517

     11 CHOICE OF LAW, VENUE AND JURY TRIAL WAIVER

California law governs the Loan Documents without regard to principles of conflicts of law. Borrower and Bank each submit to the exclusive jurisdiction of the State and Federal courts in Santa Clara County, California; provided, however, that nothing in this Agreement shall be deemed to operate to preclude Bank from bringing suit or taking other legal action in any other jurisdiction to realize on the Collateral or any other security for the Obligations, or to enforce a judgment or other court order in favor of Bank. Borrower expressly submits and consents in advance to such jurisdiction in any action or suit commenced in any such court, and Borrower hereby waives any objection that it may have based upon lack of personal jurisdiction, improper venue, or forum non conveniens and hereby consents to the granting of such legal or equitable relief as is deemed appropriate by such court. Borrower hereby waives personal service of the summons, complaints, and other process issued in such action or suit and agrees that service of such summons, complaints, and other process may be made by registered or certified mail addressed to Borrower at the address set forth in Section 10 of this Agreement and that service so made shall be deemed completed upon the earlier to occur of Borrower’s actual receipt thereof or three (3) days after deposit in the U.S. mails, proper postage prepaid.

TO THE EXTENT PERMITTED BY APPLICABLE LAW, BORROWER AND BANK EACH WAIVE THEIR RIGHT TO A JURY TRIAL OF ANY CLAIM OR CAUSE OF ACTION ARISING OUT OF OR BASED UPON THIS AGREEMENT, THE LOAN DOCUMENTS OR ANY CONTEMPLATED TRANSACTION, INCLUDING CONTRACT, TORT, BREACH OF DUTY AND ALL OTHER CLAIMS. THIS WAIVER IS A MATERIAL INDUCEMENT FOR BOTH PARTIES TO ENTER INTO THIS AGREEMENT. EACH PARTY HAS REVIEWED THIS WAIVER WITH ITS COUNSEL.

WITHOUT INTENDING IN ANY WAY TO LIMIT THE PARTIES’ AGREEMENT TO WAIVE THEIR RESPECTIVE RIGHT TO A TRIAL BY JURY, if the above waiver of the right to a trial by jury is not enforceable, the parties hereto agree that any and all disputes or controversies of any nature between them arising at any time

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shall be decided by a reference to a private judge, mutually selected by the parties (or, if they cannot agree, by the Presiding Judge of the Santa Clara County, California Superior Court) appointed in accordance with California Code of Civil Procedure Section 638 (or pursuant to comparable provisions of federal law if the dispute falls within the exclusive jurisdiction of the federal courts), sitting without a jury, in Santa Clara County, California; and the parties hereby submit to the jurisdiction of such court. The reference proceedings shall be conducted pursuant to and in accordance with the provisions of California Code of Civil Procedure §§ 638 through 645.1, inclusive. The private judge shall have the power, among others, to grant provisional relief, including without limitation, entering temporary restraining orders, issuing preliminary and permanent injunctions and appointing receivers. All such proceedings shall be closed to the public and confidential and all records relating thereto shall be permanently sealed. If during the course of any dispute, a party desires to seek provisional relief, but a judge has not been appointed at that point pursuant to the judicial reference procedures, then such party may apply to the Santa Clara County, California Superior Court for such relief. The proceeding before the private judge shall be conducted in the same manner as it would be before a court under the rules of evidence applicable to judicial proceedings. The parties shall be entitled to discovery which shall be conducted in the same manner as it would be before a court under the rules of discovery applicable to judicial proceedings. The private judge shall oversee discovery and may enforce all discovery rules and order applicable to judicial proceedings in the same manner as a trial court judge. The parties agree that the selected or appointed private judge shall have the power to decide all issues in the action or proceeding, whether of fact or of law, and shall report a statement of decision thereon pursuant to the California Code of Civil Procedure § 644(a). Nothing in this paragraph shall limit the right of any party at any time to exercise self-help remedies, foreclose against collateral, or obtain provisional remedies. The private judge shall also determine all issues relating to the applicability, interpretation, and enforceability of this paragraph.

     12 GENERAL PROVISIONS

     12.1 Successors and Assigns. This Agreement binds and is for the benefit of the successors and permitted assigns of each party. Borrower may not assign this Agreement or any rights or obligations under it without Bank’s prior written consent (which may be granted or withheld in Bank’s discretion). Bank has the right, without the consent of or notice to Borrower, to sell, transfer, negotiate, or grant participation in all or any part of, or any interest in, Bank’s obligations, rights, and benefits under this Agreement and the other Loan Documents.

     12.2 Indemnification. Borrower agrees to indemnify, defend and hold Bank and its directors, officers, employees, agents, attorneys, or any other Person affiliated with or representing Bank harmless against: (a) all obligations, demands, claims, and liabilities (collectively, “Claims”) asserted by any other party in connection with the transactions contemplated by the Loan Documents; and (b) all losses or Bank Expenses incurred, or paid by Bank from, following, or arising from transactions between Bank and Borrower (including reasonable attorneys’ fees and expenses), except for Claims and/or losses directly caused by Bank’s gross negligence or willful misconduct.

     12.3 Time of Essence. Time is of the essence for the performance of all Obligations in this Agreement.

     12.4 Severability of Provisions. Each provision of this Agreement is severable from every other provision in determining the enforceability of any provision.

     12.5 Amendments in Writing; Integration. All amendments to this Agreement must be in writing signed by both Bank and Borrower. This Agreement and the Loan Documents represent the entire agreement about this subject matter and supersede prior negotiations or agreements. All prior agreements, understandings, representations, warranties, and negotiations between the parties about the subject matter of this Agreement and the Loan Documents merge into this Agreement and the Loan Documents.

     12.6 Counterparts. This Agreement may be executed in any number of counterparts and by different parties on separate counterparts, each of which, when executed and delivered, are an original, and all taken together, constitute one Agreement.

     12.7 Survival. All covenants, representations and warranties made in this Agreement continue in full force until this Agreement has terminated pursuant to its terms and all Obligations (other than inchoate indemnity obligations and any other obligations which, by their terms, are to survive the termination of this Agreement) have

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been satisfied. The obligation of Borrower in Section 12.2 to indemnify Bank shall survive until the statute of limitations with respect to such claim or cause of action shall have run.

     12.8 Confidentiality. In handling any confidential information, Bank shall exercise the same degree of care that it exercises for its own proprietary information, but disclosure of information may be made: (a) to Bank’s Subsidiaries or Affiliates; (b) to prospective transferees or purchasers of any interest in the Credit Extensions (provided, however, Bank shall use commercially reasonable efforts to obtain such prospective transferee’s or purchaser’s agreement to the terms of this provision); (c) as required by law, regulation, subpoena, or other order; (d) to Bank’s regulators or as otherwise required in connection with Bank’s examination or audit; and (e) as Bank considers appropriate in exercising remedies under this Agreement. Confidential information does not include information that either: (i) is in the public domain or in Bank’s possession when disclosed to Bank, or becomes part of the public domain after disclosure to Bank; or (ii) is disclosed to Bank by a third party, if Bank does not know that the third party is prohibited from disclosing the information.

     12.9 Attorneys’ Fees, Costs and Expenses. In any action or proceeding between Borrower and Bank arising out of or relating to the Loan Documents, the prevailing party shall be entitled to recover its reasonable attorneys’ fees and other costs and expenses incurred, in addition to any other relief to which it may be entitled.

     13 DEFINITIONS

     13.1 Definitions. As used in this Agreement, the following terms have the following meanings:

     “Account” is any “account” as defined in the Code with such additions to such term as may hereafter be made, and includes, without limitation, all accounts receivable and other sums owing to Borrower.

     “Account Debtor” is any “account debtor” as defined in the Code with such additions to such term as may hereafter be made.

     “Advance” or “Advances” means an advance (or advances) under the Revolving Line.

     “Affiliate” of any Person is a Person that owns or controls directly or indirectly the Person, any Person that controls or is controlled by or is under common control with the Person, and each of that Person’s senior executive officers, directors, partners and, for any Person that is a limited liability company, that Person’s managers and members.

     “Agreement” is defined in the preamble hereof.

     “Bank” is defined in the preamble hereof.

     “Bank Expenses” are all audit fees and expenses, costs, and expenses (including reasonable attorneys’ fees and expenses) for preparing, negotiating, administering, defending and enforcing the Loan Documents (including, without limitation, those incurred in connection with appeals or Insolvency Proceedings) or otherwise incurred with respect to Borrower.

     “Bankruptcy-Related Defaults” is defined in Section 9.1.

     “Borrower” is defined in the preamble hereof

     “Borrower’s Books” are all Borrower’s books and records including ledgers, federal and state tax returns, records regarding Borrower’s assets or liabilities, the Collateral, business operations or financial condition, and all computer programs or storage or any equipment containing such information.

     “Borrowing Base” is (a) $7,000,000 plus (b) 80% of Eligible Accounts, as determined by Bank from Borrower’s most recent Borrowing Base Certificate; provided, however, that Bank may decrease the foregoing percentages in its good faith business judgment based on events (including without limitation, the initial field audit examination and the on-going periodic examinations), conditions, contingencies, or risks which, as determined by Bank, may adversely affect Collateral.

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     “Borrowing Base Certificate” is that certain certificate in the form attached hereto as Exhibit C.

     “Borrowing Resolutions” are, with respect to any Person, those resolutions adopted by such Person’s Board of Directors and delivered by such Person to Bank approving the Loan Documents to which such Person is a party and the transactions contemplated thereby, together with a certificate executed by its secretary on behalf of such Person certifying that (a) such Person has the authority to execute, deliver, and perform its obligations under each of the Loan Documents to which it is a party, (b) that attached to such certificate is a true, correct, and complete copy of the resolutions then in full force and effect authorizing and ratifying the execution, delivery, and performance by such Person of the Loan Documents to which it is a party, (c) the name(s) of the Person(s) authorized to execute the Loan Documents on behalf of such Person, together with a sample of the true signature(s) of such Person(s), and (d) that Bank may conclusively rely on such certificate unless and until such Person shall have delivered to Bank a further certificate canceling or amending such prior certificate.

     “Business Day” is any day that is not a Saturday, Sunday or a day on which Bank is closed.

     “Cash Equivalents” means (a) marketable direct obligations issued or unconditionally guaranteed by the United States or any agency or any State thereof having maturities of not more than one (1) year from the date of acquisition; (b) commercial paper maturing no more than one (1) year after its creation and having the highest rating from either Standard & Poor’s Ratings Group or Moody’s Investors Service, Inc., (c) Bank’s certificates of deposit issued maturing no more than one (1) year after issue; and (d) money market funds at least ninety-five percent (95%) of the assets of which constitute Cash Equivalents of the kinds described in clauses (a) through (c) of this definition.

     “Cash Management Services” is defined in Section 2.1.4.

     “Cash Management Services Sublimit” is defined in Section 2.1.4.

     “Change in Control” means any event, transaction, or occurrence as a result of which (a) any “person” (as such term is defined in Sections 3(a)(9) and 13(d)(3) of the Securities Exchange Act of 1934, as an amended (the “Exchange Act”)), other than a trustee or other fiduciary holding securities under an employee benefit plan of Borrower, is or becomes a beneficial owner (within the meaning Rule 13d-3 promulgated under the Exchange Act), directly or indirectly, of securities of Borrower, representing fifty percent (50%) or more of the combined voting power of Borrower’s then outstanding securities; or (b) during any period of twelve consecutive calendar months, individuals who at the beginning of such period constituted the Board of Directors of Borrower (together with any new directors whose election by the Board of Directors of Borrower was approved or ratified by at least a majority of the directors then still in office who either were directions at the beginning of such period or whose election or nomination for election was previously so approved) cease for any reason other than death or disability to constitute a majority of the directors then in office.

     “Code” is the Uniform Commercial Code, as the same may, from time to time, be enacted and in effect in the State of California; provided, that, to the extent that the Code is used to define any term herein or in any Loan Document and such term is defined differently in different Articles or Divisions of the Code, the definition of such term contained in Article or Division 9 shall govern; provided further, that in the event that, by reason of mandatory provisions of law, any or all of the attachment, perfection, or priority of, or remedies with respect to, Bank’s Lien on any Collateral is governed by the Uniform Commercial Code in effect in a jurisdiction other than the State of California, the term “Code” shall mean the Uniform Commercial Code as enacted and in effect in such other jurisdiction solely for purposes on the provisions thereof relating to such attachment, perfection, priority, or remedies and for purposes of definitions relating to such provisions.

     “Collateral” is any and all properties, rights and assets of Borrower described on Exhibit A.

     “Collateral Account” is any Deposit Account, Securities Account, or Commodity Account maintained by Borrower or a Domestic Subsidiary where such account is located in the United States.

     “Commodity Account” is any “commodity account” as defined in the Code with such additions to such term as may hereafter be made.

     “Communication” is defined in Section 10.

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     “Compliance Certificate” is that certain certificate in the form attached hereto as Exhibit D.

     “Contingent Obligation” is, for any Person, any direct or indirect liability, contingent or not, of that Person for (a) any indebtedness, lease, dividend, letter of credit or other obligation of another such as an obligation directly or indirectly guaranteed, endorsed, co-made, discounted or sold with recourse by that Person, or for which that Person is directly or indirectly liable; (b) any obligations for undrawn letters of credit for the account of that Person; and (c) all obligations from any interest rate, currency or commodity swap agreement, interest rate cap or collar agreement, or other agreement or arrangement designated to protect a Person against fluctuation in interest rates, currency exchange rates or commodity prices; but “Contingent Obligation” does not include endorsements in the ordinary course of business. The amount of a Contingent Obligation is the stated or determined amount of the primary obligation for which the Contingent Obligation is made or, if not determinable, the maximum reasonably anticipated liability for it determined by the Person in good faith; but the amount may not exceed the maximum of the obligations under any guarantee or other support arrangement.

     “Control Agreement” is any control agreement entered into among the depository institution at which Borrower maintains a Deposit Account or the securities intermediary or commodity intermediary at which Borrower maintains a Securities Account or a Commodity account, Borrower, and Bank pursuant to which Bank obtains control (within the meaning of the Code) over such Deposit Account, Securities Account, or Commodity Account.

     “Credit Extension” is any Advance, Letter of Credit, FX Forward Contract, amount utilized for Cash Management Services or any other extension of credit by Bank for Borrower’s benefit.

     “Current Liabilities” are all obligations and liabilities of Borrower to Bank, plus, without duplication, the aggregate amount of Borrower’s Total Liabilities that mature within one (1) year.

     “Default” means any event which with notice or passage of time or both, would constitute an Event of Default.

     “Default Rate” is defined in Section 2.3(b).

     “Deposit Account” is any “deposit account” as defined in the Code with such additions to such term as may hereafter be made.

     “Designated Deposit Account” is Borrower’s deposit account, account number 3300556715, maintained with Bank.

     “Dollars,” “dollars” and “$” each mean lawful money of the United States.

     “Domestic Subsidiary” means a Subsidiary organized under the laws of the United States or any state or territory thereof or the District of Columbia.

     “Effective Date” is the date Bank executes this Agreement and as indicated on the signature page hereof.

     “Eligible Accounts” are Accounts which arise in the ordinary course of Borrower’s business that meet all Borrower’s representations and warranties in Section 5.3. Bank reserves the right at any time and from time to time after the Effective Date, to adjust any of the criteria set forth below and to establish new criteria in its good faith business judgment. Unless Bank agrees otherwise in writing, Eligible Accounts shall not include:

     (a) Accounts that the Account Debtor has not paid within ninety (90) days of invoice date;

     (b) Accounts owing from an Account Debtor, fifty percent (50%) or more of whose Accounts have not been paid within ninety (90) days of invoice date;

     (c) Credit balances over ninety (90) days from invoice date;

     (d) Accounts owing from an Account Debtor, including Affiliates, whose total obligations to Borrower exceed twenty-five (25%) of all Accounts, for the amounts that exceed that percentage, unless Bank approves in writing;

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     (e) Accounts owing from an Account Debtor which does not have its principal place of business in the United States except for Eligible Foreign Accounts;

     (f) Accounts owing from an Account Debtor which is a federal, state or local government entity or any department, agency, or instrumentality thereof except for Accounts of the United States if Borrower has assigned its payment rights to Bank and the assignment has been acknowledged under the Federal Assignment of Claims Act of 1940, as amended;

     (g) Accounts owing from an Account Debtor to the extent that Borrower is indebted or obligated in any manner to the Account Debtor (as creditor, lessor, supplier or otherwise — sometimes called “contra” accounts, accounts payable, customer deposits or credit accounts), with the exception of customary credits, adjustments and/or discounts given to an Account Debtor by Borrower in the ordinary course of its business;

     (h) Accounts for demonstration or promotional equipment, or in which goods are consigned, or sold on a “sale guaranteed”, “sale or return”, “sale on approval”, “bill and hold”, or other terms if Account Debtor’s payment may be conditional;

     (i) Accounts for which the Account Debtor is Borrower’s Affiliate, officer, employee, or agent;

     (j) Accounts in which the Account Debtor disputes liability or makes any claim (but only up to the disputed or claimed amount), or if the Account Debtor is subject to an Insolvency Proceeding, or becomes insolvent, or goes out of business;

     (k) Accounts owing from an Account Debtor with respect to which Borrower has received deferred revenue (but only to the extent of such deferred revenue);

     (l) Accounts for which Bank in its good faith business judgment determines collection to be doubtful; and

     (m) other Accounts Bank deems ineligible in the exercise of its good faith business judgment.

     “Eligible Foreign Accounts” are Accounts for which the Account Debtor does not have its principal place of business in the United States but are otherwise Eligible Accounts that are (a) either covered by credit insurance satisfactory to Bank, less any deductible or supported by letter(s) of credit acceptable to Bank; and (b) approved by Bank in writing.

     “Equipment” is all “equipment” as defined in the Code with such additions to such term as may hereafter be made, and includes without limitation all machinery, fixtures, goods, vehicles (including motor vehicles and trailers), and any interest in any of the foregoing.

     “ERISA” is the Employment Retirement Income Security Act of 1974, and its regulations.

     “Event of Default” is defined in Section 8.

     “Foreign Currency” means lawful money of a country other than the United States.

     “Foreign Subsidiary” means any Subsidiary which is not a Domestic Subsidiary.

     “Funding Date” is any date on which a Credit Extension is made to or on account of Borrower which shall be a Business Day.

     “FX Business Day” is any day when (a) Bank’s Foreign Exchange Department is conducting its normal business and (b) the Foreign Currency being purchased or sold by Borrower is available to Bank from the entity from which Bank shall buy or sell such Foreign Currency.

     “FX Forward Contract” is defined in Section 2.1.3.

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     “FX Reserve” is defined in Section 2.1.3.

     “GAAP” is generally accepted accounting principles set forth in the opinions and pronouncements of the Accounting Principles Board of the American Institute of Certified Public Accountants and statements and pronouncements of the Financial Accounting Standards Board or in such other statements by such other Person as may be approved by a significant segment of the accounting profession, which are applicable to the circumstances as of the date of determination.

     “General Intangibles” is all “general intangibles” as defined in the Code in effect on the date hereof with such additions to such term as may hereafter be made, and includes without limitation, all copyright rights, copyright applications, copyright registrations and like protections in each work of authorship and derivative work, whether published or unpublished, any patents, trademarks, service marks and, to the extent permitted under applicable law, any applications therefor, whether registered or not, any trade secret rights, including any rights to unpatented inventions, payment intangibles, royalties, contract rights, goodwill, franchise agreements, purchase orders, customer lists, route lists, telephone numbers, domain names, claims, income and other tax refunds, security and other deposits, options to purchase or sell real or personal property, rights in all litigation presently or hereafter pending (whether in contract, tort or otherwise), insurance policies (including without limitation key man, property damage, and business interruption insurance), payments of insurance and rights to payment of any kind.

     “Guarantor” is any present or future guarantor of the Obligations.

     “Indebtedness” is (a) indebtedness for borrowed money or the deferred price of property or services, such as reimbursement and other obligations for surety bonds and letters of credit, (b) obligations evidenced by notes, bonds, debentures or similar instruments, (c) capital lease obligations, and (d) Contingent Obligations.

     “Insolvency Proceeding” is any proceeding by or against any Person under the United States Bankruptcy Code, or any other bankruptcy or insolvency law, including assignments for the benefit of creditors, compositions, extensions generally with its creditors, or proceedings seeking reorganization, arrangement, or other relief.

     “Inventory” is all “inventory” as defined in the Code in effect on the date hereof with such additions to such term as may hereafter be made, and includes without limitation all merchandise, raw materials, parts, supplies, packing and shipping materials, work in process and finished products, including without limitation such inventory as is temporarily out of Borrower’s custody or possession or in transit and including any returned goods and any documents of title representing any of the above.

     “Investment” is any beneficial ownership interest in any Person (including stock, partnership interest or other securities), and any loan, advance or capital contribution to any Person.

     “Letter of Credit” means a standby letter of credit issued by Bank or another institution based upon an application, guarantee, indemnity or similar agreement on the part of Bank as set forth in Section 2.1.2.

     “Letter of Credit Application” is defined in Section 2.1.2(a).

     “Letter of Credit Reserve” has the meaning set forth in Section 2.1.2(d).

     “Lien” is a mortgage, lien, deed of trust, charge, pledge, security interest or other encumbrance.

     “Loan Amount” in respect of each Equipment Advance is the original principal amount of such Equipment Advance.

     “Loan Documents” are, collectively, this Agreement, the Perfection Certificate, the Subordination Agreement, any note, or notes or guaranties executed by Borrower or any Guarantor, and any other present or future agreement between Borrower any Guarantor and/or for the benefit of Bank in connection with this Agreement, all as amended, restated, or otherwise modified.

     “Material Adverse Change” is (a) a material impairment in the perfection or priority of Bank’s Lien in the Collateral or in the value of such Collateral; (b) a material adverse change in the business, operations, or condition (financial or otherwise) of Borrower and the Guarantors, taken as a whole; or (c) a material impairment of

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the prospect of repayment of any portion of the Obligations or (d) Bank determines, based upon information available to it and in its reasonable judgment, that there is a reasonable likelihood that Borrower shall fail to comply with one or more of the financial covenants in Section 6 during the next succeeding financial reporting period.

     “Material Indebtedness” is any Indebtedness the principal amount of which is equal to or greater than $1,000,000.

     “Net Income” means, as calculated on a consolidated basis for Borrower and its Subsidiaries for any period as at any date of determination, the net profit (or loss), after provision for taxes, of Borrower and its Subsidiaries for such period taken as a single accounting period.

     “Obligations” are Borrower’s obligation to pay when due any debts, principal, interest, Bank Expenses and other amounts Borrower owes Bank now or later, whether under this Agreement, the Loan Documents, or otherwise, including, without limitation, all obligations relating to letters of credit, cash management services, and foreign exchange contracts, if any, and including interest accruing after Insolvency Proceedings begin and debts, liabilities, or obligations of Borrower assigned to Bank, and the performance of Borrower’s duties under the Loan Documents.

     “Operating Documents” are, for any Person, such Person’s formation documents, as certified with the Secretary of State of such Person’s state of formation, and, (a) if such Person is a corporation, its bylaws in current form, (b) if such Person is a limited liability company, its limited liability company agreement (or similar agreement), and (c) if such Person is a partnership, its partnership agreement (or similar agreement), each of the foregoing with all current amendments or modifications thereto.

     “Payment/Advance Form” is that certain form attached hereto as Exhibit B.

     “Perfection Certificate” is defined in Section 5.1.

     “Permitted Distributions” means:

     (a) purchases of capital stock from former employees, consultants and directors pursuant to repurchase agreements or other similar agreements in an aggregate amount not to exceed $500,000 in any fiscal year provided that at the time of such purchase no Default or Event of Default has occurred and is continuing;

     (b) distributions or dividends consisting solely of Borrower’s capital stock;

     (c) purchases for value of any rights distributed in connection with any stockholder rights plan;

     (d) purchases of capital stock or options to acquire such capital stock with the proceeds received from a substantially concurrent issuance of capital stock or convertible securities;

     (e) purchases of capital stock pledged as collateral for loans to employees;

     (f) purchases of capital stock in connection with the exercise of stock options or stock appreciation rights by way of cashless exercise or in connection with the satisfaction of withholding tax obligations;

     (g) purchases of fractional shares of capital stock arising out of stock dividends, splits or combinations or business combinations; and

     (h) the settlement or performance of such Person’s obligations under any equity derivative transaction, option contract or similar transaction or combination of transactions.

     “Permitted Indebtedness” is:

     (a) Borrower’s Indebtedness to Bank under this Agreement or any other Loan Document;

     (b) any Indebtedness shown on the Perfection Certificate and satisfactory to Bank;

     (c) Subordinated Debt;

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     (d) unsecured Indebtedness to trade creditors and with respect to surety bonds and similar obligations incurred in the ordinary course of business;

     (e) guaranties of Permitted Indebtedness;

     (f) Indebtedness incurred as a result of endorsing negotiable instruments received in the ordinary course of business;

     (g) Indebtedness consisting of interest rate, currency, or commodity swap agreements, interest rate cap or collar agreements or arrangements designated to protect a Person against fluctuations in interest rates, currency exchange rates, or commodity prices;

     (h) Indebtedness between Borrower and any of its Subsidiaries or among any of Borrower’s Subsidiaries;

     (i) capitalized leases and purchase money Indebtedness not to exceed $1,000,000 in the aggregate in any fiscal year secured by Permitted Liens;

     (j) Indebtedness incurred by a Foreign Subsidiary that is not a Guarantor;

     (k) refinanced Permitted Indebtedness, provided that the amount of such Indebtedness is not increased except by an amount equal to a reasonable premium or other reasonable amount paid in connection with such refinancing and by an amount equal to any existing, but unutilized, commitment thereunder; and

     (l) other Indebtedness, if, on the date of incurring any Indebtedness pursuant to this clause (l), the outstanding aggregate amount of all Indebtedness incurred pursuant to this clause (l) does not exceed $1,000,000.

     “Permitted Investments” are:

     (a) Investments existing on the Effective Date;

     (b) (i) marketable direct obligations issued or unconditionally guaranteed by the United States or its agencies or any State maturing within 1 year from its acquisition, (ii) commercial paper maturing no more than 2 years after its creation and having the highest rating from either Standard & Poor’s Corporation or Moody’s Investors Service, Inc., and (iii) Bank’s certificates of deposit maturing no more than 2 years after issue;

     (c) Investments approved by the Borrower’s Board of Directors or otherwise pursuant to a Board-approved investment policy;

     (d) Investments in or to Borrower or any of its Subsidiaries existing on the date hereof and any Investment by Borrower in any Guarantor after the date hereof;

     (e) Investments consisting of Collateral Accounts in the name of Borrower or any Subsidiary so long as Bank has a first priority, perfected security interest in such Collateral Accounts;

     (f) Investments consisting of extensions of credit to Borrower’s or its Subsidiaries’ customers in the nature of accounts receivable, prepaid royalties or notes receivable arising from the sale or lease of goods, provision of services or licensing activities of Borrower;

     (g) Investments received in satisfaction or partial satisfaction of obligations owed by financially troubled obligors;

     (h) Investments acquired in exchange for any other Investments in connection with or as a result of a bankruptcy, workout, reorganization or recapitalization;

     (i) Investments acquired as a result of a foreclosure with respect to any secured Investment;

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     (j) Investments consisting of interest rate, currency, or commodity swap agreements, interest rate cap or collar agreements or arrangements designated to protect a Person against fluctuations in interest rates, currency exchange rates, or commodity prices;

     (k) Investments consisting of loans and advances to employees in an aggregate amount not to exceed $250,000 at any time;

     (l) (i) Investments by any Subsidiary in or to the Borrower or any Guarantor; and (ii) Investments by any Subsidiary that is not a Guarantor in or to any other Subsidiary that is not a Guarantor;

     (m) (i) (A) Investments by Borrower or any Guarantor in or to any Subsidiary that is not a Guarantor and (B) Investments by RAE Systems (Asia) Limited or its Subsidiaries in a Chinese joint venture; provided however, the sum of (1) the amounts invested under clause (A) that are not related (directly or indirectly) to the funding or reimbursement of amounts necessary to fund Investments of the type described in clause (B), plus (2) the amount invested under clause (B), plus (3) the amount of Transfers under Section 7.1(b)(iv), does not exceed $10,000,000 in the aggregate during fiscal year 2007 and (ii) Investments by Borrower or any Guarantor in or to any Subsidiary that is not a Guarantor, in an aggregate amount (when added together with Transfers under Section 7.1(b)(iv)), does not exceed $5,000,000 in the aggregate during fiscal year 2008;

     (n) other Investments in joint ventures, strategic alliances, licensing and similar arrangements customary in Borrower’s industry; provided that such Investments do not require Borrower or Subsidiary to transfer assets with a value in excess of $1,000,000 in any fiscal year; and

     (o) Investments not otherwise permitted hereunder, provided, that the aggregate book value of all such Investments by Borrower and its Subsidiaries, together, shall not exceed (when added together with the amount of Transfers pursuant to Section 7.1(k) $1,000,000 in any fiscal year.

     “Permitted Liens” are:

     (a) (i) Liens securing Permitted Indebtedness described under clause (b) of the definition of “Permitted Indebtedness” or (ii) Liens arising under this Agreement or other Loan Documents;

     (b) Liens for taxes, fees, assessments or other government charges or levies, either not delinquent or being contested in good faith and for which Borrower maintains adequate reserves on its Books, if they have no priority over any of Bank’s Liens;

     (c) Liens (including with respect to capital leases) (i) on property (including accessions, additions, parts, replacements, fixtures, improvements and attachments thereto, and the proceeds thereof) acquired or held by Borrower or its Subsidiaries incurred for financing such property (including accessions, additions, parts, replacements, fixtures, improvements and attachments thereto, and the proceeds thereof), or (ii) existing on property (and accessions, additions, parts, replacements, fixtures, improvements and attachments thereto, and the proceeds thereof) when acquired, if the Lien is confined to such property (including accessions, additions, parts, replacements, fixtures, improvements and attachments thereto, and the proceeds thereof);

     (d) Liens incurred in the extension, renewal or refinancing of the indebtedness secured by Liens described in (a) through (c), but any extension, renewal or replacement Lien must be limited to the property encumbered by the existing Lien and the principal amount of the indebtedness it secures may not increase;

     (e) leases or subleases of real property granted in the ordinary course of business, and leases, subleases, non-exclusive licenses or sublicenses of property (other than real property or intellectual property) granted in the ordinary course of Borrower’s business, if the leases, subleases, licenses and sublicenses do not prohibit granting Bank a security interest;

     (f) non-exclusive license of intellectual property granted to third parties in the ordinary course of business,and licenses of intellectual property that could not result in a legal transfer of title of the licensed property that may be exclusive in respects other than territory and that may be exclusive as to territory only as to discreet geographical areas outside of the United States;

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     (g) leases or subleases granted in the ordinary course of Borrower’s business, including in connection with Borrower’s leased premises or leased property;

     (h) Liens in favor of custom and revenue authorities arising as a matter of law to secure the payment of custom duties in connection with the importation of goods;

     (i) Liens on insurance proceeds securing the payment of financed insurance premiums;

     (j) customary Liens granted in favor of a trustee to secure fees and other amounts owing to such trustee under an indenture or other similar agreement;

     (k) Liens consisting of pledges of cash, cash equivalents or government securities to secure swap or foreign exchange contracts or letters of credit;

     (l) Liens arising from judgments, decrees or attachments in circumstances not constituting an Event of Default under Sections 8.4 or 8.7;

     (m) Liens in favor of other financial institutions arising in connection with Borrower’s deposit or securities accounts held at such institutions;

     (n) carriers’, warehousemen’s, mechanics’, materialmen’s, repairmen’s or other like Liens arising in the ordinary course of business which are not overdue for a period of more than 30 days or which are being contested in good faith and by appropriate proceeding if adequate reserves with respect thereto are maintained on the books of the applicable Person;

     (o) Liens on property of Foreign Subsidiaries that are not Guarantors;

     (p) pledges or deposits in the ordinary course of business in connection with workers’ compensation, unemployment insurance and compliance with other social security requirements applicable to Borrower; and

     (q) deposits to secure the performance of bids, trade contracts (other than for borrowed money), contracts for the purchase of property, leases, statutory obligations, surety and appeal bonds, performance bonds and other obligations of a like nature, in each case, incurred in the ordinary course of business and not representing an obligation for borrowed money.

     “Person” is any individual, sole proprietorship, partnership, limited liability company, joint venture, company, trust, unincorporated organization, association, corporation, institution, public benefit corporation, firm, joint stock company, estate, entity or government agency.

     “Prime Rate” is Bank’s most recently announced “prime rate,” even if it is not Bank’s lowest rate.

     “Quick Assets” is, on any date, Borrower’s consolidated, unrestricted cash, Cash Equivalents, net billed accounts receivable and short and long term investments.

     “Registered Organization” is any “registered organization” as defined in the Code with such additions to such term as may hereafter be made.

     “Responsible Officer” is any of the Chief Executive Officer, President, Chief Financial Officer, Treasurer and Controller of Borrower.

     “Revolving Line” is an Advance or Advances in an aggregate amount of up to $15,000,000 outstanding at any time.

     “Revolving Line Maturity Date” is March 14, 2008.

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     “Securities Account” is any “securities account” as defined in the Code with such additions to such term as may hereafter be made.

     “Settlement Date” is defined in Section 2.1.3.

     “Subordinated Debt” is (a) Indebtedness incurred by Borrower subordinated to Borrower’s Indebtedness owed to Bank and which is reflected in a written agreement in a manner and form reasonably acceptable to Bank and approved by Bank in writing, and (b) to the extent the terms of subordination do not change adversely to Bank, refinancings, refundings, renewals, amendments or extensions of any of the foregoing.

     “Subsidiary” means, with respect to any Person, any Person of which more than 50% of the voting stock or other equity interests is owned or controlled, directly or indirectly, by such Person or one or more Affiliates of such Person.

     “Tangible Net Worth” is, on any date, the consolidated total assets of Borrower and its Subsidiaries minus (a) any amounts attributable to (i) goodwill, (ii) intangible items including unamortized debt discount and expense, patents, trade and service marks and names, copyrights and research and development expenses except prepaid expenses, and (iii) reserves not already deducted from assets, minus (b) Total Liabilities including all Subordinated Debt.

     “Total Liabilities” is on any day, obligations that should, under GAAP, be classified as liabilities on Borrower’s consolidated balance sheet, including all Indebtedness.

     “Transfer” is defined in Section 7.1.

     “Unused Revolving Line Facility Fee” is defined in Section 2.4(c).

[Signature page follows.]

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     IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed as of the Effective Date.

BORROWER:
RAE SYSTEMS INC.
By Name:	/s/ Randall K. Gausman Randall K. Gausman
Title:	Chief Financial Officer
BANK:
SILICON VALLEY BANK
By	/s/ Thomas Smith
Name:	Thomas Smith
Title:	Senior Relationship Manager
Effective Date: March 14, 2007

[Signature page to Loan and Security Agreement]

EXHIBIT A

The Collateral consists of all of Borrower’s right, title and interest in and to the following personal property:

     All goods, Accounts (including health-care receivables), Equipment, Inventory, contract rights or rights to payment of money, leases, license agreements, franchise agreements, General Intangibles (except as provided below), commercial tort claims, documents, instruments (including any promissory notes), chattel paper (whether tangible or electronic), cash, deposit accounts, fixtures, letters of credit rights (whether or not the letter of credit is evidenced by a writing), securities, and all other investment property, supporting obligations, and financial assets, whether now owned or hereafter acquired, wherever located; and

     all Borrower’s Books relating to the foregoing, and any and all claims, rights and interests in any of the above and all substitutions for, additions, attachments, accessories, accessions and improvements to and replacements, products, proceeds and insurance proceeds of any or all of the foregoing.

     Notwithstanding the foregoing, the Collateral does not include any of the following, whether now owned or hereafter acquired: (a) to the extent a pledge of the capital stock owned by Borrower or any Guarantor of any Foreign Subsidiary results in material adverse tax circumstances, such pledge shall not exceed 65% of the presently existing and hereafter arising issued and outstanding shares of capital stock owned by Borrower or any Guarantor of any Foreign Subsidiary which shares entitle the holder thereof to vote for directors or any other matter or (b) any copyright rights, copyright applications, copyright registrations and like protections in each work of authorship and derivative work, whether published or unpublished, any patents, patent applications and like protections, including improvements, divisions, continuations, renewals, reissues, extensions, and continuations-in-part of the same, trademarks, service marks and, to the extent permitted under applicable law, any applications therefor, whether registered or not, and the goodwill of the business of Borrower connected with and symbolized thereby, know-how, operating manuals, trade secret rights, rights to unpatented inventions, and any claims for damage by way of any past, present, or future infringement of any of the foregoing; provided, however, the Collateral shall include all Accounts, license and royalty fees and other revenues, proceeds, or income arising out of or relating to any of the foregoing.

     Borrower has agreed not to encumber any of its copyright rights, copyright applications, copyright registrations and like protections in each work of authorship and derivative work, whether published or unpublished, any patents, patent applications and like protections, including improvements, divisions, continuations, renewals, reissues, extensions, and continuations-in-part of the same, trademarks, service marks and, to the extent permitted under applicable law, any applications therefor, whether registered or not, and the goodwill of the business of Borrower connected with and symbolized thereby, know-how, operating manuals, trade secret rights, rights to unpatented inventions, and any claims for damage by way of any past, present, or future infringement of any of the foregoing, without Bank’s prior written consent.

1 

EXHIBIT B

Loan Payment/Advance Request Form

Deadline for same day processing is Noon P.S.T.

Fax To: Date:                                         

LOAN PAYMENT :

From Account #
	(Deposit Account #)

Principal $

Authorized Signature:

Print Name/Title:

     
 [RAE SYSTEMS INC.]

To Account #
	(Loan Account #)

and/or Interest $

          Phone Number:

Loan Advance :

Complete Outgoing Wire Request section below if all or a portion of the funds from this loan advance are for an outgoing wire.

From Account #
	(Loan Account #)

Amount of Advance $

To Account #
	(Deposit Account #)

All Borrower’s representations and warranties in the Loan and Security Agreement are true, correct and complete in all material respects on the date of the request for an advance; provided, however, that such materiality qualifier shall not be applicable to any representations and warranties that already are qualified or modified by materiality in the text thereof; and provided, further that those representations and warranties expressly referring to a specific date shall be true, accurate and complete in all material respects as of such date:

Authorized Signature:

Print Name/Title:

Phone Number:

Outgoing Wire Request :
Complete only if all or a portion of funds from the loan advance above is to be wired.
Deadline for same day processing is noon, P.S.T.

Beneficiary Name:

Beneficiary Bank:

City and State:

Amount of Wire: $

Account Number:

Beneficiary Bank Transit (ABA) #:

Beneficiary Bank Code (Swift, Sort, Chip, etc.):

(For International Wire Only)

Intermediary Bank:

Transit (ABA) #:

For Further Credit to:

Special Instruction:

By signing below, I (we) acknowledge and agree that my (our) funds transfer request shall be processed in accordance with and subject to the terms and conditions set forth in the agreements(s) covering funds transfer service(s), which agreements(s) were previously received and executed by me (us).

Authorized Signature:

Print Name/Title:

Telephone #:

2^nd Signature (if required):

Print Name/Title:

Telephone #:

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EXHIBIT C

BORROWING BASE CERTIFICATE

Borrower: RAE Systems Inc.
Lender: Silicon Valley Bank
Commitment Amount: $15,000,000

ACCOUNTS RECEIVABLE
1.	Accounts Receivable Book Value as of	$
2.	Additions (please explain on reverse)	$
3.	TOTAL ACCOUNTS RECEIVABLE	$
ACCOUNTS RECEIVABLE DEDUCTIONS (without duplication)
4.	Amounts over 90 days due	$
5.	Balance of 50% over 90 day accounts	$
6.	Credit balances over 90 days	$
7.	Concentration Limits	$
8.	Foreign Accounts	$
9.	Governmental Accounts	$
10.	Contra Accounts	$
11.	Promotion or Demo Accounts	$
12.	Intercompany/Employee Accounts	$
13.	Disputed Accounts	$
14.	Deferred Revenue	$
15.	Other (please explain on reverse)	$
16.	TOTAL ACCOUNTS RECEIVABLE DEDUCTIONS	$
17.	Eligible Accounts (#3 minus #16)	$
18.	ELIGIBLE AMOUNT OF ACCOUNTS ( 80% of #17)	$
BALANCES
19.	Maximum Loan Amount	$15,000,000
20.	Total Funds Available [Lesser of #19 or #18 plus $7,000,000)]	$
21.	Present balance owing on Line of Credit	$
22.	Outstanding under Sublimits	$
23.	RESERVE POSITION (#20 minus #21 and #22)	$

The undersigned represents and warrants that this is true, complete and correct, and that the information in this Borrowing Base Certificate complies with the representations and warranties in the Loan and Security Agreement between the undersigned and Silicon Valley Bank.

COMMENTS:

By:	Authorized Signer
Date:

BANK USE ONLY

Received by:               authorized signer

Date:
Verified:	authorized signer
Date:

Compliance Status: Yes       No

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EXHIBIT D

COMPLIANCE CERTIFICATE

TO:       SILICON VALLEY BANK	Date:
FROM: RAE SYSTEMS INC.

     The undersigned authorized officer of RAE Systems Inc. (“Borrower”) certifies that under the terms and conditions of the Loan and Security Agreement between Borrower and Bank (the “Agreement”), (1) Borrower is in complete compliance for the period ending ___with all required covenants except as noted below, (2) there are no Events of Default, (3) all representations and warranties in the Agreement are true and correct in all material respects on this date except as noted below; provided, however, that such materiality qualifier shall not be applicable to any representations and warranties that already are qualified or modified by materiality in the text thereof; and provided, further that those representations and warranties expressly referring to a specific date shall be true, accurate and complete in all material respects as of such date, (4) Borrower, and each of its Subsidiaries, has timely filed all required tax returns and reports, and Borrower has timely paid all foreign, federal, state and local taxes, assessments, deposits and contributions owed by Borrower except as otherwise permitted pursuant to the terms of Section 5.9 of the Agreement, and (5) no Liens have been levied or claims made against Borrower or any of its Subsidiaries relating to unpaid employee payroll or benefits of which Borrower has not previously provided written notification to Bank. Attached are the required documents supporting the certification. The undersigned certifies that these are prepared in accordance with generally GAAP consistently applied from one period to the next except as explained in an accompanying letter or footnotes. The undersigned acknowledges that no borrowings may be requested at any time or date of determination that Borrower is not in compliance with any of the terms of the Agreement, and that compliance is determined not just at the date this certificate is delivered. Capitalized terms used but not otherwise defined herein shall have the meanings given them in the Agreement.

Please indicate compliance status by circling Yes/No under “Complies” column.

Reporting Covenant	Required	Complies
Quarterly financial statements with Compliance Certificate	Quarterly within earlier of 5 days of filing 10Q or 50 days of quarter end	Yes    No
Annual financial statement (CPA Audited) + CC	within earlier of 5 days of filing 10K or 90 days of FYE	Yes    No
8-K	Within 5 days after filing with SEC	Yes    No
Borrowing Base Certificate A/R & A/P Agings	When the outstanding Obligations under Section 2.1 are equal to or greater than $3,000,000 for longer than 3 consecutive Business Days within a calendar month, monthly within 30 days	Yes    No
Projections	Within 45 days of FYE	Yes    No
Cash balance report	Within 30 days of end of month	Yes    No

Financial Covenant	Required		Actual	Complies
Maintain at all times:
Tested as of the last day of each fiscal quarter, a Minimum Quick Ratio		1.0:1.0	___:1.0	Yes    No
Tested as of the last day of each fiscal quarter, a Minimum Tangible Net Worth plus 50% of Net Income plus 50% of net cash proceeds of equity issuances	$	35,000,000	$___	Yes    No

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     The following financial covenant analys[is][es] and information set forth in Schedule 1 attached hereto are true and accurate as of the date of this Certificate.

     The following are the exceptions with respect to the certification above: (If no exceptions exist, state “No exceptions to note.”)

RAE SYSTEMS INC.	BANK USE ONLY
	Received by:	authorized signer
By:	Date:
Name:	Verified:	authorized signer
Tital:	Date:
	Compliance Status:            Yes            No

2

Schedule 1 to Compliance Certificate

Financial Covenants of Borrower

Dated:                     

I. Quick Ratio (Section 6.7(a))

Required:         1.00:1.00

Actual:

A.	Aggregate value of the unrestricted cash and cash equivalents of Borrower and its Subsidiaries	$
B.	Aggregate value of the net billed accounts receivable of Borrower and its Subsidiaries	$
C.	Aggregate value of the Investments (short and long term) of Borrower and it Subsidiaries	$
D.	Quick Assets (the sum of lines A through C)	$
E.	Aggregate value of Obligations to Bank	$
F.	Aggregate value of liabilities of Borrower and its Subsidiaries (including all Indebtedness) that matures within one (1) year and current portion of Subordinated Debt permitted by Bank to be paid by Borrower	$
G.	Current Liabilities (the sum of lines E and F)	$
H.	Quick Ratio (line D divided by line G)

Is line H equal to or greater than ___:1:00?

                     No, not in compliance                      Yes, in compliance

II. Tangible Net Worth plus 50% of Net Income plus 50% of net cash proceeds of equity issuances (Section 6.7(b))

Required:          $35,000,000

Actual:

A.	Aggregate value of total assets of Borrower and its Subsidiaries	$
B.	Aggregate value of goodwill of Borrower and its Subsidiaries	$
C.	Aggregate value of intangible assets of Borrower and its Subsidiaries	$
D.	Aggregate value of any reserves not already deducted from assets	$
E.	Aggregate amount of Total Liabilities including Subordinated Debt	$
F.	Tangible Net Worth (line A minus line B minus line C minus line D minus line E)	$

3

G.	New net cash proceeds of equity issuances	$
H.	Net Income	$
I.	Line F plus line 50% of line G plus 50% of line H	$

Is line I equal to or greater than $35,000,000?

                     No, not in compliance                      Yes, in compliance

EX-10.14

EXHIBIT 10.14

SINO-FOREIGN EQUITY JOINT VENTURE CONTRACT

Table of Contents

Chapter 1 General Provisions
Chapter 2 Parties to the Joint Venture and the Joint Venture
Chapter 3 Representations and Warranties of the Parties
Chapter 4 Total Amount of Investment and the Registered Capital
Chapter 5 Business Scope and Scale of the Joint Venture
Chapter 6 Operation Premise of the Joint Venture
Chapter 7 Responsibilities of Both Parties to the Joint Venture
Chapter 8 Transfer and Protection of Technologies
Chapter 9 Management on Technologies, Know-How and Patents
Chapter 10 Procurement and Sale of the Joint Venture
Chapter 11 The Board of Directors
Chapter 12 Business Management
Chapter 13 Labor Management
Chapter 14 Annual Operation Plan and Budget
Chapter 15 Taxation, Three Funds and Profit Distribution
Chapter 16 Financial Affairs and Accounting
Chapter 17 Bank Account and Foreign Exchange
Chapter 18 Confidential and Non-Competition Provisions
Chapter 19 The Term of the Joint Venture
Chapter 20 Early Termination
Chapter 21 Dissolution and Liquidation
Chapter 22 Liability for Breach of Contract
Chapter 23 Force Majeure
Chapter 24 Applicable Law
Chapter 25 Special Provisions
Chapter 26 Settlement of Disputes
Chapter 27 Language
Chapter 28 Effectiveness of the Contract and Miscellaneous

1

Chapter 1 General Provisions

This Sino-Foreign Equity Joint Venture Contract (the “Contract”) is made by and between Liaoning Coal Industry Group Co., Ltd. (“Party A”) and RAE Systems (Asia) Ltd. (“Party B”) through friendly negotiation:

WHEREAS,

1. Party A intends to cooperate closely and exclusively with Party B to run a manufacturing business of safety equipments for coal industry based on its existing subsidiaries like Fushun Plant of Safety Instruments for Coal Mines (“Safety Instruments Plant”) and its subsidiaries and Fushun Coal Mine Safety Instruments Co., Ltd. (“Safety Instruments Company”).

2. Party A will clear up its assets in Safety Instruments Company, Safety Instruments Plant and its subsidiaries, and upon confirmation of all of the good assets by both Parties, will form a “joint venture” with Party B.

3. Party A’s superior governing body, namely, the State-Owned Assets Supervision and Administration Committee of Liaoning Province, has acknowledged Party A’s authority and power to meet the two requirements above.

4. Party B intends to make investment in cash in the joint venture.

Based on the above, in accordance with the Law of the People’s Republic of China on Sino-Foreign Equity Joint Ventures, Implementing Rules of the People’s Republic of China on Sino-Foreign Equity Joint Ventures and other relevant regulations promulgated by Chinese government (the “Laws”), Party A and Party B have reached the agreement to jointly invest to establish RAE Coal Mine Safety Instruments (Fushun) Co., Ltd. (the “Joint Venture”) in the People’s Republic of China (“China”).

Article 1 Definition

Unless otherwise indicated, the following terms in this Contract shall have the meanings set forth below:

1. “Affiliated Company” (in terms of either Party) means any company, partnership, joint venture or other entities (not include the Joint Venture) controlling or controlled by the Party or under common control with the Party. Should any person or entity has direct or indirect authority to instruct or lead the management and policy-making of another person or entity, the former shall be deemed as “being controlling” the latter.

2. “Approval Authority” means the Ministry of Commerce of China or local authorities having legal authority to approve the Contract.

3. “Articles of Association” means the Articles of Association of the Joint Venture established on the date of the Contract by Party A and Party B, including the contents amended or restated from time to time by both Parties (see basic terms in Appendix 1 to the Contract).

4. “Business License” means the Business License of People’s Republic of China

2

to the Joint Venture issued by the governing body under the State Administration of Industry and Commerce (the “SAIC”).

5. “Confidential Information” means any technology, know-how, commercial secret, strategic business or market information, business forecast, confidential technique and other technique, data, formula, program, manual, design, sketch, photo, plan, drawing, specification, report, research, finding, non-patent invention and conception, and other information on production, packaging, usage, pricing, sale and marketing, designated as confidential information and offered by any Party or its Affiliated Companies to facilitate the establishment of the Joint Venture, the handling of the related issues and the launch and/or engagement of the business under the Contract or the business under other contracts related to the Contract, regardless of its nature of technology, engineering, operation, commerce or economy. However, the Confidential Information shall not include the information that was in the public domain currently or in the future with due authorization for publication, the information that the receiving Party could prove its possession prior to its obtaining thereof and the information that the receiving Party will obtain from other channels rather than directly or indirectly through the offering Party or any source that is under the confidentiality obligations to the offering Party.

6. “Effective Date” means the date on which the Approval Authority approves this Contract.

7. “Establishment Date” means the date on which the Business License of the Joint Venture is issued.

8. “Force Majeure” means any event beyond the reasonable control and avoidance of a Party, which was unforeseen, and as a result of which either party is unable to perform all of or part of its obligations under this Contract. .

9. “Management Personnel” means any one in a managerial and operational roles who is required to enter into a Employment Agreement for Key Employee with Party B.

10. “Report on Feasibility Study” means the feasibility study report prepared together by Party A and Party B (see Appendix 2 to the Contract).

Chapter 2 Parties to the Joint Venture and the Joint Venture

Article 2	The Parties to this Contract are as follows:
Party A:	Liaoning Coal Industry Group Co., Ltd.
	Place of Incorporation: China
	Registered Address: No. 13 Xiannongtan Rd. Shenhe District Shenyang City
	Legal Representative: Liu Shuyuan
	Position: Chairman

3

	Nationality: Chinese
Party B:	RAE Systems (Asia), Ltd.
	Place of Incorporation: Hong Kong, China
	Registered Address: Room 608,6/F Hong Leong Plaza, 33 Lok Yip Road, Fanling, New Territories, Hong Kong
	Legal Representative: Robert Chen
	Position: President and Chief Executive Officer
	Nationality: U.S.A.
Article 3	The Joint Venture

Name in Chinese:

Name in English: RAE Coal Mine Safety Instruments (Fushun) Co., Ltd.
Registered Address: No. 3, Binhe Rd., Fushun Economic Development Zone, Liaoning Province, China

Production Address: No. 39, Middle Xincheng Rd., Shuncheng District Fushun City, Liaoning Province, China before the construction of the new plant, which will be relocated to the registered address upon the completion of the construction of the new plant.

Article 4 The purpose of the Joint Venture is to strengthen economic cooperation and technical exchanges, to provide Chinese and overseas customers with high quality coal mine safety equipments and to bring in profits to each investor.

Article 5 The Joint Venture is a legal person of China. All of its activities shall be governed and protected by the laws, regulations and relevant rules and regulations of China. It shall also abide by all of the provisions of this Contract and the Articles of Association.

Article 6 The Joint Venture is a limited liability company. The liability of each party with respect to the Joint Venture shall be limited to its respective capital contribution required under this Contract, and the profits, risks and losses of the Joint Venture shall be shared by the Parties in proportion to their contributions to the registered capital.

Chapter 3 Representations and Warranties of the Parties

Article 7 Party A’s Representations

Party A has obtained all of the approvals, permits and authorizations necessary and has full power and authority to execute this Contract and other agreements to be executed under the Contract and perform its responsibilities and obligations hereunder

4

and thereunder; however, the Contract shall not come into effect until being finally approved by the State-Owned Assets Supervision and Administration Committee of Liaoning Province.

Article 8 Party A’s Warranties

1. Party A warrants that all of the assets it invests in the Joint Venture are free of any flaw and not claimed by any third party, and Party A will undertake any loss thus incurred.

(1) Upon the execution of the Contract, the Safety Instruments Company will complete clear-up of all of its assets and will put all of the good assets (as provided in Appendix 3 to the Contract) confirmed by Party A and Party B into the Joint Venture as Party A’s contribution to the Joint Venture;

(2) The Safety Instruments Plant under Party A and its subsidiaries and the Safety Instruments Company will terminate all of the labor contracts with their employees at least a month prior to the Joint Venture’s formal employment of employees. All of the liabilities to their employees shall have been discharged before the execution of this Contract, including social insurances (including but not limited to retirement pension plan, medical insurance, unemployment insurance and worker’s injury insurance), housing fund, income tax, accrued wage, tax, salary, commission and payments related to employee’s benefit plan etc.;

(3) Upon the effectiveness of this Contract, the Safety Instruments Plant and Safety Instruments Company shall cease all of the production and operation activities. If necessary, the [Safety Instruments Rescue Company] shall be terminated and shall finish the procedures for merging into the Joint Venture in three months after the Establishment Date of the Joint Venture.

2. Party A warrants that it will contribute all of the good assets to the Joint Venture. Party A will have the complete ownership of the assets it intends to contribute to the Joint Venture and shall has the right to transfer the assets. These assets are free of mortgage right, pledge and lien to any person or other creditors’ rights. Furthermore, they are under no risk of accusation or administrative disposal.

3. Party A warrants that the assets it will contribute to the Joint Venture meet the requirements as described below:

(1) Fixed Assets: Including but not limited to machinery equipments, vehicles and office articles etc. (see Appendix 3 to the Contract for details). Party A possesses the complete property rights of these fixed assets and they are free of mortgage right, pledge and lien of any type of nature or other creditors’ rights. Their conditions and ages are correct as described in the Appendix. They shall be kept in good and normal operation condition and maintained regularly, when delivered as its contribution.

(2) Inventories: All of the inventories have been stored in good condition according to relevent governing laws, regulations and rules of governments, validly certified, ready for sale, serves the purposes as expected, and meet the requirements

5

for normal operation both in quality and quantity.

(3) Receivables: Except the reserve for bad debts in normal operation, all of the receivables are true, which can be received in full amount in the course of normal operation (without any restrictions by any accusation, counterclaim or discount).

(4) Intangible assets: Intangible assets include invention, patent, trade mark, proposed trade mark, business name, copyright, industrial design, non-patent technology, name of enterprise, brand of enterprise, goodwill, qualification, market, certification mark, identifying appearance, style of enterprise and other intangible assets (regardless of the fact whether they have been registered).

Party A warrants that the Joint Venture possess all of the intangible assets to be invested and all of the applications related to them (including detailed information on the application of the registration of the intangible assets). All of these intangible assets do not involve infringement, and free and clear of all creditor’s rights or mortgage.

The intangible assets to be invested in the Joint Venture will be appraised by an appraisal institution agreed by both Parties, and shall be priced based on the Parties’ consultation.

(5) Party A warrants that there is no undisclosed losses with respect to the assets to be invested mentioned above.

(6) Party A warrants that all of the information it provided be correct and complete, free from any flaw, defect undiscovered by Party B or any possible economic loss.

Article 9 Before the Joint Venture relocates to its registered address, Party A will lease the operation premise of the Safety Instruments Plant to the Joint Venture as its operation premise. As the sole property owner of the premise, the Safety Instruments Plant herein warrants that it has never signed any document with any other party to lease, sublease, transfer or allow the use of the premise. The premise is free and clear of any mortgage, pledge, lien or other encumbrances to any person. The said assets are not under any risk of claim, arbitration or administrative proceedings.

Article 10 Party A warrants that its employees or its subsidiaries’ employees (excluding the Joint Venture) shall not directly or indirectly engage in businesses that are the same as or similar to the businesses of the Joint Venture. Unless being required by the Joint Venture, they will not involve in the said businesses in any manner.

Article 11 Party B’s Representations

Party B has obtained all of the approvals, permits and authorizations necessary and has full power and authority to execute the Contract and other agreements to be entered under the Contract and perform its responsibilities and obligations hereunder and thereunder; however, the Contract shall not come into effect until being approved by the State-Owned Assets Supervision and Administration Committee of Liaoning

6

Province.

Article 12 Party B’s Warranties

Should Party A implements its warranties hereunder, Party B shall inject funds into the Joint Venture as provided by the Contract.

Party B shall provide favorable price, when it transfers technologies to the Joint Venture as provided by the Contract.

Chapter 4 Total Amount of Investment and the Registered Capital

Article 13 The total amount of investment of the Joint Venture is expected to be RMB 250 million yuan, and the total investment for this term is RMB 120 million yuan.

Article 14 Investment contributed by the Parties is RMB 120 million yuan, which will be the registered capital of the Joint Venture.

     Of which:

     Party A shall contribute RMB 36 million Yuan, accounting for 30% of the registered capital; See the List of Assets (see Appendix 5 to the Contract) for details about Party A’s investment.

     Party B shall contribute RMB 84 million Yuan, accounting for 70% of the registered capital.

     Party B will contribute cash in US dollar as its investment. The exchange rate from RMB to US dollar shall be based on the exchange rate on the date of delivery (date of receipt) announced by the State Administration of Foreign Exchange.

Article 15 Should the value of the good assets invested by Party A in the Joint Venture exceeds RMB 36 million Yuan, as confirmed by both Parties, the Joint Venture shall purchase the portion that exceeds the value of RMB 36 million Yuan, by cash.

Article 16 Once the JV company is established, Party A should pay his 30% of capital contribution from the good assets immediately. Party B should pay his 20% capital injection of RMB16,800,000 yuan to the Joint Venture at the same time Party A’s contribution. The first capital injection date is expected to be December 20, 2006. Party B should pay his remaining 30% of capital of RMB25,200,000 yuan within 20 business days upon the compliance of relevant procedures with US Securities and Exchange Commission. The party B’s second capital injection date is expected to be April 15, 2007. The party B’s remaining 50% of capital of RMB42,000,000 yuan is expected to be made before the end of 2007.

Article 17 The Joint Venture’s capital account shall be the Bank of China, National Industrial and Commercial Bank of China, Construction Bank of China and Agriculture Bank of China or any other banks approved by Board of Directors. Both Party B’s investment in foreign currency and the Joint Venture’s income in foreign currency shall be deposited in the banks mentioned above. Party A shall help the Joint

7

Venture to exchange all of the foreign currencies into RMB in a timely manner to meet its demands for expenditures in China.

Article 18 After the Parties to the Joint Venture contribute their investment respectively, the Joint Venture shall engage qualified registered public accountant of China to verify their investments and to provide a verification report, issue an investment certificate respectively to each Party and file it with relevant government authorities in China.

Article 19 Party B shall not lose its status as the largest shareholder of the Joint Venture in three years as a result of transferring its equity in the Joint Venture. In case either Party to the Joint Venture intends to transfer all or part of its investment to a third party, prior consent shall be obtained from the other Party to the Joint Venture, and approval from the examination and approval authority is required. Should the other Party reject the transfer, it shall purchase the investment to be assigned; if such other Party fails to acquire the investment in given period, it shall be deemed that it has approved the transfer.

Article 20 The increase of the registered capital of the Joint Venture shall be approved by the Board of Directors and approved by relevant government authorities. After obtaining all of the approvals as required, the Joint Venture shall go through the registration procedure for increasing registered capital at relevant commerce and industry administration.

Chapter 5 Business Scope and Scale of the Joint Venture

Article 21 The business scope of the Joint Venture is: the manufacture of collective monitoring systems for safe production of coal mines, precaution testing instruments, a series of safety lamps, safety and rescuing instruments and equipment for coal mine safety and matching products, low-voltage power supply equipment for coal mines and comprehensive protective instruments, devices to draw and release gas, individual protection equipment and matching products; and the integration, development, design and technical consultations for network engineering, network systems and network software, installation and technical consultations for fire protection equipment, breathing apparatuses for medical use, pressure bottles, automatic resuscitators, oxygen forwarders, air compressors, oxygen filling pumps, fire escape devices, check meters for resuscitators and oxygen transmission devices, and training and simulation devices for fire protection and rescue drills.

Article 22 The development scale of the Joint Venture shall be subject to the provisions of the Feasibility Study Report of the Joint Venture.

The Board of Directors of the Joint Venture may adjust the development scale of the Joint Venture from time to time in its actual production and operation according to market demand, its ability to use related technologies, and other factors.

Chapter 6 Operation Premise of the Joint Venture

Article 23 The place of registration of the Joint Venture is No. 3, Binhe Rd., Fushun Economic Development Zone, Liaoning Province, China, and a plant will be built at the place of registration. During the construction period, the Joint Venture will rent all the existing plant buildings and equipments of the Safety Instruments Plant to

8

conduct the production and operation activities with the lease term ending till the Joint Venture has moved to the new business premises. The monthly rental is RMB200,000 yuan, which shall be borne by the Joint Venture. If the JV desires to terminate the rental contract, it shall notify Party A and the Safety Instruments Plant three months in advance.

Article 24 During the construction period after the establishment of the Joint Venture, Party A shall be responsible for coordinating with the related authorities to provide the land for the construction of the premises, the supporting civil works and the facilities such as water, power and heating supply with preferential conditions.

Article 25 In accordance with the relevant provisions of Chinese government, the land use fees arising from the new business premises self-built by the Joint Venture shall be borne by the Joint Venture.

Chapter 7 Responsibilities of Both Parties to the Joint Venture

Article 26 In addition to performing the responsibilities provided for in the other terms of this Contract, Party A shall perform the following obligations as well:

1.	Going through all the licenses, approvals, permits and registration formalities necessary for the operation of the Joint Venture;
2.	Guaranteeing the completeness of the business premises and equipments of the Joint Venture to secure the continuity of the operation;
3.	Designating the managers, management personnel, technical personnel and other working personnel with certain qualifications and actual working experience to undertake the work of the Joint Venture after being examined and confirmed by the Joint Venture;
4.	Ensuring the changes of various qualifications necessary for the Joint Venture;
5.	Assisting the Joint Venture to go through the formalities related to the foreign exchange, customs, industry and commerce and taxation necessary for conducting the business activities in accordance with the provisions of this Contract; and
6.	Assisting the Joint Venture to go through the possible tax reduction, tax rebate and tax exemption formalities.

Article 27 In addition to performing the responsibilities provided for in the other terms of this Contract, Party B shall perform the following responsibilities as well:

1.	Designating the excellent management personnel and technical personnel to participate in the management of the Joint Venture upon its request; and
2.	Assisting the Joint Venture to explore the overseas market outside China and introduce advanced foreign technologies and products.

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Chapter 8 Technology Transfer and Confidentiality

Article 28 The Joint Venture may execute a technology transfer agreement with Party A, Party B or any third party so as to obtain the advanced technologies, patents and know-hows necessary for achieving the operation purpose and the business scope and scale provided for in this Contract. The transfer price for the technology transfer between either Party A or Party B and the Joint Venture shall be determined on the basis of negotiation. The Joint Venture’s external selling of the know-hows or key technologies that were in the possession of Party A before the Joint Venture was established and were contributed into the Joint Venture afterwards shall be subject to the unanimous consent by the Board of Directors.

Article 29 The inventions, know-hows or patents obtained by the Joint Venture during its operation shall vest in the Joint Venture, and all the relevant information shall be independently kept by the Joint Venture.

Article 30 The confidentiality for the patents or know-hows obtained by the Joint Venture through the technology transfer agreement shall be handled in accordance with the provisions of the relevant transfer agreement executed between the Parties.

Article 31 Without the approval by the Joint Venture, neither Party to the Joint Venture may use the expertise in the possession of the Joint Venture. Should any Party to the Joint Venture intend to use such expertise of the Joint Venture, it must execute the technology transfer agreement with the Joint Venture and perform the confidentiality clause provided for in the agreement, and the Joint Venture will collect the technology use or transfer fees at a preferential price.

Article 32 The Parties to the Joint Venture shall request the personnel respectively designated by them to work in the Joint Venture to perform the confidentiality duties for the said expertise.

Chapter 9 Management of Technologies, Know-hows and Patents

Article 33 The ownership of the inventions, software or inventions or improvements of know-hows formed by the employees, subcontractors or agents of the Joint Venture when working for the Joint Venture shall vest in the Joint Venture, and the application for the intellectual property rights related hereto shall be made in the name of the Joint Venture.

Article 34 The intangible assets used by Party A for investment, such as the technological achievements, know-hows, patents, etc., shall be transferred to the Joint Venture upon the effectiveness of the Contract and be exclusively owned and used by the Joint Venture. The use of such intangible assets by any third party shall be subject to the approval by the Board of Directors of the Joint Venture.

Chapter 10 Procurement and Sale of the Joint Venture

Article 35 The raw materials and equipments needed by the Joint Venture shall be purchased in China on a priority basis. The Joint Venture shall strive for the same prices for its procurement inside China as enjoyed by the other enterprises in China, and the payment shall be made in RMB. Should the commodities procured in the

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Chinese market fail to meet the Joint Venture’s requirements (including but not limited to the price, quantity, quality, performance and usability), the Joint Venture may procure them from Party B at the preferential prices. However, in case that Party B’s price is higher than the price in the international market, the Joint Venture may make the procurement in the international market by itself. In case of the procurement in the international market, the Joint Venture shall inform Party B of the prices and conditions.

Article 36 The Joint Venture’s products may be sold inside or outside China by the Joint Venture and its subsidiaries or by both Parties to the Joint Venture or any third party as an agent based on due entrustment. Under the condition of competitiveness, the prices of the said products shall ensure the profitability of the Joint Venture’s operation. With the consent and guidance by Party B, the Joint Venture may sell Party B’s products, and ensure the profitability of the Joint Venture’s operation.

Chapter 11 The Board of Directors

Article 37 The date of registration of the Joint Venture shall be the date of the establishment of the Board of Directors of the Joint Venture. The highest authority of the Joint Venture shall be its Board of Directors. It shall decide all of major issues concerning the Joint Venture. Its major roles and authorities are set forth as below:

1.	making decisions on and approving important reports (like production plans, annual operation reports and capital plans etc.) prepared by managerial departments;
2.	approving annual financial statements, income and expenditure budgets and schemes of annual profit distribution;
3.	approving the major rules and regulations of the Company;
4.	concluding labor contracts;
5.	making decisions on establishing subsidiaries;
6.	discussing and approving amendments to the Articles of Association of the Joint Venture;
7.	discussing and making decisions on issues related to the suspension or termination of the Joint Venture and its merging with another economic organization;
8.	making decisions on engaging senior management like the General Manager, Deputy General Manager, Chief Engineering, Chief Accountant and auditor etc.;
9.	taking charge of the liquidation of the Joint Venture at the moment of its termination and expiration;
10.	dealing with other important issues subject to the decision(s) of the Board of Directors.

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Article 38 The Board of Directors is composed of 7 directors, of which 2 shall be appointed by Party A, 5 by Party B. The Chairman of the Board shall be appointed by Party B, and its Vice-Chairman by Party A. The term of office for the directors, Chairman and Vice-Chairman is four years, and their term of office may be renewed if continuously appointed by the relevant Party.

Article 39 The Chairman of the Board is the legal representative of the Joint Venture.

The Chairman of the Board is empowered to:

1.	convene and preside meetings of the Board;
2.	supervise the implementation of the Board’s resolutions;
3.	issue the certificate of investment in the Joint Venture;
4.	sign and approve the Board’s documents and other documents to be signed by the legal representative;
5.	exercise other rights authorized by the Board of Directors.

Should the Chairman be unable to exercise his responsibilities for any reason, he/she may temporarily authorize the Vice-Chairman as the representative.

Article 40 Any director of the Board may entrust another person to attend the Board meeting and excise the director’s rights on his/her behalf. In such condition, a power of attorney shall be submitted to the Board.

Article 41 Each director shall have one vote and any decision shall be approved by the majority of the directors attending the meeting in person or by proxy. However, major matters shall be approved by all of the directors unanimously either in person or in proxy. Major matters include the following:

1.	amendment to any term of the Article of Association of the Joint Venture;
2.	termination and dissolution of the Joint Venture;
3.	increase or assignment of the registered capital of the Joint Venture;
4.	a merge with or separation from the Joint Venture;
5.	the profit distribution scheme of the Joint Venture;
6.	any conclusion of a contract with the contract price over RMB 5 million yuan by either Party to the Joint Venture or its associated person(s);
7.	any establishment or revocation of any subsidiary or branch of the Joint Venture;
8.	any significant investment or financing by the Joint Venture.

Article 42 Approval by a one-half majority of the Board is required for decision(s)

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on the following issues:

1.	the engagement, dismissal, remuneration and bonuses of the General Manager, Deputy General Manager, Chief Engineer, Chief Accountant and Chief Officer of Human Resources of the Joint Venture;
2.	decisions on the budget of, or approval of the final accounts of, the Joint Venture;
3.	any change of the business scope of the Joint Venture;
4.	establishment of the managerial organization, structure and key rules and regulations of the Joint Venture.

Article 43 The Board of Directors shall convene and hold meetings at least once each 6-month period. The Chairman of the Board shall convene and preside over each meeting of the Board. Should the Chairman be unable to convene or preside over any meeting of the Board, then the Vice-Chairman shall convene or hold the relevant Board meeting. The Board shall also have an interim meeting of the Board if requested to do so by the Chairman or at least one-third (1/3) of the Directors when necessary, in special circumstances.

The attendance of more than two-third of directors is required to convene a Board’s meeting.

Board’s meeting is usually held at the registered address of the Joint Venture and may be convened at other places as decided by the Board.

Notice on Board’s meeting shall be made by fax and E-mail etc. to inform specific meeting agenda, date and place of the meeting. All of the meetings shall have written records, which shall be signed and confirmed by the directors attending the meetings.

Chapter 12 Business Management

Article 44 The Joint Venture shall adopt a management system under which the General Manger shall be responsible, and shall be supervised by the Board of Directors. The joint Venture shall have one General Manager and several Deputy General Managers, nominated by Party A and Party B; Chief Accountant and Chief Officer of Human Resource shall be nominated by Party B. These managerial officers whose terms of office shall be 4 years, and shall be appointed by the Board of Directors and may be reappointed upon the Board’s approval. The employment terms shall be governed by the employment agreement.

Article 45 The responsibility of the General Manager is to carry out the decisions of the Board and organize and conduct the daily operation and management of the Joint Venture. The Deputy General Managers shall assist the General Manager in his work.

Several department managers may be established under the management office. The department managers shall be responsible for the work in various departments of the Joint Venture respectively, handle the matters handed over by the General Manager and Deputy General Managers and shall be responsible to them. Department

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managers shall be appointed by the General Manager.

Article 46 In the case of grave or serious derelictions of duty, failure or inability to perform the duties of, or to run the Joint Venture successfully, on the part of the General Manager, Deputy General Managers, Chief Accountant and Chief Officer of Human Resources, the Board of Directors shall have the authority and power to replace any such officer at any time.

Article 47 Each key Employee of the Joint Venture shall enter into an Employment Agreement forKey Employee (See Appendix 4 to the Contract) with the Joint Venture to set forth the rights and obligations of the key employee and the Joint Venture.

Chapter 13 Labor Management

Article 48 In the first recruitment of employees of the Joint Venture, Party A shall enjoy the priority to recommend candidate for the Joint Venture, who may be employed by the Joint Venture once they pass the examination organized by the Joint Venture. The Joint Venture shall work together with Party A and Party B to select, examine and recruit employees. When conducting recruitment activities on the date of its establishment, the Joint Venture shall give a priority to Party A’s employees, and the number of Party A’s employees employed by the Joint Venture shall not be less than 90% of the the number of formal employees (see Appendix 6) of the Safety Instruments Plant as of October 31, 2006.

Article 49 The employment, dismissal and resignation of the staff and workers of the Joint Venture, and their salary, welfare, labor insurance, labor protection, labor discipline and other matters shall be decided by the Board of Directors and then covered in labor contracts between the staff and the Joint Venture in compliance with “Regulations of the People’s Republic of China on Labor Management in Joint Ventures Using Chinese and Foreign Investment” and its implementation rules.

Article 50 The employment, wages, social insurance, welfare, standard of business traveling costs and other matters concerning the senior administrative personnel recommended by Party A and Party B shall be subject to the discussion and decision of the Board of Directors.

Article 51 The administrative personnel and staff of the Joint Venture are not allowed to receive sideline appointment directly or indirectly from companies other than the Joint Venture with a view to conducting operation activities of any nature.

Chapter 14 Annual Operation Plan and Budget

Article 34 The General Manager shall be responsible for preparing an annual operation plan and budget of the Joint Venture. The annual operation plan and budget of the Joint Venture for the coming financial year shall be submitted to the Board of Directors for examination and approval before November 1 of each year.

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Article 35 The Board of Directors shall complete the examination and approval of the annual operation plan and budget for the next year before December 31 of each year. The General Manager shall be responsible for carrying out the annual operation plan and budget approved by the Board.

Chapter 15 Taxation, Three Funds and Profit distribution

Article 54 The Joint Venture shall pay taxes in accordance with the provisions of Chinese laws and other relative regulations. The Parties shall use their best effort to obtain the benefits of tax deduction and exemption.

Article 55 Besides reserves used to fill up all of the accumulated losses of previous years and perform tax obligations according to related laws and regulations of China, allocation to the reserve funds, the enterprise development funds, and bonuses and welfare funds for staff and workers shall be set aside by the Company. The annual proportion of allocations shall be decided by the Board of Directors in accordance with Chinese law and the financial situation of the Joint Venture.

Article 56 After performing tax obligations required and setting aside the three funds, the Joint Venture shall declare the balance of its profit as distributable dividend to Party A and Party B. Within three months following each fiscal year, the General Manager shall propose a profit distribution plan to the Board of Directors for its reference, approval or amendment. While drafting the plan, the General Manager shall take into account whether the Joint Venture has enough funds to pay the dividends planned while meeting the demands of the capital expenditures of the annual budget and cash flow that has been approved for current budget year. No profit shall be distributed before all of the losses of pervious fiscal years are filled up. Undistributed profits of previous years may be distributed together with current year’s profits and the Board of Directors may approve the distribution of undistributed profits of pervious years at any time.

Article 57 The distributable profits shall be distributed according to the proportion of each Party’s respective shares of the registered capital at the time of the distribution. Dividend allocated to Party B shall be paid in US dollar in accordance with governing laws of China. The payment shall be exchanged from RMB to US dollar at the rate announced by People’s Bank of China on the declaration date.

Chapter 16 Financial Affairs and Accounting

Article 58 The finance and accounting system and foreign exchange management of the Joint Venture shall be handled in accordance with relevant laws and regulations of the People’s Republic of China. The Chief Accountant is responsible for managing the finance of the Joint Venture.

Article 59 The accounting of the Joint Venture shall adopt the internationally used accrual basis and debit and credit accounting system in their work. All of the vouchers, receipts, accounting statements and reports, accounting books shall be written in Chinese and English according to the requirements of the Joint Venture. Its income and expenditure in RMB and US dollar shall be recorded separately and unified in RMB for accounting purpose. The fiscal year of the Joint Venture shall be from January 1 to December 31 in each calendar year.

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Article 60 For the purpose of monitoring the financial condition of the Joint Venture, both Parties to the Joint Venture reserve the rights to examine and duplicate any and all necessary or related accounting books, records, receipts, agreements and documents. Each Party may examine or copy materials required during the normal working hours of the Joint Venture, but unreasonable disturbance of the business and operation of the Joint Venture is not allowed. Either Party may exercise the aforesaid rights by its agent, employee or the independent accounting firm appointed by the Party.

Article 61 The Joint Venture is obliged to prepare the following statements and provide them to both Party A and Party B:

1.	In the first five days after the end of each fiscal year, the Joint Venture shall prepare and provide the balance sheet as of the fiscal year and the profit and loss statement and statement of cash flow of the fiscal year that has just ended before they are audited.
2.	In the first five days after the end of each fiscal quarter, the Joint Venture shall prepare and provide the balance sheet as of the fiscal quarter and the profit and loss statement (of the quarter and current year) before they are audited.
3.	In the first five days after the end of each month, the Joint Venture shall prepare and provide the profit and loss statement of the month and report on the financial results estimated for the coming period of current fiscal quarter, including but not limited to the number of staff, revenue, balance of cash and expenditure.
4.	Should the Joint Venture fails to provide the said statements and reports on time, it shall arrange schedule to provide the statements and reports after their expiration.

Article 62 Upon approval of the Board, the Joint Venture may invite an accounting firm accepted by both Parties to undertake its audit matters and to report the auditing results to the Board and General Manager.

Either Party of the Joint Venture has the right to appoint independently on its behalf and at its expense an accountant, to audit the operation of the Joint Venture twice a year. The Joint Venture shall cooperation on the audit.

Chapter 17 Bank Account and Foreign Exchange

Article 63 The Joint Venture shall open RMB accounts and foreign exchange accounts at banks permitted to engage such business in China. The Joint Venture’s procedure to issue checks is subject to the decision of the Board of Directors. With the approval of related governmental authorities, the Joint Venture may also open foreign exchange accounts at overseas banks appointed by the Board.

Article 64 All of the income of the Joint Venture in foreign currency shall be deposited to its foreign exchange accounts and all of its payment in foreign currency shall be remitted from its foreign exchange accounts.

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Chapter 18 Confidential and Non-Competition Provisions

Article 65 Both Parties acknowledge and agree that it is unavoidable for either Party to disclose the Confidential Information while performing its obligations in accordance with the Contract and other agreements and documents required to be executed by the Parties under the Contract. Each Party may only use the confidential information solely for the prescribed purposes in accordance with the Contract and other agreements or documents required to be executed by the Parties under the Contract. Without the advanced written permit of the Party providing the Confidential Information, the receiving Party shall not disclose the Confidential Information to any third party. However, if it is necessary for either Party to provide the Confidential Information it has received to any of its Affiliated Companies in the course of performing any of its obligations under the Contract, the Articles of Association, or other agreements or documents stipulated by the Contract, it shall have the right to disclose the Confidential Information to the Affiliated Company upon conclusion of a confidential agreement between the latter and the Party providing the Confidential Information.

The confidential obligation of this Article shall continue to be effective in the term of the Joint Venture and for five years after the termination of the Contract.

Article 66 After the establishment of the Joint Venture, Party A and its affiliated enterprises guarantee that they shall cease to engage in any business similar or competitive to the business of the Joint Venture or to be involved in any of such business in any manner, unless with the approval of the Board of Directors of the Joint Venture.

Chapter 19 The Term of the Joint Venture

Article 67 The term of the Joint Venture is 50 years, commencing on the date of issuance of the business license of the Joint Venture.

Article 68 If both Parties agree to extend the term of the Joint Venture, a written application shall be submitted to the Approval Authority six months prior to the expiry date of the term of the Joint Venture upon resolution of the meeting of the Board of Directors. With the approval of the Approval Authority, the term may be extended and the formalities for alteration of registration shall be completed with the authority in charge of administration for industry and commerce.

Chapter 20 Early Termination

Article 69 This Contract may be terminated prior to its expiration under any of the following circumstances:

1.	If either Party is ordered by any pertinent governmental authority to suspend operation, is dissolved for liquidation, or goes bankrupt, such Party shall have the right to terminate this Contract by serving a termination notice;
2.	If either Party is in serious breach of this Contract or the Articles of Association, rendering the Joint Venture unable to continue its

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	operations or to realize the operation goals stipulated hereunder, then the performing Party shall have the right to terminate this Contract by serving a termination notice;
3.	If both Party A and Party B agree that the termination of the operation of the Joint Venture is to the greatest interests of both Parties, the operation of the Joint Venture may be early terminated; the early termination of the operation of the Joint Venture requires the unanimous approval of the Board of Directors and the approval of the Approval Authority originally approving this Contract;
4.	If an event of Force Majeure prevails for more than 90 days, rendering the Joint Venture unable to continue its operations, then, with the unanimous approval of the Board of Directors and the approval of the Approval Authority originally approving the Contract, the Joint Venture may be early dissolved.

Chapter 21 Dissolution and Liquidation

Article 70 Should the term of the Joint Venture not be extended upon expiration of thereof, or should it be early terminated and dissolved, the Board of Directors shall form a liquidation committee to propose the liquidation procedures.

Article 71 The assets of the Joint Venture shall be liquidated based on their book values as of the time of liquidation. The cash assets shall be distributed in cash. Other assets, including receivables, shall be exchanged into cash at the highest prices available in Chinese or international markets. After all debts are discharged, the liquidation assets shall be distributed to Party A and Party B in proportion to their investments in the Joint Venture. The Joint Venture shall remit the distribution to the deposit bank of each Party immediately upon the completion of assets distribution. The patented technologies of the Joint Venture shall be evaluated by the evaluation organization appointed by the liquidation committee and sold out, and the income from the sale shall be distributed to each Party according to the proportion of its investment in the Joint Venture.

Article 72 If the Joint Venture is still in possession of any asset or any product in any of its distribution regions at the time of termination of the Contract, the Parties may purchase such asset or product at a price no more than its cost of purchase and agreed by the Joint Venture and the income generated therefrom shall be deemed as liquidation asset.

Article 73 Articles 71 and 72 shall be applicable upon termination of the Contract, and either Party shall have the preemptive right to purchase the assets distributed to the other Party in the liquidation.

Article 74 Upon the completion of the liquidation and effective dissolution of the Joint Venture, a written document shall be executed by the duly authorized representatives of Party A and Party B for termination of the Contract, the Articles of Association, and all other agreements stipulated by this Contract.

Chapter 22 Liability for Breach of Contract

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Article 75 If either Party fails to perform any of its obligations provided by the Contract or the Articles of Association other than as a result of an event of Force Majeure, or any representation or warranty made by either Party hereunder is false or inaccurate, such Party shall be deemed to be in breach of this Contract.

Article 76 If a Party is in breach of this Contract, it is liable to indemnify and hold harmless the Joint Venture against any and all expenses, costs, liabilities or losses (including but not limited to profit loss) incurred by the Joint Venture as a result of the breach.

Article 77 If a Party is in breach of this Contract, it is liable to indemnify and hold harmless the performing Party against any and all expenses, costs, liabilities or losses (including but not limited to profit loss) incurred by the performing Party as a result of the breach.

Article 78 If a Party is in serious breach of any of the terms of the Contract or the Articles of Association for any reason other than an event of Force Majeure, thereby rendering the Joint Venture unable to continue its operations or to realize the operation goals set forth hereunder, such breach shall constitute a material breach. Under such condition, the other Party shall have the right to terminate the Contract according to the provisions hereof in addition to its right to claim for compensation from the breaching Party. Should both Parties still intend to continue the operations of the Joint Venture, the breaching Party shall compensate the economic losses of the Joint Venture.

Article 79 Either Party in breach of this Contract shall indemnify the other Party for all the economic losses. The breaching Party shall use its investment (equity) in the Joint Venture as a security for its liability for indemnification.

Article 80 In case both Parties are in breach of this Contract, each Party shall undertake its own breaching liabilities attributable to it.

Chapter 23 Force Majeure

Article 81 In the event that the performance of this Contract is directly affected by, or this Contract is unable to be performed as agreed due to, an earthquake, typhoon, flood, fire, war or other event of Force Majeure which are unforeseeable and of which the occurrence and consequences are unpreventable and unavoidable, the Party sustaining such Force Majeure shall notify the other party by telegram without any delay, and, within 15 days, provide to the other Party with the detailed information of the event and a valid written evidence showing the damage or impact to the operations of the Joint Venture. Both Parties shall, through consultations, decide whether to dissolve the Joint Venture or to partially exempt or temporarily defer the business operations of the Joint Venture, or to cease the business operations of the Joint Venture, according to the degree of damage or impact of the event to the Joint Venture.

Chapter 24 Applicable Law

Article 82 The formation, validity, interpretation, and execution of this Contract and the settlement of disputes in respect of this Contract shall be governed by the laws

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of the People’s Republic of China. Where Chinese laws are silent on any particular matter, reference shall be made to general international practices.

Chapter 25 Special Provisions

Article 83 Both Parties agree that, after the formal establishment of the Joint Venture, the good assets confirmed by both Parties and in excess of the amount of capital contribution of made by Party A shall be purchased with cash in the name of the Joint Venture. The agreement of trade price (Appendix 7) shall be signed and come into effect together with this Contract. The Joint Venture shall complete the purchase of the good tangible assets of Fushun Safety Instruments and Rescue Company within three months at the price to be negotiated based on the results of asset evaluation (the assets of Fushun Safety Instruments and Rescue Company are not covered by the deal hereunder.) After Party A’s receivables are transferred to the Joint Venture after the evaluation, the Joint Venture is liable for any and all the costs arising from collecting the receivables.

Article 84 If any of the terms of the Contract cannot be executed partially or fully due to the amendments of the relevant laws and rules of the Chinese government or American government or the change of said governments, the Party affected shall inform the other Party immediately and provide related documents for its reference.

In case of the occurrence of the aforesaid situation, both Parties shall amend the Contract accordingly through negotiation for keeping each Party free from any loss. Should either Party refuse to make such amendment, the other Party shall have the right to terminate the Contract according to Article 69 of this Contract, provided that it shall give a written notice to the other Party 30 days in advance.

Article 85 Both Parties agree that the consideration for all of Party A’s good assets (including fixed assets, intangible assets, receivables, and inventories) is confirmed to be RMB 66,660,000 Yuan (based on the valuation cut-off date of Oct. 31, 2006). Apart from the capital contribution of RMB 36,000,000 Yuan, the remaining balance of the good assets with a value of RMB 30,660,000 Yuan shall be purchased by the Joint Venture from Party A.

Chapter 26 Settlement of Disputes

Article 86 Any dispute arising in the performance of this Contract shall be settled through consultations between both Parties. In case no settlement can be reached through consultations in 60 days, the dispute shall be submitted to China International Economic and Trade Arbitration Commission for arbitration in accordance with its Arbitration Rules. The arbitral award is final. During the arbitration, the Contract shall continue to be performed by both Parties except for the matters in dispute.

Chapter 27 Language

Article 87 The Contract shall be written in Chinese and English. Both language versions are equally authentic. In the event of any discrepancy between the two aforementioned versions, the Chinese version shall prevail.

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Chapter 28 Effectiveness of the Contract and Miscellaneous

Article 88 The Safety Instruments Plant is responsible for confirming this Contract (see Appendix 5 to the Contract for details), and guarantees to perform the obligations hereunder relating to it.

Article 89 This Contract, including the agenda, documents and lists appended hereto, shall only come into effect after signed by the representatives authorized by both Parties and approved by the relevant authorities of China.

Article 90 The Appendices hereto are an integral part of this Contract and are equally effective with this Contract.

Article 91 Any amendment to the Contract and its appendices shall be made based on a writing agreement signed by both Parties, which shall only come into effect after approved by the authority originally approving this Contract.

Article 92 Notice from either Party to the other can be sent by telex or e-mail etc. Where a notice involves the material rights or obligations of the Parties, it shall also be served with a written document simultaneously. In case of mailed notice, post-paid registered airmail shall be used.

The legal addresses of Party A and Party B listed in this Contract shall be the addresses for notice.

Article 93 The Contract is signed in both English and Chinese versions in Shenyang, China by the authorized representatives of both Parties on December 10, 2006.

Article 94 The effective term of the Contract coincides with the term of the Joint Venture.

Article 95 The Contract comes into effect after both Parties set their hands and seals on it. This Contract shall have 4 counterparts, two of which shall be held by each Party.

Appendix 1 Articles of Association

Appendix 2 Report on Feasibility Study

Appendix 3 List of Assets Invested by Party A

Appendix 4 Employment Agreement for Key Employee

Appendix 5 Letter of Confirmation from Fushun Safety Instruments Plant

Appendix 6 Roster of Staff of Fushun Safety Instruments Plant (as of Oct. 31, 2006)

Appendix 7 Price List of Assets

Appendix 8 US GAAP Report for SEC Filing

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Signature Page:

Signature & Seal:

Party A: Liaoning Coal Industry Group Co., Ltd.

Legal Representative:

December 10, 2006

Party B: RAE Systems (Asia) Ltd.

Legal Representative:

December 10, 2006

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EX-21.1

EXHIBIT 21.1

Subsidiaries of the Registrant

RAE Systems Inc, a California corporation

RAE Systems (Asia) Limited, incorporated in Hong Kong

RAE Systems (Hong Kong) Limited, incorporated in Hong Kong

RAE Systems Europe ApS, incorporated in Denmark

RAE United Kingdom Limited, incorporated in the United Kingdom

S.A.R.L RAE France, incorporated in France

RAE Systems (Shanghai) Incorporated, incorporated in the Jiading District of Shanghai

RAE-KLH (Beijing) Co., Limited, incorporated in Beijing

RAE Coal Mine Safety Instrument (Fushun) Co., Limited, incorporated in Fushun, China

EX-23.1

EXHIBIT 23.1

Consent of Independent Registered Public Accounting Firm

RAE Systems Inc.
San Jose, California

We hereby consent to the incorporation by reference in the Registration Statements on Form S-3 (Nos. 333-113437 and 333-109840) and Form S-8 (Nos. 333-105368, 333-88684, 333-85720, and 333-32678) of RAE Systems Inc. of our reports dated March 16, 2007, relating to the consolidated financial statements of RAE Systems Inc. and the effectiveness of RAE Systems Inc.’s internal control over financial reporting, which appear in this Annual Report on Form 10-K.

/s/ BDO SEIDMAN, LLP

BDO Seidman, LLP
San Jose, California
March 16, 2007

EX-31.1

EXHIBIT 31.1

CERTIFICATIONS

I, Robert I. Chen, certify that:

1. I have reviewed this annual report on Form 10-K of RAE Systems Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)	Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
(c)	Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d)	Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b)	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 16, 2007

/s/ Robert I. Chen

Robert I. Chen

President, Chief Executive Officer

and Chairman of the Board

EX-31.2

EXHIBIT 31.2

CERTIFICATIONS

I, Randall Gausman, certify that:

1. I have reviewed this annual report on Form 10-K of RAE Systems Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)	Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
(c)	Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d)	Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b)	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 16, 2007

/s/ Randall Gausman

Randall Gausman

Vice President and Chief Financial Officer

EX-32.1

EXHIBIT 32.1

CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

     In connection with the Annual Report of RAE Systems Inc. (the “Company”) on Form 10-K for the year ended December 31, 2006, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Robert I. Chen, President, Chief Executive Officer and Chairman of the Board of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (“Section 906”), that:

(1)	The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78m); and
(2)	The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

	/s/ Robert I. Chen
Date: March 16, 2007	Robert I. Chen President, Chief Executive Officer and Chairman of the Board

     A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.

EX-32.2

EXHIBIT 32.2

CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

     In connection with the Annual Report of RAE Systems Inc. (the “Company”) on Form 10-K for the year ended December 31, 2006, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Randall Gausman, Vice President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (“Section 906”), that:

(1) The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78m); and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

	/s/ Randall Gausman
Date: March 16, 2007	Randall Gausman Vice President and Chief Financial Officer

     A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.