10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2007

OR

¨ 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: 000-51071

ORANGE 21 INC.

(Exact name of registrant as specified in its charter)

Delaware	33-0580186
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
2070 Las Palmas Drive, Carlsbad, CA 92011	(760) 804-8420
(Address of principal executive offices)	(Registrant’s telephone number, including area code)

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

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

Common Stock, par value $0.0001 per share

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

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

Indicate by check mark whether the registrant (1) has filed all reports required 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. x

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) 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. x

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

Large accelerated filer ¨	Accelerated filer ¨
Non-accelerated filer ¨	Smaller reporting company x

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

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant computed by reference to the closing price as reported on the NASDAQ Global Market on June 30, 2007 was $45,215,000. As of March 10, 2008, there were 8,164,312 shares of Common Stock, par value $0.0001 per share, issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Items 10, 11, 12, 13 and 14 of Part III incorporate by reference information from the registrant’s proxy statement to be filed with the Securities and Exchange Commission in connection with the solicitation of proxies for the registrant’s 2008 Annual Meeting of Stockholders.

ORANGE 21 INC. AND SUBSIDIARIES

TABLE OF CONTENTS

2007 FORM 10-K

PART I		1
	Item 1. Business	1
	Item 1A. Risk Factors	14
	Item 1B. Unresolved Staff Comments	25
	Item 2. Properties	25
	Item 3. Legal Proceedings	25
	Item 4. Submission of Matters to a Vote of Security Holders	25
PART II		26
	Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	26
	Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
	Item 8. Financial Statements and Supplementary Data	38
	Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure	86
	Item 9A. Controls and Procedures	86
	Item 9B. Other Information	88
PART III		89
	Item 10. Directors, Executive Officers and Corporate Governance	89
	Item 11. Executive Compensation	89
	Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters	89
	Item 13. Certain Relationships and Related Transactions, Director Independence	89
	Item 14. Principal Accounting Fees and Services	89
PART IV		90
	Item 15. Exhibits, Financial Statement Schedules	90

EXPLANATORY NOTE ABOUT RESTATEMENT

We have restated herein our consolidated financial statements for the fiscal year ended December 31, 2006 and our consolidated financial information for each of the three, six and nine months ended March 31, June 30 and September 30, 2006 and 2007, respectively, to correct errors in such consolidated financial statements and financial information. These errors were attributable principally to the following material weaknesses in internal control over financial reporting that we identified as existing as of December 31, 2007:

• An appropriate review of the open purchase orders and goods/services received but not invoiced was not being performed timely or thoroughly at the company’s Italian subsidiary, Spy, S.r.l.

• A proper search for unrecorded liabilities was not being conducted at Spy, S.r.l.

• A calculation to determine appropriate inventory costs had not been performed on an accurate or timely basis at the company and at Spy, S.r.l.

We have remediated these material weakness subsequent to the fiscal year end. The restatement adjustments also include previously identified errors which were not initially corrected in the respective years based on materiality. More information regarding the impact of the restatements on our consolidated financial statements for fiscal year 2006 is disclosed in Note 2 to the Consolidated Financial Statements, and the impact of the restatements on our consolidated financial information for the interim periods of fiscal years 2007 and 2006 is disclosed in Note 17 to the Consolidated Financial Statements.

PART I

Item 1. Business

Overview

We own various trademarks and trade names used in our business, such as Spy, SpyOptic, Eye Spy, Windows for your head, Scoop, Delta Photochromatic, Dri Force, ARC, a Trident Design, Plus System, Gemini, Mosaic, Isotron, Espion, and a Cross Design; and our unregistered or pending marks include, but are not limited to: Spy (various), Selectron, Zed, Apollo, Haymaker, Hielo, Prodigus Metal Alloy, Bias, Logan, HSX, MC2, SpyOptic, Decker, Double Decker, Viente, a “triangle with cross” design, a “cross with bar” design, and a “cross” design. Other trademarks referenced herein are the property of their respective owners.

We design, develop and market premium products for the action sports, motorsports and youth lifestyle markets. Our principal products, sunglasses and goggles, are marketed primarily under the brands, Spy™ and SpyOptic™. These products target the action sport and power sports markets, including surfing, skateboarding, snowboarding, ski, motocross, and the youth lifestyle market within fashion, music and entertainment. We have built our Spy^® brand by developing innovative, proprietary products that utilize high-quality materials and optical lens technology to convey performance, style, quality and value. We sell our products in approximately 3,300 retail locations in the United States and Canada and internationally through approximately 2,000 retail locations serviced by us and our international distributors. We have developed strong relationships with key multi-store action sport and youth lifestyle retailers in the United States, such as Cycle Gear, Inc., No Fear, Inc., Pacific Sunwear of California, Inc., Tilly’s Clothing, Shoes & Accessories and Zumiez, Inc., and a strategically selective collection of specialized surf, skate, snow and motocross stores.

We focus our marketing and sales efforts on the action sports, motorsports, and youth lifestyle markets, and specifically, persons ranging in age from 17 to 35. We separate our eyewear products into two groups: sunglasses, which includes fashion, performance sport and women-specific sunglasses, and goggles, which includes snowsport and motocross goggles. In addition, we sell branded sunglass and goggle accessories. In managing our business, we are particularly focused on ensuring that our product designs are keyed to current trends in the fashion industry, incorporate the most advanced technologies to enhance performance and provide value to our target market.

We began as a grassroots brand in Southern California and entered the action sports and youth lifestyle markets with innovative and performance-driven products and an authentic connection to the action sports and youth lifestyle markets under the Spy Optic™ brand. We have two wholly owned subsidiaries incorporated in Italy, Spy Optic, S.r.l. and LEM (our primary manufacturer which we acquired on January 16, 2006), and a wholly owned subsidiary incorporated in California, Spy Optic, Inc., which we consolidate in our financial statements. We were incorporated as Sports Colors, Inc. in California in August 1992. From August 1992 to April 1994, we had no operations. In April 1994, we changed our name to Spy Optic, Inc. In November 2004, we reincorporated in Delaware and changed our name to Orange 21 Inc.

The information contained in, or that can be accessed through, our website is not a part of this Annual Report. References in this Annual Report to “we,” “our,” “us” and “Orange 21” refer to Orange 21 Inc. and our consolidated subsidiaries, Spy Optic, S.r.l., LEM and Spy Optic, Inc., except where it is made clear that the term means only the parent company.

Target Market

We focus our marketing and sales efforts on the action sports, motorsports, snowsports and youth lifestyle markets, and specifically, persons ranging in age from 17 to 35. Individuals born between approximately 1978 and 1994, more commonly referred to as Generation Y, represent the core of this target demographic. Generation

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Y is a powerful demographic supported by solid growth and spending power. Comprising more than 73 million people within the United States, or nearly 26% of the U.S. population, Generation Y represents the second largest demographic next to the Baby Boomer generation. The U.S. Census Bureau estimates that Generation Y will represent as much as 41% of the U.S. population by the end of the decade. Annual spending in this age group has climbed nearly 61% since 1995, reaching approximately $175 billion in 2003, with direct (i.e., our consumer) and indirect (i.e., the parents of our consumers) purchasing power that is estimated to exceed $650 billion annually by the end of the decade. We believe this combination of Generation Y’s youth and purchasing power has made it a powerful driver of trends in fashion, music and sports.

We have initially targeted the action sports and youth lifestyle markets due to their popularity with Generation Y and the need for premium quality, high performance eyewear in these markets. We believe the nexus between Generation Y and action sports generates tremendous crossover appeal between sport and fashion in our target demographic, members of Generation Y who are seeking premium quality eyewear products. The need for high performance eyewear products within action sports and the influence of the athletes in such action sports has fueled our growth and led to strong appeal for our products and brand recognition. We have leveraged this success into expanding our product lines into fashion forward designs for the youth lifestyle market.

As the action sports markets have grown and aged, we have broadened our core audience. While these sports were in their infancy twenty years ago and unknown to many parents, today they are accepted sports that are entering the mainstream. In fact, action sports like snowboarding and BMX have entered the Olympics, while traditional mainstream sports like baseball are being removed. While we market exclusively to the younger end of the demographic, many of our customers from a decade ago have stayed with the brand and begun to raise the age of our customer base.

Business Strategy

Our long-term goal is to capitalize on the strengths of our growing consumer brand by providing consumers with stylish, high-quality, performance-driven products. We seek to differentiate our brand by offering diverse product lines that emphasize authenticity, functionality, quality and comfort. In pursuit of this goal, we are pursuing the following operating and growth strategies that provide the framework for our future growth, while maintaining the quality and integrity of our brand.

Operating Strategy

• Drive Product Demand Through Premium Quality and Innovative Design.    We believe our reputation for premium quality, innovation and technical leadership distinguishes our products from those of our competitors and provides us with significant competitive advantages. Our sunglasses are forged from materials such as grilamid, propionate and acetate, which we believe are superior to the materials used by many of our competitors. These materials provide product characteristics such as flexible sport frames, more comfortable fashion frames and, in the case of acetate, allow us to hand cut and polish our fashion frames. Our use of hand painting techniques and specialized trims, including metal logos, hinges and temple plates, create unique premium sunglasses and goggles. We intend to continue developing innovative styles and products in order to preserve and strengthen our leadership position as having a progressive action sports and youth lifestyle brand.

• Sustain Brand Authenticity.    To sustain the authenticity of our Spy^® brand, our grassroots marketing programs feature advertising in action sports and youth lifestyle media at a global level, participation in and sponsorship of hundreds of events annually and sponsorship of action sports athletes. Our advertising campaign, found in print media such as Surfer, Transworld Snowboarding and Racer X magazines, fuses athletes, lifestyle, innovative product photography and our unique style. Our approach to event marketing utilizes our fleet of Spy^® branded vehicles to showcase our products and athletes at events such as the Eastern Surfing Association, X Games, Wakestock, the U.S. Open of Surfing and the Whistler Ski and Snowboard Festival.

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• Actively Manage Retail Relationships.    We manage the retail sales process by monitoring customer sales and inventory levels by product category and style to ensure optimal brand representation and product offerings. Our sales programs, including in-store clinics, point-of-purchase displays and marketing materials, assist our authorized retailers in promoting the authenticity of our brand and products and maximize the implementation of our consumer marketing initiatives. We will continue to develop a strategically selective, specialty-focused retail base to ensure brand authenticity and to prevent over-saturation of our brand. As a result, we believe we enjoy close relationships with our retailers, which enables us to influence the assortment and positioning of our products and to optimize inventory mix.

• Maximize benefits of Company owned manufacturer.    In January 2006, we acquired our principal manufacturer located in Italy, LEM. We expect the benefits of this acquisition to include better management of our primary product supply, improvement in gross profit margins, shorter production lead times, and joint product development of new technologies.

Growth Strategy

• Expand Domestic Distribution and Brand Recognition Outside of California.    We believe that significant opportunities exist to increase our sales by expanding domestic distribution of our products. We plan to increase significantly our marketing and distribution efforts throughout the United States by expanding our internal and external sales teams and growing our distribution base.

• Expand International Distribution.    We believe significant opportunities exist to increase our sales outside of the United States. To increase the distribution of our products on a global basis, historically we have utilized several different distribution models based on the needs for each individual territory. The three current distribution models are Direct, Traditional Distributor and Hybrid.

Direct: This model is currently utilized in four countries (France, Italy, Germany, and Austria). This model emulates the distribution model currently utilized in the United States. We hire a sales force and sell products directly to our dealer network within these countries. This model provides the best opportunity to accelerate growth within these countries, but also requires the most upfront investment to establish the dealer network, sales force and internal infrastructure.

Traditional Distribution: This model is currently utilized in 27 countries. This model allows us to sell products within certain countries without making a substantial investment in that country. Products are sold to an Authorized Distributor in the country who in turn provides all sales, service, marketing and accounting functions for the dealer base within that country. While this model allows us to enter target countries with limited investment, it also limits our ability to grow within that country due to our limited control over the marketing efforts, sales force and distribution channel.

Hybrid: This model is used for our sunglass product line within certain key countries in Europe. This model combines the benefits of both the Traditional and Direct model by allowing us to utilize a distributor within the territory, but to drop ship orders solicited by the distributor directly to dealers within the specific countries. This allows us to reduce the risk of inventory returns from the distributors, maximize penetration within the dealer network, and increase communication directly to the distributor sales force and dealer network. For the distributor this model mitigates our distributors’ inventory risk for sunglasses and enables them to invest in brand building programs within their territories.

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We are continuously evaluating alternative distribution models with a view towards increasing our international sales.

• Introduce New Products and Product Lines Under Our Existing Brand.    We intend to increase our sales by developing and introducing new products and product lines under our existing brand that embody our standards of design, performance, value and quality. We will continue to introduce new eyewear product lines such as handmade products, products with premium lenses, and special limited edition collections. We have also expanded our women’s product line and have launched several product lines within the optical prescription eyewear market.

• Build or Acquire New Brands.    We intend to focus on developing or acquiring new brands that we believe complement our action sports and youth lifestyle brand. We believe that brand acquisition opportunities currently exist in the action sports and youth lifestyle markets that would allow us to expand both our product offerings and our target demographics.

Products

We design, develop and market premium eyewear products, apparel and accessories. Our current product matrix consists of six product categories, including fashion sunglasses, women-specific sunglasses, performance sport sunglasses, snowsport goggles, motocross goggles and accessories.

Fashion Sunglasses

We currently offer 27 models of fashion sunglass products. The majority of our fashion sunglass frames are constructed of propionate or epsylon, which enable us to produce smooth, dense products that are adjustable to the contours of each individual’s face and are very comfortable to wear. We are one of the few brands in the action sports and youth lifestyle markets to offer high-quality fashion sunglass frames constructed from propionate or epsylon. These frames are engineered utilizing a wide variety of unique colorations and color fades that are created and/or polished for a high-gloss finish. The majority of our fashion sunglass frames, including all color fades, are hand painted in Italy. We also incorporate adjustable wire-core temples into seven of our fashion sunglass products so that our sunglass frames will provide a more custom fit for each individual. In addition, we offer handmade acetate sunglass frames and eyewear forged from pliable yet strong nickel silver and aluminum. Retail prices for these models range from $70 to $170.

Women-Specific Sunglasses

We currently offer seven models of women-specific sunglass products. These models are constructed of propionate or luxurious acetate, which are engineered utilizing a wide variety of unique colorations and color fades that are polished for a high-gloss finish. Other materials utilized in this product line include epsylon and galvanized nickel silver. Retail prices for these models range from $85 to $170.

Performance Sport Sunglasses

We currently offer three Spy^® branded performance sport sunglass products, which are designed to meet the demands of action sports athletes while offering innovative styling. The frames are constructed from injection-molded grilamid, an exceptionally lightweight material that is shatter-resistant and remains pliable in all weather conditions. These models incorporate our patented Scoop airflow technology, contain our ARC lenses and are engineered to incorporate interchangeable lenses. Most models also are available with our Trident polarized lenses and Hytrel rubber on the bridge and temple tips of the frames to prevent slippage. Retail prices for these models range from $85 to $165.

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Snowsport Goggles

We currently offer seven models of snowsport goggle products. All of our models of snowsport goggles are constructed of injected polyurethane, incorporate our patented Scoop airflow technology, anti-fog lens construction and Isotron foam, and offer 100% ultraviolet, or UV, protection. Three of the models utilize our ARC spherical, dual-lens system, while the other models utilize cylindrical, dual-pane lens technology. Retail prices for these models range from $50 to $210.

Motocross Goggles

We currently offer four models of motocross goggles. Similar to our line of snowsport goggles, our motocross goggles are constructed of injected polyurethane and incorporate our patented Scoop airflow technology, Isotron foam and polycarbonate hard-coated scratch-resistant lenses. For perspiration absorption, we use either our moisture-wicking Dri-Force fleece, which is bonded to our Isotron foam, or our two-stage Sweat Absorption System. All of the models of motocross goggles utilize our high-quality, anti-fog coating and are compatible with tear-off lens systems. Retail prices for these models range from $33 to $95.

Accessories

We offer a full range of accessories, including sunglass and goggle cases and lens replacement kits, which enable consumers to interchange the color of lenses in our performance eyewear products to adjust to various light conditions. Retail prices for our accessories range from $18 to $125.

Sales and Distribution

Our distribution strategy is based on our belief that the integrity and success of our brand is dependent on strategic growth and careful selection of the retail accounts where our products are merchandised and sold. We sell our products in approximately 3,300 retail locations in the United States and internationally through approximately 2,000 retail locations serviced by us and our international distributors. Although we intend to increase our distribution within the action sports and youth lifestyle markets, we believe that the largest growth opportunity for our brand is in the sunglass-focused distribution channel, including sunglass specialty and optical retailers. As a result, we intend to devote substantial resources towards growing sales of our products to these types of retail accounts. For each of the fiscal years ended December 31, 2007 and 2006, we did not have any single customer or group of related customers that represented 10% or more of our net sales.

Domestic Sales and Distribution

We sell our products to retailers who merchandise our products in a manner consistent with the image of our brand and the quality of our products. We have developed long-term relationships with key multi-store action sport and youth lifestyle retailers in the United States, such as Cycle Gear, Inc., No Fear, Inc., Pacific Sunwear of California, Inc., Tilly’s Clothing, Shoes & Accessories and Zumiez, Inc., and a large collection of action sport retailers that focus on surfing, skateboarding, snowboarding, snow skiing, motocross, wakeboarding and mountain biking. We have entered into dealer arrangements with our retailers pursuant to which they issue a purchase order for our products. These arrangements do not contain minimum purchase commitments and can be terminated by either party at any time. In order to be recognized as having a premium brand, we generally elect to sell through specialty stores instead of mass discount and general sporting goods retail chains. This has enabled us to maintain brand authenticity by partnering with retailers who share the same focus on influential action sport-oriented youth. Our domestic sales force consists of approximately 29 independent, non-exclusive field sales representatives, 10 independent, exclusive field sales representatives, 11 sub-sales representatives, four internal regional sales managers and 13 internal sales and customer service representatives.

We require our retailers and distributors to maintain specific standards in representing our brand at the point of sale, including minimum inventory levels, point-of-purchase branding, authorized dealer identification

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and an agreement that ensures store inventory is consistent with our current product collection. Our retailers also must agree not to resell or divert products through unauthorized channels of distribution. To preserve and enhance our brand, retailers not adhering to strict guidelines are coached to ensure compliance to such guidelines. Retailers that are not able to comply with such guidelines are eliminated from our authorized dealer network.

We understand that our retail partners represent the link between our brand and the consumer; therefore, we have focused on building relationships with buyers, merchandisers and retail sales staff. Our retail marketing and sales support teams ensure that our sales representatives and retailers have the tools, knowledge and support to sell our products. We provide dealer catalogs, clinic tools, displays, point-of-purchase materials, dealer mailings, sales representative training and an in- house sales support staff to ensure that we focus on all aspects of selling our products and building relationships with our retailers. We also utilize a unique regional fleet of mobile sales support vehicles operated by key sales representatives. These vehicles effectively promote our brand at regional action sports events and provide a variety of retailer support services, including merchandising and onsite training.

International Sales and Distribution

Our products are currently sold in over 40 countries outside of the United States. Net sales to foreign countries accounted for 26% and 23% of our total net sales for the years ended December 31, 2007 and 2006, respectively. Substantially all of our sales, marketing, and distribution activities outside of the United States and Canada are serviced directly by our wholly owned European subsidiary, Spy Optic, S.r.l., located in Varese, Italy. Our international sales are generated by our direct sales force (France, Italy, Spain, Germany and Austria) and our international distributors. Our direct sales force consists of 22 independent sales reps and 2 sales agencies. Our international distributors utilize an independent sales force consisting of over 100 non-exclusive sales representatives in Europe and the Asia/Pacific region. This local representation allows us to ensure that each region is provided with the marketing, sales support and product mix that is complementary to the needs of retailers within their respective territories.

In addition to our traditional distribution model, we have developed two models of international distribution which do not rely exclusively upon our international distributors and their sales representatives. The first method consists of collaborating with international distributors or sales agencies to eliminate duplicate supply-chain infrastructure, which we refer to as our Hybrid Distribution program. We provide marketing oversight, as well as internal operational functions such as shipping certain product lines from our European distribution center directly to the retailer, while our regional distributors provide sales, customer service and collections functions. This distribution model eliminates our fixed cost risks associated with maintaining a direct international sales team. Partnerships with regional distributors or sales agencies also provide us with feedback that we can utilize to conduct regional sales and marketing initiatives specific to a particular sales territory.

Our second method of international distribution consists of targeting sales territories where product demand is expected to support the establishment of direct operations in such territory, which we refer to as our Dealer Direct program. This program utilizes regional independent or agency sales representatives that provide all on-site retail services, while we provide all marketing, accounting and fulfillment operations. Fulfillment services can be provided by our United States or European based distribution centers, depending on the location of the Dealer Direct territory. We have implemented the Dealer Direct program in Canada, Italy, France, Germany and Austria. We may continue to expand this program in other countries in the future.

We are continuously evaluating alternative distribution models with a view towards increasing our international sales.

Promotion and Advertising

All marketing and branding is managed by our in-house staff, which enables us to deliver a targeted, consistent and recognized advertising message. Our commitment to marketing at the grassroots level in the action

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sports market and the youth lifestyle market within fashion, music and entertainment is the foundation of the promotion and advertising of our brand and products. We focus our marketing efforts on Generation Y, which we believe is one of the most influential and growing demographics in contemporary culture. We seek to increase our brand’s support and influence within the action sports and youth lifestyle markets through our athlete sponsorship program, a variety of consumer print advertising campaigns and grassroots marketing initiatives, such as sponsorship of action sports events and promotional vehicle tours.

We employ managers for the surf, skateboard, snowboard, motocross, ski and wakeboard sectors of the action sports market, each of whom possesses expertise within his or her specific sport. Many of our managers were professional athletes and remain immersed within their specific sports. Our managers are responsible for selecting sponsored athletes, grassroots marketing and event initiatives, maintaining industry relationships and directing print advertising within their segment. We are extremely selective with athlete sponsorship and only sign athletes who we believe are able to influence youth culture on a regional or global level. Some of our athletes include: surfers Dean Morrison and Clay Marzo; snowboarders Eero Niemela, Marc Frank Montoya and Todd Richards; skateboarders Rob Dyrdek; motocross riders Jeremy McGrath, Grant Langston and Kevin Windham; wakeboarder Danny Harf; and NASCAR driver Dale Earnhardt, Jr.

We sponsor regional and national action sports events and employ a vehicle-marketing program to drive the growth of our brand at trade shows and action sports, music and lifestyle events. Our vehicle marketing program primarily consists of a promotional tour bus and regional sales and marketing vehicles, which we utilize to create a dynamic and unique event experience. We also have given away a Spy^® branded wakeboarding boat in each of the previous four years in conjunction with Air Nautique and several action sports magazines.

Our advertising campaign fuses athletes, lifestyle, innovative product photography and our unique style. We utilize the exposure generated by our athletes as an editorial endorsement of product performance and style. Major trade magazines, including Transworld Snowboarding Business and Snow Industries of America Daily News, publish special product reports, including reports featuring our products, in conjunction with international and domestic action sports and power sports trade shows. We take advantage of this by strategically timing product releases to coincide with these trade shows and eyewear dealers’ purchasing schedules. We also attend most of the major action sport trade shows in North America, Europe and the Asia/Pacific region to promote our brand and products.

Product Design and Development

Our products are designed for individuals who embrace the action sports and youth lifestyle markets. We believe our most valuable input comes from our managers, employees, sponsored athletes and sales representatives who are actively involved in action sports. This connection with the action sports and youth lifestyle markets continues to be the driving force for the design and performance features of our products and is key to our reputation for innovative and authentic product designs.

In order to respond effectively to changing consumer preferences, we attempt to stay abreast of emerging lifestyle and fashion trends in the action sports and youth lifestyle markets. Our design teams constantly monitor regional and global fashion in order to identify trends that may be incorporated into future product designs.

Every eyewear design starts with a hand-drawn sketch, which is then converted into a computer-rendered technical drawing. The computer-rendered technical drawing is then fabricated into a hand-finished prototype. This prototype is extensively analyzed and measured through laboratory and field-testing to ensure that it reflects the design integrity of the original sketch and that the fit meets our exacting standards. In addition, we often incorporate key changes and improvements for our eyewear through input from our sponsored athletes, sales representatives, managers and employees. Once the prototype is thoroughly tested and optimized, the design is translated into a hand-polished, steel injection-mold.

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We differentiate our products from those of our competitors by incorporating innovative designs, advanced optical technology, and premium components and materials. In certain instances, we believe that such innovations have allowed us to grow consumer acceptance of our products with only nominal increases in manufacturing costs. We believe that the substantial experience of our design team will greatly enhance our ability to maintain our position as having one of the leading brands in the action sports and youth lifestyle markets and to expand the scope of our product lines.

We have entered into an agreement with our primary product designer, Jerome Mage, through his business Mage Design LLC, for the design and development of our eyewear, apparel and accessory product lines. Mr. Mage has agreed to provide his services to us as an independent consultant through December 31, 2008, and to be bound by confidentiality obligations. Mr. Mage has also agreed not to provide design services to any entity that is engaged principally in the business of designing, manufacturing or selling sunglasses, goggles or other optical products during the term of the agreement. Mr. Mage has developed products primarily for the Spy Optic brand. Under the agreement, Mr. Mage assigns all ideas, inventions and other intellectual property rights created or developed on our behalf during the term of the agreement to us. The agreement may be terminated by either party if the other party defaults or breaches a material provision of the agreement.

Research and development expenses during the years ended December 31, 2007 and 2006 were approximately $1,245,000 and $1,003,000, respectively.

Product Technologies

Scoop Airflow Technology

Our patented airflow system is referred to as Scoop airflow technology. The Scoop ventilation system forces air through strategically placed vents on goggle and sunglass frames, which reduces pressure and eliminates fogging. Our Scoop technology is protected by four U.S. patents. Currently, we license our Scoop technology to two sunglass companies on a non-exclusive basis. We do not receive any material amount of revenue from this license at present.

Sunglass Lens Technology

Our Accurate Radius Curvature, or ARC, prismatic lenses are utilized in most of our sunglass frames to provide optically correct, distortion-free vision and a total absence of prismatic aberration and astigmatism. Our ARC lens becomes thinner as it moves away from the optical center of the lens, thereby complementing the natural curvature of the human eye to provide clarity at all angles of vision, eliminate distortion and selectively filter out light waves that cause eye fatigue and discomfort. The lens properties, combined with high-quality, vacuum-applied surface coatings, manipulate the light spectrum to ensure maximum visual performance with no distortion. We also offer a number of surface coatings to achieve different lens colors by absorbing and reflecting different wavelengths in the light spectrum. In addition, we integrate filtering agents into our lens manufacturing process to provide eye protection in every type of environment. All of our lenses provide complete UV protection, including UVA, UVB, and UVC energy wavelengths, and provide powerful protection against the harmful effects of all types of solar radiation.

Some of our products incorporate high-quality injected polarized lenses. Our Trident polarized lenses are designed to diffuse glare through the use of a highly advanced polarizing filter placed between two injected lens layers, allowing incredible clarity even in the harshest conditions and effectively eliminating almost all blinding glare.

In addition, we market Delta Photochromic and Delta Photochromic Trident polarized lenses on several sunglass models. Delta Photochromic lenses are engineered to automatically adjust to nearly any light condition. Delta Photochromic Trident polarized lenses combined this self adjusting lens tint with our Trident polarized

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filters for improved depth perception and glare protection. The result is an unbreakable, auto-tinting lens that is designed to stop over 95% of blinding glare.

Our Mosaic lens technology combines retro aesthetics with advanced engineered optics. Mosaic features a dynamic lens curvature that closely conforms to the contours of the face with a “multi” base curvature that varies from 3.5 base to 24 base. The entire lens surface has been engineered for superior optical performance.

Snowsport Goggle Technology

• ARC Spherical Goggle Lenses.    Our ARC spherical goggle lenses employ the same technology as our sunglass lenses. Our goggle lenses consist of an integrated dual lens system that enables the inner lens to conform to body temperature and the outer lens to conform to environmental temperature to eliminate fogging of the lenses. The outer lens is a high-density, scratch-resistant injected ARC polycarbonate lens. The thermal spacer between the two lenses consists of an engineered acrylic-based bonding agent and closed-cell foam gasket. The inner lens is made of spherically thermoformed, anti-fog impregnated propionate.

• Isotron Foam.    The interior lining of our snowsport goggles where they make contact with an individual’s face, which we refer to as Isotron foam, is engineered from high-quality, ergonomic thermoformed foam to provide each user with a comfortable, custom fit and a superior seal around his or her face. On several models our Isotron foam is designed to work in conjunction with our Dri-Force fleece to wick moisture away from an individual’s face.

• Gemini Lens Technology.    This patent pending lens system features two lenses joined with a polyurethane base glue in a moisture free chamber, creating not only a consistent seal but also an airtight environment between the lenses. This dual lens is then depressurized to a level consistent with the atmospheric pressure common to approximately 2,000 meters. This way, when lenses are brought to higher altitudes, they are already calibrated for that height, mitigating the fogging, warping, and distortion that can often happen with standard foam gasket lenses. The result is a lens that is designed to be nearly impossible to fog and one that does not get deformed by variations in altitude.

Motocross Goggle Technology

• Engineered Visual Optics.    We use polycarbonate hard-coated, scratch-resistant extruded lens material on all of our motocross goggles. All lenses are cut precisely for an exact fit between the lens and the frames. We also impregnate a high-quality anti-fog coating into the internal surface of the lenses on our motocross goggles which cannot be wiped off. The hard coating on the external surface of our lenses is designed to prevent scratching.

• Tear-Offs.    We utilize engineered thin, antistatic, low-haze tear-off lens sheets to be used with our motocross goggles to enable riders to retain a clear field of vision. This ultra-thin material is designed to enable a rider to stack these lens sheets onto the goggle lens and tear them off while riding in order to maintain a clear field of vision without having to wipe off the goggle lens.

• Isotron Foam.    Our motocross goggles, like our snowboard goggles, utilize our Isotron foam to create a comfortable, ergonomic fit and superior seal around an individual’s face. Our Alloy SAS model utilizes our Dri-Force fleece, which is bonded to single density Isotron foam, and is designed to be used with our two-stage Sweat Absorption System. All of our motocross goggles also utilize high-density filter foam which is designed to prevent dust and dirt from entering the rider’s field of vision and to enhance air circulation to minimize fogging of the lens.

• Sweat Absorption System.    We have developed a two-stage moisture-wicking system that absorbs significantly more perspiration than our standard fleece-lined Isotron foam, which we refer to as

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Sweat Absorption System, or SAS. Our SAS consists of a removable pad which can be replaced at any time to prevent perspiration from entering a user’s eyes. We have obtained a U.S. patent for our SAS two-stage moisture wicking system.

• Selectron Removable Foam System.    Our Magneto motocross goggle features patent pending Selectron foam, a completely removable and replaceable face-foam system. The idea behind Selectron is to allow riders to pick the foam that best meets their fit needs. In addition, it enables riders to replace old, sweat-saturated foam with a fresh part.

Manufacturing

We manufacture a majority of our sunglass products through our wholly owned subsidiary, LEM S.r.l. We presently rely upon LEM for the manufacture of a substantial majority of our sunglass products, and we expect that we will rely on LEM for the manufacture of an increasing portion of such products.

Our sunglass manufacturing process begins with fabrication of the eyewear frames. The final mold for each model of our eyewear products is injected with intensely heated materials, such as grilamid or propionate. The components of each frame are then placed in a wood chip or ceramic chip tumbling machine for up to 48 hours to ensure that every frame piece is completely smooth without any imperfections. After the tumbling process, the frames are washed in high-speed ultra-sonic vibration machines to ensure that each piece is completely clean and dust-free prior to the extensive inspections, polish, and painting process.

Our highly specialized painting process includes up to five layers of paint; substantially all of which are applied by hand. Each of these layers includes an elaborate, multi-day painting, drying and curing process. We also hand set all of our polished metal logos and accents. Our lenses are cut and inserted into frames with exacting standards. The machinery used to cut each lens ensures that our products will perform to the highest optical standards.

Once the assembly process is completed, we test all of our products for optical clarity based on United States, European and Australian standards. The American National Standards Institute and the American Society for Testing and Materials have established specific testing criteria for eyewear. These tests analyze product safety and provide quantitative measure of optical quality, UV protection, light transmission and impact resistance. In addition, we perform a broad range of eyewear durability testing and mechanical integrity testing that includes extremes of UV, heat, condensation and humidity. Our testing process also utilizes a laser-based lens testing technique to ensure that our lenses meet a variety of optical distortion standards. After lens testing, each product is inspected for paint quality, fit, finish and overall appearance.

While our premium goggles are manufactured by LEM, a portion of our goggle frames are manufactured by third party factories. Our goggle manufacturing process begins with the fabrication of the goggle frame. The final mold for each goggle model is injected with intensely heated polyurethane. The frame components are then carefully washed using specialized cleaning processes that ensure secure paint adherence. After cleaning, each frame is subjected to our extensive painting process, which can include up to four layers of paint and often includes a specialized method of printing custom paint designs. Several key components of our products are assembled using overmolding or a sonic welding process to ensure a secure bond between materials, and all of our metal logos and details are hand painted and set into the frame. All of our goggles utilize what we believe to be the highest quality materials and components from the most reputable suppliers in the industry. Our lenses are carefully assembled using specialized machinery designed to ensure strict anti-fogging lens performance.

Once the assembly process is completed, we test our goggles to ensure they meet and exceed all international directives for goggle safety and performance. These directives analyze product safety by testing for optical clarity, impact resistance, anti-fog protection, light transmission, UV protection and quality of frame materials. In addition to independent laboratory testing, we perform extensive testing at each of our

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manufacturers, including analyzing our goggles for product strength, wear and accelerated weather testing. Prior to shipment, each goggle is inspected for paint quality, fit, finish and overall appearance.

Each of our apparel and accessory manufacturers is carefully selected based upon quality standards, manufacturing methods and ability to produce custom designed products. All apparel and accessories are manufactured to exacting standards and specifications using high-quality materials. Treatments and fits are carefully inspected upon receipt, and products that do not fall within our specification sheets are rejected. To ensure quality, we require our manufacturers to source specific fabrics, buckles, labels, micro-injected logos and other materials.

Customers

Our products are currently sold in the United States, Canada and in 40 countries in the rest of the world. Our customer base reflects our heritage and influence across the action sports and youth lifestyle markets and a distribution strategy which focuses on action sport and youth lifestyle retailers. Our net sales are spread over a large customer base. No single customer accounted for more than 10% of our net sales during each of the years ended December 31, 2007 and 2006.

Government Regulation

Our products are subject to governmental health safety regulations in most countries where they are sold, including the United States and the European Union, as well as import duties and tariffs on products being imported into countries outside of the United States. In addition, we are subject to various state and federal regulations generally applicable to similar businesses. We regularly inspect our production techniques and standards to ensure compliance with applicable requirements.

Intellectual Property

We use a combination of patent, trademark, copyright, trade secret and trade dress laws, as well as confidentiality agreements, to aggressively protect our intellectual property, including product designs, product research and development and recognized trademarks. We have four U.S. utility patents for our Scoop airflow technology, which expire between 2012 and 2015. We have 24 U.S. design patents with respect to our products as follows: 17 regarding certain of our sunglasses (expire between 2010 and 2012), three additional sunglass designs (expire between 2017 and 2019), one regarding certain of our goggles (expires in 2013), two regarding certain of our sunglass cases (expire in 2013), and one regarding our eyewear retail display case (expires in 2010). We also have submitted patent applications for our new dual lens/screen goggle and method of forming the same for use in our snowsport goggles. We are continuing to file patent applications on our inventions that are significant to our business and pursue trademarks where applicable.

Our registered trademarks include: Spy, SpyOptic, Eye Spy, Windows for your head, Scoop, Delta Photochromatic, Dri Force, ARC, a Trident design, Plus System, Isotron, Gemini, Mosaic, Espion, and a “cross” design; and our unregistered or pending marks include, but are not limited to: Spy (various), Selectron, Zed, Apollo, Haymaker, Hielo, Prodigus Metal Alloy, Bias, Logan, HSX, MC2, SpyOptic, Decker, Double Decker, Viente, a “triangle with cross” design, a “cross with bar” design, and a “cross” design. We actively combat counterfeiting through monitoring of the global marketplace. We utilize our employees, sales representatives, distributors and retailers to police against infringing products by encouraging them to notify us of any suspect products, confiscating counterfeit products and assisting law enforcement agencies. Our sales representatives are also educated on our patents and trade dress and assist in preventing potentially infringing products from obtaining retail shelf space.

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Competition

We compete with sunglass and goggle brands in various niches of the action sports market including Von Zipper, Electric Visual, Arnette, Oakley, Scott and Smith Optics. We also compete with broader youth lifestyle brands that offer eyewear products, such as Quiksilver. In both markets, we compete primarily on the basis of design, performance, price, value, quality, brand name, marketing and distribution.

We also compete in the broader fashion sunglass sector of the eyewear market, which is fragmented and highly competitive. The major competitive factors in the sector of the market include fashion trends, brand recognition, distribution channels and the number and range of products offered. We compete with a number of brands in this sector of the market, including Armani, Christian Dior, Dolce & Gabbana, Gucci, Prada and Versace.

We believe that our principal competitive advantages are quality, design, performance, brand name and value. We believe that many of our competitors enjoy significantly greater financial resources than we have, which enables them to promote their products more heavily than we can. Also, many of our competitors have greater brand recognition, a longer operating history and more comprehensive product lines than us.

Segments

We focus our business on two geographic segments: North America (including the U.S. and Canada) and foreign, and operate in two business segments: distribution and manufacturing. See Note 16 “Operating Segments and Geographic Information,” to our financial statements for a further description of these segments.

Seasonality

Our net sales fluctuate from quarter to quarter as a result of changes in demand for our products. Historically, we have experienced greater net sales in the second half of the fiscal year as a result of the seasonality of our products and the markets in which we sell our products. We generally sell more of our sunglass products in the second and third quarters of the fiscal year and a majority of our goggle products in the last half of the fiscal year. We anticipate that this seasonal impact on our net sales is likely to continue. As a result, our net sales and operating results have fluctuated significantly from period-to-period in the past and are likely to do so in the future.

Employees

As of December 31, 2007, we employed 95 full-time employees and one part-time employee, including 80 employees in the United States and 16 employees in the rest of the world, excluding LEM. This aggregate number of employees consists of 45 in sales and marketing, 23 in general and administration, 2 in design and development and 26 in manufacturing support and fulfillment operations. We have never had a work stoppage. We consider our employee relations to be good.

LEM, our wholly owned subsidiary and primary manufacturer, also has 110 full-time employees. We consider the relations between LEM and its employees to be good.

Currently, none of our employees are members of a union.

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Executive Officers of the Registrant

Our executive officers are as follows:

Name	Age	Position
Mark Simo	48	Chief Executive Officer
Jerry Collazo	49	Chief Financial Officer
Barry Buchholtz	37	President, Italian Operations
Fran Richards	44	Vice President of Marketing

Our executive officers are appointed by the Board of Directors on an annual basis and serve at the discretion of the Board, subject to the terms of any employment agreements they may have with us. The following is a brief description of the present and past business experience of each of our executive officers.

Mark Simo rejoined us in October 2006 as our Chief Executive Officer. He formerly served as our Chief Executive Officer from August 1994 to July 2004, and has served as the Chairman of our Board of Directors since August 1994. Since September 1990, Mr. Simo has served as a member of the Board of Directors of No Fear, Inc. He also served as No Fear Inc.’s Chief Executive Officer from September 1990 until he stepped down in October 2006. From February 1984 to August 1990, Mr. Simo served as a Vice President of Life’s A Beach, an apparel company.

Jerry Collazo joined us in August 2006 as our Chief Financial Officer. Mr. Collazo has over 20 years of diversified executive, operational and financial management experience. From 2005 to 2006, Mr. Collazo served as the Chief Financial Officer of Channell Commercial Corporation, a publicly traded company providing telecommunications infrastructure and water conservation products including development and manufacturing operations throughout the U.S., Canada, Europe, Asia and Australia. From 2000 to 2004, Mr. Collazo served as Chief Executive Officer and Chief Financial Officer of Worldwide Wireless Networks, a publically traded company providing fixed wireless broadband services. Mr. Collazo began his career at Ernst & Young. Mr. Collazo is a Certified Public Accountant and received an MBA from the University of California, Los Angeles.

Barry Buchholtz joined us in September 1997 as our Chief Operations Officer and served as our President from January 2000 until July 2004. In July 2004, Mr. Buchholtz was promoted to Chief Executive Officer and was elected to our Board of Directors. Effective October 2006, Mr. Buchholtz resigned as our Chief Executive Officer and was appointed as the President of our Italian operations. From February 1996 to September 1997, Mr. Buchholtz was a partner in Global Management Group, a computer industry consulting firm to companies such as Dow Jones, Telerate and Andrea Electronics. From June 1993 to January 1996, Mr. Buchholtz was Vice President, Operations for Vision Technologies, LLC, a manufacturer of personal computers and peripherals. From June 1988 to May 1993, Mr. Buchholtz was Chief Operating Officer for Syntax Computer Corp., a manufacturer of personal computers and peripherals. From 1987 to 1988, Mr. Buchholtz was Vice President, Operations for Kaypro Corporation, a manufacturer of personal computers and peripherals.

Fran Richards joined us in April of 2006 as Vice President of Marketing, with over twenty years of action sports and youth culture marketing experience. Prior to joining us, Mr. Richards was the founder of Group Publisher of Future USA’s action sports media group, a division of Future PLC, a publisher of video game and music enthusiast magazines. From 2003 to 2004 Mr. Richards was president of Modern World LLC, a youth marketing firm whose blue chip clients included Universal Music Group’s Island Records, Warner Strategic Marketing, ski resort operator Intrawest, and NBC’s Gravity Games. From 1988 until 2003, Mr. Richards was a magazine group publisher and marketing executive at Transworld Media, currently the largest action sports media company.

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Item 1A. Risk Factors

Risks Related to Our Business

You should consider each of the following factors as well as the other information in this Annual Report in evaluating our business and our prospects. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our business operations. If any of the following risks actually occur, our business and financial results could be harmed. In that case, the trading price of our common stock could decline. You should also refer to the other information set forth in this Annual Report, including our financial statements and the related notes.

Fluctuations in foreign currency exchange rates could harm our results of operations.

We sell a majority of our products in transactions denominated in U.S. Dollars; however, we purchase a substantial portion of our products from our manufacturers in transactions denominated in Euros. As a result, recent weakening of the U.S. Dollar has increased our cost of sales substantially and if the U.S. Dollar continues to weaken against the Euro, our cost of sales could further increase. We also are exposed to gains and losses resulting from the effect that fluctuations in foreign currency exchange rates have on the reported results in our consolidated financial statements due to the translation of the operating results and financial position of our Italian subsidiaries Spy Optic, S.r.l. and LEM, and due to net sales in Canada. Between January 1, 2006 and March 24, 2008, the Euro exchange rate has ranged from US$ 1.18 to US$ 1.59. Between January 1, 2006 and December 31, 2007, the Canadian Dollar exchange rate has ranged from US$ 0.84 to US$ 1.10. For the years ended December 31, 2007 and 2006, we had a net foreign currency gain and a net foreign currency loss of $114,000 and ($53,000), respectively, which represented zero percent of our net sales for both periods. As of December 31, 2007, we had no foreign currency contracts.

The effect of foreign exchange rates on our financial results can be significant. Therefore we have engaged in certain hedging activities to mitigate over time the impact of the translation of foreign currencies on our financial results. Our hedging activities reduce, but do not eliminate, the effects of foreign currency fluctuations. Factors that could affect the effectiveness of our hedging activities include the volatility of currency markets and the availability of hedging instruments. The degree to which our financial results are affected will depend in part upon the effectiveness or ineffectiveness of our hedging activities.

The current substantial downturn in the economy may affect consumer purchases of discretionary items, which would reduce our net sales.

The retail industry historically has been subject to substantial cyclical variations. The merchandise sold by us is generally a discretionary expense for our customers. The substantial downturn or a recession in the general economy that is currently occurring in the United States or uncertainties regarding future economic prospects may significantly reduce consumer spending which could reduce our sales, perhaps substantially.

We have a history of significant losses. If we do not achieve or sustain profitability, our financial condition and stock price could suffer.

We have a history of losses and we may continue to incur losses for the foreseeable future. As of December 31, 2007, our accumulated deficit was $17.3 million and, in fiscal 2007, the Company incurred a net loss of $8.0 million. We have not achieved profitability for a full fiscal year since our initial public offering. If our revenues grow more slowly than we anticipate, or if our operating expenses exceed our expectations, we may not be able to achieve full fiscal year profitability in the near future or at all. Even if we do achieve full fiscal year profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. If we are unable to achieve full fiscal year profitability within a short period of time, or at all, or if we are unable to sustain profitability at satisfactory levels, our financial condition and stock price could be adversely affected.

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We may not successfully address problems encountered in connection with our acquisition of LEM or any future acquisitions, which could result in operating difficulties and other harmful consequences.

In January 2006, we acquired LEM. The aggregate purchase price was 3.5 million Euros or $4.2 million in cash, plus a two year earn-out based on LEM’s future sales. Under the terms of the earn-out, we are obligated to make quarterly payments based on unit sales, up to a maximum of 1.4 million Euros, through December 31, 2007. The maximum amount of additional consideration was earned and paid out as of December 31, 2007. We expect to continue to consider other opportunities to acquire or make investments in other technologies, products and businesses that could enhance our capabilities, complement our current products or expand the breadth of our markets or customer base, although we have no specific agreements with respect to potential acquisitions or investments. We have limited experience in acquiring other businesses and technologies. Potential and completed acquisitions, including our acquisition of LEM, and strategic investments involve numerous risks, including:

• problems assimilating the purchased technologies, products or business operations;

• problems maintaining uniform standards, procedures, controls and policies;

• unanticipated costs associated with the acquisition;

• diversion of management’s attention from our core business;

• harm to our existing business relationships with manufacturers and customers;

• risks associated with entering new markets in which we have no or limited prior experience; and

• potential loss of key employees of acquired businesses.

If we fail to properly evaluate and execute acquisitions and strategic investments, our management team may be distracted from our day-to-day operations, our business may be disrupted and our operating results may suffer. In addition, if we finance acquisitions by issuing equity or convertible debt securities, our stockholders would be diluted.

In addition, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), we are required to test goodwill for impairment at least annually, or more frequently if events or circumstances exist which indicate that goodwill may be impaired. As a result of changes in circumstances after valuing assets in connection with acquisitions, we may be required to take write-downs of intangible assets, including goodwill, which could be significant.

If we are unable to continue to develop innovative and stylish products, demand for our products may decrease.

The action sports and youth lifestyle markets are subject to constantly changing consumer preferences based on fashion and performance trends. Our success depends largely on the continued strength of our brand and our ability to continue to introduce innovative and stylish products that are accepted by consumers in our target markets. We must anticipate the rapidly changing preferences of consumers and provide products that appeal to their preferences in a timely manner while preserving the relevancy and authenticity of our brand. Achieving market acceptance for new products may also require substantial marketing and product development efforts and expenditures to create consumer demand. Decisions regarding product designs must be made several months in advance of the time when consumer acceptance can be measured. If we do not continue to develop innovative and stylish products that provide greater performance and design attributes than the products of our competitors and that are accepted by our targeted consumers, we may lose customer loyalty, which could result in a decline in our net sales and market share.

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We may not be able to compete effectively, which will cause our net sales and market share to decline.

The action sports and youth lifestyle markets in which we compete are intensely competitive. We compete with sunglass and goggle brands in various niches of the action sports market including Von Zipper, Electric Visual, Arnette, Oakley, Scott and Smith Optics. We also compete with broader youth lifestyle brands that offer eyewear products, such as Quiksilver, and in the broader fashion sunglass sector of the eyewear market, which is fragmented and highly competitive. We compete with a number of brands in these sectors of the market, including brands such as Armani, Christian Dior, Dolce & Gabbana, Gucci, Prada and Versace. In both markets, we compete primarily on the basis of fashion trends, design, performance, value, quality, brand recognition, marketing and distribution channels.

The purchasing decisions of consumers are highly subjective and can be influenced by many factors, such as marketing programs, product design and brand image. Several of our competitors enjoy substantial competitive advantages, including greater brand recognition, a longer operating history, more comprehensive lines of products and greater financial resources for competitive activities, such as sales and marketing, research and development and strategic acquisitions. Our competitors may enter into business combinations or alliances that strengthen their competitive positions or prevent us from taking advantage of such combinations or alliances. They also may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or consumer preferences.

If our marketing efforts are not effective, our brand may not achieve the broad recognition necessary to our success.

We believe that broader recognition and favorable perception of our brand by persons ranging in age from 17 to 35 is essential to our future success. Accordingly, we intend to continue an aggressive brand strategy through a variety of marketing techniques designed to foster an authentic action sports and youth lifestyle company culture, including athlete sponsorship, sponsorship of surfing, snowboarding, skateboarding, wakeboarding, and motocross events, vehicle marketing, internet and print media, action sports industry relationships, sponsorship of concerts and music festivals and celebrity endorsements. If we are unsuccessful, these expenses may never be offset, and we may be unable to increase net sales. Successful positioning of our brand will depend largely on:

• the success of our advertising and promotional efforts;

• preservation of the relevancy and authenticity of our brand in our target demographic; and

• our ability to continue to provide innovative, stylish and high-quality products to our customers.

To increase brand recognition, we must continue to spend significant amounts of time and resources on advertising and promotions. These expenditures may not result in a sufficient increase in net sales to cover such advertising and promotional expenses. In addition, even if brand recognition increases, our customer base may decline or fail to increase and our net sales may not continue at present levels or may decline.

If we are unable to leverage our business strategy successfully to develop new products, our business may suffer.

We are continuously evaluating potential entries into or expansion of new product offerings. In expanding our product offerings, we intend to leverage our sales and marketing platform and customer base to develop these opportunities. While we have generally been successful promoting our sunglasses and goggles in our target markets, we cannot predict whether we will be successful in gaining market acceptance for any new products that we may develop. In addition, expansion of our business strategy into new product offerings will require us to incur significant sales and marketing expenses. These requirements could strain our management and financial and operational resources. Additional challenges that may affect our ability to expand our product offerings include our ability to:

• increase awareness and popularity of our existing Spy^® brand;

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• establish awareness of any new brands we may introduce or acquire;

• increase customer demand for our existing products and establish customer demand for any new product offering;

• attract, acquire and retain customers at a reasonable cost;

• achieve and maintain a critical mass of customers and orders across all of our product offerings;

• maintain or improve our gross margins; and

• compete effectively in highly competitive markets.

We may not be able to address successfully any or all of these challenges in a manner that will enable us to expand our business in a cost-effective or timely manner. If new products we develop are not received favorably by consumers, our reputation and the value of our brand could be damaged. The lack of market acceptance of new products we develop or our inability to generate satisfactory net sales from any new products to offset their cost could harm our business.

Substantially all of our assets are pledged to secure obligations under our line of credit.

On February 26, 2007, Spy Optic, Inc. entered into a Loan and Security Agreement (the “Loan Agreement”) with BFI Business Finance (“BFI”) with a maximum borrowing capacity of $5.0 million, which was extended to $8.0 million. Actual borrowing availability is based on Spy Optic, Inc.’s eligible trade receivables and inventory levels. Loans extended pursuant to the Loan Agreement will bear interest at a rate per annum equal to the prime rate as reported in the Western Edition of the Wall Street Journal from time to time plus 2.5%. Interest will be payable monthly in arrears and Spy Optic, Inc. is required to pay at least $2,000 a month in interest regardless of the amounts outstanding under the Loan Agreement at any particular time. The Loan Agreement also imposes certain covenants on Spy Optic, Inc., including covenants requiring it to (i) deliver financial statements and inventory and accounts payable reports to BFI; (ii) maintain certain minimum levels of insurance; (iii) make required payments under all leases; (iv) refrain from incurring additional debt in excess of $100,000; (v) maintain its corporate name, structure and existence; (vi) refrain from paying dividends; (vii) notify BFI in advance of relocating its premises; and (viii) refrain from substantially changing its management or business. As of December 31, 2007, there were outstanding borrowings under the Loan Agreement of $4.5 million.

Spy Optic, Inc. granted a security interest in all of its assets, except for its copyrights, patents, trademarks, servicemarks and related applications, to BFI as security for its obligations under the Loan Agreement. Spy Optic, Inc. also established a bank account in BFI’s name into which collections on accounts receivable and other collateral are deposited (the “Collateral Account”). Pursuant to the deposit control account agreement between Spy Optic, Inc. and BFI with respect to the Collateral Account, BFI is entitled to sweep all amounts deposited into the Collateral Account and apply the funds to outstanding obligations under the Loan Agreement; provided that BFI is required to distribute to Spy Optic, Inc. any amounts remaining after payment of all amounts due under the Loan Agreement. Additionally, Orange 21 Inc. guarantied Spy Optic, Inc.’s obligations under the Loan Agreement and granted BFI a blanket security interest in all of its assets, except for its stock in Spy Optic, Inc., which it covenanted not to pledge to any other person or entity, as security for its obligations under its guaranty.

If Spy Optic, Inc. defaults in any of its obligations under the Loan Agreement, BFI will be entitled to exercise its remedies under the Loan Agreement and applicable law, which could harm our results of operations and reputation. Specifically, the remedies available to BFI include, without limitation, increasing the applicable interest rate on all amounts outstanding under the Loan Agreement, declaring all amounts under the Loan Agreement immediately due and payable, assuming control of the Collateral Account or any other assets pledged by Spy Optic, Inc. or Orange 21 Inc. and directing our customers to make payments directly to BFI.

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Our business could be impacted negatively if our sales are concentrated in a small number of popular products.

If sales become concentrated in a limited number of our products, we could be exposed to risk if consumer demand for such products were to decline. For the year ended December 31, 2007, 64% and 31% of our net sales were derived from sales of our sunglass and goggle products, respectively. Excluding net sales from LEM, for the year ended December 31, 2006, 64% of our net sales were derived from sales of our sunglass products and 35% of our net sales were derived from sales of our goggle products. As a result of these concentrations in net sales, our operating results could be harmed if sales of any of these products were to decline substantially and we were not able to increase sales of other products to replace such lost sales.

Our business could be harmed if we fail to maintain proper inventory levels.

We place orders with our manufacturers for some of our products prior to the time we receive orders for these products from our customers. We do this to minimize purchasing costs, the time necessary to fill customer orders and the risk of non-delivery. We also maintain an inventory of selected products that we anticipate will be in high demand. We may be unable to sell the products we have ordered in advance from manufacturers or that we have in our inventory. Inventory levels in excess of customer demand may result in inventory write-downs, and the sale of excess inventory at discounted prices could significantly impair our brand image and harm our operating results and financial condition. Conversely, if we underestimate consumer demand for our products or if our manufacturers fail to supply the quality products that we require at the time we need them, we may experience inventory shortages. Inventory shortages might delay shipments to customers, negatively impact retailer and distributor relationships and diminish brand loyalty, thereby harming our business.

During the years ended December 31, 2007 and 2006, we experienced delays in manufacturing and shipping of our sunglass and goggle products. These delays have materially affected our results of operations. We may continue to experience similar delays, which could have a material effect on our results of operations.

Our manufacturers must be able to continue to procure raw materials and we must continue to receive timely deliveries from our manufacturers to sell our products profitably.

The capacity of our manufacturers, including our subsidiary LEM, to manufacture our products is dependent in substantial part, upon the availability of raw materials used in the fabrication of sunglasses and goggles. Any shortage of raw materials or inability of a manufacturer to manufacture or ship our products in a timely manner, or at all, could impair our ability to ship orders of our products in a timely manner and could cause us to miss the delivery requirements of our customers. As a result, we could experience cancellation of orders, refusal to accept deliveries or a reduction in purchase prices, any of which could harm our net sales, results of operations and reputation. Our manufacturers, including LEM, have experienced in the past, and may experience in the future, shortages of raw materials and other production delays, which have resulted in, and may in the future result in, delays in deliveries of our products up to several months. These delays have materially affected our results of operations. Such delays may continue to have a material effect on our results of operations.

In addition, LEM provides manufacturing services to other companies under supply agreements. The inability of LEM and our other suppliers to manufacture and ship products in a timely manner could result in breaches of the agreements with our customers, which could harm our results of operations, reputation and demand for our products.

If we are unable to recruit and retain key personnel necessary to operate our business, our ability to develop and market our products successfully may be harmed.

We are heavily dependent on our current executive officers and management. The loss of any key employee or the inability to attract or retain qualified personnel, including product design and sales and marketing personnel, could delay the development and introduction of, and harm our ability to sell our products and damage our brand. We believe that our future success is highly dependent on the contributions of Mark Simo, who became our Chief Executive Officer in October 2006 as well as Jerry Collazo, our Chief Financial

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Officer. We do not have an employment agreement with Mr. Simo. The loss of the services of Mr. Simo or Mr. Collazo would be very difficult to replace. Our future success may also depend on our ability to attract and retain additional qualified management, design and sales and marketing personnel. We do not carry key man insurance. If our management team is unable to execute on our business strategy, our business may be harmed, which could adversely impact our branding strategy, product development strategy and net sales.

If we are unable to retain the services of our primary product designer, our ability to design and develop new products likely will be harmed.

We are heavily dependent on our primary product designer, Jerome Mage, for the design and development of our eyewear products. Mr. Mage provides his services to us as an independent consultant through his business, Mage Design, LLC. Our agreement with Mage Design, LLC expires on December 31, 2008. We cannot be certain that Mr. Mage will not be recruited by our competitors or otherwise terminate his relationship with us at or prior to the time our agreement with him expires. If Mr. Mage terminates his relationship with us, we will need to obtain the services of another qualified product designer to design our eyewear products, and even if we are able to locate a qualified product designer, we may not be able to agree on commercially reasonable terms acceptable to us with such designer. If we were to enter into an agreement with a qualified product designer, we could experience a delay in the design and development of new sunglass and goggle product lines, and we may not experience the same level of consumer acceptance with any such product offerings. Any such delay in the introduction of new product lines or the failure by customers to accept new product lines could reduce our net sales.

If we are unable to maintain and expand our endorsements by professional athletes, our ability to market and sell our products may be harmed.

A key element of our marketing strategy has been to obtain endorsements from prominent action sports athletes to sell our products and preserve the authenticity of our brand. We generally enter into endorsement contracts with our athletes for terms of one to three years. There can be no assurance that we will be able to maintain our existing relationships with these individuals in the future or that we will be able to attract new athletes or public personalities to endorse our products in order to grow our brand or product categories. Further, we may not select athletes that are sufficiently popular with our target demographics or successful in their respective action sports. Even if we do select successful athletes, we may not be successful in negotiating commercially reasonable terms with those individuals. If we are unable in the future to secure athletes or arrange athlete endorsements of our products on terms we deem to be reasonable, we may be required to modify our marketing platform and to rely more heavily on other forms of marketing and promotion which may not prove to be as effective as endorsements. In addition, negative publicity concerning any of our sponsored athletes could harm our brand and adversely impact our business.

Any interruption or termination of our relationships with our manufacturers could harm our business.

We purchase substantially all of our sunglass products from our wholly owned subsidiary, LEM and over half of our goggle products are manufactured by OGK in China. We expect in 2008 to continue to manufacture more than half of our goggles through OGK. We do not have long-term agreements with any of our other manufacturers other than LEM or with vendors that supply raw materials to LEM. We cannot be certain that we will not experience difficulties with our manufacturers, such as reductions in the availability of production capacity, errors in complying with product specifications, insufficient quality control, failures to meet production deadlines or increases in manufacturing costs and failures to comply with our requirements for the proper utilization of our intellectual property. If our relationship with any of our manufacturers is interrupted or terminated for any reason, including the failure of any manufacturer to perform its obligations under our agreement or the termination of our agreement by any of our manufacturers, we would need to locate alternative manufacturing sources. The establishment of new manufacturing relationships involves numerous uncertainties, and we cannot be certain that we would be able to obtain alternative manufacturing sources in a manner that

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would enable us to meet our customer orders on a timely basis or on satisfactory commercial terms. If we are required to change any of our major manufacturers, we would likely experience increased costs, substantial disruptions in the manufacture and shipment of our products and a loss of net sales.

During 2007 and 2006, we experienced delays in manufacturing and shipping our sunglass and goggle products. These delays have materially affected our results of operations. We anticipate that we may continue to experience manufacturing and shipping delays and that such delays may continue to have a material effect on our results of operations.

Any failure to maintain ongoing sales through our independent sales representatives or maintain our international distributor relationships could harm our business.

We sell our products to retail locations in the United States and internationally through retail locations serviced by us through our direct sales team and a network of independent sales representatives in the United States, and through our international distributors. We rely on these independent sales representatives and distributors to provide customer contacts and market our products directly to our customer base. Our independent sales representatives are not obligated to continue selling our products, and they may terminate their arrangements with us at any time with limited notice. We do not have long-term agreements with all our international distributors. Our ability to maintain or increase our net sales will depend in large part on our success in developing and maintaining relationships with our independent sales representatives and our international distributors. It is possible that we may not be able to maintain or expand these relationships successfully or secure agreements with additional sales representatives or distributors on commercially reasonable terms, or at all. Any failure to develop and maintain our relationships with our independent sales representatives or our international distributors, and any failure of our independent sales representatives or international distributors to effectively market our products, could harm our net sales.

We face business, political, operational, financial and economic risks because a significant portion of our operations and sales are to customers outside of the United States.

Our European sales and administration operations as well as our primary manufacturers are located in Italy. In addition, we distribute our products from an outsourced facility based in the Netherlands. We are subject to risks inherent in international business, many of which are beyond our control, including:

• difficulties in obtaining domestic and foreign export, import and other governmental approvals, permits and licenses and compliance with foreign laws, including employment laws;

• difficulties in staffing and managing foreign operations, including cultural differences in the conduct of business, labor and other workforce requirements;

• transportation delays and difficulties of managing international distribution channels;

• longer payment cycles for, and greater difficulty collecting, accounts receivable;

• ability to finance our foreign operations;

• trade restrictions, higher tariffs or the imposition of additional regulations relating to import or export of our products;

• unexpected changes in regulatory requirements, royalties and withholding taxes that restrict the repatriation of earnings and effects on our effective income tax rate due to profits generated or lost in foreign countries;

• political and economic instability, including wars, terrorism, political unrest, boycotts, curtailment of trade and other business restrictions; and

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• difficulties in obtaining the protections of the intellectual property laws of other countries.

Any of these factors could reduce our net sales, decrease our gross margins or increase our expenses.

We may experience conflicts of interest with our significant stockholder, No Fear, Inc., which could harm our other stockholders.

No Fear, Inc. (“No Fear”) and its affiliates beneficially own approximately 13% of our outstanding common stock. As a result of this ownership interest, No Fear and its affiliates have the ability to influence who is elected to our Board of Directors each year and, through those directors, to influence our management, operations and potential significant corporate actions. Specifically, Mark Simo, our Chief Executive Officer and a Co-Chairman of our Board of Directors, is a member of No Fear’s Board of Directors, was the Chief Executive Officer of No Fear through October 2006, and owns approximately 37% of No Fear’s outstanding common stock. As a result of his position in No Fear, Mr. Simo may face conflicts of interest in connection with transactions between us and No Fear. In addition, as a purchaser of our products, No Fear accounted for approximately $1,305,000 and $795,000 of our net sales for the years ended December 31, 2007 and 2006, respectively. No Fear and its affiliates may have interests that conflict with, or are different from, the interests of our other stockholders. These conflicts of interest could include potential competitive business activities, corporate opportunities, indemnity arrangements, registration rights, sales or distributions by No Fear of our common stock and the exercise by No Fear of its ability to influence our management and affairs. Further, this concentration of ownership may discourage, delay or prevent a change of control of our company, which could deprive our other stockholders of an opportunity to receive a premium for their stock as part of a sale of our company, could harm the market price of our common stock and could impede the growth of our company. Our certificate of incorporation does not contain any provisions designed to facilitate resolution of actual or potential conflicts of interest or to ensure that potential business opportunities that may become available to both No Fear and us will be reserved for or made available to us. If these conflicts of interest are not resolved in a manner favorable to our stockholders, our stockholders’ interests may be substantially harmed.

If we fail to secure or protect our intellectual property rights, competitors may be able to use our technologies, which could weaken our competitive position, reduce our net sales or increase our costs.

We rely on patent, trademark, copyright, trade secret and trade dress laws to protect our proprietary rights with respect to product designs, product research and trademarks. Our efforts to protect our intellectual property may not be effective and may be challenged by third parties. Despite our efforts, third parties may have violated and may in the future violate our intellectual property rights. In addition, other parties may independently develop similar or competing technologies. If we fail to protect our proprietary rights adequately, our competitors could imitate our products using processes or technologies developed by us and thereby potentially harm our competitive position and our financial condition. We are also susceptible to injury from parallel trade (i.e., gray markets) and counterfeiting of our products, which could harm our reputation for producing high-quality products from premium materials. Infringement claims and lawsuits likely would be expensive to resolve and would require substantial management time and resources. Any adverse determination in litigation could subject us to the loss of our rights to a particular patent, trademark, copyright or trade secret, could require us to obtain licenses from third parties, could prevent us from manufacturing, selling or using certain aspects of our products or could subject us to substantial liability, any of which would harm our results of operations.

Since we sell our products internationally and are dependent on foreign manufacturing in Italy and China, we also are dependent on the laws of foreign countries to protect our intellectual property. These laws may not protect intellectual property rights to the same extent or in the same manner as the laws of the U.S. Although we will continue to devote substantial resources to the establishment and protection of our intellectual property on a worldwide basis, we cannot be certain that these efforts will be successful or that the costs associated with protecting our rights abroad will not be significant. We have been unable to register Spy as a trademark for our products in a few selected markets in which we do business. In addition, although we have filed applications for federal registration, we have no trademark registrations for Spy for our accessory products currently being sold.

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We may face significant expenses and liability in connection with the protection of our intellectual property rights both inside and outside of the United States and, if we are unable to successfully protect our intellectual property rights or resolve any conflicts, our results of operations may be harmed.

We may be subject to claims by third parties for alleged infringement of their proprietary rights, which are costly to defend, could require us to pay damages and could limit our ability to use certain technologies in the future.

From time to time, we may receive notices of claims of infringement, misappropriation or misuse of other parties’ proprietary rights. Some of these claims may lead to litigation. Any intellectual property lawsuit, whether or not determined in our favor or settled, could be costly, could harm our reputation and could divert our management from normal business operations. Adverse determinations in litigation could subject us to significant liability and could result in the loss of our proprietary rights. A successful lawsuit against us could also force us to cease sales or to develop redesigned products or brands. In addition, we could be required to seek a license from the holder of the intellectual property to use the infringed technology, and it is possible that we may not be able to obtain a license on reasonable terms, or at all. If we are unable to redesign our products or obtain a license, we may have to discontinue a particular product offering. If we fail to develop a non-infringing technology on a timely basis or to license the infringed technology on acceptable terms, our business, financial condition and results of operations could be harmed.

If we fail to manage any growth that we might experience, our business could be harmed and we may have to incur significant expenditures to address this growth.

If we continue to experience growth in our operations, our operational and financial systems, procedures and controls may need to be expanded and we may need to train and manage an increasing number of employees, any of which will distract our management team from our business plan and involve increased expenses. Our future success will depend substantially on the ability of our management team to manage any growth effectively. These challenges may include:

• maintaining our cost structure at an appropriate level based on the net sales we generate;

• implementing and improving our operational and financial systems, procedures and controls;

• managing operations in multiple locations and multiple time zones; and

• ensuring the distribution of our products in a timely manner.

We incur significant expenses as a result of being a public company.

We incur significant legal, accounting, insurance and other expenses as a result of being a public company. The Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC and NASDAQ, has required changes in corporate governance practices of public companies. These new rules and regulations have, and will continue, to increase our legal and financial compliance costs and make some activities more time-consuming and costly. These new rules and regulations have also made, and will continue to make, it more difficult and more expensive for us to obtain director and officer liability insurance.

Our eyewear products and business may subject us to product liability claims or other litigation, which are expensive to defend, distracting to our management and may require us to pay damages.

Due to the nature of our products and the activities in which our products may be used, we may be subject to product liability claims or other litigation, including claims for serious personal injury, breach of contract, shareholder litigation, or other litigation. Successful assertion against us of one or a series of large claims could harm our business by causing us to incur legal fees, distracting our management or causing us to pay damage awards.

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We could incur substantial costs to comply with foreign environmental laws, and violations of such laws may increase our costs or require us to change certain business practices.

Because we manufacture a wide variety of eyewear products at our Italian manufacturing facility, we use and generate numerous chemicals and other hazardous by-products in our manufacturing operations. As a result, we are subject to a broad range of foreign environmental laws and regulations. These environmental laws govern, among other things, air emissions, wastewater discharges and the acquisition, handling, use, storage and release of wastes and hazardous substances. Such laws and regulations can be complex and change often. Contaminants have been detected at some of our present facilities, principally in connection with historical practices conducted at LEM. We have undertaken to remediate these contaminants. Although we currently do not expect that these remediation efforts will involve substantial expenditure of resources by us, the costs associated with this remediation could be substantial, which would reduce our cash available for operations, consume valuable management time, reduce our profits or impair our financial condition.

In the event we are unable to remedy any deficiency we identify in our system of internal controls over financial reporting, or if our internal controls are not effective, our business and our stock price could suffer.

Under Section 404 of the Sarbanes-Oxley Act, or Section 404, management is required to assess the adequacy of our internal controls, remediate any deficiency that may be identified for which there are no compensating controls in place, validate that controls are functioning as documented and implement a continuous reporting and improvement process for internal controls. As part of this continuous process, we may discover deficiencies that require us to improve our procedures, processes and systems in order to ensure that our internal controls are adequate and effective and that we are in compliance with the requirements of Section 404. If any deficiency we may find from time to time is not adequately addressed, or if we are unable to complete all of our testing and any remediation in time for compliance with the requirements of Section 404 and the SEC rules thereunder, we would be unable to conclude that our internal controls over financial reporting are effective, which could adversely affect investor confidence in our internal controls over financial reporting.

Risks Related to the Market for Our Common Stock

Our stock price may be volatile, and you may not be able to resell our shares at a profit or at all.

The trading price of our common stock fluctuates due to the factors discussed in this section and elsewhere in this report. For example, between January 1, 2007 and March 10, 2008, our stock has traded as high as $6.75 and as low as $3.75. In addition, the trading market for our common stock may be influenced by the public float that exists in our stock from time to time. For example, although we have approximately 8.1 million shares outstanding, approximately 5.8 million, which is more than 70%, of those shares are held by less than 10 stockholders. If any of those investors were to decide to sell a substantial portion of their respective shares, it would place substantial downward pressure on our stock price. We also have 37,500 shares reserved for the issuance of common stock upon vesting of restricted stock awards. In addition, we have 937,875 shares of our common stock reserved for the exercise of outstanding stock options, of which 640,797 are fully vested and exercisable as of December 31, 2007. Additionally, in connection with our initial public offering, we issued warrants to purchase up to 147,000 shares of common stock to Roth Capital Partners, LLC, and an affiliate, which are fully vested as of December 31, 2007. All 8,161,814 of our outstanding shares of common stock may be sold in the open market, subject to certain limitations.

The trading market for our common stock also is influenced by the research and reports that industry or securities analysts publish about us or our industry. If one or more of the analysts who cover us were to publish an unfavorable research report or to downgrade our stock, our stock price likely would decline. If one or more of these analysts were to cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.

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Fluctuations in our operating results on a quarterly and annual basis could cause the market price of our common stock to decline.

Our operating results fluctuate from quarter to quarter as a result of changes in demand for our products, our effectiveness in managing our suppliers and costs, the timing of the introduction of new products and weather patterns. Historically, we have experienced greater net sales in the second and third quarters of the fiscal year as a result of the seasonality of our products and the markets in which we sell our products, and our first and fourth fiscal quarters have traditionally been our weakest operating quarters due to seasonality. We generally sell more of our sunglass products in the first half of the fiscal year and a majority of our goggle products in the last half of the fiscal year. We anticipate that this seasonal impact on our net sales will continue. As a result, our net sales and operating results have fluctuated significantly from period to period in the past and are likely to do so in the future. These fluctuations could cause the market price of our common stock to decline. You should not rely on period-to-period comparisons of our operating results as an indication of our future performance. In future periods, our net sales and results of operations may be below the expectations of analysts and investors, which could cause the market price of our common stock to decline.

Our expense levels in the future will be based, in large part, on our expectations regarding net sales and based on acquisitions we may complete. Many of our expenses are fixed in the short term or are incurred in advance of anticipated sales. We may not be able to decrease our expenses in a timely manner to offset any shortfall of sales.

Delaware law and our corporate charter and bylaws contain anti-takeover provisions that could delay or discourage takeover attempts that stockholders may consider favorable.

Provisions in our certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following:

• the establishment of a classified Board of Directors requiring that not all directors be elected at one time;

• the size of our Board of Directors can be expanded by resolution of our Board of Directors;

• any vacancy on our board can be filled by a resolution of our Board of Directors;

• advance notice requirements for nominations for election to the Board of Directors or for proposing matters that can be acted upon at a stockholders’ meeting;

• the ability of the Board of Directors to alter our bylaws without obtaining stockholder approval;

• the ability of the Board of Directors to issue and designate the rights of, without stockholder approval, up to 5,000,000 shares of preferred stock, which rights could be senior to those of common stock; and

• the elimination of the right of stockholders to call a special meeting of stockholders and to take action by written consent.

In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, or Delaware law. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us. The provisions in our charter, bylaws and Delaware law could discourage potential takeover attempts and could reduce the price that investors might be willing to pay for shares of our common stock in the future, resulting in the market price being lower than it would be without these provisions.

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Item 1B. Unresolved Staff Comments

None

Item 2. Properties

Our corporate headquarters totals 30,556 square feet and is located in Carlsbad, California. Our current monthly rent for this facility is approximately $38,000 per month, which we lease on a month to month basis. We also lease two buildings in Varese, Italy totaling approximately 11,000 square feet with monthly lease payments of approximately $9,000. These facilities are used for international sales and distribution and the leases expire between March 2008 and September 2009; however, we have an option to terminate these leases upon six months’ notice. Additionally, our subsidiary LEM leases four buildings in Italy totaling approximately 38,000 square feet with monthly lease payments of approximately $29,000. These facilities are used for office space, warehousing and manufacturing and the leases expire between October 2008 and January 2011. In addition, we utilize some third party warehousing in both the United States and Europe.

We believe our facilities are adequate for our current needs and that suitable additional or substitute space will be available to accommodate foreseeable expansion of our operations or to move our operations in the event one or more of our leases can no longer be renewed on commercially reasonable terms.

Item 3. Legal Proceedings

On October 30, 2007, John Flynn Caro, our former sales representative, and his wife filed an action against Spy Optic, Inc. in Puerto Rico seeking damages of not less than $200,000 relating to the termination of a sales representative agreement. The action was removed to federal district court on January 3, 2008, and we filed an answer and counterclaim on January 10, 2008. The Company presently has no estimate of any potential loss or range of loss with respect to the lawsuit or any estimate as to the potential costs of defending the lawsuit.

Additionally, from time to time we are involved in various lawsuits and legal proceedings which arise in the ordinary course of business. An adverse result in the matter described above or any other legal matters that may arise from time to time may harm our business.

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

Principal Market and Holders

Our common stock, par value $0.0001, is traded on the NASDAQ Global Market (formerly the NASDAQ National Market) under the symbol “ORNG”. At March 7, 2008, there were approximately 70 stockholders of record of our common stock. Many of the holders are brokers and other institutions on behalf of stockholders; therefore, we are unable to estimate the total number of beneficial owners represented by these stockholders of record.

Dividends

We have never declared or paid any cash dividend on our common stock, nor do we currently intend to pay any cash dividend on our common stock in the foreseeable future. We expect to retain our earnings, if any, for the growth and development of our business. In addition, the terms of our credit facility limit our ability to pay cash dividends on our common stock. A description of our credit facility can be found in this Annual Report under Item 7 under the caption “Liquidity and Capital Resources” and Item 8 under the caption “Financial Statements”.

Common Stock Prices

As of March 31, 2008, the closing sales price for the common stock was $4.42. The following table sets forth, for the periods indicated, the range of high and low sales prices for our common stock on the NASDAQ Global Market:

	Stock Prices
	High		Low
2007
Fourth Quarter	$	5.02	$	3.75
Third Quarter		6.53		4.05
Second Quarter		6.75		5.39
First Quarter		6.00		4.87
2006
Fourth Quarter	$	5.05	$	3.25
Third Quarter		5.85		4.29
Second Quarter		6.00		3.86
First Quarter		4.99		3.62

Securities Authorized for Issuance under Compensation Plans

Set forth in the table below is certain information regarding the number of shares of our common stock that were subject to outstanding stock options or other compensation plan grants and awards as of December 31, 2007.

Plan Category	Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights	Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights		Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a))
	( a )	( b )		( c )
Equity compensation plans approved by security holders (1)	843,500	$	6.74	619,625
Total	843,500	$	6.74	619,625

(1) Includes vesting of restricted stock

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Annual Report (including the following section regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations) contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Annual Report. Additionally, statements concerning future matters such as the development of new products, our ability to increase manufacturing capacity, sales levels, expense levels and other statements regarding matters that are not historical are forward-looking statements.

Although forward-looking statements in this Annual Report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include but are not limited to: risks related to our ability to manage growth; risks related to the limited visibility of future orders; the ability to identify and work with qualified manufacturing partners and consultants; the ability to expand distribution channels and retail operations in a timely manner; unanticipated changes in general market conditions or other factors, which may result in cancellations of advance orders or a reduction in the rate of reorders placed by retailers; the ability to continue to develop, produce and introduce innovative new products in a timely manner; the ability to source raw materials and finished products at favorable prices; the ability to identify and execute successfully cost control initiatives; uncertainties associated with our ability to maintain a sufficient supply of products and to manufacture successfully our products and inventory levels; the integration of the LEM acquisition; the performance of new products and continued acceptance of current products; the execution of strategic initiatives and alliances; uncertainties associated with intellectual property protection for our products; matters generally affecting the domestic and global economy, such as changes in interest and currency rates; and other factors described in Item 1A of Part II of this Annual Report under the caption “Risk Factors,” as well as those discussed elsewhere in this Annual Report. Readers are urged not to place undue reliance on forward-looking statements, which speak only as of the date of this Annual Report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Annual Report. Readers are urged to carefully review and consider the various disclosures made in this Annual Report, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing elsewhere in this Annual Report.

Overview

The following discussion includes the operations of Orange 21 Inc. and its subsidiaries for each of the periods discussed.

We design, develop and market premium products for the action sports, motorsports and youth lifestyle markets. Our principal products, sunglasses and goggles, are marketed primarily under the brands, Spy™ and SpyOptic™. These products target the action sport and power sports markets, including surfing, skateboarding, snowboarding, ski, motocross, and the youth lifestyle market within fashion, music and entertainment. We have built our Spy ^® brand by developing innovative, proprietary products that utilize high-quality materials and optical lens technology to convey performance, style, quality and value. We sell our products in approximately 3,300 retail locations in the United States and Canada and internationally through approximately 2,000 retail

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locations serviced by us and our international distributors. We have developed strong relationships with key multi-store action sport and youth lifestyle retailers in the United States, such as Cycle Gear, Inc., No Fear, Inc., Pacific Sunwear of California, Inc., Tilly’s Clothing, Shoes & Accessories and Zumiez, Inc., and a strategically selective collection of specialized surf, skate, snow and motocross stores.

We focus our marketing and sales efforts on the action sports, motorsports, and youth lifestyle markets, and specifically, persons ranging in age from 17 to 35. We separate our eyewear products into two groups: sunglasses, which includes fashion, performance sport and women-specific sunglasses, and goggles, which includes snowsport and motocross goggles. In addition, we sell branded sunglass and goggle accessories. In managing our business, we are particularly focused on ensuring that our product designs are keyed to current trends in the fashion industry, incorporate the most advanced technologies to enhance performance and provide value to our target market.

We began as a grassroots brand in Southern California and entered the action sports and youth lifestyle markets with innovative and performance-driven products and an authentic connection to the action sports and youth lifestyle markets under the Spy Optic™ brand. We have two wholly owned subsidiaries incorporated in Italy, Spy Optic, S.r.l. and LEM (our primary manufacturer which we acquired on January 16, 2006), and a wholly owned subsidiary incorporated in California, Spy Optic, Inc., which we consolidate in our financial statements. We were incorporated as Sports Colors, Inc. in California in August 1992. From August 1992 to April 1994, we had no operations. In April 1994, we changed our name to Spy Optic, Inc. In November 2004, we reincorporated in Delaware and changed our name to Orange 21 Inc.

Results of Operations

Years Ended December 31, 2007 and 2006

Net Sales

Consolidated net sales increased 10% to $46.5 million for the year ended December 31, 2007 from $42.4 million for the year ended December 31, 2006. The increase is partly due to increased sales and marketing efforts, including an increase in sales force, and an improvement in product mix.

Domestic net sales represented 72% and 77% of total net sales for the years ended December 31, 2007 and 2006, respectively. Foreign net sales represented 28% and 23% of total net sales for the years ended December 31, 2007 and 2006, respectively. The sales mix on a dollar basis for the years ended December 31, 2007 and 2006 was 95% and 99%, respectively, for eyewear and 5% and 1%, respectively, for apparel and accessories.

Cost of Sales and Gross Profit

Our consolidated gross profit increased 30% to $22.8 million for the year ended December 31, 2007 from $17.5 million for the year ended December 31, 2006. Gross profit as a percentage of sales increased to 49% for the year ended December 31, 2007 from 41% for the year ended December 31, 2006. The increase in gross profit and gross profit as a percentage of sales is partly due to efficiencies achieved at LEM, our subsidiary and primary manufacturer, and a more favorable product mix. The increase is also due to net decreases in inventory reserves for slow moving and obsolete inventory that is no longer being marketed for resale of approximately of $1.4 million. During the year ended December 31, 2007, inventory with an adjusted basis of $0.8 million was sold for approximately $1.8 million in revenue, affecting margins by $1.0 million or 2% of net sales. The remaining decrease in the inventory reserve was mainly due to the disposal of product which has no effect on the results of operations.

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Sales and Marketing Expense

Sales and marketing expense increased 12% to $16.2 million for the year ended December 31, 2007 from $14.5 million for the year ended December 31, 2006. The increase was primarily due to a $2.0 million write off of point-of-purchase displays in the U.S., which was a result of transferring ownership of the point-of-purchase displays to our customers during June 2007. In addition, in the U.S., further purchases of point-of-purchase displays will no longer be capitalized since the displays will be owned by the customers. The cost of these displays will be charged to sales and marketing expense. We do not expect this change to materially affect our results of operations in future periods.

General and Administrative Expense

General and administrative expense increased 2% to $9.6 million for the year ended December 31, 2007 from $9.4 million for the year ended December 31, 2006. The increase in general and administrative expense was primarily due to increased legal fees of $0.4 million which included $0.2 million in legal fees related to negotiations for the acquisition of the retail stores division of No Fear which did not materialize, a $0.3 million increase for employee-related compensation expense at LEM including severance pay for LEM employees and related legal fees, increased consulting fees of $0.3 million, increased share-based compensation in accordance with SFAS No. 123(R) of $0.2 million, and increases in depreciation and amortization costs and rent expense. The increases were partly offset by decreases in audit fees of $0.4 million, bad debt expense of $0.3 million, $0.2 million payroll costs in the U.S., investor relations related costs, travel and business insurance.

Shipping and Warehousing Expense

Shipping and warehousing expense consists primarily of wages and related payroll and employee benefit costs, packaging supplies, third-party warehousing and third-party fulfillment costs, facility costs and utilities. Shipping and warehousing expense remained consistent at $1.8 million for each of the years ended December 31, 2007 and 2006.

Research and Development Expense

Research and development expense increased 24% to $1.2 million for the year ended December 31, 2007 from $1.0 million for the year ended December 31, 2006. The increase is mainly due to an increase in employee-related compensation expense.

Other Net Expense

Other net expense was $0.5 million for the year ended December 31, 2007 compared to other net expense of $0.4 million for the year ended December 31, 2006. The change in other net expense is primarily due to increases in net interest expense partly offset by an increase in foreign currency transaction gains in 2007 compared to foreign currency losses in 2006.

Income Tax (Benefit) Provision

The income tax provision for the year ended December 31, 2007 was $1.5 million compared to a $2.3 million benefit for the year ended December 31, 2006. The effective tax rate for the years ended December 31, 2007 and 2006 was (22%) and 25%, respectively. The decrease in the effective tax rate was due to a larger proportion of the pretax losses incurred in the U.S. versus in Italy, offset by the valuation allowance of $3.2 million recorded in the U.S. booked in 2007 versus no valuation allowance recorded in 2006 for the U.S.

Net Loss

A net loss of $8.0 million was incurred for the year ended December 31, 2007 compared to a net loss of $7.2 million for the year ended December 31, 2006.

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Liquidity and Capital Resources

Cash flow activities

Cash provided by or used in operating activities consists primarily of net income (loss) adjusted for certain non-cash items, including depreciation, amortization, deferred income taxes, provision for bad debts, stock compensation expense and the effect of changes in working capital and other activities. Cash used in operating activities for the year ended December 31, 2007 was approximately $2.6 million, which consisted of a net loss of $8.0 million, adjustments for non-cash items of approximately $6.7 million and $1.3 million used in working capital and other activities. Working capital and other activities includes a $1.6 million increase in net inventory due primarily to an increase in inventory in anticipation of future sales and a $0.3 million decrease in accounts payable and accrued liabilities due to timing of invoices received and payments made offset partly and a $0.7 million decrease in income tax receivable and a $0.3 million decrease in prepaid and other current assets.

Cash provided for by operating activities for the year ended December 31, 2006 was $2.1 million which consisted of a net loss of $7.2 million, adjustments for non-cash items of approximately $3.9 million, and $5.4 million provided for by working capital and other activities. Working capital and other activities consisted primarily of a $4.3 million decrease in inventory due to an increase in sales and inventory reserves due to slow and obsolete inventory which we no longer market for resale, a $1.8 million increase in accounts payable and accrued liabilities due to timing of payments of vendor invoices and an offsetting $0.7 million increase in accounts receivable due to timing of customer receipts.

Cash used in investing activities during the year ended December 31, 2007 was $0.7 million and was primarily attributable to the purchase of $1.9 million of fixed assets, including retail point-of-purchase displays. Going forward, point-of-purchase displays in the U.S. will be expensed as a sales and marketing expense. We also made $1.0 million in payments related to requirements of the purchase agreement for the acquisition of LEM that were paid out during the year. We had an offset of approximately $0.5 million due to net proceeds received on short-term investments. Additionally, we released $1.7 million of restricted cash related to collateralization of our financing arrangements of $1.2 million and $0.5 million that was held in escrow related to the acquisition of LEM.

Cash used in investing activities during the year ended December 31, 2006 was $4.7 million and was primarily attributable to the purchase of $4.6 million of fixed assets, including our new enterprise resource planning system and retail point-of-purchase displays and $3.5 million for the purchase of LEM, our primary manufacturer. Additionally, we made a $1.7 investment in restricted cash of which $0.7 million is related to requirements of the purchase agreement for the acquisition of LEM and $1.0 million is related to collateralization of our financing arrangements with Comerica Bank. We had an offset of approximately $5.0 million due to net proceeds received on short-term investments.

Cash provided by financing activities for the year ended December 31, 2007 was $2.7 million and was mainly attributable to $2.7 million in net proceeds received through our lines of credit and $0.8 million in net proceeds received through the issuance of notes payable, partially offset by $0.8 million for notes payable and capital lease principal payments.

Cash provided by financing activities for the year ended December 31, 2006 was $0.6 million and was mainly attributable to $0.7 million in net proceeds received through our line of credit facilities and $0.3 million received through the issuance of notes payable, partially offset by $0.5 million for capital lease principal payments.

Credit Facilities

At December 31, 2006, we had financing arrangements with Comerica Bank consisting of a line of credit facility with a $5.0 million limit, a foreign exchange facility and letter of credit accommodations. These

30

arrangements were secured by all our assets, excluding our intellectual property, and a $1.0 million collateral cash deposit with Comerica, and were subject to certain covenants, including several liquidity, debt coverage and minimum equity ratios. The $5.0 million available line of credit was reduced by the amount of outstanding letters of credit (sub limit of $4.1 million) and 10% of outstanding foreign exchange forward contracts ($0.9 million sub limit). Borrowings were limited to cover any outstanding letters of credit issued to San Paolo IMI on behalf of LEM (3.0 million Euros or $3.9 million at December 31, 2006).

Our foreign exchange facility allowed us to purchase currency contracts which we used primarily to hedge our foreign currency exposure. The amount of allowable purchases of such contracts was $9.0 million. At December 31, 2006, net foreign exchange forward contracts outstanding amounted to $5.7 million, which reduced the amount available to us under the line of credit by $570,000. As a result, at December 31, 2006, we had an unused line of credit of approximately $0.5 million with Comerica Bank.

At December 31, 2006, we were not in compliance with two financial covenants under the financing arrangements with Comerica related to maintaining a minimum tangible net worth and not incurring net losses in two consecutive quarters. On February 22, 2007, we amended our financing arrangements with Comerica, which decreased our letter of credit sub limit to $1.8 million, decreased our foreign exchange facility limit from $9.0 million to $7.2 million and extended the expiration date to May 15, 2007. We later replaced this line of credit with a line of credit from BFI Business Finance on February 26, 2007, as described below.

On February 26, 2007, Spy Optic, Inc. entered into a Loan and Security Agreement (“Loan Agreement”) with BFI Business Finance (“BFI”) with a maximum borrowing capacity of $5.0 million, which was subsequently modified to extend the maximum borrowing capacity to $8.0 million and to affect certain other changes. Actual borrowing availability under the Loan Agreement is based on eligible trade receivable and inventory levels of Spy Optic, Inc. Loans extended pursuant to the Loan Agreement will bear interest at a rate per annum equal to the prime rate as reported in the Western Edition of the Wall Street Journal from time to time plus 2.5%, with a minimum monthly interest charge of $2,000. We granted BFI a security interest in all of Spy Optic, Inc.’s assets as security for its obligations under the Loan Agreement, except for its copyrights, patents, trademarks, servicemarks and related applications. Additionally, the obligations under the Loan Agreement are guaranteed by Orange 21 Inc.

The Loan Agreement imposes certain covenants on Spy Optic, Inc., including, but not limited to, covenants requiring it to provide certain periodic reports to BFI, inform BFI of certain changes in the business, refrain from incurring additional debt in excess of $100,000 and refrain from paying dividends. Spy Optic, Inc. also established a bank account in BFI’s name into which collections on accounts receivable and other collateral are deposited (the “Collateral Account”). Pursuant to the deposit control account agreement between Spy Optic, Inc. and BFI with respect to the Collateral Account, BFI is entitled to sweep all amounts deposited into the Collateral Account and apply the funds to outstanding obligations under the Loan Agreement; provided that BFI is required to distribute to Spy Optic, Inc. any amounts remaining after payment of all amounts due under the Loan Agreement. To secure its obligations under the guaranty, Orange 21 Inc. granted BFI a blanket security interest in all of its assets, except for its stock in Spy Optic, Inc., which it has covenanted not to pledge to any other person or entity. We were in compliance with the covenants at December 31, 2007.

We received a loan in the amount of $650,000 upon the execution of the Loan Agreement. These proceeds were used to fully collateralize Comerica Bank for the letter of credit issued by Comerica on behalf of Orange 21 Inc. and LEM to San Paolo IMI in the amount of 1.2 million Euros. The letter of credit with Comerica expired in May 2007. The collateral of 1.2 million Euros was transferred to an interest bearing account with San Paolo IMI in Italy to serve as collateral for the LEM San Paolo IMI line of credit. During September 2007 San Paolo released the collateral requirement in conjunction with the reduction of the San Paolo IMI line of credit.

At December 31, 2007, there were outstanding borrowings of $4.5 million under the Loan Agreement, bearing an interest rate of 10.62% and availability under this line of $3.5 million subject to eligible accounts receivable and inventory levels.

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At December 31, 2006, we also had a 2.2 million Euros line of credit in Italy with San Paolo IMI for LEM. During October 2007 the line of credit was reduced to 1.4 million Euros. Borrowing availability is based on eligible accounts receivable and export orders received at LEM. At December 31, 2007, there was approximately 0.5 million Euros available under this line of credit. At December 31, 2007 and 2006, amounts outstanding under this line of credit amounted to $1.3 million and $3.0 million, respectively. The interest rate at December 31, 2007 was 5.88%.

If we are able to achieve anticipated net sales, manage our inventory and manage operating expenses, we believe that our cash on hand and available loan facilities will be sufficient to enable us to meet our financing and operating requirements for at least the next 12 months. Otherwise, changes in operating plans, lower than anticipated net sales, increased expenses or other events, including those described in Item 1A, “Risk Factors,” may require us to seek additional debt or equity financing in the future. Our future capital requirements will depend on many factors, including our rate of net sales growth, continuing financing requirements related to our recent acquisition of LEM, the expansion of our sales and marketing activities and the continuing market acceptance of our product designs. We may be required to seek equity or debt financing in the future, which would result in additional dilution of our stockholders. Additional debt would result in increased interest expense and could result in covenants that would restrict our operations.

Off-balance sheet arrangements

We did not enter into any off-balance sheet arrangements during the years ended December 31, 2007 and 2006, nor did we have any off-balance sheet arrangements outstanding at December 31, 2007 and 2006.

Income Taxes

In assessing the realization of 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 deferred tax assets is dependent upon 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, projected future taxable income, and tax planning strategies in making this assessment. Based on the level of historical operating results and projections for the taxable income for the future, management has determined that it is more likely than not that the deferred tax assets, net of the valuation allowance, will be realized in the U.S. at December 31, 2007. Accordingly, we have recorded a valuation allowance for our U.S. operations at December 31, 2007 and 2006 of $3,164,000 and $0, respectively. At December 31, 2007 and 2006, we have recorded a full valuation allowance for our wholly owned subsidiaries, Spy Optic, S.r.l and LEM.

Backlog

Historically, purchases of sunglass and motocross eyewear products have not involved significant pre-booking activity. Purchases of our snow goggle products are generally pre-booked and shipped primarily from August to October.

We experienced delays in manufacturing and shipping our sunglass and goggle products during 2007 and 2006. These delays have materially affected our results of operations. We anticipate that we may continue to experience manufacturing and shipping delays, and that such delays may continue to have a material effect on our results of operations.

Seasonality

Our net sales fluctuate from quarter to quarter as a result of changes in demand for our products. Historically, we have experienced greater net sales in the second half of the fiscal year as a result of the seasonality of our products and the markets in which we sell our products. We generally sell more of our

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sunglass products in the first half of the fiscal year and a majority of our goggle products in the last half of the fiscal year. We anticipate that this seasonal impact on our net sales will continue. As a result, our net sales and operating results have fluctuated significantly from period-to-period in the past and are likely to do so in the future.

Inflation

We do not believe inflation has had a material impact on our operations in the past, although there can be no assurance that this will be the case in the future.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of consolidated financial statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, net sales and expenses and related disclosures. On an ongoing basis, we evaluate our estimates, including those related to inventories, sales returns, income taxes, accounts receivable allowances, share-based compensation, impairment testing and warranty. We base our estimates on historical experience, performance metrics and various other assumptions that we believe 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 will differ from these estimates under different assumptions or conditions.

We apply the following critical accounting policies in the preparation of our consolidated financial statements:

Revenue Recognition

The Company’s revenue is primarily generated through sales of sunglasses, goggles and apparel, net of returns and discounts. Revenue is recognized in accordance with Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 104 (“SAB 104”), Revenue Recognition. Under SAB 104, revenue from product sales is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured. These criteria are usually met upon delivery to our carrier, which is also when the risk of ownership and title passes to our customers.

Generally, we extend credit to our customers after performing credit evaluations and do not require collateral. Our payment terms generally range from net-30 to net-90, depending on the country or whether we sell directly to retailers in the country or to a distributor. Our distributors are typically set up as prepay accounts; however credit may be extended to certain distributors, usually upon receipt of a letter of credit. Generally, our sales agreements with our customers, including distributors, do not provide for any rights of return or price protection. However, we do approve returns on a case-by-case basis in our sole discretion. We record an allowance for estimated returns when revenues are recorded. The allowance is calculated using historical evidence of actual returns. Historically, actual returns have been within our expectations. If future returns are higher than our estimates, our earnings would be adversely affected.

Accounts Receivable, Reserve for Refunds and Returns and Allowance for Doubtful Accounts

Throughout the year, we perform credit evaluations of our customers, and we adjust credit limits based on payment history and the customer’s current creditworthiness. We continuously monitor our collections and maintain a reserve for estimated credit. We reserve for estimated future refunds and returns at the time of shipment based upon historical data. We adjust reserves as we consider necessary. We make judgments as to our ability to collect outstanding receivables and provide allowances for anticipated bad debts and refunds. Provisions are made based upon a review of all significant outstanding invoices and overall quality and age of

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those invoices not specifically reviewed. In determining the provision for invoices not specifically reviewed, we analyze collection experience, customer credit-worthiness and current economic trends. If the data used to calculate these allowances does not reflect our future ability to collect outstanding receivables, an adjustment in the reserve for refunds may be required. Historically, our losses have been consistent with our estimates, but there can be no assurance that we will continue to experience the same credit loss rates that we have experienced in the past. Unforeseen, material financial difficulties experienced by our customers could have an adverse impact on our profits.

Share-based Compensation Expense

We account for share-based compensation in accordance with SFAS No. 123(R), which requires us to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized in the consolidated statement of operations over the period during which the employee is required to provide service in exchange for the award—the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. The grant-date fair value of employee share options and similar instruments is estimated using option-pricing models adjusted for the unique characteristics of those instruments. SFAS No. 123(R) eliminates the use of Accounting Principles Board (“APB”) Opinion 25 and the option for pro forma disclosure in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”).

Determining Fair Value under SFAS No. 123(R)

Valuation and Amortization Method. Consistent with the valuation method used for the disclosure only provisions of SFAS No. 123, we are using the Black-Scholes option-pricing valuation model (single option approach) to calculate the fair value of stock option grants. For options with graded vesting, the option grant is treated as a single award and compensation cost is recognized on a straight-line basis over the vesting period of the entire award.

Expected Term. The expected term of options granted represents the period of time that the option is expected to be outstanding. We estimate the expected term of the option grants based on historical exercise patterns that we believe to be representative of future behavior as well as other various factors.

Expected Volatility. We estimate our volatility using our historical share price performance over the expected life of the options, which management believes is materially indicative of expectations about expected future volatility.

Risk-Free Interest Rate. We use risk-free interest rates in the Black-Scholes option valuation model that are based on U.S. Treasury zero-coupon issues with a remaining term equal to the expected life of the options.

Dividend Rate. We have not paid dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Therefore, we use an expected dividend yield of zero.

Forfeitures. SFAS No. 123(R) requires companies to estimate forfeitures at the time of grant and revise those estimates in subsequent reporting periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. For purposes of calculating pro forma information under SFAS No. 123 for periods prior to the date of adoption of SFAS No. 123(R), we accounted for forfeitures as they occurred. The impact of the adoption of SFAS No. 123(R) related to forfeitures was not material to our financial statements.

Inventories

Inventories consist primarily of raw materials and finished products, including sunglasses, goggles, apparel and accessories, product components such as replacement lenses and purchasing and quality control

34

costs. Inventory items are carried on the books at the lower of cost or market using the weighted average cost method for LEM and first in first out method for our distribution business. Periodic physical counts of inventory items are conducted to help verify the balance of inventory.

A reserve is maintained for obsolete or slow moving inventory. Products are reserved at certain percentages based on their probability of selling, which is estimated based on current and estimated future customer demands and market conditions. Historically, there has been variability in the amount of write offs, compared to estimated reserves. These estimates could vary significantly, either favorably or unfavorably, from actual experience if future economic conditions, levels of consumer demand, customer inventory or competitive conditions differ from expectations.

Goodwill

Goodwill is not amortized but instead is measured for impairment at least annually, or when events indicate that a likely impairment exists. We evaluate the recoverability of goodwill at least annually based on a two-step impairment test. The first step compares the fair value of each reporting unit with its carrying amount, including goodwill. If the carrying amount exceeds fair value, then the second step of the impairment test is performed to measure the amount of any impairment loss. The fair value of each reporting unit was determined using a combination of the income approach and the market approach. Under the income approach, the fair value of a reporting unit is calculated based on the present value of estimated future cash flows. The present value of estimated future cash flows uses our estimates of profit for the reporting units, driven by assumed market growth rates and assumed market segment share, and estimated costs as well as appropriate discount rates. These estimates are consistent with the plans and estimates that we use to manage the underlying business. Under the market approach, fair value is estimated based on market multiples of earnings for comparable companies and similar transactions.

We performed our annual test of goodwill as of October 1, 2007, which did not indicate any impairment and thus the second step was not performed. Determining fair value under the first step of the goodwill impairment test is subjective in nature and often involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the extent of such charge.

Research and Development

We expense research and development costs as incurred. We capitalize product molds and tooling and depreciate these costs over the useful life of the asset.

Income Taxes

We account for income taxes pursuant to the asset and liability method, whereby deferred tax assets and liabilities are computed at each balance sheet date for temporary differences between the consolidated financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted laws and rates applicable to the periods in which the temporary differences are expected to affect taxable income. We consider future taxable income and ongoing, prudent and feasible tax planning strategies in assessing the value of our deferred tax assets. If we determine that it is more likely than not that these assets will not be realized, we will reduce the value of these assets to their expected realizable value, thereby decreasing our net income. Evaluating the value of these assets is necessarily based on our management’s judgment. If we subsequently determine that the deferred tax assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made.

We have established a valuation allowance against our deferred tax assets in each jurisdiction where we cannot conclude that it is more likely than not that those assets will be realized. In the event that actual results

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differ from our forecasts or we adjust the forecast or assumptions in the future, the change in the valuation allowance could have a significant impact on future income tax expense.

We are subject to income taxes in the United States and foreign jurisdictions. In the ordinary course of our business, there are calculations and transactions, including transfer pricing, where the ultimate tax determination is uncertain. In addition, changes in tax laws and regulations as well as adverse judicial rulings could materially affect the income tax provision.

Foreign Currency and Derivative Instruments

The functional currency of each of our foreign wholly owned subsidiaries, Spy Optic, S.r.l., LEM and our Canadian division is the respective local currency. Accordingly, we are exposed to transaction gains and losses that could result from changes in foreign currency. Assets and liabilities denominated in foreign currencies are translated at the rate of exchange on the balance sheet date. Revenues and expenses are translated using the average exchange rate for the period. Gains and losses from translation of foreign subsidiary financial statements are included in accumulated other comprehensive income (loss).

We designate our derivatives based upon the criteria established by SFAS No. 133, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS No. 133, as amended by SFAS No. 138 “Accounting for Certain Derivative Instruments and Certain Hedging Activities – an amendment of SFAS 133”, (“SFAS No. 138”) and SFAS No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS No. 149”), requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The accounting for the changes in the fair value of the derivative depends on the intended use of the derivative and the resulting designation. For a derivative designated as a cash flow hedge, the effective portion of the derivative’s fair value gain or loss is initially reported as a component of accumulated other comprehensive income (loss). Any realized gain or loss on such derivative is reported in cost of goods sold in the accounting period in which the hedged transaction affects earnings. The fair value gain or loss from the ineffective portion of the derivative is reported in other income (expense) immediately. For a derivative that does not qualify as a cash flow hedge, the change in fair value is recognized at the end of each accounting period in other income (expense).

Commitments and Contingencies

We have entered into operating leases, primarily for facilities, and have commitments under endorsement contracts with selected athletes and others who endorse our products. We also have an agreement with our primary product designer.

Recently Issued Accounting Pronouncements

On January 1, 2007, we adopted the provisions of FIN 48, which prescribe a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. There has been no material effect on our financial statements as a result of the adoption of FIN 48 as of December 31, 2007.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for us beginning January 1, 2008. We are currently assessing the potential impact that the adoption of SFAS No. 157 will have on our financial statements.

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In February 2007, the FASB released SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”), which is effective for fiscal years beginning after November 15, 2007. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. We are currently assessing the impact the adoption of this pronouncement will have on the financial statements. SFAS No. 157 will need to be adopted in order to adopt SFAS No. 159.

In December 2007, the FASB issued SFAS No. 141 (Revised), “Business Combinations” (“SFAS No. 141 (R)”), replacing SFAS No. 141, “Business Combinations” (“SFAS No. 141”). SFAS No. 141 (R) retains the fundamental requirements of SFAS No. 141, broadens its scope by applying the acquisition method to all transactions and other events in which one entity obtains control over one or more other businesses, and requires, among other things, that assets acquired and liabilities assumed be measured at fair value as of the acquisition date, that liabilities related to contingent consideration be recognized at the acquisition date and remeasured at fair value in each subsequent reporting period, that acquisition-related costs be expensed as incurred, and that income be recognized if the fair value of the net assets acquired exceeds the fair value of the consideration transferred. SFAS No. 141 (R) is to be applied prospectively in financial statements issued for fiscal years beginning after December 15, 2008. We do not expect that the adoption of SFAS No. 141 (R) will have a material effect on our consolidated financial statements.

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Item 8. Financial Statements and Supplementary Data

ORANGE 21 INC. AND SUBSIDIARIES

Index to Consolidated Financial Statements

	Page
Report of Independent Registered Public Accounting Firm	39
Consolidated Financial Statements:
Consolidated Balance Sheets as of December 31, 2007 and 2006 (Restated)	40
Consolidated Statements of Operations for the years ended December 31, 2007 and 2006 (Restated)	41
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2007 and 2006 (Restated)	42
Consolidated Statements of Cash Flows for the years ended December 31, 2007 and 2006 (Restated)	43
Notes to Consolidated Financial Statements	44

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of

Orange 21 Inc. and Subsidiaries

Carlsbad, California

We have audited the accompanying consolidated balance sheets of Orange 21 Inc. (a Delaware corporation) and its subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity and cash flows for the years then ended. We have also audited the financial statement schedule listed at Item 15(a). These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and the schedule 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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. 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 presentation of the financial statements. 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 consolidated financial position of Orange 21 Inc. and its subsidiaries as of December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the schedule presents fairly, in all material respects, the information set forth therein.

As discussed in Note 2 of the consolidated financial statements, the Company restated its 2006 consolidated financial statements.

/s/ Mayer Hoffman McCann P.C.

San Diego, California

April 8, 2008

39

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Thousands, except number of shares and per share amounts)

	December 31,
	2007			2006
				(As Restated. See Note 2)
Assets
Current assets
Cash and cash equivalents	$	555		$	1,279
Restricted cash		—			1,728
Short-term investments		—			500
Accounts receivable, net		10,510			10,014
Inventories, net		11,297			9,098
Prepaid expenses and other current assets		1,460			1,584
Income taxes receivable		123			606
Deferred income taxes		1,722			1,827
Total current assets		25,667			26,636
Property and equipment, net		5,775			8,042
Goodwill		9,735			8,727
Intangible assets, net of accumulated amortization of $504 and $376 at December 31, 2007 and 2006, respectively		493			530
Deferred income taxes		719			1,632
Other long-term assets		202			69
Total assets	$	42,591		$	45,636
Liabilities and Shareholders’ Equity
Current liabilities
Lines of credit	$	5,805		$	2,976
Current portion of capital leases		378			410
Current portion of notes payable		498			251
Accounts payable		6,715			6,418
Accrued expenses and other liabilities		4,964			4,458
Deferred purchase price obligation		—			1,020
Income taxes payable		207			—
Total current liabilities		18,567			15,533
Notes payable, less current portion		837			593
Capitalized leases, less current portion		704			647
Deferred income taxes		384			300
Total liabilities		20,492			17,073
Stockholders’ equity
Preferred stock: par value $0.0001; 5,000,000 authorized; none issued		—			—
Common stock: par value $0.0001; 100,000,000 shares authorized; 8,161,814 and 8,100,564 shares issued and outstanding at December 31, 2007 and 2006, respectively		1			1
Additional paid-in-capital		36,845			36,336
Accumulated other comprehensive income		2,526			1,505
Accumulated deficit		(17,273	)		(9,279	)
Total stockholders’ equity		22,099			28,563
Total liabilities and stockholders’ equity	$	42,591		$	45,636

The accompanying notes are an integral part of these consolidated financial statements.

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ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Thousands, except per share amounts)

	Year Ended December 31,
	2007			2006
				(As Restated. See Note 2)
Net sales	$	46,541		$	42,406
Cost of sales		23,727			24,881
Gross profit		22,814			17,525
Operating expenses:
Sales and marketing		16,244			14,486
General and administrative		9,597			9,372
Shipping and warehousing		1,768			1,768
Research and development		1,245			1,003
Total operating expenses		28,854			26,629
Loss from operations		(6,040	)		(9,104	)
Other expense:
Interest expense		(592	)		(241	)
Foreign currency transaction gain (loss)		114			(53	)
Other expense		(24	)		(129	)
Total other expense		(502	)		(423	)
Loss before benefit for income taxes		(6,542	)		(9,527	)
Income tax provision (benefit)		1,452			(2,342	)
Net loss	$	(7,994	)	$	(7,185	)
Net loss per share of Common Stock
Basic	$	(0.98	)	$	(0.89	)
Diluted	$	(0.98	)	$	(0.89	)
Shares used in computing net loss per share of Common Stock
Basic		8,126			8,089
Diluted		8,126			8,089

The accompanying notes are an integral part of these consolidated financial statements.

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ORANGE 21 INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

	Common Stock			Paid-in Capital		Accumulated Other Income (Loss)			Accumulated Deficit			Total
	Shares	Amount
	(Thousands)
Balance at December 31, 2005 (As Reported)	8,084	$	1	$	36,100	$	32		$	(1,902	)	$	34,231
Adjustments	1		—		—		—			(192	)		(192	)
Balance at December 31, 2005 (Restated)	8,085		1		36,100		32			(2,094	)		34,039
Exercise of stock options	6		—		20		—			—			20
Tax benefit related to exercise of stock options	—		—		4		—			—			4
Share-based compensation	10		—		212		—			—			212
Comprehensive income (loss):
Foreign currency translation adjustment	—		—		—		399			—			399
Unrealized gain on available for sale securities	—		—		—		2			—			2
Unrealized gain on foreign currency cash flow hedges	—		—		—		643			—			643
Unrealized gain on foreign currency exposure of net investment in foreign operations	—		—		—		429			—			429
Net loss (As Restated. See Note 2)	—		—		—		—			(7,185	)		(7,185	)
Comprehensive income (loss)	—		—		—		1,473			(7,185	)		(5,712	)
Balance at December 31, 2006 (Restated)	8,101		1		36,336		1,505			(9,279	)		28,563
Exercise of stock options	9		—		30		—			—			30
Tax benefit related to exercise of stock options	—		—		4		—			—			4
Vesting of restricted stock awards	52		—		—		—			—			—
Share-based compensation	—		—		475		—			—			475
Comprehensive income (loss):
Foreign currency translation adjustment	—		—		—		841			—			841
Unrealized loss on foreign currency cash flow hedges	—		—		—		(345	)		—			(345	)
Unrealized gain on foreign currency exposure of net investment in foreign operations	—		—		—		525			—			525
Net loss	—		—		—		—			(7,994	)		(7,994	)
Comprehensive income (loss)	—		—		—		1,021			(7,994	)		(6,973	)
Balance at December 31, 2007	8,162	$	1	$	36,845	$	2,526		$	(17,273	)	$	22,099

42

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Thousands)

	Year Ended December 31,
	2007			2006
				(As Restated. See Note 2)
Operating Activities
Net loss	$	(7,994	)	$	(7,185	)
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		2,809			3,949
Deferred income taxes		1,065			(1,485	)
Share-based compensation		475			212
Provision for bad debts		198			604
Loss on sale/transfer of property and equipment		2,064			502
Impairment of property and equipment		147			88
Change in operating assets and liabilities:		—
Accounts receivable		(362	)		(664	)
Inventories, net		(1,633	)		4,333
Prepaid expenses and other current assets		272			380
Other assets		(19	)		10
Accounts payable		(267	)		1,718
Accrued expenses and other liabilities		(50	)		75
Income tax payable/receivable		674			(437	)
Net cash (used in) / provided by operating activities		(2,621	)		2,100
Investing Activities
Purchases of property and equipment		(1,933	)		(4,644	)
Purchases of short-term investments		—			(2,000	)
Proceeds from maturities of short-term investments		500			6,980
Release of / (investment in) restricted cash		1,741			(1,728	)
Proceeds from sale of property and equipment		87			269
Acquisition of business, net of cash acquired		(1,012	)		(3,505	)
Purchase of intangibles		(83	)		(38	)
Net cash used in investing activities		(700	)		(4,666	)
Financing Activities
Line of credit borrowings, net		2,697			708
Principal payments on notes payable		(409	)		(1,273	)
Proceeds from issuance of notes payable		788			1,553
Principal payments on capital leases		(420	)		(452	)
Proceeds from exercise of stock options		34			24
Net cash provided by financing activities		2,690			560
Effect of exchange rate changes on cash and cash equivalents		(93	)		616
Net decrease in cash and cash equivalents		(724	)		(1,390	)
Cash and cash equivalents at beginning of period		1,279			2,669
Cash and cash equivalents at end of period	$	555		$	1,279
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	488		$	371
Income taxes	$	2		$	346
Summary of noncash financing and investing activities:
Acquisition of property and equipment through capital leases	$	327		$	—
Non-cash income tax benefit related to the exercise of stock options	$	4		$	4

The accompanying notes are an integral part of these consolidated financial statements.

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ORANGE 21 INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Organization and Significant Accounting Policies

Description of Business

Orange 21 Inc. (the “Company”) was originally formed as a California corporation in 1992. On November 29, 2004, upon reincorporation in the State of Delaware, the Company changed its name from Spy Optic, Inc. to Orange 21 Inc. and the Board of Directors of the Company approved a 16 to 1 reverse stock split and authorized 5,000,000 shares of preferred stock. All financial data and share data in these consolidated financial statements give retroactive effect to this split.

The Company designs, develops, manufactures and distributes high quality and high performance products for the action sports, motor sports and youth lifestyle markets. The Company’s current products include sunglasses, snowsport and motocross goggles and branded accessories. Spy Optic, S.r.l., a wholly owned subsidiary, was incorporated in Italy in July 2001. Spy Optic, S.r.l. manages the distribution, sales, customer service and administration for the Company’s business outside of North America. Spy Optic, Inc., a California corporation, was formed on December 20, 2004 as a wholly owned subsidiary. In January 2006, the Company completed the acquisition of its primary manufacturer LEM S.r.l. (“LEM”) (Note 18).

Basis of Presentation

The consolidated financial statements include the accounts of the Company and its subsidiaries. Intercompany accounts and transactions have been eliminated in the consolidated financial statements.

Certain prior year amounts have been reclassified to conform to current year presentation.

Use of Estimates

The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Significant estimates used in preparing these consolidated financial statements include those assumed in computing allowance for doubtful accounts receivable, reserve for obsolete inventory, reserve for sales returns, the testing of goodwill and long-lived assets for impairment and the valuation allowance on deferred tax assets. Accordingly, actual results could differ from those estimates.

Cash, Cash Equivalents and Short-Term Investments

The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. The Company’s investments, which generally have maturities between three and twelve months at time of acquisition, are considered short-term and classified as available for sale. Cash, cash equivalents and short-term investments consist primarily of corporate obligations such as commercial paper and corporate bonds, but may also include government agency notes, certificates of deposit, bank time deposits and institutional money market funds.

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The following table summarizes short-term investments by security type at December 31, 2006. There were no short-term investments at December 31, 2007.

	Amortized Cost		Gross Unrealized Losses		Estimated Fair Value
	(Thousands)
December 31, 2006
Auction rate securities	$	500	$	—	$	500
	$	500	$	—	$	500

The following table summarizes the contractual maturities of the Company’s short-term investments:

	Year Ended December 31,
	2007		2006
	(Thousands)
Less than one year	$	—	$	—
Due in one to five years		—		—
Due after five years		—		500
Total	$	—	$	500

At December 31, 2006, short-term investments consisted of auction rate securities of $500,000, which had no unrealized gains or losses at December 31, 2006. Auction rate securities, for which the interest rate resets approximately every 7 to 28 days, have been allocated within the contractual maturities table based upon the set maturity date of the security. During the years ended December 31, 2007 and 2006, the Company did not record any realized gains or losses on its short-term investments. At December 31, 2007 and 2006, the Company had no investments that have been in a continuous unrealized loss position for a period of 12 months.

Restricted Cash

At December 31, 2007 and 2006, the Company had $0 and $728,000, respectively of restricted cash which was held in an escrow account as required in accordance with the purchase agreement pursuant to which the Company acquired LEM, its manufacturing subsidiary. The escrow account relates to the earn-out provision of the purchase agreement. The escrow account was required to be maintained at a minimum level of 300,000 Euros through June 30, 2007 and was released in October 2007 in conjunction with the final payment. At December 31, 2007 and 2006, the Company also had $0 and $1.0 million, respectively, on deposit to be used as collateral to secure the line of credit facility. See Note 7.

Accounts Receivable, Reserve for Refunds and Returns and Allowance for Doubtful Accounts

Throughout the year, the Company performs credit evaluations of its customers, and adjusts credit limits based on payment history and the customer’s current creditworthiness. The Company continuously monitors its collections and maintains a reserve for estimated credits. The Company reserves for estimated future refunds and returns at the time of shipment based upon historical data and adjusts reserves as considered necessary. The Company makes judgments as to its ability to collect outstanding receivables and provide allowances for anticipated bad debts and refunds. Provisions are made based upon a review of all significant outstanding invoices and overall quality and age of those invoices not specifically reviewed. In determining the provision for invoices not specifically reviewed, the Company analyzes collection experience, customer credit-worthiness and current economic trends. If the data used to calculate these allowances does not reflect future ability to collect outstanding receivables, an adjustment in the reserve for refunds may be required. Historically, the Company’s losses have been consistent with estimates, but there can be no assurance that it will continue to experience the same credit loss rates that it has experienced in the past. Unforeseen, material financial difficulties experienced by its customers could have an adverse impact on profits.

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Inventories

Inventories consist primarily of raw materials and finished products, including sunglasses, goggles, apparel and accessories, product components such as replacement lenses and purchasing and quality control costs. Inventory items are carried on the books at the lower of cost or market using the weighted average cost method for LEM and first in first out method for our distribution business. Periodic physical counts of inventory items are conducted to help verify the balance of inventory. A reserve is maintained for obsolete or slow moving inventory. Products are reserved at certain percentages based on their probability of selling, which is estimated based on current and estimated future customer demands and market conditions.

Long-Lived Assets

Property and equipment are recorded at cost and are depreciated over the estimated useful lives of the assets (two to thirty three years) using the straight-line method. Amortization of leasehold improvements is computed on the straight-line method over the shorter of the remaining lease term or the estimated useful lives of the assets. Expenditures for repairs and maintenance are expensed as incurred. Gains and losses from the sale or retirement of property and equipment are charged to operations in the period realized or incurred.

Intangible assets consist of trademarks, patents and a customer related intangible that are being amortized on a straight-line basis over 5 to 8.3 years. Amortization expense was approximately $141,000 and $50,000 for the years ended December 31, 2007 and 2006, respectively. Amortization expense related to intangible assets at December 31, 2007 in each of the next five years and beyond is expected to be incurred as follows:

	(Thousands)
2008	$	100
2009		100
2010		99
2011		94
2012		75
Thereafter		25
	$	493

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), the Company evaluates the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that such carrying values may not be recoverable. Under SFAS No. 144, the Company estimates the future undiscounted cash flows derived from an asset to assess whether or not a potential impairment exists when events or circumstances indicate the carrying value of a long-lived asset may differ. If the sum of the undiscounted cash flows is less than the carrying value, an impairment loss will be recognized, measured as the amount by which the carrying value exceeds the fair value of the asset. The Company uses its best judgment based on the most current facts and circumstances surrounding its business when applying these impairment rules to determine the timing of the impairment test, the undiscounted cash flows used to assess impairments and the fair value of a potentially impaired asset. Changes in assumptions used could have a significant impact on the Company’s assessment of recoverability. Numerous factors, including changes in the Company’s business, industry segment or the global economy could significantly impact management’s decision to retain, dispose of or idle certain of its long-lived assets. For the years ended December 31, 2007 and 2006, the Company recorded impairment charges of approximately $147,000 and $88,000, respectively. See Note 5, Property and Equipment, for information regarding asset impairment charges recognized by the Company. At December 31, 2007 and 2006, no impairment of the intangible assets had occurred and the amortization periods remain appropriate.

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Goodwill

Goodwill is not amortized but instead is measured for impairment at least annually, or when events indicate that a likely impairment exists. The Company evaluates the recoverability of goodwill at least annually based on a two-step impairment test. The first step compares the fair value of each reporting unit with its carrying amount, including goodwill. If the carrying amount exceeds fair value, then the second step of the impairment test is performed to measure the amount of any impairment loss. The fair value of each reporting unit was determined using a combination of the income approach and the market approach. Under the income approach, the fair value of a reporting unit is calculated based on the present value of estimated future cash flows. The present value of estimated future cash flows uses our estimates of profit for the reporting units, driven by assumed market growth rates and assumed market segment share, and estimated costs as well as appropriate discount rates. These estimates are consistent with the plans and estimates that we use to manage the underlying business. Under the market approach, fair value is estimated based on market multiples of earnings for comparable companies and similar transactions.

The Company performed its annual test of goodwill as of October 1, 2007, which did not indicate any impairment and thus the second step was not performed. Determining fair value under the first step of the goodwill impairment test is subjective in nature and often involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the extent of such charge.

Point-of-Purchase Displays

During June 2007, the Company expensed approximately $2.0 million (the balance net of accumulated depreciation) of point-of-purchase displays in the U.S. to sales and marketing expense, as a result of transferring ownership of these displays to customers. In addition, in the U.S., future point-of-purchase displays are no longer capitalized since the displays are owned by the customers. The cost of these displays is currently being charged to sales and marketing expense.

Revenue Recognition

The Company’s revenue is primarily generated through sales of sunglasses, goggles and apparel, net of returns and discounts. Revenue is recognized in accordance with Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 104 (“SAB 104”), Revenue Recognition. Under SAB 104, revenue from product sales is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured. These criteria are usually met upon delivery to the Company’s carrier, which is also when the risk of ownership and title passes to the Company’s customers.

Generally, the Company extends credit to its customers after performing credit evaluations and does not require collateral. The Company’s payment terms generally range from net-30 to net-90, depending on the country or whether it sells directly to retailers in the country or to a distributor. The Company’s distributors are typically set up as prepay accounts; however credit may be extended to certain distributors, usually upon receipt of a letter of credit. Generally, the Company’s sales agreements with its customers, including distributors, do not provide for any rights of return or price protection. However, the Company does approve returns on a case-by-case basis in its sole discretion. The Company records an allowance for estimated returns when revenues are recorded. The allowance is calculated using historical evidence of actual returns. Historically, actual returns have been within the Company’s expectations. If future returns are higher than the Company’s estimates, the Company’s earnings would be adversely affected.

Advertising

The Company expenses advertising costs as incurred. Total advertising expense was approximately $612,000 and $647,000 for the years ended December 31, 2007 and 2006, respectively.

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Product Warranty

The Company warrants its products for one year. The standard warranty requires the Company to replace any product or portion thereof that is deemed a manufacturer’s defect. The Company’s product warranty accrual reflects management’s best estimate of probable liability under its product warranties, and is included in accrued expenses. Management determines the warranty accrual based on historical information.

Changes in product warranty accrual for the years ended December 31, 2007 and 2006 were as follows:

	Year Ended December 31,
	2007			2006
	(Thousands)
Balance at January 1,	$	—		$	16
Charged to expense		289			156
Amounts charged to reserve		(289	)		(172	)
Balance at December 31,	$	—		$	—

Research and Development

The Company expenses research and development costs as incurred. We capitalize product molds and tooling and depreciate these costs over the useful life of the asset.

Shipping and Handling

The Company records shipping and handling costs charged to customers as revenue and other shipping and handling costs to cost of sales as incurred.

Financial Instruments

The Company’s financial instruments consist primarily of cash, short-term investments, accounts receivable, accounts payable, capital leases and notes payable. These financial instruments are stated at their respective carrying values, which approximate their fair values.

Foreign Currency

The functional currencies of the Company’s wholly owned subsidiaries, Spy Optic S.r.l. and LEM are their respective local currency. Accordingly, the Company is exposed to transaction gains and losses that could result from changes in foreign currencies. Assets and liabilities denominated in foreign currencies are translated at the rate of exchange on the balance sheet date. Revenues and expenses are translated using the average exchange rate for the period. Gains and losses from translation of foreign subsidiary financial statements are included in accumulated other comprehensive income (loss).

Derivatives and Hedging

The Company is exposed to gains and losses resulting from fluctuations in foreign currency exchange rates relating to forecasted product purchases denominated in foreign currencies and transactions of its foreign subsidiaries. As part of its overall strategy to manage the level of exposure to the risk of fluctuations in foreign currency exchange rates, the Company has used foreign exchange contracts in the form of forward contracts.

The Company uses forward contracts designated as cash flow hedges primarily to protect against the foreign exchange risks inherent in its forecasted purchase of products at prices denominated in currencies other than the U.S. Dollar. For derivative instruments that are designated and qualify as cash flow hedges, the Company records the effective portion of the gain or loss on the derivative in accumulated other comprehensive

48

income as a separate component of stockholders’ equity and subsequently reclassifies these amounts into earnings in the period during which the hedged transaction is recognized in earnings. The Company reports the effective portion of cash flow hedges in the same financial statement line as the changes in the value of the hedged item. As of December 31, 2007 and 2006, the notional amounts of the Company’s foreign exchange contracts designated as cash flow hedges were approximately $0 and $5,023,000, respectively. As of December 31, 2007 and 2006, a net gain of approximately $11,000 and $355,000, respectively, related to derivative instruments designated as cash flow hedges was recorded in accumulated other comprehensive loss. It is expected that $11,000 will be reclassified into earnings in the next 12 months along with the earnings effects of the related forecasted transactions.

Net gains on cash flow hedges included in OCI are as follows:

	Year Ended December 31,
	2007			2006
	(Thousands)
Beginning balance	$	355		$	(288	)
Change in net gains		21			623
Net (gains) losses reclassified into earnings		(365	)		20
Accumulated other comprehensive income	$	11		$	355

During the years ended December 31, 2007 and 2006, the Company did not discontinue any cash flow hedges for which it was probable that a forecasted transaction would not occur.

For foreign currency contracts designated as cash flow hedges, hedge effectiveness is measured using the spot rate. Changes in the spot-forward differential are excluded from the test of hedge effectiveness and are recorded currently in earnings in the foreign currency transaction gain. The Company measures effectiveness by comparing the cumulative change in the hedge contract with the cumulative change in the hedged item.

Other derivatives designated as cash flow hedges under SFAS No. 133 “Accounting for Derivative Instruments and Hedges” (“SFAS No. 133”) consist primarily of forward contracts the Company uses to hedge foreign currency balance sheet exposures and interest rate swaps. For derivative instruments not designated as cash flow hedges under SFAS No. 133, the Company recognizes changes in fair value in earnings in the period of change. The Company recognizes the gains or losses on foreign currency forward contracts used to hedge balance sheet exposures in the foreign currency transaction gain.

As of December 31, 2007 and 2006, the notional amounts of the Company’s foreign exchange contracts not designated as hedging instruments were approximately $0 and $647,000, respectively.

As part of the acquisition of LEM in January 2006, the Company acquired an interest rate swap with a notional amount of 1.0 million Euros as of December 31, 2006. The interest rate swap was closed in February 2007 at a loss of approximately 10,000 Euro or $13,000.

Foreign currency derivatives are used only to meet the Company’s objectives of minimizing variability in the Company’s operating results arising from foreign exchange rate movements which may include derivatives that do not meet the criteria for hedge accounting. The Company does not enter into foreign exchange contracts for speculative purposes.

Earnings (Loss) Per Share

Basic earnings (loss) per share is computed by dividing net income or loss by the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share is calculated by including the additional shares of common stock issuable upon exercise of outstanding options and warrants and

49

upon vesting of restricted stock, using the treasury stock method. The following table lists the potentially dilutive equity instruments, each convertible into one share of common stock, used in the calculation of diluted earnings per share for the periods presented:

	Year Ended December 31,
	2007	2006
	(Thousands)
Weighted average common shares outstanding—basic	8,126	8,089
Assumed conversion of dilutive stock options, restricted stock and warrants	—	—
Weighted average common shares outstanding—dilutive	8,126	8,089

The following potentially dilutive instruments were not included in the diluted per share calculation for periods presented as their inclusion would have been antidilutive:

	Year Ended December 31,
	2007	2006
	(Thousands)
Stock options	938	805
Restricted stock	38	110
Warrants	147	147
Total	1,123	1,062

Income Taxes

In assessing the realization of 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 deferred tax assets is dependent upon 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, projected future taxable income, and tax planning strategies in making this assessment. Based on the level of historical operating results and projections for the taxable income for the future, management has determined that it is more likely than not that the deferred tax assets, net of the valuation allowance, will be realized. Accordingly, we have recorded a valuation allowance for our U.S. operations at December 31, 2007 and 2006 of $3,164,000 and $0, respectively. At December 31, 2007 and 2006, we have recorded a full valuation allowance for our wholly owned subsidiaries, Spy Optic, S.r.l and LEM.

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Royalties

The Company has several royalty agreements with third parties which represent agreements that the Company has with several athletes to use them in endorsing or advertising several of its products.

Comprehensive Income (Loss)

Comprehensive income (loss) represents the results of operations adjusted to reflect all items recognized under accounting standards as components of comprehensive income (loss). Total comprehensive loss for the years ended December 31, 2007 and 2006 was $7.0 million and $5.7 million, respectively.

The components of accumulated other comprehensive income, net of tax, are as follows:

	December 31,
	2007		2006
	(Thousands)
Unrealized gain on cash flow hedges, net of tax	$	11	$	355
Equity adjustment from foreign currency translation		1,882		1,041
Unrealized gain on foreign currency exposure of net investment in foreign operations		633		109
Accumulated other comprehensive income	$	2,526	$	1,505

Share-Based Compensation

On January 1, 2006, the Company adopted SFAS No. 123(R) “Share-Based Payments” (“SFAS No. 123(R)”), which requires the Company to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized in the consolidated statement of operations over the period during which the employee is required to provide service in exchange for the award—the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. The grant-date fair value of employee share options and similar instruments is estimated using option-pricing models adjusted for the unique characteristics of those instruments.

Recently Issued Accounting Pronouncements

On January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation Number 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. There has been no material effect on the Company’s financial statements as a result of the adoption of FIN 48 as of December 31, 2007.

In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for the Company beginning January 1, 2008. The Company is currently assessing the potential impact that the adoption of SFAS No. 157 will have on its financial statements.

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In February 2007, the FASB released SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” and is effective for fiscal years beginning after November 15, 2007. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The Company is currently assessing the impact the adoption of this pronouncement will have on the financial statements.

In December 2007, the FASB issued SFAS No. 141 (Revised), “Business Combinations” (“SFAS No. 141 (R)”), replacing SFAS No. 141, “Business Combinations” (“SFAS No. 141”). SFAS No. 141 (R) retains the fundamental requirements of SFAS No. 141, broadens its scope by applying the acquisition method to all transactions and other events in which one entity obtains control over one or more other businesses, and requires, among other things, that assets acquired and liabilities assumed be measured at fair value as of the acquisition date, that liabilities related to contingent consideration be recognized at the acquisition date and remeasured at fair value in each subsequent reporting period, that acquisition-related costs be expensed as incurred, and that income be recognized if the fair value of the net assets acquired exceeds the fair value of the consideration transferred. SFAS No. 141 (R) is to be applied prospectively in financial statements issued for fiscal years beginning after December 15, 2008. We do not expect that the adoption of SFAS No. 141 (R) will have a material effect on our consolidated financial statements.

2. Restatement

The Company has restated its consolidated financial statements for the fiscal year ended December 31, 2006, in accordance with Staff Accounting Bulletin No. 108 Considering the Effect of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”), to correct errors in such consolidated financial statements that would have a material effect on the financial statements for 2007 if not corrected. The restatement adjustments also include the correction of errors in previous periods which were not initially corrected in their respective years based on materiality. The impact of the restatements on periods prior to January 1, 2006 is reflected as an increase of $192,000 to beginning accumulated deficit, a decrease of $236,000 to inventory and an increase to deferred tax assets of $44,000. The net impact to fiscal year 2006 is a $67,000 increase to net income (loss), a decrease of $178,000 to net inventories, an increase of $57,000 to deferred tax assets and an increase of $4,000 to accrued liabilities.

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ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Thousands, except number of shares and per share amounts)

	December 31, 2006
	As reported			Adjustments			As restated
Assets
Current assets
Cash and cash equivalents	$	1,279		$	—		$	1,279
Restricted cash		1,728			—			1,728
Short-term investments		500			—			500
Accounts receivable, net		10,014			—			10,014
Inventories, net (1)		9,276			(178	)		9,098
Prepaid expenses and other current assets		1,584			—			1,584
Income taxes receivable		606			—			606
Deferred income taxes		1,827			—			1,827
Total current assets		26,814			(178	)		26,636
Property and equipment, net		8,042			—			8,042
Goodwill		8,727			—			8,727
Intangible assets, net of accumulated amortization of $376 at December 31, 2006		530			—			530
Deferred income taxes (3)		1,575			57			1,632
Other long-term assets		69			—			69
Total assets	$	45,757		$	(121	)	$	45,636
Liabilities and Shareholders’ Equity
Current liabilities
Lines of credit	$	2,976		$	—		$	2,976
Current portion of capital leases		410			—			410
Current portion of notes payable		251			—			251
Accounts payable		6,418			—			6,418
Accrued expenses and other liabilities (2)		4,454			4			4,458
Deferred purchase price obligation		1,020			—			1,020
Income taxes payable		—			—			—
Total current liabilities		15,529			4			15,533
Notes payable, less current portion		593			—			593
Capitalized leases, less current portion		647			—			647
Deferred income taxes		300			—			300
Total liabilities		17,069			4			17,073
Stockholders’ equity
Preferred stock: par value $0.0001; 5,000,000 authorized; none issued		—			—			—
Common stock: par value $0.0001; 100,000,000 shares authorized; 8,100,564 shares issued and outstanding at December 31, 2006		1			—			1
Additional paid-in-capital		36,336			—			36,336
Accumulated other comprehensive income		1,505			—			1,505
Accumulated deficit (1) (2) (3)		(9,154	)		(125	)		(9,279	)
Total stockholders’ equity		28,688			(125	)		28,563
Total liabilities and stockholders’ equity	$	45,757		$	(121	)	$	45,636

(1) Adjustments for overhead calculation of intransit inventory.

(2) Adjustments for unrecorded liabilities for general and administrative ($1,000) and sales and marketing expenses ($3,000) at Spy S.r.l.

(3) Tax effect of adjustments noted in (1) and (2) above.

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ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Thousands, except per share amounts)

	Year Ended December 31, 2006
	As Reported			Adjustments			As Restated
Net sales	$	42,406		$	—		$	42,406
Cost of sales (1)		24,939			(58	)		24,881
Gross profit		17,467			58			17,525
Operating expenses:
Sales and marketing (2)		14,483			3			14,486
General and administrative (2)		9,371			1			9,372
Shipping and warehousing		1,768			—			1,768
Research and development		1,003			—			1,003
Total operating expenses		26,625			4			26,629
Loss from operations		(9,158	)		54			(9,104	)
Other expense:
Interest expense		(241	)		—			(241	)
Foreign currency transaction loss		(53	)		—			(53	)
Other expense		(129	)		—			(129	)
Total other expense		(423	)		—			(423	)
Loss before benefit for income taxes		(9,581	)		54			(9,527	)
Income tax benefit (3)		(2,329	)		(13	)		(2,342	)
Net (loss ) income	$	(7,252	)	$	67		$	(7,185	)
Net (loss) income per share of Common Stock
Basic	$	(0.90	)	$	0.01		$	(0.89	)
Diluted	$	(0.90	)	$	0.01		$	(0.89	)
Shares used in computing net (loss) income per share of Common Stock
Basic		8,089			8,089			8,089
Diluted		8,089			8,089			8,089

(1) Adjustments for overhead calculation of intransit inventory.

(2) Adjustments for unrecorded liabilities for general and administrative ($1,000) and sales and marketing expenses ($3,000) at Spy S.r.l.

(3) Tax effect of adjustments noted in (1) and (2) above.

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ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Thousands)

	Year Ended December 31, 2006
	As Reported			Adjustments			As Restated
Operating Activities
Net (loss) income (1) (2) (3)	$	(7,252	)	$	67		$	(7,185	)
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Depreciation and amortization		3,949			—			3,949
Deferred income taxes (3)		(1,472	)		(13	)		(1,485	)
Share-based compensation		212			—			212
Provision for bad debts		604			—			604
Loss on sale/transfer of property and equipment		502			—			502
Impairment of property and equipment		88			—			88
Change in operating assets and liabilities:
Accounts receivable		(664	)		—			(664	)
Inventories, net (1)		4,391			(58	)		4,333
Prepaid expenses and other current assets		380			—			380
Other assets		10			—			10
Accounts payable		1,718			—			1,718
Accrued expenses and other liabilities (2)		71			4			75
Income tax payable/receivable		(437	)		—			(437	)
Net cash provided by operating activities		2,100			—			2,100
Investing Activities
Purchases of property and equipment		(4,644	)		—			(4,644	)
Purchases of short-term investments		(2,000	)		—			(2,000	)
Proceeds from maturities of short-term investments		6,980			—			6,980
Release of / (investment in) restricted cash		(1,728	)		—			(1,728	)
Proceeds from sale of property and equipment		269			—			269
Acquisition of business, net of cash acquired		(3,505	)		—			(3,505	)
Purchase of intangibles		(38	)		—			(38	)
Net cash used in investing activities		(4,666	)		—			(4,666	)
Financing Activities
Line of credit borrowings, net		708			—			708
Principal payments on notes payable		(1,273	)		—			(1,273	)
Proceeds from issuance of notes payable		1,553			—			1,553
Principal payments on capital leases		(452	)		—			(452	)
Proceeds from exercise of stock options		24			—			24
Net cash provided by financing activities		560			—			560
Effect of exchange rate changes on cash and cash equivalents		616			—			616
Net decrease in cash and cash equivalents		(1,390	)		—			(1,390	)
Cash and cash equivalents at beginning of period		2,669			—			2,669
Cash and cash equivalents at end of period	$	1,279		$	—		$	1,279
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	371		$	—		$	371
Income taxes	$	346		$	—		$	346
Summary of noncash financing and investing activities:
Non-cash income tax benefit related to the exercise of stock options	$	4		$	—		$	4

(1) Adjustments for overhead calculation of intransit inventory.

(2) Adjustments for unrecorded liabilities for general and administrative ($1,000) and sales and marketing expenses ($3,000) at Spy S.r.l.

(3) Tax effect of adjustments noted in (1) and (2) above.

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3. Accounts Receivable

Accounts receivable consisted of the following:

	December 31,
	2007			2006
	(Thousands)
Trade receivables	$	13,240		$	12,893
Less allowance for doubtful accounts		(775	)		(847	)
Less allowance for returns		(1,955	)		(2,032	)
Accounts receivable, net	$	10,510		$	10,014

4. Inventories

Inventories consisted of the following:

	December 31,
	2007		2006
			(As Restated)
	(Thousands)
Raw materials	$	1,756	$	2,301
Work in process		350		1,024
Finished goods		9,191		5,773
Inventories, net	$	11,297	$	9,098

The Company’s balances are net of an allowance for obsolescence of approximately $2,264,000 and $3,677,000 at December 31, 2007 and 2006, respectively.

5. Property and Equipment

Property and equipment consisted of the following:

	December 31,
	2007			2006
	(Thousands)
Displays	$	931		$	4,506
Molds and tooling		1,664			2,311
Machinery and equipment		5,212			1,924
Buildings and leasehold improvements		2,496			4,218
Computer equipment and software		1,909			667
Furniture and fixtures		695			785
Vehicles		458			2,260
		13,365			16,671
Less accumulated depreciation and amortization		(7,590	)		(8,629	)
Property and equipment, net	$	5,775		$	8,042

Impairment charges of $147,000 were recorded during the year ended December 31, 2007 related to molds and tooling no longer in service and is recorded under the caption “Cost of Sales” in the accompanying Consolidated Statement of Operations. Impairment charges of $88,000 were recorded during the year ended December 31, 2006 related to the evaluation of currently capitalized internal use software projects for future benefit and for property and equipment no longer in service and are recorded under the caption “General and administrative” in the accompanying Consolidated Statements of Operations.

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Depreciation and amortization expense was approximately $2,809,000 and $3,949,000 for the years ended December 31, 2007 and 2006, respectively. The year ended December 31, 2006 includes approximately $701,000 or ($0.09) per basic and diluted share in depreciation expense as a result of a change in estimated useful lives to two years for our retail point-of-purchase displays. The effect of this change on depreciation expense for the years ended December 31, 2007, 2008, 2009 and 2010 would have been an increase of $626,000, a decrease of $386,000, a decrease of $565,000 and a decrease of $146,000, respectively. However, during June 2007, the Company expensed approximately $2.0 million (the balance net of accumulated depreciation) of point-of-purchase displays in the U.S. to sales and marketing expense, as a result of transferring ownership of these displays to customers. In addition, in the U.S., future point-of-purchase displays are no longer capitalized since the displays are owned by the customers. The cost of these displays is currently being charged to sales and marketing expense.

6. Accrued Expenses

Accrued expenses consisted of the following:

	December 31,
	2007		2006
			(As Restated)
	(Thousands)
Compensation and benefits	$	3,060	$	2,260
Sales and marketing		511		242
Production and warehouse		425		663
Commissions		399		250
Customers with credit balances		215		—
Other		203		385
Professional fees		151		558
Unrealized foreign currency adjustments		—		100
	$	4,964	$	4,458

7. Financing Arrangements

Credit Facilities

At December 31, 2006, the Company had financing arrangements with Comerica Bank consisting of a line of credit facility with a $5.0 million limit, a foreign exchange facility and letter of credit accommodations. These arrangements were secured by all of the Company’s assets, excluding its intellectual property, and a $1.0 million collateral cash deposit with Comerica, and were subject to certain covenants, including several liquidity, debt coverage and minimum equity ratios. The $5.0 million available line of credit was reduced by the amount of outstanding letters of credit (sub limit of $4.1 million) and 10% of outstanding foreign exchange forward contracts ($0.9 million sub limit). Borrowings were limited to cover any outstanding letters of credit issued to San Paolo IMI on behalf of LEM (3.0 million Euros or $3.9 million at December 31, 2006).

The Company’s foreign exchange facility allowed for the purchase of currency contracts which were used primarily to hedge foreign currency exposure. The amount of allowable purchases of such contracts was $9.0 million. At December 31, 2006, net foreign exchange forward contracts outstanding amounted to $5.7 million, which reduced the amount available under the line of credit by $570,000. As a result, at December 31, 2006, the unused line of credit was approximately $0.5 million with Comerica Bank.

At December 31, 2006, the Company was not in compliance with two financial covenants under the financing arrangement with Comerica related to maintaining a minimum tangible net worth and not incurring more than two consecutive quarterly net losses. On February 22, 2007, the Company amended its financing

57

arrangements with Comerica, which decreased its letter of credit sub limit to $1.8 million, decreased its foreign exchange facility limit from $9.0 million to $7.2 million and extended the expiration date to May 15, 2007.

On February 26, 2007, Spy Optic, Inc. entered into a Loan and Security Agreement (“Loan Agreement”) with BFI Business Finance (“BFI”) with a maximum borrowing capacity of $5.0 million, which was subsequently modified on December 7, 2007 and February 12, 2008 to extend the maximum borrowing capacity to $8.0 million and affect certain other changes. Actual borrowing availability under the Loan Agreement is based on eligible trade receivable and inventory levels of Spy Optic Inc. Loans extended pursuant to the Loan Agreement will bear interest at a rate per annum equal to the prime rate as reported in the Western Edition of the Wall Street Journal from time to time plus 2.5% with a minimum monthly interest charge of $2,000. The Company granted BFI a security interest in all of Spy Optic, Inc.’s assets as security for its obligations under the Agreement, except for its copyrights, patents, trademarks, servicemarks and related applications. Additionally, the obligations under the Loan Agreement are guaranteed by Orange 21 Inc.

The Loan Agreement imposes certain covenants on Spy Optic, Inc., including, but not limited to, covenants requiring the Company to provide certain periodic reports to BFI, inform BFI of certain changes in the business, refrain from incurring additional debt in excess of $100,000 and refrain from paying dividends. Spy Optic, Inc. also established a bank account in BFI’s name into which collections on accounts receivable and other collateral are deposited (the “Collateral Account”). Pursuant to the deposit control account agreement between Spy Optic, Inc. and BFI with respect to the Collateral Account, BFI is entitled to sweep all amounts deposited into the Collateral Account and apply the funds to outstanding obligations under the Loan Agreement; provided that BFI is required to distribute to Spy Optic, Inc. any amounts remaining after payment of all amounts due under the Loan Agreement. To secure its obligations under the guaranty, Orange 21 Inc. granted BFI a blanket security interest in all of its assets, except for its stock in Spy Optic, Inc., which it has covenanted not to pledge to any other person or entity. The Company was in compliance with the covenants at December 31, 2007.

The Company received a loan in the amount of $650,000 upon the execution of the Loan Agreement. These proceeds were used to fully collateralize Comerica Bank for the letter of credit issued by Comerica on behalf of Orange 21 Inc. and LEM to San Paolo IMI in the amount of 1.2 million Euros. The letter of credit with Comerica expired in May 2007. The collateral of 1.2 million Euros was transferred to an interest bearing account with San Paolo IMI in Italy to serve as collateral for the LEM San Paolo IMI line of credit. During September 2007 San Paolo released the collateral requirement in conjunction with the reduction of the San Paolo IMI line of credit.

At December 31, 2007, there were outstanding borrowings of $4.5 million under the Loan Agreement, bearing an interest rate of 10.62% and availability under this line of $3.5 million subject to eligible accounts receivable and inventory levels.

At December 31, 2006, the Company also had a 2.2 million Euros line of credit in Italy with San Paolo IMI for LEM. During October 2007 the line of credit was reduced to 1.4 million Euros. Borrowing availability is based on eligible accounts receivable and export orders received at LEM. At December 31, 2007, there was approximately 0.5 million Euros available under this line of credit. At December 31, 2007 and 2006, outstanding amounts under this line of credit amounted to $1.3 million and $3.0 million, respectively. The interest rate at December 31, 2007 was 5.88%.

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8. Notes Payable

Notes payables at December 31, 2007 consist of the following:

	(Thousands)
Unsecured San Paolo IMI long-term debt, EURIBOR 6 months interest rate plus 1.0% spread, payable in half year installments due from March 2007 to February 2011	$	716
Unsecured long-term debt, EURIBOR 1-month interest rate plus 1.5% spread, payable in half year installments due from December 2005 to December 2010		161
Unsecured long-term debt, fixed interest rate at 0.5%, payable in half year installments due from December 2005 to December 2010		66
Secured notes payable for software purchases, 4.55% interest rate with monthly payments of $15,000 due through August 2009 and 7.45% interest rate with monthly payments of $4,200 due through March 2010. Both secured by software.		392
		1,335
Less current portion		(498	)
Notes payable, less current portion	$	837

Future minimum payments under long-term debt agreements are as follows:

Year ended December 31,	Thousands
2008	$	498
2009		464
2010		331
2011		42
Total	$	1,335

9. Stockholder’s Equity

Common Stock

During December 2007, options with respect to 9,375 shares of common stock held by one individual were exercised at a price of $3.20, resulting in the issuance of 9,375 shares of common stock for aggregate proceeds of approximately $30,000.

During 2007 an aggregate of 51,875 shares of common stock were issued to individuals upon vesting of restricted stock awards.

During December 2006, options with respect to 6,250 shares of common stock held by one individual were exercised at a price of $3.20 per share, resulting in the issuance of 6,250 shares of common stock for aggregate proceeds of approximately $20,000.

During 2006, an aggregate of 10,000 shares of common stock were issued to four members of the Company’s Board of Directors.

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Shares Reserved

The Company had 100,000,000 authorized shares of common stock at December 31, 2007. The table below outlines common shares reserved for future issuance:

	(Thousands)
Total Authorized Shares	100,000
Common shares issued	(8,161	)
Shares reserved for future issuance:
Stock options outstanding	(938	)
Restricted stock awards	(38	)
Warrants	(147	)
Remaining Authorized Shares	90,716

10. Share-Based Compensation

In December 2004, the Board of Directors of the Company adopted, and the stockholders of the Company approved, the 2004 Stock Incentive Plan (the “Plan”). The Plan provides for the grant of incentive stock options to employees only, and restricted stock, stock units, nonqualified options or SARS to employees, consultants and outside directors. The Plan is administered by the Compensation Committee who determines the vesting period, exercise price and other details for each award. In April 2007, in connection with a determination by the Board of Directors to reduce the annual cash compensation paid to the non-employee directors of the Company, the Board of Directors approved an amendment and restatement of the Plan that: (1) increases the number of shares of the Company’s Common Stock underlying the non-qualified stock options that are automatically granted to the Company’s non-employee directors upon their appointment to the Board of Directors and on an annual basis thereafter and (2) modifies the vesting schedule for the automatic option grants made to non-employee directors upon their initial appointment to the Board of Directors. The amendment and restatement of the Plan was approved by the Company’s stockholders at the annual meeting held on June 12, 2007.

Prior to the adoption of the Plan, the Company had periodically granted nonqualified common stock options to certain employees and officers of the Company. These stock options generally vest ratably over a five-year period and expire ratably five years after each vesting date. Generally, the exercise price of all stock options granted equaled the fair value of the Company’s common stock on the date of grant, which resulted in no compensation expense when the stock options were issued.

Stock Option Activity

	Shares		Weighted- Average Exercise Price		Weighted-Average Remaining Contractual Term (years)	Aggregate Intrinsic Value
						(Thousands)
Options outstanding at December 31, 2005	1,020,624		$	6.69
Granted	60,000			5.00
Exercised	(6,250	)		3.20		$	10
Forfeited	(269,686	)		6.54
Options outstanding at December 31, 2006	804,688			6.64
Granted	276,000			5.73
Exercised	(9,375	)		3.20			42
Forfeited	(133,438	)		5.68
Options outstanding at December 31, 2007	937,875		$	6.54	7.16	$	180
Options exercisable at December 31, 2007	640,797		$	6.94	6.21	$	177

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Intrinsic value is defined as the difference between the relevant current market value of the common stock and the grant price for options with exercise prices less than the market values on such dates. During the years ended December 31, 2007 and 2006, the Company received $30,000 and $20,000, respectively, in cash proceeds from the exercise of stock options. The actual tax benefit realized from these exercises was approximately $4,000 for both years, and was included in additional paid in capital in the statement of stockholder’s equity for all periods presented and in the financing activities of the statement of cash flows beginning in the year ended December 31, 2006.

Information regarding stock options outstanding as of December 31, 2007 is as follows:

	Options Outstanding				Options Exercisable
Price Range	Shares	Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (years)	Shares	Weighted- Average Exercise Price
$  1.60 - $3.20	62,500	$	2.40	4.05	62,500	$	2.40
$  3.21 - $4.80	69,375	$	4.80	0.95	57,187	$	4.80
$  4.81 - $5.11	70,000	$	5.00	8.49	61,110	$	5.01
$  5.12 - $5.38	186,000	$	5.38	9.66	—	$	—
$  5.39 - 6.12	115,000	$	6.09	7.67	115,000	$	6.09
$  6.46	90,000	$	6.46	9.45	—	$	—
$  8.75	345,000	$	8.75	6.58	345,000	$	8.75
Total	937,875	$	6.54	7.16	640,797	$	6.94

Restricted Stock Awards

The Company periodically issues restricted stock awards to certain key employees subject to certain vesting requirements based on future service.

Restricted Stock Award Activity

	Shares		Weighted- Average Grant Date Fair Value
Non-vested at December 31, 2005	—		$	—
Granted	117,500			4.99
Forfeited	(7,500	)		5.01
Non-vested at December 31, 2006	110,000			4.99
Released	(51,875	)		4.96
Forfeited	(20,625	)		5.01
Non-vested at December 31, 2007	37,500		$	5.01

Adoption of SFAS No. 123(R)

On January 1, 2006, the Company adopted SFAS No. 123(R) “Share-Based Payments” (“SFAS No. 123(R)”), which requires the Company to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized in the consolidated statement of operations over the period during which the employee is required to provide service in exchange for the award—the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. The grant-date fair value of employee share options and

61

similar instruments is estimated using option-pricing models adjusted for the unique characteristics of those instruments. SFAS No. 123(R) eliminates the use of APB Opinion 25 and the option for pro forma disclosure in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”).

SFAS No. 123(R) permits public companies to adopt its requirements using one of the two following methods: (1) a “modified prospective” method in which compensation cost is recognized beginning with the effective date based on both (a) the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and (b) the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date; and (2) a “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits companies to restate prior periods based on the amounts previously recognized under SFAS No. 123 for purposes of pro forma disclosures, either (a) for all prior periods presented or (b) prior interim periods of the year of adoption. The Company adopted SFAS No. 123(R) using the modified-prospective method and therefore prior periods are not restated.

SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a cash flow from financing activities, rather than a cash flow from operating activities as required under previous guidance. This requirement may reduce operating cash flows and increase net financing cash flows in periods after adoption. The adoption of SFAS No. 123(R) did not have a material impact on the Company’s cash flows during the year ended December 31, 2006.

The Company recognized the following share-based compensation expense during the years ended December 31, 2007 and 2006 in accordance with SFAS No. 123(R):

	Year Ended December 31,
	2007			2006
Stock options
General and administrative expense	$	327		$	103
Stock		—			51
Restricted stock
General and administrative expense		130			36
Selling and marketing		11			16
Research and development		7			6
Total		475			212
Income tax benefit		(162	)		(72	)
Stock-based compensation expense, net of taxes		313			140
Effect of stock-based compensation on net loss per share:
Basic		(0.04	)		(0.02	)
Diluted		(0.04	)		(0.02	)

The following table summarizes the approximate unrecognized compensation cost for the share-based compensation awards and the weighted average remaining years over which the cost will be recognized:

	Total Unrecognized Compensation Expense		Weighted Average Remaining Years
	(Thousands)
Stock options	$	602	1.89
Restricted stock awards		276	2.45
Total	$	878

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Determining Fair Value under SFAS No. 123(R)

Valuation and Amortization Method.    Consistent with the valuation method used for the disclosure only provisions of SFAS No. 123, we are using the Black-Scholes option-pricing valuation model (single option approach) to calculate the fair value of stock option grants. For options with graded vesting, the option grant is treated as a single award and compensation cost is recognized on a straight-line basis over the vesting period of the entire award.

Expected Term.    The expected term of options granted represents the period of time that the option is expected to be outstanding. We estimate the expected term of the option grants based on historical exercise patterns that we believe to be representative of future behavior as well as other various factors.

Expected Volatility.    We estimate our volatility using our historical share price performance over the expected life of the options, which management believes is materially indicative of expectations about expected future volatility.

Risk-Free Interest Rate.    We use risk-free interest rates in the Black-Scholes option valuation model that are based on U.S. Treasury zero-coupon issues with a remaining term equal to the expected life of the options.

Dividend Rate.    We have not paid dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Therefore, we use an expected dividend yield of zero.

Forfeitures.    SFAS No. 123(R) requires companies to estimate forfeitures at the time of grant and revise those estimates in subsequent reporting periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. For purposes of calculating pro forma information under SFAS No. 123 for periods prior to the date of adoption of SFAS No. 123(R), we accounted for forfeitures as they occurred. The impact of the adoption of SFAS No. 123(R) related to forfeitures was not material to our financial statements.

The following weighted average assumptions were used to estimate the fair value of options granted during the years ended December 31, 2007 and 2006:

	Year ended December 31,
	2007		2006
Expected volatility	51.5	%	59.2	%
Risk-free interest rate	4.6	%	5.0	%
Expectation term (in years)	5.0		5.3
Dividend yield	—		—

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11. Income Taxes

Income tax expense (benefit) attributed to income from operations consists of:

	Year Ended December 31,
	2007			2006
				(As Restated)
	(Thousands)
Current
Federal	$	(29	)	$	(551	)
State		(27	)		(22	)
Foreign		202			137
Total		146			(436	)
Deferred
Federal		838			(1,599	)
State		418			(607	)
Foreign		50			300
Total		1,306			(1,906	)
Income tax provision	$	1,452		$	(2,342	)

The components that comprise deferred tax assets and liabilities at December 31, 2007 and 2006 are as follows:

	2007			2006
				(As Restated)
	(Thousands)
Deferred tax assets:
NOL carryforwards	$	3,494		$	1,721
Allowance for doubtful accounts		186			205
Compensation and vacation accrual		96			91
Accrued professional fees					73
Reserve for returns and allowances		734			625
Unrealized foreign currency loss		342			208
Inventory reserve		319			879
Net foreign deferred tax asset before valuation allowance		2,777			2,447
Non-cash compensation		209			82
Depreciation and amortization		225			—
Benefit of state tax items		1			1
Other		6			(4	)
Gross deferred tax assets		8,389			6,328
Deferred tax liabilities:
Depreciation and amortization		—			(164	)
Unrealized foreign currency loss		(7	)		(258	)
Net deferred tax asset before valuation allowance		8,382			5,906
Valuation allowance		(6,325	)		(2,747	)
Net deferred tax asset	$	2,057		$	3,159

64

The reconciliation of computed “expected” income taxes to effective income tax expense by applying the federal statutory rate of 34% is as follows:

	Year Ending December 31,
	2007			2006
				(As Restated)
	(Thousands)
Computed “expected” tax expense	$	(2,076	)	$	(3,145	)
State taxes, net of federal benefit		(355	)		(540	)
Foreign tax expense		251			437
Foreign subsidiary (income) loss		353			794
Meals and entertainment		28			37
U.S. valuation allowances		3,164			—
Other, net		87			75
	$	1,452		$	(2,342	)

The change in the valuation allowance for the years ended December 31, 2007 and 2006 was an increase of $3,578,000 and $2,115,000, respectively. In assessing the realization of 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 deferred tax assets is dependent upon 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, projected future taxable income, and tax planning strategies in making this assessment. Based on the level of historical operating results and projections for the taxable income for the future, management has determined that it is more likely than not that the deferred tax assets, net of the valuation allowance will be realized. Accordingly, the Company has recorded a valuation allowance for its U.S. operations at December 31, 2007 and 2006 of $3,164,000 and $0, respectively. The Company has recorded a $1,642,000 and $1,107,000 valuation allowance for its wholly owned subsidiary, Spy Optic, S.r.l. at December 31, 2007 and 2006, respectively. The Company has recorded a $1,519,000 and $1,640,000 valuation allowance for its wholly owned subsidiary, LEM at December 31, 2007 and 2006, respectively.

12. Employee Benefit Plans

In 1998, the Company adopted the Spy Optic 401(k) Plan, or the “Plan.” The Plan covers all employees who meet the eligibility requirements of a minimum of 270 hours of service and 18 years of age. The Plan is subject to the provisions of the Employee Retirement Income Security Act of 1974. Under the provisions of the Plan, eligible participants may contribute up to 15% of their annual compensation, not to exceed the maximum legal deferral. The Company is not required to contribute to the Plan and made no contributions to the Plan during the years ended December 31, 2007 and 2006.

13. Related Party Transactions

Customer Sales

No Fear, Inc. (“No Fear”), a stockholder, owns retail stores that purchase products from the Company. Aggregated sales to these stores during the years ended December 31, 2007 and 2006 were approximately $1,305,000 and $795,000, respectively. Accounts receivable due from these stores amounted to $529,000 and $222,000 at December 31, 2007 and 2006, respectively.

Stockholders of the Company, other than No Fear, own retail stores and distribution companies that purchase products from the Company. Aggregated sales to these stores during the years ended December 31,

65

2007 and 2006 were approximately $1,498,000 and $946,000, respectively. Accounts receivable due from these entities amounted to approximately $880,000, and $440,000 at December 31, 2007 and 2006, respectively.

Polinelli S.r.l., a stockholder and a former shareholder of the Company’s wholly owned subsidiary LEM, purchases products from the Company. Aggregated sales to Polinelli S.r.l., during the years ended December 31, 2007 and 2006 were $499,000 and $955,000, respectively. Accounts receivable due from Polinelli S.r.l. amounted to $68,000 and $341,000 at December 31, 2007 and 2006, respectively.

14. Commitments and Contingencies

Operating Leases

The Company leases its principal administrative and distribution facilities in Carlsbad, California and a warehouse facility in Varese, Italy, which is used primarily for international sales and distribution. LEM leases four buildings in Italy that are used for office space, warehousing and manufacturing. In addition, the Company utilizes some third party warehousing in both the United States and Europe. The Company also leases certain computer equipment, vehicles and temporary housing in Italy. Rent expense was approximately $719,000 and $553,000 for the years ended December 31, 2007 and 2006, respectively.

Future minimum rental payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year are as follows:

Year Ending December 31,	(Thousands)
2008	$	250
2009		141
2010		64
2011		65
2012		61
Total	$	581

Capital Leases

Future minimum lease payments under capital leases are as follows:

Year Ending December 31,	(Thousands)
2008	$	421
2009		326
2010		260
2011		206
Total minimum lease payments		1,213
Amount representing interest		(131	)
Present value of minimum lease payments		1,082
Less current portion		(378	)
Long-term portion	$	704

The cost of buildings and improvements and machinery under capital lease at December 31, 2007 was approximately $1,445,000 and $1,177,000, respectively. The amount of accumulated depreciation at December 31, 2007 was $284,000 and $321,000, respectively. Amortization of assets held under capital leases is included in depreciation expense.

66

Athlete Contracts

The Company has entered into endorsement contracts with athletes to actively wear and endorse the Company’s products. These contracts are based on minimum annual payments and may include additional performance-based incentives and/or product-specific sales incentives.

The minimum annual contracted payments are as follows:

Year Ending December 31,	(Thousands)
2008	$	456
2009		147
2010		14
Total	$	617

Product Design

The Company has entered into an agreement with its primary product designer, Jerome Mage, through his business Mage Design LLC, for the design and development of its eyewear, apparel and accessory product lines. Mr. Mage has agreed to provide his services to the Company as an independent consultant through December 31, 2008, and to be bound by confidentiality obligations. Mr. Mage has also agreed not to provide design services to any entity that is engaged principally in the business of designing, manufacturing or selling sunglasses, goggles or other optical products during the term of the agreement. Mr. Mage has developed products primarily for the Spy Optic brand. Under the agreement, Mr. Mage assigns all ideas, inventions and other intellectual property rights created or developed on the Company’s behalf during the term of the agreement to the Company. The agreement may be terminated by either party if the other party defaults or breaches a material provision of the agreement and has monthly minimum payments due. The minimum annual contracted payments due in 2008 are approximately $391,000.

Litigation

On October 30, 2007, John Flynn Caro a former sales representative of the Company and his wife filed an action against Spy Optic, Inc. in Puerto Rico seeking damages of not less than $200,000 relating to the termination of a sales representative agreement. The action was removed to federal district court on January 3, 2008, and Spy Optic, Inc. filed an answer and counterclaim on January 10, 2008. The Company presently has no estimate of any potential loss or range of loss with respect to the lawsuit or any estimate as to the potential costs of defending the lawsuit.

Additionally, from time to time we are involved in various lawsuits and legal proceedings which arise in the ordinary course of business. An adverse result in the matter described above or any other legal matters that may arise from time to time may harm our business.

15. Concentrations

Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and accounts receivable. The Company grants unsecured credit to substantially all of its customers. Management does not believe that it is exposed to any extraordinary credit risk as a result of this policy.

The Company maintains cash balances at various financial institutions primarily located in San Diego and in Italy. Accounts at the U.S. institutions are secured by the Federal Deposit Insurance Corporation up to

67

$100,000. At times, balances may exceed federally insured limits. The Company has not experienced any losses in such accounts. Management believes that the Company is not exposed to any significant credit risk with respect to its cash and cash equivalents.

Customer

For the years ended December 31, 2007 and 2006, the Company had no sales to third party customers that accounted for 10% or more of total net sales.

Supplier

For the years ended December 31, 2007 and 2006, the Company had no purchases from third party suppliers that accounted for 10% or more of the Company’s total purchases.

16. Operating Segments and Geographic Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company’s management in deciding how to allocate resources and in assessing performance. The Company designs, produces and distributes sunglasses, snow and motocross goggles, and branded apparel and accessories for the action sports and lifestyle markets. In January 2006, the Company acquired its primary manufacturer LEM located in Italy. LEM continues to manufacture products for non-competing brands in addition to most of the Company’s sunglass products. Results for LEM reflect operations of this manufacturer after elimination of intercompany transactions. Since the acquisition of LEM, the Company has operated in two business segments: distribution and manufacturing.

Information related to the Company’s operating segments is as follows:

	Year Ended December 31,
	2007			2006
				(As Restated)
	(Thousands)
Net sales:
Distribution	$	40,632		$	37,876
Manufacturing		5,909			4,530
Intersegment		13,978			9,619
Eliminations		(13,978	)		(9,619	)
Total	$	46,541		$	42,406
Operating income (loss):
Distribution	$	(6,057	)	$	(8,585	)
Manufacturing		17			(519	)
Total	$	(6,040	)	$	(9,104	)
Net loss:
Distribution	$	(7,516	)	$	(6,051	)
Manufacturing		(464	)		(1,134	)
Total	$	(7,980	)	$	(7,185	)

68

	December 31,
	2007		2006
	(Thousands)
Tangible long-lived assets:
Distribution	$	2,225	$	4,922
Manufacturing		3,550		3,120
Total	$	5,775	$	8,042

The Company markets its products domestically and internationally, with its principal international market being Europe. Revenue is attributed to the location from which the product was shipped. Identifiable assets are based on location of domicile.

	Year Ended December 31,
	U.S. and Canada		Europe and Asia Pacific		Consolidated		Intersegment
			(Thousands)				(Thousands)
	2007						2007
Net sales	$	33,732	$	12,809	$	46,541	$	13,978
	2006						2006
Net sales	$	32,750	$	9,656	$	42,406	$	9,619

	December 31,
	2007		2006
	(Thousands)
Tangible long-lived assets:
U.S. and Canada	$	1,648	$	4,171
Europe and Asia Pacific		4,127		3,871
Total	$	5,775	$	8,042

69

17. Quarterly Financial Data (unaudited)

	First Quarter			Second Quarter			Third Quarter			Fourth Quarter
	(As Restated)			(As Restated)			(As Restated)
	(Thousands, except per share data)
Year ended December 31, 2007:
Net sales	$	9,389		$	11,956		$	13,179		$	12,017
Gross profit		4,923			7,079			6,553			4,259
Loss before provision (benefit) for income taxes		(2,262	)		(2,030	)		(24	)		(2,226	)
Net loss		(1,673	)		(1,601	)		(58	)		(4,662	)
Basic net loss per share	$	(0.21	)	$	(0.20	)	$	(0.01	)	$	(0.57	)
Diluted net loss per share	$	(0.21	)	$	(0.20	)	$	(0.01	)	$	(0.57	)
Year ended December 31, 2006:	(As Restated)			(As Restated)			(As Restated)			(As Restated)
Net sales	$	9,382		$	10,271		$	11,379		$	11,374
Gross profit		4,619			5,316			5,669			1,921
Loss before provision (benefit) for income taxes		(1,837	)		(1,371	)		(877	)		(5,442	)
Net loss		(1,659	)		(903	)		(650	)		(3,973	)
Basic net loss per share	$	(0.21	)	$	(0.11	)	$	(0.08	)	$	(0.49	)
Diluted net loss per share	$	(0.21	)	$	(0.11	)	$	(0.08	)	$	(0.49	)

As discussed in Note 2, the Company has restated herein its consolidated financial statements for the fiscal year ended December 31, 2006, in accordance with SAB 108 to correct errors in such consolidated financial statements that would have a material effect on the financial statements for 2007 if not corrected. The Company has also restated its unaudited consolidated financial information for each of the previously reported interim periods of fiscal years 2007 and 2006 to correct errors in such consolidated financial statements and financial information, the effects of which are shown below. The restatement adjustments also include the correction of errors in previous periods which were not initially corrected in the respective years based on materiality.

70

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Thousands, except number of shares and per share amounts)

	March 31, 2007
	As reported			Adjustments			As restated
Assets
Current assets
Cash and cash equivalents	$	1,230		$	—		$	1,230
Restricted cash		2,070			—			2,070
Accounts receivable, net		8,033			—			8,033
Inventories, net (1)		10,578			(7	)		10,571
Prepaid expenses and other current assets		1,128			—			1,128
Income taxes receivable		598			—			598
Deferred income taxes		1,402			—			1,402
Total current assets		25,039			(7	)		25,032
Property and equipment, net		7,873			—			7,873
Goodwill		8,814			—			8,814
Intangible assets, net of accumulated amortization of $430 at March 31, 2007		518			—			518
Deferred income taxes (2)		2,768			(5	)		2,763
Other long-term assets		72			—			72
Total assets	$	45,084		$	(12	)	$	45,072
Liabilities and Shareholders’ Equity
Current liabilities
Lines of credit	$	2,670		$	—		$	2,670
Current portion of capital leases		382			—			382
Current portion of notes payable		1,023			—			1,023
Accounts payable		7,655			—			7,655
Accrued expenses and other liabilities (3)		3,641			18			3,659
Deferred purchase price obligation		676			—			676
Total current liabilities		16,047			18			16,065
Notes payable, less current portion		1,142			—			1,142
Capitalized leases, less current portion		583			—			583
Deferred income taxes		316			—			316
Total liabilities		18,088			18			18,106
Stockholders’ equity
Preferred stock: par value $0.0001; 5,000,000 authorized; none issued		—			—			—
Common stock: par value $0.0001; 100,000,000 shares authorized; 8,100,564 shares issued and outstanding at March 31, 2007		1			—			1
Additional paid-in-capital		36,397			—			36,397
Accumulated other comprehensive income		1,521			—			1,521
Accumulated deficit (4)		(10,923	)		(30	)		(10,953	)
Total stockholders’ equity		26,996			(30	)		26,966
Total liabilities and stockholders’ equity	$	45,084		$	(12	)	$	45,072

71

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Thousands, except per share amounts)

	Three Months Ended
	March 31, 2007									March 31, 2006
	As Reported			Adjustments			As Restated			As Reported			Adjustments			As Restated
Net sales	$	9,389		$	—		$	9,389		$	9,382		$	—		$	9,382
Cost of sales (5)		4,480			(14	)		4,466			4,867			(104	)		4,763
Gross profit		4,909			14			4,923			4,515			104			4,619
Operating expenses:
Sales and marketing (6)		3,822			89			3,911			3,507			—			3,507
General and administrative (7)		2,510			13			2,523			2,139			—			2,139
Shipping and warehousing (8)		637			(245	)		392			476			—			476
Research and development		193			—			193			266			—			266
Total operating expenses		7,162			(143	)		7,019			6,388			—			6,388
(Loss) income from operations		(2,253	)		157			(2,096	)		(1,873	)		104			(1,769	)
Other expense:
Interest expense		(67	)		—			(67	)		(34	)		—			(34	)
Foreign currency transaction loss		(51	)		—			(51	)		(28	)		—			(28	)
Other expense		(48	)		—			(48	)		(6	)		—			(6	)
Total other expense		(166	)		—			(166	)		(68	)		—			(68	)
Loss before benefit for income taxes		(2,419	)		157			(2,262	)		(1,941	)		104			(1,837	)
Income tax benefit (9)		(651	)		62			(589	)		(207	)		29			(178	)
Net (loss) income	$	(1,768	)	$	95		$	(1,673	)	$	(1,734	)	$	75		$	(1,659	)
Net loss per share of Common Stock
Basic	$	(0.22	)	$	0.01		$	(0.21	)	$	(0.21	)	$	(0.00	)	$	(0.21	)
Diluted	$	(0.22	)	$	0.01		$	(0.21	)	$	(0.21	)	$	(0.00	)	$	(0.21	)
Shares used in computing net (loss) income per share of Common Stock
Basic		8,101			8,101			8,101			8,084			8,084			8,084
Diluted		8,101			8,101			8,101			8,084			8,084			8,084

72

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Thousands)

	Three Months Ended
	March 31, 2007									March 31, 2006
	As Reported			Adjustments			As Restated			As Reported			Adjustments			As Restated
Operating Activities
Net (loss) income	$	(1,768	)	$	95		$	(1,673	)	$	(1,734	)	$	75		$	(1,659	)
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		1,044			—			1,044			721			—			721
Deferred income taxes (10)		(754	)		62			(692	)		(104	)		29			(75	)
Share-based compensation		62			—			62			22			—			22
Provision for bad debts		59			—			59			(21	)		—			(21	)
Loss on sale/transfer of property and equipment		19			—			19			—			—			—
Change in operating assets and liabilities:
Accounts receivable		1,942			—			1,942			1,883			—			1,883
Inventories, net (11)		(1,249	)		(171	)		(1,420	)		2,031			(104	)		1,927
Prepaid expenses and other current assets		1,473			—			1,473			(151	)		—			(151	)
Other assets		(3	)		—			(3	)		10			—			10
Accounts payable		1,118			—			1,118			(489	)		—			(489	)
Accrued expenses and other liabilities (12)		(1,849	)		14			(1,835	)		(606	)		—			(606	)
Income tax payable/receivable		64			—			64			(154	)		—			(154	)
Net cash provided by operating activities		158			—			158			1,408			—			1,408
Investing Activities
Purchases of property and equipment		(844	)		—			(844	)		(707	)		—			(707	)
Purchases of short-term investments		—			—			—			(501	)		—			(501	)
Proceeds from maturities of short-term investments		500			—			500			4,500			—			4,500
Release of (investment in) restricted cash		(343	)		—			(343	)		(847	)		—			(847	)
Proceeds from sale of property and equipment		41			—			41			10			—			10
Acquisition of business, net of cash acquired		(345	)		—			(345	)		(2,829	)		—			(2,829	)
Purchase of intangibles		(40	)		—			(40	)		—			—			—
Net cash used in investing activities		(1,031	)		—			(1,031	)		(374	)		—			(374	)
Financing Activities
Line of credit borrowings, net		253			—			253			743			—			743
Principal payments on notes payable		(39	)		—			(39	)		(83	)		—			(83	)
Proceeds from issuance of notes payable		772			—			772			—			—			—
Principal payments on capital leases		(100	)		—			(100	)		(106	)		—			(106	)
Proceeds from exercise of stock options		—			—			—			—			—			—
Net cash provided by financing activities		886			—			886			554			—			554
Effect of exchange rate changes on cash and cash equivalents		(62	)		—			(62	)		135			—			135
Net (decrease) increase in cash and cash equivalents		(49	)		—			(49	)		1,723			—			1,723
Cash and cash equivalents at beginning of period		1,279			—			1,279			2,669			—			2,669
Cash and cash equivalents at end of period	$	1,230		$	—		$	1,230		$	4,392		$	—		$	4,392
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	52		$	—		$	52		$	60		$	—		$	60
Income taxes	$	—		$	—		$	—		$	190		$	—		$	190

73

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Thousands, except number of shares and per share amounts)

	June 30, 2007
	As reported			Adjustments			As restated
Assets
Current assets
Cash and cash equivalents	$	1,203		$	—		$	1,203
Restricted cash		2,023			—			2,023
Accounts receivable, net		8,893			—			8,893
Inventories, net (1)		12,543			(110	)		12,433
Prepaid expenses and other current assets		1,246			—			1,246
Income taxes receivable		629			—			629
Deferred income taxes		1,780			—			1,780
Total current assets		28,317			(110	)		28,207
Property and equipment, net		5,773			—			5,773
Goodwill		8,907			—			8,907
Intangible assets, net of accumulated amortization of $456 at June 30, 2007		497			—			497
Deferred income taxes (2)		2,923			21			2,944
Other long-term assets		62			—			62
Total assets	$	46,479		$	(89	)	$	46,390
Liabilities and Shareholders’ Equity
Current liabilities
Lines of credit	$	5,096		$	—		$	5,096
Current portion of capital leases		410			—			410
Current portion of notes payable		840			—			840
Accounts payable		7,036			—			7,036
Accrued expenses and other liabilities (3)		5,006			46			5,052
Deferred purchase price obligation		480			—			480
Income taxes payable		88			—			88
Total current liabilities		18,956			46			19,002
Notes payable, less current portion		1,020			—			1,020
Capitalized leases, less current portion		605			—			605
Deferred income taxes		333			—			333
Total liabilities		20,914			46			20,960
Stockholders’ equity
Preferred stock: par value $0.0001; 5,000,000 authorized; none issued		—			—			—
Common stock: par value $0.0001; 100,000,000 shares authorized; 8,123,064 shares issued and outstanding at June 30, 2007		1			—			1
Additional paid-in-capital		36,471			—			36,471
Accumulated other comprehensive income		1,510			—			1,510
Accumulated deficit (4)		(12,417	)		(135	)		(12,552	)
Total stockholders’ equity		25,565			(135	)		25,430
Total liabilities and stockholders’ equity	$	46,479		$	(89	)	$	46,390

74

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Thousands, except per share amounts)

	Six Months Ended
	June 30, 2007									June 30, 2006
	As Reported			Adjustments			As Restated			As Reported			Adjustments			As Restated
Net sales	$	21,345		$	—		$	21,345		$	19,653		$	—		$	19,653
Cost of sales (5)		9,106			236			9,342			9,628			90			9,718
Gross profit		12,239			(236	)		12,003			10,025			(90	)		9,935
Operating expenses:
Sales and marketing (6)		9,354			190			9,544			7,002			—			7,002
General and administrative (7)		5,043			24			5,067			4,600			—			4,600
Shipping and warehousing (8)		1,283			(476	)		807			950			—			950
Research and development		434			—			434			519			—			519
Total operating expenses		16,114			(262	)		15,852			13,071			—			13,071
(Loss) income from operations		(3,875	)		26			(3,849	)		(3,046	)		(90	)		(3,136	)
Other expense:
Interest expense		(214	)		—			(214	)		(124	)		—			(124	)
Foreign currency transaction loss		(181	)		—			(181	)		47			—			47
Other expense		(47	)		—			(47	)		5			—			5
Total other expense		(442	)		—			(442	)		(72	)		—			(72	)
(Loss) income before benefit for income taxes		(4,317	)		26			(4,291	)		(3,118	)		(90	)		(3,208	)
Income tax (benefit) provision (9)		(1,054	)		36			(1,018	)		(626	)		(20	)		(646	)
Net loss	$	(3,263	)	$	(10	)	$	(3,273	)	$	(2,492	)	$	(70	)	$	(2,562	)
Net loss per share of Common Stock
Basic	$	(0.40	)	$	(0.00	)	$	(0.40	)	$	(0.31	)	$	(0.01	)	$	(0.32	)
Diluted	$	(0.40	)	$	(0.00	)	$	(0.40	)	$	(0.31	)	$	(0.01	)	$	(0.32	)
Shares used in computing net loss per share of Common Stock
Basic		8,104			8,104			8,104			8,084			8,084			8,084
Diluted		8,104			8,104			8,104			8,084			8,084			8,084

75

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Thousands)

	Six Months Ended
	June 30, 2007									June 30, 2006
	As Reported			Adjustments			As Restated			As Reported			Adjustments			As Restated
Operating Activities
Net loss	$	(3,263	)	$	(10	)	$	(3,273	)	$	(2,492	)	$	(70	)	$	(2,562	)
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		1,910			—			1,910			1,522			—			1,522
Deferred income taxes (10)		(1,275	)		36			(1,239	)		(321	)		(20	)		(341	)
Share-based compensation		135			—			135			50			—			50
Provision for bad debts		187			—			187			224			—			224
Loss on sale/transfer of property and equipment		2,038			—			2,038			122			—			122
Change in operating assets and liabilities:
Accounts receivable		1,171			—			1,171			1,427			—			1,427
Inventories, net (11)		(3,161	)		(68	)		(3,229	)		1,020			90			1,110
Prepaid expenses and other current assets		352			—			352			(339	)		—			(339	)
Other assets		8			—			8			10			—			10
Accounts payable		505			—			505			696			—			696
Accrued expenses and other liabilities (12)		440			42			482			(105	)		—			(105	)
Income tax payable/receivable		65			—			65			(289	)		—			(289	)
Net cash (used in) provided by operating activities		(888	)		—			(888	)		1,525			—			1,525
Investing Activities
Purchases of property and equipment		(1,444	)		—			(1,444	)		(2,308	)		—			(2,308	)
Purchases of short-term investments		—			—			—			(1,500	)		—			(1,500	)
Proceeds from maturities of short-term investments		500			—			500			5,980			—			5,980
Investment in restricted cash		(296	)		—			(296	)		(850	)		—			(850	)
Proceeds from sale of property and equipment		88			—			88			35			—			35
Acquisition of business, net of cash acquired		(675	)		—			(675	)		(2,982	)		—			(2,982	)
Purchase of intangibles		(54	)		—			(54	)		(4	)		—			(4	)
Net cash used in investing activities		(1,881	)		—			(1,881	)		(1,629	)		—			(1,629	)
Financing Activities
Line of credit borrowings, net		2,463			—			2,463			(112	)		—			(112	)
Principal payments on notes payable		(175	)		—			(175	)		(225	)		—			(225	)
Proceeds from issuance of notes payable		788			—			788			491			—			491
Principal payments on capital leases		(216	)		—			(216	)		(230	)		—			(230	)
Proceeds from exercise of stock options		—			—			—			—			—			—
Net cash provided by (used in) financing activities		2,860			—			2,860			(76	)		—			(76	)
Effect of exchange rate changes on cash and cash equivalents		(167	)		—			(167	)		515			—			515
Net (decrease) increase in cash and cash equivalents		(76	)		—			(76	)		335			—			335
Cash and cash equivalents at beginning of period		1,279			—			1,279			2,669			—			2,669
Cash and cash equivalents at end of period	$	1,203		$	—		$	1,203		$	3,004		$	—		$	3,004
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	175		$	—		$	175		$	188		$	—		$	188
Income taxes	$	2		$	—		$	2		$	283		$	—		$	283
Summary of noncash financing and investing activities:
Acquisition of property and equipment through capital leases	$	155		$	—		$	155		$	—		$	—		$	—

76

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Thousands, except number of shares and per share amounts)

	September 30, 2007
	As reported			Adjustments			As restated
Assets
Current assets
Cash and cash equivalents	$	996		$	—		$	996
Restricted cash		71			—			71
Accounts receivable, net		10,329			—			10,329
Inventories, net (1)		12,971			52			13,023
Prepaid expenses and other current assets		1,359			—			1,359
Income taxes receivable		27			—			27
Deferred income taxes		1,864			—			1,864
Total current assets		27,617			52			27,669
Property and equipment, net		5,889			—			5,889
Goodwill		9,433			—			9,433
Intangible assets, net of accumulated amortization of $480 at September 30, 2007		499			—			499
Deferred income taxes (2)		3,058			(60	)		2,998
Other long-term assets		65			—			65
Total assets	$	46,561		$	(8	)	$	46,553
Liabilities and Shareholders’ Equity
Current liabilities
Lines of credit	$	4,045		$	—		$	4,045
Current portion of capital leases		384			—			384
Current portion of notes payable		483			—			483
Accounts payable		7,684			—			7,684
Accrued expenses and other liabilities (3)		4,974			218			5,192
Deferred purchase price obligation		161			—			161
Income taxes payable		208			—			208
Total current liabilities		17,939			218			18,157
Notes payable, less current portion		959			—			959
Capitalized leases, less current portion		769			—			769
Deferred income taxes		365			—			365
Total liabilities		20,032			218			20,250
Stockholders’ equity
Preferred stock: par value $0.0001; 5,000,000 authorized; none issued		—			—			—
Common stock: par value $0.0001; 100,000,000 shares authorized; 8,148,376 shares issued and outstanding at September 30, 2007		1			—			1
Additional paid-in-capital		36,708			—			36,708
Accumulated other comprehensive income		2,204			—			2,204
Accumulated deficit (4)		(12,384	)		(226	)		(12,610	)
Total stockholders’ equity		26,529			(226	)		26,303
Total liabilities and stockholders’ equity	$	46,561		$	(8	)	$	46,553

77

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Thousands, except per share amounts)

	Nine Months Ended
	September 30, 2007									September 30, 2006
	As Reported			Adjustments			As Restated			As Reported			Adjustments			As Restated
Net sales	$	34,524		$	—		$	34,524		$	31,032		$	—		$	31,032
Cost of sales (5)		16,346			(378	)		15,968			15,487			(59	)		15,428
Gross profit		18,178			378			18,556			15,545			59			15,604
Operating expenses:
Sales and marketing (6)		12,286			324			12,610			10,494			—			10,494
General and administrative (7)		7,604			38			7,642			6,887			—			6,887
Shipping and warehousing (8)		1,211			—			1,211			1,293			—			1,293
Research and development		860			—			860			786			—			786
Total operating expenses		21,961			362			22,323			19,460			—			19,460
(Loss) income from operations		(3,783	)		16			(3,767	)		(3,915	)		59			(3,856	)
Other expense:
Interest expense		(402	)		—			(402	)		(168	)		—			(168	)
Foreign currency transaction loss		(102	)		—			(102	)		(47	)		—			(47	)
Other expense		(44	)		—			(44	)		(14	)		—			(14	)
Total other expense		(548	)		—			(548	)		(229	)		—			(229	)
(Loss) income before benefit for income taxes		(4,331	)		16			(4,315	)		(4,144	)		59			(4,085	)
Income tax (benefit) provision (9)		(1,101	)		117			(984	)		(874	)		1			(873	)
Net (loss) income	$	(3,230	)	$	(101	)	$	(3,331	)	$	(3,270	)	$	58		$	(3,212	)
Net (loss) income per share of Common Stock
Basic	$	(0.40	)	$	(0.01	)	$	(0.41	)	$	(0.40	)	$	(0.00	)	$	(0.40	)
Diluted	$	(0.40	)	$	(0.01	)	$	(0.41	)	$	(0.40	)	$	(0.00	)	$	(0.40	)
Shares used in computing net loss per share of Common Stock
Basic		8,116			8,116			8,116			8,087			8,087			8,087
Diluted		8,116			8,116			8,116			8,087			8,087			8,087

78

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Thousands)

	Nine Months Ended
	September 30, 2007									September 30, 2006
	As Reported			Adjustments			As Restated			As Reported			Adjustments			As Restated
Operating Activities
Net (loss) income	$	(3,230	)	$	(101	)	$	(3,331	)	$	(3,270	)	$	58		$	(3,212	)
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Depreciation and amortization		2,338			—			2,338			2,383			—			2,383
Deferred income taxes (10)		(1,481	)		117			(1,364	)		(620	)		1			(619	)
Share-based compensation		373			—			373			150			—			150
Provision for bad debts		190			—			190			417			—			417
Loss on sale/transfer of property and equipment		2,064			—			2,064			159			—			159
Impairment of property and equipment		—			—			—			—			—			—
Change in operating assets and liabilities:
Accounts receivable		(206	)		—			(206	)		1,428			—			1,428
Inventories, net (11)		(3,283	)		(230	)		(3,513	)		1,224			(59	)		1,165
Prepaid expenses and other current assets		411			—			411			408			—			408
Other assets		(83	)		—			(83	)		10			—			10
Accounts payable		820			—			820			854			—			854
Accrued expenses and other liabilities (12)		444			214			658			(236	)		—			(236	)
Income tax payable/receivable		777			—			777			(271	)		—			(271	)
Net cash (used in) provided by operating activities		(866	)		—			(866	)		2,636			—			2,636
Investing Activities
Purchases of property and equipment		(1,585	)		—			(1,585	)		(3,768	)		—			(3,768	)
Purchases of short-term investments		—			—			—			(1,500	)		—			(1,500	)
Proceeds from maturities of short-term investments		512			—			512			6,980			—			6,980
Release of (investment in) restricted cash		1,670			—			1,670			(857	)		—			(857	)
Proceeds from sale of property and equipment		88			—			88			119			—			119
Acquisition of business, net of cash acquired		(1,012	)		—			(1,012	)		(2,982	)		—			(2,982	)
Purchase of intangibles		(68	)		—			(68	)		(12	)		—			(12	)
Net cash used in investing activities		(395	)		—			(395	)		(2,020	)		—			(2,020	)
Financing Activities
Line of credit borrowings, net		972			—			972			(71	)		—			(71	)
Principal payments on notes payable		(272	)		—			(272	)		(889	)		—			(889	)
Proceeds from issuance of notes payable		788			—			788			1,553			—			1,553
Principal payments on capital leases		(314	)		—			(314	)		(349	)		—			(349	)
Proceeds from exercise of stock options		—			—			—			—			—			—
Net cash provided by financing activities		1,174			—			1,174			244			—			244
Effect of exchange rate changes on cash and cash equivalents		(196	)		—			(196	)		491			—			491
Net (decrease) increase in cash and cash equivalents		(283	)		—			(283	)		1,351			—			1,351
Cash and cash equivalents at beginning of period		1,279			—			1,279			2,669			—			2,669
Cash and cash equivalents at end of period	$	996		$	—		$	996		$	4,020		$	—		$	4,020
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	338		$	—		$	338		$	261		$	—		$	261
Income taxes	$	2		$	—		$	2		$	283		$	—		$	283
Summary of noncash financing and investing activities:
Acquisition of property and equipment through capital leases	$	327		$	—		$	327		$	—		$	—		$	—

79

Notes to Restated Consolidated Balance Sheets

(1) Adjustments for overhead costs capitalized in intransit inventory, standard costing errors and purchase price variance capitalized costs errors.

	2007
	March 31,			June 30,			September 30,
	(Thousands)
Capitalized overhead on intransit Inventory	$	(151	)	$	(329	)	$	(141	)
Standard costing errors		—			—			(107	)
Purchase price variance capitalized in inventory		144			219			300
Total	$	(7	)	$	(110	)	$	52

(2) Adjustments for deferred income taxes for the effect of the adjustments listed below in notes 5 through 8.

	2007
	March 31,			June 30,		September 30,
	(Thousands)
Income tax effect of adjustments	$	(5	)	$	21	$	(60	)
Total	$	(5	)	$	21	$	(60	)

(3) Adjustments for unrecorded freight costs, general and administrative costs and sales and marketing costs.

	2007
	March 31,		June 30,		September 30,
	(Thousands)
Unrecorded freight costs	$	—	$	6	$	100
Unrecorded sales and marketing costs		4		15		79
Unrecorded general and administrative costs		14		25		39
Total	$	18	$	46	$	218

(4) Adjustments to accumulated deficit for errors described in notes 5 through 9 below.

Notes to Restated Consolidated Statement of Operations

(5) Adjustments for overhead costs capitalized in intransit inventory, standard costing errors, unrecorded freight costs, new system setup errors and purchase price variance capitalized costs errors.

	Three Months Ended
	March 31, 2007			June 30, 2007			September 30, 2007			March 31, 2006			June 30, 2006		September 30, 2006			December 31, 2006
				(Thousands)
Capitalized overhead on intransit Inventory	$	(27	)	$	178		$	(188	)	$	(104	)	$	194	$	(149	)	$	1
Standard costing errors		—			—			107			—			—		—			—
Unrecorded freight costs		—			6			94			—			—		—			—
New system setup errors—reclass		157			141			(70	)		—			—		—			—
Purchase price variance capitalized in inventory		(144	)		(75	)		(81	)		—			—		—			—
Total	$	(14	)	$	250		$	(138	)	$	(104	)	$	194	$	(149	)	$	1

80

(6) Adjustments for unrecorded general and administrative costs.

	Three Months Ended
	March 31, 2007		June 30, 2007		September 30, 2007		March 31, 2006		June 30, 2006		September 30, 2006		December 31, 2006
	(Thousands)
Unrecorded general and administrative costs	$	13	$	11	$	14	$	—	$	—	$	—	$	1
Total	$	13	$	11	$	14	$	—	$	—	$	—	$	1

81

(7) Adjustments for unrecorded sales and marketing costs and new system setup errors.

	Three Months Ended
	March 31, 2007		June 30, 2007		September 30, 2007		March 31, 2006		June 30, 2006		September 30, 2006		December 31, 2006
	(Thousands)
Unrecorded sales and marketing costs	$	1	$	11	$	64	$	—	$	—	$	—	$	3
New system setup errors—reclass		88		90		70		—		—		—		—
Total	$	89	$	101	$	134	$	—	$	—	$	—	$	3

(8) Adjustments for new system setup errors.

	Three Months Ended
	March 31, 2007			June 30, 2007			September 30, 2007		March 31, 2006		June 30, 2006		September 30, 2006		December 31, 2006
	(Thousands)
New system setup errors—reclass	$	(245	)	$	(231	)	$	—	$	—	$	—	$	—	$	—
Total	$	(245	)	$	(231	)	$	—	$	—	$	—	$	—	$	—

(9) Adjustments for income tax effect of adjustments above in notes 5 through 8.

	Three Months Ended
	March 31, 2007		June 30, 2007			September 30, 2007		March 31, 2006		June 30, 2006			September 30, 2006		December 31, 2006
	(Thousands)
Income tax effect of adjustments	$	62	$	(26	)	$	81	$	29	$	(49	)	$	21	$	(14	)
Total	$	62	$	(26	)	$	81	$	29	$	(49	)	$	21	$	(14	)

Notes to Restated Consolidated Statements of Cash Flows

(10) Adjustments for deferred income taxes for the effect of the adjustments listed above in notes 5 through 8.

	2007						2006
	Fiscal Year to Date Ended						Fiscal Year to Date Ended
	March 31,		June 30,		September 30,		March 31,		June 30,			September 30,
			(Thousands)
Income tax effect of adjustments	$	62	$	36	$	117	$	29	$	(20	)	$	1
Total	$	62	$	36	$	117	$	29	$	(20	)	$	1

(11) Adjustments for overhead costs capitalized in intransit inventory, standard costing errors and purchase price variance capitalized costs errors.

	2007									2006
	Fiscal Year to Date Ended									Fiscal Year to Date Ended
	March 31,			June 30,			September 30,			March 31,			June 30,		September 30,
				(Thousands)
Capitalized overhead on intransit Inventory	$	(27	)	$	151		$	(37	)	$	(104	)	$	90	$	(59	)
Standard costing errors		—			—			107			—			—		—
Purchase price variance capitalized in inventory		(144	)		(219	)		(300	)		—			—		—
Total	$	(171	)	$	(68	)	$	(230	)	$	(104	)	$	90	$	(59	)

(12) Adjustments for unrecorded freight costs, general and administrative costs and sales and marketing costs.

82

	2007						2006
	Fiscal Year to Date Ended						Fiscal Year to Date Ended
	March 31,		June 30,		September 30,		March 31,		June 30,		September 30,
			(Thousands)
Unrecorded freight costs	$	—	$	6	$	100	$	—	$	—	$	—
Unrecorded sales and marketing costs		1		12		76		—		—		—
Unrecorded general and administrative costs		13		24		38		—		—		—
Total	$	14	$	42	$	214	$	—	$	—	$	—

83

18. Acquisitions

On January 16, 2006, the Company completed the acquisition of its primary manufacturer LEM. The total purchase price for LEM was 3.5 million Euros or $4.2 million in cash, plus a two year earn-out based on LEM’s future sales. Under the terms of the earn-out, the Company was obligated to make quarterly payments based on unit sales, up to a maximum of 1.4 million Euros, through December 31, 2007. The maximum amount of additional consideration was earned and paid out as of December 31, 2007. Accordingly, the entire amount has been included in the purchase price allocation. The acquisition of LEM has allowed the Company to control its primary manufacturer and ensure a continued source of supply for the Company’s products.

The acquisition was accounted for under the purchase method of accounting; and, accordingly, the purchased assets and liabilities assumed were recorded at their estimated fair values at the date of the acquisition based on internal valuations and third party appraisals. The purchase price allocation for this acquisition resulted in an excess of the purchase price over net tangible assets acquired of approximately $8.2 million, of which $0.2 million was allocated to customer relationships, which is being amortized on a straight-line basis over the estimated useful life of 7 years. The remaining $8.0 million was allocated to goodwill. An estimate of the fair value of the intangible asset acquired was made using the income approach and the residual earnings method. Significant assumptions used in the residual earnings method included an income tax rate of 37.25%, a target EBIT margin of 13% and a long-term growth rate of 3.0%. Goodwill arises from the Company being able to control its primary manufacturer.

The following table summarizes the total purchase price, estimated fair values of the assets acquired and liabilities assumed.

	(Thousands)
Cash	$	4,159
Deferred purchase price		1,696
Acquisition costs		240
Total purchase price	$	6,095
Cash acquired	$	—
Accounts receivable		611
Inventories		1,939
Prepaid expense and other current assets		341
Fixed assets		3,146
Other assets		70
Intangible assets		217
Goodwill		7,963
Total assets acquired		14,287
Line of credit		1,143
Notes payable		1,406
Capital leases		1,367
Accounts payable		2,592
Other liabilities		1,684
Net assets acquired	$	6,095

Goodwill at December 31, 2007 and 2006 was $9.7 million and $8.7 million, respectively. The change in goodwill represents a difference in foreign exchange spot rates used in translation of LEM’s, our Italian subsidiary, books during consolidation in accordance with FAS No. 52.

If the results of LEM from January 1, 2006 through January 15, 2006 had been included in the Company’s results for the year ended December 31, 2006, the amounts would not have had a significant difference to consolidated net sales, net loss or net loss per share.

84

Orange 21 Inc. and Subsidiaries

Schedule II—Valuation and Qualifying Accounts

For the Years Ended December 31, 2007 and 2006

	Balance at Beginning of Year		Charges to Expense/Against Revenue		Write-Offs, Disposals, Costs and Other			Balance at End of Year
	(Thousands)
Allowance for doubtful accounts:
Year ended December 31, 2007	$	847	$	198	$	(270	)	$	775
Year ended December 31, 2006	$	505	$	607	$	(265	)	$	847
Allowance for sales returns:
Year ended December 31, 2007	$	2,032	$	85	$	(162	)	$	1,955
Year ended December 31, 2006	$	1,986	$	4,246	$	(4,200	)	$	2,032
Allowance for inventory reserve:
Year ended December 31, 2007	$	3,677	$	471	$	(1,884	)	$	2,264
Year ended December 31, 2006	$	2,183	$	2,980	$	(1,486	)	$	3,677

Note: Additions to the allowance for doubtful accounts are charged to bad debt expense. Additions to the allowance for sales returns are charged against revenues. Additions to the allowance for inventory reserve are charged against cost of goods sold.

All other schedules have been omitted because they are either inapplicable or the required information has been provided in the Consolidated Financial Statements or the Notes thereto.

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Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A. Controls and Procedures

Restatement of Previously Issued Financial Statements

As discussed in Notes 2 and 17 to the consolidated financial statements contained in Item 8 of this Annual Report on Form 10-K, our management and Audit Committee determined that it was appropriate to restate: (i) our consolidated financial statements for the year ended December 31, 2006 as contained in our Form 10-K for the year ended December 31, 2006; (ii) the unaudited quarterly financial data for each of the first three quarters in the fiscal year ended December 31, 2007; and (iii) the unaudited quarterly financial data for all quarters in the fiscal year ended December 31, 2006 (as more fully described in Notes 2 and 17 to the consolidated financial statements included in this Form 10-K). In reaching this conclusion and in connection with the restatement process, our management and Audit Committee has also determined that our disclosure controls and procedures and our internal control over financial reporting were not effective as of December 31, 2007, as more fully described in this section under “Evaluation of Disclosure Controls and Procedures” and “Management’s Report on Internal Control Over Financial Reporting.”

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, or the Exchange Act. 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. Our internal control over financial reporting includes policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (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 our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on our 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 of controls 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.

A material weakness is a deficiency or combination of deficiencies, in internal controls over financial reporting such that there is a reasonable probability that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. Under the supervision and with the participation of management, including our Chief Executive Officer, or CEO and Chief Financial Officer, or CFO, management conducted an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2007. In making this assessment, management used the following criteria established in Internal Control-Integrated Framework issued by the Commission of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this evaluation and on the criteria, management has concluded that as of December 31, 2007, there were control deficiencies that constituted material weaknesses, as described below.

Description of Material Weaknesses as of December 31, 2007

Management identified the following material weaknesses in internal control over financial reporting as of December 31, 2007:

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• An appropriate review of the open purchase orders and goods/services received but not invoiced was not being performed timely or thoroughly at our Italian-based subsidiary, Spy S.r.l.

• A proper search for unrecorded liabilities was not being conducted at our Italian-based subsidiary, Spy S.r.l.

• A calculation to determine appropriate inventory costs had not been performed on an accurate or timely basis in both the U.S. and at our Italian-based subsidiary, Spy S.r.l.

The above weaknesses resulted in the restatement of the Company’s previously issued financial statements as presented in this Annual Report on Form 10-K and adjustments to our fiscal 2007 quarterly unaudited financial statements.

This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.

Changes in Internal Control Over Financial Reporting

We have made significant control improvements through multiple initiatives in preparation for the adoption of Section 404 of the Sarbanes-Oxley Act. In addition, in order to remediate our material weaknesses listed above, we have improved our controls and procedures in our Italian-based subsidiary, Spy S.r.l. as follows:

• An analysis and review of certain accrued liabilities, including a review of open purchase orders on a monthly basis to identify goods and services received, but not invoiced.

• A monthly review of the reasonableness of related expense accounts in conjunction with a search for unrecorded liabilities to ensure expenses have been recorded properly on a timely basis.

• We have also improved our controls and processes in both the U.S. and Italy regarding capitalization of inventory costs.

We have remediated these material weaknesses subsequent to the fiscal year end.

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is (i) recorded, processed, summarized and reported in a timely manner and (ii) accumulated and communicated to management, including our CEO and CFO as appropriate, to permit timely decisions regarding our disclosure. These controls and procedures are designed to provide reasonable assurance of achieving our objectives. Based on their evaluation as of the end of the period covered by this report, under the supervision and with the participation of our management, our CEO and CFO have concluded that as of December 31, 2007, in light of the material weakness noted above, our disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”) were not effective at that reasonable assurance level in timely making known to them material information relating

87

to the Company required to be disclosed in our reports filed or submitted under the Exchange Act.

Notwithstanding the material weaknesses described above, the Company performed additional analyses and other post-closing procedures to ensure the Company’s consolidated financial statements are prepared in accordance with generally accepted accounting principles. Accordingly, management believes that the financial statements included in this report fairly represent in all material respects the Company’s financial condition, results of operations and cash flows as of and for the periods presented.

Item 9B. Other Information

None.

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PART III

Documents Incorporated by Reference

In response to Part III, Items 10, 11, 12, 13 and 14, parts of the Company’s definitive proxy statement (to be filed pursuant to Regulation 14A within 120 days after Registrant’s fiscal year-end of December 31, 2007) for its annual stockholders’ meeting are incorporated by reference in this Form 10-K.

Item 10. Directors, Executive Officers and Corporate Governance

Certain information regarding our executive officers required by this item is set forth in Part I of this Annual Report under the caption “Executive Officers of the Registrant.” The remaining information required by Item 10 will be contained in, and is hereby incorporated by reference to, our Proxy Statement relating to our 2008 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year ended December 31, 2007.

Item 11. Executive Compensation

The information required by Item 11 will be contained in, and is hereby incorporated by reference to, our Proxy Statement relating to our 2008 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year ended December 31, 2007.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters

The information required by Item 12 will be contained in, and is hereby incorporated by reference to, our Proxy Statement relating to our 2008 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year ended December 31, 2007.

Item 13. Certain Relationships and Related Transactions, and Director Independence

The information required by Item 13 will be contained in, and is hereby incorporated by reference to, our Proxy Statement relating to our 2008 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year ended December 31, 2007.

Item 14. Principal Accounting Fees and Services

The information required by Item 14 will be contained in, and is hereby incorporated by reference to, our Proxy Statement relating to our 2008 Annual Meeting of Stockholders.

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PART IV

Item 15. Exhibits and Financial Statement Schedules

(a) Documents filed as part of this report:

(1) Financial Statements

Reference is made to the Index to Consolidated Financial Statements of Orange 21 Inc., under Item 8 of Part II hereof.

(2) Financial Statement Schedules

The following financial statement schedule of Orange 21 Inc. is filed as part of this Form 10-K (under Item 8 of Part II hereof):

Schedule II – Valuation and Qualifying Accounts

All other financial statement schedules have been omitted because they are not applicable or not required or because the information is included elsewhere in the Consolidated Financial Statements or the Notes thereto.

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Exhibits

Exhibit Number	Description of Document
3.2	Restated Certificate of Incorporation (incorporated by reference to Form S-1 (File No. 333-119024) declared effective on December 13, 2004)
3.4	Amended and Restated Bylaws (incorporated by reference to Form S-1 (File No. 333-119024) declared effective on December 13, 2004)
4.1	Form of Common Stock Certificate (incorporated by reference to Form S-1 (File No. 333-119024) declared effective on December 13, 2004)
4.2	Common Stock Purchase Warrant to Purchase 142,000 shares of Common Stock of Orange 21 Inc. issued to Roth Capital Partners, LLC dated June 22, 2005 (incorporated by reference to Form 10-Q filed August 11, 2005)
4.3	Common Stock Purchase Warrant to Purchase 5,000 shares of Common Stock of Orange 21 Inc. issued to Dana Mackie dated June 22, 2005 (incorporated by reference to Form 10-Q filed August 11, 2005)
10.2+	2004 Stock Incentive Plan (incorporated by reference to Form S-1 (File No. 333-119024) declared effective on December 13, 2004)
10.3+	Form of Stock Option Agreement under the 2004 Stock Incentive Plan (incorporated by reference to Form 10-Q filed November 14, 2005)
10.42	Loan and Security Agreement entered February 26, 2007 by and between Spy Optic, Inc. and BFI Business Finance (incorporated by reference to Form 8-K filed March 2, 2007)
10.43	General Continuing Guaranty entered February 26, 2007 by and between Orange 21 Inc. and BFI Business Finance (incorporated by reference to Form 8-K filed March 2, 2007)
10.44	First modification to Loan and Security Agreement entered into on December 7, 2007 by and between Spy Optic, Inc. and BFI Business Finance (incorporated by reference to Form 8-K filed December 12, 2007)
10.45	Second modification to Loan and Security Agreement entered into on February 12, 2008 by and between Spy Optic, Inc. and BFI Business Finance
14.1	Code of Ethics for Senior Officers (incorporated by reference to Form 10-K filed March 31, 2005)
14.2	Code of Business Conduct (incorporated by reference to Form 10-K filed March 31, 2005)
21.1	List of subsidiaries
23.1	Consent of Mayer Hoffman McCann P.C., independent registered certified public accountants
24.1	Power of Attorney (included in signature page)
31.1	Section 302 Certification of the Company’s Chief Executive Officer
31.2	Section 302 Certification of the Company’s Chief Financial Officer
32.1	Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350)
32.2	Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350)

+ Management contract or compensatory plan or arrangement.

91

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.

	Orange 21 Inc.
Date: April 8, 2008
	By	/s/ Jerry Collazo
		Jerry Collazo Chief Financial Officer

POWER OF ATTORNEY

KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Mark Simo and Jerry Collazo, and each of them, his true and lawful attorneys-in-fact, each with full power of substitution, for him in any and all capacities, to sign any amendments to this report on Form 10-K and each amendment hereto and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact or their substitute or substitutes may do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Name	Title	Date
/s/ Mark Simo Mark Simo	Chief Executive Officer and Chairman of the Board of Directors	April 8, 2008
/s/ Jerry Collazo Jerry Collazo	Chief Financial Officer Secretary and Treasurer	April 8, 2008
/s/ John Pound John Pound	Co Chairman of the Board of Directors	April 8, 2008
/s/ Harry Casari Harry Casari	Director	April 8, 2008
/s/ David Mitchell David Mitchell	Director	April 8, 2008
/s/ Ted Roth Ted Roth	Director	April 8, 2008
/s/ Greg Theiss Greg Theiss	Director	April 8, 2008
/s/ Jeffrey Theodosakis Jeffrey Theodosakis	Director	April 8, 2008

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EX-10.45

Exhibit 10.45

Second Modification to Loan and Security Agreement

This Second Modification to Loan and Security Agreement (this “Modification”) is entered into by and between Spy Optic, Inc. (“Borrower”) and BFI Business Finance (“Lender”) as of this 12th day of February, 2008, at San Jose, California.

RECITALS

A. Lender and Borrower have previously entered into or are concurrently herewith entering into a Loan and Security Agreement (the “Agreement”) dated February 26, 2007.

B. Lender and Borrower may have previously executed one or more Modifications to Loan and Security Agreement (the “Previous Modification(s)”).

C. Borrower has requested, and Lender has agreed, to modify the Agreement as set forth below.

AGREEMENT

For good and valuable consideration, the parties agree as set forth below:

1. Incorporation by Reference. The Agreement and the Previous Modification(s), if any, as modified hereby and the Recitals are incorporated herein by this reference.

2. Effective Date. The terms of this Modification shall be in full force and effect as of February 12, 2008.

3. Modification to Agreement. The Agreement is hereby modified to amend and restate the section(s) referenced below:

“Borrowing Base” means the sum of the following:

(a) Eighty percent (80%) of the Net Face Amount of Prime Accounts, but in any event not in an aggregate amount in excess of the Maximum Account Advance (the “A R Borrowing Base”) excepting therefrom the Accounts of No Fear where Fifty percent (50%) of the Net Face Amount of Prime Accounts shall be allowed up to a maximum amount of Two Hundred Fifty Thousand and 00/100 Dollars ($250,000.00) so long as there is availability under the line; plus

(b) Twenty-Five percent (25%) of the Current Market Cost of raw materials that constitute Eligible Inventory; plus Twenty-Five percent (25%) of the Current Market Cost of finished goods that constitute Eligible Inventory, but in any event not in an aggregate amount in excess of the Maximum Inventory Advance (the “Inventory Borrowing Base”).

“Maximum Account Advance” means Eight Million and 00/100 Dollars ($8,000,000.00).

“Maximum Amount” means Eight Million and 00/100 Dollars ($8,000,000.00).

“Maximum Inventory Advance” means the lesser of One Million Five Hundred Thousand and 00/100 Dollars ($1,500,000.00) or fifty percent (50%) of the A R Borrowing Base.

Page 1 of 2 Initial Here         

“Prime Rate” means the variable rate of interest announced as the “prime” rate in the Western Edition of the Wall Street Journal which is in effect from time to time; provided that the Prime Rate shall at all times be deemed to be not less than —N/A— percent (—N/A—%) per annum (the “Deemed Prime Rate”).

4. Fee. At the time of execution of the Modification, Borrower agrees to pay a one-time fee in the amount of —N/A— and 00/100 Dollars ($—n/a—).

5. Legal Effect. Except as specifically set forth in this Modification, all of the terms and conditions of the Agreement remain in full force and effect.

6. Integration. This is an integrated Modification and supersedes all prior negotiations and agreements regarding the subject matter hereof. All amendments hereto must be in writing and signed by the parties.

IN WITNESS WHEREOF, the parties have executed this Second Modification to Loan and Security Agreement as of the date first set forth above.

BFI Business Finance		Spy Optic, Inc.
/s/ David Drogos		/s/ Mark Simo
By:	David Drogos	By:	Mark Simo
Its:	President	Its:	Chief Executive Officer

Page 2 of 2

EX-21.1

Exhibit 21.1

List of Subsidiaries

Name	Jurisdiction of Organization
Spy Optic, Inc.	California
Spy Optic, S.r.l.	Italy
LEM S.r.l.	Italy (effective January 16, 2006)

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We hereby consent to the incorporation by reference in the previously filed Registration Statement (No. 333-121223) on Form S-8 of Orange 21 Inc. of our report dated April 8, 2008, relating to the consolidated financial statements and the financial statement schedule of Orange 21 Inc. and subsidiaries, appearing in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

/s/ Mayer Hoffman McCann P.C.

San Diego, California

April 8, 2008

EX-31.1

Exhibit 31.1

CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER

I, Mark Simo, certify that:

1.        I have reviewed this annual report on Form 10-K for the year ended December 31, 2007 of Orange 21 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)) 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 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 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: April 8, 2008
By:	/s/ Mark Simo
	Mark Simo
	Chief Executive Officer
	(Principal Executive Officer)

EX-31.2

Exhibit 31.2

CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER

I, Jerry Collazo, certify that:

1.        I have reviewed this annual report on Form 10-K for the year ended December 31, 2007 of Orange 21 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)) 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 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 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: April 8, 2008
By:	/s/ Jerry Collazo
	Jerry Collazo
	Chief Financial Officer
	(Principal Financial Officer)

EX-32.1

Exhibit 32.1

CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER UNDER 18 U.S.C. SECTION 1350

AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

I, Mark Simo, the Chief Executive Officer of Orange 21 Inc. (the “Company”), certify for the purposes of section 1350 of chapter 63 of title 18 of the United States Code that, to my knowledge,

(i) the Annual Report of the Company on Form 10-K for the year ended December 31, 2007 (the “Report”), fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934, and

(ii) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: April 8, 2008

By:	/s/ Mark Simo
	Mark Simo
	Chief Executive Officer
	(Principal Executive Officer)

EX-32.2

Exhibit 32.2

CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER UNDER 18 U.S.C. SECTION 1350

AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

I, Mark Simo, the Chief Executive Officer of Orange 21 Inc. (the “Company”), certify for the purposes of section 1350 of chapter 63 of title 18 of the United States Code that, to my knowledge,

(i) the Annual Report of the Company on Form 10-K for the year ended December 31, 2007 (the “Report”), fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934, and

(ii) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: April 8, 2008

By:	/s/ Jerry Collazo
	Jerry Collazo
	Chief Financial Officer
	(Principal Financial Officer)