June 30,			December 31,
		2008			2007
Parts and materials		$	—		$	247
Finished goods held at customer locations			2,489			1,243
Finished goods held at manufacturing partner			3,547			5,120
Total inventories		$	6,036		$	6,610

-8-

---

 

Parts and materials consist of components purchased by us in order to reduce the production lead time of our products. Finished goods held at manufacturing partner locations consist of N2 phones and accessories located at our manufacturing partner or with our web sales partner. Finished goods held at customer locations consists of N2 phones that have been shipped to distributors but remain in their inventories at the end of the period for which revenue has been deferred.

 

In January 2008, we discovered a technical issue that affected the quality of the reception of our phones in the 900 Megahertz bandwidth and lower. As a result, we undertook a voluntary program to recall and modify the phones that our customers held in inventory in order to bring the quality of the reception up to our standards. Due to the recall, we stopped all shipments of our N2 phones during the first quarter of 2008, and our customers withheld payment of amounts due to until such time as we are able to return the modified phones to them. As the modifications were completed we redistributed the inventory that had not been paid for to new customers or are holding it in our inventory for future shipment to new customers. We completed the product modification in May 2008. We have experienced limited success in selling our N2 mobile phone since introduction in the third quarter of 2007 and have reevaluated our selling efforts and the potential markets for the N2 during the second quarter of 2008. Based upon this reevaluation, we decided that it was probable that we may have to reduce the selling price of our N2 phones and/or offer our customers substantial incentives in order to sell the N2. As a result of our revaluation, we recorded a $7.7 million write-down of our inventory during the second quarter of 2008 reducing the value of our inventory to $6.0 million, which represents the estimated realizable value after selling costs of our inventory at June 30, 2008.

 

4.   Convertible Debt and Notes Payable

Our convertible debt and notes payable consists of the following (in thousands):

 

		June 30,			December 31,
		2008			2007
Senior Convertible Secured August 2007 Bridge Notes (face value $3,003)		$	2,665		$	2,634
Senior Convertible Secured Notes September 2007 (face value $3,053 at June 30, 2008 and $3,085 at December 31, 2007)			1,100			1,112
Loan - Almi Företagspartner			103			120
Capital leases - office copying machines			92			72
Total			3,960			3,938
Unamortized debt discount			3,240			3,746
Total debt, net of debt discount			720			192
Less: short-term portion of long-term debt			643			132
Long-term debt		$	77		$	60

 

Future maturities of notes payable (in thousands):

 

Year ended December 31,		Future Maturity of Notes Payable
2008 remaining		$	2,879
2009			24
2010			3,053
Thereafter			-
Total principal payments		$	5,956

-9-

---

Senior Convertible Secured August Bridge Notes

Year Ended December 31, 2007

On August 8, 2007, we made an offering of convertible notes pursuant to a Note Purchase Agreement (August Bridge Notes or Bridge Notes), dated as of July 31, 2007, amended August 1, 2007, September 26, 2007 and March 24, 2008. The August Bridge Notes are convertible into the units offered in the September 26, 2007 financing agreement described below. We received $3,250,000 from the Bridge Note offering and issued an option to invest $750,000, at the same terms and conditions as the Bridge Notes, to one of the Bridge Note investors/financial advisor as part of a longer range financing plan. The August Bridge Notes originally matured on December 31, 2007, however the maturity of these notes was extended to June 30, 2008 in conjunction with the September 2007 financing described below and extended again until December 31, 2008 in conjunction with the May 2008 financing described below.

The August Bridge Notes, due December 31, 2008, bear 8% per annum interest and are convertible into purchase units that are made up of a combination of shares of our common stock, debt and warrants in accordance with the September 26, 2007 financing agreement. The note holders have a right to convert their notes plus accrued interest anytime before December 31, 2008 into purchase units. Each purchase unit of $3,000 is comprised of one $1,500 three-year promissory note bearing the higher of LIBOR plus 3% or 8% interest per annum, convertible into shares of our common stock at a conversion price of $3.50 per share, 600 shares of our common stock and 5 year warrants to purchase 696.5 shares of our common stock at a price of $1.27 per share. For accounting purposes the embedded conversion feature was determined to meet the definition of a derivative and was recorded as liability. This was because the holder of the notes could convert debt and accrued interest, where interest is at the greater of 8% or LIBOR plus 3%, and therefore, the total number of shares the instrument could be convertible into was not fixed. Accordingly, the embedded conversion feature is bifurcated from the debt host instrument and treated as a liability, with the offset to debt discount. The related warrants were also recorded as a liability for the same reason.

The fair value of the embedded conversion feature related to the Bridge Notes was calculated at September 26, 2007 using the Black-Scholes option pricing model and amounted to $3.3 million. The assumptions used for the Black-Scholes option pricing model were a term of 0.76 years, volatility of 99% and a risk-free interest rate of 4.16%. The $3.3 million was recorded as “Embedded derivatives of convertible debt” and a debt discount. The debt discount exceeded the amount of recorded debt, which resulted in a charge of $654,000 for the difference between the debt discount and the value of the debt. The remaining debt discount balance was allocated to interest expense based on the effective interest rate method, with an effective interest rate of 393%, over the remaining term of the notes. The value of the embedded conversion feature is revalued at each period-end and the liability is adjusted with the offset recorded as “Non-cash financial items.”

On September 26, 2007, the August Bridge Note holders that had not converted their debt were given three year warrants to purchase up to 219,074 shares of our common stock at a price of $3.92 per share in exchange for an agreement to extend the term of their notes from the original date of December 31, 2007 until June 30, 2008. In addition, the Bridge Note holders agreed to delay the right to convert their Bridge Notes until after March 15, 2008 and until June 30, 2008. The fair value of the warrants issued to the holders of the $2.8 million of Bridge Note was calculated at September 26, 2007 as $706,000 using the Black-Scholes option pricing model. The fair value of the warrants was recorded as a debt issuance cost to be allocated to interest expense based on the effective interest rate method over the nine month term of the notes with the offsetting entry to a liability. The warrants were classified as a liability due to the same reason as above. The assumptions used for the Black-Scholes option pricing model were a term of 0.76 years, volatility of 116% and a risk-free interest rate of 4.16%. As a result of the extension of the loan maturity period, the agreement to delay conversion of the bridge notes and the issuance of additional warrants, the modifications were significant enough to trigger debt extinguishment accounting resulting in a debt extinguishment charge amounting to $540,000. The liability for the warrants issued to the August Bridge Note holders is revalued at the end of each reporting period and the change in the liability is recorded as “Non-cash financing items”.

The initial fair value of option issued in August 2007 to purchase $750,000 of August Bridge Notes at a future date amounted to $716,000 based on the Black-Scholes option pricing model. The assumptions used for the Black-Scholes option pricing model were a term of 0.39 years, volatility of 99% and interest rate of 4.16%. The fair value was recorded as a deferred financing fee to be allocated to interest expense using the effective interest rate method over the nine month term of the notes with the offset recorded as other current liability. At December 31, 2007, this option was extended to March 31, 2008 as part of debt negotiations in a private placement that was abandoned in February 2008. At December 31, 2007, the value of the extension of this option was calculated amounting to $475,000 and recorded as a deferred financing fee under “Prepaid expense” relating to the financing under negotiation at December 31, 2007. The assumptions used for the Black-Scholes option pricing model were a term of 0.27 years, volatility of 99%-157% and interest rates of 3.36 to 3.49%. When this financing package was abandoned in February 2008, the value of the option recorded as deferred financing fees was charged to “Financing fees and other non-cash financing items”.

 

-10-

---

Quarter Ended March 31, 2008

On March, 31, 2008, the expiration of the option to invest $750,000 was extended again to June 30, 2008. The value of the extension of this option was calculated using the Black-Scholes option pricing model and amounted to $43,000. The assumptions used for the Black-Scholes option pricing model were a term of 0.27 years, volatility of 72% and interest rate of 1.24%. The $43,000 value of the warrants was recorded as a liability with the corresponding amount recorded as a non-cash finance expense.

The liability of the embedded conversion feature related to the Bridge Notes amounted to $3,235,000 at March 31, 2008 which is an increase of $1,140,000 from December 31, 2007. The assumptions used for the Black-Scholes option pricing model at March 31, 2008 were a term of 0.25 years, volatility of 79% and a risk-free interest rate of 1.38%.

At March 31, 2008, the revalued liability related to the Bridge Notes three year warrants to purchase up to 219,074 shares of our common stock at a price of $3.92 per share amounted to $472,000 resulting in a decrease from December 31, 2007 in “Non-cash financial items” of $135,000. The assumptions used for the Black-Scholes option pricing model when calculating the value of the warrants at March 31, 2008 were a term of 2.5 years, volatility of 127.58% and a risk-free interest rate of 1.71%.

Quarter Ended June 30, 2008

On April 17, 2008, the option holder exercised $375,000 of the original $750,000 option amount and was issued a note, at the same terms and conditions as the August Bridge Notes. The option to invest $750,000 had an original expiration date of December 31, 2007 when issued, however, this option was extended until June 30, 2008 and the $375,000 unexercised portion was extended again until December 31, 2008 in conjunction with the May 2008 financing.

On May 21, 2008, the option holder who exercised a portion of the option to invest in the August Bridge Notes converted an aggregate of $375,000 of debt into the common stock and warrants issued in the May 21, 2008 financing described below. Upon conversion we issued 295,275 shares of our common stock and 5-year warrants to purchase 590,550 shares of our common stock at an exercise price of $1.45 per share. The fair value of the 5-year warrants totaled $1.1 million and was calculated using the Black-Scholes option pricing model. The assumptions used for the Black-Scholes option pricing model were a term of 5 years, volatility of 110.28% and interest rate of 3.09%. The warrants were recorded among “Liability for warrants to purchase common stock” and are valued at fair valued at the end of each reporting period.

		Weighted Average Number of Shares			Exercise Price Per Share			Weighted Average Exercise Price
Outstanding at December 31, 2007			2,434,732		$	1.42 - $27.50		$	2.58
Granted			570,000			0.60 - 3.45			3.17
Cancelled or expired			(1,180,677	)		1.84 - 3.45			2.24
Exercised			(21,000	)		1.84 - 1.84			1.84
Outstanding at June 30, 2008			1,803,055		$	0.60 - $27.50		$	2.99

 

The 1996 Plan terminated effective January 17, 2006 and the 1998 Plan terminated effective June 15, 2008 and although we can no longer issue stock options out of the plans, the outstanding options at the date of termination will remain outstanding and vest in accordance with their terms. Options granted under the Director Plan vest over a one to four-year period, expire five to seven years after the date of grant and have exercise prices reflecting market value of the shares of our common stock on the date of grant. Stock options granted under the 1996, 1998 and 2006 and are exercisable over a maximum term of ten years from the date of grant, vest in various installments over a one to four-year period and have exercise prices reflecting the market value of the shares of common stock on the date of grant.

 

-17-

---

The Neonode Plan has been designed for participants (i) who are subject to Swedish income taxation (each, a Swedish Participant) and (ii) who are not subject to Swedish income taxation (each, a Non-Swedish Participant). The options issued under the plan to the Non-Swedish Participant are five year options with 25% vesting immediately and the remaining vesting over a three year period. The options issued to Swedish participants are vested immediately upon issuance. The fair value of the options issued out of the Neonode Plan at the date of issuance was calculated using the Black-Scholes option pricing model. These calculations assumed risk free interest rates ranging from 4.5% to 4.875%, a volatility of 50% and a share prices ranging from $4.69 to $4.78. We will not grant any additional equity awards out of the Neonode Plan.

 

Depreciation and amortization		$	257
Write-down of inventory			7,704
Deferred interest			(124	)
Valuation charges for conversion features and warrants			6,110
Stock-based compensation expense			949
		$	14,896

At December 31, 2007, we had outstanding $5.7 million in bank guaranties that were provided at various times during the 12 month period then ended. These bank guaranties were provided as collateral for the performance of our obligations under our agreement with our manufacturing partner except for an amount of $169,000 relating to the leasing agreement for our new premises beginning in April 2008. All the outstanding bank guaranties relating to our manufacturing partner expired at December 29, 2007 and the funds were released by our bank to cash on January 2, 2008 leaving $169,000 as restricted cash at June 30, 2008.

Adjusted working capital (current assets less current liabilities not including non-cash liabilities related to warrants and embedded derivatives) was a deficit of $3.9 million at June 30, 2008 compared to an adjusted working capital of $5.8 million at December 31, 2007.

In the six month period ended June 30, 2008, we purchased $312,000 of fixed assets, consisting primarily of manufacturing tooling, computers and engineering equipment.

On March 4, 2008, we sold $4.5 million in securities, net cash proceeds to us of $4.0 million, in a private placement to accredited investors. We sold 1,800,000 shares of our common stock for $2.50 per share. After placement agent fees and offering expenses, we received net proceeds of approximately $4.0 million. Empire Asset Management Company acted as financial advisor for the transaction and was paid a cash fee of approximately $450,000 and received 120,000 shares of our common stock

On May 21, 2008, we completed a $5.1 million, net cash proceeds to us of $4.1 million, primarily to prior security holders, directors, affiliates of management and institutional investors .We offered our existing warrant holders an opportunity to exercise Neonode common stock purchase warrants on a discounted basis for a limited period, ended May 19, 2008. In all, 4,004,793 outstanding warrants were exercised at a strike price of $1.27 per warrant (including $375,000 of surrender of debt). We issued 4,004,793 shares of our common stock and two new common stock purchase warrants, with an exercise price of $1.45, for each outstanding warrant exercised. A total of 8,009,586 new common stock purchase warrants were issued to investors who surrendered or purchased shares under the warrant exchange offer. We also extended the maturity date of $2.85 million of convertible debt that was due on June 30, 2008 until December 31, 2008 by issuing the note holders 510,293 common stock purchase warrants, with an exercise price of $1.45. Empire Asset Management Company acted as financial advisor for the transaction and was paid a cash fee of approximately $510,000 and received a warrant to purchase 400,480 shares of our common stock at $1.27 per share and a warrant to purchase 800,959 shares of our common stock at $1.45 per share.

 

-32-

---

The majority of our cash has been provided by borrowings from senior secured notes and bridge notes that have been or are convertible into shares of our common stock or from the sale of our common stock and common stock purchase warrants to private investors. We have been able to extended the maturity date until December 31, 2008 of approximately $3.0 million of notes and accrued interest that are convertible into shares of our common stock . No assurance can be given that the note holders will chose to convert their debt into shares of our common stock or that we will have the cash on hand to satisfy the payment of the notes and accrued interest when they come due on December 31, 2008. We will require sources of capital in addition to cash on hand to continue operations and to implement our strategy. Our operations are not cash flow positive and we will be forced to seek credit line facilities from financial institutions, additional private equity investment or debt arrangements. No assurances can be given that we will be successful in obtaining such additional financing on reasonable terms, or at all. If adequate funds are not available on acceptable terms, or at all, we may be unable to adequately fund our business plans and it could have a negative effect on our business, results of operations and financial condition. In addition, if funds are available, the issuance of equity securities or securities convertible into equity could dilute the value of shares of our common stock and cause the market price to fall, and the issuance of debt securities could impose restrictive covenants that could impair our ability to engage in certain business transactions.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

Under the supervision of and with the participation of our management, including the Company’s Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of June 30, 2008. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective for the reasons described below.

During the audit of our consolidated financial statements for the year ended December 31, 2007, management determined that we had certain material weaknesses relating to our revenue recognition policies and our accounting for certain financing transactions, including convertible debt and derivative financial instruments. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a Company’s annual or interim financial statements will not be prevented or detected on a timely basis. During mid-2007 we began shipping products to customers and initially recorded revenue as products were shipped. After evaluation of contracts and actual sell through, we determined that the proper revenue recognition methods would be “sell through.” This change resulted in certain accounting adjustments during our year-end audit. In addition, we entered into several complex financing transactions (including convertible debt, derivatives, bifurcation and complex valuation and measurement activities) that resulted in accounting adjustments during our year-end audit. Because these material weaknesses as to internal control over financial reporting also bear upon our disclosure controls and procedures, our Chief Executive Officer and Chief Financial Officer were unable to conclude our disclosure controls and procedures were effective.

 

The factors described below under “Internal Control of Financial Reporting” related to the integration and consolidation of the Swedish operating subsidiary we acquired on August 10, 2007 further contributed to the conclusion of our Chief Executive Officer and Chief Financial Officer.

Despite the conclusion that disclosure controls and procedures were not effective as of the end of period covered by this report, the Chief Executive Officer and Chief Financial Officer believe that the financial statements and other information contained in this annual report present fairly, in all material respects, our business, financial condition and results of operations.

 

-33-

---

Changes in Internal Control over Financial Reporting

 

During the quarter ended June 30, 2008 we continued moving towards complete integration and consolidation of business and financial operations of SBE and Neonode and we expect to take additional steps to both remedy the material weaknesses described above and facilitate our management’s assessment of internal control over financial reporting in accordance the Sarbanes-Oxley Act and Commission rules. Our planned steps include:

	·	adding personnel to our financial department, consultants, or other resources (including those with public company reporting experience) to enhance our policies and procedures, including those related to revenue recognition;
	·	exploring the suitability of further upgrades to our accounting system to complement the new management reporting system software described above;
	·	modifying the documentation and testing programs SBE was developing prior to the merger to appropriately apply to the new Neonode; and
	·	engaging a qualified consultant in 2008 to perform an assessment of the effectiveness of our internal control over financial reporting and assist us in implementing appropriate internal controls on weaknesses determined, if any, documenting, and then testing the effectiveness of those controls.

Other than as described above, there have not been any other changes in our internal control over financial reporting as of the quarter ended June 30, 2008 that has materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

PART II. Other Information

 

ITEM 1A. RISK FACTORS