10-Q 1 strasbaugh_10q-093009.txt STRASBAUGH ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended SEPTEMBER 30, 2009 | | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission File Number: 000-23576 STRASBAUGH (Exact name of registrant as specified in its charter) CALIFORNIA 77-0057484 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 825 BUCKLEY ROAD, SAN LUIS OBISPO, CALIFORNIA 93401 (Address of principal executive offices) (Zip Code) (805) 541-6424 (Registrant's telephone number, including area code) NOT APPLICABLE (Former name, former address and former fiscal year, if changed since last report) 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 |X| No | | Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes | | No | | Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes | | No |X| As of October 31, 2009, there were 14,705,587 shares of the issuer's common stock issued and outstanding. ================================================================================ CAUTIONARY STATEMENT All statements included or incorporated by reference in this Quarterly Report on Form 10-Q, other than statements or characterizations of historical fact, are "forward-looking statements." Examples of forward-looking statements include, but are not limited to, statements concerning projected net sales, costs and expenses and gross margins; our accounting estimates, assumptions and judgments; the demand for our products; the competitive nature of and anticipated growth in our industry; and our prospective needs for additional capital. These forward-looking statements are based on our current expectations, estimates, approximations and projections about our industry and business, management's beliefs, and certain assumptions made by us, all of which are subject to change. Forward-looking statements can often be identified by such words as "anticipates," "expects," "intends," "plans," "predicts," "believes," "seeks," "estimates," "may," "will," "should," "would," "could," "potential," "continue," "ongoing," similar expressions and variations or negatives of these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, some of which are set forth in the "Risk Factors" section of our Annual Report on Form 10-K for the year ended December 31, 2008, which could cause our financial results, including our net income or loss or growth in net income or loss to differ materially from prior results, which in turn could, among other things, cause the price of our common stock to fluctuate substantially. These forward-looking statements speak only as of the date of this report. We undertake no obligation to revise or update publicly any forward-looking statement for any reason, except as otherwise required by law. -i- TABLE OF CONTENTS PART I FINANCIAL INFORMATION PAGE Item 1. Financial Statements..................................................1 Condensed Consolidated Balance Sheets as of September 30, 2009 (unaudited) and December 31, 2008 (audited)........................1 Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2009 and 2008 (unaudited)......2 Condensed Consolidated Statement of Redeemable Convertible Preferred Stock and Shareholders' Deficit for the Nine Months Ended September 30, 2009 (unaudited)........................3 Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2009 and 2008 (unaudited)...............4 Notes to Condensed Consolidated Financial Statements for the Three and Nine Months Ended September 30, 2009 (unaudited).........5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.........................................31 Item 3. Quantitative and Qualitative Disclosures About Market Risk ..........43 Item 4. Controls and Procedures .............................................44 PART II OTHER INFORMATION Item 1. Legal Proceedings ...................................................44 Item 1A. Risk Factors ........................................................45 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds .........45 Item 3. Defaults Upon Senior Securities .....................................45 Item 4. Submission of Matters to a Vote of Security Holders .................45 Item 5. Other Information ...................................................45 Item 6. Exhibits ............................................................46 Signatures ...................................................................46 Exhibits Filed with this Report

STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND DESCRIPTION OF BUSINESS The condensed consolidated financial statements include the accounts of Strasbaugh, a California corporation formerly known as CTK Windup Corporation ("Strasbaugh"), and its wholly-owned subsidiary, R. H. Strasbaugh, a California corporation ("R. H. Strasbaugh," and together with Strasbaugh, the "Company"). All material inter-company accounts and transactions have been eliminated in the consolidation. The Company designs and manufactures precision surfacing systems and solutions for the global semiconductor, electronics, precision optics, and aerospace industries. Products are sold to customers throughout the United States, Europe, and Asia and Pacific Rim countries. SHARE EXCHANGE TRANSACTION On May 24, 2007, Strasbaugh (formerly known as CTK Windup Corporation) completed a share exchange transaction (the "Share Exchange Transaction") with R. H. Strasbaugh (formerly known as Strasbaugh). Upon completion of the Share Exchange Transaction, Strasbaugh acquired all of the issued and outstanding shares of R. H. Strasbaugh's capital stock in exchange for an aggregate of 13,770,366 shares of Strasbaugh's common stock. The Share Exchange Transaction was accounted for as a recapitalization of R. H. Strasbaugh with R. H. Strasbaugh being the accounting acquiror. As a result, the historical financial statements of R. H. Strasbaugh are the financial statements of the legal acquiror, Strasbaugh (formerly known as CTK Windup Corporation). BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (the "SEC" or the "Commission") and therefore do not include all information and footnotes necessary for a complete presentation of the financial position, results of operations and cash flows in conformity with accounting principles generally accepted in the United States of America. The unaudited condensed consolidated financial statements do, however, reflect all adjustments, consisting of only normal recurring adjustments, which are, in the opinion of management, necessary to state fairly the financial position as of September 30, 2009 and the results of operations and cash flows for the related interim periods ended September 30, 2009 and 2008. However, these results are not necessarily indicative of results for any other interim period or for the year. It is suggested that the accompanying condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto contained in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2008. We have evaluated subsequent events through November 12, 2009, which is the date these financial statements were issued. -5- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) ESTIMATES AND ASSUMPTIONS The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, or GAAP, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of increases and decreases in revenues and expenses during the reporting periods. Actual results could differ from those estimates and those differences could be material. Significant estimates include the fair value of the Company's common stock and the fair value of options, preferred stock related embedded derivatives and warrants to purchase common stock, inventory obsolescence, and depreciation and amortization. Certain prior year amounts in the accompanying condensed consolidated financial statements have been reclassified to conform to the current year's presentation. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION NINE MONTHS ENDED SEPTEMBER 30, ---------------------------- 2009 2008 ------------- ------------- Cash paid for income taxes..................... $ -- $ -- ============= ============= Fair value accretion on redeemable convertible preferred stock................. $ 937,000 $ 366,000 ============= ============= Preferred stock dividend....................... $ 858,000 $ 797,000 ============= ============= Property and equipment transferred to/from inventory, net $ 19,000 $ 71,000 ============= ============= CONCENTRATIONS OF CREDIT RISK Financial instruments that subject the Company to credit risk consist primarily of cash, cash equivalents and trade accounts receivable. With regard to cash and cash equivalents, the Company maintains its excess cash balances in checking and money market accounts at high-credit quality financial institution(s). The Company has not experienced any significant losses in any of the short-term investment instruments we have used for excess cash balances. The Company does not require collateral on its trade receivables. Historically, the Company has not suffered significant losses with respect to trade accounts receivable. However, recent developments in the global economy and credit markets have caused unusual fluctuations in the values of various investment instruments. Additionally, these developments have, in some cases, limited the availability of credit funds that borrowers such as the Company normally utilize in day-to-day operations which could impact the timing or ultimate recovery of trade accounts. No assurances can be given that these recent developments will not negatively impact the Company's operations as a result of concentrations of these investments. The Company sells its products on credit terms, performs ongoing credit evaluations of its customers, and maintains an allowance for potential credit losses. During the three and nine month periods ended September 30, 2009, the Company's top 10 customers accounted for 80% and 65% of net revenues, respectively, and 67% and 64% for the three and nine month periods ended September 30, 2008, respectively. Sales to major customers (over 10%) as a percentage of net revenues were 52% and 45%, for the three and nine months ended September 30, 2009, respectively, and 40% and 32%, for the three and nine month periods ended September 30, 2008, respectively. -6- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CONCENTRATIONS OF CREDIT RISK (CONTINUED) A decision by a significant customer to substantially decrease or delay purchases from the Company, or the Company's inability to collect receivables from these customers, could have a material adverse effect on the Company's financial condition and results of operations. As of September 30, 2009, the amount due from the major customers (over 10%) discussed above represented 35% of the Company's total accounts receivable. PRODUCT WARRANTIES The Company provides limited warranty for the replacement or repair of defective products at no cost to its customers within a specified time period after the sale. The Company makes no other guarantees or warranties, expressed or implied, of any nature whatsoever as to the goods including without limitation, warranties to merchantability, fit for a particular purpose of non-infringement of patent or the like unless agreed upon in writing. The Company estimates the costs that may be incurred under its limited warranty and maintains reserves based on actual historical warranty claims coupled with an analysis of unfulfilled claims at the balance sheet date. Warranty claims costs are not material given the nature of the Company's products and services which normally result in repairs and returns in the same accounting period. FAIR VALUE OF FINANCIAL ASSETS AND LIABILITIES The carrying value of financial instruments approximates their fair values. The carrying values of cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses approximate fair value because of the short-term maturity of these instruments. The carrying values of notes payable approximate fair value because the interest rates on these instruments approximate market interest rates currently available to the Company. The Company's assets (liabilities) measured at fair value on a recurring basis were determined using the following inputs:

-7- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) FAIR VALUE OF FINANCIAL ASSETS AND LIABILITIES (CONTINUED)

The Company's investments were comprised of available-for-sale securities with carrying amounts totaling $239,000 at December 31, 2008. The Company has no assets measured at fair value on a recurring basis at September 30, 2009. The Company's financial assets that were measured at fair value on a recurring basis were comprised of fixed income available for sale securities at December 31, 2008. At December 31, 2008, fixed income available-for-sale securities generally included U.S. government agency securities, state and municipal bonds, and corporate bonds and notes. Valuations were based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices for securities that were traded less frequently than exchange-traded instruments or quoted prices in markets that were not active; or other inputs that were observable or could have been corroborated by observable market data. Beginning January 1, 2009, the Company carried its preferred stock related embedded derivative and investor warrants on its balance sheet as liabilities (see Note 2) carried at fair value determined by using the Black Scholes valuation model. As of September 30, 2009, the assumptions used in the valuation of the preferred stock related embedded derivative included the Series A Preferred Stock conversion price of $2.20 and in the valuation of the investor warrants the conversion price of $2.42, as well as the Company's stock price of $0.25, discount rate of 1.1%, and volatility of 56%. There are no assets or liabilities measured at fair value on a nonrecurring basis. SEGMENT INFORMATION The Company's results of operations for the nine months ended September 30, 2009 and 2008, represent a single segment referred to as global semiconductor and semiconductor equipment, silicon wafer and silicon wafer equipment, LED, data storage and precision optics industries. Export sales represent approximately 31% and 26% of sales for the three and nine months ended September 30, 2009, and approximately 71% and 33% of sales for the three and nine months ended September 30, 2008, respectively. -8- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) SEGMENT INFORMATION (CONTINUED) The geographic breakdown of the Company's sales was as follows:

The geographic breakdown of the Company's accounts receivable was as follows: SEPTEMBER 30, DECEMBER 31, 2009 2008 --------------- -------------- United States 66% 43% Europe 6% 21% Asia and Pacific Rim countries 28% 36% CASH AND CASH EQUIVALENTS For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. ACCOUNTS RECEIVABLE Accounts receivable are due from companies operating primarily in the global semiconductor, electronics, precision optics, and aerospace industries located throughout the United States, Europe, Asia and the Pacific Rim countries. Credit is extended to both domestic and international customers based on an evaluation of the customer's financial condition and generally collateral is usually not required. For international customers, additional evaluation steps are performed, where required, and more stringent terms, such as letters of credit, are used as necessary. The Company estimates an allowance for uncollectible accounts receivable. The allowance for probable uncollectible receivables is based on a combination of historical data, cash payment trends, specific customer issues, write-off trends, general economic conditions and other factors. These factors are continuously monitored by management to arrive at the estimate for the amount of accounts receivable that may be ultimately uncollectible. In circumstances where the Company is aware of a specific customer's inability to meet its financial obligations, the Company records a specific allowance for doubtful accounts against amounts due, to reduce the net recognized receivable to the amount it reasonably believes will be collected. Management believes that the allowance for doubtful accounts at September 30, 2009 is reasonably stated. -9- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) INVESTMENTS IN SECURITIES The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. The Company determines the appropriate classification of its investments in debt and equity securities at the time of purchase and reevaluates such determinations at each balance sheet date. Debt securities are classified as held-to-maturity when the Company has the positive intent and ability to hold the securities to maturity. Debt securities for which the Company does not have the intent or ability to hold to maturity are classified as available-for-sale. Held-to-maturity securities are recorded as either short term or long term on the balance sheet based on the contractual maturity date and are stated at amortized cost. Marketable securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and are reported at fair value, with unrealized gains and losses recognized in earnings (loss). Debt and marketable equity securities not classified as held-to-maturity or as trading, are classified as available-for-sale, and are carried at fair market value, with the unrealized gains and losses, net of tax, included in the determination of comprehensive income (loss) and reported in shareholders' equity (deficit). At December 31, 2008, the Company's investments were classified as available-for-sale and were included in current assets because the investments were likely to be sold prior to maturity and within one year from the balance sheet date. The Company's investments in corporate debt securities had maturity dates ranging from 2 to 10 years at December 31, 2008. The Company had realized losses on the sales of securities of $6,000, for the three and nine months ended September 30, 2009, and had no realized gains or losses from sales of investments in 2008. Total other than temporary impairment recognized in accumulated other comprehensive income was $0, at September 30, 2009 and December 31, 2008. Total gains for securities with net gains in accumulated other comprehensive income were $0, at September 30, 2009 and December 31, 2008. There were no investments in securities at September 30, 2009. Investments in securities at December 31, 2008 were as follows:

-10- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) OTHER COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) consists of net income (loss) and other gains and losses affecting shareholders' equity (deficit) that, under generally accepted accounting principles, are excluded from net income (loss). The Company's other comprehensive gains and losses (net of taxes of $0) consisted of unrealized gains on investments of $0 and $61,000 for the three and nine month periods ended September 30, 2009, respectively, and unrealized losses on investments of $24,000 and $62,000 for the three and nine month periods ended September 30, 2008, respectively. REVENUE RECOGNITION The Company derives revenues principally from the sale of tools, parts and services. The Company recognizes revenue pursuant to SEC staff guidance covering revenue recognition. Revenue is recognized when there is persuasive evidence an arrangement exists, delivery has occurred or services have been rendered, the Company's price to the customer is fixed or determinable, and collection of the related receivable is reasonably assured. Selling arrangements may include contractual customer acceptance provisions and installation of the product occurs after shipment and transfer of title. The Company recognizes revenue upon shipment of products or performance of services and defers recognition of revenue for any amounts subject to acceptance until such acceptance occurs. Provisions for the estimated future cost of warranty are recorded at the time the products are shipped. Generally, the Company obtains a non-refundable down-payment from the customer. These fees are deferred and recognized as the tool is shipped. All sales contract fees are payable no later than 60 days after delivery and payment is not contingent upon installation. In addition, the Company's tool sales have no right of return, or cancellation rights. Tools are typically modified to some degree to fit the needs of the customer and, therefore, once a purchase order has been accepted by the Company and the manufacturing process has begun, there is no right to cancel, return or refuse the order. The Company has evaluated its arrangements with customers and revenue recognition policies under the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 605-25, "Revenue Recognition-Multiple-Element Arrangements," and determined that its components of revenue are separate units of accounting. Each unit has value to the customer on a standalone basis, there is objective and reliable evidence of the fair value of each unit, and there is no right to cancel, return or refuse an order. The Company's revenue recognition policies for its specific units of accounting are as follows: 1 Tools - The Company recognizes revenue once a customer has visited the plant and signed off on the tool or it has met the required specifications and the tool is completed and shipped. 2 Parts - The Company recognizes revenue when the parts are shipped. -11- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) REVENUE RECOGNITION (CONTINUED) 3 Service - Revenue from maintenance contracts is deferred and recognized over the life of the contract, which is generally one to three years. Maintenance contracts are separate components of revenue and not bundled with our tools. If a customer does not have a maintenance contract, then the customer is billed for time and material and the Company recognizes revenue after the service has been completed. 4 Upgrades - The Company offers a suite of products known as "enhancements" which are generally comprised of one-time parts and/or software upgrades to existing Strasbaugh and non-Strasbaugh tools. These enhancements are not required for the tools to function, are not part of the original contract and do not include any obligation to provide any future upgrades. The Company recognizes revenue once these upgrades and enhancements are complete. Revenue is recognized on equipment upgrades when the Company completes the installation of the upgrade parts and/or software on the customer's equipment and the equipment is accepted by the customer. The upgrade contracts cover a one-time upgrade of a customer's equipment with new or modified parts and/or software. After installation of the upgrade, the Company has no further obligation on the contracts, other than standard warranty provisions. The Company includes software in its tools. Software is considered an incidental element of the tooling contracts and only minor modifications which are incidental to the production effort may be necessary to meet customer requirements. The software is used solely in connection with operating the tools and is not sold, licensed or marketed separately. The tools and software are fully functional when the tool is completed, and after shipment, the software is not updated for new versions that may be subsequently developed and, the Company has no additional obligations relative to the software. However, software modifications may be included in tool upgrade contracts. The Company's software is incidental to the tool contracts as a whole. The software and physical tool modifications occur and are completed concurrently. The completed tool is tested by either the customer or the Company to ensure it has met all required specifications and then accepted by the customer prior to shipment, at which point revenue is recognized. The revenue recognition requirements of FASB ASC 985-605, "Software-Revenue Recognition," are met when there is persuasive evidence an arrangement exists, the fee is fixed or determinable, collectability is probable and delivery and acceptance of the equipment has occurred, including upgrade contracts for parts and/or software, to the customer. Installation of a tool occurs after the tool is completed, tested, formally accepted by the customer and shipped. The Company does not charge the customer for installation nor recognize revenue for installation as it is an inconsequential or perfunctory obligation and it is not considered a separate element of the sales contract or unit of accounting. If the Company does not perform the installation service there is no effect on the price or payment terms, there are no refunds, and the tool may not be rejected by the customer. In addition, installation is not essential to the functionality of the equipment because the equipment is a standard product, installation does not significantly alter the equipment's capabilities, and other companies are available to perform the installation. Also, the fair value of the installation service has historically been insignificant relative to the Company's tools. -12- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) DERIVATIVE INCOME In accordance with FASB ASC 815-40-15 "Derivatives and Hedging-Contracts in Entity's Own Equity-Scope and Scope Exceptions" (Note 2), the Company is required to account for the preferred stock related embedded derivative and investor warrants as derivative liabilities. The Company is required to mark to market each reporting quarter the value of the embedded derivative and investor warrants. The Company revalues these derivative liabilities at the end of each reporting period. The periodic change in value of the derivative liabilities is recorded as either non-cash derivative income (if the value of the embedded derivative and investor warrants decrease) or as non-cash derivative expense (if the value of the embedded derivative and investor warrants increase). Although the values of the embedded derivative and warrants are affected by interest rates, the remaining contractual conversion period and the Company's stock volatility, the primary cause of the change in the values will be the value of the Company's Common Stock. If the stock price goes up, the value of these derivatives will generally increase and if the stock price goes down the value of these derivatives will generally decrease. SHIPPING COSTS During the three and nine month periods ended September 30, 2009, freight and handling amounts billed to customers by the Company and included in revenues totaled approximately $ 0 and $8,000, respectively, and $0 and $7,000 for the three and nine month periods ended September 30, 2008, respectively. Freight and handling fees incurred by the Company of approximately $5,000 and $34,000 are included in cost of sales for the three and nine month periods ended September 30, 2009, respectively, and $9,000 and $43,000 for the three and nine month periods ended September 30, 2008, respectively. FOREIGN CURRENCY TRANSACTIONS The accounts of the Company are maintained in U.S. dollars. Transactions denominated in foreign currencies are recorded at the rate of exchange in effect on the dates of the transactions. Balances payable in foreign currencies are translated at the current rate of exchange when settled. EARNINGS PER SHARE Basic net income (loss) per share is computed by dividing net income (loss) available to common stockholders by the weighted average number of outstanding common shares for the period. Diluted net income (loss) per share is computed by using the treasury stock method and dividing net income available to common stockholders plus the effect of assumed conversions (if applicable) by the weighted average number of outstanding common shares after giving effect to all potential dilutive common stock, including options, warrants, common stock subject to repurchase and convertible preferred stock, if any. -13- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) EARNINGS PER SHARE (CONTINUED) Reconciliations of the numerator and denominator used in the calculation of basic and diluted net loss per common share are as follows:

-14- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) EARNINGS PER SHARE (CONTINUED) For the three and nine months ended September 30, 2009, the Company has excluded from the computation of diluted earnings per common share 5,909,089 shares issuable pursuant to the Series A Preferred Stock, 1,271,797 shares issuable pursuant to outstanding warrants, 285,846 shares issuable upon exercise of outstanding stock options and 1,008,000 stock options cancelled pending the issuance of 504,000 restricted common shares (see Note 6), because the Company had a loss from continuing operations for the period and to include the representative share increments would have been anti-dilutive. For the three and nine months ended September 30, 2008, the 5,909,089 shares issuable pursuant to the Series A Preferred Stock, 1,271,797 shares issuable pursuant to outstanding warrants and 1,339,166 shares issuable upon the exercise of outstanding stock options were excluded from the computation of diluted earnings per share because the Company had a loss from continuing operations for the period and to include the representative share increments would have been anti-dilutive. Accordingly, for the three and nine months ended September 30, 2009 and 2008, basic and diluted net loss per common share is computed based solely on the weighted average number of shares of common stock outstanding during the period. INCOME TAXES AND DEFERRED INCOME TAXES Income taxes are provided for the effects of transactions reported in the financial statements and consist of taxes currently due plus deferred taxes related primarily to differences between the basis of certain assets and liabilities for financial and income tax reporting. Deferred taxes are classified as current or noncurrent depending on the classification of the assets and liabilities to which they relate. Deferred taxes arising from temporary differences that are not related to an asset or liability are classified as current or noncurrent, depending on the periods in which the temporary differences are expected to reverse. A valuation allowance is established when necessary to reduce deferred tax assets if it is more likely than not that all, or some portion of, such deferred tax assets will not be realized. SERIES A PREFERRED STOCK AND WARRANTS The Company evaluates its Series A Preferred Stock and Warrants (as defined in Note 8) on an ongoing basis considering the provisions of FASB ASC Topic 480, "Distinguishing Liabilities from Equity" which establishes standards for issuers of financial instruments with characteristics of both liabilities and equity related to the classification and measurement of those instruments The Series A Preferred Stock conversion feature and Warrants are evaluated considering the provisions of FASB ASC Topic 815, "Derivatives and Hedging," which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities, considering FASB ASC 815-40, "Derivatives and Hedging-Contracts in Entity's Own Equity." -15- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) IMPACTS OF NEW ACCOUNTING PRONOUNCEMENTS In April 2009, the Financial Accounting Standards Board issued Staff Position (FSP) Financial Accounting Standard (FAS) 157-4 "Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly" which was primarily codified into Topic 820, "Fair Value Measurements and Disclosures." Based on the guidance, if an entity determines that the level of activity for an asset or liability has significantly decreased and that a transaction is not orderly, further analysis of transactions or quoted prices is needed, and a significant adjustment to the transaction or quoted prices may be necessary to estimate fair value in accordance with this guidance. This guidance is to be applied prospectively and is effective for interim and annual periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009. Implementation of this standard had no impact on the Company's financial condition or results of operations. In April 2009, the FASB issued FSP FAS 115-2 and FAS 124-2 "Recognition and Presentation of Other-Than-Temporary Impairments," which was primarily codified into Topic 320, "INVESTMENTS -- DEBT AND EQUITY SECURITIES" and Topic 325 "INVESTMENTS -- OTHER" in the ASC. The guidance applies to investments in debt securities for which other-than-temporary impairments may be recorded. If an entity's management asserts that it does not have the intent to sell a debt security and it is more likely than not that it will not have to sell the security before recovery of its cost basis, then an entity may separate other-than-temporary impairments into two components: 1) the amount related to credit losses (recorded in earnings), and 2) all other amounts (recorded in other comprehensive income). This guidance is to be applied prospectively and is effective for interim and annual periods ending after June 15, 2009. Implementation of this guidance had no impact on the Company's financial condition or results of operations. In April 2009, the FASB issued FSP FAS 107-1 and Accounting Principles Board (APB) 28-1 "Interim Disclosures about Fair Value of Financial Instruments," which was primarily codified into Topic 825 "FINANCIAL INSTRUMENTS" in the ASC. This standard extends the disclosure requirements concerning the fair value of financial instruments to interim financial statements of publicly traded companies. This standard is to be applied prospectively and is effective for interim and annual periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009. The Company has included the required disclosures in these condensed consolidated financial statements. In June 2008, the FASB ratified EITF Issue No. 07-5, "Determining Whether an Instrument (Or an Embedded Feature) is Indexed to an Entity's Own Stock," which was primarily codified into FASB ASC 815-40, "Derivatives and Hedging-Contracts in Entity's Own Equity." The guidance provides that an entity should use a two-step approach to evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument's contingent exercise and settlement provisions. This guidance was effective for financial statements issued for fiscal years beginning after December 15, 2008. Early application is not permitted. Implementation of this guidance has had a significant impact on the Company's financial condition and results of operations (See Note 2). -16- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) IMPACTS OF NEW ACCOUNTING PRONOUNCEMENTS (CONTINUED) In May 2009, the FASB issued SFAS No. 165, "SUBSEQUENT EVENTS", which was primarily codified into Topic 855 "SUBSEQUENT EVENTS" in the ASC. This guidance establishes general standards of accounting for, and requires disclosure of, events that occur after the balance sheet date but before financial statements are issued or are available to be issued. We adopted the provisions of SFAS 165 for the quarter ended September 30, 2009. The adoption of these provisions did not have a material effect on our condensed consolidated financial statements. In June 2009, the FASB issued SFAS No. 167 "AMENDMENTS TO FASB INTERPRETATION NO. 46(R)", which has not yet been codified in the ASC. This guidance is a revision to pre-existing guidance pertaining to the consolidation and disclosures of variable interest entities. Specifically, it changes how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a reporting entity is required to consolidate another entity is based on, among other things, the other entity's purpose and design and the reporting entity's ability to direct the activities of the other entity that most significantly impact the other entity's economic performance. This guidance will require a reporting entity to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A reporting entity will be required to disclose how its involvement with a variable interest entity affects the reporting entity's financial statements. This guidance will be effective at the start of a reporting entity's first fiscal year beginning after November 15, 2009. Early application is not permitted. The Company is currently evaluating the impact on its financial statements, if any, upon adoption. In April 2008, the FASB issued FSP FAS No. 142-3 "Determination of the Useful Life of Intangible Assets," which was primarily codified into Topic 350 "INTANGIBLES - GOODWILL AND OTHER" in the ASC. This guidance amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset and requires enhanced related disclosures. This guidance must be applied prospectively to all intangible assets acquired as of and subsequent to fiscal years beginning after December 15, 2008. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008. Although future transactions involving intangible assets may be impacted by this guidance, it did not impact the Company's financial statements as the Company did not acquire any intangible assets during the nine months ended September 30, 2009. -17- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) IMPACTS OF NEW ACCOUNTING PRONOUNCEMENTS (CONTINUED) In June 2009, the FASB issued SFAS No. 168, "THE FASB ACCOUNTING STANDARDS CODIFICATION AND THE HIERARCHY OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES", which was primarily codified into Topic 105 "GENERALLY ACCEPTED ACCOUNTING STANDARDS" in the ASC. This standard will become the single source of authoritative nongovernmental U.S. generally accepted accounting principles ("GAAP"), superseding existing FASB, American Institute of Certified Public Accountants ("AICPA"), Emerging Issues Task Force ("EITF"), and related accounting literature. This standard reorganizes the thousands of GAAP pronouncements into roughly 90 accounting topics and displays them using a consistent structure. Also included is relevant Securities and Exchange Commission guidance organized using the same topical structure in separate sections. The FASB will not issue new standards in the form of Statements, FASB Staff Positions or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates ("ASUs"). The FASB will not consider ASUs as authoritative in their own right. ASUs will serve only to update the Codification, provide background information about the guidance and provide the bases for conclusions on the change(s) in the Codification. This guidance will be effective for financial statements issued for reporting periods that end after September 15, 2009. Beginning in the third quarter of 2009, this guidance impacts the Company's financial statements and related disclosures as all references to authoritative accounting literature reflect the newly adopted codification. In October 2009, the FASB issued ASU 2009-13, MULTIPLE-DELIVERABLE REVENUE ARRANGEMENTS, (amendments to FASB ASC Topic 605, REVENUE RECOGNITION) ("ASU 2009-13") and ASU 2009-14, CERTAIN ARRANGEMENTS THAT INCLUDE SOFTWARE ELEMENTS, (amendments to FASB ASC Topic 985, SOFTWARE) ("ASU 2009-14"). ASU 2009-13 requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The amendments eliminate the residual method of revenue allocation and require revenue to be allocated using the relative selling price method. ASU 2009-14 removes tangible products from the scope of software revenue guidance and provides guidance on determining whether software deliverables in an arrangement that includes a tangible product are covered by the scope of the software revenue guidance. ASU 2009-13 and ASU 2009-14 should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. The Company does not expect adoption of ASU 2009-13 or ASU 2009-14 to have a material impact on the Company's consolidated results of operations or financial condition. -18- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 2 - IMPLEMENTATION OF FASB ASC 815-40-15 "DERIVATIVES AND HEDGING-CONTRACTS IN ENTITY'S OWN EQUITY-SCOPE AND SCOPE EXCEPTIONS" In June 2008, the FASB ratified guidance included in ASC 815-40-15 "Derivatives and Hedging-Contracts in Entity's Own Equity-Scope and Scope Exceptions," which provides that an entity should use a two-step approach to evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument's contingent exercise and settlement provisions. ASC 815-40-15 contains provisions describing conditions when an instrument or embedded feature would be considered indexed to an entity's own stock for purposes of evaluating the instrument or embedded feature under FASB ASC Topic 815, "Derivatives and Hedging," which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts. FASB ASC 815-10-15-74(a) indicates that "contracts issued or held by that reporting entity that are both (1) indexed to its own stock and (2) classified in stockholders' equity in its statement of financial position" should not be considered derivative instruments ("Topic 815 Scope Exception"). The Company's convertible Series A Preferred Stock (Note 8) has been recognized as "temporary equity," or outside of permanent equity and liabilities, in the Company's consolidated balance sheet. The Series A Preferred Stock does not meet the definition of mandatorily redeemable under FASB ASC Topic 480, "Distinguishing Liabilities from Equity" because redemption is contingent upon the holders not exercising their conversion option and the host contract is classified as temporary equity in accordance with SEC guidance. The two embedded features in the Series A Preferred Stock did not require bifurcation under ASC Topic 815 since, prior to the implementation of ASC 815-40-15, the conversion feature met the Topic 815 Scope Exception and the applicable criteria in the FASB guidance covering the accounting for derivative financial instruments indexed to, and potentially settled in, a company's own stock, and the redemption feature was determined to be clearly and closely related to the host contract, therefore, failing the FASB criteria requiring bifurcation. Since there was no bifurcation of the embedded features there was no separate accounting for those features. The Investor Warrants (Note 8) have previously been recognized as permanent equity in the Company's statement of financial position. Prior to the implementation of ASC 815-40-15, the Investor Warrants were classified as permanent equity because they met the Topic 815 Scope Exception and all of the criteria in the FASB guidance covering the accounting for derivative financial instruments indexed to, and potentially settled in, a company's own stock. However, both the convertible Series A Preferred Stock conversion feature and Investor Warrants contain settlement provisions such that if the Company makes certain equity offerings in the future at a price lower than the conversion prices of the instruments, the conversion ratio would be adjusted. FASB ASC 815-40-15 provides that an instrument's strike price or the number of shares used to calculate the settlement amount are not fixed if its terms provide for any potential adjustment, regardless of the probability of such adjustment(s) or whether such adjustments are in the entity's control. If the instrument's strike price or the number of shares used to calculate the settlement amount are not fixed, the instrument (or embedded feature) would still be considered indexed to an entity's own stock if the only variables that could affect the settlement amount would be inputs to the fair value of a "fixed-for-fixed" forward or option on equity shares. -19- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 2 - IMPLEMENTATION OF FASB ASC 815-40-15 "DERIVATIVES AND HEDGING-CONTRACTS IN ENTITY'S OWN EQUITY-SCOPE AND SCOPE EXCEPTIONS" (CONTINUED) Accordingly, under the provisions of ASC 815-40-15 the embedded conversion feature in the Company's Series A Preferred Stock (the "Series A Conversion Feature") and the Investor Warrants are not considered indexed to the Company's stock because future equity offerings (or sales) of the Company's stock are not an input to the fair value of a "fixed-for-fixed" option on equity shares. As a result of the settlement provisions in the Company's Series A Conversion Feature and the application of ASC 815-40-15, effective January 1, 2009, the Series A Conversion Feature no longer qualified for the Topic 815 Scope Exception, and was required to be bifurcated from its host, in accordance with FASB guidance covering the recognition of embedded derivatives in ASC Topic 815, and accounted for as a derivative instrument. Also, as a result of the settlement provision in the Investor Warrants and the application of ASC 815-40-15, effective January 1, 2009, the Investor Warrants no longer qualified for the Topic 815 Scope Exception, and were required to be accounted for as derivatives. In determining the classification of the Series A Conversion Feature and the Investor Warrants the Company considered guidance in ASC 815-40-15 indicating that an instrument considered indexed to its own stock is evaluated under the applicable FASB guidance to determine whether it should be classified as equity, or as an asset or a liability, however, if the terms are such that it is not considered to be indexed to the entity's own stock then equity classification is precluded. Accordingly, effective January 1, 2009 the Company's Series A Conversion Feature and Investor Warrants are recognized as liabilities in the Company's consolidated balance sheet. In accordance with FASB ASC 815-10-65-3 "Derivatives and Hedging-Overall-Transition and Open Effective Date Information-Transition Related to EITF Issue No. 07-5, "Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity's Own Stock," the cumulative effect of this change in accounting principle is recognized as an adjustment to the opening balance of the Company's equity on January 1, 2009. The Series A Preferred Stock host, the Series A Conversion Feature, the Investor Warrant and the cumulative effect adjustment are determined based on amounts that would have been recognized if the guidance in ASC 815-40-15 had been applied from the date the preferred stock and warrants were issued. The Series A Preferred Stock host will remain classified in temporary equity and stated at its fair value as the accounting for the instrument, excluding the Series A Conversion Feature, follows the applicable SEC guidance. In accordance with FASB guidance covering the recognition of embedded derivatives in ASC Topic 815, the fair value of the Series A Conversion Feature is bifurcated from the host instrument and recognized as a liability on the Company's consolidated balance sheet. The Investor Warrants are recognized at fair value as a liability on the Company's consolidated balance sheet. The fair value of the conversion feature, the warrants and other issuance costs of the Series A Preferred Stock financing transaction, are recognized as a discount to the Series A Preferred Stock host. The discount will be accreted to the Series A Preferred Stock host from the Company's paid in capital, treated as a deemed dividend, over the period from the issuance date through the earliest redemption date of the Series A Preferred Stock. -20- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 2 - IMPLEMENTATION OF FASB ASC 815-40-15 "DERIVATIVES AND HEDGING-CONTRACTS IN ENTITY'S OWN EQUITY-SCOPE AND SCOPE EXCEPTIONS" (CONTINUED) The following table illustrates the changes to the Company's consolidated balance sheet resulting from the implementation of ASC 815-40-15 effective January 1, 2009:

Depreciation expense totaled approximately $80,000 and $82,000 for the three month periods ended September 30, 2009 and 2008, respectively, and $247,000 and $255,000 for the nine month periods ended September 30, 2009 and 2008, respectively. -23- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 6 - STOCK COMPENSATION PLANS In February 2007, the Company established the 2007 Share Incentive Plan (the "2007 Plan"), under which 2,000,000 shares of the Company's common stock are available for issuance. The 2007 Plan provides for the grant to employees, consultants and outside directors, of equity based awards including stock options and restricted shares of the Company's common stock. On August 1, 2009, options to purchase 36,000 shares of common stock with an exercise price of $1.10 per share were granted to certain members of the Company's board of directors. The options expire ten years from the date of issuance and vest over a period of three years. On July 22, 2009, the Company issued an offer to holders of outstanding stock options issued under the 2007 Plan ("Eligible Options"), to exchange their Eligible Options for shares of common stock of the Company on a 2 for 1 basis. The offer expired on September 25, 2009. As result of this offer, as of September 30, 2009, 1,008,000 stock options were accepted for exchange and cancellation. STOCK OPTIONS The Company uses the Black-Scholes option pricing model to calculate the grant-date fair value of an award. The fair values of option grants were calculated using the following estimated weighted-average assumptions: FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2009 ---------------------- Options granted 36,000 Weighted-average exercise prices of options $1.10 Weighted-average stock price $1.10 Assumptions: Weighted-average expected volatility 56% Weighted-average expected term 4.6 years Risk-free interest rate 2.14% Expected dividend yield 0% 0% The exercise prices of the options granted were determined based on the market price of the Company's stock on the date of the grant. The fair value per share of the common stock on the date of grant was deemed to be equal to the closing selling price per share of the Company's common stock at the close of regular hours trading on the OTC Bulletin Board on that date, as the price was reported by the National Association of Securities Dealers. The volatility and expected life for the options have been determined based on an analysis of reported data for a peer group of companies that issued options with substantially similar terms. The expected volatility of options granted has been determined using an average of the historical volatility measures of this peer group of companies for a period equal to the expected life of the option. The risk-free interest rate is based on United States treasury instruments whose terms are consistent with the expected life of the stock options. The Company does not anticipate paying cash dividends on its shares of common stock; therefore, the expected dividend yield is assumed to be zero. In addition, FASB ASC Topic 718, "Compensation-Stock Compensation" requires companies to utilize an estimated forfeiture rate when calculating the expense for the period. As a result, the Company applied an estimated annual forfeiture rate over the vesting period, based on adjusted historical experience, of 10% for the three and nine months ended September 30, 2009. -24- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 6 - STOCK COMPENSATION PLANS (CONTINUED) STOCK OPTIONS (CONTINUED) The status of the options under the 2007 Plan is summarized below:

RESTRICTED STOCK As of September 30, 2009, the Company had accepted and cancelled 1,008,000 Eligible Options in exchange for 504,000 shares of its restricted common stock, which were issued on October 12, 2009. Fair value of this award on the grant date was $.25 per share. The grant date fair value of the restricted stock award was determined by using the closing price of the Company's common stock on September 25, 2009. The excess of the aggregate grant date fair value of the Company's restricted common stock of $126,000 over the fair value of the stock options canceled of $15,000 was added to the unamortized value of the options canceled on September 25, 2009, which amounted to $205,000. The total of the unamortized value of the canceled options and the modification charge are being amortized over the vesting period of the restricted common stock. The restricted shares vest on March 31, 2010. At September 30, 2009, the unamortized value of the restricted share award was approximately $103,000, net of estimated forfeitures. The unamortized portion will be expensed over a weighted average period of six months. For the three and nine months ended September 30, 2009, a cost of $3,000 was recognized in connection with the vesting of the restricted share award. The Company's executive officers were entitled to participate in the exchange offer, and as a group accounted for approximately 66% of the stock options exchanged and cancelled and 66% of the shares of restricted common stock issued in the offer. The weighted average grant-date fair value of options granted during the three and nine months ended September 30, 2009 was $0.53. As of September 30, 2009, a total of 1,210,154 common shares were available for future grants under the Company's 2007 Plan. -25- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 6 - STOCK COMPENSATION PLANS (CONTINUED) RESTRICTED STOCK (CONTINUED) Share based compensation expense is measured at grant date, based on the fair value of the award, and is recognized over the employee's requisite service period. The share based compensation expense for the three months ended September 30, 2009 and 2008 was $180,000 and $44,000, respectively, and $362,000 and $138,000 for the nine months ended September 30, 2009 and 2008, respectively. For the three and nine months ended September 30, 2009 and 2008, the breakdown of share-based compensation charges by category of expense was as follows:

As of September 30, 2009, there was $361,000 of total unrecognized compensation cost related to nonvested share-based compensation arrangements. The cost is expected to be recognized over a weighted-average remaining recognition period of 0.7 years. NOTE 7 - COMMITMENTS AND CONTINGENCIES LITIGATION The Company is a party to an action filed by April Paletsas, former wife of Alan Strasbaugh, Chairman and a significant shareholder of the Company, requesting a declaration by the court that its subsidiary, R. H. Strasbaugh, is required to install a new roof on the leased facilities in San Luis Obispo under the repair and maintenance covenants of the lease covering its corporate facilities, between Alan Strasbaugh and Ms. Paletsas, as co-landlords, and R. H. Strasbaugh, as lessee. The Company is presently unable to evaluate the likelihood of an unfavorable result in this dispute or the range of potential loss. However, management intends to vigorously defend against this case and believes that all of its defenses are meritorious. The court issued an order appointing a receiver to sell the property; thereafter, the receiver received an offer to purchase the premises from Alan Strasbaugh. The offer was accepted and confirmed by the San Luis Obispo County Superior Court in March of 2009, but Mr. Strasbaugh was unable to complete the transaction due to lack of available financing. Mr. Strasbaugh submitted another offer to purchase the property, and a hearing has been scheduled on the receiver's motion to accept the offer. However, the offer is contingent on obtaining financing for the purchase, and such financing is subject to the execution of an acceptable lease with the Company. Mr. Strasbaugh has advised the Company that he plans to continue with his efforts to acquire the property. The Company does not have a lease for its premises, except for a holdover month-to-month tenancy at this time. Although management believes that purchase of the property by Mr. Strasbaugh, if consummated, may resolve the claim relating to roof maintenance, that claim remains pending. -26- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 7 - COMMITMENTS AND CONTINGENCIES (CONTINUED) LITIGATION (CONTINUED) The Company is subject to various lawsuits and claims with respect to such matters as product liabilities, employment matters and other actions arising out of the normal course of business. While the effect on future financial results is not subject to reasonable estimation because considerable uncertainty exists, in the opinion of Company counsel, the ultimate liabilities resulting from such lawsuits and claims will not materially affect the financial condition or results of operations. SUBLEASE AGREEMENT The Company entered into two sublease agreements with unaffiliated third parties during 2008. The first sublease agreement provides for monthly rent of approximately $24,000 and expires on February 28, 2010 and the second agreement provides for monthly rent of approximately $11,000 and expires July 31, 2011. Rental income totaled approximately $144,000 and $92,000 for the three month periods ended September 30, 2009 and 2008, respectively, and $436,000 and $197,000 for the nine month periods ended September 30, 2009 and 2008, respectively. NOTE 8 - REDEEMABLE CONVERTIBLE SERIES A PREFERRED STOCK SERIES A PREFERRED STOCK FINANCING On May 24, 2007, immediately after the closing of the Share Exchange Transaction, the Company entered into an agreement with 21 accredited investors for the sale by it in a private offering of 5,909,089 shares of its Series A Preferred Stock at a purchase price of $2.20 per share, for gross proceeds of $13,000,000. -27- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 8 - REDEEMABLE CONVERTIBLE SERIES A PREFERRED STOCK (CONTINUED) SERIES A PREFERRED STOCK FINANCING (CONTINUED) The Series A Preferred Stock ranks senior in liquidation and dividend preferences to the Company's common stock. Holders of the Series A Preferred Stock are entitled to semi-annual cumulative dividends payable in arrears in cash in an amount equal to 8% of the purchase price per share of the Series A Preferred Stock. Each share of Series A Preferred Stock is convertible by the holder at any time after its initial issuance at an initial conversion price of $2.20 per share such that one share of common stock would be issued for each share of Series A Preferred Stock. Subject to certain exceptions, the conversion ratio is subject to customary antidilution adjustments and adjustments if the Company subsequently issues certain equity securities at a price equivalent of less than $2.20 per share. The conversion ratio is not subject to an antidilution adjustment as a result of stock option grants under the Company's 2007 Plan with exercise prices lower than the conversion price of the Series A Preferred Stock. In addition, the Company has no present intention to issue equity securities at a price equivalent of less than $2.20 per share. The shares of Series A Preferred Stock are also subject to forced conversion, at a conversion price as last adjusted, anytime after May 24, 2008, if the closing price of the Company's common stock exceeds 200% of the conversion price then in effect for 20 consecutive trading days. As of September 30, 2009, the shares of Series A Preferred Stock have not been subject to forced conversion. The holders of Series A Preferred Stock vote together as a single class with the holders of the Company's other classes and series of voting stock on all actions to be taken by its shareholders. Each share of Series A Preferred Stock entitles the holder to the number of votes equal to the number of shares of our common stock into which each share of Series A Preferred Stock is convertible. In addition, the holders of Series A Preferred Stock are afforded numerous customary protective provisions with respect to certain actions that may only be approved by holders of a majority of the shares of Series A Preferred Stock. The Company is also required at all times to reserve and keep available out of its authorized but unissued shares of common stock, such number of shares of common stock sufficient to effect the conversion of all outstanding shares of Series A Preferred Stock. On or after May 24, 2012 the holders of then outstanding shares of our Series A Preferred Stock will be entitled to redemption rights. The redemption price is equal to the per-share purchase price of the Series A Preferred Stock, which is subject to adjustment as discussed above and in the Company's articles of incorporation, plus any accrued but unpaid dividends. The Series A Preferred Stock contain provisions prohibiting certain conversions of the Series A Preferred Stock. WARRANTS In connection with the Series A Preferred Stock Financing, the Company issued to the investors five-year warrants ("Investor Warrants") to purchase an aggregate of 886,363 shares of common stock and issued to its placement agent, B. Riley and Co. Inc. and its assignees, five-year warrants ("Placement Warrants") to purchase an aggregate of 385,434 shares of common stock. As of September 30, 2009, the Investor Warrants and the Placement Warrants remain outstanding and have an exercise price of $2.42 per share. The Investor Warrants became exercisable beginning 180 days after May 24, 2007 and the Placement Warrants became immediately exercisable upon issuance on May 24, 2007. -28- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 9 - EQUITY REGISTRATION RIGHTS AGREEMENT The Company is obligated under a registration rights agreement related to the Series A Preferred Stock Financing to file a registration statement with the Commission, registering for resale shares of common stock underlying the Series A Preferred Stock and shares of common stock underlying Investor Warrants, issued in connection with the Series A Preferred Stock Financing. The registration obligations require, among other things, that a registration statement be declared effective by the Commission on or before October 6, 2007. As the Company was unable to meet this obligation in accordance with the requirements contained in the registration rights agreement the Company entered into with the investors, the Company is required to pay to each investor liquidated damages equal to 1% per month of the amount paid by the investor for the common shares still owned by the investor on the date of the default and 1% of the amount paid by the investor for the common shares still owned by the investor on each monthly anniversary of the date of the default that occurs prior to the cure of the default. The maximum aggregate liquidated damages payable to any investor will be equal to 10% of the aggregate amount paid by the investor for the shares of the Company's Series A Preferred Stock. Accordingly, the maximum aggregate liquidation damages that the Company would be required to pay under this provision is $1,300,000. However, the Company is not obligated to pay any liquidated damages with respect to any shares of common stock not included on the registration statement as a result of limitations imposed by the SEC relating to Rule 415 under the Securities Act. The Company's registration statement was declared effective by the SEC on November 6, 2008. Based on the number of shares registered and the length of the default period, the penalties and interest under the agreement were estimated and accrued at September 30, 2009 and December 31, 2008, in the amounts of $240,000 and $223,000, respectively. NOTE 10 - INCOME TAXES The Company estimates its income tax expense for interim periods using an estimated annual effective tax rate. The tax benefit recognized for the nine months ended September 30, 2009 resulted from refunds received during the period of taxes paid in prior years. There was no provision for the three or nine months ended September 30, 2008 as a result of the net operating losses. The Company has a valuation allowance covering its deferred tax assets, including its net operating loss carryforwards, because management believes that it is more likely than not that all, or some portion of, such deferred tax assets will not be realized. The Company has federal and state net operating loss carryforwards of approximately $30,525,000 and $12,686,000, respectively, at September 30, 2009, which will begin to expire in 2019 for federal purposes. Annual utilization of the federal net operating loss carryforwards may be limited for federal tax purposes as a result of an Internal Revenue Code Section 382 change in ownership rules. The state net operating loss carryforwards expire at various dates through 2029. Included in the balance at September 30, 2009, are $0 of tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility. Because of the impact of deferred tax accounting, other than interest and penalties, the disallowance of the shorter deductibility period would not affect the annual effective tax rate but would accelerate the payment of cash to taxing authorities to an earlier period. Also included in the balance at September 30, 2009, are $0 of unrecognized tax benefits that, if recognized, would impact the effective tax rate. The Company made no adjustment to its amount of unrecognized tax benefits during the three month period ended September 30, 2009. -29- STRASBAUGH AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 (UNAUDITED) NOTE 10 - INCOME TAXES (CONTINUED) The Company recognizes interest and penalties accrued related to unrecognized tax benefits in income tax expense. The Company had no amount accrued for the payment of interest and penalties at September 30, 2009. NOTE 11 - SUBSEQUENT EVENT ISSUANCE OF RESTRICTED SHARES On October 12, 2009, the Company issued 504,000 shares of restricted Common Stock to holders of its employee stock options, in exchange for cancellation of options to purchase 1,008,000 shares of Common Stock (see Note 6). The issuance was pursuant to the Company's Option Exchange Program, in which employees were entitled to exchange options for Common Stock at the rate of two options for one share of Common Stock. The shares issued are subject to vesting, so that any of the shares issued to an employee who ceases to be employed on or before March 31, 2010 will be cancelled. The options surrendered were exercisable at prices ranging from $1.20 to $1.71 per share. There was no other consideration given. -30- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2009 and the related notes and the other financial information included elsewhere in this report. This report and our financial statements and notes to financial statements contain forward-looking statements, which generally include the plans and objectives of management for future operations, including plans and objectives relating to our future economic performance and our current beliefs regarding revenues we might generate and profits we might earn if we are successful in implementing our business strategies. Our actual results could differ materially from those expressed in these forward-looking statements as a result of any number of factors, including those set forth under the "Risk Factors" section of our Annual Report on Form 10-K for the year ended December 31, 2008 and elsewhere in this report. The forward-looking statements and associated risks may include, relate to or be qualified by other important factors, including, without limitation: 1 the projected growth or contraction in the industries within which we operate; 2 our business strategy for expanding, maintaining or contracting our presence in these markets; 3 anticipated trends in our financial condition and results of operations, including the recent decline in sales which resulted in lower net revenues for 2008 as compared to 2007 and an overall net loss for the year ended December 31, 2008 and 2007; and 4 our ability to distinguish ourselves from our current and future competitors. We do not undertake to update, revise or correct any forward-looking statements. Any of the factors described above or in the "Risk Factors" section of our Annual Report on Form 10-K for the year ended December 31, 2008 could cause our financial results, including our net income or loss or growth in net income or loss to differ materially from prior results, which in turn could, among other things, cause the price of our common stock to fluctuate substantially. OVERVIEW We develop, manufacture, market and sell an extensive line of precision surfacing products, including polishing, grinding and precision optics tools and systems, to customers in the semiconductor and silicon wafer fabrication, data storage, LED and precision optics markets worldwide. Many of our products are used by our customers in the fabrication of semiconductors and silicon wafers. Our net revenues increased by $422,000, or 17%, to $2,889,000 for the three months ended September 30, 2009 as compared to $2,467,000 for the three months ended September 30, 2008 and decreased by $1,627,000, or 21%, to $6,191,000 for the nine months ended September 30, 2009 as compared to $7,818,000 for the nine months ended September 30, 2008. We reported a net loss of $795,000 for the three months ended September 30, 2009 as compared to a net loss of $423,000 for the three months ended September 30, 2008, and a net loss of $1,517,000 for the nine months ended September 30, 2009 as compared to a net loss of $1,956,000 for the nine months ended September 30, 2008. Excluding the non-cash gains totaling $1,679,000 on our preferred stock related embedded derivative and warrants, our net loss increased by $1,240,000 during the nine months ended September 30, 2009 compared to the same period in 2008. Our financial performance during the first nine months of 2009 and 2008 has been negatively affected by a slowdown in the semiconductor industry. As a result of -31- the industry slowdown, we experienced a substantial decline in tool system sales as customers delayed major purchasing decisions and we expect this slowdown to continue for the remainder of 2009, though management is of the opinion the industry is poised for some level of growth in the fourth quarter of 2009 and into 2010. Our priority over the next several months is to continue to find ways to strengthen our balance sheet and conserve cash. With that in mind, our total headcount has been maintained at a reduced level of approximately 74 full and part-time employees at September 30, 2009. While additional headcount reductions are not planned at this time, we may need to further reduce our headcount in order to reduce expenses if the decline in our business continues for a prolonged length of time. IMPLEMENTATION OF FINANCIAL ACCOUNTING STANDARDS BOARD ("FASB") ACCOUNTING STANDARDS CODIFICATION ("ASC") 815-40-15 "DERIVATIVES AND HEDGING-CONTRACTS IN ENTITY'S OWN EQUITY-SCOPE AND SCOPE EXCEPTIONS" In June 2008, the FASB ratified guidance included in ASC 815-40-15 "Derivatives and Hedging-Contracts in Entity's Own Equity-Scope and Scope Exceptions," which provides that an entity should use a two-step approach to evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument's contingent exercise and settlement provisions. ASC 815-40-15 contains provisions describing conditions when an instrument or embedded feature would be considered indexed to an entity's own stock for purposes of evaluating the instrument or embedded feature under FASB ASC Topic 815, "Derivatives and Hedging," which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts. FASB ASC 815-10-15-74(a) indicates that "contracts issued or held by that reporting entity that are both (1) indexed to its own stock and (2) classified in stockholders' equity in its statement of financial position" should not be considered derivative instruments ("Topic 815 Scope Exception"). The Company's convertible Series A Preferred Stock has been recognized as "temporary equity," or outside of permanent equity and liabilities, in the Company's consolidated balance sheet. The Series A Preferred Stock does not meet the definition of mandatorily redeemable under FASB ASC Topic 480, "Distinguishing Liabilities from Equity" because redemption is contingent upon the holders not exercising their conversion option and the host contract is classified as temporary equity in accordance with SEC guidance. The two embedded features in the Series A Preferred Stock did not require bifurcation under ASC Topic 815 since, prior to the implementation of ASC 815-40-15, the conversion feature met the Topic 815 Scope Exception and the applicable criteria in the FASB guidance covering the accounting for derivative financial instruments indexed to, and potentially settled in, a company's own stock, and the redemption feature was determined to be clearly and closely related to the host contract, therefore, failing the FASB criteria requiring bifurcation. Since there was no bifurcation of the embedded features there was no separate accounting for those features. The Investor Warrants have previously been recognized as permanent equity in the Company's statement of financial position. Prior to the implementation of ASC 815-40-15, the Investor Warrants were classified as permanent equity because they met the Topic 815 Scope Exception and all of the criteria in the FASB guidance covering the accounting for derivative financial instruments indexed to, and potentially settled in, a company's own stock. However, both the convertible Series A Preferred Stock conversion feature and Investor Warrants contain settlement provisions such that if the Company makes certain equity offerings in the future at a price lower than the conversion prices of the instruments, the conversion ratio would be adjusted. -32- FASB ASC 815-40-15 provides that an instrument's strike price or the number of shares used to calculate the settlement amount are not fixed if its terms provide for any potential adjustment, regardless of the probability of such adjustment(s) or whether such adjustments are in the entity's control. If the instrument's strike price or the number of shares used to calculate the settlement amount are not fixed, the instrument (or embedded feature) would still be considered indexed to an entity's own stock if the only variables that could affect the settlement amount would be inputs to the fair value of a "fixed-for-fixed" forward or option on equity shares. Accordingly, under the provisions of ASC 815-40-15 the embedded conversion feature in the Company's Series A Preferred Stock (the "Series A Conversion Feature") and the Investor Warrants are not considered indexed to the Company's stock because future equity offerings (or sales) of the Company's stock are not an input to the fair value of a "fixed-for-fixed" option on equity shares. As a result of the settlement provisions in the Company's Series A Conversion Feature and the application of ASC 815-40-15, effective January 1, 2009, the Series A Conversion Feature no longer qualified for the Topic 815 Scope Exception, and was required to be bifurcated from its host, in accordance with FASB guidance covering the recognition of embedded derivatives in ASC Topic 815, and accounted for as a derivative instrument. Also, as a result of the settlement provision in the Investor Warrants and the application of ASC 815-40-15, effective January 1, 2009, the Investor Warrants no longer qualified for the Topic 815 Scope Exception, and were required to be accounted for as derivatives. In determining the classification of the Series A Conversion Feature and the Investor Warrants the Company considered guidance in ASC 815-40-15 indicating that an instrument considered indexed to its own stock is evaluated under the applicable FASB guidance to determine whether it should be classified as equity, or as an asset or a liability, however, if the terms are such that it is not considered to be indexed to the entity's own stock then equity classification is precluded. Accordingly, effective January 1, 2009 the Company's Series A Conversion Feature and Investor Warrants are recognized as liabilities in the Company's consolidated balance sheet. In accordance with FASB ASC 815-10-65-3 "Derivatives and Hedging-Overall-Transition and Open Effective Date Information-Transition Related to EITF Issue No. 07-5, "Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity's Own Stock," the cumulative effect of this change in accounting principle is recognized as an adjustment to the opening balance of the Company's equity on January 1, 2009. The Series A Preferred Stock host, the Series A Conversion Feature, the Investor Warrant and the cumulative effect adjustment are determined based on amounts that would have been recognized if the guidance in ASC 815-40-15 had been applied from the date the preferred stock and warrants were issued. The Series A Preferred Stock host will remain classified in temporary equity and stated at its fair value as the accounting for the instrument, excluding the Series A Conversion Feature, follows the applicable SEC guidance. In accordance with FASB guidance covering the recognition of embedded derivatives in ASC Topic 815, the fair value of the Series A Conversion Feature is bifurcated from the host instrument and recognized as a liability on the Company's consolidated balance sheet. The Investor Warrants are recognized at fair value as a liability on the Company's consolidated balance sheet. The fair value of the conversion feature, the warrants and other issuance costs of the Series A Preferred Stock financing transaction, are recognized as a discount to the Series A Preferred Stock host. The discount will be accreted to the Series A Preferred Stock host from the Company's paid in capital, treated as a deemed dividend, over the period from the issuance date through the earliest redemption date of the Series A Preferred Stock. -33- The following table illustrates the changes to the Company's consolidated balance sheet resulting from the implementation of ASC 815-40-15 effective January 1, 2009:

The fair value of the Series A Conversion Feature at the issuance date of the Series A Preferred Stock (May 24, 2007) was estimated to be $4,085,000 using the Black Scholes model. The assumptions used in the model included the Series A Preferred Stock conversion price of $2.20, the Company's stock price of $1.71, discount rate of 4.8%, and volatility of 48%. The accretion of the additional discount to the preferred stock resulting from bifurcating the Series A Conversion Feature totaled $894,000 through January 1, 2009. The cumulative effect of these adjustments on January 1, 2009 was a reduction of the Series A Preferred Stock balance of $3,191,000. The fair value of the Investor Warrants of $244,000 was included in additional paid in capital on the issuance date of the warrants (May 24, 2007). As a result of reclassifying these warrants from equity to liabilities, and the additional preferred stock accretion noted above, the cumulative effect of these adjustments on January 1, 2009 was a reduction of additional paid in capital of $1,138,000. The fair value of the Series A Conversion Feature, included in the "Preferred stock related embedded derivative" liability on the Company's consolidated balance sheet, on January 1, 2009 was estimated to be $1,493,000 using the Black Scholes model. The assumptions used in the model included the Series A Preferred Stock conversion price of $2.20, the Company's stock price on January 1, 2009 of $1.19, discount rate of 1.12%, and volatility of 53%. The fair value of the Investor Warrants, included in the "Warrants" liability on the Company's consolidated balance sheet, on January 1, 2009 was estimated to be $199,000 using the Black Scholes model. The assumptions used in the model included the Investor Warrants conversion prices of $2.42, the Company's stock price on January 1, 2009 of $1.19, discount rate of 1.12%, and volatility of 53%. The Company determined that, using the Black Scholes model, the fair value of the preferred stock related embedded derivative and investor warrants had declined as of January 1, 2009. Accordingly, the Company recorded as a cumulative effect adjustment, the reduction of the fair value of these derivative liabilities totaling $2,637,000 as a reduction of the Company's accumulated deficit. As of September 30, 2009, the Company determined that, using the Black Scholes model, the fair value of the preferred stock related embedded derivative and the investor warrants had declined since January 1, 2009. Accordingly, the Company has recorded a gain on the change in fair value of the embedded derivative and warrants and recorded a corresponding reduction in the "Preferred stock related embedded derivative" and "Warrant" liability of $1,481,000, and $198,000, respectively, for the period from January 1, 2009 to September 30, 2009. The effect of the income from these derivatives on the loss from continuing operations and net loss for the nine months ended September 30, 2009 was to reduce the net loss of $3,196,000 to a net loss of $1,517,000, and to reduce the net loss per common share from $0.35 to a net loss per common share of $0.23. For the three months ended September 30, 2009, the Company recorded a gain on the change in fair value of the embedded derivative and warrants and recorded a corresponding decrease in the "Preferred stock related embedded derivative" and "Warrant" liability of $107,000 and $13,000, respectively. The effect of the gain from these derivatives on the loss from continuing operations and net loss for the three months ended September 30, 2009 was to decrease the net loss of $915,000 to a net loss of $795,000, and to reduce the net loss per common share from $0.11 to a net loss per common share of $0.10. -34- CRITICAL ACCOUNTING POLICIES Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis of making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our financial statements: REVENUE RECOGNITION. We derive revenues principally from the sale of tools, parts and services. We recognize revenue pursuant to SEC staff guidance covering revenue recognition. Revenue is recognized when there is persuasive evidence an arrangement exists, delivery has occurred or services have been rendered, our price to the customer is fixed or determinable, and collection of the related receivable is reasonably assured. Selling arrangements may include contractual customer acceptance provisions and installation of the product occurs after shipment and transfer of title. We recognize revenue upon shipment of products or performance of services and defer recognition of revenue for any amounts subject to acceptance until such acceptance occurs. Provisions for the estimated future cost of warranty are recorded at the time the products are shipped. Generally, we obtain a non-refundable down-payment from the customer. These fees are deferred and recognized as the tool is shipped. All sales contract fees are payable no later than 60 days after delivery and payment is not contingent upon installation. In addition, our tool sales have no right of return, or cancellation rights. Tools are typically modified to some degree to fit the needs of the customer and, therefore, once a purchase order has been accepted by us and the manufacturing process has begun, there is no right to cancel, return or refuse the order. We have evaluated our arrangements with customers and revenue recognition policies under FASB ASC 605-25, "Revenue Recognition-Multiple-Element Arrangements," and determined that our components of revenue are separate units of accounting. Each unit has value to the customer on a standalone basis, there is objective and reliable evidence of the fair value of each unit, and there is no right to cancel, return or refuse an order. Our revenue recognition policies for our specific units of accounting are as follows: 1 Tools - We recognize revenue once a customer has visited the plant and signed off on the tool or it has met the required specifications and the tool is completed and shipped. 2 Parts - We recognize revenue when the parts are shipped. 3 Service - Revenue from maintenance contracts is deferred and recognized over the life of the contract, which is generally one to three years. Maintenance contracts are separate components of revenue and not bundled with our tools. If a customer does not have a maintenance contract, then the customer is billed for time and material and we recognize revenue after the service has been completed. 4 Upgrades - We offer a suite of products known as "enhancements" which are generally comprised of one-time parts and/or software upgrades to existing Strasbaugh and non-Strasbaugh tools. These enhancements are not required for the tools to function, are not part of the original contract and do not include any obligation to provide any future upgrades. We recognize revenue once these upgrades and enhancements are complete. Revenue is recognized on equipment upgrades when we complete the installation of the upgrade parts and/or software on the customer's equipment and the equipment is accepted by the customer. The upgrade contracts cover a one-time upgrade of a customer's equipment with new or modified parts and/or software. After installation of the upgrade, we have no further obligation on the contracts, other than standard warranty provisions. -35- We include software in our tools. Software is considered an incidental element of the tooling contracts and only minor modifications which are incidental to the production effort may be necessary to meet customer requirements. The software is used solely in connection with operating the tools and is not sold, licensed or marketed separately. The tools and software are fully functional when the tool is completed, and after shipment, the software is not updated for new versions that may be subsequently developed and, we have no additional obligations relative to the software. However, software modifications may be included in tool upgrade contracts. Our software is incidental to the tool contracts as a whole. The software and physical tool modifications occur and are completed concurrently. The completed tool is tested by either the customer or us to ensure it has met all required specifications and then accepted by the customer prior to shipment, at which point revenue is recognized. The revenue recognition requirements of FASB ASC 985-605, "Software-Revenue Recognition," are met when there is persuasive evidence an arrangement exists, the fee is fixed or determinable, collectibility is probable and delivery and acceptance of the equipment has occurred, including upgrade contracts for parts and/or software, to the customer. Installation of a tool occurs after the tool is completed, tested, formally accepted by the customer and shipped. We do not charge the customer for installation nor recognize revenue for installation as it is an inconsequential or perfunctory obligation and it is not considered a separate element of the sales contract or unit of accounting. If we do not perform the installation service there is no effect on the price or payment terms, there are no refunds, and the tool may not be rejected by the customer. In addition, installation is not essential to the functionality of the equipment because the equipment is a standard product, installation does not significantly alter the equipment's capabilities, and other companies are available to perform the installation. Also, the fair value of the installation service has historically been insignificant relative to our tools. DERIVATIVE INCOME. In accordance with FASB ASC 815-40-15 "Derivatives and Hedging-Contracts in Entity's Own Equity-Scope and Scope Exceptions," the Company is required to account for the preferred stock related embedded derivative and investor warrants as derivative liabilities. The Company is required to mark to market each reporting quarter the value of the embedded derivative and investor warrants. The Company revalues these derivative liabilities at the end of each reporting period. The periodic change in value of the derivative liabilities is recorded as either non-cash derivative income (if the value of the embedded derivative and investor warrants decrease) or as non-cash derivative expense (if the value of the embedded derivative and investor warrants increase). Although the values of the embedded derivative and warrants are affected by interest rates, the remaining contractual conversion period and the Company's stock volatility, the primary cause of the change in the values will be the value of the Company's Common Stock. If the stock price goes up, the value of these derivatives will generally increase and if the stock price goes down the value of these derivatives will generally decrease. WARRANTY COSTS. Warranty reserves are provided by management based on historical experience and expected future claims. Management believes that the current reserves are adequate to meet any foreseeable contingencies with respect to warranty claims. ALLOWANCE FOR DOUBTFUL ACCOUNTS. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is based on specific identification of customer accounts and our best estimate of the likelihood of potential loss, taking into account such factors as the financial condition and payment history of major customers. We evaluate the collectability of our receivables at least quarterly. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Management believes that our current allowances for doubtful accounts are adequate to meet any foreseeable contingencies. -36- INVENTORY. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value-based upon assumptions about future demand, future pricing and market conditions. If actual future demand, future pricing or market conditions are less favorable than those projected by management, additional inventory write-downs may be required and the differences could be material. Once established, write-downs are considered permanent adjustments to the cost basis of the obsolete or unmarketable inventories. VALUATION OF INTANGIBLES. From time to time, we acquire intangible assets that are beneficial to our product development processes. We use our best judgment based on the current facts and circumstances relating to our business when determining whether any significant impairment factors exist. DEFERRED TAXES. We record a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized. We have considered estimated future taxable income and ongoing tax planning strategies in assessing the amount needed for the valuation allowance. Based on these estimates, all of our deferred tax assets have been reserved. If actual results differ favorably from those estimates used, we may be able to realize all or part of our net deferred tax assets. LITIGATION. We account for litigation losses in accordance with FASB ASC 450-20, "Contingencies-Loss Contingencies." Under ASC 450-20, loss contingency provisions are recorded for probable losses at management's best estimate of a loss, or when a best estimate cannot be made, a minimum loss contingency amount is recorded. These estimates are often initially developed substantially earlier than the ultimate loss is known, and the estimates are refined each accounting period, as additional information is known. Accordingly, we are often initially unable to develop a best estimate of loss; therefore, the minimum amount, which could be zero, is recorded. As information becomes known, either the minimum loss amount is increased or a best estimate can be made, resulting in additional loss provisions. Occasionally, a best estimate amount is changed to a lower amount when events result in an expectation of a more favorable outcome than previously expected. Due to the nature of current litigation matters, the factors that could lead to changes in loss reserves might change quickly and the range of actual losses could be significant, which could adversely affect our results of operations and cash flows from operating activities. SERIES A PREFERRED STOCK AND WARRANTS. We evaluate our Series A Preferred Stock and warrants on an ongoing basis considering the provisions of FASB ASC Topic 480, "Distinguishing Liabilities from Equity" which establishes standards for issuers of financial instruments with characteristics of both liabilities and equity related to the classification and measurement of those instruments The Series A Preferred Stock conversion feature and Warrants are evaluated considering the provisions of FASB ASC Topic 815, "Derivatives and Hedging," which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities, considering FASB ASC 815-40, "Derivatives and Hedging-Contracts in Entity's Own Equity." RESULTS OF OPERATIONS The tables presented below, which compare our results of operations from one period to another, present the results for each period, the change in those results from one period to another in both dollars and percentage change, and the results for each period as a percentage of net revenues. The columns present the following: 1 The first two data columns in each table show the absolute results for each period presented. -37- 2 The columns entitled "Dollar Variance" and "Percentage Variance" show the change in results, both in dollars and percentages. These two columns show favorable changes as a positive and unfavorable changes as negative. For example, when our net revenues increase from one period to the next, that change is shown as a positive number in both columns. Conversely, when expenses increase from one period to the next, that change is shown as a negative in both columns. 3 The last two columns in each table show the results for each period as a percentage of net revenues. THREE MONTHS ENDED SEPTEMBER 30, 2009 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 2008

NET REVENUES. Net revenues increased by $422,000, to $2,889,000 in the third quarter of 2009 compared to the same period in 2008. Sales of tool systems increased by $658,000, to $1,551,000, in the third quarter of 2009 compared to $893,000 for the same period in 2008. Revenue from parts and services declined by $236,000, to $1,338,000 in the third quarter of 2009, compared to $1,574,000 for the same period in 2008. GROSS PROFIT. The $273,000 decrease in gross profit as well as the drop in gross margin to 26% in 2009 versus 42% for the same period in 2008 is a result of discounts offered to customers in 2009, which management approved as part of the Company's efforts to complete sales in a down-economy. Management considers that the discounts offered are more generous than usual for the Company and does not anticipate that such deep-discounts will be repeated in the foreseeable future. In general, the Company's gross margin tends to report in the low 40% range. In addition, the Company, as a result of an anticipated growth in the industry, has recently increased the base price of its tools as demand for those tools appears to be increasing. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses increased only $90,000 as the Company continues its cost cutting measures, including a lower head-count of employees, initiated during 2008. RESEARCH AND DEVELOPMENT EXPENSES. The $209,000 increase in research and development expense represents primarily on-going engineering improvements on existing product lines developed over the past five years, as well as efforts to develop new technology for our future. We expect that research and development spending will continue to increase during the remainder of 2009 as we complete the work on new technology and position the Company to launch those products. -38- OTHER INCOME (EXPENSE). The $200,000 increase in other income was primarily due to non-cash gains totaling $120,000 resulting from the decrease in the fair value of our preferred stock related embedded derivative and warrant liabilities during the three months ended September 30, 2009, and a $52,000 increase in rental income. NINE MONTHS ENDED SEPTEMBER 30, 2009 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 2008

NET REVENUES. Net revenues decreased by $1,627,000, to $6,191,000 in the first three quarters of 2009 compared to the same period in 2008. Sales of tool systems decreased by $78,000 to $2,637,000, in the first three quarters of 2009 compared to $2,715,000 for the same period in 2008. Revenue from parts sales and services declined by $1,549,000 to $3,554,000, in the first three quarters of 2009, compared to $5,103,000 for the same period in 2008. GROSS PROFIT. The $1,199,000 decrease in gross profit was primarily due to the lower volume of product shipments and unfavorable product mix. The gross margin as a percentage of sales was lower for the first nine months of 2009 compared to the same period in 2008 primarily as a result of discounts offered to customers in 2009. As discussed above, management does not expect to repeat those discounts in the foreseeable future. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. The $386,000 decrease in selling, general and administrative expenses is a result of cost cutting measures, including lower head-count of employees, initiated during 2008. RESEARCH AND DEVELOPMENT EXPENSES. The $598,000 increase in research and development expense represents primarily on-going engineering improvements on existing product lines developed over the past five years, as well as efforts to develop new technology for our future. We expect that research and development spending will continue to increase during the remainder of 2009. OTHER INCOME (EXPENSE). The $1,837,000 increase in other income was primarily due to non-cash gains totaling $1,679,000 resulting from the decrease in the fair value of our preferred stock related embedded derivative and warrant liabilities during the nine months ended September 30, 2009. LIQUIDITY AND CAPITAL RESOURCES As of September 30, 2009, we had working capital of $1,312,000, as compared to $4,009,000 at December 31, 2008, as cash from collections of receivables, customer deposits on tool contracts and proceeds from sales of investment securities were used to support operations during the first three quarters of 2009. At September 30, 2009 and December 31, 2008 we had an accumulated deficit of $31,066,000 and $32,186,000, respectively, and cash and cash equivalents of $3,356,000 and $49,000, respectively. -39- Our available capital resources at September 30, 2009 consisted primarily of approximately $3,356,000 in cash and cash equivalents and $803,000 in accounts receivable. We expect that our future available capital resources will consist primarily of cash on hand, cash generated from our business, and future debt and/or equity financings, if any. Cash provided by operating activities for the nine months ended September 30, 2009 was $3,192,000, as compared to $624,000 of cash used in operating activities for the nine months ended September 30, 2008, and included net losses of $1,517,000 and $1,956,000 for the nine months ended September 30, 2009 and 2008, respectively. Included in the results for the first three quarters of 2009 were non-cash gains of $1,679,000 from derivative liabilities, as well as non-cash charges for depreciation and amortization of $274,000 and stock-based compensation of $362,000. Material changes in assets and liabilities at September 30, 2009 occurring since December 31, 2008 that affected these results include: 1 a decrease in accounts receivable before reserves of $506,000; 2 a decrease in accounts payable of $366,000; and 3 an increase in customer deposits of $5,576,000. Cash provided by investing activities totaled $115,000 for the nine months ended September 30, 2009 as compared to $531,000 of cash provided by investing activities for the nine months ended September 30, 2008. Included in the results for the nine months ended September 30, 2009 are proceeds of $294,000 from sales of investment securities, $137,000 of equipment purchases and $42,000 representing the capitalized cost of intellectual property. There were no cash flows from financing activities in the first nine months of 2009 compared to net cash used in financing activities totaling $1,116,000 for the nine months ended September 30, 2008. The cash used in financing activities in the first nine months of 2008 was attributable to the dividend payment and issuance costs related to the Series A Preferred Stock. On December 4, 2007, we entered into two Loan and Security Agreements with Silicon Valley Bank ("SVB") providing for a credit facility in the aggregate amount of $7.5 million, under which the Company had no borrowings or amounts outstanding. The Company was not in compliance with all of the covenants in the agreements at December 31, 2008 and in 2009, and was unable to negotiate suitable amendments to the agreements; accordingly, the line of credit with SVB is no longer available to the Company. Management believes that, barring unforeseen events, there will be no need to seek additional credit in the foreseeable future, and given the high cost of credit under the current market conditions, management is not seeking alternative credit facilities at this time. Management has informed Silicon Valley Bank that it will revisit the topic of a credit line sometime in 2010 as market and banking conditions improve. On May 24, 2007, immediately after the closing of the Share Exchange Transaction, we issued to 21 accredited investors in the Series A Preferred Stock Financing an aggregate of 5,909,089 shares of our Series A Preferred Stock at a purchase price of $2.20 per share and five-year investor warrants, or Investor Warrants, to purchase an aggregate of 886,363 shares of common stock at an exercise price of $2.42 per share, for total gross proceeds of $13,000,000. The Investor Warrants are initially exercisable 180 days after May 24, 2007. We paid cash placement agent fees and expenses of approximately $1.1 million and issued five-year placement warrants, or Placement Warrants, to purchase 385,434 shares of common stock at an exercise price of $2.42 per share in connection with the offering. Additional costs related to the financing including placement agent, legal, accounting and consulting fees that totaled approximately $2,482,000 through December 31, 2008. -40- We are obligated under a registration rights agreement related to the Series A Preferred Stock Financing to file a registration statement with the SEC, registering for resale shares of common stock underlying the Series A Preferred Stock and shares of common stock underlying Investor Warrants, issued in connection with the Series A Preferred Stock Financing. The registration obligations require, among other things, that a registration statement be declared effective by the SEC on or before October 6, 2007. Because we were unable to have the initial registration statement declared effective by the SEC by October 6, 2007, we are generally required to pay to each investor liquidated damages equal to 1% of the amount paid by the investor for the underlying shares of common stock still owned by the investor on the date of the default and 1% of the amount paid by the investor for the underlying shares of common stock still owned by the investor on each monthly anniversary of the date of the default that occurs prior to the cure of the default. However, we are not obligated to pay any liquidated damages with respect to any shares of common stock not included on the registration statement as a result of limitations imposed by the SEC relating to Rule 415 under the Securities Act. The maximum aggregate liquidated damages payable to any investor will be equal to 10% of the aggregate amount paid by the investor for the shares of our Series A Preferred Stock. Accordingly, the maximum aggregate liquidation damages that we would be required to pay under this provision is $1.3 million. The registration statement was declared effective on November 6, 2008 and the Company has accrued approximately $240,000 as liquidated damages and is accruing 10% interest per annum on that amount until such time as the payment is made to the preferred shareholders. We believe that current and future available capital resources, revenues generated from operations, and other existing sources of liquidity, will be adequate to meet our anticipated working capital and capital expenditure requirements for at least the next twelve months. If, however, our capital requirements or cash flow vary materially from our current projections or if unforeseen circumstances occur, we may require additional financing. Our failure to raise capital, if needed, could restrict our growth, limit our development of new products or hinder our ability to compete. BACKLOG As of November 12, 2009, we had a backlog of approximately $11 million. Our backlog includes firm customer commitments for 10 tools and approximately $981,000 in parts and upgrades. Management believes that all products currently in our backlog will be shipped by the first quarter of 2010. EFFECTS OF INFLATION The impact of inflation and changing prices has not been significant on the financial condition or results of operations of either our company or our operating subsidiary. IMPACTS OF NEW ACCOUNTING PRONOUNCEMENTS In April 2009, the Financial Accounting Standards Board issued Staff Position (FSP) Financial Accounting Standard (FAS) 157-4 "Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly" which was primarily codified into Topic 820, "Fair Value Measurements and Disclosures." Based on the guidance, if an entity determines that the level of activity for an asset or liability has significantly decreased and that a transaction is not orderly, further analysis of transactions or quoted prices is needed, and a significant adjustment to the transaction or quoted prices may be necessary to estimate fair value in accordance with this guidance. This guidance is to be applied prospectively and is effective for interim and annual periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009. Implementation of this standard on April 1, 2009 had no impact on the Company's financial condition or results of operations. -41- In April 2009, the FASB issued FSP FAS 115-2 and FAS 124-2 "Recognition and Presentation of Other-Than-Temporary Impairments," which was primarily codified into Topic 320, "INVESTMENTS -- DEBT AND EQUITY SECURITIES" and Topic 325 "INVESTMENTS -- OTHER" in the ASC. The guidance applies to investments in debt securities for which other-than-temporary impairments may be recorded. If an entity's management asserts that it does not have the intent to sell a debt security and it is more likely than not that it will not have to sell the security before recovery of its cost basis, then an entity may separate other-than-temporary impairments into two components: 1) the amount related to credit losses (recorded in earnings), and 2) all other amounts (recorded in other comprehensive income). This guidance is to be applied prospectively and is effective for interim and annual periods ending after June 15, 2009. Implementation of this guidance on April 1, 2009 had no impact on the Company's financial condition or results of operations. In April 2009, the FASB issued FSP FAS 107-1 and Accounting Principles Board (APB) 28-1 "Interim Disclosures about Fair Value of Financial Instruments," which was primarily codified into Topic 825 "FINANCIAL INSTRUMENTS" in the ASC. This standard extends the disclosure requirements concerning the fair value of financial instruments to interim financial statements of publicly traded companies. This standard is to be applied prospectively and is effective for interim and annual periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009. The Company has included the required disclosures in these condensed consolidated financial statements. In June 2008, the FASB ratified EITF Issue No. 07-5, "Determining Whether an Instrument (Or an Embedded Feature) is Indexed to an Entity's Own Stock," which was primarily codified into FASB ASC 815-40, "Derivatives and Hedging-Contracts in Entity's Own Equity." The guidance provides that an entity should use a two-step approach to evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument's contingent exercise and settlement provisions. This guidance was effective for financial statements issued for fiscal years beginning after December 15, 2008. Early application is not permitted. Implementation of this guidance has had a significant impact on the Company's financial condition and results of operations (See "Accounting Change" above). In May 2009, the FASB issued SFAS No. 165, "SUBSEQUENT EVENTS", which was primarily codified into Topic 855 "SUBSEQUENT EVENTS" in the ASC. This guidance establishes general standards of accounting for, and requires disclosure of, events that occur after the balance sheet date but before financial statements are issued or are available to be issued. We adopted the provisions of SFAS 165 for the quarter ended September 30, 2009. The adoption of these provisions did not have a material effect on our condensed consolidated financial statements. In June 2009, the FASB issued SFAS No. 167 "AMENDMENTS TO FASB INTERPRETATION NO. 46(R)", which has not yet been codified in the ASC. This guidance is a revision to pre-existing guidance pertaining to the consolidation and disclosures of variable interest entities. Specifically, it changes how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a reporting entity is required to consolidate another entity is based on, among other things, the other entity's purpose and design and the reporting entity's ability to direct the activities of the other entity that most significantly impact the other entity's economic performance. This guidance will require a reporting entity to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A reporting entity will be required to disclose how its involvement with a variable interest entity affects the reporting entity's financial statements. This guidance will be effective at the start of a reporting entity's first fiscal year beginning after November 15, 2009. Early application is not permitted. The Company is currently evaluating the impact on its financial statements, if any, upon adoption. -42- In April 2008, the FASB issued FSP FAS No. 142-3 "Determination of the Useful Life of Intangible Assets," which was primarily codified into Topic 350 "INTANGIBLES - GOODWILL AND OTHER" in the ASC. This guidance amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset and requires enhanced related disclosures. This guidance must be applied prospectively to all intangible assets acquired as of and subsequent to fiscal years beginning after December 15, 2008. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008. Although future transactions involving intangible assets may be impacted by this guidance, it did not impact the Company's financial statements as the Company did not acquire any intangible assets during the nine months ended September 30, 2009. In June 2009, the FASB issued SFAS No. 168, "THE FASB ACCOUNTING STANDARDS CODIFICATION AND THE HIERARCHY OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES", which was primarily codified into Topic 105 "GENERALLY ACCEPTED ACCOUNTING STANDARDS" in the ASC. This standard will become the single source of authoritative nongovernmental U.S. generally accepted accounting principles ("GAAP"), superseding existing FASB, American Institute of Certified Public Accountants ("AICPA"), Emerging Issues Task Force ("EITF"), and related accounting literature. This standard reorganizes the thousands of GAAP pronouncements into roughly 90 accounting topics and displays them using a consistent structure. Also included is relevant Securities and Exchange Commission guidance organized using the same topical structure in separate sections. The FASB will not issue new standards in the form of Statements, FASB Staff Positions or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates ("ASUs"). The FASB will not consider ASUs as authoritative in their own right. ASUs will serve only to update the Codification, provide background information about the guidance and provide the bases for conclusions on the change(s) in the Codification. This guidance will be effective for financial statements issued for reporting periods that end after September 15, 2009. Beginning in the third quarter of 2009, this guidance impacts the Company's financial statements and related disclosures as all references to authoritative accounting literature reflect the newly adopted codification. In October 2009, the FASB issued ASU 2009-13, MULTIPLE-DELIVERABLE REVENUE ARRANGEMENTS, (amendments to FASB ASC Topic 605, REVENUE RECOGNITION) ("ASU 2009-13") and ASU 2009-14, CERTAIN ARRANGEMENTS THAT INCLUDE SOFTWARE ELEMENTS, (amendments to FASB ASC Topic 985, SOFTWARE) ("ASU 2009-14"). ASU 2009-13 requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The amendments eliminate the residual method of revenue allocation and require revenue to be allocated using the relative selling price method. ASU 2009-14 removes tangible products from the scope of software revenue guidance and provides guidance on determining whether software deliverables in an arrangement that includes a tangible product are covered by the scope of the software revenue guidance. ASU 2009-13 and ASU 2009-14 should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. The Company does not expect adoption of ASU 2009-13 or ASU 2009-14 to have a material impact on the Company's consolidated results of operations or financial condition. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. -43- ITEM 4. CONTROLS AND PROCEDURES An evaluation of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended ("Exchange Act")) was carried out under the supervision and with the participation of the Company's management, including the Chief Executive Officer and the Chief Financial Officer ("the Certifying Officers") as of September 30, 2009. Based on that evaluation, the Certifying Officers concluded that the Company's disclosure controls and procedures are effective. There have been no changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended September 30, 2009 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS We are subject to various legal proceedings, claims and litigation with respect to such matters as product liabilities, employment matters and other actions arising out of the normal course of business. While the amounts claimed may be substantial, the ultimate liability cannot presently be determined because of considerable uncertainties that exist. Therefore, it is possible that the outcome of those legal proceedings, claims and litigation could adversely affect our quarterly or annual operating results or cash flows when resolved in a future period. However, based on facts currently available, management believes such matters will not adversely affect our financial position, results of operations or cash flows. The Company is a party to an action filed by April Paletsas, former wife of Alan Strasbaugh, Chairman and a significant shareholder of the Company, requesting a declaration by the court that its subsidiary, R. H. Strasbaugh, is required to install a new roof on the leased facilities in San Luis Obispo under the repair and maintenance covenants of the lease covering its corporate facilities, between Alan Strasbaugh and Ms. Paletsas, as co-landlords, and R. H. Strasbaugh, as lessee. The Company is presently unable to evaluate the likelihood of an unfavorable result in this dispute or the range of potential loss. However, management intends to vigorously defend against this case and believes that all of its defenses are meritorious. The court issued an order appointing a receiver to sell the property; thereafter, the receiver received an offer to purchase the premises from Alan Strasbaugh. The offer was accepted and confirmed by the San Luis Obispo County Superior Court in March of 2009, but Mr. Strasbaugh was unable to complete the transaction due to lack of available financing. Mr. Strasbaugh submitted another offer to purchase the property, and a hearing has been scheduled on the receiver's motion to accept the offer. However, the offer is contingent on obtaining financing for the purchase, and such financing is subject to the execution of an acceptable lease with the Company. Mr. Strasbaugh has advised the Company that he plans to continue with his efforts to acquire the property. The Company does not have a lease for its premises, except for a holdover month-to-month tenancy at this time. Although, management believes that purchase of the property by Mr. Strasbaugh, if consummated, may resolve the claim relating to roof maintenance, that claim remains pending. -44- ITEM 1A. RISK FACTORS In addition to the other information set forth in this report, you should carefully consider the factors discussed under "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2008, which could materially affect our business, financial condition and results of operations. The risks described in our Annual Report on Form 10-K for the year ended December 31, 2008 are not the only risks we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and results of operations. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS On October 12, 2009, the Company issued 504,000 shares of restricted Common Stock to holders of its employee stock options, in exchange for cancellation of options to purchase 1,008,000 shares of Common Stock. The issuance was pursuant to the Company's Option Exchange Program, in which employees were entitled to exchange options for Common Stock at the rate of two options for one share of Common Stock. The shares issued are subject to vesting, so that any of the shares issued to an employee who ceases to be employed on or before March 31, 2010 will be cancelled. The options surrendered were exercisable at prices ranging from $1.20 to $1.71 per share. There was no other consideration given. The Company believes that the issuance of the shares of restricted Common Stock was exempt from the registration requirements of the Securities Act of 1933, as amended, by reason of Section 4(2) thereof and Regulation D thereunder. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. -45- ITEM 6. EXHIBITS Exhibit Number Description ------ ----------- 31.1 Certification Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (*) 31.2 Certification Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (*) 32.1 Certification of President and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (*) ------------------- (*) Filed herewith. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. STRASBAUGH Dated: November 16, 2009 By: /s/ RICHARD NANCE --------------------------------- Richard Nance, Chief Financial Officer (principal financial and accounting officer) EXHIBITS FILED WITH THIS REPORT Exhibit Number Description ------ ----------- 31.1 Certification Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification of President and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 -46-

Strasbaugh 10-Q