UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

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

Commission file number 1-8402

IRVINE SENSORS CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Delaware (State or Other Jurisdiction of Incorporation or Organization)		33-0280334 (I.R.S. Employer Identification No.)

3001 Red Hill Avenue,
Costa Mesa, California 92626
(Address of Principal Executive Offices) (Zip Code)

(714) 549-8211
(Registrant’s Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o		Accelerated filer o		Non-accelerated filer o		Smaller reporting company þ

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

As of August 3, 2009, there were 8,025,458 shares of common stock outstanding.

 

 

IRVINE SENSORS CORPORATION

QUARTERLY REPORT ON FORM 10-Q
FOR THE FISCAL PERIOD ENDED JUNE 28, 2009

TABLE OF CONTENTS

		PAGE
PART I FINANCIAL INFORMATION
Item 1. Financial Statements			3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			44
Item 3. Quantitative and Qualitative Disclosures About Market Risk			63
Item 4T. Controls and Procedures			63
PART II OTHER INFORMATION
Item 1. Legal Proceedings			64
Item 1A. Risk Factors			65
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			77
Item 3. Defaults Upon Senior Securities			77
Item 4. Submission of Matters to a Vote of Security Holders			77
Item 5. Other Information			78
Item 6. Exhibits			79
Signatures.			82
Exhibit 31.1
Exhibit 31.2
Exhibit 32

In this report, the terms “Irvine Sensors,” “Company,” “we,” “us” and “our” refer to Irvine Sensors Corporation (“ISC”) and its subsidiaries.

Irvine Sensors^®, Neo-Chip™, Neo-Stack^®, TOWHAWK™, Novalog™, Personal Miniature Thermal Viewer™, PMTV^®, Cam-Noir™, Eagle Boards™, RedHawk™ and Silicon MicroRing Gyro™ are among the Company’s trademarks. Any other trademarks or trade names mentioned in this report are the property of their respective owners.

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

IRVINE SENSORS CORPORATION
CONSOLIDATED BALANCE SHEETS
(Unaudited)

		June 28, 2009				September 28, 2008
Assets
Current assets:
Cash and cash equivalents		$	79,700			$	638,600
Restricted cash			46,300				41,700
Accounts receivable, net of allowance for doubtful accounts of $15,000 and $15,000, respectively			1,011,700				662,400
Unbilled revenues on uncompleted contracts, net of allowance of $0 and $18,400, respectively			599,300				1,279,700
Inventory, net			1,355,600				1,126,900
Prepaid expenses and other current assets			170,700				64,800
Current assets of discontinued operations			—				7,494,700
Total current assets			3,263,300				11,308,800
Property and equipment, net			3,241,400				4,328,300
Intangible assets, net			85,600				1,005,500
Deferred costs			—				260,100
Deposits			37,500				101,000
Non-current assets of discontinued operations			—				5,880,300
Total assets		$	6,627,800			$	22,884,000
Liabilities and Stockholders’ Deficit
Current liabilities:
Accounts payable		$	1,328,200			$	4,047,100
Accrued expenses			3,449,600				4,595,200
Accrued estimated loss on contracts			—				144,500
Advance billings on uncompleted contracts			155,000				21,900
Advances against accounts receivable			448,200				—
Deferred revenue			270,000				385,000
Income taxes payable			8,200				14,400
Restructured debt, net of discounts			—				11,788,800
Promissory note payable			400,000				400,000
Subordinated term loan			2,000,000				2,000,000
Capital lease obligations — current portion			17,000				29,100
Current liabilities of discontinued operations			—				4,009,600
Total current liabilities			8,076,200				27,435,600
Restructured debt, net of discounts			188,400				—
Deferred interest			18,400				—
Executive Salary Continuation Plan liability			3,391,600				3,484,800
Capital lease obligations, less current portion			—				11,200
Minority interest in consolidated subsidiaries			324,400				411,600
Total liabilities			11,999,000				31,343,200
Commitments and contingencies (Note 12)
Stockholders’ deficit:
Preferred stock, $0.01 par value, 1,000,000 and 500,000 shares authorized, respectively; 146,900 and 126,000 shares issued and outstanding, respectively (1)			1,500				1,300
Common stock, $0.01 par value, 150,000,000 and 80,000,000 shares authorized, respectively; 8,023,300 and 3,557,200 shares issued and outstanding, respectively (1)			80,200				35,600
Common stock warrants, 1,187,800 and 717,900 warrants outstanding, respectively (1)			—				—
Prepaid stock-based compensation			(187,500	)			—
Common stock held by Rabbi Trust			(1,169,600	)			(1,214,100	)
Deferred compensation liability			1,169,600				1,214,100
Paid-in capital			162,479,500				159,717,800
Accumulated deficit			(167,744,900	)			(168,213,900	)
Total stockholders’ deficit			(5,371,200	)			(8,459,200	)
		$	6,627,800			$	22,884,000

See Accompanying Condensed Notes to Consolidated Financial Statements.

IRVINE SENSORS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

		13 Weeks Ended								39 Weeks Ended
		June 28,				June 29,				June 28,				June 29,
		2009				2008				2009				2008
Revenues:
Contract research and development revenue		$	2,508,500			$	4,189,900			$	7,247,000			$	11,266,100
Product sales			262,700				482,000				1,099,400				2,385,900
Other revenue			3,300				8,000				12,800				20,500
Total revenues			2,774,500				4,679,900				8,359,200				13,672,500
Cost and expenses:
Cost of contract research and development revenue			1,705,200				3,176,800				5,651,100				8,868,300
Cost of product sales			323,000				332,400				1,110,800				1,775,300
General and administrative expense			2,862,500				2,439,400				6,982,200				7,012,600
Research and development expense			531,300				454,600				1,318,000				1,094,700
Total costs and expenses			5,422,000				6,403,200				15,062,100				18,750,900
Gain on sale or disposal of assets			8,000				314,800				8,640,800				315,600
Income (loss) from operations			(2,639,500	)			(1,408,500	)			1,937,900				(4,762,800	)
Interest expense			(218,400	)			(1,464,600	)			(1,458,100	)			(4,847,400	)
Other income			5,000				900				51,700				1,900
Income (loss) from continuing operations before minority interest and provision for income taxes			(2,852,900	)			(2,872,200	)			531,500				(9,608,300	)
Minority interest in income of subsidiaries			—				100				100				200
Credit (provision) for income taxes			308,000				(4,300	)			(121,000	)			(19,300	)
Income (loss) from continuing operations			(2,544,900	)			(2,876,400	)			410,600				(9,627,400	)
Discontinued operations:
Income (loss) from operations of discontinued operations			—				267,100				58,400				(162,300	)
Net income (loss)		$	(2,544,900	)		$	(2,609,300	)		$	469,000			$	(9,789,700	)
Basic net income (loss) per common share information
From continuing operations		$	(0.35	)		$	(0.97	)		$	0.01			$	(3.33	)
From discontinued operations			—				0.09				0.01				(0.06	)
Basic net income (loss) per common share		$	(0.35	)		$	(0.88	)		$	0.02			$	(3.39	)
Diluted net income (loss) per common share information
From continuing operations		$	(0.35	)		$	(0.97	)		$	0.01			$	(3.33	)
From discontinued operations			—				0.09				0.01				(0.06	)
Diluted net income (loss) per common share		$	(0.35	)		$	(0.88	)		$	0.02			$	(3.39	)
Weighted average number of common shares outstanding			7,708,400				3,059,000				6,257,000				2,917,100

See Accompanying Condensed Notes to Consolidated Financial Statements.

IRVINE SENSORS CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT)

																		Common
																		Stock																Total
		Preferred Stock								Common Stock								Warrants				Prepaid												Stockholders’
		Shares Issued (11)								Shares Issued (1)								Issued (1)				Stock-Based				Paid-in				Accumulated				Equity
		Number				Amount				Number				Amount				Number				Compensation				Capital				Deficit				(Deficit)
Balance at September 30, 2007			—			$	—				2,684,300			$	26,800				614,500			$	—			$	151,105,500			$	(146,655,000	)		$	4,477,300
Common stock issued to employee retirement plans			—				—				522,300				5,300				—				(1,499,000	)			1,606,600				—				112,900
Common stock and warrants issued to pay operating expenses			—				—				162,100				1,600				50,000				—				1,444,500				—				1,446,100
Stock-based compensation expense — vested stock			—				—				41,800				400				—				—				234,500				—				234,900
Common stock options exercised			—				—				53,200				500				—				—				830,500				—				831,000
Additional common stock warrants issued under anti-dilution provisions			—				—				—				—				71,700				—				—				—				—
Common stock warrants expired			—				—				—				—				(18,300	)			—				—				—				—
Preferred stock issued to pay interest			39,600				400				—				—				—				—				1,188,100				—				1,188,500
Preferred stock issued to retire debt			93,700				900				—				—				—				—				2,810,600				—				2,811,500
Common stock issued upon conversion of preferred stock			(7,300	)			—				73,300				800				—				—				(800	)			—				—
Stock-based compensation expense — options			—				—				—				—				—				—				251,200				—				251,200
Amortization of deferred stock-based compensation			—				—				—				—				—				—				247,300				—				247,300
Issuance of nonvested stock			—				—				20,200				200				—				—				(200	)			—				—
Amortization of employee retirement plan contributions			—				—				—				—				—				1,499,000				—				—				1,499,000
Net loss			—				—				—				—				—				—				—				(21,558,900	)			(21,558,900	)
Balance at September 28, 2008			126,000				1,300				3,557,200				35,600				717,900				—				159,717,800				(168,213,900	)			(8,459,200	)
Common stock issued to employee retirement plans			—				—				1,785,700				17,900				—				(750,000	)			732,100				—				—
Common stock issued to pay operating expenses			—				—				1,215,400				12,100				—				—				490,900				—				503,000
Stock-based compensation expense — vested stock			—				—				1,600				—				—				—				600				—				600
Common stock warrants issued			—				—				—				—				299,300				—				92,100				—				92,100
Additional common stock warrants issued under anti-dilution provisions			—				—				—				—				230,500				—				—				—				—
Common stock warrants expired			—				—				—				—				(59,900	)			—				—				—				—
Stock-based compensation expense — options			—				—				—				—				—				—				25,600				—				25,600
Preferred stock issued to retire debt			25,000				300				—				—				—				—				999,700				—				1,000,000
Common stock issued upon conversion of preferred stock			(4,100	)			(100	)			306,300				3,100				—				—				(3,000	)			—				—
Common stock issued to convert debt			—				—				1,089,000				10,800				—				—				337,600				—				348,400
Amortization of deferred stock-based compensation			—				—				—				—				—				—				86,800				—				86,800
Issuance of nonvested stock			—				—				70,400				700				—				—				(700	)			—				—
Forfeiture of nonvested stock			—				—				(2,300	)			—				—				—				—				—				—
Amortization of employee retirement plan contributions			—				—				—				—				—				562,500				—				—				562,500
Net income			—				—				—				—				—				—				—				469,000				469,000
Balance at June 28, 2009 (Unaudited)			146,900			$	1,500				8,023,300			$	80,200				1,187,800			$	(187,500	)		$	162,479,500			$	(167,744,900	)		$	(5,371,200	)

See Accompanying Condensed Notes to Consolidated Financial Statements.

IRVINE SENSORS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

		39 Weeks Ended
		June 28, 2009				June 29, 2008
Cash flows from operating activities:
Net income (loss)		$	469,000			$	(9,789,700	)
Add back (income) loss from discontinued operations			(58,400	)			162,300
Income (loss) from continuing operations			410,600				(9,627,400	)
Adjustments to reconcile income (loss) from continuing operations to net cash used in operating activities:
Depreciation and amortization			1,398,600				1,590,100
Provision for allowance for inventory valuation			121,000				—
Non-cash interest expense			829,200				2,990,000
Non-cash employee retirement plan contributions			562,500				1,124,400
Gain on sale or disposal of assets			(8,640,800	)			(315,600	)
Minority interest in net loss of subsidiaries			(100	)			(200	)
Common stock issued to pay operating expenses			503,000				1,446,100
Non-cash stock based compensation			112,900				573,600
Decrease (increase) in accounts receivable			(349,300	)			502,700
Decrease (increase) in unbilled revenues on uncompleted contracts			680,400				(90,900	)
Increase in inventory			(349,700	)			(300,700	)
Increase in prepaid expenses and other current assets			(105,900	)			(89,200	)
Decrease (increase) in other assets			63,500				(35,200	)
(Decrease) increase in accounts payable and accrued expenses			(2,665,700	)			2,188,200
Decrease in accrued estimated loss on contracts			(144,500	)			(200,100	)
(Decrease) increase in income taxes payable			(13,100	)			2,200
Decrease in Executive Salary Continuation Plan liability			(93,200	)			(99,800	)
Increase (decrease) in advance billings on uncompleted contracts			133,100				(334,100	)
Decrease in deferred revenue			(115,000	)			(86,000	)
Total adjustments			(8,073,100	)			8,865,500
Net cash used in operating activities			(7,662,500	)			(761,900	)
Cash flows from investing activities:
Property and equipment expenditures			(62,500	)			(785,800	)
Gross proceeds from sale of fixed assets and intangibles			9,500,000				—
Transfer of fixed asset from contract expense			(43,000	)			438,100
Acquisition and costs related to patents			(145,500	)			(85,500	)
Increase in restricted cash			(4,600	)			(1,200	)
Net cash provided by (used in) investing activities			9,244,400				(434,400	)
Cash flows from financing activities:
Principal payments of notes payable			(3,063,700	)			—
Proceeds from senior promissory notes			1,000,000				—
Debt issuance costs paid			(227,000	)			—
Proceeds from options and warrants exercised			—				831,100
Proceeds from advances against accounts receivable			448,200				—
Principal payments of capital leases			(23,300	)			(35,600	)
Net cash (used in) provided by financing activities			(1,865,800	)			795,500
Cash flows from discontinued operations:
Net cash used in operating activities			(275,000	)			(9,000	)
Net decrease in cash and cash equivalents			(558,900	)			(409,800	)
Cash and cash equivalents at beginning of period			638,600				937,600
Cash and cash equivalents at end of period		$	79,700			$	527,800
Non-cash investing and financing activities:
Non-cash debt conversion to common stock		$	330,000			$	—
Non-cash interest conversion to common stock		$	18,500			$	—
Non-cash debt conversion to preferred stock		$	1,000,000			$	2,811,500
Non-cash interest conversion to preferred stock		$	—			$	1,188,500
Supplemental cash flow information:
Cash paid for interest		$	283,600			$	8,200
Cash paid for income taxes		$	91,700			$	17,000

See Accompanying Condensed Notes to Consolidated Financial Statements.

IRVINE SENSORS CORPORATION
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1 — General

The information contained in the following Condensed Notes to Consolidated Financial Statements is condensed from that which would appear in the audited consolidated financial statements for Irvine Sensors Corporation (“ISC”) and its subsidiaries (together with ISC, the “Company”), and the accompanying unaudited condensed consolidated financial statements do not include certain financial presentations normally required under accounting principles generally accepted in the United States of America (“GAAP”). Accordingly, the unaudited consolidated financial statements included herein should be read with the audited consolidated financial statements and related notes thereto contained in the Annual Report on Form 10-K of the Company for the fiscal year ended September 28, 2008 (“fiscal 2008”). It should be understood that accounting measurements at interim dates inherently involve greater reliance on estimates than at year-end. The results of operations for the interim periods presented are not necessarily indicative of the results expected for the entire year.

The consolidated financial information for the 13-week and 39-week periods ended June 28, 2009 and June 29, 2008 included herein is unaudited but includes all normal recurring adjustments which, in the opinion of management of the Company, are necessary to present fairly the consolidated financial position of the Company at June 28, 2009 and the results of its operations and its cash flows for the 13-week and 39-week periods ended June 28, 2009 and June 29, 2008.

On October 14, 2008, substantially all of the assets of Optex Systems, Inc. (“Optex”), a Texas corporation and a wholly-owned subsidiary of ISC, were sold pursuant to a UCC public foreclosure sale (the “Optex Asset Sale”). The Optex Asset Sale was completed as contemplated by a binding Memorandum of Understanding for Settlement and Debt Conversion Agreement dated September 19, 2008 (the “MOU”) between the Company and its senior lenders, Longview Fund, L.P. (“Longview”) and Alpha Capital Anstalt (“Alpha”). Longview and Alpha are sometimes collectively referred to as the “Lenders.” As agreed to in the MOU, Optex Systems, Inc., a Delaware corporation controlled by the Lenders (“Optex-Delaware”), credit bid $15 million in this UCC public foreclosure sale, and its offer was the winning bid. As a result, $15 million of the Company’s aggregate indebtedness to the Lenders was extinguished. All the Company’s financial statements and notes and schedules thereto give effect to this event and report Optex as a discontinued operation for both the current and prior fiscal periods.

The consolidated financial information as of September 28, 2008 included herein has been derived from the Company’s audited consolidated financial statements as of, and for the fiscal year ended, September 28, 2008.

Description of Business

The Company is a vision systems company enabled by technology for three-dimensional packaging of electronics and manufacturing of electro-optical products. The Company designs, develops, manufactures and sells vision systems, miniaturized electronic products and higher level systems incorporating such products for defense, security and commercial applications. The Company also performs customer-funded contract research and development related to these systems and products, mostly for U.S. government customers or prime contractors. Most of the Company’s historical business relates to the application of its technologies for stacking either packaged or unpackaged semiconductors into more compact three-dimensional forms, which the Company believes offer volume, power, weight and operational advantages over competing packaging approaches, and which the Company believes allows it to offer higher level products with unique operational features.

None of the Company’s subsidiaries accounted for more than 10% of the Company’s total assets at June 28, 2009 or had separate employees or facilities at such date.

Summary of Significant Accounting Policies

Consolidation. The consolidated financial statements include the accounts of ISC and its subsidiaries, Optex, MicroSensors, Inc. (“MSI”), RedHawk Vision Systems, Inc. and iNetWorks Corporation. All significant intercompany transactions and balances have been eliminated in the consolidation.

Reverse Stock Split. On August 26, 2008, the Company effected a 1-for-10 reverse split of the Company’s common stock (the “2008 Reverse Stock Split”). All references in these financial statements and schedules to the number of shares of common stock of the Company and related per share references have been restated to give effect to this reverse split.

Fiscal Periods. The Company’s fiscal year ends on the Sunday nearest September 30. Fiscal 2008 ended on September 28, 2008 and included 52 weeks. The fiscal year ending September 27, 2009 (“fiscal 2009”) will also include 52 weeks. The Company’s first three quarters of fiscal 2009 was the 39-week period ended June 28, 2009.

Subsequent Events. The Company evaluates events that occur subsequent to the balance sheet date of periodic reports, but before financial statements are issued for periods ending on such balance sheet dates, for possible adjustment to such financial statements or other disclosure. This evaluation generally occurs through the date at which the Company’s financial statements are electronically prepared for filing with the SEC. For the financial statements as of and for the periods ending June 28, 2009, this date was August 5, 2009.

Use of Estimates. The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The Company believes its estimates of inventory reserves and estimated costs to complete contracts, as further discussed below, to be the most sensitive estimates impacting financial position and results of operations in the near term.

Inventory Reserves. Each quarter, the Company evaluates its inventories for excess quantities and obsolescence. Inventories that are considered obsolete are written off. Remaining inventory balances are adjusted to approximate the lower of cost or market value. The valuation of inventories at the lower of cost or market requires the use of estimates as to the amounts of current inventories that will be sold. These estimates are dependent on management’s assessment of current and expected orders from the Company’s customers.

From time to time, the Company capitalizes material, labor and overhead costs expected to be recovered from a probable new contract. Due to the uncertain timing of new or follow-on research and development contracts, the Company maintains significant reserves for this inventory to avoid overstating its value. The Company has adopted this practice because it is typically able to more fully recover such costs under the provisions of government contracts by direct billing of inventory rather than by seeking recovery of such costs through permitted indirect rates.

Estimated Costs to Complete and Accrued Loss on Contracts. The Company reviews and reports on the performance of its contracts and product orders against the respective resource plans for such contracts and orders. These reviews are summarized in the form of estimates of costs to complete (“ETCs”). ETCs include management’s current estimates of remaining amounts for direct labor, material, subcontract support and indirect costs based on each contract’s or product order’s completion status and either the current or re-planned future requirements under the contract or product order. If an ETC indicates a potential overrun against budgeted resources for a cost reimbursable contract or a fixed price level of effort contract, management generally seeks to revise the program plan in a manner consistent with customer objectives to eliminate such overrun and to secure necessary customer agreement to such revision. To mitigate the financial risk of such re-planning, the Company attempts to negotiate the deliverable requirements of its research and development contracts to allow as much flexibility as possible in technical outcomes.

If an ETC indicates a potential overrun against budgeted resources for a fixed price contract or a product order, management first seeks to evaluate lower cost solutions to achieve requirements of the fixed price contract or product order, and if such solutions do not appear practicable, makes a determination whether to seek renegotiation of contract or order requirements from the customer. If neither re-planning within budgets nor renegotiation appear probable, an accrual for contract overrun is recorded based on the most recent ETC of the particular program or product order.

During the 39 weeks ended June 28, 2009, the Company’s accrued estimated loss on contracts decreased $144,500, from $144,500 to $0. This decrease reflects a change in the Company’s aggregate estimate (excluding contingencies), which management believes reflects ETCs for contracts in progress based on their completion status at June 28, 2009 and current and future technical requirements under the program contracts.

Revenues. The Company derives revenue from contract research and development, as well as from product sales. Revenues derived from contracts to develop prototypes and provide research, development, design, testing and evaluation of complex detection and control defense systems were the principal contributor to total revenues in the first 39 weeks of fiscal 2009 and fiscal 2008. The Company’s research and development contracts are usually cost reimbursement plus fixed fee, fixed price level of effort or occasionally firm fixed price. The Company’s cost reimbursement plus fixed fee research and development contracts require the Company’s good faith performance of a statement of work within overall budgetary constraints, but with latitude as to resources utilized. The Company’s fixed price level of effort research and development contracts require the Company to deliver a specified number of labor hours in the performance of a statement of work. The Company’s firm fixed price research and development contracts require the Company to deliver specified items of work independent of resources utilized to achieve the required deliverables. Revenues for all types of research and development contracts are recognized as costs are incurred and include applicable fees or profits primarily in the proportion that costs incurred bear to estimated final costs. Costs and estimated earnings in excess of billings under government research and development contracts are accounted for as unbilled revenues on uncompleted contracts, stated at estimated realizable value and are expected to be realized in cash within one year.

United States government research and development contract costs, including indirect costs, are subject to audit and adjustment from time to time by negotiations between the Company and government representatives. The government has approved the Company’s indirect contract costs through the 53 weeks ended October 3, 2004 (“fiscal 2004”) but has not yet scheduled audits of the Company’s indirect contract costs for the 52 weeks ended October 2, 2005 (“fiscal 2005”), the 52 weeks ended October 1, 2006 (“fiscal 2006”), the 52 weeks ended September 30, 2007 (“fiscal 2007”) and fiscal 2008. Research and development contract revenues have been recorded in amounts that are expected to be realized upon final determination of allowable direct and indirect costs for the affected contracts.

Revenues derived from product sales in the 39 weeks ended June 28, 2009 and June 29, 2008 were primarily the result of shipments of stacked chip products, largely memory stacks, and sales of the Company’s miniaturized camera products, including both infrared viewers and visible spectrum cameras. Production orders for the Company’s products are generally priced in accordance with established price lists. Memory stack products and visible spectrum cameras are primarily shipped to original equipment manufacturers (“OEMs”). Infrared viewers are both subsystem and system level products for shipment to either OEMs or to end user customers, initially for military applications. Revenues are recorded when products are shipped, provided that the following conditions are met:

	•		there are no unfulfilled contingencies associated with the sale;
	•		the Company has a sales contract or purchase order with the customer; and
	•		the Company is reasonably assured that the sales price can be collected.

The absence of any of these conditions, including the lack of shipment, would cause revenue recognition to be deferred. Terms are Freight on Board (“FOB”) shipping point.

The Company’s products have been shipped for developmental and qualification use or have not been sold under formal warranty terms. The Company does not offer contractual price protection on any of its products. Accordingly, the Company does not presently maintain any reserves for returns under warranty or post-shipment price adjustments. However, the Company anticipates future shipments of products that may include formal warranty terms and may therefore include reserves for returns under warranty in future periods.

The Company does not utilize distributors for the sale of its products nor does it enter into revenue transactions in which the customer has the right to return product. Accordingly, no provisions are made for sales returns, contractual price protection or adjustments in the recognition of revenue.

Advances Against Accounts Receivable. From time-to-time, the Company engages in accounts receivables financing or factoring. When such arrangements involve full-recourse agreements with lenders, the advances received by the Company are recorded as current liabilities and the gross amount of the financed or factored receivables are included in current accounts receivables.

Allowance for Doubtful Accounts. Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The Company’s allowance for doubtful accounts is management’s best estimate of losses resulting from the inability of the Company’s customers to make their required payments. The Company maintains an allowance for doubtful accounts based on a variety of factors, including historical experience, length of time receivables are past due, current economic trends and changes in customer payment behavior. Also, the Company records specific provisions for individual accounts when management becomes aware of a customer’s inability to meet its financial obligations to the Company, such as in the case of bankruptcy filings or deterioration in the customer’s operating results or financial position. If circumstances related to a customer change, the Company’s estimates of the recoverability of the receivables would be further adjusted, either upward or downward.

Research and Development Costs. A major portion of the Company’s operations is comprised of customer-funded research and prototype development or related activities that are recorded as cost of contract revenues. The Company also incurs costs for internal research and development of new concepts in products. Such non-customer sponsored research and development costs are charged to research and development expense as incurred.

Inventory. Product inventory is valued at the lower of cost or market. Cost of the Company’s product inventory includes direct material and labor costs, as well as manufacturing overhead costs allocated based on direct labor dollars. Inventory cost is determined using the average cost method. Inventories are reviewed quarterly to determine salability and obsolescence. A reserve is established for slow moving and obsolete product inventory items. In addition, the Company believes that its marketing of probable new research and development contracts under specific government budgets and programs is facilitated by the capitalization of material, labor and overhead costs that are eventually recoverable under such contracts. Due to the uncertain timing of such contract awards, the Company maintains significant reserves for this inventory to avoid overstating its value. (See Note 8).

Property and Equipment. The Company capitalizes costs of additions to property and equipment, together with major renewals and betterments. The Company takes several years to complete some in-house projects, which are classified as construction in progress and are not subject to depreciation until placed into service. Such in-house projects include expansion of the Company’s clean room facilities and related equipment. The Company capitalizes overhead costs, including interest costs, for all in-house capital projects. Maintenance, repairs, and minor renewals and betterments are charged to expense. When assets are sold or otherwise disposed of, the cost and related accumulated depreciation for such assets are removed from the accounts and any resulting gain or loss is recognized. Depreciation of property and equipment is provided over the estimated useful lives of the assets, primarily using the straight-line method. The useful lives of such assets are typically three to five years. Leasehold improvements are amortized over their useful lives or, if shorter, the terms of the leases.

Deferred Costs. The Company has incurred debt issuance costs in connection with various financings, which are amortized over the term of the related debt instruments using the effective interest method.

Accounting for Stock-Based Compensation. The Company accounts for stock-based compensation under Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”), which requires the fair value of all option grants or stock issuances made to employees or directors on or after its implementation date (the beginning of fiscal 2006), as well as a portion of the fair value of each option and stock grant made to employees or directors prior to the implementation date that represents the nonvested portion of these share-based awards as of such implementation date, to be recognized as an expense. These amounts are expensed over the respective vesting periods of each award using the straight-line attribution method. The Company calculates stock option-based compensation by estimating the fair value of each option as of its date of grant using the Black-Scholes option pricing model.

The Company has historically issued stock options and vested and nonvested stock grants to employees and outside directors whose only condition for vesting has been continued employment or service during the related vesting or restriction period. Typically, the vesting period for such stock option grants has been four years for non-officer employee awards, and either two-year or immediate vesting for officers and directors, although options have sometimes been granted with other vesting periods. Starting in fiscal 2007, the Company began to issue nonvested stock grants, typically with vesting periods of three years.

During the 13-week and 39-week periods ended June 28, 2009, the Company granted options to purchase 110,000 and 122,000 shares of its common stock, respectively. During the 13-week and 39-week periods ended June 29, 2008, the Company granted options to purchase 0 and 121,000 shares of its common stock, respectively. The following assumptions were used for the valuation of the grants in the 13-week and 39-week periods ended June 28, 2009 and June 29, 2008.

		13 Weeks Ended				39 Weeks Ended				13 Weeks Ended				39 Weeks Ended
		June 28, 2009				June 28, 2009				June 29, 2008				June 29, 2008
Risk free interest rate			1.93	%			1.93	%			—				4.04	%
Expected life		2.5 years				2.5 years					—			5.63 years
Expected volatility			84.6	%			84.6	%			—				80.1	%
Expected dividend yield		None				None					—			None

Expected life of options granted is computed using the mid-point between the vesting period and contractual life of the options granted (the “simplified method”) due to the Company’s inability to estimate expected life based on the limited history of option exercises over the last several years. Expected volatilities are based on the historical volatility of the Company’s stock price and other factors.

Previously granted options to purchase 71,900 shares of the Company’s common stock with a weighted average exercise price of $10.41 per share and a weighted average fair value of $0.32 per share were unvested as of June 28, 2009. Total stock-based compensation expense during the 13-week and 39-week periods ended June 28, 2009 was $58,300 and $113,000, respectively, of which $17,000 and $30,900, respectively, was charged to cost of contract research and development, and $41,300 and $82,100, respectively, was charged to general and administrative expense. Total stock-based compensation expense during the 13-week and 39-week periods ended June 29, 2008 was $50,100 and $573,500, respectively, of which $11,300 and $78,000 respectively, was charged to cost of contract research and development, and $38,800 and $495,500, respectively, was charged to general and administrative expense during such periods.

SFAS 123(R) requires the cash flows from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. There were no tax benefits resulting from the exercise of stock options during the 13-week and 39-week periods ended June 28, 2009 and June 29, 2008.

The Company’s subsidiaries did not grant any options during the 13-week and 39-week periods ended June 28, 2009 and June 29, 2008.

The Company granted 70,400 shares and 68,100 shares of nonvested stock, respectively, net of 0 shares and 2,300 shares forfeited, respectively, in the 13-week and 39-week periods ended June 28, 2009. The Company cancelled 0 shares and 2,300 shares of nonvested stock due to forfeitures in the 13-week and 39-week periods ended June 28, 2009, respectively. During the 13-week periods ended June 28, 2009 and June 29, 2008, 2,600 and 10,800 previously issued nonvested shares, respectively, were vested. The Company did not grant any shares of nonvested stock in the 13-week period ended June 29, 2008. The Company granted 204,300 shares of nonvested stock, net of 49,800 shares forfeited, in the 39-week period ended June 29, 2008. During the 39-week periods ended June 28, 2009 and June 29, 2008, 5,400 and 5,700 previously issued nonvested shares, respectively, were vested. The Company granted 3,100 and 12,300 shares of vested stock, including vesting of 2,600 and 10,800 previously nonvested shares, respectively, valued at $41,500 and $63,400, in the 13-week and 39-week periods ended June 28, 2009, respectively. The Company granted 800 and 182,000 shares of vested stock, including vesting of 800 and 6,300 previously nonvested shares, valued at $16,000 and $1,483,800, in the 13-week and 39-week periods ended June 29, 2008, respectively.

The Company recognizes compensation expense on a straight-line basis over the vesting period of the option after consideration of the estimated forfeiture rate, which was 7% during fiscal 2008 and the 39-week period ended June 28, 2009. At June 28, 2009, the total compensation costs related to nonvested options not yet recognized was $6,000 and the weighted-average remaining vesting period of unvested options at June 28, 2009 was 0.7 years. Such amounts do not include the cost of new options that may be granted in future periods or any future changes in the Company’s forfeiture rate.

Accounting for Stock and Warrant-Based Operating Expense. Under the fair value based method, expense is recorded based on the fair value of common stock and warrants issued to service providers at the date of such issuance and is recognized over the vesting period. In the 13-week period ended June 28, 2009, the Company issued no shares of common stock to service providers. In the 39-week period ended June 28, 2009, 339,800 shares of common stock, valued at $112,100 were issued to a non-employee service provider as operating expense. In the 13-week and 39-week periods ended June 28, 2009, the Company issued no warrants to non-employee service providers as operating expense, although warrants were issued to an investment banker in connection with a financing. (See Notes 4 and 6 and “Warrant Valuation and Beneficial Conversion Feature” below). In the 13-week and 39-week periods ended June 29, 2008, 15,000 shares and 162,100 shares of common stock, respectively, valued at $39,000 and $1,216,100, respectively, were issued to non-employee service providers. (See Note 14). In the 13-week period ended June 29, 2008, the Company did not issue warrants to purchase shares of the Company’s common stock to non-employee service providers. In the 39-week period ended June 29, 2008, the Company issued a single five-year warrant to purchase up to 50,000 shares of the Company’s common stock to a non-employee service provider. (See Note 6).

Software Development and Purchased Software. At June 28, 2009, the Company had capitalized software of approximately $68,800, net of accumulated amortization of $2,325,800. The Company capitalizes software in accordance with Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use (“SOP 98-1”). SOP 98-1 requires that certain costs incurred, either from internal or external sources, be capitalized as part of intangible assets and amortized on a straight-line basis over the useful life of the software. Planning, training, support and maintenance costs incurred either prior to or following the implementation phase are recognized as expense in the period in which they occur. The Company evaluates the carrying values of capitalized software to determine if the carrying values are impaired, and, if necessary, the Company would recognize an impairment loss in the period in which the impairment occurred.

Goodwill and Other Intangible Assets. Goodwill represents the cost of acquired businesses in excess of fair value of the related net assets at acquisition. The Company does not amortize goodwill, but tests it annually, as of the first day of its fourth fiscal quarter and between annual testing periods if circumstances warrant, for impairment using a fair value approach. As a result of the Optex Asset Sale and the discontinuation of Optex’s operations, the Company determined that goodwill related to the Optex reporting unit had been impaired by approximately $7.2 million. Such impairment was recorded at September 28, 2008, and the impairment charge was presented in the loss on disposal of discontinued operations in the consolidated statements of operations for fiscal 2008. The remaining goodwill was reclassified into the non-current assets of discontinued operations at September 28, 2008 pending disposition pursuant to the Optex Asset Sale, which disposition occurred on October 14, 2008 pursuant to such sale. Therefore, as of June 28, 2009, there was no goodwill remaining on the books of the Company.

The Company amortizes the cost of other intangibles over their estimated useful lives unless such lives are deemed indefinite. Amortizable intangible assets are tested for impairment based on undiscounted cash flows and, if impaired, written down to fair value based on either discounted cash flows, appraised values or other market-based information. As a result of the Optex Asset Sale and the discontinuation of Optex’s operations, the Company reclassified identified amortizable intangible assets related to Optex, principally non-competition agreements and customer backlog, into the non-current assets of discontinued operations at September 28, 2008 pending disposition pursuant to the Optex Asset Sale, which disposition occurred on October 14, 2008 pursuant to such sale. Therefore, as of June 28, 2009, there were no amortizable intangible assets related to the Optex reporting unit remaining on the books of the Company. Intangible assets with indefinite lives are tested annually for impairment as of the first day of the Company’s fourth fiscal quarter and between annual periods if impairment indicators exist, and are written down to fair value as required. The Company’s other intangible assets with definite lives at June 28, 2009 and September 28, 2008 consisted principally of patents and trademarks related to the Company’s various technologies. In March 2009, the Company sold most of its patent assets for cash proceeds of $9.5 million and a worldwide, royalty-free license to use the sold patent assets (the “Patent Sale and License”). Capitalized costs include amounts paid to third parties for legal fees, application fees and other direct costs incurred in the filing and prosecution of patent and trademark applications. These assets are amortized on a straight-line method over the shorter of their useful or legal life, generally ten years.

Warrant Valuation and Beneficial Conversion Feature. The Company calculates the fair value of warrants issued with debt using the Black Scholes valuation method. The total proceeds received in the sale of debt and related warrants is allocated among these financial instruments based on their relative fair values. The debt discount arising from assigning a portion of the total proceeds to the warrants issued is recognized as interest expense from the date of issuance to the earlier of the maturity date of the debt or the conversion dates using the effective yield method. Additionally, when issuing convertible debt, including convertible debt issued with detachable warrants, the Company tests for the existence of a beneficial conversion feature in accordance with Financial Accounting Standards Board (“FASB”) Emerging Issues Task Force Issue (“EITF”) No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, and FASB EITF No. 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments. The Company records the amount of any beneficial conversion feature (“BCF”), calculated in accordance with these accounting standards, whenever it issues convertible debt that has conversion features at fixed rates that are in the money using the effective per share conversion price when issued. The calculated amount of the BCF is accounted for as a contribution to additional paid-in capital and as a debt discount that is recognized as interest expense from the date of issuance to the earlier of the maturity date of the debt or the conversion dates using the effective yield method. The maximum amount of BCF that can be recognized is limited to the amount that will reduce the net carrying amount of the debt to zero.

Tangible Long-Lived Assets. The Company frequently monitors events or changes in circumstances that could indicate that the carrying amount of tangible long-lived assets to be held and used may not be recoverable. The determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. When impairment is indicated for a tangible long-lived asset, the amount of impairment loss is the excess of net book value of the asset over its fair value. Tangible long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. At June 28, 2009, management believed no indications of impairment existed.

Income Taxes. The Company provides for income taxes under the liability method. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities as measured by the enacted tax rates which are expected to be in effect when these differences reverse. To the extent net deferred tax assets are not realizable on a more likely than not basis, a valuation allowance is provided against such net deferred tax assets. In fiscal 2008, the Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes: An interpretation of FASB Statement No. 109, Interpretation 48 (“FIN 48”), which clarifies Statement 109, Accounting for Income Taxes, and establishes the criterion that an individual tax position has to meet for some or all of the benefits of that position to be recognized in the Company’s financial statements. There was no impact on the Company’s consolidated financial statements with respect to the Company’s adoption of FIN 48.

Basic and Diluted Net Income (Loss) per Share. Basic net income (loss) per share is based upon the weighted average number of shares of common stock outstanding. Diluted net income (loss) per share is based on the assumption that options, warrants and other instruments convertible into common stock are included in the calculation of diluted net income (loss) per share, except when their effect would be anti-dilutive. For instruments in which consideration is to be received for exercise, such as options or warrants, dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to be exercised at the beginning of the period (or at the time of actual issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period. Cumulative dividends on the Company’s cumulative convertible preferred stock, although not declared, constitute a preferential claim against future dividends, if any, and are treated as an incremental decrease in net income from continuing operations or increase in net loss from continuing operations for purposes of determining basic and diluted net income (loss) from continuing operations per common share (See Note 7).

Statements of Cash Flows. For purposes of the Consolidated Statements of Cash Flows, the Company considers all demand deposits and certificates of deposit with original maturities of 90 days or less to be cash equivalents.

Fair Value of Financial Instruments. Financial instruments include cash and cash equivalents, accounts receivable and payable, other current liabilities and long-term debt. The carrying amounts reported in the balance sheets for cash and cash equivalents, accounts receivable and payable and other current liabilities approximate fair value due to the short-term nature of these items.

As discussed further in Note 3, in December 2006, the Company repaid the borrowings from its then senior bank lender with funds from a new $8.25 million term loan, bearing interest at 11% per annum, from the Lenders. Concurrent with these refinancing transactions, the Lenders also purchased through assignment the Company’s $10 million subordinated convertible notes from the original two holders of these notes. These debt refinancing transactions occurred on December 29, 2006, when the closing price of the Company’s common stock was $20.50 per share, and included the issuance to the Lenders, for no separate consideration, of five-year warrants to purchase an aggregate of 300,000 shares of the Company’s common stock at an exercise price of $13.00 per share, which resulted in the subordinated convertible notes becoming convertible into 769,231 shares of the Company’s common stock. This warrant issuance, in turn, triggered an anti-dilution provision in the $10 million subordinated convertible notes that reduced the per share price at which said notes are convertible into shares of the Company’s common stock from $26.00 per share to $13.00 per share. After accounting for the portion of the warrant’s value assigned to the transferred $10 million subordinated convertible notes and the intrinsic value of the beneficial conversion feature arising from the subordinated convertible notes new per share conversion price, the carrying amount of the $10 million subordinated convertible notes at December 31, 2006 was reduced to zero. Additionally, assigning a portion of the new five-year warrant’s value to the $8.25 million term loan reduced the term loan’s carrying value by approximately $1.5 million. In July 2007, the Company borrowed $2 million under a 6-month promissory note from one of its Lenders. (See Note 3). The Company had the option of prepaying this note in August 2007, which it elected not to do. As a result, the principal of this note was increased by $100,000, the Company issued 30,000 shares of its common stock valued at $400,000 and a warrant to purchase 50,000 shares of its common stock valued at $405,000 to the Lender, resulting in an aggregate of $905,000 of debt discounts. In November 2007, the Company restructured all of its debt obligations with its senior lenders effective September 30, 2007, extending the due date

of the principal and interest under these obligations to December 30, 2009. In consideration for the restructuring, the Company issued restructuring promissory notes in the aggregate principal amount of $1,115,000, due December 30, 2009, to the Lenders (the “Restructuring Notes”). In October 2008, the remaining balance due under $8.25 million term loan and the Restructuring Notes and a substantial portion of the amounts due under the $10 million subordinated convertible notes and the $2.1 million promissory note were extinguished pursuant to the Optex Asset Sale. In March 2009, all but approximately $0.2 million of the remaining amounts due under the $2.1 million promissory note and all but approximately $1.0 million of the principal due under the $10 million subordinated convertible notes were retired with proceeds from the Patent Sale and License. In April 2009, the Company issued 24,999 shares of its Series A-2 cumulative convertible preferred stock in exchange for cancellation of the approximate $1.0 million principal balance remaining under the $10 million subordinated convertible notes. Because of the substantial initial debt discounts involved in these debt transactions, management believes that it is not practicable to estimate the fair value of the remaining approximate $0.2 million due under the $2.1 million promissory note at June 28, 2009 without incurring unreasonable costs. Furthermore, because of the scale of the discounts already recorded, management does not believe that an estimation of the fair value of the debt instruments would result in a materially different result than what the Company has already recorded.

Concentration of Credit Risk. Most of the Company’s accounts receivable are derived from sales to U.S. government agencies or prime government contractors. The Company does not believe that this concentration increases credit risks because of the financial strength of the payees. At times, the Company has cash deposits at U.S. banks and financial institutions, which exceed federally insured limits. The Company is exposed to credit loss for amounts in excess of insured limits in the event of non-performance by the institution; however, the Company does not anticipate such loss.

Reclassifications. Certain reclassifications have been made to the Company’s financial statements for the 13-week and 39-week periods ended June 29, 2008 to conform to the current period presentation, largely to reflect the discontinuation of Optex’s operations.

Derivatives. A derivative is an instrument whose value is “derived” from an underlying instrument or index such as a future, forward, swap, option contract, or other financial instrument with similar characteristics, including certain derivative instruments embedded in other contracts (“embedded derivatives”) and for hedging activities. As a matter of policy, the Company does not invest in separable financial derivatives or engage in hedging transactions. However, complex transactions that the Company entered into in order to originally finance the Initial Acquisition of Optex, and the subsequent restructuring of such debt transactions, involved financial instruments containing certain features that have resulted in the instruments being deemed derivatives or containing embedded derivatives. The Company may engage in other similar complex debt transactions in the future, but not with the intention to enter into derivative instruments. Derivatives and embedded derivatives, if applicable, are measured at fair value and marked to market through earnings, as required by SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (“SFAS 133”). However, such new and/or complex instruments may have immature or limited markets. As a result, the pricing models used for valuation often incorporate significant estimates and assumptions, which may impact the level of precision in the financial statements.

Recently Issued Accounting Pronouncements. In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141R”), which replaces FASB Statement No. 141. SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date. SFAS 141R also requires shares issued in consideration for a business combination to be measured at fair value on the acquisition date, acquisition-related transaction costs to be expensed as incurred and establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for fiscal years beginning after December 15, 2008. The Company does not expect the adoption of SFAS 141R will have a material impact on its consolidated financial statements.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statement—Amendments of ARB No. 51 (“SFAS 160”). SFAS 160 states that accounting and reporting for minority interests will be recharacterized as noncontrolling interests and classified as a component of equity. SFAS 160 also establishes reporting requirements that provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The Company does not expect the adoption of SFAS 160 to have a material impact on its consolidated financial statements.

In May 2008, the FASB issued the final version of Accounting Principles Bulletin (“APB”) No. 14-1, Accounting for Convertible Debt Instruments That May be Settled in Cash upon Conversion (Including Partial Cash Settlement) (“APB 14-1”), which requires the liability and equity components of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) to be separately accounted for in a manner that reflects the issuer’s nonconvertible debt borrowing rate. APB 14-1 is effective for fiscal years beginning after December 15, 2008, which for the Company will be fiscal 2010, and interim periods within those fiscal years and must be applied retrospectively to all periods presented, which for the Company would include the comparative quarterly presentations for fiscal 2009. Accordingly, commencing in fiscal 2010, the Company will present prior period comparative results reflecting the impact of APB 14-1 if determined to apply to the Company at that time. The Company does not expect the adoption of APB 14-1 to have a material impact on its consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities—an Amendment of FASB Statement 133 (“SFAS 161”). SFAS 161 requires companies with derivative instruments to disclose information that should enable financial-statement users to understand how and why a company uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133 and how derivative instruments and related hedged items affect a company’s financial position, financial performance and cash. SFAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008. The Company is currently evaluating the impact of this pronouncement on its consolidated financial statements, if any.

In April 2008, the FASB issued Staff Position No. FAS 142-3, Determination of the Useful Life of Intangible Assets (“FAS 142-3”) that amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). The intent of FAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141 and other U.S. generally accepted accounting principles. FAS 142-3 is effective for fiscal years and interim periods beginning after December 15, 2008. The Company is currently evaluating the impact of this pronouncement on its consolidated financial statements, if any.

In June 2008, the FASB ratified the consensus reached on EITF Issue No. 07-05, Determining Whether an Instrument (or an Embedded Feature) is Indexed to an Entity’s Own Stock (“EITF 07-05”). EITF 07-05 provides guidance for determining whether an equity-linked financial instrument (or embedded feature) is indexed to an entity’s own stock. EITF 07-05 applies to any freestanding financial instrument or embedded feature that has all the characteristics of a derivative under paragraphs 6-9 of SFAS 133, for purposes of determining whether that instrument or embedded feature qualifies for the first part of the scope exception under paragraph 11(a) of SFAS 133 and for purposes of determining whether that instrument is within the scope of EITF No. 00-19 Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock (EITF 00-19), which provides accounting guidance for instruments that are indexed to, and potentially settled in, the issuer’s own stock. EITF 07-05 is effective for fiscal years beginning after December 15, 2008, which for the Company is fiscal 2010, and early adoption is not permitted. The Company is currently evaluating the impact of this pronouncement on its consolidated financial statements.

In June 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles (a replacement of FASB Statement No. 162) (“SFAS 168”). SFAS 168 establishes the FASB Accounting Standards Codification (“Codification”) as the single source of authoritative GAAP. The Codification does not create any new GAAP standards but incorporates existing accounting and reporting standards into a new topical structure. The Codification will be effective for the Company July 1, 2009, and beginning with the year end report, a new referencing system will be used to identify authoritative accounting standards, replacing the existing references to SFAS, EITF, FSP, etc. Existing standards will be designated by their Accounting Standards Codification (ASC) topical reference and new standards will be designated as Accounting Standards Updates, with a year and assigned sequence number.

Note 2 — Going Concern

These consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and settlement of obligations in the normal course of business. The Company generated significant net losses in the prior three fiscal years. In the first three quarters of fiscal 2009, the Company generated net income of approximately $469,000, but this was largely due to the approximately $8.6 million gain realized by the Patent Sale and License.

Management believes that the Company’s losses in recent years have primarily resulted from a combination of insufficient contract research and development revenue to support the Company’s skilled and diverse technical staff believed to be necessary to support exploitation of the Company’s technologies, amplified by the effects of discretionary investments to productize a variety of those technologies. The Company has not yet been successful in most of these product activities, nor has it been able to raise sufficient capital to fund the future development of many of these technologies. Accordingly, the Company has sharply curtailed the breadth of its product investments, and instead has focused on the potential growth of its chip stacking business, various miniaturized camera products and a system application incorporating such camera products. In addition, the initial acquisition of Optex in December 2005 and the ultimate discontinuation of Optex’s operations in October 2008 pursuant to the Optex Asset Sale contributed to increases in the Company’s consolidated net losses, rather than expected loss reductions, largely due to inadequate gross margins on Optex’s products and related consequential impacts.

As of June 28, 2009, the Company also had negative working capital and stockholders’ deficit of approximately $4.8 million and $5.4 million, respectively. Approximately $3.0 million of the current obligations recorded on the Company’s consolidated balance sheet at June 28, 2009 relate to principal and accrued interest on promissory notes of the Company and Optex, its subsidiary that has discontinued operations, which are related to on-going litigation. (See Note 12). The outcome of litigation is inherently uncertain and the amount of such obligations, if any, that the Company may ultimately be required to satisfy could vary substantially depending on such outcome. If the Company receives an unfavorable outcome in the ongoing litigation, there could be a material and adverse effect on the financial condition of the Company. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern.

Management is focused on managing costs in line with estimated total revenues for the balance of fiscal 2009 and beyond, including contingencies for cost reductions if projected revenues are not fully realized. However, there can be no assurance that anticipated revenues will be realized or that the Company will successfully implement its plans. Accordingly, it is likely that the Company will need to raise additional funds in the near future to meet its continuing obligations.

As noted above, largely as the net result of the Optex Asset Sale, partially offset by the Patent Sale and License, the Company’s stockholders’ deficit at June 28, 2009 was approximately $5.4 million, substantially below $2.5 million of stockholders’ equity, one of Nasdaq’s minimum continued listing criteria. At June 28, 2009, the Company also did not meet either of the other Nasdaq minimum listing criteria related to market capitalization or historical results. The Company received a delisting notice from the Nasdaq staff on April 30, 2009. The Company made an appeal before a Nasdaq Hearing Panel, as permitted by Nasdaq regulations, on June 11, 2009 and, on June 30, 2009, the Nasdaq Hearing Panel granted the Company’s request for continued listing, subject to the Company publicly disclosing on or before October 27, 2009 an income statement (which may be unaudited) that evidences that the Company has generated net income from continuing operations of greater than $500,000 for fiscal 2009, or demonstrating compliance with one of Nasdaq’s alternative listing maintenance criteria. There can be no assurance that the Company will be able to regain compliance with Nasdaq’s continued listing requirements. Furthermore, the Company’s common stock has traded below the $1.00 per share minimum Nasdaq continued listing criterion for substantial periods of time recently. Although Nasdaq suspended application of this rule and the public float market value rule for all Nasdaq traded securities until July 31, 2009, these requirements have been reinstated, and there can be no assurance that the Company will be able to comply with the minimum $1.00 per share trading rule or the public float market value rule, or be able to maintain its listing on the Nasdaq Capital Market. Delisting from the Nasdaq Capital Market for any present or future noncompliance with Nasdaq’s listing requirements could significantly limit the Company’s ability to raise capital and adversely impact the price of the Company’s common stock. If the Company requires additional financing to meet its working capital needs, there can be no assurance that suitable financing will be available on acceptable terms, on a timely basis, or at all.

Note 3 — Restructured Debt

The Company’s restructured debt was largely derived from its acquisition of Optex and related transactions, beginning in December 2005. In November 2007, the Company restructured all of its debt obligations with Longview and Alpha, its senior lenders, effective September 30, 2007. Pursuant to this restructuring, the maturity date of all principal and interest payment obligations under the Company’s Series 1 and Series 2 senior subordinated secured convertible notes (collectively the “Notes”) with the then aggregate principal balance of $8,445,000, the Company’s senior term notes (the “Term Notes”) with the then aggregate principal balance of $8,250,000, and the Company’s non-convertible promissory note initially due in January 2008 (the “Promissory Note”), with the then principal balance of $2,100,000, were extended to December 30, 2009. The stated interest rate payable on the Series 1 notes increased to 10% per annum, compounding monthly. The interest rate on all of the other obligations to Longview and Alpha remained unchanged, except that interest compounds on a monthly basis. In March 2009, the maturity date of the remaining balance of the Series 1 Note and the Promissory Note was further extended to September 30, 2010 pursuant to partial repayment terms related to the Patent Sale and License.

In consideration for the restructuring, the Company issued the Restructuring Notes to Longview and Alpha in the aggregate principal amount of $1.0 million and $115,000, respectively, which Restructuring Notes did not accrue interest and, in general, were not due and payable until December 30, 2009. The Restructuring Notes were secured by substantially all of the assets of the Company and Optex but the Restructuring Notes were extinguished in connection with the Optex Asset Sale.

As part of this restructuring, the Company also issued promissory notes to Longview and Alpha in the aggregate principal amount of $1.0 million and $115,000, respectively (the “Contingent Notes”). In consideration for the Contingent Notes, the Company was relieved of its obligation to register with the SEC and any state regulatory body or agency, the resale of any of the Company’s securities held by Alpha, Longview, Jolie Kahn and Barbara Mittman (collectively, the “Investors”). The Investors waived (i) any event of default arising from the Company’s failure to register such securities for resale, and (ii) any liquidated damages for such failure that may have accrued or could accrue (as well as any default interest that may have accrued or could accrue on such damages).

The Contingent Notes are in substantially the same form as the Restructuring Notes; however, the Contingent Notes to Longview and Alpha will be discharged (and cancelled) in pro rata proportion to the amount the total indebtedness owed to each that is repaid in full by September 30, 2010. If the total principal and accrued interest payable to Longview and Alpha on existing obligations (excluding the Restructuring Notes) is repaid in full by September 30, 2010, then the Contingent Notes will be cancelled in their entirety. The Contingent Notes, to the extent not cancelled, will be due and payable on September 30, 2010, and do not accrue interest. The Contingent Notes are also secured by substantially all of the assets of the Company and Optex. At June 28, 2009, all but $16,900 of the Contingent Notes have been discharged as a result of debt extinguishment pursuant to the Optex Asset Sale, repayment of debt from proceeds of the Patent Sale and License and exchange of debt through the issuance of preferred stock.

Debt Exchange/Cancellation of Debt

In April 2008, the Company sold and issued 133,332 shares of its newly-created Series A-1 10% Cumulative Convertible Preferred Stock, a non-voting convertible preferred stock bearing 10% cumulative dividends per annum (the “Series A-1 Stock”) to its senior lenders, Longview and Alpha, at a purchase price of $30 per share. (See Note 5). The approximate $4,000,000 aggregate purchase price for the Series A-1 Stock was paid solely by the Lenders’ exchange of a portion of the Term Notes held by them. As a result, approximately $1,188,500 of accrued and unpaid interest and approximately $2,811,500 of principal balance under the Term Notes was cancelled.

In April 2009, the Company sold and issued 24,999 shares of its newly-created Series A-2 10% Cumulative Convertible Preferred Stock, a non-voting convertible preferred stock bearing 10% cumulative dividends per annum (the “Series A-2 Stock”) to Longview and Alpha at a purchase price of $40 per share. The aggregate purchase price for the Series A-2 Stock was paid solely by the exchange of all of the remaining obligations under the Series 1 Notes held by Longview and Alpha.

Extinguishment of Debt Pursuant to Optex Asset Sale

In September 2008, the Lenders and the Company entered into the MOU at the Lenders’ direction, which required the sale of the assets of Optex in a UCC public foreclosure sale. On October 14, 2008, the UCC foreclosure sale took place, and the $15 million credit bid of Optex-Delaware (an entity controlled by the Lenders) was the winning bid in said UCC foreclosure sale. As a result, Irvine Sensors Corporation transferred to Optex-Delaware substantially all of the assets and certain liabilities of Optex in the Optex Asset Sale in exchange for the extinguishment of (i) certain of the Company’s indebtedness to the Lenders in the aggregate principal balance of approximately $13.5 million, and (ii) approximately $1.5 million of accrued but unpaid interest. As a result of the Optex Asset Sale, all of the Company’s obligations under the Term Notes, the Series 2 Notes and the Restructuring Notes were cancelled. In addition, all but approximately $3,133,200 of the principal obligations under the Series 1 Notes and approximately $448,900 of the principal obligations under the Promissory Note were also cancelled in the Optex Asset Sale.

Repayment of Debt From Proceeds of Patent Sale and License

In March 2009, approximately $79,700 of accrued and unpaid interest and approximately $2.1 million of principal balance under the Notes was paid by the Company from proceeds of the Patent Sale and License. In addition, in March 2009, approximately $23,700 of accrued and unpaid interest and approximately $260,500 of principal balance under the Promissory Note was paid by the Company from proceeds of the Patent Sale and License.

The Series 1 and Series 2 Notes, the Term Notes, the Promissory Note and the Restructuring Notes are collectively referred to as the “Restructured Debt.” Set forth below are the components of the Restructured Debt at June 28, 2009 and September 28, 2008:

		June 28,				September 28,
		2009				2008
Series 1 Notes payable — principal plus interest at an initial stated rate of 10.0% per annum payable on September 30, 2010. (Since all payments on these notes will be accounted for as interest expense the effective interest rate of the notes is not calculable) (1)		$	7,445,500			$	7,445,500
Less: Cumulative principal amount of Series 1 Notes payable converted to common stock			(230,000	)			(230,000	)
Less: Principal amount of Series 1 Notes payable cancelled pursuant to credit bid			(4,082,300	)			—
Less: Principal amount of Series 1 Notes payable repaid from proceeds of Patent Sale and License			(2,133,200	)			—
Less: Principal amount of Series 1 Notes exchanged for issuance of Series A-2 Stock			(1,000,000	)			—
Series 2 Notes payable — principal plus interest at an initial stated rate of 3.5% per annum payable on September 30, 2010. (Since all payments on these notes will be accounted for as interest expense the effective interest rate of the notes is not calculable) (1)			2,554,500				2,554,500
Less: Cumulative principal amount of Series 2 Notes payable converted to common stock			(1,325,000	)			(1,325,000	)
Less: Principal amount of Series 2 Notes payable cancelled pursuant to credit bid			(1,229,500	)			—
Term Notes payable — principal plus interest at an initial stated interest rate of 11% per annum, with 100% principal and interest due on or before September 30, 2010 (initial effective interest rate of 19.4%) (1)			8,250,000				8,250,000
Less: Principal amount of Term Notes exchanged for Series A-1 Stock			(2,811,500	)			(2,811,500	)
Less: Principal amount of Term Notes cancelled pursuant to credit bid			(5,438,500	)			—
Promissory Note payable — aggregate principal amount of $2,100,000 with 100% principal due on or before September 30, 2010, along with interest accrued at a stated rate of 12% per annum (initial effective interest rate of 41.3%)			2,100,000				2,100,000
Less: Principal amount of Promissory Note cancelled pursuant to credit bid			(1,651,100	)			—
Less: Principal amount of Promissory Note repaid from proceeds of Patent Sale and License			(260,500	)			—
Restructuring Notes payable — aggregate principal amount of $1,115,000 with 100% principal due on or before September 30, 20010, non-interest bearing			1,115,000				1,115,000
Less: Principal amount of Restructuring Notes cancelled pursuant to credit bid			(1,115,000	)			—
Less: Unamortized debt discounts related to warrants, beneficial conversion feature, principal increase in Promissory Note, stock issued in lieu of continuation fee and Restructuring Notes			—				(5,309,700	)
		$	188,400			$	11,788,800

The components of the Restructured Debt are discussed more fully below.

Subordinated Convertible Debt

To partially finance the initial acquisition of 70% of the outstanding capital stock of Optex (the “Initial Acquisition”), on December 30, 2005, the Company borrowed $10 million by issuing $10.0 million of senior subordinated secured convertible notes in two series, collectively the Notes. The first series of Notes (the “Series 1 Notes”) had an initial principal amount of $7,445,500, and the second series of Notes (the “Series 2 Notes”) had an initial principal amount of $2,554,500.

In the period January 2007 through August 2007, an aggregate of $230,000 and $1,325,000 of the principal balance of the Series 1 Notes and Series 2 Notes, respectively, was retired through conversion to common stock. As a result, an extra $1,555,000 of debt discount was accreted to interest expense in fiscal 2007 due to these debt retirements. No conversion on the Notes occurred during fiscal 2008. Pursuant to the Optex Asset Sale in October 2008, $4,082,300 of the outstanding principal balance of the Series 1 Notes was retired and all $1,229,500 of the then outstanding principal balance of the Series 2 Notes was retired, resulting in the cancellation of the balance of the Series 2 Notes. In March 2009, $2,133,200 of the then outstanding principal balance of the Series 1 Notes was repaid from proceeds of the Patent Sale and License, resulting in an outstanding principal balance of the Series 1 Notes of $1,000,000 at June 28, 2009. In April 2009, the $1 million outstanding principal balance of the Series 1 Notes was cancelled through the exchange of such Series 1 Notes for the issuance of 24,999 shares of Series A-2 Stock and cash in lieu of fractional shares of said Series A-2 Stock to Longview and Alpha.

Senior Debt

On December 29, 2006, the Company borrowed $8.25 million from Longview and Alpha under the Term Notes and used a portion of the proceeds from this borrowing to repay the Company’s borrowings from, and satisfy all obligations to, Square 1 Bank, the Company’s prior senior lender, of approximately $5.9 million.

The Term Notes bore interest at 11% per annum and required only quarterly interest payments until their initial maturity in December 2008, which was extended to December 30, 2009 as part of the November 2007 debt restructuring and subsequently to December 30, 2010 in connection with repayment in connection with the Patent Sale and License. Interest payments could initially be made in cash or at the Company’s election, and subject to certain conditions, in shares of the Company’s common stock valued at 80% of specified closing prices, as measured by the average of the three lowest closing prices in the twenty-day trading period prior to the payment of interest. If there was to have been an uncured event of default in the Company’s compliance with the conditions of the Term Notes, Longview and Alpha could have required immediate repayment of all outstanding amounts and the Term Notes’ interest rate could have increased to 18%, which would have to be paid in cash. Principal payments in any amount could have been made without premium or penalty at any date prior to maturity with 15 days notice to the Lenders; however, any principal balance outstanding at the Term Notes’ maturity would have had to been repaid at 110% of the outstanding principal balance. The Term Notes were secured by a lien on all assets of the Company and of Optex, as well as all Company owned shares of the capital stock of Optex.

In April 2008, approximately $2.8 million of the Term Notes’ principal and approximately $1.2 million of related deferred interest was retired in connection with the exchange of a portion of the Term Notes for the issuance of Series A-1 Stock. In October 2008, the balance of the Term Notes’ principal and related deferred interest was retired pursuant to the Optex Asset Sale.

$2.1 Million Secured Promissory Note

In July 2007, the Company entered into an agreement with Longview, one of the Lenders, pursuant to which the Company closed a $2.0 million non-convertible loan, initially with a six-month term, under a secured promissory note (the “Promissory Note”). Interest under the Promissory Note accrues at the rate of 12% per annum and was initially due together with the unpaid principal amount when the Promissory Note was originally scheduled to mature on January 19, 2008 (which maturity date was extended; see debt restructuring discussion above). If the Company failed to pay the principal and accrued interest within ten days after the maturity date, as extended, it would incur a late fee equal to 5% of such amounts. The Company had the right to prepay on or prior to August 15, 2007, all of the outstanding principal under the Promissory Note by paying to Longview an amount equal to 120% of the principal amount of the Promissory Note, together with accrued but unpaid interest. To effectuate this right, the Company was required to provide written notice of such prepayment election on or prior to August 8, 2007. The Company declined to give such notice and to prepay the Promissory Note, and pursuant to its terms, the principal amount of the Promissory Note was automatically increased by $100,000 on August 15, 2007, and the Company issued to Longview 30,000 unregistered shares of the Company’s common stock in lieu of a $400,000 cash continuation fee for continuing the term of the Promissory Note beyond August 15, 2007 and a five-year warrant to purchase 50,000 unregistered shares of the Company’s common stock at a price equal to $14.60 per share, subject to adjustment for stock splits, stock dividends, recapitalizations and the like. As a result of the April 2008 debt exchange, the exercise price of this warrant was reset to $3.00 per share. As a result of November 2008 and December 2008 closings of a bridge financing, the exercise price of this warrant was reset to $0.40 per share. The fair value of the principal increase of $100,000, the 30,000 shares of common stock and the warrant to purchase 50,000 shares of common stock was recorded as a discount on the debt and is being amortized to interest expense over the term of the Promissory Note. The original discount on the debt associated with the cash payment and the issuance of common stock and warrants totaled $905,000.

The Company’s obligations under the Promissory Note are secured by all or substantially all of the Company’s assets, the assets of the Company’s subsidiaries, and the capital stock of the Company’s subsidiaries held by the Company, pursuant to already existing security agreements and guarantees dated December 30, 2005 and December 29, 2006 between the Company and its subsidiaries on the one hand and Longview and/or Alpha, on the other, and additionally pursuant to an Unconditional Guaranty between Optex and Longview. Such security interests and guarantees are granted on a pari passu basis with the already existing senior security interests and guarantee rights held by Longview and Alpha.

In connection with the Promissory Note, Longview and Alpha waived various rights, including the right, pursuant to certain technical defaults, among other things, to accelerate or demand repurchase of the obligations under any agreement or instrument between the Company and/or its subsidiaries and Longview and/or Alpha and exercising remedies with respect to collateral. In connection with its November 2007 restructuring of its obligations to Longview and Alpha, the Company bought out certain waiver restrictions of the Promissory Notes related to various registration obligations to Longview and Alpha.

In connection with the Promissory Note, the Company also has agreed that, for so long as the Notes remained outstanding and held by Longview, except for certain specified issuances, the Company will not, without the prior written consent of Longview, enter into an agreement to issue any individual equity security, convertible debt security or other individual security convertible into the Company’s common stock or equity of the Company at a price that would trigger the anti-dilution provisions set forth in Section 10(d) of the Notes; provided however, that no consent of Longview shall be required for the issuance of any convertible security that has an exercise price or conversion price above the conversion price as defined in the Notes.

In connection with the Optex Asset Sale in October 2008, approximately $1,651,100 of the principal balance of the Promissory Note was retired. In March 2009, $260,500 of the then outstanding principal balance of the Promissory Note was repaid from proceeds of the Patent Sale and License, resulting in an outstanding principal balance of the Promissory Note of $188,400 at June 28, 2009.

Schedule of Principal Payments

The schedule of principal payments required under the outstanding Restructured Debt at June 28, 2009 is shown below.

		Promissory
Fiscal Year		Note				Total
2010		$	188,400			$	188,400
Future principal payments (1)		$	188,400			$	188,400

Debt Default Waivers and Forbearance Agreement

Although the Company’s failure to obtain consent of its Lenders to its May 2007 issuance of a warrant to purchase up to 20,000 shares of common stock (the “Consent Default”) and the Company’s failure to register shares of the Company’s common stock issued or issuable to its Lenders constituted technical defaults under certain agreements the Company entered into with its Lenders in December 2006, the Company received waivers of such failures solely for purposes of accelerating or requiring repurchase of the obligations under any agreement or instrument between the Company and/or its subsidiaries and such lenders, triggering default interest under any such agreement or instrument (but only with respect to the Consent Default), exercising remedies with respect to collateral (including without limitation account collections, settlements, adjustments or compromises, returned inventory, and inspection, audit and appraisal) securing the obligations under any such agreement or instrument, claiming a cross-default under any such agreement or instrument, tolling any restriction periods in any such agreement or instrument, preventing the payment of interest in shares of the Company’s common stock under any such agreement or instrument (but only with respect to a Consent Default), or preventing the Company’s ability to repurchase stock from former employees or directors of the Company under any such agreement or instrument. In connection with its November 2007 restructuring of its obligations to Longview and Alpha, the Company bought out certain waiver restrictions related to various registration obligations to Longview and Alpha.

In October 2008, the Company received from the Lenders a notice of default and an acceleration of amounts due under the Restructured Debt, resulting in the Optex Asset Sale. An aggregate of approximately $13.5 million of the principal due under the Restructured Debt and approximately $1.5 million of related deferred interest was extinguished in October 2008 in connection with the Optex Asset Sale. In February 2009, the Company completed a bridge financing that triggered an obligation of Longview and Alpha to exchange $1.0 million of the obligations under the Restructured Debt for new convertible preferred stock, subject to certain conditions. In April 2009, these conditions were satisfied and $1.0 million of the obligations under the Restructured Debt was exchanged for the new Series A-2 Stock.

The December 2006 debt refinancing transactions resulted in the recognition of $14,470,000 of additional stockholders’ equity from the issuance of warrants to purchase up to 486,390 shares of the Company’s common stock ($7,180,000) and recognition of a beneficial conversion feature in the Notes ($7,290,000). Of this total non-cash increase in stockholders’ equity, $2,950,000 was recognized as a part of the loss on extinguishment of debt expense reported in the 13-week period ended December 31, 2006 and the remaining $11,520,000 was recognized as interest expense over the period the Notes and the Term Notes were outstanding through March 29, 2009. In addition, the issuance of the Promissory Note in July 2007 resulted in the recognition of $805,000 of additional stockholders’ equity from the related issuance of common stock and warrants that was recognized as non-cash interest expense over the term of the Promissory Note through March 29, 2009. Therefore, these non-cash transactions, aggregating $12,325,000 in value, did not result in a permanent increase in the equity of the Company, but rather represented differences in the timing of the recognition of values assigned to issued equity securities and the recognition of such values as expenses of the Company. In addition to the recognition of these equity-related debt discounts, the $100,000 of principal increase of the Promissory Note in August 2007 and the full $1,115,000 principal value of the Restructuring Notes was recognized as interest over the term of the Restructured Debt through March 29, 2009. The aggregate of these debt discounts and interest effects is $13,540,000, all of which was recognized as interest over the term of the Restructured Debt through March 29, 2009 using the effective interest method. Accordingly, at June 28, 2009, none of this $13,540,000 aggregate expense remained unamortized. At September 28, 2008, $5,309,700 of this $13,540,000 aggregate expense was yet to be amortized.

Note 4 — Private Placement of Secured Promissory Notes

On November 5, 2008, December 10, 2008, January 7, 2009 and February 3, 2009, the Company entered into subscription agreements (the “Subscription Agreements”) with accredited individual investors (each, an “Investor” and collectively, the “Investors”), pursuant to which the Company closed a private placement (the “Private Placement”) of secured promissory notes.

On November 5, 2008, the Company entered into a Subscription Agreement with eight accredited individual investors (the “1^st Closing Investors”) in a first closing of the Private Placement and issued secured promissory notes in the original aggregate principal amount of $502,000 (the “1^st Closing Notes”) and, as consideration for making the advances under the 1^st Closing Notes, agreed to issue to the 1^st Closing Investors an aggregate of 267,021 shares of the Company’s Common Stock (the “1^st Closing Shares”). The number of 1^st Closing Shares to be issued equaled 25% of the principal amount of the 1^st Closing Notes divided by $0.47, which was the last reported closing sales price of the Company’s Common Stock immediately preceding the Company entering into the binding Subscription Agreement to issue the 1^st Closing Notes (the “1^st Market Value”).

On December 10, 2008, the Company expanded the Private Placement by entering into a Subscription Agreement with six accredited individual investors (the “2^nd Closing Investors”) pursuant to which the Company issued secured promissory notes in the original aggregate principal amount of $138,000 (the “2^nd Closing Notes”) and, as consideration for making the advances under the 2^nd Closing Notes, agreed to issue to the 2^nd Closing Investors an aggregate of 86,250 shares of the Company’s Common Stock (the “2^nd Closing Shares”). The number of 2^nd Closing Shares to be issued equaled 25% of the principal amount of the Notes divided by $0.40, which was the last reported closing sales price of the Company’s Common Stock immediately preceding the Company entering into the binding Subscription Agreement to issue the 2^nd Closing Notes (the “2^nd Market Value”).

On January 7, 2009, the Company expanded the Private Placement by entering into a Subscription Agreement with five accredited individual investors (the “3^rd Closing Investors”) pursuant to which the Company issued secured promissory notes in the original aggregate principal amount of $178,000 (the “3^rd Closing Notes”) and, as consideration for making the advances under the 3^rd Closing Notes, agreed to issue to the 3^rd Closing Investors an aggregate of 108,536 shares of the Company’s Common Stock (the “3^rd Closing Shares”). The number of 3^rd Closing Shares to be issued equaled 25% of the principal amount of the Notes divided by $0.41, which was the last reported closing sales price of the Company’s Common Stock as reported by Nasdaq immediately preceding the Company entering into the binding Subscription Agreement to issue the 3^rd Closing Notes (the “3^rd Market Value”).

On February 3, 2009, the Company completed the fourth and final closing of the Private Placement and issued to five accredited individual investors (the “4^th Closing Investors”) secured promissory notes in the original aggregate principal amount of $182,000 (the “4^th Closing Notes”) and, as consideration for making the advances under the 4^th Closing Notes, agreed to issue to the 4^th Closing Investors an aggregate of 113,750 shares of the Company’s Common Stock (the “4^th Closing Shares”). The number of 4^th Closing Shares to be issued equaled 25% of the principal amount of the Notes divided by $0.40 (the “4th Market Value”), which was higher than the last reported closing sales price of the Company’s Common Stock as reported by Nasdaq immediately preceding the Company entering into the binding Subscription Agreement to issue the 4^th Closing Notes. The 1^st, 2^nd, 3^rd and 4^th Closing Shares were issued in April 2009.

The 1^st, 2^nd and 3^rd Closing Notes bore interest at 12.0% per annum and were to mature and become payable 18 months following their respective issuance. The 4^th Closing Notes bore interest at 12.0% per annum and were to mature and become payable 6 months following their issuance. All amounts payable under the 1^st, 2^nd, 3^rd and 4^th Closing Notes (collectively, the “Bridge Notes”) would be accelerated upon the occurrence of certain bankruptcy-related events. The Bridge Notes were secured by a security agreement in substantially all of the Company’s assets and such security interest was senior to certain obligations of the Company to Longview and Alpha pursuant to an intercreditor agreement and collateral agent agreement.

The 1^st, 2^nd and 3^rd Closing Notes also required the Company to issue an additional number of shares of the Company’s Common Stock with a value equal to 12.5% of the principal amount of each 1^st, 2^nd and 3^rd Closing Notes in the event that such Closing Notes had not been paid in full on or before the six month anniversary of the issuance date of such Closing Notes (the “Six Month Date”), based on the greater of (x) the fair market value of the Company’s Common Stock as of the Six Month Date or (y) the fair market value of the Company’s Common Stock as of the date of issuance of said Closing Notes; and an additional number of shares of the Company’s Common Stock with a value equal to 12.5% of the principal amount of each such Closing Note in the event that such Closing Note had not been paid in full on or before the twelve month anniversary of the issuance date of such Closing Note (the “Twelve Month Date”), based on the greater of (x) the fair market value of the Company’s Common Stock as of the Twelve Month Date or (y) the fair market value of the Company’s Common Stock as of the date of issuance of such Closing Note.

In consideration for services rendered as the lead placement agent in the Private Placement, the Company issued to J.P. Turner & Company, LLC (“JP Turner”) five-year warrants to purchase 138,851, 44,850, 56,439 and 59,150 shares of the Company’s Common Stock at an exercise price of $0.47 per share, $0.40 per share, $0.41 per share and $0.40 per share, respectively (the “JP Warrants”), for the 1^st, 2^nd, 3^rd and 4^th Closings of the Private Placement, which represents 13% of the gross proceeds of each closing divided by the respective Market Value of such closing. JP Turner also received, in consideration for services rendered as lead placement agent, (i) cash commissions aggregating $80,000, which represents 8% of the aggregate gross proceeds of the 1^st, 2^nd, 3^rd and 4^th Closing, (ii) a management fee of $20,000, which represents 2% of the aggregate gross proceeds of the 1^st, 2^nd, 3^rd and 4^th Closings and (iii) an expense allowance fee of $30,000, which represents 3% of the aggregate gross proceeds of the 1^st, 2^nd, 3^rd and 4^th Closings.

The aggregate fair value of the 1^st, 2^nd, 3^rd and 4^th Closing Shares, $250,000, as determined by the Market Values at their respective closings and which is 25% of the aggregate principal amount of the 1^st, 2^nd, 3^rd and 4^th Closing Notes has been recorded as a debt discount, $0 and $250,000 of which, respectively, has been expensed in the 13-week and 39-week periods ended June 28, 2009. The fair value of the JP Turner Warrants, $92,100, the aggregate cash commission and expense reimbursements of $130,000 paid to JP Turner and an additional $97,000 of costs, largely legal expenses, were capitalized as debt issuance costs to be amortized over the respective terms of the Bridge Notes. In order to release the security interests of the Bridge Notes to effectuate the Patent Sale and License, the Company entered into an agreement for early payment of the Bridge Notes in March 2009, resulting in the corresponding acceleration of amortization of the debt issuance costs of the Bridge Notes. Accordingly, approximately $0 and $319,100 of debt issuance cost amortization expense was recorded in the 13-week and 39-week periods ended June 28, 2009, respectively.

The completion of the Private Placement to realize aggregate gross proceeds to the Company of $1.0 million satisfied the requirement of the MOU that bound Longview and Alpha to exchange $1.0 million of the obligations under the Restructured Debt for new convertible preferred stock. This exchange occurred in April 2009. In March 2009, pursuant to the terms of a release of security interests of the Bridge Notes in order to consummate the Patent Sale and License, the Company repaid $670,000 of the principal balance of the Bridge Notes in cash and, in April 2009, the Company satisfied the remaining $330,000 of the principal balance of the Bridge Notes in exchange for the issuance of common stock of the Company. (See Note 6).

The 1^st, 2^nd, 3^rd and 4^th Closing Investors are sometimes referred to herein as the “Bridge Investors.”

Note 5 — Notes Payable

In December 2006, in consideration for amendments to its Stock Purchase Agreement, the Buyer Option Agreement and the Escrow Agreement with Timothy Looney initially entered into on December 30, 2005, the Company issued an unsecured subordinated promissory note to Mr. Looney in the original principal amount of $400,000, bearing interest at a rate of 11% per annum. The principal and accrued interest under this note was due and payable in full to Mr. Looney on December 29, 2007. As discussed below, payment to Mr. Looney was prohibited under a subordination agreement, but the Company has been advised that this subordination agreement is no longer in effect and Mr. Looney has submitted a demand for payment. The Company has recorded this obligation as a current liability.

In January 2007, the Company amended its earnout agreement with Timothy Looney, which was entered into in connection with the Initial Acquisition of Optex, to extend the earnout period through December 2009, with a reduction to $3.9 million in the maximum potential payment, in consideration for TWL Group, L.P., an entity owned by Mr. Looney providing the Company’s Optex subsidiary with a secured subordinated term note providing for advances of up to $2 million, bearing interest at 10% per annum and maturing on the earlier of February 2009 or sixty days after repayment or refinancing of the Company’s senior debt. Aggregate advances of $2 million were provided to Optex in January 2007 pursuant to the secured subordinated term note, and said advances were outstanding at June 28, 2009 and September 28, 2008.

In January 2008, Mr. Looney filed a lawsuit against the Company and its senior lenders, Longview and Alpha, in the Superior Court of California, County of Orange, alleging that the Company breached its obligations to register the shares of the Company’s common stock issued to him to purchase the final 30% of Optex. Mr. Looney’s registration rights agreement provides for liquidated damages under certain circumstances at the rate of $10,000 per month upon an event of default. Mr. Looney also alleged that the Company’s senior lenders tortiously and negligently interfered with his contractual rights with the Company by requiring the Company to refrain from registering his securities. Mr. Looney was seeking partial liquidated damages, unspecified compensatory damages, and declaratory and injunctive relief compelling the Company to register such shares. Although the Company believed that it had meritorious defenses against this claim, the Company has recorded a liability of $105,000 within accrued expenses in the Consolidated Balance Sheet at June 28, 2009 for this matter. The Company has paid approximately $543,000 to the Lenders pursuant to the Company’s indemnification obligations related to the Looney litigation and Optex Asset Sale pursuant to the Company’s loan agreements with the Lenders. No additional liability for such expense has been recorded at June 28, 2009. The Company has been advised by the Lenders that their litigation with Mr. Looney has been settled.

In June 2008, the Company filed a cross-complaint against Mr. Looney in the Superior Court of California, County of Orange, in response to the January 2008 action discussed above, alleging that Mr. Looney fraudulently and negligently misrepresented the financial condition of Optex prior to its sale to the Company and breached his contractual obligations to the Company subsequent to that sale. Pursuant to this cross-complaint, the Company was seeking compensatory and punitive damages and attorneys’ fees.

Trial of Mr. Looney’s January 2008 lawsuit against the Company and the Company’s June 2008 cross-complaint against Mr. Looney was completed in July 2009. A jury verdict was reached awarding Mr. Looney liquidated damages of $105,000, with the court rejecting Mr. Looney’s claim for additional compensatory damages based on the Company’s motion, and the Company’s cross-complaint against Mr. Looney with respect to allegations of fraud was denied. The results of the trial are potentially subject to post trial motions and appeal by either or both parties. Depending on the disposition of pending matters or appeals, the Company may also be subject to judgment for some portion of Mr. Looney’s legal expenses, but such an outcome is presently indeterminable. (See Note 12).

The Company has received notices from Mr. Looney claiming that it is in default under the $400,000 one-year unsecured subordinated promissory note for the alleged nonpayment of principal and interest and that Optex is in default under its $2 million secured subordinated note with TWL Group, LP, an entity owned by Mr. Looney, for the alleged nonpayment of principal and interest. The Company has received a demand from Mr. Looney for payment pursuant to the $400,000 one-year unsecured subordinated promissory note, and Optex has received a demand from TWL Group, LP for payment pursuant to the $2 million secured subordinated note. These notes are in dispute as they relate to the litigation between the Company and Mr. Looney, and Mr. Looney and TWL Group, LP, have initiated litigation in Texas seeking their enforcement, the outcome of which is presently not determinable. (See Note 12). Accordingly, the ultimate amount, if any, that may be required to be paid by the Company or by Optex pursuant to these notes is presently unknown, although the Company has recorded the principal and accrued interest amount of these notes in its Consolidated Balance Sheets at June 28, 2009 and September 28, 2008. The $2 million note is an obligation of Optex, not Irvine Sensors Corporation, and Optex has discontinued operations effective October 2008.

Note 6 — Common Stock and Common Stock Warrants, Preferred Stock, Stock Incentive Plans, Employee Retirement Plan and Deferred Compensation Plans

During the 39-week period ended June 28, 2009, the Company issued an aggregate of 4,466,000 shares of common stock, net of the forfeiture of 2,300 shares of nonvested stock, in various transactions. All of the 4,466,000 shares were issued in non-cash transactions to effectuate various transactions with an aggregate valuation of $1,728,900, net of forfeitures. These transactions are separately discussed below.

Non-Cash Common Stock Transactions. The 4,466,000 shares of common stock issued during the 39-week period ended June 28, 2009 in non-cash transactions were issued in the following amounts: (1) 1,785,700 shares were issued to effectuate $750,000 of non-cash contributions by the Company to the Company’s ESBP for fiscal 2009; (2) after giving effect to the forfeiture of 2,300 shares of nonvested stock, there was a net increase of 69,700 shares, resulting in an net expense increase of $5,000, issued to employees as compensation for services rendered; (3) 300,000 shares, valued at $141,000, were issued to an investment banking firm for services rendered in connection with the Optex Asset Sale and the Company’s debt workout with Longview and Alpha; (4) 339,800 shares, valued at $112,000, were issued to a non-employee service provider as compensation for services; (5) in accordance with terms of the Company’s aggregate $1 million of secured promissory notes purchased by investors in November 2008, December 2008, January 2009 and February 2009, 575,600 shares, valued at $250,000, were issued to investors that purchased said secured promissory notes; and (6) 1,089,000 shares, valued at $348,400, were issued in exchange for the cancellation of $348,400 of principal and interest obligations owed pursuant to said secured promissory notes and (7) 306,200 shares, valued at $122,500, were issued pursuant to conversion of shares of Series A-1 Stock. (See Note 4.) The value of all of the non-cash issuances of common stock was based on the last reported closing sales price of the Company’s common stock as reported by the Nasdaq Capital Market prior to the various issuances or entering into the contractual obligations for such issuances.

Common Stock Warrants. In the 39-week period ended June 28, 2009, five-year warrants to purchase an aggregate of 299,300 shares of common stock, at exercise prices ranging from $0.40 per share to $0.47 per share, were issued to an investment banker as partial consideration for the private placement of a debt financing. The estimated fair value of these warrants, $92,100, is a portion of the deferred debt issuance costs that was amortized over the term of the debt instruments. (See also Note 4). In the 39-week period ended June 29, 2008, the Company issued a five-year warrant to purchase up to 50,000 shares of the Company’s common stock at an exercise price of $13.00 per share, to a financial advisory and investment banking firm that the Company engaged to assist it to raise additional capital and to provide financial advisory services. In the 39-week period ended June 28, 2009, as a result of the Company’s issuance of common shares to the ESBP in October 2008, issuance of common shares and options to employees in October 2008, issuance of common shares to a service provider in February 2009 and closings of financings in November 2008, December 2008, January 2009 and February 2009, warrants to purchase 258,100 shares at $9.39 per share were automatically adjusted to purchase 488,600 shares at $4.96 per share. In the 39-week period ended June 29, 2008, as a result of issuance of preferred stock in April 2008 and issuance of common shares to an investment banker in June 2008, warrants to purchase 186,400 shares at $13.00 per share were automatically adjusted to purchase 242,300 shares at $10.00 per share. Warrants to purchase 59,900 and 0 shares of the Company’s common stock expired during the 39-week periods ended June 28, 2009 and June 29, 2008, respectively. At June 28, 2009 and September 28, 2008, there were warrants outstanding to purchase 1,187,800 and 717,900 shares of the Company’s common stock, respectively

Preferred Stock. In fiscal 2008, the Company’s stockholders approved an amendment to the Company’s Certificate of Incorporation increasing the number of authorized shares of preferred stock from 500,000 to 1,000,000. This increase did not have an effect on the Company’s historical financial statements.

During fiscal 2008, the Company sold and issued 133,332 shares of its newly created Series A-1 Stock to its senior lenders, Longview and Alpha, at a purchase price of $30 per share. The approximate $4,000,000 aggregate purchase price for the Series A-1 Stock was paid solely by the Investors’ exchange of a portion of the Company’s Term Notes dated December 29, 2006 (the “Debt Exchange”). As a result of the Debt Exchange, approximately $1,188,500 of accrued and unpaid interest and approximately $2,811,500 of principal balance under the Term Notes were cancelled. During fiscal 2008, 7,333 shares of Series A-1 Stock were converted into 73,333 shares of the Company’s common stock.

Each share of Series A-1 Stock was initially convertible at any time at the holder’s option into 10 shares of common stock at an initial conversion price of $3.00 per share of common stock, which was above the closing price of the Company’s common stock on March 31, 2008, the day before a binding letter of intent for the Debt Exchange was executed. The conversion price of the Series A-1 Stock is subject to ratchet price dilution protection in the event the Company issues securities (other than certain excepted issuances) at a price below the then current conversion price, subject to the limitation of the authorized capital of the Company. As a result of various issuances of common stock subsequent to the issuance of the Series A-1 Stock, at June 28, 2009, the conversion price of the Series A-1 Stock had been adjusted pursuant to its terms to $0.40 per share and each share of Series A-1 Stock is now convertible at any time at the holder’s option into 75 shares at such conversion price. The conversion price of the Series A-1 Stock also is subject to adjustment for stock splits, stock dividends, recapitalizations and the like. The Series A-1 Stock is non-voting (except to the extent required by law), but ranks senior to the common stock and pari passu with the Company’s Series A-2 Stock, with respect to dividends and with respect to distributions upon a deemed dissolution, liquidation or winding-up of the Company. In the event the Company declares dividends in the future, the Series A-1 Stock is preferentially entitled to receive 10% cumulative dividends per annum, payable in arrears starting December 30, 2009, which may increase to 20% during the existence of certain events of default. Absent the declaration of dividends, this cumulative feature of the Series A-1 Stock does not result in an accrual of a liability, but does affect the composition of loss per share. (See Note 7). The Series A-1 Stock is not redeemable by the holder thereof, but is callable at the election of the Company (provided an event of default has not occurred and is continuing) upon 30 days prior notice at a redemption price equal to the initial purchase price plus any accrued but unpaid dividends. The Series A-1 Stock is subject to a blocker (the “Blocker”) that would prevent each holder’s common stock ownership at any given time from exceeding 4.99% of the Company’s outstanding common stock (which percentage may increase but never above 9.99%).

On March 31, 2009, the Company’s stockholders approved the creation and issuance of the Company’s Series A-2 Stock, a 10% cumulative convertible non-voting preferred stock. The February 2009 completion of the Company’s Private Placement raising $1.0 million of gross proceeds, satisfied the requirements of the Company’s binding Memorandum of Understanding with Longview and Alpha for the exchange of $1.0 million of obligations under the Restructured Debt for new convertible preferred stock, and the Company entered into a Subscription Agreement in March 2009 for such exchange. The approval of the Company’s stockholders and the occurrence of certain other events satisfied the conditions in the Subscription Agreement and, accordingly, on April 30, 2009, the Company sold and issued 24,999 shares of the Series A-2 Stock to Longview and Alpha at a purchase price of $40 per share. The approximate $1,000,000 aggregate purchase price for the Series A-2 Stock was satisfied solely by Longview’s and Alpha’s exchange of all the remaining portion of the Series 1 Notes.

Each share of Series A-2 Stock is convertible at any time at the holder’s option into 100 shares of common stock at an initial conversion price of $0.40 per share of common stock, the conversion price approved by stockholders, which was the last reported closing sales price of the Company’s common stock on the date the Company entered into the Subscription Agreement for such issuance and was above the last reported closing sales price of the Company’s common stock on March 31, 2009, the date stockholder approval was received. The conversion price of the Series A-2 Stock is subject to ratchet price dilution protection in the event the Company issues securities (other than certain excepted issuances) at a price below the then current conversion price, subject to the limitation of the authorized capital of the Company. The conversion price of the Series A-2 Stock also is subject to adjustment for stock splits, stock dividends, recapitalizations and the like. The Series A-2 Stock is non-voting (except to the extent required by law), but ranks senior to the common stock, and pari passu with the Company’s Series A-1 Stock, with respect to dividends and with respect to distributions upon a deemed dissolution, liquidation or winding-up of the Company. The Series A-2 Stock is entitled to 10% cumulative dividends per annum, payable in arrears starting December 30, 2010, which may increase to 20% during the existence of certain events of default. The Series A-2 Stock is not redeemable by the holder thereof, but is callable at the election of the Company (provided an event of default has not occurred and is continuing) upon 30 days prior notice at a redemption price equal to the initial purchase price plus any accrued but unpaid dividends. The Series A-2 Stock is subject to a blocker (the “Blocker”) that would prevent each holder’s common stock ownership at any given time from exceeding 4.99% of the Company’s outstanding common stock (which percentage may increase but never above 9.99%).

In the 13-week and 39-week periods ended June 28, 2009, 4,083 shares of the Series A-1 Stock was converted by Longview and Alpha into 306,250 shares of the Company’s common stock. In the 13-week and 39-week periods ended June 29, 2008, 7,333 shares of the Series A-1 Stock was converted by Alpha into 73,300 shares of the Company’s common stock.

Stock Incentive Plans. In June 2006, the Company’s stockholders approved the Company’s 2006 Omnibus Incentive Plan (the “2006 Plan”), which is designed to serve as a comprehensive equity incentive program to attract and retain the services of individuals essential to the Company’s long-term growth and financial success. The 2006 Plan permits the granting of stock options (including both incentive and non-qualified stock options), stock-only stock appreciation rights, nonvested stock and nonvested stock units, performance awards of cash, stock or property, dividend equivalents and other stock grants. Upon approval of the 2006 Plan in June 2006, the Company’s 2003 Stock Incentive Plan, 2001 Compensation Plan, 2001 Non-Qualified Stock Option Plan, 2001 Stock Option Plan, 2000 Non-Qualified Stock Option Plan and 1999 Stock Option Plan (the “Prior Plans”) were terminated, but existing options issued pursuant to the Prior Plans remain outstanding in accordance with the terms of their original grants. The number of shares of common stock reserved under the 2006 Plan initially was set to be increased on the first day of each fiscal year, beginning on October 2, 2006, in an amount equal to the lesser of (a) 100,000 shares or (b) such lesser number as determined by the Board. Pursuant to those terms, at June 28, 2009, the aggregate number of shares of common stock remaining available for issuance under future stock-based awards that may be made under the 2006 Plan was 415,900 shares. On March 31, 2009, stockholders approved an amendment to the 2006 Plan to increase the number of shares of common stock reserved for issuance thereunder by 500,000 shares, which share reservation shall automatically increase at the beginning of each subsequent fiscal year by the lesser of 1,250,000 shares or 5% of the common stock of the Company then outstanding. Under the 2006 Plan, options and nonvested and vested stock may be granted to the Company’s employees, directors and bona fide consultants. As of June 28, 2009, there were options to purchase 249,600 shares of the Company’s common stock outstanding under the 2006 Plan, 84,200 shares of nonvested stock were issued and outstanding pursuant to the 2006 Plan and 236,900 shares of vested stock were issued and outstanding pursuant to the 2006 Plan.

The following table summarizes stock options outstanding as of June 28, 2009 as well as activity during the 39-week period then ended:

						Weighted Average
		Shares (1)				Exercise Price
Outstanding at September 28, 2008			477,900			$	22.49
Granted			122,000				0.37
Exercised			—				—
Forfeited			(31,000	)			21.87
Outstanding at June 28, 2009			568,900			$	17.70
Exercisable at June 28, 2009			497,100			$	18.76

At June 28, 2009, the weighted-average remaining contractual life of options outstanding and exercisable was 5.6 years and 5.2 years, respectively.

At June 28, 2009, the aggregate intrinsic value of unvested options outstanding and options exercisable was $0 and $5,500, respectively. The intrinsic value of a stock option is the amount by which the market value of the underlying stock exceeds the exercise price of the option. There were no options exercised during the 39 weeks ended June 28, 2009.

The weighted average grant date fair value of options granted during fiscal 2006, fiscal 2007 and fiscal 2008 was $14.70, $14.10 and $1.72, respectively. The total intrinsic value of options exercised during fiscal 2006, fiscal 2007 and fiscal 2008 was $170,300, $37,300 and $9,300, respectively.

The amount of compensation expense related to outstanding stock options not yet recognized at June 28, 2009 was $6,000 and, assuming the grantees continue to be employed by or remain as directors of the Company, that amount will be recognized as compensation expense as follows:

FY 2009 (remainder of year)		$	1,000
FY 2010			3,600
FY 2011			1,400
Total		$	6,000

The following table summarizes nonvested stock grants outstanding as of June 28, 2009 as well as activity during the 39-week period then ended:

						Weighted
						Average Grant
		Nonvested Shares				Date Fair Value
		(1)				per Share
Outstanding at September 28, 2008			26,900			$	11.30
Granted			70,400				0.36
Vested			(10,800	)			10.90
Forfeited			(2,300	)			8.83
Outstanding at June 28, 2009			84,200			$	2.27

The amount of compensation expense related to nonvested stock grants not yet recognized at June 28, 2009 was $100,800 and, assuming the grantees continue to be employed by or remain as directors of the Company, that amount will be recognized as compensation expense as follows:

FY 2009 (remainder of year)		$	26,700
FY 2010			65,200
FY 2011			8,200
FY 2012			700
Total		$	100,800

Employee Stock Benefit Plan. In October 2008, the Board of Directors authorized the Company to make a contribution to the Company’s ESBP in the amount of $750,000, which represented a contribution for fiscal 2009 equal to approximately 9% of the Company’s expected gross salary and wages of its employees for fiscal 2009. As has been the Company’s prior practice, the $750,000 contribution for fiscal 2009 was made in shares of the Company’s common stock valued at the closing sales price of the Company’s common stock on the date of the authorization of the contribution by the Board of Directors. Of the fiscal 2009 contribution, $562,500 was amortized in the 39-week period ended June 28, 2009. The $187,500 portion of the fiscal 2009 contribution that had not been amortized at June 28, 2009 has been recorded as a prepaid ESBP contribution in equity and will be amortized over the remaining quarter of fiscal 2009. Pursuant to the ESBP provision, vesting requirements are met as services are performed and fulfilled at each fiscal year end.

Deferred Compensation Plan. In September 2002, the Company established a deferred compensation plan, the Non-Qualified Deferred Compensation Plan, for certain key employees with long-term service with the Company. At the discretion of the Board of Directors, annual contributions of common stock of the Company are made to a Rabbi Trust under such plan to be held for the benefit of the deferred compensation plan participants. In October 2007, the Board of Directors authorized a fiscal 2008 contribution to the deferred compensation plan in the amount of 10,000 shares of common stock valued at $99,000. Of this contribution, $74,200 was amortized in the 39-week period ended June 29, 2008. The $24,800 portion of the fiscal 2008 contribution that had not been amortized at June 29, 2008 was recorded as a prepaid contribution in equity to be amortized over the remaining quarter of fiscal 2008. As of June 28, 2009, the Board of Directors had not authorized a fiscal 2009 contribution to the deferred compensation plan and no accrual for such expense has been recorded in the Company’s financial statements. Participants’ potential distributions from the Rabbi Trust represent unsecured claims against the Company. The Rabbi Trust was established by the Company and is subject to creditors’ claims. Shares in this plan may be distributed to each plan beneficiary when they retire from service with the Company. At June 28, 2009, 65,000 shares of the Company’s common stock were in the Rabbi Trust.

Executive Salary Continuation Plan (the “ESCP”). In February 1996, the Company established a deferred compensation plan, the ESCP, for select key employees of the Company. Benefits payable under the ESCP are established on the basis of years of service with the Company, age at retirement and base salary, subject to a maximum benefits limitation of $137,000 per year for any individual. The ESCP is an unfunded plan. The recorded liability for future expense under the ESCP is determined based on expected lifetime of participants using Social Security mortality tables and discount rates comparable to that of rates of return on high quality investments providing yields in amount and timing equivalent to expected benefit payments. At the end of each fiscal year, the Company determines the assumed discount rate to be used to discount the ESCP liability. The Company considered various sources in making this determination for fiscal 2008, including the Citigroup Pension Liability Index, which at September 30, 2008 was 7.5%. Based on this review, the Company used a 7% discount rate for determining the ESCP liability at September 28, 2008. There are presently two retired executives of the Company who are receiving lifetime benefits aggregating $184,700 per annum under the ESCP. Two current executives of the Company are eligible for lifetime benefits of $137,000 per annum each upon their retirement. The current and long-term portions of the ESCP liability at June 28, 2009 are $184,700 and $3,391,600, respectively, for an aggregate liability of $3,576,300. The current and long-term portions of the ESCP liability at September 28, 2008 are $184,700 and $3,484,800, respectively, for an aggregate liability of $3,669,500.

Note 7 — Income (Loss) per Share

The Company had a net loss for all current and prior periods presented except for the 39-week period ended June 28, 2009. Accordingly, for the 13-week period ended June 28, 2009, the 13-week period June 29, 2008 and the 39-week period ended June 29, 2008, there was no difference between basic and diluted loss per share in each period. In the 39-week period ended June 28, 2009, application of the “as-if-converted” method to the Company’s convertible preferred stock resulted in said instruments being anti-dilutive and therefore not impacting calculation of income per share. However, as of June 28, 2009, the Company had outstanding stock options and nonvested stock with exercise or valuation prices less than the average closing market price of the Company’s common stock over the 39-week period ended June 28, 2009. Such “in-the money” instruments are assumed to have been exercised or vested at the beginning of a period (or at time of issuance, if later) for purposes of calculating diluted income per share if the Company has recorded a year-to-date income through said period, which was the case in the 39-week period ended June 28, 2009. As a result, basic and diluted net income per common share are different for the 39-week period ended June 28, 2009. Cumulative dividends on the Series A-1 Stock and Series A-2 Stock, although not declared, constitute a preferential claim against future dividends, if any, and are treated as an incremental expense of continuing operations for purposes of determining basic and diluted net income (loss) from continuing operations per common share.

The following table sets forth the computation of basic and diluted net income (loss) per common share:

		13 Weeks Ended								39 Weeks Ended
		June 28, 2009				June 29, 2008				June 28, 2009				June 29, 2008
Continuing Operations Numerator:
Income (loss) from continuing operations		$	(2,544,900	)		$	(2,876,400	)		$	410,600			$	(9,627,400	)
Undeclared cumulative dividends on Series A-1 and Series A-2 preferred stock			(121,700	)			(78,400	)			(325,900	)			(78,400	)
Adjusted basic and diluted net income (loss) applicable to common stockholders		$	(2,666,600	)		$	(2,954,800	)		$	84,700			$	(9,705,800	)
Discontinued Operations Numerator:
Income (loss) from discontinued operations		$	—			$	267,100			$	58,400			$	(162,300	)
Basic Net Income (Loss) Continuing and Discontinued Operations Denominator:
Weighted average number of common shares outstanding			7,708,400				3,059,000				6,257,000				2,917,100
Basic net income (loss) per share information:
From continuing operations		$	(0.35	)		$	(0.97	)		$	0.01			$	(3.33	)
From discontinued operations			(0.00	)			0.09				0.01				(0.06	)
Basic net income (loss) per common share		$	(0.35	)		$	(0.88	)		$	0.02			$	(3.39	)
Diluted Net Income (Loss) Continuing and Discontinued Operations Denominator:
Assumed net exercise and vesting of options and nonvested stock			—				—				2,500				—
Weighted average number of common shares outstanding			7,708,400				3,059,000				6,257,000				2,917,100
Assumed weighted common shares outstanding			7,708,400				3,059,000				6,259,500				2,917,100
Diluted net income (loss) per share information:
From continuing operations		$	(0.35	)		$	(0.97	)		$	0.01			$	(3.36	)
From discontinued operations			(0.00	)			0.09				0.01				(0.06	)
Diluted net income (loss) per common share		$	(0.35	)		$	(0.88	)		$	0.02			$	(3.39	)

Note 8 — Inventories, Net

Net inventories at June 28, 2009 and September 28, 2008 are set forth below.

		June 28,				September 28,
		2009				2008
Inventory:
Work in process		$	1,100,500			$	1,827,700
Raw materials			471,500				494,600
Finished goods			160,900				70,800
			1,732,900				2,393,100
Less reserve for obsolete inventory			(377,300	)			(1,266,200	)
		$	1,355,600			$	1,126,900

Title to all inventories remains with the Company. Inventoried materials and costs relate to: work orders from customers; the Company’s generic module parts and memory stacks; and capitalized material, labor and overhead costs expected to be recovered from probable new research and development contracts. Work in process includes amounts that may be sold as products or under contracts. Such inventoried costs are stated generally at the total of the direct production costs including overhead. Inventory valuations do not include general and administrative expenses. Inventories are reviewed quarterly to determine salability and obsolescence. The net book value of capitalized pre-contract costs, which gross costs are included in the caption “Work in process,” at June 28, 2009 and September 28, 2008 was $567,400 and $676,000, respectively.

Note 9 — Intangible Assets, Net

The Company’s intangible assets are reported at cost less accumulated amortization and consist of patents and trademarks related to the Company’s various technologies and capitalized software. Net intangible assets at June 28, 2009 and September 28, 2008 are set forth below.

		June 28,				September 28,
		2009				2008
Intangible assets, net:
Patents and trademarks		$	21,500			$	1,617,500
Software			2,394,600				2,456,600
			2,416,100				4,074,100
Less accumulated amortization			(2,330,500	)			(3,068,600	)
		$	85,600			$	1,005,500

Capitalized software is being amortized on a straight-line basis over its useful life of two to eight years. Capitalized costs of patents and trademarks include amounts paid to third parties for legal fees, application fees and other direct costs incurred in the filing and prosecution of patent and trademark applications. These assets are amortized on a straight-line method over the shorter of their estimated useful or legal life, generally ten years.

Pursuant to the Patent Sale and License in March 2009, the Company sold most of its patents in consideration for a cash payment of $9.5 million, $8.5 million of which was paid to the Company in March 2009 and the remaining $1.0 million was paid in April 2009. The Patent Sale and License was with an unrelated party, the purchase price was nonrefundable, control over the purchased assets was fully transferred to the purchaser at the time of sale and there were no obligations precluding full recognition of the transaction. The carrying value of the patents sold at the transaction date was approximately $867,200 and accordingly was removed from the Company’s books. The purchaser granted the Company, for no charge, a royalty-free, worldwide, non-exclusive license to use in the Company’s business the patents sold pursuant to the Patent Sale and License. The Company realized a gain of $0 and $8,632,800 from the sale of these patent assets in the 13-week and 39-week periods ended June 28, 2009, respectively.

The patent and trademark amortization expense for the 13-week and 39-week periods ended June 28, 2009 was $2,100 and $92,300, respectively. The patent and trademark amortization expense for fiscal 2008 was $154,200, of which $38,000 and $114,200 was incurred in the 13-week and 39-week periods ended June 29, 2008. The aggregate amortization of identifiable intangible assets for the 39-week periods ended June 28, 2009 and June 29, 2008 was $165,000 and $280,600, respectively. The unamortized balance of intangible assets at June 28, 2009 is estimated to be amortized over the balance of this fiscal year and the next five fiscal years thereafter as follows:

For the Fiscal Year		Estimated Amortization Expense
2009 (remainder of year)		$	20,200
2010			51,500
2011			2,200
2012			2,200
2013			2,200
2014			1,900

The Company reviews its intangible assets for impairment when and if impairment indicators occur as required by SFAS 142, in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. At June 28, 2009 and September 28, 2008, management believed no indications of impairment existed.

Note 10 — Reportable Segments

The Company manages its operations through two reportable segments, the contract research and development segment and the product segment.

The Company’s contract research and development segment provides services, largely to U.S. government agencies and government contractors, under contracts to develop prototypes and provide research, development, design, testing and evaluation of complex detection and control defense systems. The Company’s research and development contracts are usually cost reimbursement plus fixed fee, which require the Company’s good faith performance of a statement of work within overall budgetary constraints, but with latitude as to resources utilized, or fixed price level of effort, which require the Company to deliver a specified number of labor hours in the performance of a statement of work. Occasionally, the Company’s research and development contracts are firm fixed price, which require the delivery of specified work products independent of the resources or means employed to satisfy the required deliveries.

Currently, the Company’s product segment primarily consists of stacked semiconductor chip assemblies, electronic chips and miniaturized cameras, largely all of which are based on proprietary designs of the Company.

The Company’s management evaluates financial information to review the performance of the Company’s research and development contract business separately from the Company’s product business, but only to the extent of the revenues and the cost of revenues of the two segments. Because the various indirect expense operations of the Company, as well as its assets, now support all of its revenue-generating operations in a matrix manner, frequently in circumstances in which a distinction between research and development contract support and product support is difficult to identify, segregation of these indirect costs and assets is impracticable. The revenues and gross profit or loss of the Company’s two reportable segments for the 13-week and 39-week periods ended June 28, 2009 and June 29, 2008 are shown in the following table. The accounting policies used to develop segment information correspond to those described in the summary of significant accounting policies.

		13 Weeks Ended								39 Weeks Ended
		June 28,				June 29,				June 28,				June 29,
		2009				2008				2009				2008
Contract research and development revenue		$	2,508,500			$	4,189,900			$	7,247,000			$	11,266,100
Cost of contract research and development revenue			1,705,200				3,176,800				5,651,100				8,868,300
Contract research and development segment gross profit		$	803,300			$	1,013,100			$	1,595,900			$	2,397,800
Product sales		$	262,700			$	482,000			$	1,099,400			$	2,385,900
Cost of product sales			323,000				332,400				1,110,800				1,775,300
Product segment gross profit (loss)		$	(60,300	)		$	149,600			$	(11,400	)		$	610,600

Reconciliations of segment revenues to total revenues are as follows:

		13 Weeks Ended								39 Weeks Ended
		June 28,				June 29,				June 28,				June 29,
		2009				2008				2009				2008
Contract research and development revenue		$	2,508,500			$	4,189,900			$	7,247,000			$	11,266,100
Product sales			262,700				482,000				1,099,400				2,385,900
Other revenue			3,300				8,000				12,800				20,500
Total revenues		$	2,774,500			$	4,679,900			$	8,359,200			$	13,672,500

Reconciliations of segment gross profit to income (loss) from continuing operations before minority interest and provision for income taxes are as follows:

		13 Weeks Ended								39 Weeks Ended
		June 28,				June 29,				June 28,				June 29,
		2009				2008				2009				2008
Contract research and development segment gross profit		$	803,300			$	1,013,100			$	1,595,900			$	2,397,800
Product segment gross profit (loss)			(60,300	)			149,600				(11,400	)			610,600
Net segment gross profit			743,000				1,162,700				1,584,500				3,008,400
Add (deduct)
Other revenue			3,300				8,000				12,800				20,500
General and administrative expense			(2,862,500	)			(2,439,400	)			(6,982,200	)			(7,012,600	)
Research and development expense			(531,300	)			(454,600	)			(1,318,000	)			(1,094,700	)
Interest expense			(218,400	)			(1,464,600	)			(1,458,100	)			(4,847,400	)
Gain on sale or disposal of assets			8,000				314,800				8,640,800				315,600
Other income			5,000				900				51,700				1,900
Income (loss) from continuing operations before minority interest and provision for income taxes		$	(2,852,900	)		$	(2,872,200	)		$	531,500			$	(9,608,300	)

Note 11 — Concentration of Revenues and Sources of Supply

In the 13-week and 39-week periods ended June 28, 2009, direct contracts with the U.S. government accounted for 57% and 57%, respectively, of the Company’s total revenues, and second-tier government contracts with prime government contractors accounted for 39% and 26% of total revenues, respectively. The remaining 4% and 17% of the Company’s total revenues in the 13-week and 39-week periods ended June 28, 2009, respectively, were derived from non-government sources. Of the revenues derived directly or indirectly from U.S. government agencies, the U. S. Air Force and the U.S. Army accounted for 41% and 12%, respectively, of total revenues in the 13-week period ended June 28, 2009 and 33% and 13%, respectively, of total revenues in the 39-week period ended June 28, 2009. Loss of any of these customers would have a material adverse impact on our business, financial condition and results of operations. No other single governmental or non-governmental customer accounted for more than 10% of the total consolidated revenues in the 13-week and 39-week periods ended June 28, 2009.

In the 13-week and 39-week periods ended June 29, 2008, direct contracts with the U.S. government accounted for 44% and 38%, respectively, of the Company’s total revenues, and second-tier government contracts with government contractors accounted for 40% and 44% of total revenues, respectively. The remaining 16% and 18% of the Company’s total revenues in the 13-week and 39-week periods ended June 29, 2008, respectively, were derived from non-government sources, of which 16% and 13%, respectively, of the Company’s total revenues in the 13-week and 39-week periods ended June 29, 2008 were derived from Pixel Optics. Of the revenues derived directly or indirectly from U.S. government agencies, the U.S. Air Force, SAIC, a government contractor, and OASYS Technology, a government contractor, accounted for 37%, 21% and 7%, respectively, of total revenues in the 13-week period ended June 29, 2008 and 31%, 19% and 11%, respectively, of total revenues in the 39-week period ended June 29, 2008.

The Company primarily uses contract manufacturers to fabricate and assemble its stacked chip, microchip and sensor products. At current limited levels of sales, the Company typically uses a single contract manufacturer for such products and, as a result, is vulnerable to disruptions in supply. The Company also uses contract manufacturers for production of its visible camera products, except for final testing, which the Company performs itself. The Company currently assembles, calibrates and tests its thermal camera and software products itself, given the relatively low volumes of these products. The Company’s various thermal and visible camera products presently rely on a limited number of suppliers of imaging chips that meet the quality and performance requirements of the Company’s products, which makes the Company vulnerable to potential disruptions in supply of such imaging chips.

Note 12 — Commitments and Contingencies

Litigation. In January 2008, Timothy Looney, the former shareholder of Optex, filed a lawsuit in the Superior Court of California, County of Orange, against the Company and its senior lenders alleging that the Company had breached its contract to register the shares of the Company’s common stock issued to Mr. Looney to purchase the final 30% of Optex. Mr. Looney also alleged that the Company’s senior lenders had tortiously and negligently interfered with his contractual rights with the Company by requiring the Company to refrain from registering his securities. In March of 2009, the Company received notice that the senior lenders had reached a settlement with Mr. Looney, the terms of which are unknown. The senior lenders have notified the Company that they believe they are entitled to indemnification by the Company for this claim under their loan arrangements with the Company, and the Company has paid such indemnification expense. (See also Note 5). Pursuant to this lawsuit, Mr. Looney is seeking partial liquidated damages, declarative and injunctive relief compelling the Company to register his shares and unspecified compensatory damages.

In June 2008, the Company filed a cross-complaint against Mr. Looney in the Superior Court of California, County of Orange, in response to the January 2008 action discussed above, alleging that Mr. Looney fraudulently and negligently misrepresented the financial condition of Optex prior to its sale to the Company and breached his contractual obligations to the Company subsequent to that sale. Pursuant to this cross-complaint, the Company sought compensatory and punitive damages and attorney’s fees.

Trial of Mr. Looney’s January 2008 lawsuit against the Company and the Company’s June 2008 cross-complaint against Mr. Looney was completed in July 2009. A jury verdict was reached awarding Mr. Looney liquidated damages of $105,000, with the court rejecting Mr. Looney’s claim for additional compensatory damages based on the Company’s motion, and the Company’s cross-complaint against Mr. Looney with respect to allegations of fraud was denied. The results of the trial are potentially subject to post trial motions and appeal by either or both parties. Depending on the disposition of pending matters or appeals, the Company may also be subject to judgment for Mr. Looney’s legal expenses, but such an outcome is presently indeterminable.

In December 2008, Mr. Looney filed another lawsuit in the Superior Court of California, County of Orange alleging breach of contract. Mr. Looney alleges that the UCC foreclosure sale of the assets of Optex constituted a “change-in-control” and claims that the Company is required to pay him an earn-out payment of $3.9 million. The Company believes that it has meritorious defenses to this claim. The Company has also filed a cross-complaint against Mr. Looney in this proceeding, repeating the allegations of the earlier suit that Mr. Looney fraudulently and negligently misrepresented the financial condition of Optex prior to its sale to the Company and breached his contractual obligations to the Company subsequent to that sale. Pursuant to this cross-complaint, the Company is seeking compensatory and punitive damages and attorney’s fees. On July 30, 2009, the court denied Mr. Looney’s motion for summary adjudication of his claim. This litigation is set for trial on January 25, 2010.

In September 2008, Mr. Looney filed a lawsuit in the United States District Court, Central District of California, against John Carson, the Company’s CEO, and John Stuart, the Company’s CFO, alleging that Messrs. Carson and Stuart negligently misrepresented financial information of the Company when the Company was negotiating with Mr. Looney regarding the acquisition of Optex. Mr. Carson and Mr. Stuart strongly deny these allegations. Pursuant to this lawsuit, Mr. Looney is seeking recovery of damages, interest and costs. Because the alleged actions of Mr. Carson and Mr. Stuart were arguably in their capacity as officers of the Company, the Company has agreed to defend Messrs. Carson and Stuart in this lawsuit, subject to waivers of any conflict of interests that may arise, and may be required to indemnify Messrs. Carson and Stuart in this matter. Trial of this matter is currently set for October 20, 2009.

In April 2009, Mr. Looney initiated litigation against the Company for breach of contract for alleged default under the $400,000 one-year unsecured subordinated promissory note in the State District Court of Dallas County, Texas. Also in April 2009, TWL Group, LP, an entity owned by Mr. Looney, initiated litigation against Optex for breach of contract for alleged default under a $2 million secured subordinated note. As a result of the Company’s filings, the litigation on the $400,000 note has been removed to the Federal District Court of Northern Texas. The Company’s defenses against each of these matters are related to its defenses and cross-claims in the California courts, defenses the Company intends to pursue vigorously in each venue.

The outcome of litigation is inherently uncertain, and it is currently not possible to estimate the range of possible loss that the Company might realize in the event of an adverse outcome from the various litigations with Mr. Looney. In the event of one or more unfavorable outcomes, there could be a material and adverse effect on the financial condition of the Company.

In April 2008, the Company filed a lawsuit in the Superior Court of California, County of Orange, against Elizabeth Cooper, LLC doing business as iPIG Dev., Elizabeth Cooper, an individual, Eveready Industrial Services Inc., and Steve Morrison, an individual, in his capacity as Eveready’s agent. The lawsuit alleged various causes of action relating to breach of contract, interference with contract, business torts and indemnity claims arising out of a March 2007 development agreement between the Company and iPIG with respect to prototype development of electronic hardware. Because of iPIG’s alleged breaches, the Company had discontinued work under the development agreement in February 2008, which in turn, generated a demand for arbitration by iPIG in March 2008 under an arbitration clause in the agreement. The arbitration demand requested that the Company continue work on the project without compensation and that it deliver the prototype designs developed at the Company’s expense to iPIG. In November 2008, this litigation was settled in consideration of a cash payment to the Company and the return of certain materials to the defendants related to the development agreement.

In March 2009, FirstMark III, LP, formerly known as Pequot Private Equity Fund III, LP, filed a lawsuit in the state Supreme Court of New York County, New York, against the Company. The litigation alleges breach of a December 29, 2006, settlement agreement between FirstMark III, LP’s predecessor, and the Company that was intended to resolve certain disputes relating to convertible notes owed by the Company. The Company is currently in negotiations with FirstMark III, LP, to resolve the matter without further litigation, but such an outcome cannot be assured.

The Company has been, and may from time to time become, a party to various other legal proceedings arising in the ordinary course of its business. Management does not presently know of any such matters, the disposition of which would be likely to incur a material effect on the Company’s consolidated financial position, results of operations or liquidity.

Note 13 — Income Taxes

The income tax provision is based upon management’s review of the Company’s estimated annual income tax rate, including state taxes. The income tax provisions for fiscal 2008 are based solely on an allocable portion of state minimum taxes. The income tax provisions for fiscal 2009 are based on an allocable portion of federal alternative minimum taxes and state taxes resulting from the expiration of state carryforward loss provisions.

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. The accounting provisions of FIN 48 became effective for the Company beginning October 1, 2007. The Company evaluated the application of FIN 48 for the quarter ended December 30, 2007 and concluded that under its provisions no additional accrual for taxes, penalty or interest was required. Interest and penalties related to uncertain tax positions will be reflected in income tax expense.

At September 28, 2008, the Company had net operating loss (“NOL”) carryforwards of approximately $131,342,000 for financial reporting and federal income tax purposes expiring in varying amounts from fiscal 2009 through fiscal year 2028, and $58,242,000 for California tax purposes expiring in varying amounts from fiscal 2009 through fiscal year 2018, available to offset future federal and California taxable income. In addition, as of September 28, 2008, the Company had qualified research credits of $2,127,000, expiring in varying amounts through fiscal year 2028, which are available to offset future income taxes. The ability of the Company to utilize the net operating loss and credit carryforwards is likely to be restricted by certain provisions of the Internal Revenue Code due to changes in ownership of the Company’s common stock. Because realization of such tax benefits is uncertain, the Company has provided a 100% valuation allowance as of June 28, 2009 and September 28, 2008. In general, an ownership change results from transactions increasing the ownership of certain shareholders or public groups in the stock of a corporation by more than 50 percentage points over a three-year period. Since the Company’s formation, the Company has raised capital through the issuance of capital stock on numerous occasions which, combined with the purchasing stockholders’ subsequent disposition of those shares, may have resulted in a change of control for tax purposes or could result in a change of control for tax purposes in the future upon subsequent disposition. The Company has not currently completed a study to assess whether a change in control for tax purposes has occurred or whether there have been multiple changes of control for tax purposes since the Company’s formation due to the significant complexity and cost associated with such study and that there could be additional changes in the future. If the Company has experienced a change of control for tax purposes at any time since Company formation, utilization of the Company’s NOL or R&D credit carryforwards would be subject to an annual limitation under Sections 382 and 383 of the Internal Revenue Code, determined by first multiplying the value of the Company’s stock at the time of the ownership change by the applicable long-term tax-exempt rate, and then could be subject to additional adjustments, as required. Any limitation may result in expiration of a portion of the NOL or R&D credit carryforwards before utilization.

Note 14 — Related Party Transactions

In December 2005, the Company amended and restated its consulting agreement entered into in May 2005 and amended in August 2005, with one of the Company’s then directors, Chris Toffales, and his consulting firm, CTC Aero, LLC, of which he is sole owner. The December 2005 amendment extended the term of the agreement from one year to three years, increased the monthly consulting fee for business development services from $15,000 to $21,000 per month and changed the terms for payment of any fee that could have been earned by CTC Aero and Mr. Toffales in connection with potential acquisition activities of the Company. In accordance with this agreement, Mr. Toffales earned a fee of $500,000 as a result of the acquisition of Optex plus due diligence fees and expenses of $20,300. Pursuant to the December 2005 amendment, the Company also was to pay an additional amount in cash equal to 35% of the acquisition related fee and future acquisition fees, if any, were to be payable in unregistered shares of the Company’s common stock in an amount equal to between 5% and 1% of the total purchase price paid by the Company for such acquisition, which percentage was to decrease based upon the total acquisition purchase price, and valued at the same per share purchase price as agreed upon in the applicable acquisition. The minimum acquisition related fee, if any, remained unchanged by the December 2005 amendment at $150,000. The acquisition related fee and other amounts due to Mr. Toffales under the consulting agreement were retired in December 2007 pursuant to a Consulting Termination Agreement and Release (the “Release”). Pursuant to the Release, the consulting agreement by and among the Company, CTC and Mr. Toffales, as amended and restated in December 2005, was terminated. In consideration for prior services rendered to the Company, (i) the Company issued to Mr. Toffales 50,000 shares of restricted common stock of the Company under the Company’s 2006 Omnibus Incentive Plan, which shares vested in full on January 6, 2008, and (ii) the Company issued to Mr. Toffales an additional 50,000 shares of unrestricted common stock of the Company under the Company’s 2006 Omnibus Incentive Plan on January 7, 2008. In addition, the Company also made a cash payment to each of Mr. Toffales and CTC in the amount of $500, and the parties to the Release released all claims against the other parties and certain of their affiliates. The Release further provided that Mr. Toffales resign from the Company’s Board of Directors, which resignation became effective on December 28, 2007, and as a consultant to the Company, which resignation became effective in January 2008. The value assigned to the shares issued under the Release, $800,000, based on the $8.00 per share closing price of the Company’s common stock on December 28, 2007, was approximately equal to unpaid amounts previously accrued under the terminated consulting agreement as services were performed thereunder. CTC Aero also earned a fee of $127,500 paid by Pequot, the Company’s then lender, in connection with the private placement of the convertible debt entered into by the Company to partially finance the Initial Acquisition of Optex.

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

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

•

our ability to obtain additional financing for working capital on acceptable terms in a timely manner;

•

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

•

the outcome of existing litigation;

•

our ability to continue as a going concern;

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

the pace at which new markets develop;

•

our ability to establish strategic partnerships to develop our business;

•

our limited market capitalization;

•

general economic and political instability; and

•

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

We do not undertake any obligation to revise or update publicly any forward-looking statements for any reason, except as required by law. Additional information on the various risks and uncertainties potentially affecting our operating results are discussed below and are contained in our publicly filed documents available through the SEC’s website (www.sec.gov) or upon written request to our Investor Relations Department at 3001 Red Hill Avenue, Costa Mesa, California 92626.

Overview

We are a vision systems company enabled by technology for three-dimensional packaging of electronics and manufacturing of electro-optical products. We design, develop, manufacture and sell vision systems and miniaturized electronic products for defense, security and commercial applications. We also perform customer-funded contract research and development related to these products, mostly for U.S. government customers or prime contractors. Most of our historical business relates to application of our technologies for stacking either packaged or unpackaged semiconductors into more compact three-dimensional forms, which we believe offer volume, power, weight and operational advantages over competing packaging approaches, and which we believe allows us to offer higher level products with unique operational features.

In December 2005, we completed the Initial Acquisition of Optex, a privately held manufacturer of telescopes, periscopes, lenses and other optical systems and instruments whose customers were primarily agencies of and prime contractors to the U.S. Government. In consideration for the Initial Acquisition, we made an initial cash payment to the sole shareholder of Optex, Timothy Looney, in the amount of $14.0 million and made an additional cash payment of $64,200 to Mr. Looney in July 2006 upon completion of the audit of Optex’s financial statements for the year ended December 31, 2005. As additional consideration, we were initially required to pay to Mr. Looney cash earnout payments in the aggregate amount up to $4.0 million based upon the net cash generated from the Optex business, after debt service, for fiscal 2006 and the next two subsequent fiscal years. Mr. Looney was not entitled to any earnout payments for fiscal 2006, for fiscal 2007 or for fiscal 2008. In January 2007, we negotiated an amendment to our earnout agreement with Mr. Looney that extended his earnout period to December 2009 and reduced the aggregate maximum potential earnout by $100,000 to $3.9 million in consideration for a secured subordinated term loan providing for advances from an entity owned by Mr. Looney to Optex of up to $2 million. This term loan bears interest at 10% per annum and matures on the earlier of February 2009 or 60 days after repayment of our senior debt. As of June 28, 2009, this term loan was fully advanced to Optex. Mr. Looney has brought a lawsuit against the Company alleging that the Company is obligated to pay him the full earnout as a result of the Optex Asset Sale. (See Part II, Item 1, Legal Proceedings).

In connection with the Initial Acquisition, we entered into the Buyer Option with Mr. Looney, pursuant to which we agreed to purchase the remaining 30% of the capital stock of Optex held by Mr. Looney. On December 29, 2006, we amended certain of our agreements with Mr. Looney regarding the Buyer Option. In consideration for such amendments, we issued a one-year unsecured subordinated promissory note to Mr. Looney in the principal amount of $400,000, bearing interest at a rate of 11% per annum. We exercised the Buyer Option on December 29, 2006 and issued Mr. Looney approximately 269,231 shares of our common stock as consideration for our purchase of the remaining 30% of the outstanding common stock of Optex held by him. As a result of the Initial Acquisition and exercise of the Buyer Option, Optex became our wholly-owned subsidiary.

We financed the Initial Acquisition of Optex by a combination of $4.9 million of senior secured debt from Square 1 Bank under a term loan and $10.0 million of senior subordinated secured convertible notes from two private equity funds, which are sometimes referred to in this report collectively as “Pequot.” In December 2006, both of these obligations were refinanced with two new senior Lenders, Longview and Alpha. These transactions resulted in approximately $4.4 million of non-recurring debt extinguishment expenses, which were largely non-cash, and approximately $12.4 million of future additional interest expense resulting from debt discounts and issuance costs. In November 2007, we restructured these obligations, as well as a short-term $2.1 million debt obligation to Longview, to extend the maturity date of all of such obligations, including the related interest, to December 30, 2009 in consideration for a restructuring fee of approximately $1.1 million, which fee was also initially payable December 30, 2009, but which was extended to September 30, 2010 in connection with partial repayment related to the Patent Sale and License.

In September 2008, we entered into a binding Memorandum of Understanding for Settlement and Debt Conversion Agreement (the “MOU”) with the Lenders with the intent to effect a global settlement and restructuring of our aggregate outstanding indebtedness payable to the Lenders, which was then approximately $18.4 million. In October 2008, pursuant to the MOU, an entity controlled by the Lenders delivered a notice to us and to Optex of the occurrence of an event of default and acceleration of the obligations due to the Lenders and their assignee and conducted the Optex Asset Sale, which was a public UCC foreclosure sale of the assets of Optex. The entity controlled by the Lenders credit bid $15 million in the Optex Asset Sale, which was the winning bid. As a result, $15 million of our aggregate indebtedness to the Lenders was extinguished. All financial statements and notes and schedules thereto give effect to this event and report Optex as a discontinued operation for both the current and prior fiscal periods. We recorded a loss on disposal of the Optex discontinued operations of approximately $7.6 million during the fiscal year ended September 28, 2008.

In March 2009, we sold most of our patent portfolio to a patent acquisition company for $9.5 million in cash, $8.5 million of which was paid in March 2009 and $1.0 million of which was paid in April 2009, and the patent acquisition company granted us a perpetual, worldwide, royalty-free, non-exclusive license to use the sold patents in our business (the “Patent Sale and License”). In order to secure the release of security interests to effectuate the Patent Sale and License, we agreed to pay $2.8 million of the aggregate principal and accrued interest owed to the Lenders from the proceeds of the Patent Sale and License. After such payment, our aggregate principal and accrued interest owed to the Lenders was approximately $1.2 million. Subject to satisfying certain conditions, including our consummation of a $1.0 million bridge debt financing, the Lenders had agreed to exchange Notes in the amount of $1.0 million of such residual principal for a new class of non-voting convertible preferred stock of the Company. We completed such a bridge financing in February 2009 and satisfied other conditions for such exchange in April 2009, and $1.0 million of principal under our obligations was cancelled in through the exchange of Notes for the issuance of 24,999 shares of our newly-created Series A-2 Stock on April 30, 2009. The conversion of the Series A-2 Stock into shares of our common stock is subject to the same conversion blocker as contained in our Series A-1 Preferred Stock.

Since 2002, and prior to our acquisition of Optex, we historically derived a substantial majority of our total revenues from government-funded research and development rather than from product sales. Optex also historically derived most of its revenues from product sales to government agencies or prime contractors. We anticipate that a substantial majority of our total revenues will continue to be derived from government-funded sources in the immediately foreseeable future. Prior to fiscal 2005, with a few exceptions, our government-funded research and development contracts were largely early-stage in nature and relatively modest in size. As a result, our revenues from this source during that period were not significantly affected by changes in the U.S. defense budget. In fiscal 2008, our contract research and development revenues were adversely affected by

procurement delays, as well as diversion of management and financial resources to address supply chain and margin issues at Optex. Our current marketing efforts are focused on government programs that we believe have the potential to transition to government production contracts. If we are successful in this transition, our future revenues may become more dependent upon U.S. defense budgets, funding approvals and political agendas. We are also attempting to increase our revenues from product sales by introducing new products with commercial applications, in particular, miniaturized cameras and stacked computer memory chips. We cannot assure you that we will be able to complete development, successfully launch or profitably manufacture and sell any such products on a timely basis, if at all. We generally use contract manufacturers to produce these products, and all of our other current operations occur at a single, leased facility in Costa Mesa, California. Prior to the Optex Asset Sale, Optex manufactured its products at its leased facility in Richardson, Texas.

We have a history of unprofitable operations due in part to our investment in Optex and due to discretionary investments that we have made to commercialize our technologies and to maintain our technical staff and corporate infrastructure at levels that we believed were required for future growth. These investments have yet to produce profitable operating results, except for the current 39-week period ended June 28, 2009 as a result of the Patent Sale and License. With respect to our investments in staff and infrastructure, the advanced technical and multi-disciplinary content of our technologies places a premium on a stable and well-trained work force. As a result, we generally maintain the size of our work force even when anticipated government contracts are delayed, a circumstance that has occurred with some frequency in the past and that has resulted in under-utilization of our labor force for revenue generation from time to time. Delays in receipt of research and development contracts are unpredictable, but we believe such delays represent a recurring characteristic of our research and development contract business. We anticipate that the impact on our business of future delays can be mitigated by the achievement of greater contract backlog and are seeking growth in our research and development contract revenue to that end. We are also seeking to expand the contribution to our total revenues from product sales, which have not historically experienced the same types of delays that can occur in research and development contracts. We have not yet demonstrated the level of sustained research and development contract revenue or product sales that we believe is required to achieve profitable operations. Our ability to recover our investments through the cost-reimbursement features of our government contracts is constrained due to both regulatory and competitive pricing considerations.

To offset the adverse working capital effect of our net losses, we have historically financed our operations through issuance of various equity and debt instruments. To finance the acquisition of Optex, we also incurred material long-term debt, and we have exchanged a significant portion of that debt into preferred stock that is convertible into our common stock. Since the beginning of fiscal 2006 through June 28, 2009, we have issued approximately 6.2 million shares of our common stock, an increase of approximately 330% over the approximately 1.9 million shares of our common stock outstanding at the beginning of that period, and a substantial dilution of stockholder interests. At June 28, 2009, our fully diluted common stock position was approximately 21.4 million shares, which assumes the conversion into common stock of all preferred stock outstanding as of June 28, 2009 and the exercise for cash of all outstanding warrants and options to purchase the Company’s securities. At June 28, 2009, we had approximately $588,400 of debt, exclusive of debt discounts and exclusive of the $2.0 million of debt owed by Optex.

None of our subsidiaries accounted for more than 10% of our total assets at June 28, 2009 or have separate employees or facilities. We currently report our operating results and financial condition in two operating segments, our research and development business and our product business.

Critical Accounting Estimates

Our consolidated financial statements have been prepared in conformity with GAAP. As such, management is required to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The significant accounting policies that are most critical to aid in fully understanding and evaluating reported financial results include the following:

Revenue Recognition. Our consolidated total revenues during the 39 weeks ended June 28, 2009 were primarily derived from contracts to develop prototypes and provide research, development, design, testing and evaluation of complex detection and control defense systems. Our research and development contracts are usually cost reimbursement plus a fixed fee, fixed price with billing entitlements based on the level of effort we expended or occasionally firm fixed price. Our cost reimbursement plus fixed fee research and development contracts require our good faith performance of a statement of work within overall budgetary constraints, but with latitude as to resources utilized. Our fixed price level of effort research and development contracts require us to deliver a specified number of labor hours in the performance of a statement of work. Our firm fixed price research and development contracts require us to deliver specified items of work independent of resources utilized to achieve the required deliverables. For all types of research and development contracts, we recognize revenues as we incur costs and include applicable fees or profits primarily in the proportion that costs incurred bear to estimated final costs. Costs and estimated earnings in excess of billings under government research and development contracts are accounted for as unbilled revenues on uncompleted contracts, stated at estimated realizable value and are expected to be realized in cash within one year.

Upon the initiation of each research and development contract, a detailed cost budget is established for direct labor, material, subcontract support and allowable indirect costs based on our proposal and the required scope of the contract as may have been modified by negotiation with the customer, usually a U.S. government agency or prime contractor. A program manager is assigned to secure the needed labor, material and subcontract in the program budget to achieve the stated goals of the contract and to manage the deployment of those resources against the program plan. Our accounting department collects the direct labor, material and subcontract charges for each contract on a weekly basis and provides such information to the respective program managers and senior management.

The program managers review and report the performance of their contracts against the respective program plans with our senior management on a monthly basis. These reviews are summarized in the form of estimates of costs to complete the contracts (“ETCs”). If an ETC indicates a potential overrun against budgeted program resources, it is the responsibility of the program manager to revise the program plan in a manner consistent with the customer’s objectives to eliminate such overrun and achieve planned contract profitability, and to seek necessary customer agreement to such revision. To mitigate the financial risk of such re-planning, we attempt to negotiate the deliverable requirements of our research and development contracts to allow as much flexibility as possible in technical outcomes. Given the inherent technical uncertainty involved in research and development contracts, in which new technology is being invented, explored or enhanced, such flexibility in terms is frequently achievable. When re-planning does not appear possible within program budgets, senior management makes a judgment as to whether the program statement of work will require additional resources to be expended to meet contractual obligations or whether it is in our interest to supplement the customer’s budget with our own funds. If either determination is made, we record an accrual for the anticipated contract overrun based on the most recent ETC of the particular contract.

We provide for anticipated losses on contracts by recording a charge to earnings during the period in which a potential for loss is first identified. We adjust the accrual for contract losses quarterly based on the review of outstanding contracts. Upon completion of a contract, we reduce any associated accrual of anticipated loss on such contract as the previously recorded obligations are satisfied. Costs and estimated earnings in excess of billings under government contracts are accounted for as unbilled revenues on uncompleted contracts and are stated at estimated realizable value.

We consider many factors when applying GAAP related to revenue recognition. These factors generally include, but are not limited to:

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The actual contractual terms, such as payment terms, delivery dates, and pricing terms of the various product and service elements of a contract;

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Time period over which services are to be performed;

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Costs incurred to date;

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Total estimated costs of the project;

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Anticipated losses on contracts; and

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Collectibility of the revenues.

We analyze each of the relevant factors to determine its impact, individually and collectively with other factors, on the revenue to be recognized for any particular contract with a customer. Our management is required to make judgments regarding the significance of each factor in applying the revenue recognition standards, as well as whether or not each factor complies with such standards. Any misjudgment or error by our management in evaluation of the factors and the application of the standards could have a material adverse effect on our future operating results.

We recognize revenue from product sales upon shipment, provided that the following conditions are met: