Edgar Filing: EMAGIN CORP

Form 10-Q/A for eMagin Corporation

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q/A

	(Mark One)
R	QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended September 30, 2006
	or

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

	For the transition period from to

Commission file number 001-15751

eMAGIN CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	56-1764501
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

10500 NE 8^th Street, Suite 1400, Bellevue, Washington 98004

(Address of principal executive offices)

(425) 749-3600

(Registrant’s telephone number, including area code)

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

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.001 Par Value Per Share

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

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

Large accelerated filer £

Accelerated filer £

Non-accelerated filer R

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

The number of shares of common stock outstanding as of October 31, 2006 was 10,180,841.

EXPLANATORY NOTE

All common share amounts and per share amounts in the accompanying financial statements and in this Quarterly Report on Form 10-Q/A for the three and nine months ended September 30, 2006 reflect the one-for-ten reverse stock split of the issued and outstanding shares of common stock of the Company, effective on November 3, 2006 (See Notes 1 and 8 to the accompanying Condensed Consolidated Financial Statements).

This amended Quarterly Report on Form 10-Q/A is being filed for the sole purpose of restating its financial statements as reported by the Company on March 28, 2007, on Form 8-K as to non-reliance on previously issued financial statements for the three and nine months ended September 30, 2006. The restatement is to correct an error in the valuation of the derivative liability and debt discount associated with the warrants issued on July 21, 2006 when the Company entered in several Note Purchase Agreements (“the Notes”). The Black-Scholes calculation used to determine the fair values of the derivative liability and debt discount initially used the 18 month life of the Notes as the term. The fair value of the warrants has been amended to the warrant life of 5 years and a corresponding risk free interest rate which has resulted in a higher valuation of the derivative liability and debt discount. The restated statements reflect the increase of approximately $1.3 million of additional derivative liability and approximately $1.2 million of unamortized debt discount. In addition, interest expense increased approximately $155,000 and the gain on warrant derivative liability increased approximately $80,000, resulting in an increase of net other expense of approximately $75,000. The Company has also corrected the presentation of the short-term and long-term portions of the Notes.

The Condensed Consolidated Balance Sheets, Condensed Consolidated Statements of Operations, Condensed Statement of Changes in Shareholders’ Equity, Condensed Consolidated Statements of Cash Flows, and Selected Notes to the Condensed Consolidated Financial Statements are labeled as “restated” as applicable. In all other material respects this Amended Quarterly Report on Form 10-Q/A is unchanged from the Quarterly Report on Form 10-Q previously filed on November 20, 2006.

In addition, we are revising Item 4, Controls and Procedures, to disclose that the Company’s management believes that its controls and procedures were not effective as of the end of the period covered by this report due to the restatements to the Company’s financial statements as set forth above.

The following tables present the impact of the corrections:

Statement of Operations Data (In thousands, except per share data) (Unaudited)

	Three Months Ended September 30, 2006						Nine Months Ended September 30, 2006
	Originally filed			Restated			Originally filed			Restated

Interest expense	$	(354	)	$	(509	)	$	(354	)	$	(509	)

Net loss	$	(3,694	)	$	(3,769	)	$	(13,692	)	$	(13,767	)

Loss per share, basic and diluted	$	(0.37	)	$	(0.37	)	$	(1.36	)	$	(1.37	)

Unaudited Balance Sheet Data (In thousands)
	September 30, 2006
	Originally filed			Restated

Current portion of debt	$	2,963		$	1,241

Derivative liability - warrants	$	2,107		$	3,423

Long-term debt	$	1,311		$	1,792

Accumulated deficit	$	(179,251	)	$	(179,326	)

Total shareholders’ deficit	$	(540	)	$	(615	)

eMagin Corporation

Form 10-Q/A

For the Quarter ended September 30, 2006

Table of Contents


		Page
PART I FINANCIAL INFORMATION

Item 1	Condensed Consolidated Financial Statements

	Condensed Consolidated Balance Sheets as of September 30, 2006 (unaudited and restated) and December 31, 2005	4

	Condensed Consolidated Statements of Operations for the Three and Nine Months ended September 30, 2006 (restated) and 2005 (unaudited )	5

	Condensed Consolidated Statements of Changes in Shareholders’ Equity (Capital Deficit) for the Nine Months ended September 30, 2006 (unaudited and restated)	6

	Condensed Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2006 (restated) and 2005 (unaudited)	7

	Notes to Condensed Consolidated Financial Statements (unaudited and restated)	8

Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17

Item 3	Quantitative and Qualitative Disclosures About Market Risk	21

Item 4	Controls and Procedures	22

PART II OTHER INFORMATION

Item 1	Legal Proceedings	23

Item 1A	Risk Factors	23

Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	29

Item 3	Defaults Upon Senior Securities	29

Item 4	Submission of Matters to a Vote of Security Holders	29

Item 5	Other Information	29

Item 6	Exhibits	29

SIGNATURES

CERTIFICATIONS

ITEM 1. Condensed Consolidated Financial Statements

eMAGIN CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

	September 30,
	2006 (unaudited)			December 31, 2005
	(Restated)
ASSETS

Current assets:
Cash and cash equivalents	$	1,407		$	6,727
Investments - held to maturity		124			120
Accounts receivable, net		1,119			762
Inventory		2,940			3,839
Prepaid expenses and other current assets		1,053			1,045
Total current assets		6,643			12,493
Equipment, furniture and leasehold improvements, net		802			1,299
Intangible assets, net		56			57
Other assets		390			233
Deferred costs		549			—
Total assets	$	8,440		$	14,082

LIABILITIES AND SHAREHOLDERS’ (DEFICIT) EQUITY

Current liabilities:
Accounts payable	$	272		$	562
Accrued compensation		791			1,010
Other accrued expenses		1,361			1,894
Deferred revenue		116			96
Current portion of capitalized lease obligations		10			16
Current portion of debt		1,241			—
Derivative liability - warrants		3,423			—
Other current liabilities		49			47
Total current liabilities		7,263			3,625

Capitalized lease obligations		—			6
Long-term debt		1,792			50
Total liabilities		9,055			3,681

Commitments and contingencies

Shareholders’ (deficit) equity:
Preferred stock, $.001 par value: authorized 10,000,000 shares; no shares issued and outstanding		—			—
Common stock, $.001 par value: authorized 200,000,000 shares, issued and outstanding, 10,136,789 shares as of September 30, 2006 and 9,997,247 shares as of December 31, 2005		10			10
Additional paid-in capital		178,701			175,950
Accumulated deficit		(179,326	)		(165,559	)
Total shareholders’ (deficit) equity		(615	)		10,401
Total liabilities and shareholders’ (deficit) equity	$	8,440		$	14,082

See notes to Condensed Consolidated Financial Statements.

eMAGIN CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share data)

(unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Revenue:	(Restated)						(Restated)

Product revenue	$	2,242		$	1,131		$	5,487		$	2,437
Contract revenue		50			—			120			36

Total revenue, net		2,292			1,131			5,607			2,473

Cost of goods sold		2,940			2,686			8,934			7,031

Gross loss		(648	)		(1,555	)		(3,327	)		(4,558	)

Operating expenses:

Research and development		965			1,022			3,507			3,038
Selling, general and administrative		1,838			1,220			6,674			4,315
Total operating expenses		2,803			2,242			10,181			7,353

Loss from operations		(3,451	)		(3,797	)		(13,508	)		(11,911	)

Other (expense) income:

Interest expense		(509	)		(1	)		(509	)		(3	)
Gain on warrant derivative liability		177			—			177			—
Other income, net		14			35			73			184
Total other (expense) income		(318	)		34			(259	)		181

Net loss	$	(3,769	)	$	(3,763	)	$	(13,767	)	$	(11,730	)


Loss per share, basic and diluted	$	(0.37	)	$	(0.45	)	$	(1.37	)	$	(1.42	)

Weighted average number of shares outstanding:

Basic and diluted		10,077,260			8,303,647			10,030,988			8,232,010

See notes to Condensed Consolidated Financial Statements.

eMAGIN CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (DEFICIT)

(In thousands)

(Restated)

					Additional					Total
	Common Stock				Paid-In		Accumulated			Shareholders’
	Shares		Amount		Capital		Deficit			Equity

Balance, December 31, 2005		9,997	$	10	$	175,950	$	(165,559	)	$	10,401
Stock-based compensation		—		—		2,270		—			2,270
Debt conversion to equity		27		—		70		—			70
Exercise of options		5		—		10		—			10
Issuance of common stock for services		108		—		401		—			401
Net loss		—		—		—		(13,767	)		(13,767	)
Balance, September 30, 2006, (unaudited)		10,137	$	10	$	178,701	$	(179,326	)	$	(615	)

(1) The number of shares outstanding per shares amounts, common stock and additional paid-in capital for all periods has been adjusted to reflect a one-for-ten reverse stock split

effective in November 2006.

See notes to Condensed Consolidated Financial Statements.

eMAGIN CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

	Nine Months Ended
	September 30,
	2006(Restated)			2005
	(unaudited)
Cash flows from operating activities:
Net loss	$	(13,767	)	$	(11,730	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		792			630
Reduction in provision for sales returns and doubtful accounts		(18	)		(419	)
Stock-based compensation		2,270			—
Issuance of common stock for services, net		375			397
Amortization of discount on notes payable		382			—
Gain on warrant derivative liability		(177	)		—
Changes in operating assets and liabilities:
Accounts receivable		(339	)		179
Inventory		899			(1,574	)
Prepaid expenses and other current assets		(8	)		(382	)
Deferred revenue		20			---
Accounts payable, accrued compensation, and other accrued expenses		(899	)		586
Other current liabilities		101			68
Net cash used in operating activities		(10,369	)		(12,245	)
Cash flows from investing activities:
Purchase of equipment		(204	)		(665	)
Purchase of investments - held to maturity		(4	)		—
Purchase of intangibles and other assets		(2	)		(46	)
Net cash used by investing activities		(210	)		(711	)
Cash flows from financing activities:
Proceeds from exercise of stock options and warrants		10			1,594
Net proceeds from issuance of debt		5,379			—
Payments of long-term debt and capital leases		(130	)		(10	)
Net cash provided by financing activities		5,259			1,584
Net (decrease) in cash and cash equivalents		(5,320	)		(11,372	)
Cash and cash equivalents beginning of period		6,727			13,457
Cash and cash equivalents end of period	$	1,407		$	2,085

Cash paid for interest	$	127		$	8
Cash paid for taxes	$	35		$	---

Supplemental non-cash information:
During the nine months ended September 30, 2006, the Company
· entered into several Note Purchase Agreements with investors and issued warrants that are exercisable at $3.60 per share into approximately 1.6 million shares of common stock valued at $3.4 million;
· issued warrants that are exercisable at $2.60 per share into approximately 190,000 shares of common stock valued at approximately $158,000.
· issued 10,000 shares of common stock in lieu of cash payment of $26,000 as compensation for services performed and recorded as deferred costs; and
· issued approximately 27,000 shares for the conversion of Notes totaling $70,000.

See notes to Condensed Consolidated Financial Statements.

eMAGIN CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1: Description of the Business and Summary of Significant Account Policies

The Business

eMagin Corporation is a developer and manufacturer of optical systems and microdisplays for use in the electronics industry. eMagin also develops and markets microdisplay systems and optics technology for commercial, industrial and military applications.

Basis of Presentation (Restated)

In the opinion of management, the accompanying unaudited condensed consolidated financial statements of eMagin Corporation and its subsidiary reflects all adjustments, including normal recurring accruals, necessary for a fair presentation. Certain information and footnote disclosure normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to instruction, rules and regulations prescribed by the Securities and Exchange Commission. The Company believes that the disclosures provided herein are adequate to make the information presented not misleading when these unaudited condensed consolidated financial statements are read in conjunction with the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

Certain prior-period balances have been reclassified to conform to the current period presentation. These reclassifications had no impact on revenue, net loss, assets or liabilities in either period presented. The results of operations for the period ended September 30, 2006 are not necessarily indicative of the results to be expected for the full year.

On November 3, 2006, the Company effected a one-for-ten (1-for-10) reverse stock split of its issued and outstanding common stock - see Note 8. All common share amounts and per share amounts in the accompanying financial statements and this Form 10-Q have been adjusted to reflect the 1-for-10 reverse stock split. The Company has adjusted its shareholders’ equity accounts by reducing its stated capital and increasing its additional paid-in capital by approximately $91,000 as of September 30, 2006 and December 31, 2005, to reflect the reduction in outstanding shares as a result of the reverse stock split.

The condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company has had recurring losses from operations which it believes will continue through 2006 and 2007. The Company’s cash requirements over the next 12 months are greater than our current cash on hand. These factors raise substantial doubt regarding the Company’s ability to continue as a going concern without continuing to obtain additional funding. The Company does not have commitments for such financing and no assurance can be given that additional financing will be available, or if available, will be on acceptable terms. If the Company is unable to obtain sufficient funds during the next 6 months, the Company will further reduce the size of its organization and/or curtail operations which will have a material adverse impact on our business prospects. The condensed consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Restatement

This Amended Quarterly Report on Form 10-Q/A is being filed to correct an error in the valuation of the derivative liability and debt discount associated with the warrants issued on July 21, 2006 when the Company entered in several Note Purchase Agreements (“the Notes”). The Black-Scholes calculation used to determine the fair values of the derivative liability and debt discount initially used the 18 month life of the Notes as the term. The fair value of the warrants has been amended to the warrant life of 5 years and a corresponding risk-free interest rate which has resulted in a higher valuation of the derivative liability and debt discount. The restated statements reflect the increase of approximately $1.3 million of additional derivative liability and approximately $1.2 million of unamortized debt discount. In addition, interest expense increased approximately $155,000 and the gain on warrant derivative liability increased approximately $80,000, resulting in an increase of net other expense of approximately $75,000. The Company has also corrected the presentation of the short-term and long-term portions of the Notes. In all other material respects this Amended Quarterly Report on Form 10-Q/A is unchanged from the Quarterly Report on Form 10-Q previously filed on November 20, 2006.

The following tables present the impact of the corrections:

Statement of Operations Data (In thousands, except per share data) (Unaudited)

	Three Months Ended September 30, 2006						Nine Months Ended September 30, 2006
	Originally filed			Restated			Originally filed			Restated

Interest expense	$	(354	)	$	(509	)	$	(354	)	$	(509	)

Net loss	$	(3,694	)	$	(3,769	)	$	(13,692	)	$	(13,767	)

Loss per share, basic and diluted	$	(0.37	)	$	(0.37	)	$	(1.36	)	$	(1.37	)

Unaudited Balance Sheet Data (In thousands)
	September 30, 2006
	Originally filed			Restated

Current portion of debt	$	2,963		$	1,241

Derivative liability - warrants	$	2,107		$	3,423

Long-term debt	$	1,311		$	1,792

Accumulated deficit	$	(179,251	)	$	(179,326	)

Total shareholders’ deficit	$	(540	)	$	(615	)

Use of Estimates

In accordance with accounting principles generally accepted in the United States, management utilizes certain estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments. Management bases its estimates and judgments on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates.

Revenue Recognition

Revenue is recognized when products are shipped to customers, net of allowances for anticipated returns. The Company’s revenue-earning activities generally involve delivering products and revenues are considered to be earned when the Company has completed the process by which it is entitled to such revenues. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the selling price is fixed or determinable and collection is reasonably assured. The Company defers revenue recognition on products sold directly to the consumer with a fifteen day right of return. Revenue is recognized upon the expiration of the right of return.

The Company also earns revenues from certain R&D activities under both firm fixed-price contracts and cost-type contracts, including some cost-plus-fee contracts. Revenues relating to firm fixed-price contracts are generally recognized on the percentage-of-completion method of accounting as costs are incurred (cost-to-cost basis). Revenues on cost-plus-fee contracts include costs incurred plus a portion of estimated fees or profits based on the relationship of costs incurred to total estimated costs. Contract costs include all direct material and labor costs and an allocation of allowable indirect costs as defined by each contract, as periodically adjusted to reflect revised agreed upon rates. These rates are subject to audit by the other party.

Stock-based Compensation

The Company maintains several stock equity incentive plans. The 2005 Employee Stock Purchase Plan (the “ESPP”) provides the Company’s employees with the opportunity to purchase common stock through payroll deductions. Employees purchase stock semi-annually at a price that is 85% of the fair market value at certain plan-defined dates. As of September 30, 2006, the number of shares of common stock available for issuance was 150,000. As of September 30, 2006, the plan had not been implemented.

The 2003 Stock Option Plan (the”2003 Plan”) provides for grants of shares of common stock and options to purchase shares of common stock to employees, officers, directors and consultants. Under the 2003 plan, an ISO grant is granted at the market value of the Company’s common stock at the date of the grant and a non-ISO is granted at a price not to be less than 85% of the market value of the common stock at the date of grant. These options have a term of up to 10 years and vest over a schedule determined by the Board of Directors, generally five years. The amended 2003 Plan provides for an annual increase of 3% of the diluted shares outstanding on January 1 of each year for a period of nine (9) years which commenced January 1, 2005.

On January 1, 2006, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123(R), “Share-Based Payment”, (“SFAS No. 123R”), which requires the Company to recognize expense related to the fair value of the Company’s share-based compensation. Prior to January 1, 2006, the Company accounted for share-based compensation under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25 ("APB No. 25"), “Accounting for Stock Issued to Employees”, and related interpretations, as permitted by FASB Statement No. 123, "Accounting for Stock-Based Compensation" (“SFAS No. 123”). In accordance with APB No. 25, no compensation cost was required to be recognized for options granted that had an exercise price equal to the market value of the underlying common stock on the date of grant.

The Company adopted SFAS No. 123R using the modified prospective transition method and consequently has not retroactively adjusted results for prior periods. Under this transition method, compensation cost associated with stock options includes: a) compensation cost for all share-based compensation granted prior to, but not vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No.123 and b) compensation cost for all share-based compensation granted beginning January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No.123R. The Company uses the straight-line method for recognizing compensation expense. Compensation expense for awards under SFAS 123R includes an estimate for forfeitures.

See Note 7 for further information regarding the Company’s stock-based compensation assumptions and expenses, including the impact of adoption on the Company’s condensed Consolidated Financial Statements and pro forma disclosures for prior periods as if we had recorded stock-based compensation expense.

Note 2: Receivables

The majority of the Company’s commercial accounts receivable are due from Original Equipment Manufacturers ("OEM’s”). Credit is extended based on evaluation of a customer’s financial condition and, generally, collateral is not required. Accounts receivable are payable in U.S. dollars, are due within 30-90 days and are stated at amounts due from customers, net of an allowance for doubtful accounts. Any account outstanding longer than the contractual payment terms is considered past due.

The Company determines the allowance for doubtful accounts by considering a number of factors, including the length of time the trade accounts receivable are past due, eMagin's previous loss history, the customer's current ability to pay its obligation, and the condition of the general economy and the industry as a whole. The Company will record a specific reserve for individual accounts when the Company becomes aware of a customer's inability to meet its financial obligations, such as in the case of bankruptcy filings or deterioration in the customer's operating results or financial position. If circumstances related to customers change, the Company would further adjust estimates of the recoverability of receivables.

Receivables consisted of the following (in thousands):

	September 30, 2006 (unaudited)			December 31, 2005
Accounts receivable	$	1,588		$	1,249
Less allowance for doubtful accounts		(469	)		(487	)
Net receivables	$	1,119		$	762

Note 3: Research and Development Costs

Research and development costs are expensed as incurred.

Note 4: Net Loss per Common Share

In accordance with SFAS No. 128, net loss per common share amounts ("basic EPS") was computed by dividing net loss by the weighted average number of common shares outstanding and excluding any potential dilution. Net loss per common share assuming dilution ("diluted EPS") was computed by reflecting potential dilution from the exercise of stock options and warrants. Common stock equivalent shares are excluded from the computation if their effect is antidilutive. As of September 30, 2006 and 2005, there were stock options and warrants outstanding to acquire 4,893,921 and 3,519,393 shares of our common stock, respectively. These shares were excluded from the computation of diluted loss per share because their effect would be antidilutive.

Note 5: Inventories

Inventory is stated at the lower of cost or market. Cost is determined using the first-in first-out method. The Company reviews the value of its inventory and reduces the inventory value to its net realizable value based upon current market prices and contracts for future sales. The components of inventories are as follows (in thousands):

	September 30, 2006 (unaudited)		December 31, 2005
Raw materials	$	1,396	$	2,353
Work in process		266		107
Finished goods		1,278		1,379
Total Inventory	$	2,940	$	3,839

Note 6: Debt (Restated)

Debt is as follows (in thousands):

	September 30, 2006 (unaudited) (Restated)		December 31, 2005
Current portion of capitalized lease obligations	$	10	$	16
Current portion of debt		1,241
Long-term capitalized lease obligations		—		6
Long-term debt		3,130		—
Less: Unamortized discount on notes payable - long term		1,338		—
Long-term debt, net		1,792		50
Total debt	$	3,043	$	72

On July 21, 2006, the Company entered into several Note Purchase Agreements for the sale of approximately $5.99 million of senior secured debentures (the “Notes”) together with warrants to purchase approximately 1.8 million shares of common stock, par value $.0001 per share. 50% of the aggregate principal amount matures on July 21, 2007 and the remaining 50% matures on January 21, 2008. The Notes pay 6% interest quarterly beginning September 1, 2006. Approximately $37,000 of interest was paid to investors on September 1, 2006.

The Company accounted for the net proceeds from the issuance of the Notes as two separate components: a detachable warrant component and a debt component. The Company determined the relative fair value of warrants to be $3.4 million which was recorded as debt discount, a reduction of the carrying value of the Notes. The following assumptions were used to determine the fair value of the warrants:

Dividend yield		0%
Risk free interest rates		4.99%
Expected volatility		122%
Expected term (in years)		5.0 years

The discount is being amortized to interest expense over the term of the Note. For the three and nine months ended September 30, 2006, debt discount of $382,000 was amortized to interest expense - see Note 8: Shareholders’ Equity for additional information on the Notes.

Note 7: Stock-based Compensation

On January 1, 2006, the Company adopted the provisions of SFAS No. 123R, which requires the Company to recognize expense related to the fair value of the Company’s share-based compensation issued to employees and directors. Prior to January 1, 2006, the Company accounted for share-based compensation under the recognition and measurement provisions of APB No. 25 and related interpretations, as permitted by SFAS No. 123. We adopted SFAS No. 123R using the modified prospective transition method. Accordingly, periods prior to adoption have not been restated. Compensation cost recognized for the three and nine months ended September 30, 2006 includes a) compensation cost for all share-based compensation granted prior to, but not vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No.123 and b) compensation cost for all share-based compensation granted beginning January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No.123R. The compensation cost was recognized using the straight-line attribution method.

The following table summarizes the allocation of non-cash stock-based compensation to our expense categories for the three and nine month periods ended September 30, 2006 (in thousands):

	Three Months Ended September 30, 2006		Nine Months Ended September 30, 2006

Cost of revenue	$	112	$	370
Research and development		119		378
Selling, general and administrative		459		1,522
Total stock compensation expense	$	690	$	2,270

For the three and nine months ended September 30, 2006, stock compensation was approximately $0.7 million and $2.3 million, respectively. At September 30, 2006, total unrecognized non-cash compensation costs related to stock options was approximately $4.8 million, net of estimated forfeitures. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures and is expected to be recognized over a weighted average period of approximately 5.4 years.

The Company recognizes compensation expense for options granted to non-employees in accordance with the provision of Emerging Issues Task Force (“EITF”) consensus Issue 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services,” which requires using a fair value options pricing model and re-measuring such stock options to the current fair market value at each reporting period as the underlying options vest and services are rendered.

In determining the fair value of stock options granted during the nine month periods ended September 30, 2006 and 2005, the following key assumptions were used in the Black-Scholes option pricing model:

	For the Nine Months Ended September 30,
	2006			2005
Dividend yield		0	%		0	%
Risk free interest rates		4.59	%		4.39	%
Expected volatility		126	%		52	%
Expected term (in years)		5 years			10 years

We have not declared or paid any dividends and do not currently expect to do so in the near future. The risk-free interest rate used in the Black-Scholes is based on the implied yield currently available on U.S. Treasury securities with an equivalent term. Expected volatility is based on the weighted average historical volatility of the Company’s common stock for the most recent five year period. The expected term of options represents the period that our stock-based awards are expected to be outstanding and was determined based on historical experience and vesting schedules of similar awards.

The following table shows the proforma effect on our net loss and net loss per share had compensation expense been determined based on the fair value at the award grant date in accordance with SFAS No. 123 for the three and nine months ended September 30, 2005 (in thousands, except per share data):

	Three Months Ended September 30, 2005			Nine Months Ended September 30, 2005

Net loss, as reported	$	(3,763	)	$	(11,730	)
Deduct: Stock-based employee compensation expense determined under fair value method		(465	)		(2,809	)
Pro forma net loss	$	(4,228	)	$	(14,539	)
Net loss per share:
Basic and diluted, as reported	$	(0.45	)	$	(1.42	)
Basic and diluted, pro forma	$	(0.51	)	$	(1.77	)

A summary of the Company’s stock option activity for the nine months ended September 30, 2006 is presented in the following tables:

	Number of Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (In Years)		Aggregate Intrinsic Value
Outstanding at January 1, 2006		1,805,264		$	10.90
Options granted		185,744			4.30
Options exercised		(5,000	)		2.10			$	2,000
Options forfeited		(365,420	)		8.74
Options cancelled		(467,148	)		11.97
Outstanding at September 30, 2006		1,153,440		$	2.88		3.96	$	47,681
Vested or expected to vest at September 30, 2006 (1)		1,072,699		$	2.88		3.96	$	47,681
Exercisable at September 30, 2006		684,342		$	2.78		2.81	$	47,681

	Options Outstanding						Options Exercisable
	Number Outstanding		Weighted Average Remaining Contractual Life (In Years)		Weighted Average Exercise Price		Number Exercisable		Weighted Average Exercisable Price
$2.10 - $2.70		1,140,034		4.21	$	2.25		581,269	$	2.50
$3.40 - $5.80		109,424		1.49		3.76		94,924		3.45
$6.60 - $22.5		29,982		4.71		10.82		8,149		14.81
		1,153,440		3.96	$	2.88		684,342	$	2.78

(1) The expected to vest options are the result of applying the pre-vesting forfeiture rate assumptions to total outstanding options.

The aggregate intrinsic value in the table above represents the difference between the exercise price of the underlying options and the quoted price of the Company’s common stock for the 125,202 options that were in-the-money at September 30, 2006. The Company’s closing stock price was $2.50 as of September 30, 2006. The Company issues new shares of common stock upon exercise of stock options.

On July 21, 2006, certain employees and Directors of the Company agreed to forfeit approximately 467,000 shares underlying existing stock options in return for the re-pricing of approximately 869,000 existing options at $2.60 per share having a weighted average original exercise price of $11.97. Option grants that have not been re-priced will remain unchanged. The unvested options which were re-priced will continue to vest on original vesting schedules, but in no event prior to January 19, 2007. Previously vested options which were re-priced will now vest on January 19, 2007. Re-priced grants will be forfeited if the individual leaves voluntarily. The Company has accounted for the re-pricing and cancellation transactions as a modification under SFAS No. 123R. The Company will recognize the additional compensation charges over the four months ended January 19, 2007 for previously vested options and over the remaining vesting period for unvested options.

Note 8: Shareholders’ Equity (Restated)

At the Company’s 2006 Annual Meeting of Shareholders in October 2006, the Company’s shareholders approved an amendment to the Company’s certificate of incorporation to effect a reverse stock split of the issued and outstanding common stock on a ratio of 1-for-10. On November 3, 2006, the reverse stock split became effective. The Company has adjusted its shareholders’ equity accounts by reducing its stated capital and increasing its additional paid-in capital by approximately $91,000 as of September 30, 2006 and December 31, 2005, to reflect the reduction in outstanding shares as a result of the reverse stock split.

On July 21, 2006, the Company entered into several Note Purchase Agreements for the sale of approximately $5.99 million of senior secured debentures (the “Notes”) and warrants to purchase approximately 1.8 million shares of common stock, par value $.001 per share. The investors purchased $5.99 million principal amount of Notes with conversion prices of $2.60 per share that may convert into approximately 2.3 million shares of common stock and 5 year warrants exercisable at $3.60 per share into approximately 1.6 million shares of common stock. If the Notes are not converted, 50% of the principal amount will be due on July 21, 2007 and the remaining 50% will be due on January 21, 2008. Commencing September 1, 2006, 6% interest is payable in quarterly installments on outstanding notes. On September 1, 2006, the Company paid approximately $37,000 to investors for the first installment of quarterly interest. In the quarter ended September 30, 2006, two note holders partially converted their promissory note valued at approximately $70,000 and were issued an aggregate of approximately 27,000 shares. The Company received approximately $5.4 million, net of deferred costs of approximately $0.6 million which are amortized over the life of the Notes.

The Company accounted for the net proceeds from the issuance of the Notes as two separate components: a detachable warrant component and a debt component. The Company determined the relative fair value of the warrants to be approximately $3.4 million which was recorded as debt discount, a reduction of the carrying value of the Notes. The following assumptions were used to determine the fair value of the warrants:

Dividend yield		0%
Risk free interest rates		4.99%
Expected volatility		122%
Expected term (in years)		5.0 years

The discount is being amortized to interest expense over the term of the Note. For the three and nine months ended September 30, 2006, debt discount of approximately $382,000 was amortized to interest expense.

An additional $0.5 million will be invested through the exercise of a warrant to purchase approximately 192,000 shares of common stock at $2.60 per share on or prior to December 14, 2006, or at the election of the Company, by the purchase of additional Notes and warrants. The Company determined the relative fair value of the warrants to be approximately $158,000 which was recorded as an other asset. The following assumptions were used to determine the fair value of the warrant:

Dividend yield		0%
Risk free interest rates		5.25%
Expected volatility		122%
Expected term (in years)		0.4 years

Under EITF 00-19 “Accounting for Derivative Financial Instruments Indexed to and Potentially Settled in, a Company’s Own Stock”, the fair value of the warrants, $3.6 million, have been recorded as a liability since the warrant agreement requires a potential net-cash settlement in the first year of the warrant agreement if the registration statement is not effective. As of September 30, 2006, the registration statement is effective. The liability will be adjusted to fair value at each reporting period. The change in the fair value of the warrants will be recorded in the Consolidated Statement of Operations as other income (expense). For the three and nine months ended September 30, 2006, the Company recorded approximately $177,000 of gain from the change in the fair value of the derivative liability.

As a result of the issuance of the Notes, the outstanding 116,576 Series A Common Stock Purchase Warrants, that were issued to certain accredited and/or institutional investors pursuant to the Securities Purchase Agreement dated January 9, 2004, were re-priced from $5.50 to $2.60 and the outstanding 650,001 Series F Common Stock Purchase Warrants, that were issued to certain accredited and/or institutional investors pursuant to the Securities Purchase Agreement dated October 25, 2004, were re-priced from $10.90 to $8.60.

A registration rights agreement was entered into in connection with the Notes which requires the Company to file a registration statement for the resale of the common stock underlying the Notes and the warrants. The Company must use its best efforts to have the registration statement declared effective by the end of a specified grace period and also maintain the effectiveness of the registration statement until all shares of common stock underlying the Notes and the warrants have been sold or may be sold without volume restrictions pursuant to Rule 144(k) of the Securities Act. If the Company fails to have the registration statement declared effective within the grace period or fails to maintain the effectiveness as set forth in the preceding sentence, the Company is required to pay each investor cash payments equal to 1.0% of the aggregate purchase price monthly until the failure is cured. If the Company fails to pay the liquidated damages, interest at 16.0% will accrue until the liquidated damages are paid in full. The registration statement was filed and declared effective by the Securities and Exchange Commission within the specified grace period. As of September 30, 2006, the registration statement remains effective.

The Company accounts for the registration rights agreement as a separate freestanding instrument and accounts for the liquidated damages provision as a derivative liability subject to SFAS 133. The estimated fair value of the liability is based on an estimate of the probability and costs of cash penalties being incurred. The Company determined that the fair value of the liability was immaterial and it is not recorded in accrued liabilities. The Company will revalue the potential liability at each balance sheet date.

For the three and nine months ended September 30, 2006, the Company received approximately $10,000 for the exercise of 5,000 options and there were no warrants exercised. For the three and nine months ended September 30, 2005, the Company received approximately $30,000 and $35,000, respectively, for the exercise of 9,600 and 10,400 options, respectively. For the three and nine months ended September 30, 2005, the Company received approximately $1.6 million for the exercise of approximately 300,000 warrants.

For the three and nine months ended September 30, 2006, the Company also issued approximately 63,000 and 108,000 shares of common stock, respectively, in lieu of cash payments in the amount of approximately $209,000 and $401,000, respectively, as compensation for services rendered and to be rendered in the future. For the three and nine months ended September 30, 2005, the Company also issued approximately 12,000 and 41,000 shares of common stock, respectively, in lieu of cash payments in the amount of approximately $121,000 and $378,000, respectively, as compensation for services rendered and to be rendered in the future.

Note 9: Commitments and Contingencies

Royalty Payments

The Company, in accordance with a royalty agreement with Eastman Kodak, is obligated to make minimum annual royalty payments of $125,000 which commenced on January 1, 2001. Under this agreement, the Company must pay to Eastman Kodak a certain percentage of net sales with respect to certain products, which percentages are defined in the agreement. The percentages are on a sliding scale depending on the amount of sales generated. Any minimum royalties paid will be credited against the amounts due based on the percentage of sales. The royalty agreement terminates upon the expiration of the issued patent which is the last to expire.

The Company paid $125,000 for the minimum amount due for 2006 and 2005. The amount was recorded in prepaid expenses and will be amortized as the Company records the royalty expense as defined in the agreement. Royalty expense was approximately $149,000 and $340,000, respectively, for the three and nine months ended September 30, 2006 and approximately $65,000 and $130,000, respectively, for the three and nine months ended September 30, 2005.

Contractual Obligations

The Company leases office facilities and office, lab and factory equipment under operating leases expiring through 2009. Certain leases provide for payments of monthly operating expenses. The Company currently has lease commitments for space in Hopewell Junction, New York and Bellevue, Washington. Rent expense was approximately $332,000 and $1.0 million for the three and nine months ended September 30, 2006, respectively, and approximately $267,000 and $742,000 for the three and nine months ended September 30, 2005, respectively.

Note 10: Legal Proceedings

On December 6, 2005, New York State Urban Development Corporation commenced action in the Supreme Court of the State of New York, County of New York against the Company, asserting breach of contract and seeking to recover a $150,000 grant which was made to the Company based on goals set forth in the agreement for recruitment of employees. On July 13, 2006, the Company agreed to a settlement with the New York State Urban Development Corporation to repay $112,200. The settlement requires that repayments be made on a monthly basis in the amount of $3,116.67 per month commencing August 1, 2006 and ending on July 1, 2009.

Note 11: Subsequent Events

At the Company’s 2006 Annual Meeting of Shareholders held on October 20, 2006, the Company’s shareholders approved an amendment to the Company’s Certificate of Incorporation to effect a reverse stock split of the Company’s outstanding common stock at an exchange ratio of one-for-ten. On November 3, 2006, the reverse stock split became effective. Each holder of ten shares of the Company’s common stock will become the holder of one share of the Company’s common stock. In addition, all outstanding options, warrants, and convertible notes will be adjusted in accordance with their terms and pursuant to the ratio of the reverse split. All fractional shares shall be rounded up to the next whole number of shares.

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

Statement of Forward-Looking Information

In this quarterly report, references to "eMagin Corporation," "eMagin," "Virtual Vision," "the Company," "we," "us," and "our" refer to eMagin Corporation and its wholly owned subsidiary, Virtual Vision, Inc.

Except for the historical information contained herein, some of the statements in this Report contain forward-looking statements that involve risks and uncertainties. These statements are found in the sections entitled "Management's Discussion and Analysis or Plan Operations" and "Risk Factors." They include statements concerning: our business strategy; expectations of market and customer response; liquidity and capital expenditures; future sources of revenues; expansion of our proposed product line; and trends in industry activity generally. In some cases, you can identify forward-looking statements by words such as "may," "will," "should," "expect," "plan," "could," "anticipate," "intend," "believe," "estimate," "predict," "potential," "goal," or "continue" or similar terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including, but not limited to, the risks outlined under "Risk Factors," that may cause our or our industry's actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. For example, assumptions that could cause actual results to vary materially from future results include, but are not limited to: our ability to successfully develop and market our products to customers; our ability to generate customer demand for our products in our target markets; the development of our target markets and market opportunities; our ability to manufacture suitable products at competitive cost; market pricing for our products and for competing products; the extent of increasing competition; technological developments in our target markets and the development of alternate, competing technologies in them; and sales of shares by existing shareholders. Although we believe that the expectations reflected in the forward looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Unless we are required to do so under federal securities laws or other applicable laws, we do not intend to update or revise any forward-looking statements.

Overview

We design, develop, manufacture, and market virtual imaging products which utilize OLEDs, or organic light emitting diodes, OLED-on-silicon microdisplays and related information technology solutions. We integrate OLED technology with silicon chips to produce high-resolution microdisplays smaller than one-inch diagonally which, when viewed through a magnifier, create virtual images that appear comparable in size to that of a computer monitor or a large-screen television. Our products enable our original equipment manufacturer, or OEM, customers to develop and market improved or new electronic products. We believe that virtual imaging will become an important way for increasingly mobile people to have quick access to high-resolution data, work, and experience new more immersive forms of communications and entertainment.

Our first commercial product, the SVGA+ (Super Video Graphics Array of 800x600 plus 52 added columns of data) OLED microdisplay, was initially offered for sampling in 2001, and our first SVGA-3D (Super Video Graphics Array plus built-in stereovision capability) OLED microdisplay was shipped in early 2002. We are in the process of completing development of 2 additional OLED microdisplays, namely the SVGA 3DS (SVGA 3D shrink, a smaller format SVGA display with a new cell architecture with embedded features) and an SXGA (1280 x 1024).

In January 2005, we announced the world's first personal display system to combine OLED technology with head-tracking and 3D stereovision, the Z800 3DVisor(tm), which was first shipped in mid-2005. This product received a CES Design and Innovations Award for the electronic gaming category and also received the coveted Best of Innovation Awards for the entire display category. The product was also recognized as a Digital Living Class of 2005 Innovators.

We license our core OLED technology from Eastman Kodak and we have developed our own technology to create high performance OLED-on-silicon microdisplays and related optical systems. We believe our technology licensing agreement with Eastman Kodak, coupled with our own intellectual property portfolio, gives us a leadership position in OLED and OLED-on-silicon microdisplay technology. We believe we are the only company to sell full-color active matrix small molecule OLED-on-silicon microdisplays.

Company History

From inception through January 1, 2003, we were a developmental stage company. We have transitioned to manufacturing our products and intend to significantly increase our marketing, sales, and research and development efforts, and expand our operating infrastructure. Most of our operating expenses are fixed in the near term. If we are unable to generate significant revenues, our net losses in any given period could be greater than expected.

CRITICAL ACCOUNTING POLICIES

The Securities and Exchange Commission ("SEC") defines "critical accounting policies" as those that require application of management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods.

Not all of the accounting policies require management to make difficult, subjective or complex judgments or estimates. However, the following policies could be deemed to be critical within the SEC definition.

Revenue Recognition

Revenue on product sales is recognized when persuasive evidence of an arrangement exists, such as when a purchase order or contract is received from the customer, the selling price is fixed, title to the goods has changed and there is a reasonable assurance of collection of the sales proceeds. We obtain written purchase authorizations from our customers for a specified amount of product at a specified price and consider delivery to have occurred at the time of shipment. Revenue is recognized at shipment and we record a reserve for estimated sales returns, which is reflected as a reduction of revenue at the time of revenue recognition. We defer revenue on products sold directly to the consumer with a fifteen day right of return. Revenue is recognized upon the expiration of the right of return.

Revenues from research and development activities relating to firm fixed-price contracts are generally recognized on the percentage-of-completion method of accounting as costs are incurred (cost-to-cost basis). Revenues from research and development activities relating to cost-plus-fee contracts include costs incurred plus a portion of estimated fees or profits based on the relationship of costs incurred to total estimated costs. Contract costs include all direct material and labor costs and an allocation of allowable indirect costs as defined by each contract, as periodically adjusted to reflect revised agreed upon rates. These rates are subject to audit by the other party.

Use of Estimates

In accordance with accounting principles generally accepted in the United States, management utilizes estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. These estimates and assumptions relate to recording net revenue, collectibility of accounts receivable, useful lives and impairment of tangible and intangible assets, accruals, income taxes, inventory realization, stock-based compensation expense and other factors. Management believes it has exercised reasonable judgment in deriving these estimates. Consequently, a change in conditions could affect these estimates.

Fair Value of Financial Instruments

The Company's cash, cash equivalents, investments, accounts receivable and accounts payable are stated at cost which approximates fair value due to the short-term nature of these instruments.

Stock-based Compensation

We maintain several stock equity incentive plans. The 2005 Employee Stock Purchase Plan (the “ESPP”) provides our employees with the opportunity to purchase common stock through payroll deductions. Employees purchase stock semi-annually at a price that is 85% of the fair market value at certain plan-defined dates. As of September 30, 2006, the number of shares of common stock available for issuance was 150,000. As of September 30, 2006, the plan had not been implemented.

The 2003 Stock Option Plan (the”2003 Plan”) provides for grants of shares of common stock and options to purchase shares of common stock to employees, officers, directors and consultants. Under the 2003 plan, an ISO grant is granted at the market value of our common stock at the date of the grant and a non-ISO is granted at a price not to be less than 85% of the market value of the common stock. These options have a term of up to 10 years and vest over a schedule determined by the Board of Directors, generally over a five year period. The amended 2003 Plan provides for an annual increase of 3% of the diluted shares outstanding on January 1 of each year for a period of 9 years which commenced January 1, 2005.

On January 1, 2006, we adopted the provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123(R), “Share-Based Payment”, and (“SFAS No. 123R”), which requires us to recognize expense related to the fair value of our share-based compensation issued to employees and directors. Prior to the January 1, 2006, we accounted for share-based compensation under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25 ("APB No. 25"), “Accounting for Stock Issued to Employees”, and related interpretations, as permitted by FASB Statement No. 123, "Accounting for Stock-Based Compensation" (“SFAS No. 123”). In accordance with APB No. 25, no compensation cost was required to be recognized for options granted that had an exercise price equal to the market value of the underlying common stock on the date of grant.

We adopted SFAS No. 123R using the modified prospective transition method and consequently have not retroactively adjusted results for prior periods. Under this transition method, compensation cost associated with stock options includes: a) compensation cost for all share-based compensation granted prior to, but not vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No.123 and b) compensation cost for all share-based compensation granted beginning January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No.123R. We use the straight-line method for recognizing compensation expense. Compensation expense for awards under SFAS 123R includes an estimate for forfeitures.

NEW ACCOUNTING PRONOUNCEMENT

The Financial Accounting Standards Board (“FASB”) has issued interpretation No. 48, “Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109” (“FIN 48”), regarding accounting for, and disclosure of, uncertain tax positions. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We do not anticipate that the adoption of this statement will have a material effect on our financial position or results of operation.

In September 2006, the FASB issued SFAS 157, “Fair Value Measurements”. SFAS 157 defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We will be evaluating the effect that the adoption of SFAS 157 may have on our financial position and results of operations.

RESULTS OF OPERATIONS

THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005

Revenues

Revenues for the three and nine months ended September 30, 2006 were approximately $2.3 million and $5.6 million, respectively, as compared to approximately $1.1 million and $2.5 million, respectively, for the three and nine months ended September 30, 2005, an increase of approximately 103% and 127%, respectively. Higher revenue for the three and nine month periods was primarily due to increased microdisplay demand and increased availability of finished displays due to manufacturing improvements.

Cost of Goods Sold

Cost of goods sold includes direct and indirect costs associated with production. Cost of goods sold for the three and nine months ended September 30, 2006 was approximately $2.9 million and $8.9 million, respectively, as compared to approximately $2.7 million and $7.0 million, respectively, for the three and nine months ended September 30, 2005, an increase of approximately $0.2 million and $1.9 million, respectively. The gross loss for the three and nine months ended September 30, 2006 was approximately ($0.6) million and ($3.3) million, respectively, as compared to approximately ($1.6) million and $(4.6) million, respectively, for the three and nine months ended September 30, 2005. This translates to a gross loss of (28%) and (59%), respectively, for the three and nine months ended September 30, 2006 as compared to a gross loss of (137%) and (184%), respectively, for the three and nine months ended September 30, 2005. The increase in cost of goods sold for the three and nine months 2006 was attributed to higher materials usage to support increased production as well as approximately $112,000 and $370,000 for the three and nine month periods, respectively, of non cash stock compensation expense reflected in accordance with SFAS No. 123R in 2006.

Operating Expenses

Research and Development. Research and development expenses included salaries, development materials and other costs specifically allocated to the development of new microdisplay products, OLED materials and subsystems. Research and development expenses for the three and nine months ended September 30, 2006 were approximately $1.0 million and $3.5 million, respectively, a decrease of approximately $57,000 and an increase of $469,000, as compared to approximately $1.0 million and $3.0 million, respectively, for the three and nine months ended September 30, 2005. The decrease in the quarter was due to reductions in research and development expenditures and personnel costs and offset in part by the stock-based compensation of $119,000 reflected in accordance with SFAS No. 123R in 2006. The increase in the nine months ended September 30, 2006 was primarily due to the stock-based compensation expense of $378,000 and slightly higher headcount for the first 6 months of the year. Options were not expensed during 2005.

Selling, General and Administrative. Selling, general and administrative expenses consist principally of salaries and fees for professional services, legal fees incurred in connection with patent filings and related matters, as well as other marketing and administrative expenses. Selling, general and administrative expenses for the three and nine months ended September 30, 2006 were approximately $1.8 million and $6.7 million, respectively, as compared to approximately $1.2 million and $4.3 million, respectively, for the three and nine months ended September 30, 2005. The increase of approximately $0.6 million for the quarter ended September 30, 2006 was primarily related to the stock-based compensation expense of approximately $458,000. The increase of approximately $2.4 million for the nine months ended September 30, 2006 was primarily due to stock-based compensation expense of approximately $1.5 million and an increase in advertising and trade show expenses related to the marketing of our Z800 3DVisor.

Other Income, net. Other income, net consists primarily of interest income earned on investments, interest expense related to the secured debentures, and gain from the change in the derivative liability. For the three and nine months ended September 30, 2006, interest income was $14,000 and $73,000, respectively, as compared to $34,000 and $157,000, respectively, for the three and nine months ended September 30, 2005. The decrease in interest income was primarily a result of lower cash balances available for investment. For the three and nine months ended September 30, 2006, interest expense was $509,000 as compared to $1,000 and $3,000, respectively, for the three and nine months ended September 30, 2005. The increase in the interest expense was a result of interest associated with our notes payable of $37,000, the amortization of the deferred costs associated with the notes payable of $88,000, and the amortization of the debt discount of $382,000. For the three and nine months ended September 30, 2006, income from the change in the derivative liability was $177,000 as compared to $0 for the three and nine months ended September 30, 2005.

Liquidity and Capital Resources

As of September 30, 2006, we had approximately $1.4 million of cash and cash equivalents as compared to $6.7 million as of December 31, 2005. The decrease of approximately $5.3 million was due primarily to $10.4 million of cash used for operating activities offset by $5.3 million of cash provided by financing activities.

Cash flow used in operating activities during the nine months of 2006 was approximately $10.4 million as compared to cash used of approximately $12.2 million during the nine months of 2005. This decrease of approximately $1.8 million was primarily attributable to an increased inventory and prepaid expenses during the first nine months of 2005 and not

repeated in 2006 as well as a reduction of approximately $400,000 in net losses before stock option expenses. In June of 2006, we took steps to reduce our use of cash for operating activities by approximately $4 million annually by reducing our headcount by 28 employees and lowering discretionary spending.

Cash used in investing activities during the nine months ended September 30, 2006 was approximately $0.2 million as compared to approximately $0.7 million during the nine months ended September 30, 2005. The reduction of cash used in investing activities was primarily due to lower purchases of equipment.

Cash provided from financing activities during the nine months ended September 30, 2006 was approximately $5.3 million as compared approximately $1.6 million during the nine months ended September 30, 2005. We received approximately $5.4 million, net, from the sale of senior secured debentures for the nine months ended September 30, 2006 and approximately $1.6 million of proceeds from the exercise of employee stock options and warrants during the same period in 2005.

Our condensed consolidated financial statements as of September 30, 2006 have been prepared under the assumption that we will continue as a going concern for the year ending December 31, 2006. Our independent registered public accounting firm have issued their report dated March 15, 2006 that included an explanatory paragraph expressing substantial doubt in our ability to continue as a going concern without additional capital becoming available. Our ability to continue as a going concern ultimately is dependent on our ability to generate a profit which is dependent upon our ability to obtain additional equity or debt financing, attain further operating efficiencies and, ultimately, to achieve profitable operations. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

As we have reported our business is currently experiencing significant revenue growth during the first nine months of 2006. This trend, if it continues, may result in higher accounts receivable levels and may require increased production and/or higher inventory levels. We anticipate that our cash requirements to fund these requirements as well as other operating or investing cash requirements over the next 6 months will be greater than our current cash on hand. While we received approximately $5.4 million, net, from the sale of senior secured debentures pursuant to the Note Purchase agreements that we entered into on July 21, 2006, and such agreements provide for the investors to purchase an additional $0.5 million prior to December 14, 2006, nevertheless we anticipate that we will still require additional funds over the next 6 months. We do not currently have commitments for these funds and no assurance can be given that additional financing will be available, or if available, will be on acceptable terms. If we are unable to obtain sufficient funds during the next 12 months we will further reduce the size of our organization and may be forced to reduce and/or curtail our production and operations, all of which could have a material adverse impact on our business prospects.

In addition to the foregoing, as previously reported, we have retained CIBC World Markets Corporation and Larkspur Capital Corporation to assist us in investigating and evaluating various strategic alternatives, ranging from investment to acquisition, in response to inquiries that we have received.

Off-Balance Sheet Arrangements

We do not have any off balance sheet arrangements that are reasonably likely to have a current or future effect on our financial condition, revenues, results of operations, liquidity or capital expenditures.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Market Rate Risk

We are exposed to market risk related to changes in interest rates and foreign currency exchanges rates.

Interest Rate Risk

We hold our assets in cash and cash equivalents. We do not hold derivative financial instruments or equity securities.

Foreign Currency Exchange Rate Risk

Our revenue and expenses are denominated in U.S. dollars. We have conducted some transactions in foreign currencies and expect to continue to do so; we do not anticipate that foreign exchange gains or losses will be significant. We have not engaged in foreign currency hedging to date.

Our international business is subject to risks typical of international activity, including, but not limited to, differing economic conditions; change in political climates; differing tax structures; and other regulations and restrictions. Accordingly, our future results could be impacted by changes in these or other factors.

ITEM 4. Controls and Procedures

a) Evaluation of Disclosure Controls and Procedures. Based on an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended) required by paragraph (b) of Rule 13a-15 or Rule 15d-15, as of September 30, 2006, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were not effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms.

We determined that the incorrect term was used in the Black-Scholes calculation in valuing the derivative liability and debt discount associated with the warrants issued in July 2006. Initially, the Notes’ life of 18 months was used as the term in the Black-Scholes calculation and the correct term was the warrant life of 5 years. As set forth in this report, the Condensed Consolidated Balance Sheets, Condensed Consolidated Statements of Operations, Condensed Statement of Changes in Shareholders’ Equity, Condensed Consolidated Statements of Cash Flows, and Selected Notes to the Condensed Consolidated Financial Statements have been “restated”, where applicable, to record the increase in valuation of the derivative liability and debt discount and the associated increase in the gain on warrant derivative liability and interest expense.

(b) Changes in Internal Controls.During the quarter ended September 30, 2006, there were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or Rule 15d-15 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 1. Legal Proceedings

On December 6, 2005, New York State Urban Development Corporation commenced action in the Supreme Court of the State of New York, County of New York against eMagin, asserting breach of contract and seeking to recover a $150,000 grant which was made to eMagin based on goals set forth in the agreement for recruitment of employees. On July 13, 2006, the Company agreed to a settlement with the New York State Urban Development Corporation to repay $112,200 of a $150,000 grant made to the Company based on goals set forth in an agreement for recruitment of employees. The settlement requires that repayments be made on a monthly-basis in the amount of $3,116.67 per month commencing August 1, 2006 and ending on July 1, 2009.

ITEM 1A. Risk Factors

In evaluating our business, prospective investors and shareholders should carefully consider the risks factors, any of which could have a material adverse impact on our business, operating results and financial condition and result in a complete loss of your investment.

RISKS RELATED TO OUR FINANCIAL RESULTS

We have a history of losses since our inception and may incur losses for the foreseeable future.

Accumulated losses excluding non-cash transactions as of September 30, 2006 were $77 million and acquisition related non-cash transactions were $102 million, which resulted in an accumulated net loss of $179 million. We have not yet achieved profitability and we can give no assurances that we will achieve profitability within the foreseeable future as we fund

operating and capital expenditures in areas such as establishment and expansion of markets, sales and marketing, operating equipment and research and development. We cannot assure investors that we will ever achieve or sustain profitability or that our operating losses will not increase in the future.

We may not be able to execute our business plan and may not generate cash from operations.

As we have reported, our business is currently experiencing significant revenue growth during the first nine months of 2006. We anticipate that our cash requirements to fund these requirements as well as other operating or investing cash requirements over the next 6 months will be greater than our current cash on hand. While we received approximately $5.4 million, net, from the sale of senior secured debentures pursuant to the Note Purchase agreements that we entered into on July 21, 2006, and such agreements provide for the investors to purchase an additional $0.5 million prior to December 14, 2006, we will nevertheless still require additional funds. We do not currently have any financing commitments and no assurance can be given that additional financing will be available, or if available, will be on acceptable terms. If we are unable to obtain sufficient funds during the next 6 months we will further reduce the size of our organization and may be forced to reduce and/or curtail our production and operations, all of which could have a material adverse impact on our business prospects.

Our independent registered public accounting firm has expressed substantial doubt about our ability to continue as a going concern, which may hinder our ability to obtain future financing.

Our consolidated financial statements as of September 30, 2006 have been prepared under the assumption that we will continue as a going concern for the year ending December 31, 2006. Our independent registered public accounting firm have issued their report dated March 15, 2006 that included an explanatory paragraph expressing substantial doubt in our ability to continue as a going concern without additional capital becoming available. Our ability to continue as a going concern ultimately is dependent on our ability to generate a profit which is likely dependant upon our ability to obtain additional equity or debt financing, attain further operating efficiencies and, ultimately, to achieve profitable operations. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

The manufacture of OLED-on-silicon is new and OLED microdisplays have not been produced in significant quantities.

If we are unable to produce our products in sufficient quantity, we will be unable to maintain and attract new customers. In addition, we cannot assure you that once we commence volume production we will attain yields at high throughput that will result in profitable gross margins or that we will not experience manufacturing problems which could result in delays in delivery of orders or product introductions.

We are dependent on a single manufacturing line.

We currently manufacture our products on a single manufacturing line. If we experience any significant disruption in the operation of our manufacturing facility or a serious failure of a critical piece of equipment, we may be unable to supply microdisplays to our customers. For this reason, some OEMs may also be reluctant to commit a broad line of products to our microdisplays without a second production facility in place. However, we try to maintain product inventory to fill the requirements under such circumstances. Interruptions in our manufacturing could be caused by manufacturing equipment problems, the introduction of new equipment into the manufacturing process or delays in the delivery of new manufacturing equipment. Lead-time for delivery of manufacturing equipment can be extensive. No assurance can be given that we will not lose potential sales or be unable to meet production orders due to production interruptions in our manufacturing line. In order to meet the requirements of certain OEMs for multiple manufacturing sites, we will have to expend capital to secure additional sites and may not be able to manage multiple sites successfully.

We could experience manufacturing interruptions, delays, or inefficiencies if we are unable to timely and reliably procure components from single-sourced suppliers.

We maintain several single-source supplier relationships, either because alternative sources are not available or the relationship is advantageous due to performance, quality, support, delivery, capacity, or price considerations. If the supply of a critical single-source material or component is delayed or curtailed, we may not be able to produce our products in desired quantities and in a timely manner. Even where alternative sources of supply are available, qualification of the alternative suppliers and establishment of reliable supplies could result in delays and a possible loss of sales, which could harm operating results.

We expect to depend on semiconductor contract manufacturers to supply our silicon integrated circuits and other suppliers of key components, materials and services.

We do not manufacture the silicon integrated circuits on which we incorporate our OLED technology. Instead, we expect to provide the design layouts to semiconductor contract manufacturers who will manufacture the integrated circuits on silicon wafers. We also expect to depend on suppliers of a variety of other components and services, including circuit boards, graphic integrated circuits, passive components, materials and chemicals, and equipment support. Our inability to obtain sufficient quantities of high quality silicon integrated circuits or other necessary components, materials or services on a timely basis could result in manufacturing delays, increased costs and ultimately in reduced or delayed sales or lost orders which could materially and adversely affect our operating results.

RISKS RELATED TO OUR INTELLECTUAL PROPERTY

We rely on our license agreement with Eastman Kodak for the development of our products.

We rely on our license agreement with Eastman Kodak for the development of our products, and the termination of this license, Eastman Kodak's licensing of its OLED technology to others for microdisplay applications, or the sublicensing by Eastman Kodak of our OLED technology to third parties, could have a material adverse impact on our business.

Our principal products and those under development utilize OLED technology that we license from Eastman Kodak. We rely upon Eastman Kodak to protect and enforce key patents, relating to OLED display technology. Eastman Kodak's patents expire at various times in the future. Our license with Eastman Kodak could terminate if we fail to perform any material term or covenant under the license agreement. Since our license is non-exclusive, Eastman Kodak could also elect to become a competitor itself or to license OLED technology for microdisplay applications to others who have the potential to compete with us. The occurrence of any of these events could have a material adverse impact on our business.

We may not be successful in protecting our intellectual property and proprietary rights.

We rely on a combination of patents, trade secret protection, licensing agreements and other arrangements to establish and protect our proprietary technologies. If we fail to successfully enforce our intellectual property rights, our competitive position could suffer, which could harm our operating results. Patents may not be issued for our current patent applications, third parties may challenge, invalidate or circumvent any patent issued to us, unauthorized parties could obtain and use information that we regard as proprietary despite our efforts to protect our proprietary rights, rights granted under patents issued to us may not afford us any competitive advantage, others may independently develop similar technology or design around our patents, our technology may be available to licensees of Eastman Kodak, and protection of our intellectual property rights may be limited in certain foreign countries. We may be required to expend significant resources to monitor and police our intellectual property rights. Any future infringement or other claims or prosecutions related to our intellectual property could have a material adverse effect on our business. Any such claims, with or without merit, could be time consuming to defend, result in costly litigation, divert management's attention and resources, or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us, if at all. Protection of intellectual property has historically been a large yearly expense for eMagin. We have not been in a financial position to properly protect all of our intellectual property, and may not be in a position to properly protect our position or stay ahead of competition in new research and the protecting of the resulting intellectual property.

RISKS RELATED TO THE MICRODISPLAY INDUSTRY

The commercial success of the microdisplay industry depends on the widespread market acceptance of microdisplay systems products.

The market for microdisplays is emerging. Our success will depend on consumer acceptance of microdisplays as well as the success of the commercialization of the microdisplay market. As an OEM supplier, our customer's products must also be well accepted. At present, it is difficult to assess or predict with any assurance the potential size, timing and viability of market opportunities for our technology in this market. The viewfinder microdisplay market sector is well established with entrenched competitors with whom we must compete.

The microdisplay systems business is intensely competitive.

We do business in intensely competitive markets that are characterized by rapid technological change, changes in market requirements and competition from both other suppliers and our potential OEM customers. Such markets are typically characterized by price erosion. This intense competition could result in pricing pressures, lower sales, reduced margins, and lower market share. Our ability to compete successfully will depend on a number of factors, both within and outside our control. We expect these factors to include the following:

·	our success in designing, manufacturing and delivering expected new products, including those implementing new technologies on a timely basis;

·	our ability to address the needs of our customers and the quality of our customer services;

·	the quality, performance, reliability, features, ease of use and pricing of our products;

·	successful expansion of our manufacturing capabilities;

·	our efficiency of production, and ability to manufacture and ship products on time;

·	the rate at which original equipment manufacturing customers incorporate our product solutions into their own products;

·	the market acceptance of our customers' products; and

·	product or technology introductions by our competitors.

Our competitive position could be damaged if one or more potential OEM customers decide to manufacture their own microdisplays, using OLED or alternate technologies. In addition, our customers may be reluctant to rely on a relatively small company such as eMagin for a critical component. We cannot assure you that we will be able to compete successfully against current and future competition, and the failure to do so would have a materially adverse effect upon our business, operating results and financial condition.

The display industry is cyclical.

The display industry is characterized by fabrication facilities that require large capital expenditures and long lead times for supplies and the subsequent processing time, leading to frequent mismatches between supply and demand. The OLED microdisplay sector may experience overcapacity if and when all of the facilities presently in the planning stage come on line leading to a difficult market in which to sell our products.

Competing products may get to market sooner than ours.

Our competitors are investing substantial resources in the development and manufacture of microdisplay systems using alternative technologies such as reflective liquid crystal displays (LCDs), LCD-on-Silicon ("LCOS") microdisplays, active matrix electroluminescence and scanning image systems, and transmissive active matrix LCDs. Our competitive position could be damaged if one or more of our competitors’ products get to the market sooner than our products. We cannot assure you that our product will get to market ahead of our competitors or that we will be able to compete successfully against current and future competition. The failure to do so would have a materially adverse effect upon our business, operating results and financial condition.

Our competitors have many advantages over us.

As the microdisplay market develops, we expect to experience intense competition from numerous domestic and foreign companies including well-established corporations possessing worldwide manufacturing and production facilities, greater name recognition, larger retail bases and significantly greater financial, technical, and marketing resources than us, as well as from emerging companies attempting to obtain a share of the various markets in which our microdisplay products have the potential to compete. We cannot assure you that we will be able to compete successfully against current and future competition, and the failure to do so would have a materially adverse effect upon our business, operating results and financial condition.

Our products are subject to lengthy OEM development periods.

We plan to sell most of our microdisplays to OEMs who will incorporate them into products they sell. OEMs determine during their product development phase whether they will incorporate our products. The time elapsed between initial sampling of our products by OEMs, the custom design of our products to meet specific OEM product requirements, and the ultimate incorporation of our products into OEM consumer products is significant. If our products fail to meet our OEM customers' cost, performance or technical requirements or if unexpected technical challenges arise in the integration of our products into OEM consumer products, our operating results could be significantly and adversely affected. Long delays in achieving customer qualification and incorporation of our products could adversely affect our business.

Our products will likely experience rapidly declining unit prices.

In the markets in which we expect to compete, prices of established products tend to decline significantly over time. In order to maintain our profit margins over the long term, we believe that we will need to continuously develop product enhancements and new technologies that will either slow price declines of our products or reduce the cost of producing and delivering our products. While we anticipate many opportunities to reduce production costs over time, there can be no assurance that these cost reduction plans will be successful nor is there any assurance that our costs can be reduced as quickly as any reduction in unit prices. We may also attempt to offset the anticipated decrease in our average selling price by introducing new products, increasing our sales volumes or adjusting our product mix. If we fail to do so, our results of operations would be materially and adversely affected.

RISKS RELATED TO OUR BUSINESS

Our success depends on attracting and retaining highly skilled and qualified technical and consulting personnel.

We must hire highly skilled technical personnel as employees and as independent contractors in order to develop our products. The competition for skilled technical employees is intense and we may not be able to retain or recruit such personnel. We must compete with companies that possess greater financial and other resources than we do, and that may be more attractive to potential employees and contractors. To be competitive, we may have to increase the compensation, bonuses, stock options and other fringe benefits offered to employees in order to attract and retain such personnel. The costs of retaining or attracting new personnel may have a materially adverse affect on our business and our operating results. In addition, difficulties in hiring and retaining technical personnel could delay the implementation of our business plan.

Our success depends in a large part on the continuing service of key personnel.

Changes in management could have an adverse effect on our business. We are dependent upon the active participation of several key management personnel, including Gary W. Jones, our chief executive officer. We will also need to recruit additional management in order to expand according to our business plan. The failure to attract and retain additional management or personnel could have a material adverse effect on our operating results and financial performance.

Our business depends on new products and technologies.

The market for our products is characterized by rapid changes in product, design and manufacturing process technologies. Our success depends to a large extent on our ability to develop and manufacture new products and technologies to match the varying requirements of different customers in order to establish a competitive position and become profitable.

Furthermore, we must adopt our products and processes to technological changes and emerging industry standards and practices on a cost-effective and timely basis. Our failure to accomplish any of the above could harm our business and operating results.

We generally do not have long-term contracts with our customers.

Our business has primarily operated on the basis of short-term purchase orders. We are now receiving longer term purchase agreements and procurement contracts, but we cannot guarantee that we will continue to do so. Our current purchase agreements can be cancelled or revised without penalty, depending on the circumstances. We plan production on the basis of internally generated forecasts of demand, which makes it difficult to accurately forecast revenues. If we fail to accurately forecast operating results, our business may suffer and the value of your investment in our company may decline.

Our business strategy may fail if we cannot continue to form strategic relationships with companies that manufacture and use products that could incorporate our OLED-on-silicon technology.

Our prospects will be significantly affected by our ability to develop strategic alliances with OEMs for incorporation of our OLED-on-silicon technology into their products. While we intend to continue to establish strategic relationships with manufacturers of electronic consumer products, personal computers, chipmakers, lens makers, equipment makers, material suppliers and/or systems assemblers, there is no assurance that we will be able to continue to establish and maintain strategic relationships on commercially acceptable terms, or that the alliances we do enter in to will realize their objectives. Failure to do so would have a material adverse effect on our business.

Our business depends to some extent on international transactions.

We purchase needed materials from companies located abroad and may be adversely affected by political and currency risk, as well as the additional costs of doing business with a foreign entity. Some customers in other countries have longer receivable periods or warranty periods. In addition, many of the OEMs that are the most likely long-term purchasers of our microdisplays are located abroad exposing us to additional political and currency risk. We may find it necessary to locate manufacturing facilities abroad to be closer to our customers which could expose us to various risks, including

management of a multi-national organization, the complexities of complying with foreign laws and customs, political instability and the complexities of taxation in multiple jurisdictions.

Our business may expose us to product liability claims.

Our business may expose us to potential product liability claims. Although no such claims have been brought against us to date, and to our knowledge no such claim is threatened or likely, we may face liability to product users for damages resulting from the faulty design or manufacture of our products. While we plan to maintain product liability insurance coverage, there can be no assurance that product liability claims will not exceed coverage limits, fall outside the scope of such coverage, or that such insurance will continue to be available at commercially reasonable rates, if at all.

Our business is subject to environmental regulations and possible liability arising from potential employee claims of exposure to harmful substances used in the development and manufacture of our products.

We are subject to various governmental regulations related to toxic, volatile, experimental and other hazardous chemicals used in our design and manufacturing process. Our failure to comply with these regulations could result in the imposition of fines or in the suspension or cessation of our operations. Compliance with these regulations could require us to acquire costly equipment or to incur other significant expenses. We develop, evaluate and utilize new chemical compounds in the manufacture of our products. While we attempt to ensure that our employees are protected from exposure to hazardous materials, we cannot assure you that potentially harmful exposure will not occur or that we will not be liable to employees as a result.

RISKS RELATED TO OUR STOCK

The substantial number of shares that are or will be eligible for sale could cause our common stock price to decline even if the company is successful.

Sales of significant amounts of common stock in the public market, or the perception that such sales may occur, could materially affect the market price of our common stock. These sales might also make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. As of September 30, 2006, we have outstanding (i) options to purchase 1,153,440 shares and (ii) warrants to purchase 3,740,481 shares of common stock.

We have a staggered board of directors and other anti-takeover provisions, which could inhibit potential investors or delay or prevent a change of control that may favor you.

Our Board of Directors is divided into three classes and our Board members are elected for terms that are staggered. This could discourage the efforts by others to obtain control of the company. Some of the provisions of our certificate of incorporation, our bylaws and Delaware law could, together or separately, discourage potential acquisition proposals or delay or prevent a change in control. In particular, our board of directors is authorized to issue up to 10,000,000 shares of preferred stock (less any outstanding shares of preferred stock) with rights and privileges that might be senior to our common stock, without the consent of the holders of the common stock.

Our common stock may be delisted from the American Stock Exchange (the “Exchange”), which may have a material adverse impact on the pricing and trading of our common stock, and which would be deemed an event of default under our 6% senior secured convertible notes.

To maintain the listing of our common stock on the Exchange, we are required to meet certain continued listing requirements, including, but not limited to, the requirement that we maintain a minimum amount in shareholder’s equity. On October 9, 2006, we received notice from the Exchange stating that we do not meet certain of the Exchange’s continued listing standards as set forth in Part 10 of the Exchange Company Guide (the “Company Guide”) and that we have become subject to the continued listing evaluation and follow-up procedures and requirements of Section 1009 of the Company Guide.

Pursuant to a review by the Exchange of our 10-Q for the three and six months ended June 30, 2006, the Exchange has determined that we are not in compliance with Sections 1003(a)(ii) and 1003(a)(iii) of the Company Guide, respectively, which state, in relevant part, that the Exchange will normally consider suspending dealings in, or removing from the list, securities of a company which (a) has stockholders' equity of less than $4,000,000 if such company has sustained losses from continuing operations and/or net losses in three of its four most recent fiscal years; or (b) has stockholders' equity of less than $6,000,000 if such company has sustained losses from continuing operations and/or net losses in its five most recent fiscal years, respectively.

We submitted a plan on November 6, 2006 advising the Exchange of actions that we will take, which may bring us into compliance with Sections 1003 (a)(ii) and 1003(a)(iii) of the Company Guide within a maximum of 18 months of receipt of the notice letter. The plan included specific milestones, quarterly financial projections, and details relating to any strategic initiatives we plan to complete. The Exchange will evaluate the plan, including supporting documentation which we submitted, and will make a determination as to whether we have made a reasonable demonstration in the plan of an ability to regain compliance with Sections 1003 (a)(ii) and 1003(a)(iii) of the Company Guide within a maximum of 18 months of receipt of the notice letter, in which case the plan will be accepted. If the plan is accepted, we may be able to continue listing during the plan of up to 18 months, during which time we will be subject to periodic review to determine if it is making progress consistent with the plan. As of the date hereof, we have not received a response from the Exchange with respect to our plan.

If our common stock were delisted from the Exchange, we would trade on the Over-the-Counter Bulletin Board and the market price for shares or our common stock could decline. In addition, it may become more difficult for us to raise funds through the sale of our common stock or securities convertible into our common stock. Further, if our common stock were delisted from the Exchange, we would be in default of our 6% Senior Secured Convertible Notes in the principal amount of $5,970,000 and unless a waiver was granted, we would be required to repay such principal amount, including a default interest rate of 12% on the outstanding principal balance. If we were required to repay the secured convertible notes, we would be required to use our limited working capital and raise additional funds. If we were unable to repay the notes when required, the note holders could commence legal action against us to recover the amounts due. Any such action would require us to curtail or cease operations.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds.

For the three months ended September 30, 2006, the Company issued 71,700 options exercisable into shares of common stock at a price equal to $2.70 per share to employees as compensation for services performed on behalf of the Company.

*All of the above issuances and sales were deemed to be exempt under Rule 506 of Regulation D and Section (2) of the Securities Act of 1933, as amended. No advertising or general solicitation was employed in offering the securities. The offerings and sales were made to a limited number of persons, all of whom were accredited investors, business associates of eMagin or executive officers of eMagin, and transfer was restricted by eMagin in accordance with the requirement of the Securities Act of 1933. In addition to representations by the above-referenced persons, we have made independent determinations that the above-referenced persons were accredited or sophisticated investors, and that they were capable of analyzing the merits and risks of their investment, and that they understood the speculative nature of their investment. Furthermore, all of the above-referenced persons were provided with access to our Securities and Exchange Commission filings.

ITEM 3. Defaults Upon Senior Securities

None.

ITEM 4. Submission of Matters to a Vote of Security Holders

None.

ITEM 5. Other Information

None.

ITEM 6. Exhibits

EXHIBIT NUMBER

DESCRIPTION

31.1

Certification by Chief Executive Officer pursuant to Sarbanes Oxley Section 302*

31.2

Certification by Chief Financial Officer pursuant to Sarbanes Oxley Section 302*

32.1

Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350*

32.2

Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350*

*Filed herewith.

SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on this 2nd day of April, 2007.


	eMAGIN CORPORATION

	By:	/s/ K.C. Park
		K.C. Park
		Interim Chief Executive Officer Principal Executive Officer




	By:	/s/ John Atherly
		John Atherly
		Chief Financial Officer Principal Accounting and Financial Officer