NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

(Unaudited)

NOTE 1. NATURE OF OPERATIONS

Energy Focus, Inc. and its subsidiaries (the “Company”) engage in the design, development, manufacturing, marketing, and installation of energy-efficient lighting systems and solutions where the Company serves two segments:

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solutions segment providing turnkey, high-quality, energy-efficient lighting application alternatives primarily to the existing public-sector building market; and

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products segment providing military, general commercial and industrial lighting and pool lighting offerings, each of which markets and sells energy-efficient lighting systems.

The Company continues to evolve its business strategy to include providing its customers with turnkey, comprehensive energy-efficient lighting solutions, which use, but are not limited to, its patented and proprietary technology. The Company’s products segment includes light-emitting diode (“LED”), fiber optic, high-intensity discharge (“HID”), fluorescent tube and other highly energy-efficient lighting technologies. Typical savings related to current technology of the Company approximates 80% in electricity costs, while providing full-spectrum light closely simulating daylight colors. The Company’s strategy also incorporates continued investment into the research of new and emerging energy sources including LED and solar energy applications.

NOTE 2. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The financial statements include the accounts of the Company and its subsidiaries, Stones River Companies, LLC (“SRC”) doing business as Energy Focus LED Solutions in Nashville, Tennessee, and Crescent Lighting Limited (“CLL”) located in the United Kingdom. All significant inter-company balances and transactions have been eliminated.

We have prepared the accompanying financial data for the three and nine months ended September 30, 2013 and 2012 pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles (“GAAP”) in the U.S. have been condensed or omitted pursuant to such rules and regulations. The accompanying financial data and information should be read in conjunction with our 2012 Annual Report on Form 10-K.

In the opinion of management, the accompanying condensed consolidated financial statements contain all normal and recurring adjustments necessary to present fairly our Condensed Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012 , Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 30 , 2013 and 2012, Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2013 and 2012 , and Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012 .

The preparation of condensed consolidated financial statements in accordance with GAAP in the U.S. requires management to make estimates and assumptions that affect the amounts reported in our condensed consolidated financial statements and accompanying notes. Management bases its estimates on historical experience and various other assumptions believed to be reasonable. Although these estimates are based on management’s best knowledge of current events and actions that may impact the company in the future, actual results may be different from the estimates. Estimates include, but are not limited to, the establishment of reserves for accounts receivable, sales returns, inventory obsolescence and warranty claims; the useful lives for property, equipment, and intangible assets; revenues recognized on a percentage-of-completion basis; and stock-based compensation. In addition, estimates and assumptions associated with the evaluation of long-lived assets for impairment requires considerable judgment. Actual results could differ from those estimates and such differences could be material.

ENERGY FOCUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

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The Company’s independent registered public accounting firm has issued an opinion in connection with the Company’s 2012 Annual Report on Form 10-K raising substantial doubt about the Company’s ability to continue as a going concern. The interim financial statements have been prepared assuming the Company will continue to operate as a going concern, which contemplates the realization of assets and the settlement of liabilities in the normal course of business. The interim financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from uncertainty related to our ability to continue as a going concern.

Update to Significant Accounting Policies

There have been no material changes to our significant accounting policies, as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012.

Earnings (Loss) per Share

Basic loss per share is computed by dividing the net loss available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted loss per share is computed giving effect to all dilutive potential common shares that were outstanding during the period. Dilutive potential common shares consist of incremental shares upon exercise of stock options, warrants, and conversion of convertible subordinated promissory notes unless the effect would be anti-dilutive.

A reconciliation of basic and diluted loss per share is provided as follows (in thousands, except per share amounts):

Options and warrants to purchase approximately 14,319,000 and 15,283,000 shares of common stock, were outstanding at September 30, 2013 and 2012, respectively, but were not included in the calculation of diluted net loss per share because their inclusion would have been anti-dilutive.

ENERGY FOCUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

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At September 30, 2013 and 2012, the Company has unamortized stock-based compensation expense of $249 thousand and $241 thousand, respectively. These costs will be charged to expense and amortized using a straight-line amortization method in future periods through the third quarter of 2016. The weighted average period over which this unearned compensation is expected to be recognized is approximately 1.6 years.

The fair value of each stock option is estimated on the date of grant using the Black-Scholes option pricing model. Estimates utilized in the calculation include the expected life of the option, risk-free interest rate, and expected volatility, and are further comparatively detailed as follows:

Option activity under the Company’s stock plans during the nine months ended September 30, 2013 was as follows:

Additionally, the Company granted 51,219 restricted stock units during the third quarter ended September 30, 2013. The fair market value on the date of grant was $0.41 per share. The shares vest one year from the grant date.

ENERGY FOCUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

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Product Warranties

The Company warrants finished goods against defects in material and workmanship under normal use and service for periods generally between one and five years for products and labor. Settlement costs consist of actual amounts expensed for warranty services which are largely a result of third-party service calls and the costs of replacement products. A liability for the estimated future costs under product warranties is maintained for products outstanding under warranty and is included in “Accrued liabilities” in the Condensed Consolidated Balance Sheets. The warranty activity for the respective periods is as follows (in thousands):

ENERGY FOCUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

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Amortization expense for intangible assets subject to amortization was $51 thousand and $104 thousand for the three months ended September 30, 2013 and 2012, respectively. For the nine months ended September 30, 2013 and 2012, amortization expense was $177 thousand and $314 thousand, respectively.

In conjunction with the settlement agreement between the Company and the former owners of SRC, the Company agreed to discontinue the use of the name “Stones River Companies, LLC” and various derivatives including SRC. Therefore, at June 30, 2013, the remaining unamortized balance of Tradenames of $325 thousand was written off. See Note 9, Settlement of Acquisition Obligations.

Customer relationships are amortized over their expected useful lives on an accelerated method that approximates the cash flows associated with those relationships. Based on the carrying value of amortized intangible assets, the Company estimates amortization expense for future years to be as follows (in thousands):

ENERGY FOCUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

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NOTE 7. DEBT

Credit Facilities

On December 22, 2011, the Company entered into a $4.5 million revolving line of credit (“credit facility”) with Rosenthal & Rosenthal. The total loan amount available to the Company under the line of credit is equal to 85% of its net amount of eligible receivables, plus available inventory (the lesser of 50% of the lower of cost or market value of eligible inventory, or $250 thousand). The credit facility is secured by a lien on the domestic assets of the Company. The interest rate for borrowing on accounts receivable is 8.5%, on inventories 10.0% and on overdrafts 13.0%. Additionally, there is an annual 1% facility fee on the entire amount of the credit facility payable at the beginning of the year. The credit facility is a three year agreement, expiring on December 31, 2014, unless terminated sooner. There are liquidated damages if the credit facility is terminated prior to December 31, 2014, which are based on the maximum credit facility amount then in effect. The damages are: 2% if terminated prior to December 31, 2013, and 1% if terminated prior to December 31, 2014. The Company is required to comply with certain financial covenants, measured quarterly, including, as defined in the agreement: a tangible net worth amount and a working capital amount. The Company was in compliance with the financial covenants at September 30, 2013. Borrowings under the revolving line of credit were $836 thousand at September 30, 2013, and $1.6 million at December 31, 2012, and are recorded in the Company’s Condensed Consolidated Balance Sheets as a current liability under the caption “Credit line borrowings.”

The unsecured convertible debt has a five percent annual interest rate, and is convertible into common stock of the Company at the rate of $0.23 per share as follows (in thousands):

ENERGY FOCUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

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$500 thousand of the convertible debt matures on December 31, 2015 and the remaining $5.2 million matures on December 31, 2016. During the second quarter, $1 million of the debt was converted into 4.3 million shares of Common Stock of the Company. Additionally, effective October 16, 2013, an additional $500 thousand of the debt was converted into 2.2 million shares of Common Stock of the Company.

As a provision of the settlement agreement between the Company and the former owners of SRC, the Company’s obligation to pay a $500 thousand convertible promissory note was cancelled in its entirety during the second quarter of 2013. See Note 9, Settlement of Acquisition Obligations.

On July 3, 2013, the Letter of Credit Agreement with Mark Plush was paid in full. See Note 13, Related Party Transactions.

For a full description of the Company’s debt financing, reference is made to Note 8, Debt, of the Company’s 2012 Annual Report on Form 10-K.

Future maturities of remaining borrowings are (in thousands):

NOTE 8. RESTRUCTURING

During the third quarter of 2013, the Company relocated its manufacturing operation from a contract manufacturing facility located in Mexico to its existing facilities in Pleasanton, California and Solon, Ohio. The Condensed Consolidated Statements of Operations includes $79 thousand in “Restructuring” for severance for the Mexican contract employees as required by the production share agreement, as amended, between the Company and the contract manufacturer.

NOTE 9. SETTLEMENT OF ACQUISITION OBLIGATIONS

On June 28, 2013, the Company entered into a Settlement Agreement with SRC, TLC Investments, LLC, Jamie Hall and Robert E. Wilson, terminating the Membership Interest Purchase Agreement and related agreements that the parties had entered into at the end of December 2009 in connection with the Company’s acquisition of SRC. As part of the Settlement Agreement, the Company’s obligation to pay a $500 thousand special fee and a $500 thousand convertible promissory note including interest of $92 thousand were cancelled in their entirety in exchange for a $200 thousand payment and the forgiveness of a net receivable due to the Company of $78 thousand. Additionally, the Company recognized a $66 thousand favorable adjustment related to the change in the estimate of a performance-related contingent obligation for a 2.5% payout based upon the fair value of projected annual billings of SRC. See Note 12, Commitments and Contingencies.

  ENERGY FOCUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

(Unaudited)

The classification of these items in the Condensed Consolidated Statements of Operations for the nine months ended September 30, 2013 is shown below (in thousands):

 

Change in estimate of contingent liabilities:
Forgiveness of net receivable due the Company		$	78
Adjustment to performance-related contingent obligation			(66	)
Net line item expense		$	12
Settlement of acquisition obligations:
Forgiveness of special fee		$	500
Forgiveness of convertible promissory note, including interest			592
Payment by the Company			(200	)
Net line item income		$	892

As a provision of the Settlement Agreement, the Company agreed to discontinue using the name Stones River Companies by July 1, 2014. As a result of this provision, the Company wrote off the remaining $325 thousand of the intangible asset for the Tradename during the second quarter of 2013. See Note 5, Intangible Assets.

NOTE 10. SEGMENTS AND GEOGRAPHIC INFORMATION

The Company has two reportable segments: products segment featuring pool lighting, general commercial and industrial lighting, government products, and research and development services, each of which markets and sells energy-efficient lighting systems; and solutions segment providing turnkey, high-quality, energy-efficient lighting application alternatives. The Company’s products are sold through a combination of direct sales employees, independent sales representatives and distributors in different geographic markets throughout the world. The Company’s solutions sales are designed to enhance total value by positively impacting customers’ profitability, the environment, and the communities it serves. These solutions are sold through the Company’s direct sales employees, as well as our SRC subsidiary, and include not only its proprietary energy-efficient lighting solutions, but also sourced lighting systems, energy audits and service agreements.

ENERGY FOCUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

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The following summarizes the Company’s reportable segment data for periods indicated (in thousands):

ENERGY FOCUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

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The following table provides additional business unit gross profitability detail for the Company’s products segment for the periods indicated (in thousands):

A geographic summary of net sales is as follows (in thousands):

A geographic summary of long-lived assets, which consists of fixed assets and intangible assets, is as follows (in thousands):

NOTE 11. INCOME TAXES

ENERGY FOCUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

(Unaudited)

As of December 31, 2012, the Company had a net operating loss carry-forward of approximately $70.7 million for federal, state and local income tax purposes. Due to changes in the Company’s capital structure, the net operating loss carry-forward available to the Company in future years to offset future taxable liabilities may be limited under Section 382 of the Internal Revenue Code (the “Code”). Management is currently reviewing the rules under this section of the Code, but believes that the limitation on the Company’s net operating loss carry-forward may be significant.

NOTE 12. COMMITMENTS AND CONTINGENCIES

In connection with the acquisition of SRC, the Company recorded a performance-related contingent obligation in December 2010 related to a 2.5% payout payable over 42 months commencing January 1, 2010 and based upon the fair value of projected annual billings of the acquired business, and a $500 thousand fee if the market price of the Company’s common stock is not equal to or greater than $2.00 per share for at least twenty trading days between June 30, 2010 and June 30, 2013 (due on June 30, 2013). The Company accrued for each of these contingent liabilities at their respective fair values at the time of the acquisition. For the three and nine months ended September 30, 2013, the Company paid $0 and $206 thousand, respectively, relating to the 2.5% payout. For the three and nine months ended September 30, 2012, the Company paid $51 thousand and $140 thousand, respectively, relating to the payout.

On June 28, 2013, the Company entered into a Settlement Agreement with Stones River Companies, LLC, TLC Investments, LLC, Jamie Hall and Robert E. Wilson, terminating the Membership Interest Purchase Agreement related to the acquisition of SRC. As part of the Settlement Agreement, the Company’s obligation to pay a $500 thousand special fee and a $500 thousand convertible promissory note including interest of $92 thousand were cancelled in their entirety. Additionally, the Company recorded at $66 thousand favorable adjustment related to the 2.5% payout discussed above. See Note 9, Settlement of Acquisition Obligations. At December 31, 2012, the Company had recorded a current liability related to these contingent obligations of $728 thousand under the caption “Accrued liabilities” in its Condensed Consolidated Balance Sheets.

NOTE 13. RELATED PARTY TRANSACTIONS

On August 11, 2011, the Company entered into a Letter of Credit Agreement (“LOC”) with Mark Plush, its former Chief Financial Officer, in the amount of $250 thousand. Effective July 8, 2013, Mr. Plush stepped down from his role and left the Company. For a full description of the terms of the LOC, reference is made to Note 10, Debt, of the Company’s 2012 Annual Report on Form 10-K. On July 3, 2013, the LOC was paid in full.

On December 12, 2012, the Board of Directors of the Company appointed James Tu to serve as its non-executive Chairman, and on April 30, 2013, Mr. Tu became the Executive Chairman assuming the duties of the Company’s Principal Executive Officer. Mr. Tu is also the Founder, Chief Executive Officer and Chief Investment Officer of 5 Elements Global Advisors, an investment advisory and management company managing the holdings of 5 Elements Global Fund LP, and 5 Elements Energy Efficiencies Ltd, a beneficial owner of more than ten percent (10%) of the Company’s Common Stock. 5 Elements Global Advisors focuses on investing in clean energy companies with breakthrough, commercialized technologies and near-term profitability potential. Mr. Tu is also Co-Founder and Managing Partner of Communal International Ltd. “(Communal”), a British Virgin Islands Company dedicated to assisting clean energy solutions companies maximize their technology and product potential and gain access to global marketing, distribution licensing, manufacturing and financing resources. Communal has a fifty percent (50%) ownership interest in 5 Elements Efficiencies (BVI) Ltd.

On February 27, 2012, the Company entered into an Asian Business Development/Collaboration Agreement with Communal International Ltd. The agreement had a 60 month term, under which the Company paid $523 thousand to Communal. Additionally, during the term of the agreement, the Company will pay Communal a five percent (5%) commission on the Company’s net sales which occur within the Territory, as defined by the agreement. The Company has incurred no commissions due under this agreement through September 30, 2013.

ENERGY FOCUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2013

(Unaudited)

Effective on January 1, 2013, the Asian Business Development/Collaboration Agreement with Communal was amended to reflect the extension of the terms of the agreement for an additional 12 months, and the addition of certain services and countries in the territory covered by the agreement. In connection with the amended and restated agreement, the Company agreed to pay an additional $425 thousand through December 2013. After December 31, 2013, the Company may terminate the agreement upon 30 days written notice. The Company paid $262 thousand related to this agreement during the first nine months of 2013, and recorded expense of $169 thousand during the first nine months 2013.

NOTE 14. SHAREHOLDERS EQUITY

During the first nine months of 2013, the Company entered into unsecured convertible notes totaling $5.2 million. The notes are convertible into shares of Common Stock of the Company at $.23 per share at various dates beginning on July 31, 2013. See Note 7, Debt. The fair market value of the Company’s Common Stock ranged from $0.21 per share to $0.42 per share during the period the note agreements were consummated. In accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification Topic Number 420, Debt, $1.8 million was recorded as a discount on these notes under the captions “Long-term debt” and “Additional paid-in capital” in its Condensed Consolidated Balance Sheets at September 30, 2013. The discount will be amortized over the term of the applicable notes through December 31, 2016 unless the notes are converted prior to maturity.

During the second quarter of 2013, an unsecured convertible noted entered into in December 2012 for $1 million was converted into 4.3 million shares of Common Stock of the Company. Additionally, effective October 16, 2013, an additional $500 thousand of the debt was converted into 2.2 million shares of Common Stock of the Company.