Basis of Presentation and Significant Accounting Policies (Policies)

9 Months Ended

Sep. 30, 2012

Nature of Operations

Nature of Operations

Luna Innovations Incorporated (“we,” “Luna Innovations” or the “Company”) is incorporated in the State of Delaware and headquartered in Roanoke, Virginia. We develop, manufacture and market fiber optic test & measurement, sensing, and instrumentation products and are focused on bringing new and innovative technology solutions to measure, monitor, protect and improve critical processes in the telecommunications, medical, composite and defense industries. We are organized into two main groups, which work closely together to turn ideas into products: our Technology Development segment, and our Products and Licensing segment. Our business model is designed to accelerate the process of bringing new and innovative technologies to market. We have a history of net losses from 2005 through the nine months ended September 30, 2012, attributable to our operations and other charges. We have historically managed our liquidity through cost reduction initiatives, debt financings and capital markets transactions. For the three months ended September 30, 2012, we experienced positive cash flow from operations of $0.6 million and overall positive cash flow of $0.1 million during that period. For the nine months ended September 30, 2012, we experienced negative cash flow from operations of $0.8 million and an overall negative cash flow of $2.2 million during that period.

Since the second half of 2008, the increased turmoil in the U.S. and global capital markets and a global slowdown of economic growth created a substantially more difficult business environment. Our ability to access the capital markets may be limited. Economic and market conditions may not improve significantly during the remainder of 2012 and into 2013 and could get worse.

Although there can be no guarantees, we believe that our current cash balance, in addition to the funds available to us under the Credit Facilities described in Note 3 below, will provide adequate liquidity for us to meet our working capital needs over the next twelve months.

Unaudited Interim Financial Information

Unaudited Interim Financial Information

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP. The unaudited condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and in the opinion of management reflect all adjustments, consisting of only normal recurring accruals considered necessary to present fairly our financial position at September 30, 2012, results of operations for the three and nine months ended September 30, 2012 and 2011, and cash flows for the nine months ended September 30, 2012 and 2011. The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.

The consolidated interim financial statements, including our significant accounting policies, should be read in conjunction with the audited Consolidated Financial Statements and the notes thereto for the year ended December 31, 2011, included in the Company’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on March 29, 2012. As used herein, the terms “Luna”, the “Company”, “we”, “our” and “us” mean Luna Innovations Incorporated and its consolidated subsidiaries.

Consolidation Policy

Consolidation Policy

Our consolidated financial statements include the accounts of the Company, our wholly owned subsidiaries and other entities in which we have a controlling financial interest. We eliminate from our financial results all significant intercompany transactions. We do not have any investments in entities we believe are variable interest entities for which we are the primary beneficiary.

Fair Value Measurements

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market in an orderly transaction between marketplace participants. Various valuation approaches can be used to determine fair value, each requiring different valuation inputs. The following hierarchy classifies the inputs used to determine fair value into three levels:

• Level 1—Quoted prices for identical instruments in active markets

• Level 2—Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets

• Level 3—Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable

The carrying values of cash and cash equivalents, contract receivables and accounts payable approximate fair value because of the short-term nature of these instruments. The carrying value of our debt approximates fair value, as we consider the floating interest rate on our credit facilities with Silicon Valley Bank to be at market. Certain nonfinancial assets and liabilities are measured at fair value on a nonrecurring basis in accordance with U.S. GAAP. This includes items such as nonfinancial assets and liabilities initially measured at fair value in a business combination and nonfinancial long-lived asset groups measured at fair value for an impairment assessment. In general, nonfinancial assets including intangible assets and property and equipment are measured at fair value when there is an indication of impairment and are recorded at fair value only when any impairment is recognized.

Use of Estimates

Use of Estimates

The preparation of our consolidated financial statements in accordance with U.S. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statements and accompanying notes. Although these estimates are based on our knowledge of current events and actions we may undertake in the future, actual results may differ from such estimates and assumptions.

Net Income/(Loss) per Share

Net Income/(Loss) per Share

Basic net income/(loss) per share is computed by dividing net income/(loss) available to common stockholders by the weighted average number of shares outstanding during the period. Diluted net income/(loss) per share is computed by dividing net income/(loss) available to common stockholders by the weighted average shares outstanding during the period increased to include, if dilutive, the number of additional common share equivalents that would have been outstanding if potential common shares had been issued using the treasury stock method. Diluted net income/(loss) per share would also include the potential common share equivalents relating to convertible securities by application of the if-converted method.

For the three and nine months ended September 30, 2012 we had a total of 7,002,200 and 6,896,405 common stock equivalents (which include conversion of preferred stock, outstanding warrants and stock options), respectively, all of which are anti-dilutive. For the three months ended September 30, 2011 we had a total of 6,975,633 common stock equivalents (which include conversion of preferred stock, outstanding warrants and stock options), of which 2,228,916 were dilutive and 4,746,717 were anti-dilutive. For the nine months ended September 30, 2011 we had a total of 6,144,661 common stock equivalents (which include conversion of preferred stock, outstanding warrants and stock options) which were anti-dilutive. In those reporting periods in which we have a net loss, anti-dilutive shares comprise the impact of those number of shares that would have been dilutive had we had net income plus the number of common stock equivalents that would be anti-dilutive had we had net income.

Stock-Based Compensation

Share-Based Compensation

We recognize share-based compensation expense based upon the fair value of the underlying equity award on the date of the grant. We have elected to use the Black-Scholes option pricing model to value any awards granted. We amortize share-based compensation for such awards on a straight-line basis over the related service period of the awards taking into account the effects of the employees’ expected exercise and post-vesting employment termination behavior. To compute the volatility used in this model we use the historical volatility of our common stock over the expected life of options granted, or the period since our initial public offering if less than the expected life of the options. The risk-free interest rate is based on U.S. Treasury interest rates, the terms of which are consistent with the expected life of the stock options. The expected life and estimated post employment termination behavior is based upon historical experience of homogeneous groups within our company. We also assume an expected dividend yield of zero for all periods, as we have never paid a dividend on our common stock and do not have any plans to do so in the future.

The fair value of each option granted during the nine months ended September 30, 2012 and 2011 was estimated as of the grant date using the Black-Scholes option pricing model with the following assumptions:

	Nine months ended September 30, 2012	Nine months ended September 30, 2011
Risk-free interest rate	1.18 – 1.49%	2.29 – 2.81%
Expected life of options (in years)	7.5	7.5
Expected stock price volatility	108%	111%

A summary of the activity for our 2003 Stock Plan and 2006 Equity Incentive Plan is presented below for the nine months ended September 30, 2012:

	Options Outstanding								Options Exercisable
	Number of Shares			Price per Share Range	Weighted Average Exercise Price		Aggregate Intrinsic Value (1)		Number of Shares		Weighted Average Exercise Price		Aggregate Intrinsic Value (1)
Balance, December 31, 2011		4,641,039		$0.35 – $ 6.74	$	2.23	$	1,509,270		3,206,994	$	2.23	$	1,258,740
Granted		896,381		$1.40 – 1.75	$	1.67
Exercised		(179,273	)	$0.35 – 0.82	$	0.36
Canceled		(60,636	)	$0.65 – 5.50	$	1.91
Balance, September 30, 2012		5,297,511		$0.35 – 6.74	$	2.20	$	1,177,163		3,575,182	$	2.37	$	1,016,110

(1) The intrinsic value of an option represents the amount by which the market value of the stock exceeds the exercise price of the option of in-the-money options only. The aggregate intrinsic value is based on the closing price of our Common Stock on the NASDAQ Capital Market, as applicable, on the respective dates.

At September 30, 2012, the outstanding stock options to purchase an aggregate of 5,297,511 shares had a weighted-average remaining contractual term of 6.6 years, and the exercisable stock options to purchase an aggregate of 3,575,182 shares had a weighted-average remaining contractual term of 5.5 years.

For the three months ended September 30, 2012 and 2011, we recognized $483,000 and $462,000, respectively, and for the nine months ended September 30, 2012 and 2011, we recognized $1,412,000 and $1,737,000, respectively, in share-based compensation expense, which is included in our selling, general and administrative expenses in the accompanying consolidated financial statements. We expect to recognize $2.3 million in share-based compensation expense over the remaining requisite service period of five years for stock options outstanding as of September 30, 2012.

Intangible Assets and Other Long Lived Assets

Intangible Assets and Other Long Lived Assets

Long-lived assets and certain identifiable intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset might not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds the fair market value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair market value, less cost to sell.

Recent Accounting Pronouncements

Recent Accounting Pronouncements

There are no recently issued accounting standards that are expected to have a material impact on our consolidated results of operations, financial position and cash flows.