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U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-Q
 
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934.

 
For the quarterly period ended March 31, 2005
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the transition period from ________ to ________.
 
Commission File Number 000-50862
 
 
LUMERA CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
 
 
 
 
 
Delaware
 
91-2011728
(State or Other Jurisdiction of
Incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
19910 North Creek Parkway, Bothell, Washington 98011
(Address of Principal Executive Offices) (Zip Code)
 
(425) 415-6900
(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 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  Yes    ¨  No
 
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    ¨  Yes    x  No
 
As of March 31, 2005, 16,574,555 shares of the Company’s common stock, $0.001 par value, were outstanding.
 
 
1

PART I
FINANCIAL INFORMATION

 
Page
Item 1 - Financial Statements  (unaudited)
  
     
 
Condensed Balance Sheets as of March 31, 2005 and December 31, 2004
3
     
 
Condensed Statements of Operations for the three months ended
March 31, 2005 and 2004
4
     
 
Condensed Statements of Comprehensive Loss for the three months ended
March 31, 2005 and 2004
5
     
 
Condensed Statement of Changes in Shareholders' Equity for the period from
January 1, 2005 to March 31, 2005
6
     
 
Condensed Statements of Cash Flows for the three months ended
March 31, 2005 and 2004
7
     
 
Notes to Condensed Financial Statements
8
     
Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations
10
     
Item 3 - Quantitative and Qualitative Disclosures About Market Risk
22
     
Item 4 - Controls and Procedures
22

PART II
OTHER INFORMATION

Item 1 - Legal Proceedings
22
   
Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds
22
   
Item 6 - Exhibits and Reports on Form 8-K
22
 
2

PART I
FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

LUMERA CORPORATION

CONDENSED BALANCE SHEETS
 
   
March 31,
2005
  
December 31,
2004
  
Assets
  
 
      
Current Assets
  
 
      
Cashand cash equivalents
  
$
2,901,000
  
$
3,505,000
  
Investment securities, available-for-sale, current
    
23,570,000
    
15,460,000
  
Accounts receivable
    
91,000
    
32,000
  
Costs and estimated earnings in excess of billings on uncompleted contracts
    
111,000
    
3,000
  
Other current assets
    
546,000
    
623,000
  
 
              
Total current assets
    
27,219,000
    
19,623,000
  
Investment securities, available-for-sale, long-term
    
987,000
    
11,216,000
  
Property and equipment, net
    
1,873,000
    
2,047,000
  
 
              
TOTAL ASSETS
  
$
30,079,000
  
$
32,886,000
  
 
              
LIABILITIES AND SHAREHOLDERS’ EQUITY
            
CURRENT LIABILITIES
            
Accounts payable
  
$
344,000
  
$
416,000
  
Research liability
    
50,000
    
101,000
  
Accrued liabilities
    
914,000
    
976,000
  
 
              
Total current liabilities
    
1,308,000
    
1,493,000
  
 
              
COMMITMENTS AND CONTINGENCIES (Note 5)
    
   
 
               
SHAREHOLDERS’ EQUITY
          
 
Common stock, $0.001 par value, 120,000,000 shares authorized; 16,574,555 shares issued and outstanding at March 31, 2005 and 16,546,430 shares issued and outstanding at December 31, 2004
    
16,000
    
16,000
  
Additional Paid-in Capital
    
70,555,000
    
70,435,000
  
Deferred stock-based compensation
    
(503,000
)
  
(666,000
)
Accumulated other comprehensive loss
    
(172,000
)
  
(145,000
)
Accumulated deficit
    
(41,125,000
)
  
(38,247,000
)
 
              
Total shareholders’ equity
   
28,771,000
    
31,393,000
  
 
              
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
 
$
30,079,000
  
$
32,886,000
  
 
 
The accompanying notes are an integral part of these condensed financial statements.
 
3

LUMERA CORPORATION

CONDENSED STATEMENTS OF OPERATIONS
 
     
Three Months Ended March 31,
  
     
2005
    
2004
  
Revenue
  
$
240,000
  
$
316,000
  
Cost of revenue
    
168,000
    
194,000
  
 
              
GROSS PROFIT
    
72,000
    
122,000
  
 
              
Research and development expense
    
1,735,000
    
1,794,000
  
Marketing, general and administrative expense
    
1,384,000
    
920,000
  
 
              
Total operating expenses
    
3,119,000
    
2,714,000
  
 
              
Loss from operations
    
(3,047,000
)
  
(2,592,000
)
Interest income
    
169,000
    
—
 
 
              
Net loss
    
(2,878,000
)
  
(2,592,000
)
Deemed dividend upon issuance of mandatorily redeemable convertible preferred stock
    
—
   
(500,000
)
 
              
NET LOSS AVAILABLE TO COMMON SHAREHOLDERS
  
$
(2,878,000
)
$
(3,092,000
)
 
              
NET LOSS PER SHARE-BASIC AND DILUTED
  
$
(0.17
)
$
(0.50
)
 
              
WEIGHTED-AVERAGE SHARES OUTSTANDING—BASIC AND DILUTED
    
16,565,403
    
6,172,000
  
 
              
 
The accompanying notes are an integral part of these condensed financial statements.
 
4
 
LUMERA CORPORATION
 
STATEMENTS OF COMPREHENSIVE LOSS
 
     
For the three months ended
March 31,
  
     
2005
    
2004
  
Net loss
  
$
(2,878,000
)
$
(2,592,000
)
Other comprehensive loss - Unrealized loss
on investment securities, available-for-sale:
    
   
 
Unrealized holding losses arising during period
    
(27,000
)
  
—
 
 
              
Net unrealized loss
    
(27,000
)
  
—
 
 
              
Comprehensive loss
  
$
(2,905,000
)
$
(2,592,000
)
 
 
The accompanying notes are an integral part of these financial statements.
 
5

LUMERA CORPORATION
 
CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
FOR THE PERIOD FROM JANUARY 1, 2005 TO MARCH 31, 2005
 
     
Common Stock
    
Paid-in
Capital
    
Deferred
Stock
Compensation 
    
Accumulated
Other
Comprehensive
Income 
    
Accumulated
Deficit 
    
Total
Shareholders’
Equity 
  
     
Shares
    
$
    
$
    
$
    
$
    
$
    
$
  
Balance at January 1, 2005
    
16,546,430
  
$
16,000
  
$
70,435,000
  
$
(666,000
)
$
(145,000
)
$
(38,247,000
)
$
31,393,000
  
Exercises of options
    
28,125
        
91,000
    
   
   
   
91,000
  
Issuance of options for services
            
45,000
                
45,000
  
Amortization of deferred compensation, net of forfeitures
    
   
   
(16,000
)
  
163,000
    
   
   
147,000
  
Other comprehensive loss
    
   
   
   
   
(27,000
)
  
   
(27,000
)
Net Loss
    
   
   
   
   
   
   
   
   
    
   
(2,878,000
)
  
(2,878,000
)
 
                              
Balance at March 31, 2005
    
16,574,555
  
$
16,000
  
$
70,555,000
  
$
(503,000
)
$
(172,000
)
$
(41,125,000
)
$
28,771,000
  
 
                                            

 
The accompanying notes are an integral part of these condensed financial statements.
 
6

LUMERA CORPORATION

CONDENSED STATEMENTS OF CASH FLOWS

 
  
Three months ended March 31,
  
 
  
2005
  
2004
  
Cash flows from operating activities
  
 
  
 
  
Net loss
  
$
(2,878,000
)
$
(2,592,000
)
Adjustments to reconcile net loss to net cash used in operations
    
   
 
Depreciation
    
341,000
    
297,000
  
Noncash expenses related to issuance of stock, options and amortization of deferred compensation
    
125,000
    
807,000
  
Change in:
    
     
Accounts receivable
    
(59,000
)
  
151,000
  
Costs and estimated earnings in excess of billings on uncompleted contracts
    
(108,000
)
  
41,000
  
Other current assets
    
77,000
    
(119,000
)
Other assets
    
—
   
33,000
  
Accounts payable
    
(72,000
)
  
134,000
  
Payable to related party
    
—
   
85,000
  
Accrued liabilities
    
5,000
    
346,000
  
Research liability
    
(51,000
)
  
182,000
  
 
              
Net cash used in operating activities
    
(2,620,000
)
  
(635,000
)
 
              
Cash flows from investing activities
    
   
 
Maturities of investment securities
    
3,500,000
    
—
 
Purchases of investment securities
    
(1,408,000
)
  
—
 
Purchases of property and equipment
    
(167,000
)
  
(15,000
)
 
              
Net cash provided by (used in) investing activities
    
1,925,000
    
(15,000
)
 
              
Cash flows from financing activities:
    
   
 
Net proceeds from issuance of stock options
    
91,000
    
—
 
Net proceeds from issuance of mandatorily redeemable convertible preferred stock
    
—
   
500,000
  
 
              
Net cash provided by financing activities
    
91,000
    
500,000
  
 
              
Net increase (decrease) in cash and cash equivalents
    
(604,000
)
  
(150,000
)
Cash and cash equivalents at beginning of period
    
3,505,000
    
560,000
  
 
              
Cash and cash equivalents at end of period
  
$
2,901,000
  
$
410,000
  


The accompanying notes are an integral part of these condensed financial statements.
 
7

Notes to Condensed Financial Statements

1. Basis of Presentation

The accompanying condensed financial statements of Lumera Corporation (“Lumera” of the “Company”) have been prepared, without audit, pursuant to the rules and regulations of the United States of America Securities and Exchange Commission (SEC). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted as permitted by such rules and regulations. These financial statements should be read in conjunction with the audited financial statements and footnotes included in the Company’s 2004 annual report on Form 10-K as filed with the SEC.
 
These financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, contain all of the adjustments (normal and recurring in nature) necessary, in our opinion, to state fairly our financial position as of March 31, 2005 and the results of operations and cash flows for the periods presented. The results of operations for the periods presented may not be indicative of those you may expect for the full year or any future period.

2. Net Loss per Share

Basic net loss per share is calculated on the basis of the weighted-average number of common shares outstanding during the periods. Net loss per share assuming dilution is calculated on the basis of the weighted-average number of common shares outstanding and the dilutive effect of all potentially dilutive securities, including common stock equivalents and convertible securities.
 
Basic and diluted net loss per share is the same because all potentially dilutive securities outstanding are anti-dilutive. Potentially dilutive securities not included in the calculation of diluted earnings per share include Series A and Series B convertible preferred stock, options and warrants to purchase Class A common stock, and warrants to purchase Series A convertible preferred stock. Total common stock options and common stock warrants not included in the calculation of diluted earnings per share were 2,691,250 and 5,520,205 for the three months ended March 31, 2005 and 2004, respectively.

3. Stock-Based Compensation 

The Company accounts for stock-based employee compensation arrangements on the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees and related amendments and interpretations. The Company complies with the disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, which requires fair value recognition for employee stock-based compensation. The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), “Share-Based Payment”, which is a revision of SFAS No. 123 and supersedes APB Opinion No. 25. SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant, and to be expensed over the applicable vesting period. Pro forma disclosure of the income statement effects of share-based payments is no longer an alternative. SFAS No. 123(R) is effective for all share-based awards granted on or after January 1, 2006. In addition, companies must also recognize compensation expense related to any awards that are not fully vested as of the effective date. Compensation expense for the unvested awards will be measured based on the fair value of the awards previously calculated in developing the pro forma disclosures in accordance with the provisions of SFAS No. 123. We are evaluating the alternative methods for implementing SFAS No. 123(R).

In March 2004 the Company granted options under the 2000 Plan to its CEO and non-employee directors to purchase an aggregate of 410,000 shares of common stock with a weighted average exercise price of $2.00 per share which was below the then current market value. During the first three months of 2005 and 2004, the Company recognized compensation expense associated with these option grants of $66,000 and $480,000, respectively. In addition, the Company granted options to purchase 65,000 shares of Class A common stock to a Microvision employee. These options have been accounted for as a dividend to Microvision and recorded at their fair value of $272,000, in accordance with the guidance in EITF Issue No. 00-23 Issue 21, Options Granted to Employees of Entities under Common Control.
 
8
In April 2004 the Company granted options under the 2000 Plan to its employees to purchase an aggregate of 156,650 shares of common stock with a weighted average exercise price of $2.00 per share which was below the then current market value. In July 2004, the Company issued options under the 2000 Plan to its employees to purchase an aggregate of 78,250 shares of common stock with a weighted average exercise price of $3.76 per share which was below the then current market value.

A summary of stock compensation expense for each period is as follows:

 
  
For the three months
ended
March 31,
  
 
  
2005
  
2004
  
Employees
  
$
119,000
  
$
29,000
  
Directors
    
26,000
    
451,000
  
Third parties
    
(20,000
)
  
168,000
  
 
              
 
  
$
125,000
  
$
648,000
  
 
              
Component of:
    
   
 
Research and development
  
$
(2,000
)
$
168,000
  
Marketing, general and administrative
    
127,000
    
480,000
  
 
              
 
  
$
125,000
  
$
648,000
  


The following table illustrates the effect on net loss and net loss per share as if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data):
 
     
For the three months ended
March 31,
  
     
2005
    
2004
  
Net loss available to common shareholders, as reported
  
$
(2,878,000
)
$
(3,092,000
)
Deduct: Stock-based employee compensation expense included in net loss available to common shareholders, as reported
    
145,000
    
480,000
  
Add: Total stock-based employee compensation expense determined under fair value-based method for all awards
    
(547,000
)
  
(660,000
)
 
              
Net loss available to common shareholders, pro forma
  
$
(3,280,000
)
$
(3,272,000
)
 
              
Net loss per share, as reported (basic and diluted)
  
$
(0.17
)
$
(0.50
)
 
              
Net loss per share, pro forma (basic and diluted)
  
$
(0.20
)
$
(0.53
)
 
4. Shareholders' Equity
  
Convertible Preferred Stock In March 2004, the Company raised $500,000 from the sale of 250,000 shares of Series B convertible preferred stock to private investors issued in March 2004. The $2 per share conversion price of the Series B convertible preferred stock issued was less than the fair value of the Class A common stock on the issuance date. As a result, the Company recorded a $500,000 beneficial conversion feature upon issuance of the preferred stock. This amount was immediately recorded as a deemed dividend to preferred shareholders because the Series B convertible preferred stock had no stated term and was immediately convertible into Class A common stock, which was automatically converted to common stock upon the Company’s initial public offering.

9

5. Commitments and Contingencies
 
Agreements with the University of Washington—In October 2000, the Company entered into a license agreement (“License Agreement”) and a research agreement (“Sponsored Research Agreement” of “SRA”) with the University of Washington (“UW”). The License Agreement grants the Company rights to certain intellectual property including technology being developed under the sponsored Research Agreement whereby the Company has a royalty-bearing license to make, sell or sublicense the licensed technology.

Under the terms of the License Agreement, the Company issued 802,414 shares of the Company’s common stock to the UW. The shares, which are fully vested, were valued $3.0 million, recorded as prepaid stock-based research expense and fully amortized to expense as of March 31, 2004. The Company is also required to pay certain costs related to filing and processing of patents and copyrights related to the agreements. Additionally, the Company is required to pay certain ongoing royalty payments at a minimum of $75,000 per annum, which are amortized to expense throughout the year. The Company has not made any royalty payments to date in excess of these minimums. We have made payments to the University of Washington under the terms of a separate letter agreement for additional research related to the optical materials.
 
Under the terms of the Sponsored Research Agreement the Company has paid the UW a total of $5,375,000 over approximately four years for research services through March 31, 2005. The SRA terminates following the final payment of $375,000, to be made during the quarter ending June 30, 2005.

The following table summarizes payments made and expense recorded during the three months ending March 31, 2005 and 2004:
 
           
Expense (Benefit) Recognized
  
(in thousands)     
Payments
Made
    
Sponsored
Research
    
Optical
Materials
    
Minimum
Royalty
    
Expense
Recorded on
Payments
    
Amortization
of
Stock
    
Total
Expense
Recorded
  
Three months ended                                            
March 31, 2005
  
$
375
  
$
325
  
$
—
  
$
19
  
$
344
  
$
—
  
$
344
  
March 31, 2004
    
—
   
183
    
50
    
19
    
252
    
159
    
411
  
 
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

The information set forth in this report in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Item 3, “Quantitative and Qualitative Disclosure about Market Risk,” includes “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and is subject to the safe harbor created by that section. Such statements may include, but are not limited to, projections of revenues, income or loss, capital expenditures, plans for product development and cooperative arrangements, future operations, financing needs or plans of Lumera, as well as assumptions relating to the foregoing. The words “believe,” “expect,” “will,” “anticipate,” “estimate,” “project,” “plan,” and similar expressions identify forward-looking statements, which speak only as of the date the statement was made. Factors that could cause results to differ materially from those projected or implied in the forward-looking statements are set forth below under the caption “Risk Factors Relating to Lumera’s Business.”
 
Overview
 
 Lumera Corporation was established in early 2000 to develop proprietary polymer materials and products based on these materials for a broad range of applications. We design and synthesize polymer materials at the molecular level by using our expertise in nanotechnology, which is the development of products and production processes at a scale smaller than 100 nanometers (a nanometer is one-billionth of a meter). Our goal is to optimize the electrical, optical and surface properties of these materials. We use these materials to improve the design, performance and functionality of products for use in biochemical analysis; in optical communications networks and in wireless antennas and systems. We believe we have developed a proprietary intellectual property position based on a combination of patents, licenses and trade secrets relating to the design and characterization of polymer materials, methods of polymer synthesis and production of polymers in commercial quantities, as well as device design, characterization, fabrication, testing and packaging technology.
 
From inception through 2004, we concentrated primarily on the development of our technology and potential products. To date, substantially all of our revenues have come from contracts to develop custom-made electro-optic materials and devices for government agencies. As we transition to a product-based company we expect to record both revenue and expense from product sales, to incur increased costs for sales and marketing and to increase general and administrative expense. Accordingly, the financial condition and results of operations reflected in our historical financial statements are not expected to be indicative of our future financial condition and results of operations. Until December 31, 2003, the Company was considered to be in the development stage. In early 2004, the Company commercialized the devices for potential wireless networking and optical networking applications and had largely completed financial planning, establishing sources of supply, acquiring plant and equipment and recruiting personnel. Therefore, the Company was considered to have exited the development stage in 2004.
 
Lumera is developing products for three distinct markets which we believe address significant market opportunities, including biotechnology disposables, electro-optic devices and wireless antennas and systems. Lumera has not yet generated commercial sales of its products in any of these markets.
 
10
The status of Lumera’s product commercialization efforts in each of these markets is summarized below:
 
Biotechnology Detection and Disposables
 
Lumera is developing various disposable biochips used in DNA analysis that are fabricated with a proprietary polymer coating and process. Product testing efforts by a prospective customer have shown positive results, creating interest in a potential supply agreement; however, restructuring within this potential customer continues to slow our plans to begin pilot production orders of our biochips. We continue to work with prospective customers and are investigating the application of our disposable chip technology in other technical applications.
 
We are currently developing a high-throughput, label-free detection platform in collaboration with the Institute for Systems Biology (”ISB”) which may enable biologists to isolate protein samples for testing and analysis. The initial prototype device is currently undergoing testing and further development at the ISB. We are developing specialized microarrays, combining our exclusive license to Helix Biopharma's Heterodimer Protein Technology (HPT) technology and Lumera's proprietary nanosurface modification chemistry which we believe will, for the first time, allow researchers to consistently take existing DNA arrays to produce protein arrays that accurately mimic the native living cell environment of the body. We expect to begin shipping products based on these technologies in 2005.
 
Electro-Optic Devices
 
We have supplied samples of our specialized electro-optic polymer material to multiple government agencies and potential partners in the semiconductor and telecommunications industries. The applications for this advanced material include electro-optic components such as modulators and ring oscillators, polymer electronics such as high performance diodes and transistors, and optical interconnects for high speed (greater than 20 billion cycles per second) inter and intra semiconductor chip communication.
 
We are currently working on two government contracts to produce polymer-based modulators for use in defense communications systems and phased array radar. Backlog on Lumera’s two governmental contracts totaled $1.1 million at March 31, 2005.
 
Wireless Antennas and Systems
 
We are developing “smart antenna” applications, which feature polymer-based technology that provides electronic rather than mechanical beam steering. Our smart antenna applications and systems permit high-quality signal transmission and reception for fixed and mobile wireless broadband applications (WiMAX). We have delivered smart antennas for a customer specific WiMAX application for testing and evaluation. We have not yet begun commercial production of smart antennas.
 
Revenue. Substantially all of our revenue since inception has been generated from cost plus fixed fee development contracts with several United States government agencies or with government contractors. Our projects have primarily been to develop specialized electro-optic polymer materials and devices. We entered into a $1.6 million contract in August 2001 with a government agency that was renewed in October 2002 for $1.0 million, again in November 2003 for $950,000 and recently in January 2005 for $1.1 million. We entered into a feasibility study with a government contractor in December 2002 for $149,000 that was extended in 2003 for an additional $400,000 until shifting governmental funding priorities terminated the project. We entered into a contract with a governmental agency in August 2003 to be approved in stages totaling $497,000, the final three stages of which have been approved. Backlog on Lumera’s two governmental contracts totaled $1.1 million at March 31, 2005.

Our revenue from government contracting has fluctuated year to year and we expect that future periods could also fluctuate significantly. Prospectively, we intend to also generate revenue through sales of our products to original equipment manufacturers, or OEMs, and industry partners and through development contracts. We expect that future revenue from U.S. government contracts will decrease as a percentage of revenue and that product revenue from the sale of commercial products will increase both on a dollar basis and as a percentage of revenue in future years.
 
Cost of Revenue. Historically, cost of revenue has consisted primarily of the direct and allocated indirect costs of performing on development contracts. Direct costs include labor, materials and other costs incurred directly in performing specific projects. Indirect costs include labor and other costs associated with our research and product development efforts and building our technical capabilities and capacity. The cost of revenue can fluctuate substantially from period to period depending on the level of both the direct costs incurred in the performance of projects and the level of indirect costs incurred. The cost of revenue as a percentage of revenue can fluctuate significantly from period to period depending on the contract mix, the cost of future planned products and the level of direct and indirect cost incurred.
 
We expect that cost of revenue on a dollar basis will increase in the future as a result of anticipated sales of products, additional development contract work that we expect to perform, and commensurate growth in our personnel and technical capacity required to perform on these contracts.

11
Research and Development Expense. Research and development expense consists primarily of:

 
•
 
compensation for employees and contractors engaged in internal research and product development activities;
 
 
•
 
research fees paid to the University of Washington under a sponsored research agreement;
 
 
•
 
stock-based research expense relating to grants of common stock made to the University of Washington;
 
 
•
 
laboratory operations, outsourced development and processing work;
 
 
•
 
fees and expenses related to patent applications, prosecution and protection;

 
•
 
stock-based research expense relating to grants of common stock made to the University of Washington;
 
 
•
 
costs incurred in acquiring and maintaining licenses; and
 
 
•
 
related operating expenses.
A significant portion of our research and development expense to date relate to cash payments and a grant of common stock pursuant to various agreements we have with the University of Washington (“UW”). We issued 802,414 shares of common stock in January 2001 under our UW Sponsored Research Agreement, recognizing $3.0 million of research expense through February 2004. Cash payments under the Sponsored Research Agreement totaled $5.4 million through March 31, 2005, and will total $5.75 million when the final payment is made in the quarter ended June 30, 2005. In addition, we have ongoing minimum royalty obligations to the UW of $75,000 annually.
 
We expect to continue to incur substantial research and development expense to develop commercial products using polymer materials technology. These expenses could increase as a result of continued development and commercialization of our polymer materials technology, including subcontracting work to potential development partners, expanding and equipping in-house laboratories, acquiring rights to additional technologies, hiring additional technical and support personnel and pursuing other potential business opportunities.

Marketing, General and Administrative Expense. Marketing, general and administrative expense consists primarily of compensation and support costs for management and administrative staff, and for other general and administrative costs, including accounting, consulting and other operating expenses. It also consists of costs associated with corporate awareness campaigns such as web site development and participation at trade shows, corporate communications initiatives and efforts with potential customers and joint venture partners to identify and evaluate product applications in which our technology could be integrated or otherwise used. Company personnel currently provide all executive, investor relations, accounting and finance, human resources, information systems and facilities services.
 
We expect marketing, general and administrative expense to increase in future periods as we:

 
•
 
significantly increase our sales and marketing staff and activities as we begin commercial sales of our products; and
 
 
•
 
increase the level of corporate and administrative activity, including increases associated with our operation as a public company.
 
Interest Income. Interest income consists of earnings from investment securities. Dividend and interest income are recognized when earned. Realized gains and losses are included in other income.
 
Results of Operations

Comparison of Three Months Ended March 31, 2005 and 2004

Revenue. Revenue decreased by $76,000 to $240,000 for the quarter ended March 31, 2005 from $316,000 for the quarter ended March 31, 2004. Aggregate revenue on the Company’s two governmental contracts was $61,000 lower than the prior year quarter primarily due to a delay in the contract renewal process for the larger of these contracts. Also contributing to the decline in current quarter comparative revenues were sales of polymer materials during the prior year quarter totaling $15,000. Backlog on Lumera’s two governmental contracts totaled $1.1 million at March 31, 2005.

Cost of Revenue. Cost of revenue decreased by $26,000 to $168,000 for the quarter ended March 31, 2005 from $194,000 for the quarter ended March 31, 2004 due primarily lower labor, materials and related overhead charges applied to the Company’s two governmental contracts during the current year quarter.

Research and Development Expense. Research and development expense decreased $59,000 to $1,735,000 for the quarter ended March 31, 2005, from $1,794,000 for the quarter ended March 31, 2004. Non-cash stock based compensation costs arising from options granted in March 2004 at below market prices were $170,000 lower during the current quarter due primarily to a lower comparative fair value associated with unvested options during each period. Expenses associated with our various agreements with the University of Washington, which are summarized in the table below, declined by approximately $67,000 compared to prior year quarter. Licensing and technology transfer fees associated with the Company’s January 2005 license agreement with Sensium Technologies totaled $94,000 during the current quarter. Additionally, professional fees, materials and supplies expense increased by approximately $150,000 during the current quarter, due in part to increased internal product development and commercialization activities.
 
12
The following table summarizes payments made and expense recorded under the various University of Washington Agreements during the three months ending March 31. 2005 and 2004:
 
       
Expense (Benefit) Recognized
  
(in thousands)  
Payments
Made
  
Sponsored
Research
  
Optical
Materials
  
Minimum
Royalty
  
Expense
Recorded on
Payments
  
Amortization
of
Stock
  
Total
Expense
Recorded
  
Three months ended
  
 
  
 
  
 
  
 
  
 
  
 
  
 
  
March 31, 2005
  
$
375
  
$
325
  
$
—
  
$
19
  
$
344
  
$
—
  
$$
344
  
March 31, 2004
    
—
   
183
    
50
    
19
    
252
    
159
    
411
  
 
Marketing, General and Administrative Expense. Marketing, general and administrative expense increased $464,000 to $1,384,000 for the quarter ended March 31, 2005, from $920,000 for the quarter ended March 31, 2004. Contributing to higher expense in the current year quarter were increased costs arising from additional headcount in marketing and finance of $381,000, increased audit and legal professional fees and insurance costs primarily associated with being a public company of $285,000, and general administrative and facilities costs of approximately $115,000, all compared with the prior year quarter. Non-cash stock based compensation costs arising from options granted in March 2004 at below market prices were $353,000 lower during the current quarter due primarily to a lower comparative fair value associated with unvested options during each period.

Interest Income. Interest income totaled $169,000 for the quarter ended March 31, 2005, due to higher cash investment balances which resulted from our initial public offering completed in July 2004. The Company had no interest income during the prior year quarter.

Deemed Dividend upon Issuance of Preferred Stock. In March 2004, we raised cash proceeds of $500,000 from the sale of 250,000 shares of Series B convertible preferred stock to private investors. The conversion price of the Series B convertible preferred stock issued was less than the fair value of the Class A common stock on the issuance date. As a result, we recorded a $500,000 beneficial conversion feature upon issuance of the preferred stock. This amount was immediately recorded as a deemed dividend to preferred shareholders because the Series B preferred stock was immediately convertible into Class A common stock.

Liquidity and Capital Resources

We have funded our operations to date primarily through the sale of common and convertible preferred stock, convertible notes and, to a lesser extent, through revenues from development contracts and sales of services. We had an accumulated deficit of $41.0 million as of March 31, 2005. At March 31, 2005 we had $27.5 million in cash and cash equivalents and investment securities available for sale, $987,000 of which was classified as long-term.

Net cash used in operating activities increased by $1,985,000 to $2,620,000 for the three months ended March 31, 2005 from $635,000 for the three months ended March 31, 2004. The Company’s net loss before non-cash expenses increased $924,000 due primarily to $381,000 in higher payroll and related benefit costs, higher audit, legal and other professional fees totaling $348,000, and general administrative and facilities costs of approximately $115,000. Changes in other current asset and liability accounts during the quarter ended March 31, 2005 reflect a use of cash of $208,000 which was primarily due to an increase in accounts receivable and earned but unbilled revenue on governmental contracts. Changes in other current asset and liability accounts during the quarter ended March 31, 2004 reflect a source of cash of $853,000 which was primarily due to a decrease in accounts receivable and earned but unbilled revenues of $192,000, an increase in accounts payable and accrued liabilities of $480,000 and an increase in amounts accrued under the various University of Washington agreements of $182,000.
 
Lumera’s Research liability declined $51,000 reflecting payment of $375,000 under the terms of our Sponsored Research Agreement with the University of Washington and $325,000 of expense amortization under the agreement.

Net cash provided by investing activities totaled $1,925,000 for the three months ended March 31, 2005 compared to net cash used by investing activities of $15,000 for the three months ended March 31, 2004. Capital expenditures were $167,000 for the three months ended March 31, 2005 compared with $15,000 for the three months ended March 31, 2004. Maturities of investment securities, net of reinvestments totaled $2,092,000 for the three months ended March 31, 2005.

Net cash provided by financing activities totaled $500,000 for the three months ended March 31, 2004. In March of 2004 we issued $500,000 of Series B Preferred Stock. No cash was provided from financing activities for the quarter ended March 31, 2005.

Our future capital requirements will depend on numerous factors, including: the progress of our research and development efforts; the rate at which we can, directly or through arrangements with original equipment manufacturers, introduce and sell products incorporating our polymer materials technology; the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights; market acceptance of our products and competing technological developments; and our ability to establish cooperative development, joint venture and licensing arrangements.

We expect that our cash used in operations will increase during 2005 and beyond as a result of:
 
13
 
 
•
 
increased production spending as our products are accepted and sold;
 
 
•
 
increased spending on marketing activities as our products are introduced into our target markets;
 
 
•
 
the addition of sales, marketing, technical and other staff to sell products, meet production needs and continue with future development efforts;
 
 
•
 
purchases of additional laboratory and production equipment;
 
 
•
 
the development of strategic relationships with systems and equipment manufacturers; and
 
 
•
 
increases in our general and administrative activities related to our operations as a public company and related corporate compliance requirements.
 
Our business does not presently generate the cash needed to finance our current and anticipated operations. We expect that the $27.5 million in cash and investments held for sale, along with revenues from our existing contractual relationships, will be sufficient to fund our operations through at least the end of 2006 (See Risk Factors). We may seek additional funding through public or private financings, including equity financings, and through other arrangements, including collaborative arrangements. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our existing stockholders may be reduced, and these securities may have rights superior to those of our common stock.
 
RISK FACTORS THAT MAY AFFECT OUR RESULTS

We have incurred substantial operating losses since our inception and may continue to incur substantial operating losses for the foreseeable future.

Since our inception, we have been engaged primarily in the research and development of our polymer materials technologies and potential products. As a result of these activities, we incurred net losses of $2.9 million from inception through December 31, 2000, $9.6 million in 2001, $8.7 million in 2002, $8.1 million in 2003, $9.4 million in 2004 and $2.9 million in the three months ended March 31, 2005. We anticipate that we will continue to incur operating losses through at least the year ending December 31, 2005. As of March 31, 2005, we had an accumulated deficit of $41.1 million.

We may not be able to generate significant additional revenue either through development contracts from the U.S. government or government subcontractors or through customer contracts for our potential products or technologies. We expect to continue to make significant operating and capital expenditures for research and development and to improve and expand production, sales, marketing and administrative systems and processes. As a result, we will need to generate significant additional revenue to achieve profitability. We cannot assure you that we will ever become profitable.

We are subject to the risks frequently experienced by early stage companies.

The likelihood of our success must be considered in light of the risks frequently encountered by early stage companies, especially those formed to develop and market new technologies. These risks include our potential inability to:
 
 
•
establish product sales and marketing capabilities;
     
 
•
establish and maintain markets for our potential products;
     
 
•
identify, attract, retain and motivate qualified personnel;
     
 
•
continue to develop and upgrade our technologies to keep pace with changes in technology and the growth of markets using polymer materials;
     
 
•
develop expanded product production facilities and outside contractor relationships;
     
 
•
maintain our reputation and build trust with customers; and
     
 
•
improve existing and implement new transaction-processing, operational and financial systems.

If we do not successfully address these risks, our business could suffer. In addition, while evolving from a research and development company into a commercial manufacturer we may not be able to:

 
•
scale up from small pilot or prototype quantities to large quantities of product on a consistent basis;
     
 
•
contract for or develop the internal skills needed to master large volume production of our products; and
     
 
•
fund the capital expenditures required to develop volume production due to the limits of our available financial resources.

14
We are entering new markets, and if we fail to accurately predict growth in these new markets, we may suffer substantial losses.

We are devoting significant resources to the development of products and the support of marketing and sales efforts in new markets, such as the WiFi market and the disposable biochip market. We expect to continue to seek to identify and develop products for new markets. New markets change rapidly and we cannot assure you that they will grow or that we will be able to accurately forecast market demand, or lack thereof, in time to respond appropriately. Our investment of resources to develop products for these markets may either be insufficient to meet actual demand or result in expenses that are excessive in light of actual sales volumes. Failure to predict growth and demand accurately in new markets may cause us to suffer substantial losses. In addition, as we enter new markets, there is a significant risk that:

 
•
the market may not accept the price and/or performance of our products;
     
 
•
there may be issued patents we are not aware of that could block our entry into the market or could result in excessive litigation; and
     
 
•
the time required for us to achieve market acceptance of our products may exceed our capital resources which would require additional investment.
 
The establishment and maintenance of original equipment manufacturer and other collaborative relationships is critical to the success of our business.

We expect to sell many of our products to original equipment manufacturers (OEMs) or through potential industry partners. For example, we expect to offer antenna products in part through vendors of complete WiFi systems. Our ability to generate revenues depends significantly on the extent to which potential OEM customers and other potential industry partners develop, promote and sell systems that incorporate our products. Any failure by potential OEM customers and other potential industry partners to successfully develop and market systems that incorporate our products could adversely affect our sales. The extent to which potential OEM customers and other industry partners develop, promote and sell systems incorporating our products is based on a number of factors that are largely beyond our ability to control.

Our future growth will suffer if we do not achieve sufficient market acceptance of our potential products.

We are developing nanotechnology-enabled polymer-based products. We do not know when a market for these potential products will develop, if at all. Our success depends, in part, upon our ability to gain market acceptance of our potential products. To be accepted, our potential products must meet the technical and performance requirements of our potential customers. The WiFi antenna and biochip markets are evolving rapidly and involve many competitors and competing technologies, and the optical communications industry is currently fragmented with many competitors developing different technologies. We expect that only a few of these technologies will ultimately gain market acceptance. Products based on polymer materials may not be accepted by OEMs and systems integrators of optical communications networks. In addition, even if we achieve some degree of market acceptance for our potential products in one industry, we may not achieve market acceptance in other industries for which we are developing products. If the markets we are targeting fail to accept polymer-based products or determine that other products are superior, we may not be able to achieve market acceptance of our potential products.

Several of our potential products are still in the development stage or are being tested by potential customers. We cannot assure you that these customer tests will be successful or that they will result in actual sales of our potential products.

Achieving market acceptance for our potential products will require marketing efforts and the expenditure of financial and other resources to create product awareness and demand by potential customers. We may be unable to offer products that compete effectively due to our limited resources and operating history. Also, certain large corporations may be predisposed against doing business with a company of our limited size and operating history. Failure to achieve broad acceptance of our products by potential customers and to compete effectively would harm our operating results.

Successful commercialization of our current and future products will require us to maintain a high level of technical expertise.

Technology in our target markets is undergoing rapid change. To succeed in our target markets, we will have to establish and maintain a leadership position in the technology supporting those markets. Accordingly, our success will depend on our ability to:
 
 
•
accurately predict the needs of our target customers and develop, in a timely manner, the technology required to support those needs;
     
 
•
provide products that are not only technologically sophisticated but are also available at a price acceptable to customers and competitive with comparable products;
     
 
•
establish and effectively defend our intellectual property; and
     
 
•
enter into relationships with other companies that have developed complementary technology into which our products may be integrated.
 
We cannot assure you that we will be able to achieve any of these objectives.

We expect some of our potential products to have long sales cycles, which may cause us to expend resources without an acceptable financial return and which makes it difficult to plan our expenses and forecast our revenues.

We expect some of our potential products to have long sales cycles that involve numerous steps, including initial customer contacts, specification writing, engineering design, prototype fabrication, pilot testing, regulatory approvals (if needed), sales and marketing and commercial manufacture. During this time, we may expend substantial financial resources and management time and effort without any assurance that product sales will result. The anticipated long sales cycle for some of our potential products makes it difficult to predict the quarter in which sales may occur. Delays in sales may cause us to expend resources without an acceptable financial return and make it difficult to plan expenses and forecast revenues.

15
We may require additional capital to continue to fund our operations. If we do not obtain additional capital, we may be required to substantially limit our operations.

Our business does not presently generate the cash needed to finance our current and anticipated operations. Based on our current operating plan and budgeted cash requirements, we believe that we will be able to fund our operations beyond the next twelve months. We may require additional capital to continue to fund our operations in future periods. We expect that we will need to seek additional funding through public or private financings, including equity financings, and through other arrangements, including collaborative arrangements. Poor financial results, unanticipated expenses or unanticipated opportunities could require additional financing sooner than we expect. Such financing may be unavailable when we need it or may not be available on acceptable terms. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our existing stockholders may be reduced, and these securities may have rights superior to those of our common stock. If adequate funds are not available to satisfy either short-term or long-term capital requirements, or if planned revenues are not generated, we may be required to limit our operations substantially. These limitations of operations may include reductions in capital expenditures and reductions in staff and discretionary costs.

We currently rely heavily on a small number of development contracts with the U.S. Department of Defense and government contractors. The termination or non-renewal of one or more of these contracts could significantly reduce our revenue.

In the first three months of 2005 and for the years ended December 31, 2004, 2003 and 2002, 100% 99% 98%, 99% and 100%, respectively, of our revenue was derived from performance on a limited number of development contracts with various agencies within the U.S. Department of Defense and with government subcontractors. Any significant disruption or deterioration of our relationships with either the Department of Defense or government subcontractors could significantly reduce our revenues. Our government programs must compete with programs managed by other contractors for limited amounts and uncertain levels of funding. The total amount and levels of funding are susceptible to significant fluctuations on a year-to-year basis. Our competitors frequently engage in efforts to expand their business relationships with the government and are likely to continue these efforts in the future. In addition, our development contracts with government agencies are subject to potential profit and cost limitations and standard provisions that allow the U.S. government to terminate such contracts at any time at its convenience. Termination of our development contracts, a shift in government spending to other programs in which we are not involved, or a reduction in government spending generally or defense spending specifically could severely harm our business. We intend to continue to compete for government contracts and we expect they will be a significant percentage of our revenue for the foreseeable future.

Our development contracts with various agencies within the U.S. Department of Defense and with General Dynamics, a government subcontractor, require ongoing compliance with applicable federal procurement regulations. Violations of these regulations can result in civil, criminal or administrative proceedings involving fines, compensatory and punitive damages, restitution and forfeitures, as well as suspensions or prohibitions from entering into such development contracts. Also, the reporting and appropriateness of costs and expenses under these development contracts are subject to extensive regulation and audit by the Defense Contract Audit Agency, an agency of the U.S. Department of Defense. Any failure to comply with applicable government regulations could jeopardize our development contracts and otherwise harm our business.

Some of our products in development are directed at the telecommunications and networking markets, which have recently been subject to overcapacity and slow growth or decline.

We are seeking to derive a substantial portion of our future sales from product sales in the telecommunications and networking markets, including sales of our electro-optic devices and our WiFi antennas. Developments that adversely affect the telecommunications or networking markets, including delays in traffic growth and changes in U.S. government regulation, could slow or halt our revenue growth from sales of our electro-optic modulators and Accupath WiFi antennas. Reduced spending and technology investment by telecommunications companies may make it more difficult for our products to gain market acceptance. Such companies may be less willing to purchase new technology such as ours or invest in new technology development when they have reduced capital expenditure budgets.

Our quarter-to-quarter performance may vary substantially, and this variance, as well as general market conditions, may cause our stock price to fluctuate greatly and potentially expose us to litigation.

Substantially all of our revenues to date have been generated from a limited number of development contracts with the U.S. government and government contractors. Because we intend to expand into commercial sales of our potential products, we are unable to accurately estimate future quarterly revenue and operating expenses based on historical performance. Our quarterly operating results may vary significantly based on many factors, including:
 
 
•
reductions or delays in funding of development programs involving new polymer materials technologies by the U.S. government;
     
 
•
additions of new customers;
     
 
•
fluctuating demand for our potential products and technologies;
     
 
•
announcements or implementation by our competitors of technological innovations or new products;
     
 
•
the status of particular development programs and the timing of performance under specific development agreements;
     
 
16
 
 
•
timing and amounts relating to the expansion of our operations; or
     
 
•
costs related to possible future acquisitions of technologies or businesses.
 
Our current and future expense estimates are based, in large part, on estimates of future revenue, which is difficult to predict. We expect to continue to make significant operating and capital expenditures in the area of research and development and to invest in and expand production, sales, marketing and administrative systems and processes. We may be unable to, or may elect not to, adjust spending quickly enough to offset any unexpected revenue shortfall. If our increased expenses are not accompanied by increased revenue in the same quarter, our quarterly operating results would be harmed.

In one or more future quarters, our results of operations may fall below the expectations of investors and the trading price of our common stock may decline as a consequence. We believe that quarter-to-quarter comparisons of our operating results will not be a good indication of our future performance and should not be relied upon to predict the future performance of our stock price. In the past, companies that have experienced volatility in the market price of their stock have often been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.

We cannot predict the pace of marketable products we may generate, and any inability to generate a sufficient number of marketable products would reduce our revenues and harm our business.

Our future revenues and profitability are dependent upon our ability to create marketable products, whether through our own research and development efforts or through collaborations with customers or industry partners. Because of the inherently uncertain nature of research and development activities, we cannot predict the pace of new product introductions. We must undertake additional research and development before we are able to develop additional products for commercial sale. Product development delays by us or potential product development partners, or the inability to enter into relationships with these potential partners, may delay or prevent us from introducing products for commercial sale. In addition, our product candidates may not result in products having the commercial potential we anticipate. Any of these factors could reduce our potential commercial sales and lead to inability to generate revenue and attain profitability.

The failure to compete successfully could harm our business.

We expect to face competitive pressures from a variety of companies in each of our target markets. Some of our present and potential competitors have or may have substantially greater research and product development capabilities, financial, scientific, marketing, manufacturing and human resources, name recognition and experience than we have. As a result, these competitors may:
 
 
•
succeed in developing products that are equal to or superior to our potential products or that will achieve greater market acceptance than our potential products;
     
 
•
devote greater resources to developing, marketing or selling their products;
     
 
•
respond more quickly to new or emerging technologies or scientific advances and changes in customer requirements, which could render our technologies or potential products obsolete;
     
 
•
introduce products that make the continued development of our potential products uneconomical;
     
 
•
obtain patents that block or otherwise inhibit our ability to develop and commercialize our potential products;
     
 
•
withstand price competition more successfully than we can;
     
 
•
establish cooperative relationships among themselves or with third parties that enhance their ability to address the needs of our prospective customers; and
     
 
•
take advantage of acquisitions or other opportunities more readily than we can.
 
The failure to compete successfully against these existing or future competitors could harm our business.

We may be unable to establish sales and marketing capabilities necessary to successfully commercialize our potential products.

We currently have limited sales and marketing capabilities. To date, we have relied on sales and marketing leadership from our Chief Executive Officer, Mr. Mino, and Chief Technology Officer, Dr. Petcavich, and our Vice President of Sales and Marketing, Mr. Lykken with two managers supporting them. We will need to either hire more sales personnel with expertise in the markets we intend to address or contract with others to provide for sales support. Although our potential products are all based on our polymer materials technology, the potential products themselves address different markets and can be offered through multiple sales channels. Addressing each market effectively will require sales and marketing resources tailored to the particular market and to the sales channels that we choose to employ. We may be unable to establish marketing and sales capabilities necessary to commercialize and gain market acceptance for our potential products. Co-promotion or other marketing arrangements with others to commercialize products could significantly limit the revenues we derive from these products, and these parties may fail to commercialize such products successfully.

17
We may be unable to obtain effective intellectual property protection for our potential products and technology.

Our intellectual property, or any intellectual property that we have or may acquire, license or develop in the future, may not provide meaningful competitive advantages. Our patents and patent applications, including those we license, may be challenged by competitors, and the rights granted under such patents or patent applications may not provide meaningful proprietary protection. For example, we are aware of numerous patents held by third parties that relate to polymer materials, WiFi antennas, biochips and electro-optic devices. These patents could be used as a basis to challenge the validity or limit the scope of our patents or patent applications. A successful challenge to the validity or limitation of the scope of our patents or patent applications could limit our ability to commercialize our polymer materials technology and, consequently, reduce our revenues.

Moreover, competitors may infringe our patents or those that we license, or successfully avoid these patents through design innovation. To combat infringement or unauthorized use, we may need to resort to litigation, which can be expensive and time-consuming and may not succeed in protecting our proprietary rights. In addition, in an infringement proceeding a court may decide that our patents or other intellectual property rights are not valid or are unenforceable, or may refuse to stop the other party from using the intellectual property at issue on the ground that it is non-infringing. Policing unauthorized use of our intellectual property is difficult and expensive, and we may not be able to, or have the resources to, prevent misappropriation of our proprietary rights, particularly in countries where the laws may not protect these rights as fully as the laws of the United States.

We also rely on the law of trade secrets to protect unpatented technology and know-how. We try to protect this technology and know-how by limiting access to those employees, contractors and strategic partners with a need to know this information and by entering into confidentiality agreements with these parties. Any of these parties could breach the agreements and disclose our trade secrets or confidential information to our competitors, or these competitors might learn of the information in other ways. Disclosure of any trade secret not protected by a patent could materially harm our business.

We may be subject to patent infringement claims, which could result in substantial costs and liability and prevent us from commercializing our potential products.

Third parties may claim that our potential products or related technologies infringe their patents. Any patent infringement claims brought against us may cause us to incur significant expenses, divert the attention of our management and key personnel from other business concerns and, if successfully asserted against us, require us to pay substantial damages. In addition, as a result of a patent infringement suit, we may be forced to stop or delay developing, manufacturing or selling potential products that are claimed to infringe a patent covering a third party’s intellectual property unless that party grants us rights to use its intellectual property. We may be unable to obtain these rights on terms acceptable to us, if at all. Even if we are able to obtain rights to a third party’s patented intellectual property, these rights may be non-exclusive, and therefore our competitors may obtain access to the same intellectual property. Ultimately, we may be unable to commercialize our potential products or may have to cease some of our business operations as a result of patent infringement claims, which could severely harm our business.

If our potential products infringe the intellectual property rights of others, we may be required to indemnify customers for any damages they suffer. Third parties may assert infringement claims against our current or potential customers. These claims may require us to initiate or defend protracted and costly litigation on behalf of customers, regardless of the merits of these claims. If any of these claims succeed, we may be forced to pay damages on behalf of these customers or may be required to obtain licenses for the products they use. If we cannot obtain all necessary licenses on commercially reasonable terms, we may be unable to continue selling such products.

The technology we license from the University of Washington may be subject to government rights and retained rights.

We license technology from the University of Washington under a sponsored research agreement, pursuant to which we fund research at the university. The University of Washington also accepts research funds from various U.S. government agencies. Under these government funding arrangements, if the research that we fund is not kept separate from the research funded by the government agency, the government agency may obtain rights over the technology that we have developed and licensed, including the right to require that a compulsory license be granted to one or more third parties selected by the government agency. We cannot guarantee that the university will keep the research that we fund separate from that funded by U.S. government agencies.

The University of Washington has retained certain rights under its licensing agreement with us, including the right to use the technology for noncommercial academic and research use, to publish general scientific findings from research related to the technology, and to make customary scientific and scholarly disclosures of information relating to the technology. It is difficult to monitor whether the university limits its use of the technology to these uses, and we could incur substantial expenses to enforce our rights to this technology in the event of misuse.

The loss of our chief executive officer, or any inability to attract and retain additional personnel, could impair our ability to maintain or expand our business.

Our future success depends to a significant extent on the continued service of our key management personnel, particularly Thomas D. Mino, our chief executive officer. We do not maintain key person life insurance on any of our executive officers other than Mr. Mino and do not intend to purchase any in the future.

Our future success will also depend on our ability to attract, retain and motivate highly skilled personnel. In particular, we will need to hire a significant number of technical personnel. Competition for qualified personnel in the polymer materials industry is intense. If we fail to hire and retain a sufficient number of engineering, sales and technical personnel, we will not be able to maintain or expand our business. Approximately 35% of our employees, including approximately 45% of our chemists, materials scientists, electrical engineers, optical physicists and other technical professionals, are citizens of countries other than the United States. Although each of these employees has applied for status as a permanent resident of the United States, one or more of these applications may be denied and one or more of such employees may have to leave the United States. The loss of any of these key personnel could adversely affect our business.

18
If we fail to develop and maintain the quality of our manufacturing processes, our operating results would be harmed.

The manufacture of our potential products is a multi-stage process that requires the use of high-quality materials and advanced manufacturing technologies. Also, polymer-related device development and manufacturing must occur in a highly controlled, clean environment to minimize particles and other yield- and quality-limiting contaminants. In spite of stringent quality controls, weaknesses in process control or minute impurities in materials may cause a substantial percentage of a product in a lot to be defective. If we are not able to develop and continue to improve on our manufacturing processes or to maintain stringent quality controls, or if contamination problems arise, our operating results would be harmed.

We are dependent on third parties to manufacture our products currently under development and our revenues could decline if these third parties do not timely complete our orders and our reputation will suffer if we do not maintain high quality standards.

We have entered into manufacturing arrangements with a number of third party manufacturers and intend to enter into agreements with additional corporate partners, OEMs and other third parties. Currently, all of our WiFi products are assembled by third-party manufacturers. We contract with manufacturing companies to perform various portions of our product manufacturing, testing, assembly and shipping and purchase components to be used in our potential products from third-party vendors. If these third parties do not timely complete our orders, or do not properly manufacture our products, our reputation could be harmed, and our revenues could decline. We cannot assure you that we will be able to negotiate arrangements with these third parties on acceptable terms, if at all, or that these arrangements will be successful in yielding commercially viable products. If we cannot maintain our current relationships or establish new arrangements, we will require additional capital to undertake those activities on our own and will require manufacturing expertise that we do not currently possess and that may be difficult to obtain.

If we decide to make commercial quantities of products at our facilities, we will be required to make significant capital expenditures to increase capacity.

We lack the internal ability to manufacture products at a level beyond the stage of early commercial introduction. To the extent we do not have an outside vendor to manufacture our products, we will have to increase our internal production capacity and we will be required to expand our existing facilities or to lease or construct new facilities or to acquire entities with additional production capacities. These activities would require us to make significant capital investments and may require us to seek additional equity or debt financing. We cannot assure you that such financing would be available to us when needed on acceptable terms, or at all. If we are unable to expand internal production capacity on a timely basis to meet increases in demand, we could lose market opportunities for sales. Further, we cannot assure you that any increased demand for our potential products would continue for a sufficient period of time to recoup our capital investments associated with increasing our internal production capacity.

In addition, we do not have experience manufacturing our potential products in large quantities. In the event of significant demand for our potential products, large-scale production might prove more difficult or costly than we anticipate and lead to quality control issues and production delays.

We may not be able to manufacture products at competitive prices.

To date, we have produced limited quantities of products for research, development and demonstration purposes. The cost per unit for these products currently exceeds the price at which we could expect to profitably sell them. If we cannot substantially lower our cost of production as we move into sales of products in commercial quantities, our financial results will be harmed.

We conduct all of our operations at a single facility, and circumstances beyond our control may result in significant interruptions.

We conduct all of our research and development, internal manufacturing and management activities at a single facility in Bothell, Washington. A disaster such as a fire, flood, earthquake, volcanic eruption or severe storm at or near this facility could prevent us from further developing our technologies or manufacturing our potential products, which would harm our business.

We could be exposed to significant product liability claims that could be time-consuming and costly and impair our ability to obtain and maintain insurance coverage.

We may be subject to product liability claims if any of our potential products are alleged to be defective or harmful. Product liability claims or other claims related to our potential products, regardless of their outcome, could require us to spend significant time and money in litigation, divert our management’s time and attention from other business concerns, require us to pay significant damages, harm our reputation or hinder acceptance of our potential products. Any successful product liability claim may prevent us from obtaining adequate product liability insurance in the future on commercially reasonable terms. Any inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could impair our ability to commercialize our potential products.

If we fail to effectively manage our growth, our business could suffer.

Failure to manage our growth could harm our business. To date, substantially all of our activities and resources have been directed at the research and development of our technology and development of potential products. The transition from research and development to a vendor of products will require effective planning and management. In addition, future expansion will be expensive and will likely strain our management and other resources.

In order to effectively manage growth, we must:
 
 
•
continue to develop an effective planning and management process to implement our business strategy;
     
 
•
hire, train and integrate new personnel in all areas of our business; and
     
 
•
expand our facilities and increase our capital investments.
 
We cannot assure you that we will be able to accomplish these tasks effectively or otherwise effectively manage our growth.

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We are subject to regulatory compliance related to our operations.

We are subject to various U.S. governmental regulations related to occupational safety and health, labor and business practices. Failure to comply with current or future regulations could result in the imposition of substantial fines, suspension of production, alterations of our production processes, cessation of operations, or other actions, which could harm our business.

We may be unable to export our potential products or technology to other countries, convey information about our technology to citizens of other countries or sell certain products commercially, if the products or technology are subject to United States export or other regulations.

We are developing certain polymer-based products that we believe the United States government and other governments may be interested in using for military and information gathering or antiterrorism activities. United States government export regulations may restrict us from selling or exporting these potential products into other countries, exporting our technology to those countries, conveying information about our technology to citizens of other countries or selling these potential products to commercial customers. We may be unable to obtain export licenses for products or technology if necessary. We currently cannot assess whether national security concerns would affect our potential products and, if so, what procedures and policies we would have to adopt to comply with applicable existing or future regulations.

Our use of the name “Lumera” may result in infringement claims and other legal challenges, which could cause us to incur significant expenses, pay substantial damages and be prevented from using this name.

Our use of the name “Lumera” may result in infringement claims and other legal challenges, which could cause us to incur significant expenses, pay substantial damages and be prevented from using this name. In April 2004 we filed a trademark application with the U.S. Patent and Trademark Office to register the trademark “Lumera.” We are aware of a company that has also applied for a trademark for the name Lumera in connection with PC-based electromechanical controls for use in the control and operation of automation equipment. We may not receive approval of our trademark application for the name “Lumera,” and, even if the application is approved, the trademark may be challenged by third parties or invalidated. As a result of such infringement claims or challenges, we may incur significant expenses, pay substantial damages and be prevented from using the name “Lumera” unless we enter into royalty or license agreements. We may not be able to obtain royalty or license agreements on terms acceptable to us, if at all. Use of the name “Lumera” or similar names by third parties may also cause confusion to our clients and confusion in the market, which could decrease the value of our brand and harm our reputation.

We may incur liability arising from the use of hazardous materials.

Our business and our facilities are subject to a number of federal, state and local laws and regulations relating to the generation, handling, treatment, storage and disposal of certain toxic or hazardous materials and waste products that we use or generate in our operations. Many of these environmental laws and regulations subject current or previous owners or occupiers of land to liability for the costs of investigation, removal or remediation of hazardous materials. In addition, these laws and regulations typically impose liability regardless of whether the owner or occupier knew of, or was responsible for, the presence of any hazardous materials and regardless of whether the actions that led to the presence were taken in compliance with the law. In our business, we use hazardous materials that are stored on site. We use various chemicals in our manufacturing process which may be toxic and covered by various environmental controls. The waste created by use of these materials is transported off-site by an unaffiliated waste hauler. Many environmental laws and regulations require generators of waste to take remedial actions at an off-site disposal location even if the disposal was conducted lawfully. The requirements of these laws and regulations are complex, change frequently and could become more stringent in the future. Failure to comply with current or future environmental laws and regulations could result in the imposition of substantial fines, suspension of production, alteration of our production processes, cessation of operations or other actions, which could severely harm our business. We cannot assure you that a claim, investigation or liability relating to environmental laws and regulations will not arise with respect to our activities.

Acquisitions or investments may be unsuccessful and may divert our management’s attention and consume significant resources.

We may in the future acquire or make investments in other businesses as well as products and technologies to complement our current business. Any future acquisition or investment may require us to use significant amounts of cash, make potentially dilutive issuances of equity securities or incur debt. In addition, acquisitions involve numerous risks, any of which could harm our business, including:
 
 
•
difficulties in integrating the operations, technologies and personnel of acquired businesses;
     
 
•
diversion of our management’s attention from other business concerns;
     
 
•
unavailability of favorable financing for future acquisitions;
     
 
•
potential loss of key employees of acquired businesses;
     
 
•
inability to maintain the key business relationships and the reputations of acquired businesses;
     
 
•
responsibility for liabilities of acquired businesses;
     
 
•
inability to maintain our standards, controls, procedures and policies; and
     
 
•
increased fixed costs.

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We may not be able to keep up with rapid technological change.

The markets for WiFi antennas, biochips and optical communications devices have been characterized by rapidly changing technologies, accelerated product obsolescence and continuously evolving industry standards. Our success will depend upon our ability to further develop our polymer materials technologies and to cost effectively introduce products in a timely manner to meet evolving customer requirements and compete with competitors’ technology and product advances. We may not succeed in these efforts because of:

 
•
delays in product development;
     
 
•
lack of market acceptance for our products; or
     
 
•
lack of funds to invest in product development and marketing.
 
The occurrence of any of these factors could result in decreased revenues and otherwise harm our business.

Our plan to develop relationships with strategic partners may not be successful.

As part of our business strategy, we have developed relationships and entered into agreements with strategic partners, such as the University of Washington and Arizona Microsystems, to conduct research and development of technologies and products. We expect to continue to evaluate similar opportunities. For these efforts to be successful, we must identify partners whose competencies complement ours. We must also successfully enter into agreements with them on terms attractive to us, and integrate and coordinate their resources and capabilities with our own. We may be unsuccessful in entering into agreements with acceptable partners or negotiating favorable terms in these agreements. Also, we may be unsuccessful in integrating the resources or capabilities of these partners. In addition, our strategic partners may prove difficult to work with or less skilled than we originally expected. If we are unsuccessful in our collaborative efforts, our ability to develop and market products could be severely limited.

As our business grows, if we need to establish global operations, we will be subject to various risks.

Many of the markets that we propose to address are global and may require us to conduct foreign operations, including the establishment of sales, manufacturing and possible research and development facilities in other countries. While the specific risks that will apply to these activities would depend on the circumstances, we could become subject to risks relating to foreign currency fluctuations, political and social unrest, local regulatory systems and varying standards for the protection of intellectual property. The existence of any of these risks will complicate our business and may lead to unexpected and adverse effects on our business. If we are required to conduct significant foreign operations, we will also need expertise in such operations, which we do not presently have.

Insiders have substantial control over us.

Our principal stockholders, directors and executive officers and entities affiliated with them beneficially own approximately 46% of the outstanding shares of our common stock. As a result, these stockholders, if they were to act together, would be able to control or significantly influence matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other extraordinary transactions. The concentration of ownership may have the effect of delaying, preventing or deterring a change in control of our company, could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company and might ultimately affect the market price of our common stock.

Microvision owns more than 33% of our common stock, and may be able to exert substantial control over our business.

Microvision currently owns securities representing more than 33% of our voting securities. Two of our six current directors, including the Chairman of our board of directors, are also directors of Microvision. Our interests may not always be aligned with Microvision’s. We do not have formal guidelines for dealing with potential conflicts of interest, but will address any such conflicts on a case by case basis. Microvision will continue to have the ability to exert considerable influence over our direction for the foreseeable future.

Our limited operating history makes financial forecasting difficult for us and for others that may publish estimates of our future financial results.

As a result of our limited operating history, it is difficult to accurately forecast our revenue and results, including product sales and government contract revenue, cost of revenue, research and development expenses, marketing, general and administrative expenses and other financial and operating data. We have a limited amount of meaningful historical financial data upon which to base projected revenue or expenses. We base our current expense levels and estimates of future expense levels on our operating plans and estimates of future revenue, and our future expenses will be dependent in large part upon our future levels of product sales. Sales and results are difficult to forecast because we do not currently have any commercial customers, we are uncertain of the extent of orders for our products and the mix, volume and timing of any such orders, and we are uncertain of the receipt of and extent of performance under government contracts. As a result, we may be unable to make accurate financial forecasts of revenue or expenses. Financial analysts and others that may seek to project our future performance face similar difficulties. This inability to accurately forecast our revenue and expenses could cause our financial results to differ materially from any projected financial results and could cause a decline in the trading price of our common stock.
 
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ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Substantially all of our cash equivalents and investment securities are at fixed interest rates, and as such, the fair value of these instruments is affected by changes in market interest rates. Due to the generally short-term maturities of these investment securities, however, we believe that the market risk arising from our holdings of these financial instruments is not material.

Our investment policy restricts investments to ensure principal preservation and liquidity. We invest cash that we expect to use within approximately sixty days in Money Market Funds and U.S. treasury-backed instruments. We invest cash in excess of sixty days of our requirements in high-quality investment securities. The investment securities portfolio is limited to U.S. government and U.S. government agency debt securities and other liquid high-grade securities generally with maturities of two years or less.

ITEM 4.    CONTROLS AND PROCEDURES

Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures (as defined under the Securities Exchange Act of 1934, as amended (Exchange Act)) were effective as of March 31, 2005 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company's management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. There were no changes in the Company’s internal control over financial reporting identified in management’s evaluation during the first quarter of fiscal 2005 that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.

We intend to review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis and to improve our controls and procedures over time and to correct any deficiencies that we may discover in the future. Our goal is to ensure that our senior management has timely access to all material financial and non-financial information concerning our business. While we believe the present design of our disclosure controls and procedures is effective to achieve our goal, future events affecting our business may cause us to modify our disclosure controls and procedures.

We are in the process of implementing the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 which requires our management to assess the effectiveness of our internal controls over financial reporting and include an assertion in our annual report as to the effectiveness of our controls. Subsequently, our independent registered public accounting firm, PricewaterhouseCoopers LLP, will be required to attest to whether our assessment of the effectiveness of our internal control over financial reporting is fairly stated in all material respects and separately report on whether it believes we maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005. We are in the process of performing the system and process documentation, evaluation and testing required for management to make this assessment and for the auditors to provide its attestation report. We have not completed this process or its assessment, and this process will require significant amounts of management time and resources. In the course of evaluation and testing, management may identify deficiencies that will need to be addressed and remediated.
 
PART II
OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

The Company is subject to various claims and pending or threatened lawsuits in the normal course of business. The Company is not currently party to any legal proceedings that management believes the adverse outcome of which would have a material adverse effect on the Company's financial position, results of operations or cash flows.
 
ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
None.
 
ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

(a)
Exhibits
   
31.1
Chief Executive Officer Certification Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
31.2
Chief Financial Officer Certification Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
32.1
Chief Executive Officer Certification pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
32.2
Chief Financial Officer Certification pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
(b)
Reports on Form 8-K

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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
     
  LUMERA CORPORATION
 
 		  
 		  
 
Date: May 11, 2005 By:   /s/ THOMAS D. MINO
 
Thomas Mino
  Chief Executive Officer
(Principal Executive Officer)
 
     
 
Date: May 11, 2005 By:   /s/ PETER J. BIERE
 
Peter J. Biere
  Chief Financial Officer and Treasurer
(Principal Accounting Officer)
 
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EXHIBIT INDEX

The following documents are filed.

Exhibit Number
Description
   
31.1
Chief Executive Officer Certification Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
31.2
Chief Financial Officer Certification Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
32.1
Chief Executive Officer Certification pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
32.2
Chief Financial Officer Certification pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
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