UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
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FORM 10-K
 

 
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED      DECEMBER 31, 2014   .
 
o 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: 0-23336
 
AROTECH CORPORATION
(Exact name of registrant as specified in its charter)
 
Delaware
 
95-4302784
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
     
1229 Oak Valley Drive, Ann Arbor, Michigan
 
48108
(Address of principal executive offices)
 
(Zip Code)

(800) 281-0356
(Registrant’s telephone number, including area code)
 
Securities registered pursuant to Section 12(b) of the Act:
 
Title of each class
 
Name of each exchange on which registered
Common Stock, $0.01 par value
 
The Nasdaq Stock Market LLC
 
Securities registered pursuant to section 12(g) of the Act: Common Stock, $0.01 par value
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
 
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 o
 
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 (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
 
 
 

 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
 
Indicate by check mark whether the registrant is large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer: o
Accelerated filer: o
Non-accelerated filer: o
Smaller reporting company: x
 
EXPLANATORY NOTE

The registrant met the “accelerated filer” requirements as of the end of its 2014 fiscal year pursuant to Rule 12b-2 of the Securities Exchange Act of 1934, as amended. However, pursuant to Rule 12b-2 and SEC Release No. 33-8876, the registrant (as a smaller reporting company transitioning to the larger reporting company system based on its public float as of June 30, 2014) is not required to satisfy the larger reporting company requirements until its first quarterly report on Form 10-Q for the 2015 fiscal year and thus is eligible to check the “Smaller Reporting Company” box on the cover of this Form 10-K.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
 
The aggregate market value of the registrant’s voting stock held by non-affiliates of the registrant as of June 30, 2014 was approximately $81,031,929 (based on the last sale price of such stock on such date as reported by The Nasdaq Global Market and assuming, for the purpose of this calculation only, that all of the registrant’s directors and executive officers are affiliates).
 
(Applicable only to corporate registrants)  Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 24,568,351 as of 3/13/2015
 
Documents incorporated by reference: None
 
SEC 1673 (01-12)
Potential persons who are to respond to the collection of information contained in this form are not required to respond unless the form displays a currently valid OMB control number.

 
 

 
TABLE OF CONTENTS
 
PART I
 
Page
     
ITEM 1.
  4
ITEM 1A.
  13
ITEM 1B.
  23
ITEM 2.
  23
ITEM 3.
  24
ITEM 4.
  24
     
PART II
   
     
ITEM 5.
  25
ITEM 6.
  25
ITEM 7.
  26
ITEM 8.
  35
ITEM 9.
  35
ITEM 9A.
  36
ITEM 9B.
  37
     
PART III
   
     
ITEM 10.
  38
ITEM 11.
  44
ITEM 12.
  52
ITEM 13.
  53
ITEM 14.
  54
     
PART IV
   
     
ITEM 15.
  55
     
    57
 
 
 

 
PRELIMINARY NOTE
 
This annual report contains historical information and forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to our business, financial condition and results of operations. The words “estimate,” “project,” “intend,” “expect” and similar expressions are intended to identify forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those contemplated in such forward-looking statements. Further, we operate in an industry sector where securities values may be volatile and may be influenced by economic and other factors beyond our control. In the context of the forward-looking information provided in this annual report and in other reports, please refer to the discussions of risk factors detailed in, as well as the other information contained in, our other filings with the Securities and Exchange Commission.
 
Electric Fuel® is a registered trademark and Arotech™, SWIPES™ and MILO Range™ are all trademarks of Arotech Corporation, formerly known as Electric Fuel Corporation. All company and product names mentioned may be trademarks or registered trademarks of their respective holders. Unless otherwise indicated, “we,” “us,” “our” and similar terms refer to Arotech and its subsidiaries.
 
As of December 31, 2014, we became an accelerated filer. We elected to provide the optional scaled disclosure allowed for smaller reporting companies in this Form 10-K to provide us with sufficient time to transition into the fuller reporting standard.
 
PART I
 
ITEM 1.                      BUSINESS
 
General
 
We are a defense and security products and services company, engaged in two business areas: interactive simulation for military, law enforcement and commercial markets; and power systems and batteries for the military, commercial and medical markets. We have organized our business into two divisions, as follows:
 
Ø
We develop, manufacture and market advanced high-tech multimedia and interactive digital solutions for use-of-force training and driving training of military, law enforcement, security, emergency services and other personnel through our Training and Simulation Division:
 
  
We provide simulators, systems engineering support and software products for military operations and vehicle driving trainings to the United States military, government, municipalities and private industry; and
 
  
We provide specialized “use-of-force” training simulators and systems for police, security personnel and the military under the trade name MILO Range™ (“MILO Range”).
 
Ø
We provide advanced battery solutions, innovative energy management and power distribution technologies and world-class product design and manufacturing services for the aerospace, defense, law enforcement, homeland security and medical markets, and we manufacture and sell lithium and Zinc-Air batteries, for defense and security products, including our Soldier Wearable Integrated Power Equipment System (SWIPES)™ power hubs, and other military applications through our Power Systems Division:
 
      
We provide high-end electronics engineering and design services, system integration services, rapid prototyping, and vertically-integrated production services for military, aerospace, and industrial customers, including: (i) hybrid power generation systems, (ii) smart power subsystems for military vehicles and dismounted applications, and (iii) aircraft and missile systems support for cutting-edge weapons and communications technologies;
 
 
We develop and sell rechargeable and primary lithium batteries and smart chargers to the military and medical markets and to private defense industry in the Middle East, Europe and Asia under our Epsilor nameplate;
 
  
We develop, manufacture and market primary Zinc-Air batteries, rechargeable batteries and battery chargers for the military, focusing on applications that demand high energy and light weight, such custom portable power systems like our Soldier Wearable Integrated Power Equipment System (SWIPES™ ) power hub product; and
 
 
We produce water-activated lifejacket lights for commercial aviation and marine applications under our Electric Fuel nameplate.
 
 
4

 
Background
 
We were incorporated in Delaware in 1990 under the name “Electric Fuel Corporation,” and we changed our name to “Arotech Corporation” on September 17, 2003. We operate through our various subsidiaries (all of which are 100% owned by us):
 
Ø
FAAC Incorporated, a Michigan corporation located in Ann Arbor, Michigan (Training and Simulation Division);

Ø
Epsilor-Electric Fuel Ltd., an Israeli corporation located in Beit Shemesh, Israel (between Jerusalem and Tel-Aviv) and in Dimona, Israel (in Israel’s Negev desert area) (Power Systems Division);
 
Ø
UEC Electronics, LLC, a South Carolina limited liability company located in Hanahan, South Carolina (Power Systems Division); and
  
Ø
Electric Fuel Battery Corporation, a Delaware corporation in the process of being relocated from Auburn, Alabama to UEC’s facilities in Hanahan, South Carolina (Power Systems Division).
 
Unless the context requires otherwise, all references to us refer collectively to Arotech Corporation and its subsidiaries.
 
Our results for 2013 and for the first three months of 2014 do not include the results of UEC Electronics, LLC, a South Carolina limited liability company that we purchased on April 1, 2014.
 
For financial information concerning the business segments in which we operate, see Note 16.b. of the Notes to the Consolidated Financial Statements. For financial information about geographic areas in which we engage in business, see Note 16.c. of the Notes to the Consolidated Financial Statements.
 
Facilities
 
Our principal executive offices are located at 1229 Oak Valley Drive, Ann Arbor, Michigan 48108, and our toll-free telephone number at our executive offices is (800) 281-0356. Our corporate website is www.arotech.com. Our periodic reports, as well as recent filings relating to transactions in our securities by our executive officers and directors, that have been filed with the Securities and Exchange Commission in EDGAR format are made available through hyperlinks located on the investor relations page of our website, at http://ir.stockpr.com/arotech/all-sec-filings , as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. Reference to our websites does not constitute incorporation of any of the information thereon or linked thereto into this annual report.
 
The offices and facilities of our Power Systems Division are located in Hanahan, South Carolina, in Auburn, Alabama (in the process of being relocated to Hanahan, South Carolina), and in Israel (in Beit Shemesh and Dimona, both of which are within Israel’s pre-1967 borders). Most of the members of our senior management work extensively out of our facilities in Beit Shemesh; our financial operations are conducted primarily from our principal executive offices in Ann Arbor, Michigan, which is the headquarters of our Simulation Division; the Simulation Division also maintains offices in Royal Oak, Michigan and in Orlando, Florida.
 
Training and Simulation Division
 
Our Training and Simulation Division develops, manufactures and markets an extensive array of trainers and simulators that provide interactive and situational training for military, law enforcement and commercial customers. Our simulators safely and economically train people, from municipal rail and bus drivers to military convoy crews, to respond immediately and appropriately in threatening and dangerous situations while under extreme pressure. During 2014 and 2013, revenues from our Training and Simulation Division were approximately $56.4 million and $63.4 million, respectively.
 
The Training and Simulation Division concentrates on three different product areas:
 
Ø  
Our Vehicle Simulation group provides high fidelity vehicle simulators for use in operator training;
 
Ø  
Our Air Warfare Simulations group provides weapon simulations used to train military pilots in the effective use of air launched weapons; and
 
Ø  
Our Use of Force group provides training products focused on the proper employment of hand carried weapons and is marketed under our MILO Range nameplate.
 
 
5

 
Vehicle Simulation
 
We provide simulators, systems engineering support and software products focused on training vehicle operators for cars and trucks. We provide these products to the United States military, government, municipalities, and private industry. Our fully interactive driver-training systems feature state-of-the-art vehicle simulator technology enabling training in situation awareness, risk analysis and decision making, emergency reaction and avoidance procedures, and proper equipment operation techniques. We also offer simulation software applications, consulting services, and custom software and hardware development services primarily for use by the automobile industry and universities engaged in the study of vehicle performance or operator/vehicle interactions. Our simulators have successfully trained hundreds of thousands of drivers.
 
Our Vehicle Simulation group focuses on the development and delivery of complete driving simulations for a wide range of vehicle types – such as trucks, automobiles, subway trains, buses, fire trucks, police cars, ambulances, airport ground vehicles, and military vehicles. Additionally, we are a prime contractor in respect of the U.S. Army’s Virtual Clearance Training Suite (VCTS) program. In 2014, our Vehicle Simulations group accounted for approximately 42.0% of our Training and Simulation Division’s revenues.
 
We believe that we have held a dominant market share in U.S. military wheeled vehicle operator driver training simulators since 1999 and that we are currently one of three significant participants in the U.S. municipal wheeled vehicle simulators market.
 
Air Warfare Simulations
 
In the area of Air Warfare Simulations, we believe we are a premier developer of validated, high fidelity analytical models and simulations of tactical air and land warfare systems for all branches of the Department of Defense and its related industrial contractors. Our simulations are found in systems ranging from instrumented air combat and maneuver training ranges (such as Top Gun), full task training devices such as the F-18 Weapon Tactics Trainer, and in the on-board computer of many fighter jet aircraft. We supply on-board software to support weapon launch decisions for the F-15, F-16, F-18, F-22 and Joint Strike Fighter (JSF) fighter aircraft. Two of our key Air Warfare Simulations programs are the VCTS and our trainer for Air National Guard boom operators. VCTS trains route clearance teams on techniques to detect and neutralize improvised explosive devices (IEDs). Our trainer for Air National Guard Boom Operators trains the boom operators for the performance of in-flight refueling. Boom operators control the equipment on a specially designed, refueling aircraft that passes fuel to other aircrafts in midair. We recently commenced production of this trainer and expect to start generate revenue from these trainers in 2015. In 2014, our Air Warfare Simulations group accounted for 35.0% of our Training and Simulation Division’s revenues.
 
Use-of-Force
 
We are a leading provider of interactive, multimedia, fully digital use-of-force training simulators for law enforcement, security, military and similar applications. With a large customer base spread over twenty countries around the world, we are a leader in the supply of simulation training products to law enforcement, governmental, and commercial clients. We conduct our interactive training activities and market our interactive training products, such as the MILO Range (Interactive Use-of-Force and Firearms Training), the MILO Classroom Trainer (a state-of-the-art Computer Based Training (CBT) system that allows students to interact with realistic interactive scenarios projected life-size in the classroom), and the MILO Range FDU (firearm diagnostics unit), using our MILO Range nameplate. In 2014, our Use-of-Force group accounted for 16.0% of our Training and Simulation Division’s revenues.
 
Warranty
 
We typically offer a one to two year warranty for most of our products. Additionally, we sell extended warranties to our existing customers.  In 2014, warranty revenue accounted for 7.0% of our Training and Simulation Division’s revenues.
 
Marketing and Customers
 
We market our Simulation Division products to all branches of the U.S. military, federal and local government, municipal transportation departments, and public safety groups. Municipalities throughout the U.S. are using our vehicle simulators and use-of-force products, and our penetration in Asia, Europe and the Americas continues through the use of commissioned sales agents and regional distributors.
 
We have long-term relationships, many of over ten years’ duration, with the U.S. Air Force, U.S. Navy, U.S. Army, U.S. Marine Corps, Department of Homeland Security, and most major Department of Defense training and simulation prime contractors and related subcontractors. The quality of our customer relationships is illustrated by the multiple program contract awards we have earned from many of our customers.
 
 
6

 
Competition
 
Our technical excellence, superior product reliability, high customer satisfaction and warranty services have enabled us to develop market leadership and attractive competitive positions in each of our product areas.
 
Vehicle Simulators
 
Several potential competitors in this segment are large, diversified defense and aerospace conglomerates, such as L-3 Communications and Leidos, who do not focus on our specific niches. As such, we are able to provide service on certain large military contracts through strategic agreements with these organizations or can compete directly with these organizations based on our strength in developing higher quality software solutions. In municipal market applications, we compete against smaller, less sophisticated software companies, such as Boron and Simulation Technology. Many of our competitors have financial, technical, marketing, sales, manufacturing, distribution and other resources significantly greater than ours.
 
Air Warfare Simulations
 
Currently no significant competitors participate in the markets we serve around our weapon simulation niche. Our nearly 45-year history in this space provides us with a library of resources that would require substantial investment by a competitor to offer a comparable product. The companies that have the potential to compete with us if they chose are the companies that now subcontract this work to us: Boeing Company (NYSE: BA) (“Boeing”), Raytheon Company (NYSE: RTN) (“Raytheon”), and Cubic Corporation (NYSE: CUB) (“Cubic”).
 
Use of Force
 
We compete against a number of established companies that provide similar products and services, many of which have financial, technical, marketing, sales, manufacturing, distribution and other resources significantly greater than ours. There are also companies whose products do not compete directly, but are sometimes closely related. Firearms Training Systems, Inc., and LaserShot Inc. are our main competitors in this space.
 
Power Systems Division
 
Our Power Systems Division develops and provides sophisticated portable energy solutions for diverse applications, including military equipment carried by soldiers, hybrid energy generation/storage in austere environments, power management and power distribution, and clean, stable power for tactical vehicles, unmanned vehicles and medical devices, all of which are designed to complex and demanding customer specifications. During 2014 and 2013, revenues from our Power Systems Division were approximately $47.2 million and $25.1 million, respectively. Revenues in 2013 and the first quarter of 2014 did not include the results of UEC, which we did not own until April 2014. On a pro forma basis, assuming we had owned all components of our Power Systems Division since January 1, 2013, Power Systems Division revenues in 2014 and 2013 would have been approximately $59.7 million and $57.6 million, respectively.
 
Electronics Engineering and Design Services for the Military
 
Introduction
 
We design, engineer, and manufacture proprietary electronics, spanning components and sub-assemblies, for a broad range of end use systems in multiple markets to include aerospace, defense, industrial and medical. We specialize in electronic/electromechanical systems, subsystems, and component level requirements, which include circuit card assemblies and wire and cable assemblies. Our products range from complex integrated assemblies up through multi-rack functional systems and test equipment.
 
 
7

 
We specialize in core, proprietary engineering capabilities in highly-demanded solution areas, including: (i) hybrid power generation systems, (ii) smart power subsystems for military vehicles and dismounted applications, and (iii) aircraft and missile systems support for cutting-edge weapons and communications technologies. Our unique brand of comprehensive service is highly sought-after by customer agencies such as the Marine Corps Systems Command (“MARCORSYSCOM”), Space and Naval Warfare Systems Command (“SPAWAR”), and Tank Automotive Command (“TACOM”), as well as large prime contractors such as Raytheon, Boeing, Lockheed Martin Corporation (NYSE: LMT) (“Lockheed Martin”), and BAE Systems plc (LON: BA) (“BEA”). Our key program areas in this field include the following:
 
·  
We supply the United States Marine Corps (USMC) with its program of record Ground Renewable Expeditionary Energy Network Systems (GREENS), a renewable power generation, intelligent energy storage and distribution system for troops serving in austere environments. GREENS is the only DoD Program of Record for renewable power generation. We are currently launching a commercial version of this product, targeting both domestic and international markets.
 
·  
We supply the USMC with Mobile Electric Hybrid Power Sources (MEHPS), a product that incorporates both solar collection and high density battery technologies to intelligently reduce run time and optimize efficiency of tactical generators. This single system is scalable to 3.5kW, 7kW and 10.5kW output making it an ideal solution for multiple military missions.
 
·  
We have designed and continue to refine a proprietary Distributed Power Control and Management System (DPCMS) that replaces electrical systems on aging tactical vehicles. This enables vehicles that have already exceeded the OEM’s recommended life to be refurbished and to take advantage of new automotive communication protocols J-1939. These refurbishments permit aging tactical vehicle fleets to function as a new vehicle, without the cost implications of replacing it with a new vehicle. This system has been successfully tested on two Light Armored Vehicles by the USMC.
 
·  
We have developed significant expertise and past performance qualifications in the area of solutions for Command, Control, Communications, Computers Intelligence. Surveillance and Reconnaissance (C4ISSR), providing these solutions to, among others, SPAWAR and Raytheon.
 
Competition
 
Our main competitors for renewable energy and power management systems products and services are ZeroBase Energy, LLC, a provider of hybrid and renewable power systems, Energy Technologies, Inc., a provider of power systems, EnerDel, Inc., a provider of compact lithium-ion-powered batteries for transportation, utility grid and industrial electronics markets, and Solar Stik, Inc., a provider of portable and custom power solutions, as well as companies that compete on proposals to Raytheon, including Celestica Inc. (NYSE: CLS), Ducommun Incorporated (NYSE: DCO), Sanmina-SCI Corporation (Nasdaq: SANM), Jabil Circuit, Inc., a supplier of manufacturing services for circuit board assemblies, and Woven Electronics Corporation, an electronics parts supplier.
 
We believe the fact that we have full-service engineering coupled with state-of-the-art manufacturing provides us with an advantage over most of our competitors, enabling us to customize solutions for customers, quickly develop prototype and first-article units, and move into full-rate production before many of our competitors are beyond the requirements definition phase. Few in the industry have both the agility and capabilities required to offer this advantage. As a manufacturer, we build our own cable harnesses, circuit cards, and integrated complex assemblies, which enables us to control our own supply chain and program schedules. These combined capabilities have resulted in lower costs and shorter lead times, both very important discriminators for our customers in this current fiscal environment.
 
Marketing and Customers
 
We market to a diverse array of customers. The renewable and hybrid energy market prior to 2015 has been primarily focused on the U.S. Department of Defense. After having achieved significant success we are modifying products to better meet commercial/industrial demands. We are refocusing marketing efforts internationally on the heels of our tremendously successful GREENS and MEHPS. Specific efforts include attendance at international trade shows, marketing videos, establishing networks within the U.S. commercial service, an increase in social media engagement and technical brochures of products.

Over ninety percent of revenues are attributed to existing customers with new requirements or referrals of new customers from our existing customer base. This fantastic customer loyalty is closely tied to our technical solutions, our on-time delivery and quality of product metrics (consistently 98% or greater).
 
 
8


Manufacturing
 
Our four AS9100 and ISO 9001 registered facilities are located in the tri-county area of Charleston, South Carolina. All facilities are well equipped with state of the art design tools and automated manufacturing equipment to support our customers’ design, testing, and production needs.
 
Lithium Batteries and Charging Systems for Military, Industrial and Medical Markets
 
We sell lithium batteries and charging systems, including the SWIPES™ power hubs we produce for the Army’s Soldier Warrior program, to the military, industrial and medical markets.
 
We specialize in the design and manufacture of primary and rechargeable batteries, related electronic circuits and associated chargers for military applications. We have experience in working with government agencies, the military and large corporations. Our technical team has significant expertise in the fields of electrochemistry, electronics, software and battery design, production, packaging and testing. We also specialize in custom products that must meet the highest possible military, industrial and medical specifications.
 
Our SWIPES™ power hub utilizes the MOLLE (Modular Lightweight Load-carrying Equipment) vest and integrates force protection electronics and communications equipment with an advanced battery. The system utilizes a modular power distribution system that is powered by BA-8180/U, BA-8140/U Zinc-Air batteries or the LI-145, BB-2590 rechargeable batteries for direct power of equipment, allowing for extended mission times without the burden of power source swaps or charging due to their high energy density, and reducing battery weight soldiers carry by up to 30%. The batteries continuously charge the secondary batteries inside various devices, such as two way radios, GPS units and shot detection systems. The SWIPES™ product allows for individual tailoring by the warfighter and is designed to accept new applications as they become available. The SWIPES™ power hub was recognized by the U.S Army Research, Development and Engineering Command as one of the U.S. Army’s ten greatest inventions of 2010.
 
Customers
 
The principal customers for our lithium batteries during 2014 were the Israel Ministry of Defense, Elbit, Air Cruisers, Aeronautics, and Thales. The principal customer for our SWIPES™ power hub during 2014 was the U.S. Army.
 
Competition
 
There are a limited number of players globally that are a one-stop-shop for high-end custom portable power. Our main competitors are Bren-Tronics, Ultralife, Enersys, Palladium Energy, SAFT, Electrochem, RRC Power Solutions and Inspired Energy,
 
Manufacturing
 
Our US manufacturing facility for batteries and chargers is in the process of being moved from Auburn, Alabama to Hanahan, South Carolina, in the Charleston area. In parallel we have manufacturing facilities in Beit Shemesh and Dimona, both located in Israel.
 
Zinc-Air Batteries and Chargers for the Military
 
Introduction
 
We base our strategy in the field of Zinc-Air military batteries on the development and commercialization of our Zinc-Air battery technology, as applied in the batteries we produce for the U.S. Army’s Communications and Electronics Command (CECOM). We will continue to seek new applications for our technology in defense projects, wherever synergistic technology and business benefits may exist. We intend to continue to develop our battery products for defense agencies, and plan to sell our products either directly to such agencies or through prime contractors. We will also look to extend our reach to military markets outside the United States.
 
Our batteries have been used in both Afghanistan (Operation Enduring Freedom) and in Iraq (Operation Iraqi Freedom). Our BA-8180/U Zinc-Air battery was recognized by the U.S Army Research, Development and Engineering Command as one of the U.S. Army’s ten greatest inventions of 2003.
 
Our manufacturing facilities for Zinc-Air batteries, rechargeable batteries and battery chargers for the military have been granted ISO 9001 “Top Quality Standard” certification.
 
 
9

 
Markets/Applications
 
As an external alternative to the popular lithium based BA-5590/U, the BA-8180/U can be used in many applications operated by the BA-5590/U. The BA-8180/U can be used for a variety of military applications.
 
Customers
 
The principal customers for our Zinc-Air batteries during 2014 were the U.S. Army’s Communications-Electronics Command (CECOM) and the Defense Logistics Agency (DLA). In addition, we continue to further penetrate Special Forces and other specific U.S. military units with direct sales.
 
Competition
 
The BA-8180/U is the only Zinc-Air battery to hold a U.S. Army battery designation and a National Stock Number (NSN). (An NSN is a Department of Defense catalog number assigned to products authorized for use by the U.S. military. With an NSN, any active, reserve or associated military personnel may purchase these products up to defined limits without need for a requisition or similar purchasing documentation.) The BA-8180/U competes with other primary (disposable) batteries, and primarily lithium based batteries. In some cases, it will also compete with rechargeable batteries.
 
Zinc-Air batteries have many advantages over primary lithium battery packs. Zinc-Air batteries are inherently safer than primary lithium battery packs in storage, transportation, use, and disposal. They are also more cost-effective than primary lithium batteries. They are lightweight, with up to twice the energy density of primary lithium battery packs. Zinc-Air batteries for the military are also under development by Spectrum Brands Holdings, Inc. (NYSE: SPB), the successor to Rayovac Corporation (“Rayovac”). Rayovac’s military Zinc-Air batteries utilize cylindrical cells, rather than the prismatic cells that we developed. While cylindrical cells may provide higher specific power than our prismatic cells, we believe they will generally have lower energy densities and may be more difficult to manufacture.
 
The most popular competing primary battery in use by the US Armed Forces is the BA-5590/U, which uses lithium-sulfur dioxide (LiSO2) cells. The largest suppliers of LiSO2 batteries to the US military are believed to be Saft America Inc. (EPA: SAFT) (“Saft”) and Eagle Picher Technologies LLC, a provider of integrated power solutions (“Eagle Picher”). The battery compartment of most military communications equipment, as well as other military equipment, is designed for the XX90 family of batteries, of which the BA-5590/U battery is the most commonly deployed. Another primary battery in this family is the BA-5390/U, which uses lithium-manganese dioxide (LiMnO2) cells. Suppliers of LiMnO2 batteries include Ultralife Batteries Inc., Saft and Eagle Picher.
 
Rechargeable batteries in the XX90 family include lithium-ion (BB-2590/U) and nickel-metal hydride (BB-390/U) batteries which may be used in training missions in order to save the higher costs associated with primary batteries. These rechargeable batteries have also become more prevalent in combat use as their energy densities improve, their availability expands and their State-of-Charge Indicator (SOCI) technologies become more reliable.
 
Our BA-8180/U does not fit inside the XX90 battery compartment of any military equipment, and therefore is connected externally using an interface adapter that we also sell to the Army. We believe that the greatly extended mission time and lower total mission cost provided by our BA-8180/U often greatly outweigh the slight inconvenience of fielding an external battery.
 
Manufacturing
 
Our facilities for Zinc-Air military batteries and chargers are in the process of being moved from Auburn, Alabama to Hanahan, South Carolina, in the Charleston area.
 
Lifejacket Lights
 
Products
 
We have a product line consisting of seven lifejacket light models. Five of these models are for use with marine life jackets and two are for use with aviation life vests. All of our lifejacket lights work in both freshwater and seawater. Each of our lifejacket lights is certified for use by relevant governmental agencies under various U.S. and international regulations, including the U.S. Federal Aviation Administration’s Technical Standard Order (“TSO”) and the International Convention for the Safety of Life at Sea (“SOLAS”). We manufacture, assemble and package all our lifejacket lights in our factory in Beit Shemesh, Israel.
 
 
10

 
Marketing
 
We market our marine safety products through our own network of distributors in Europe, the United States, Asia and Oceania. We market our lights to the commercial aviation industry through an independent company that receives a commission on sales.
 
Competition
 
Our primary competitor in the field of aviation safety products, including TSO -approved lifejacket lights, is ACR Electronics Inc. of Hollywood, Florida. Other significant competitors in the marine market include Daniamant Aps of Denmark and England, a provider of survivor location lights, and Alcares ApS of Denmark, a manufacturer of marine emergency lights.
 
Flow Battery
 
We are engaged in preliminary research and development of an iron flow battery for grid storage.
 
Electricity generation can be highly variable, especially if the supply is generated from intermittent, renewable sources such as the sun or wind. A flow battery can store a substantial amount of grid power produced by renewables and return it to the grid as needed, providing a buffer between the supply and demand of electricity. For example, in a solar power station, more power might be generated in the mid-day sun than is needed. The excess power could be stored in the flow battery during the day and used on demand without the need to generate additional electricity at that time.
 
Flow battery plants can help minimize the necessity of building new fuel-based power plants to address momentary peak demand. It can do this by using stored energy during times of peak demand and collecting energy at trough times, reducing the need to scale fuel-based energy production. This becomes even more crucial as more renewables come on line with their highly variable output. We believe this would be an integral part of the initiative to modernize the electrical power grid.
 
According to the Boston Consulting Group, the grid storage market is estimated to exceed $400 billion by 2030. This represents a global storage capacity of 430 giga-watts. To give some perspective, grid storage currently approximates 100 giga-watts, so the market is expected to more than quadruple in only 16 years.
 
Preliminary research and development into the iron flow battery has yielded what we believe to be promising results in lab tests, and we have filed a patent application covering our new technology. We are currently in our next stage of development, wherein we hope to demonstrate a lab-scale pilot battery, complete with a unique membrane and an in-house manufactured anode. We are working to complete this stage of the project, at which point we would move to the next stage: demonstrating a 20kW/100kWh pilot battery (approximately the size of a shipping container).
 
Backlog
 
We generally sell our products under standard purchase orders. Orders constituting our backlog are subject to changes in delivery schedules and are typically cancelable by our customers until a specified time prior to the scheduled delivery date. Accordingly, our backlog is not necessarily an accurate indication of future sales. As of December 31, 2014 and 2013, our funded backlog for the following year was approximately $69.9 million and $58.0 million, respectively, divided between our divisions as follows:
 
Division
 
2014
   
2013
 
Training and Simulation Division
 
$
45,731,000
   
$
45,892,000
 
Power Systems Division
   
24,175,000
     
12,067,000
 
TOAL:
 
$
69,906,000
   
$
57,959,000
 
 
Major Customers
 
During 2014 and 2013, including both of our divisions, various branches of the United States military accounted for approximately 56% and 55% of our revenues. See “Item 1A. Risk Factors – Risks Related to Government Contracts,” below.
 
 
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Patents and Trade Secrets
 
We rely on certain proprietary technology and seek to protect our interests through a combination of patents, trademarks, copyrights, know-how, trade secrets and security measures, including confidentiality agreements. Our policy generally is to secure protection for significant innovations to the fullest extent practicable. Further, we seek to expand and improve the technological base and individual features of our products through ongoing research and development programs.
 
Our intellectual property portfolio includes two issued U.S. patents, which expire between 2020 and 2030. We also have two patent applications pending for examination in foreign jurisdictions.
 
We rely on the laws of unfair competition and trade secrets to protect our proprietary rights. We attempt to protect our trade secrets and other proprietary information through confidentiality and non-disclosure agreements with customers, suppliers, employees and consultants, and through other security measures. However, we may be unable to detect the unauthorized use of, or take appropriate steps to enforce our intellectual property rights. Effective trade secret protection may not be available in every country in which we offer or intend to offer our products and services to the same extent as in the United States. Failure to adequately protect our intellectual property could harm or even destroy our brands and impair our ability to compete effectively. Further, enforcing our intellectual property rights could result in the expenditure of significant financial and managerial resources and may not prove successful. Although we intend to protect our rights vigorously, there can be no assurance that these measures will be successful.
 
Research and Development
 
During the years ended December 31, 2014 and 2013, our research and product development expenses were approximately $3.3 million and $3.0 million, respectively. Not included in these figures is research and development where the costs were underwritten by customers or charged directly to projects as non-recovered engineering costs.
 
Employees
 
As of December 31, 2014, we had approximately 531 total employees worldwide, the majority of whom were full-time employees. Our success will depend in large part on our ability to attract and retain skilled and experienced employees.
 
With respect to those of our employees who are Israeli residents, Israeli law generally requires severance pay upon the retirement or death of an employee or termination of employment without due cause; additionally, some of our senior employees have special severance arrangements, certain of which are described under “Item 11. Executive Compensation – Employment Contracts,” below. We currently partially fund our ongoing severance obligations by making monthly payments to approved severance funds or insurance policies.
 
Regulatory Matters
 
Our businesses are heavily regulated in most of our markets. We deal with numerous U.S. government agencies and entities, including, but not limited to, branches of the U.S. military and the Department of Homeland Security. Similar government authorities exist in our international markets. We are also subject to export regulations. For additional information related to export regulations, see Item 1A, entitled “Risk Factors – We may not be able to receive or retain the necessary licenses or authorizations required for us to export or re-export….”

Government Contracts
 
The U.S. government, and other governments, may terminate any of our government contracts at their convenience, as well as for default, based on our failure to meet specified performance requirements. If any of our U.S. government contracts were to be terminated for convenience, we generally would be entitled to receive payment for work completed and allowable termination or cancellation costs. If any of our government contracts were to be terminated for default, generally the U.S. government would pay only for the work that has been accepted and can require us to pay the difference between the original contract price and the cost to re-procure the contract items, net of the work accepted from the original contract. The U.S. government can also hold us liable for damages resulting from the default. For additional information related to government contracts, see Item 1A. “Risk Factors – Risks Related to Government Contracts.”
 
 
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Environmental
 
We are subject to various federal, state, local and non-U.S. laws and regulations relating to environmental protection, including the discharge, treatment, storage, disposal and remediation of hazardous substances and wastes. We continually assess our compliance status and management of environmental matters to ensure our operations are in substantial compliance with all applicable environmental laws and regulations. Investigation, remediation, operation and maintenance costs associated with environmental compliance and management of sites are a normal, recurring part of our operations. These costs often are allowable costs under our contracts with the U.S. government. It is reasonably possible that continued environmental compliance could have a material impact on our results of operations, financial condition or cash flows if additional work requirements or more stringent clean-up standards are imposed by regulators, new areas of soil and groundwater contamination are discovered and/or expansions of work scope are prompted by the results of investigations.
 
ITEM 1A.                   RISK FACTORS
 
The following factors, among others, could cause actual results to differ materially from those contained in forward-looking statements made in this Report and presented elsewhere by management from time to time.
 
Business-Related Risks
 
We have had a history of losses and may incur future losses.
 
We were incorporated in 1990 and began our operations in 1991. We have funded our operations principally from funds raised in public and private offerings of our common stock and equity and debt securities convertible or exercisable into shares of our common stock; research contracts and supply contracts; funds received under research and development grants from the Government of Israel; and sales of products that we and our subsidiaries manufacture. We have incurred significant net losses since our inception. Additionally, as of December 31, 2014, we had an accumulated deficit (including discontinued operations) of approximately $179.6 million. In an effort to reduce operating expenses and maximize available resources, we have consolidated certain of our subsidiaries, shifted personnel and reassigned responsibilities. We have also taken a variety of other measures to limit spending and will continue to assess our internal processes to seek additional cost-structure improvements. Although we believe that such steps have helped to reduce our operating expenses and maximize our available resources and enabled us to operate at a net profit in the recent past, there can be no assurance that we will be able to maintain profitability consistently or that our business will continue to exist.
 
We need significant amounts of capital to operate and grow our business and to pay our debt.
 
We require substantial funds to operate our business, including marketing our products and developing and marketing new products. To the extent that we are unable to fully fund our operations, including repaying our outstanding debt, through profitable sales of our products and services, we will need to seek additional funding, including through the issuance of equity or debt securities. In addition, based on our internal forecasts, the assumptions described under “Liquidity and Capital Resources” below, and subject to the other risk factors described herein, we believe that our present cash position and anticipated cash flows from operations and lines of credit should be sufficient to satisfy our current estimated cash requirements for 2015. However, in the event our internal forecasts and other assumptions regarding our liquidity prove to be incorrect, we may need to seek additional funding. There can be no assurance that we will obtain any such additional financing in a timely manner, on acceptable terms, or at all. If additional funds are raised by issuing equity securities or convertible debt securities, stockholders may incur further dilution. If we incur additional indebtedness, we may be subject to affirmative and negative covenants that may restrict our ability to operate or finance our business. If additional funding is not secured, we will have to modify, reduce, defer or eliminate parts of our present and anticipated future commitments and/or programs.
 
Our existing indebtedness may adversely affect our ability to obtain additional funds and may increase our vulnerability to economic or business downturns.
 
Our bank and other indebtedness (short and long term) totaled approximately $21.3 million as of December 31, 2014 (not including trade payables, other account payables, capital leases, and accrued severance pay), of which $33,000 was bank working capital lines of credit and approximately $19.3 million represents two term loans entered into to fund the UEC acquisition. In addition, we may incur additional indebtedness in the future. Accordingly, we are subject to the risks associated with significant indebtedness, including:
 
we must dedicate a portion of our cash flows from operations to pay principal and interest and, as a result, we may have less funds available for operations and other purposes;
 
it may be more difficult and expensive to obtain additional funds through financings, if available at all;
 
 
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we are more vulnerable to economic downturns and fluctuations in interest rates, less able to withstand competitive pressures and less flexible in reacting to changes in our industry and general economic conditions; and
 
if we default under any of our existing debt instruments, including paying the outstanding principal when due, and if our creditors demand payment of a portion or all of our indebtedness, we may not have sufficient funds to make such payments.
 
The occurrence of any of these events could materially adversely affect our results of operations and financial condition and adversely affect our stock price.
 
Failure to comply with the terms of our indebtedness could result in a default that could have material adverse consequences for us.
 
In February 2013, our primary bank increased our credit line (“Line of Credit”) by 50%, from $10.0 million to $15.0 million, and the expiration of the Line of Credit was extended to May 31, 2015. Additionally, in April 2014 we agreed with our bank to amend the Line of Credit to add two term loans to it: an $18.0 million 61-month senior term loan at an interest rate of 3.75% over LIBOR, and a $4.5 million 61-month B term loan at an interest rate of 5.5% over LIBOR along with extending the Line of Credit until May 2016.
 
Our amended and restated credit agreement contains certain financial covenants. Commencing with the fiscal quarter ending June 30, 2014, our “Fixed Charge Coverage Ratio”, determined on a combined basis with UEC and otherwise computed in the same manner as under the previous version of the credit agreement (the “Original Credit Agreement”), has been raised to 1.25-to-1 from 1.10-to-1. “Net Advances to Affiliates” are now defined with reference to FAAC or UEC, as the case may be, and may not increase by more than $5.5 million on a combined basis for both borrowers in any calendar year over a “Base Amount” to be determined by mutual agreement of Arotech and the bank.
 
In addition, UEC’s earnings before interest, taxes, depreciation and amortization with certain add-backs (“EBITDA”), computed on a stand-alone basis, may not be less than $4.5 million for any trailing twelve-month period ending at the end of a fiscal quarter (a “Test Period”) beginning with the Test Period ending September 30, 2014 and each succeeding fiscal quarter thereafter. Second, the ratio of “Combined Funded Indebtedness” (defined as all indebtedness (a) in respect of money borrowed, (b) evidenced by a note, debenture or other like written obligation to pay money, (c) in respect of rent or hire of property under leases or lease arrangements which under GAAP are required to be capitalized or (d) in respect of obligations under conditional sales or other title retention agreements, all as determined on a combined basis for FAAC and UEC) to “Combined Adjusted EBITDA” (defined as EBITDA of FAAC and UEC computed on a combined basis) may not exceed (a) 2.25-to-1.0 for the Test Period ending September 30, 2014 or any Test Period ending as of the end of any fiscal quarter thereafter prior to the fiscal quarter ending March 31, 2015 or (b) 2.00-to-1.0 for the Test Period ending March 31, 2015 or any Test Period ending as of the end of any fiscal quarter thereafter.
 
A failure to comply with the obligations contained in the agreements governing our indebtedness could result in an event of default under such agreements which could result in an acceleration of debt under other instruments evidencing indebtedness that contain cross-acceleration or cross-default provisions. If our indebtedness were to be accelerated, there can be no assurance that our future cash flow or assets would be sufficient to repay in full such indebtedness. We were in compliance with all debt covenants as of December 31, 2014.
 
We may not be successful in operating our electronics engineering and design services for the military business, which is a new business for us.
 
The business of electronics engineering and design services for the military is a new business for us and our management group has limited experience operating this particular type of business. Although we have retained UEC’s management personnel, we cannot assure that such personnel will continue to work for us or that we will be successful in managing this new business. Additionally, we may not be able to successfully integrate the operations and personnel of UEC into our business, and we may not realize any anticipated benefits of such acquisition. If we are unable to successfully operate this new business, our business, financial condition and results of operations could be materially impaired.
 
 
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We may consider acquisitions in the future to grow our business, and such activity could subject us to various risks.
 
We may consider acquiring companies that will complement our existing operations or provide us with an entry into markets we do not currently serve. Growth through acquisitions involves substantial risks, including the risk of improper valuation of the acquired business and the risk of inadequate integration. There can be no assurance that suitable acquisition candidates will be available, that we will be able to acquire or manage profitably such additional companies or that future acquisitions will produce returns that justify our investments in such companies. In addition, we may compete for acquisition and expansion opportunities with companies that have significantly greater resources than we do. Furthermore, acquisitions could disrupt our ongoing business, distract the attention of our senior officers, increase our expenses, make it difficult to maintain our operational standards, controls and procedures and subject us to contingent and latent risks that are different, in nature and magnitude, than the risks we currently face.
 
We may finance future acquisitions with cash from operations or additional debt or equity financings. There can be no assurance that we will be able to generate internal cash or obtain financing from external sources or that, if available, such financing will be on terms acceptable to us. The issuance of additional common stock to finance acquisitions may result in substantial dilution to our stockholders. Any debt financing may significantly increase our leverage and may involve restrictive covenants which limit our operations.
 
If we are successful in acquiring additional businesses, we may experience a period of rapid growth that could place significant additional demands on, and require us to expand, our management, resources and management information systems. Our failure to manage any such rapid growth effectively could have a material adverse effect on our financial condition, results of operations and cash flows.
 
We may not generate sufficient cash flow to service all of our debt obligations.
 
Our ability to make payments on our indebtedness and to fund our operations depends on our ability to generate cash in the future. Our future operating performance is subject to market conditions and business factors that are beyond our control. Consequently, we cannot assure you that we will generate sufficient cash flow to pay the principal and interest on our debt. If our cash flows and capital resources are insufficient to allow us to make scheduled payments on our debt, we may have to reduce or delay capital expenditures, sell assets, seek additional capital or restructure or refinance our debt. We cannot assure you that the terms of our debt will allow for these alternative measures or that such measures would satisfy our scheduled debt service obligations. In addition, in the event that we are required to dispose of material assets or restructure or refinance our debt to meet our debt obligations, we cannot assure you as to the terms of any such transaction or how quickly such transaction could be completed. Our ability to refinance our indebtedness or obtain additional financing will depend on, among other things:
 
our financial condition at the time;
 
restrictions in the agreements governing our other indebtedness; and
 
other factors, including the condition of the financial markets and our industry.
 
Our earnings may decline if we write off additional goodwill and other intangible assets.
 
As of December 31, 2014, we had recorded goodwill of $45.4 million. Any future impairment of goodwill or other intangible assets may have a significant impact on earnings. Goodwill is not amortized, but is tested for impairment at the reporting unit level. Goodwill is required to be tested for impairment annually and between annual tests if events or circumstances indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, which, in the Power Systems Division in 2014, was a six percent margin. There are numerous risks that may cause the fair value of a reporting unit to fall below its carrying amount, which could lead to the measurement and recognition of goodwill impairment. These risks include, but are not limited to, adverse changes in legal factors or the business climate, an adverse action or assessment by a regulator, a more-likely-than-not expectation that all or a significant portion of a reporting unit may be disposed of, a sustained decline in our market capitalization, significant negative variances between actual and expected financial results, and lowered expectations of future financial results.
 
Significant judgments inherent in these analyses include assumptions about appropriate sales growth rates, WACC and the amount of expected future net cash flows. The judgments and assumptions used in the estimate of fair value are generally consistent with the projections and assumptions that are used in current operating plans. Such assumptions are subject to change as a result of changing economic and competitive conditions. The determination of fair value is highly sensitive to differences between estimated and actual cash flows and changes in the related discount rate used to evaluate the fair value of the reporting units and trade name.

The goodwill of our Training and Simulation Division equaled $24.4 million and the goodwill of our Power Systems Division equaled $21.0 million at December 31, 2014. Based on the discounted cash flow valuation at December 31, 2014, an increase in the WACC or changes in other significant variables for the Power Systems Division could potentially result in impairment.
 
 
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Some of the components of our products pose potential safety risks which could create potential liability exposure for us.
 
Some of the components of our products contain elements that are known to pose potential safety risks. In addition to these risks, there can be no assurance that accidents in our facilities will not occur. Any accident, whether occasioned by the use of all or any part of our products or technology or by our manufacturing operations, could adversely affect commercial acceptance of our products and could result in significant production delays or claims for damages resulting from injuries. Any of these occurrences would materially adversely affect our operations and financial condition. In the event that our products fail to perform as specified, users of these products may assert claims for substantial amounts. These claims could have a materially adverse effect on our financial condition and results of operations. There is no assurance that the amount of the general product liability insurance that we maintain will be sufficient to cover potential claims or that the present amount of insurance can be maintained at the present level of cost, or at all.
 
We are subject to the Dodd-Frank Wall Street Reform and Consumer Protection Act disclosure requirements regarding the use of “conflict minerals”
 
Beginning in 2014, the Dodd-Frank Wall Street Reform and Consumer Protection Act imposes new disclosure requirements regarding the use of “conflict minerals” mined from the Democratic Republic of Congo and adjoining countries in products, whether or not these products are manufactured by third parties. The definition of “conflict minerals” includes tin, tantalum, tungsten and gold, and their derivatives, some of which we use in the activities of our Power Systems Division. These new requirements could affect the pricing, sourcing and availability of minerals used in the manufacture of our products. There will be additional costs associated with complying with the disclosure requirements, such as costs related to determining the source of any conflict minerals used in our products. Our supply chain is complex and we may be unable to verify the origins for all metals used in our products. We may also encounter challenges with our customers and stockholders if we are unable to certify that our products are conflict free.
 
Our fields of business are highly competitive.
 
The competition to develop defense and security products and to obtain funding for the development of these products is, and is expected to remain, intense.
 
Our defense and security products compete with other manufacturers of specialized training systems.
 
Various battery technologies are being considered for use in defense and safety products by other manufacturers and developers, including the following: lead-acid, nickel-cadmium, nickel-iron, nickel-zinc, nickel-metal hydride, sodium-sulfur, sodium-nickel chloride, zinc-bromine, lithium-ion, lithium-polymer, lithium-iron sulfide, primary lithium, rechargeable alkaline and Zinc-Air.
 
Many of our competitors have financial, technical, marketing, sales, manufacturing, distribution and other resources significantly greater than ours. If we are unable to compete successfully in each of our operating areas, our business and results of operations could be materially adversely affected.
 
Our business is dependent on proprietary rights that may be difficult to protect and could affect our ability to compete effectively.
 
Our ability to compete effectively will depend on our ability to maintain the proprietary nature of our technology and manufacturing processes through a combination of patent and trade secret protection, non-disclosure agreements and licensing arrangements.
 
Litigation, or participation in administrative proceedings, may be necessary to protect our proprietary rights. This type of litigation can be costly and time consuming and could divert company resources and management attention to defend our rights, and this could harm us even if we were to be successful in the litigation. In the absence of patent protection, and despite our reliance upon our proprietary confidential information, our competitors may be able to use innovations similar to those used by us to design and manufacture products directly competitive with our products. In addition, no assurance can be given that others will not obtain patents that we will need to license or design around. To the extent any of our products are covered by third-party patents, we could need to acquire a license under such patents to develop and market our products.
 
 
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Despite our efforts to safeguard and maintain our proprietary rights, we may not be successful in doing so. In addition, competition is intense, and there can be no assurance that our competitors will not independently develop or patent technologies that are substantially equivalent or superior to our technology. In the event of patent litigation, we cannot assure you that a court would determine that we were the first creator of inventions covered by our issued patents or pending patent applications or that we were the first to file patent applications for those inventions. If existing or future third-party patents containing broad claims were upheld by the courts or if we were found to infringe third-party patents, we may not be able to obtain the required licenses from the holders of such patents on acceptable terms, if at all. Failure to obtain these licenses could cause delays in the introduction of our products or necessitate costly attempts to design around such patents, or could foreclose the development, manufacture or sale of our products. We could also incur substantial costs in defending ourselves in patent infringement suits brought by others and in prosecuting patent infringement suits against infringers.
 
We also rely on trade secrets and proprietary know-how that we seek to protect, in part, through non-disclosure and confidentiality agreements with our customers, employees, consultants, and entities with which we maintain strategic relationships. We cannot assure you that these agreements will not be breached, that we would have adequate remedies for any breach or that our trade secrets will not otherwise become known or be independently developed by competitors.
 
We are dependent on key personnel and our business would suffer if we fail to retain them.
 
We are highly dependent on the managers of our Simulation Division and our Power Systems Division, and the loss of the services of any of these persons could adversely affect us. We are especially dependent on the services of our President and Chief Executive Officer, Steven Esses, and our Executive Chairman, Robert S. Ehrlich. The loss of either Mr. Esses or Mr. Ehrlich could have a material adverse effect on us. We are party to employment agreements with Mr. Esses and Mr. Ehrlich, both of which agreements expire at the end of 2017. We do not have key-man life insurance on either Mr. Esses or Mr. Ehrlich.
 
We face risks related to general domestic and global economic conditions.
 
In general, our operating results can be significantly affected by negative economic conditions, high labor, material and commodity costs and unforeseen changes in demand for our products and services. These risks are heightened as economic conditions globally have deteriorated significantly and may remain at recessionary levels for the foreseeable future. The current recessionary conditions could have a potentially significant negative impact on demand for our products and services, which may have a direct negative impact on our sales and profitability, as well as our ability to generate sufficient internal cash flows or access credit at reasonable rates to meet future operating expenses, service debt and fund capital expenditures.
 
There are risks involved with the international nature of our business.
 
A significant portion of our sales are made to customers located outside the U.S., primarily in Europe and Asia. In 2014 and 2013, 19.1% and 16.5%, respectively, of our revenues, were derived from sales to customers located outside the U.S. We expect that our international customers will continue to account for a substantial portion of our revenues in the near future. Sales to international customers may be subject to political and economic risks, including political instability, currency controls, exchange rate fluctuations, foreign taxes, longer payment cycles and changes in import/export regulations and tariff rates. In addition, various forms of protectionist trade legislation have been and in the future may be proposed in the U.S. and certain other countries. Any resulting changes in current tariff structures or other trade and monetary policies could adversely affect our sales to international customers. See also “Israel-Related Risks,” below.
 
Risks Related to Government Contracts
 
A significant portion of our business is dependent on government contracts and reduction or reallocation of defense or law enforcement spending could reduce our revenues.
 
Most of our customers to date have been in the public sector of the U.S., including the federal, state and local governments and the military, and in the public sectors of a number of other countries. A significant decrease in the overall level or allocation of defense or law enforcement spending in the U.S. or other countries could reduce our revenues and have a material adverse effect on our future results of operations and financial condition.
 
Sales to public sector customers are subject to a multiplicity of detailed regulatory requirements and public policies as well as to changes in training and purchasing priorities. Contracts with public sector customers may be conditioned upon the continuing availability of public funds, which in turn depends upon lengthy and complex budgetary procedures, and may be subject to certain pricing constraints. Moreover, U.S. government contracts and those of many international government customers may generally be terminated for a variety of factors when it is in the best interests of the government and contractors may be suspended or debarred for misconduct at the discretion of the government. There can be no assurance that these factors or others unique to government contracts or the loss or suspension of necessary regulatory licenses will not reduce our revenues and have a material adverse effect on our future results of operations and financial condition.
 
 
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A decline in the U.S. Government defense budget, changes in budgetary priorities or timing of contract awards may adversely affect our future revenues and limit our growth prospects.
 
Revenues under contracts with the U.S. Department of Defense (“DoD”), either as a prime contractor or subcontractor to other contractors, represent a substantial portion of our total revenues. Our operating results could be adversely affected by spending caps or changes in the budgetary priorities of the U.S. Government or the DoD, as well as delays in program starts or the award of contracts or task orders under contracts.
 
An impasse in federal budget decision-making could lead to substantial delays or reductions in federal spending. For example, as a result of inability of the U.S. Government to reach agreement on budget reduction measures required by the Budget Control Act of 2011, sequestration triggered substantial automatic spending reductions beginning in January 2013, divided between defense and domestic spending over a nine-year period. As a result, U.S. Government funding for certain of our customers may be reduced, delayed or eliminated, which could significantly impact these customers’ demand for our products and services and if so would have a material adverse effect on our business, results of operations and cash flows. While the future impact of sequestration is uncertain, these automatic across-the-board budget cuts in sequestration could have significant negative consequences to our business and industry.
 
In years when Congress does not complete its budget process before the end of its fiscal year (September 30), government operations are funded through a continuing resolution (CR) that temporarily funds federal agencies. Recent CRs have generally provided funding at the levels provided in the previous fiscal year and have not authorized new spending initiatives. When the federal government operates under a CR, delays can occur in the procurement of products and services. Historically, such delays have not had a material effect on our business; however, should sequestration not be alleviated, it could continue to have significant consequences to our business and our industry.
 
Additionally, our business could be affected if the demand for and priority of funding for combat operations overseas decreases, which may reduce the demand for our services on contracts supporting some operations and maintenance activities in the Department of Defense or if we experience an increase in set-asides for small businesses, which could result in our inability to compete directly for prime contracts.
 
Our U.S. government contracts may be terminated at any time and may contain other unfavorable provisions.
 
The U.S. government typically can terminate or modify any of its contracts with us either for its convenience or if we default by failing to perform under the terms of the applicable contract. A termination arising out of our default could expose us to liability and have a material adverse effect on our ability to re-compete for future contracts and orders. Our U.S. government contracts contain provisions that allow the U.S. government to unilaterally suspend us from receiving new contracts pending resolution of alleged violations of procurement laws or regulations, reduce the value of existing contracts, issue modifications to a contract and control and potentially prohibit the export of our products, services and associated materials.
 
Government agencies routinely audit government contracts. These agencies review a contractor's performance on its contract, pricing practices, cost structure and compliance with applicable laws, regulations and standards. If we are audited, we will not be reimbursed for any costs found to be improperly allocated to a specific contract, while we would be required to refund any improper costs for which we had already been reimbursed. Therefore, an audit could result in a substantial adjustment to our revenues. If a government audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeitures of profits, suspension of payments, fines and suspension or debarment from doing business with United States government agencies. We could suffer serious reputational harm if allegations of impropriety were made against us. A governmental determination of impropriety or illegality, or an allegation of impropriety, could have a material adverse effect on our business, financial condition or results of operations.
 
We may be liable for penalties under a variety of procurement rules and regulations, and changes in government regulations could adversely impact our revenues, operating expenses and profitability.
 
Our defense and commercial businesses must comply with and are affected by various government regulations that impact our operating costs, profit margins and our internal organization and operation of our businesses. Among the most significant regulations are the following:
 
the U.S. Federal Acquisition Regulations, which regulate the formation, administration and performance of government contracts;
 
the U.S. Truth in Negotiations Act, which requires certification and disclosure of all cost and pricing data in connection with contract negotiations; and
 
the U.S. Cost Accounting Standards, which impose accounting requirements that govern our right to reimbursement under certain cost-based government contracts.
 
 
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These regulations affect how we and our customers do business and, in some instances, impose added costs on our businesses. Any changes in applicable laws could adversely affect the financial performance of the business affected by the changed regulations. With respect to U.S. government contracts, any failure to comply with applicable laws could result in contract termination, price or fee reductions or suspension or debarment from contracting with the U.S. government.
 
We may not be able to receive or retain the necessary licenses or authorizations required for us to export or re-export our products, technical data or services, or to transfer technology from foreign sources (including our own subsidiaries) and to work collaboratively with them. Denials of such licenses and authorizations could have a material adverse effect on our business and results of operations.
 
U.S. regulations concerning export controls require us to screen potential customers, destinations, and technology to ensure that sensitive equipment, technology and services are not exported in violation of U.S. policy or diverted to improper uses or users.
 
In order for us to export certain products, technical data or services, we are required to obtain licenses from the U.S. government, often on a transaction-by-transaction basis. These licenses are generally required for the export of the military versions of our products and technical data and for defense services. We cannot be sure of our ability to obtain the U.S. government licenses or other approvals required to export our products, technical data and services for sales to foreign governments, foreign commercial customers or foreign destinations.
 
In addition, in order for us to obtain certain technical know-how from foreign vendors and to collaborate on improvements on such technology with foreign vendors, including at times our own foreign subsidiaries, we may need to obtain U.S. government approval for such collaboration through manufacturing license or technical assistance agreements approved by U.S. government export control agencies.
 
The U.S. government has the right, without notice, to revoke or suspend export licenses and authorizations for reasons of foreign policy, issues over which we have no control.
 
Failure to receive required licenses or authorizations would hinder our ability to export our products, data and services and to use some advanced technology from foreign sources. This could have a material adverse effect on our business, results of operations and financial condition.
 
Our failure to comply with export control rules could have a material adverse effect on our business.
 
Our failure to comply with these rules could expose us to significant criminal or civil enforcement action by the U.S. government, and a conviction could result in denial of export privileges, as well as contractual suspension or debarment under U.S. government contracts, either of which could have a material adverse effect on our business, results of operations and financial condition.
 
Our operating margins may decline under our fixed-price contracts if we fail to estimate accurately the time and resources necessary to satisfy our obligations.
 
Some of our contracts are fixed-price contracts under which we bear the risk of any cost overruns. Our profits are adversely affected if our costs under these contracts exceed the assumptions that we used in bidding for the contract. Often, we are required to fix the price for a contract before we finalize the project specifications, which increases the risk that we will misprice these contracts. The complexity of many of our engagements makes accurately estimating our time and resources more difficult. In the event we fail to estimate our time and resources accurately, our expenses will increase and our profitability, if any, under such contracts will decrease.
 
If we are unable to retain our contracts with the U.S. government and subcontracts under U.S. government prime contracts in the competitive rebidding process, our revenues may suffer.
 
Upon expiration of a U.S. government contract or subcontract under a U.S. government prime contract, if the government customer requires further services of the type provided in the contract, there is frequently a competitive rebidding process. We cannot guarantee that we, or if we are a subcontractor that the prime contractor, will win any particular bid, or that we will be able to replace business lost upon expiration or completion of a contract. Further, all U.S. government contracts are subject to protest by competitors. The termination or nonrenewal of several of our significant contracts could result in considerable revenue shortfalls.
 
 
19

 
The loss of, or a significant reduction in, U.S. military business would have a material adverse effect on us.
 
U.S. military contracts account for a significant portion of our business. The U.S. military funds these contracts in annual increments. These contracts require subsequent authorization and appropriation that may not occur or that may be greater than or less than the total amount of the contract. Changes in the U.S. military’s budget, spending allocations and the timing of such spending could adversely affect our ability to receive future contracts. None of our contracts with the U.S. military has a minimum purchase commitment, and the U.S. military generally has the right to cancel its contracts unilaterally without prior notice. The loss of, or a significant reduction in, U.S. military business could have a material adverse effect on our business, financial condition, results of operations and liquidity.
 
Market-Related Risks
 
The price of our common stock is volatile.
 
The market price of our common stock has been volatile in the past and may change rapidly in the future. The following factors, among others, may cause significant volatility in our stock price:
 
announcements by us, our competitors or our customers;
 
the introduction of new or enhanced products and services by us or our competitors;
 
changes in the perceived ability to commercialize our technology compared to that of our competitors;
 
rumors relating to our competitors or us;
 
actual or anticipated fluctuations in our operating results;
 
the issuance of our securities, including warrants, in connection with financings and acquisitions; and
 
general market or economic conditions.
 
If our shares were to be delisted, our stock price might decline further and we might be unable to raise additional capital.
 
One of the continued listing standards for our stock on the Nasdaq Stock Market (both the Nasdaq Global Market, on which our stock is currently listed, and the Nasdaq Capital Market) is the maintenance of a $1.00 bid price. Our stock price has periodically traded below $1.00 in the past. If our bid price were to decrease and remain below $1.00 for 30 consecutive business days, Nasdaq could notify us of our failure to meet the continued listing standards, after which we would have 180 calendar days to correct such failure or be delisted from the Nasdaq Global Market. Although we would have the opportunity to appeal any potential delisting, there can be no assurances that this appeal would be resolved favorably. As a result, there can be no assurance that our common stock will remain listed on the Nasdaq Global Market. If our common stock were to be delisted from the Nasdaq Global Market, we might apply to be listed on the Nasdaq Capital Market if we then met the initial listing standards of the Nasdaq Capital Market (other than the $1.00 minimum bid standard). If we were to move to the Nasdaq Capital Market, current Nasdaq regulations would give us the opportunity to obtain an additional 180-day grace period if we meet certain net income, stockholders’ equity or market capitalization criteria; if at the end of that period we had not yet achieved compliance with the minimum bid price rule, we would be subject to delisting from the Nasdaq Capital Market. Although we would have the opportunity to appeal any potential delisting, there can be no assurances that this appeal would be resolved favorably. In addition, we may be unable to satisfy the other continued listing requirements. As a result, there can be no assurance that our common stock will remain listed on the Nasdaq Stock Market.
 
While our stock would continue to trade on the over-the-counter bulletin board following any delisting from the Nasdaq, any such delisting of our common stock could have an adverse effect on the market price of, and the efficiency of the trading market for, our common stock. Trading volume of over-the-counter bulletin board stocks has been historically lower and more volatile than stocks traded on an exchange or the Nasdaq Stock Market. As a result, holders of our securities could find it more difficult to sell their securities. Also, if in the future we were to determine that we need to seek additional equity capital, it could have an adverse effect on our ability to raise capital in the public equity markets.
 
In addition, if we fail to maintain Nasdaq listing for our securities, and no other exclusion from the definition of a “penny stock” under the Securities Exchange Act of 1934, as amended, is available, then any broker engaging in a transaction in our securities would be required to provide any customer with a risk disclosure document, disclosure of market quotations, if any, disclosure of the compensation of the broker-dealer and its salesperson in the transaction and monthly account statements showing the market values of our securities held in the customer’s account. The bid and offer quotation and compensation information must be provided prior to effecting the transaction and must be contained on the customer’s confirmation. If brokers become subject to the “penny stock” rules when engaging in transactions in our securities, they would become less willing to engage in transactions, thereby making it more difficult for our stockholders to dispose of their shares.
 
 
20

 
Changes in internal controls or accounting guidance could cause volatility in our stock price.
 
Guidance regarding implementation and interpretation of the provisions of Section 404 of the Sarbanes-Oxley Act continues to be issued by the standards-setting community. Smaller reporting companies have been granted permanent exemption from having to obtain an auditors’ report on the effectiveness of their internal control over financial reporting. We became an accelerated filer as of December 31, 2014 and are subject to an audit of our internal controls. As a result of the ongoing interpretation of new guidance and the audit testing that may be required to be completed in the future, our internal controls over financial reporting may include an unidentified material weakness that would result in our receiving an adverse opinion on our internal controls over financial reporting from our independent registered public accounting firm. This could result in significant additional expenditures responding to the Section 404 internal control audit, heightened regulatory scrutiny and potentially an adverse effect to the price of our stock.
 
In addition, due to increased regulatory scrutiny surrounding publicly traded companies, the possibility exists that a restatement of past financial results could be necessitated by an alternative interpretation of present accounting guidance and practice. Although management does not currently anticipate that this will occur, a potential result of such interpretation could be an adverse effect on our stock price.
 
Failure to maintain effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on our business and stock price.
 
During the course of testing our disclosure controls and procedures and internal control over financial reporting, we may identify and disclose material weaknesses or significant deficiencies in internal control over financial reporting that will have to be remedied. Implementing any appropriate changes to our internal control may require specific compliance training of our directors, officers and employees, entail substantial costs to modify our existing accounting systems, and take a significant period of time to complete. Such changes may not, however, be effective in maintaining the adequacy of our internal control over financial reporting, and any failure to maintain that adequacy or inability to produce accurate financial statements on a timely basis could result in our financial statements being unreliable, increase our operating costs and materially impair our ability to operate our business.
 
Failure to achieve and maintain effective internal control over financial reporting could result in a loss of investor confidence in our financial reports and could have a material adverse effect on our stock price. Additionally, failure to maintain effective internal control over our financial reporting could result in government investigation or sanctions by regulatory authorities.
 
Compliance with public company obligations, including the securities laws and regulations, is costly and requires significant management resources, and we may fail to comply. We are now an “accelerated filer,” and beginning with our Form 10-Q for the quarter ending March 31, 2015 will no longer qualify to report under smaller reporting company disclosure rules, and as a result will be subject to more comprehensive disclosure obligations, with increased compliance costs.
 
The federal securities laws and regulations, including the corporate governance and other requirements of the Sarbanes-Oxley Act of 2002, impose complex and continually changing regulatory requirements on our operations and reporting. Because the aggregate market value of our public float was in excess of $75 million as of June 30, 2014, we became an “accelerated filer” as of the end of our 2014 fiscal year. As a result, pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, our independent registered public accounting firm auditing our financial statements is now required to attest to and report on the effectiveness of our internal control over financial reporting. The auditor attestation requirement applies to us for the first time with respect to this Annual Report on Form 10-K. In addition, beginning with our Form 10-Q for our first quarter of fiscal 2015, we will be required to satisfy all of the larger reporting company disclosure requirements. These requirements will increase our legal compliance obligations and costs, which could harm our results of operations and divert management’s attention from business operations.
 
Relatively speaking, we are a small company with limited resources.  There can be no assurances that we will be able to comply with the added “accelerated filer” requirements by applicable deadlines and to maintain compliance in the future. If our independent registered public accounting firm is unable to provide us with an unqualified report as to the effectiveness of our internal control over financial reporting for future year ends, investors could lose confidence in the reliability of our financial reporting.
 
We do not anticipate paying cash dividends.
 
We currently intend to retain any future earnings for funding growth and, as a result, do not expect to pay any cash dividends in the foreseeable future. Additionally, our ability to declare dividends, should we decide to do so, is restricted by the terms of our debt agreements.
 
 
21

 
Our certificate of incorporation and bylaws and Delaware law contain provisions that could discourage a takeover.
 
Provisions of our amended and restated certificate of incorporation may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of us. These provisions could limit the price that certain investors might be willing to pay in the future for shares of our common stock. These provisions:
 
divide our board of directors into three classes serving staggered three-year terms;
 
only permit removal of directors by stockholders “for cause,” and require the affirmative vote of at least 85% of the outstanding common stock to so remove; and
 
allow us to issue preferred stock without any vote or further action by the stockholders.
 
The classification system of electing directors and the removal provision may tend to discourage a third-party from making a tender offer or otherwise attempting to obtain control of us and may maintain the incumbency of our board of directors, as the classification of the board of directors increases the difficulty of replacing a majority of the directors. These provisions may have the effect of deferring hostile takeovers, delaying changes in our control or management or may make it more difficult for stockholders to take certain corporate actions. The amendment of any of these provisions would require approval by holders of at least 85% of the outstanding common stock.
 
Israel-Related Risks
 
A significant portion of our operations takes place in Israel, and we could be adversely affected by the economic, political and military conditions in that region.
 
The offices and facilities of Epsilor-EFL are located in Israel (in Beit Shemesh and Dimona, both of which are within Israel’s pre-1967 borders). Most of our senior management is located in Beit Shemesh. Although we expect that most of our sales will continue to be made to customers outside Israel, we are nonetheless directly affected by economic, political and military conditions in that country. Accordingly, any major hostilities involving Israel or the interruption or curtailment of trade between Israel and its present trading partners could have a material adverse effect on our operations. Since the establishment of the State of Israel in 1948, a number of armed conflicts have taken place between Israel and its Arab neighbors and a state of hostility, varying in degree and intensity, has led to security and economic problems for Israel.
 
Historically, Arab states have boycotted any direct trade with Israel and to varying degrees have imposed a secondary boycott on any company carrying on trade with or doing business in Israel. Although in October 1994, the states comprising the Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates, Kuwait, Dubai, Bahrain and Oman) announced that they would no longer adhere to the secondary boycott against Israel, and Israel has entered into certain agreements with Egypt, Jordan, the Palestine Liberation Organization and the Palestinian Authority, Israel has not entered into any peace arrangement with Syria or Lebanon. Moreover, since September 2000, there has been a significant deterioration in Israel’s relationship with the Palestinian Authority. Efforts to resolve the problem have failed to result in an agreeable solution.
 
In July and August of 2006, Israel was involved in a full-scale armed conflict with Hezbollah, a Lebanese Islamist Shiite militia group and political party, in southern Lebanon, which involved missile strikes against civilian targets in northern Israel that resulted in economic losses. On August 14, 2006, a ceasefire was declared relating to that armed conflict, although it is uncertain whether or not the ceasefire will continue to hold.
 
Israel withdrew unilaterally from the Gaza Strip and certain areas in northern Samaria in 2005. Thereafter Hamas, an Islamist terrorist group responsible for many attacks, including missile strikes against Israeli civilian targets, won the majority of the seats in the Parliament of the Palestinian Authority in January 2006 and took control of the entire Gaza Strip, by force, in June 2007. Since then, Hamas and other Palestinian movements have launched thousands of missiles from the Gaza strip into civilian targets in southern Israel. In late 2008, a sharp increase in rocket fire from Gaza on Israel’s western Negev region, extending as far as 25 miles into Israeli territory and disrupting most day-to-day civilian activity in the proximity of the border with the Gaza Strip, prompted the Israeli government to launch military operations against Hamas that lasted approximately three weeks. Israel declared a unilateral ceasefire in January 2009, which substantially diminished the frequency of, but did not eliminate, Hamas rocket attacks against Israeli cities. In November 2012, following an increase in rocket attacks and hostile activity originating from the Gaza Strip, the Israeli government launched an air attack on Hamas. Rockets were fired into Israel extending as far as Tel Aviv and Jerusalem. After seven days, a ceasefire was agreed to by Israel and Hamas. This was followed by a period of relative calm that continued until July 2014, when rocket attacks resumed, and Israel began experiencing another round of armed conflict with Hamas in the Gaza Strip, with missiles reaching throughout Israel and Israeli ground forces engaged in operations within the Gaza Strip. The landing of one rocket about a mile from Israel’s primary international airport on July 22, 2014 caused the Federal Aviation Administration to prohibit landings of U.S.-based carriers into Ben Gurion International Airport for a period of approximately 48 hours. A ceasefire was agreed to in August 2014.
 
 
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Our Israeli production facilities in the cities of Beit Shemesh and Dimona, are located approximately 27 miles and 38 miles, respectively, from the nearest point of the border with the Gaza Strip. There can be no assurance that Hamas will not begin to use on a more frequent basis longer-range missiles capable of reaching our facilities, which could result in a significant disruption of the Israel-based portion of our business. Additionally, recent political events, including political uprisings, social unrest and regime change, in various countries in the Middle East and North Africa have weakened the stability of those countries, which could result in extremists coming to power, including in countries with which Israel has signed peace treaties that may not be respected by extremists. In addition, Iran has threatened to attack Israel, and Israel is reported to be considering a pre-emptive attack on Iran, which is widely believed to be developing nuclear weapons. Iran is also believed to have a strong influence among extremist groups in the region, such as Hamas in Gaza and Hezbollah in Lebanon. These situations may potentially escalate in the future to more violent events which may affect Israel and us. Any major hostilities involving Israel, including as a result of the military conflicts between the Fatah and Hamas in Gaza Strip, Judea and Samaria, or the interruption or curtailment of trade between Israel and its present trading partners could have a material adverse effect on our business, operating results and financial condition.
 
In addition to the foregoing, since the end of 2010, numerous acts of protest and civil unrest have taken place in several countries in the Middle East and North Africa, many of which involved significant violence. The civil unrest in Egypt, which borders Israel, resulted in significant changes to the country’s government. In Syria, also bordering Israel, large and violent protests against the government are taking place. The ultimate effect of these developments on the political and security situation in the Middle East and on Israel’s position within the region is not clear at this time.
 
Service of process and enforcement of civil liabilities on us and our officers may be difficult to obtain.
 
We are organized under the laws of the State of Delaware and will be subject to service of process in the United States. However, approximately 17.9% of our assets are located outside the United States. In addition, two of our directors and some of our executive officers are residents of Israel and a portion of the assets of such directors and executive officers are located outside the United States.
 
There is doubt as to the enforceability of civil liabilities under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, in original actions instituted in Israel. As a result, it may not be possible for investors to enforce or effect service of process upon these directors and executive officers or to judgments of U.S. courts predicated upon the civil liability provisions of U.S. laws against our assets, as well as the assets of these directors and executive officers. In addition, awards of punitive damages in actions brought in the U.S. or elsewhere may be unenforceable in Israel.
 
Exchange rate fluctuations between the U.S. dollar and the Israeli NIS may negatively affect our earnings.
 
Although a substantial majority of our revenues and a substantial portion of our expenses are denominated in U.S. dollars, a portion of our costs, including personnel and facilities-related expenses, is incurred in New Israeli Shekels (NIS). Inflation in Israel will have the effect of increasing the dollar cost of our operations in Israel, unless it is offset on a timely basis by a devaluation of the NIS relative to the dollar. In 2014, the inflation-adjusted NIS depreciated against the dollar.
 
ITEM 1B.                   UNRESOLVED STAFF COMMENTS
 
None.
 
ITEM 2.                      PROPERTIES
 
Our primary executive offices are located in the offices of our Simulation Division, consisting of approximately 17,300 square feet of office and warehouse space in Ann Arbor, Michigan, pursuant to a lease expiring in July 2018. We have also leased 17,200 square feet of office and warehouse space adjacent to our main offices pursuant to a lease beginning in June 2006 and expiring in July 2018. Additionally, pursuant to a lease expiring in October 2015, we are leasing approximately 10,000 square feet of office and lab space in Orlando, Florida.

We also lease approximately 5,500 square feet in Royal Oak, Michigan pursuant to a lease terminating in November 2018.

In August 2011, we purchased 40,000 square feet of office and warehouse space in Ann Arbor, Michigan, approximately three miles from the mail location of our Simulation Division, where we began to consolidate certain of our operations beginning in 2011. Subsequently, in December 2012, we subleased 7,000 square feet of surplus space of the purchased building to a non-profit organization as office space for a term of 10 years with an option to terminate the sublease with a one year prior notice in May 2018.

Our Power Systems Division operates out of facilities in Hanahan, South Carolina, constituting approximately 72,000 square feet, which are leased from the former owners of UEC through the end of 2024. We also have 30,000 square feet of leased facilities in Auburn, Alabama through the end of April 2015 and we are in the process of consolidating all operations of our Power Systems Division to Hanahan, South Carolina.
 
 
23


Our management and administrative facilities and research, development and production facilities for the manufacture and assembly of our Survivor Locator Lights, constituting approximately 21,000 square feet, are located in Beit Shemesh, Israel, located between Jerusalem and Tel-Aviv (within Israel’s pre-1967 borders). The lease for these facilities in Israel expires on December 31, 2017. Most of the members of our senior management, including our Chief Executive Officer and our President, work extensively out of our Beit Shemesh facility. Our Chief Financial Officer works out of our Ann Arbor, Michigan facility.
 
Our Power Systems Division also maintains approximately 23,000 square feet of factory, office and warehouse space in Dimona, Israel, in Israel’s Negev desert (within Israel’s pre-1967 borders), on a month-to-month basis.
 
In March 2007, we purchased 16,700 square feet of space for the now discontinued Armor Division in Auburn, Alabama for approximately $1.1 million pursuant to a seller-financed secured purchase money mortgage. Half of the mortgage is payable over ten years in equal monthly installments based on a 20-year amortization of the full principal amount, and the remaining half is payable at the end of ten years in a balloon payment. The building was leased to a third party and was listed for sale with a local real estate agent. Additionally, the carrying value of this property was written down to zero as part of the 2011 Armor Division impairment. On February 9, 2015, we sold the building to the current tenant for $925,000. On that same date, the existing mortgage and existing building lease were terminated which ended any obligation we had for this property.
 
We believe that our existing and currently planned facilities are adequate to meet our current and foreseeable future needs.
 
ITEM 3.                      LEGAL PROCEEDINGS
 
As of the date of this filing, there were no material pending legal proceedings against us, and there were no material legal proceedings active against us during 2014.
 
ITEM 4.                      MINE SAFETY DISCLOSURES
 
None.
 
 
24

 
PART II
 
ITEM 5.                      MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
Our common stock is traded on the Nasdaq Global Market. Our Nasdaq ticker symbol is “ARTX.” The following table sets forth, for the periods indicated, the range of high and low sales prices of our common stock on the Nasdaq Global Market System:
 
Year Ended December 31, 2014
 
High
   
Low
 
Fourth Quarter
 
$
3.54
   
$
2.02
 
Third Quarter
 
$
4.73
   
$
3.13
 
Second Quarter
 
$
5.92
   
$
2.96
 
First Quarter
 
$
6.61
   
$
2.40
 
 
Year Ended December 31, 2013
 
High
   
Low
 
Fourth Quarter
 
$
3.91
   
$
1.63
 
Third Quarter
 
$
2.71
   
$
1.32
 
Second Quarter
 
$
1.93
   
$
1.00
 
First Quarter
 
$
1.31
   
$
0.91
 
 
As of February 28, 2015, we had approximately 158 holders of record of our common stock.
 
Share Repurchase Program
 
Common Stock Repurchase Program
 
In February 2009, we authorized the repurchase in the open market or in privately negotiated transactions of up to $1.0 million of our common stock (increased to $2.0 million in August 2014). Pursuant to this plan, through September 30, 2014, we repurchased an aggregate of 638,611 shares of our common stock for an aggregate purchase price of $869,931 ($857,018 net of commissions). The following table shows information relating to the repurchase of our common stock during the three months ended December 31, 2014; through such date, 738,611 shares had been purchased for a total cost of $1,098,967 ($1,084,060 net of commissions):
 
Period
 
Total Number of Shares Purchased
   
Average Price Paid Per Share(1)
   
Total Number of Shares Purchased as Part of Plan
   
Maximum Approximate Dollar Value of Shares that May Yet be Purchased
 
October 1, 2014 through October 31, 2014
   
   
$
     
   
$
1,142,982
 
November 1, 2014 through November 30, 2014
   
100,000
   
$
2.27
     
738,611
   
$
915,940
 
December 1, 2014 through December 31, 2014
   
   
$
     
   
$
915,940
 
TOTAL THIS QUARTER
   
100,000
   
$
       
738,611
   
$
   
 
(1) Average price paid per share includes commissions and is rounded to the nearest two decimal places.
 
The repurchase program is subject to management’s discretion, and expires August 11, 2015.
 
Dividends
 
We have never paid any cash dividends on our common stock. The Board of Directors presently intends to retain all earnings for use in our business. Any future determination as to payment of dividends will depend upon our financial condition and results of operations and such other factors as the Board of Directors deems relevant. Additionally, our ability to declare dividends should we decide to do so is restricted by the terms of our debt agreements.
 
ITEM 6.                      SELECTED FINANCIAL DATA
 
Not applicable.
 
 
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ITEM 7.                      MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDI­TION AND RESULTS OF OPERATION
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve inherent risks and uncertainties. When used in this discussion, the words “believes,” “anticipates,” “expects,” “estimates” and similar expressions are intended to identify such forward-looking statements. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to publicly release the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors including, but not limited to, those set forth elsewhere in this report. Please see “Risk Factors,” above, and in our other filings with the Securities and Exchange Commission.
 
The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements contained in Item 8 of this report, and the notes thereto. We have rounded amounts reported here to the nearest thousand, unless such amounts are more than $1.0 million, in which event we have rounded such amounts to the nearest hundred thousand.
 
General
 
We are a defense and security products and services company, engaged in two business areas: interactive simulation for military, law enforcement and commercial markets; and batteries and charging systems for the military, commercial and medical markets. We operate in two business units:
 
Ø
We develop, manufacture and market advanced high-tech multimedia and interactive digital solutions for use-of-force training and driving training of military, law enforcement, security, emergency services and other personnel through our Training and Simulation Division.
 
Ø
We provide advanced battery solutions, innovative energy management and power distribution technologies and world-class product design and manufacturing services for the aerospace, defense, law enforcement, homeland security markets, and we manufacture and sell lithium and Zinc-Air batteries, for defense and security products and other military applications through our Power Systems Division.
 
Our results for 2013 and for the first three months of 2014 do not include the results of UEC Electronics, LLC, a South Carolina limited liability company that we purchased on April 1, 2014.
 
Critical Accounting Policies
 
The preparation of financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, allowance for bad debts, taxes, inventory, purchase price allocation, contingencies and deferred warranty revenue, impairment of intangible assets and goodwill. We base our estimates and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Under different assumptions or conditions, actual results may differ from these estimates.
 
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
 
Revenue Recognition
 
Significant management judgments and estimates must be made and used in connection with the recognition of revenue in any accounting period. Material differences in the amount of revenue in any given period may result if these judgments or estimates prove to be incorrect or if management’s estimates change on the basis of development of the business or market conditions. Management judgments and estimates have been applied consistently and have been reliable historically.
 
 
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A portion of our revenue is derived from license agreements that entail the customization of FAAC’s simulators to the customer’s specific requirements. Revenues from initial license fees for such arrangements are recognized in accordance with FASB ASC 605-35 based on the percentage of completion method over the period from signing of the license through to customer acceptance, as such simulators require significant modification or customization that takes time to complete. The percentage of completion is measured by monitoring progress using records of actual time incurred to date in the project compared with the total estimated project requirement, which corresponds to the costs related to earned revenues. Estimates of total project requirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and are reviewed and updated regularly by management.

Similarly, UEC also uses percentage of completion for certain contracts. The percentage of completion is measured by monitoring progress using records of actual time incurred to date in the project compared with the total estimated project requirement, which corresponds to the costs related to earned revenues. Estimates of total project requirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and are reviewed and updated regularly by management.
 
We believe that the use of the percentage of completion method is appropriate as we have the ability to make reasonably dependable estimates of the extent of progress towards completion, contract revenues and contract costs. In addition, contracts executed include provisions that clearly specify the enforceable rights regarding services to be provided and received by the parties to the contracts, the consideration to be exchanged and the manner and terms of settlement. In all cases we expect to perform our contractual obligations and our licensees are expected to satisfy their obligations under the contract. The complexity of the estimation process and the issues related to the assumptions, risks and uncertainties inherent with the application of the percentage of completion method of accounting affect the amounts of revenue and related expenses reported in our consolidated financial statements. A number of internal and external factors can affect our estimates, including labor rates, utilization and specification and testing requirement changes.
 
We account for our other revenues from MILO Range simulators in accordance with the provisions of FASB ASC 985-605. We exercise judgment and use estimates in connection with the determination of the amount of software license and services revenues to be recognized in each accounting period.
 
Allowance for Doubtful Accounts
 
We make judgments as to our ability to collect outstanding receivables and provide allowances for the portion of receivables when collection becomes doubtful. If necessary, provisions are made based upon a specific review of all significant outstanding receivables. In determining the provision, we analyze our historical collection experience and current economic trends. We reassess these allowances each accounting period. Historically, our actual losses and credits have been consistent with these provisions with the exception of 2014, when we wrote off $305,000 in our Simulation Division for a bad debt with a foreign client. If actual payment experience with our customers is different than our estimates, adjustments to these allowances may be necessary resulting in additional charges to our statement of operations.
 
Accounting for Income Taxes
 
Significant judgment is required in determining our worldwide income tax expense provision. In the ordinary course of a global business, there are many transactions and calculations where the ultimate tax outcome is uncertain. Some of these uncertainties arise as a consequence of cost reimbursement arrangements among related entities, the process of identifying items of revenue and expense that qualify for preferential tax treatment and segregation of foreign and domestic income. Although we believe that our estimates are reasonable, the final tax outcome of these matters may be different than that which is reflected in our historical income tax provisions and accruals.
 
We have provided a valuation allowance on our net deferred income tax assets, which includes federal, state and foreign net operating loss carryforwards, because of the uncertainty regarding their realization. Our accounting for deferred taxes under FASB ASC 740-10, involves the evaluation of a number of factors concerning the realizability of our deferred tax assets. In concluding that a valuation allowance was required, we primarily considered such factors as our history of operating losses and expected future losses in certain jurisdictions and the nature of our deferred tax assets. We provide valuation allowances in respect of deferred tax assets resulting principally from the carryforward of tax losses. Management currently believes that it is more likely than not that our deferred tax assets in the U.S. and Israel will not be realized in the foreseeable future but as our results improve, this may change in future periods. We do not provide for U.S. federal income taxes on the undistributed earnings of our foreign subsidiaries because such earnings are re-invested and, in the opinion of management, will continue to be re-invested indefinitely.
 
 
27

 
We have indefinitely-lived intangible assets consisting of trademarks and goodwill. Pursuant to FASB ASC 350-10, these indefinitely-lived intangible assets are not amortized for financial reporting purposes. However, these assets are tax deductible, and therefore amortized over 15 years for tax purposes. As such, deferred income tax expense and a deferred tax liability arise as a result of the tax-deductibility of these indefinitely-lived intangible assets. The resulting deferred tax liability, which is expected to continue to increase over time, will have an indefinite life, resulting in what is referred to as a “naked tax credit.” This deferred tax liability could remain on our balance sheet indefinitely for continuing operations unless there is an impairment of the related assets (for financial reporting purposes), or the business to which those assets relate were to be disposed of. Due to the fact that the aforementioned deferred tax liability could have an indefinite life, it should not be netted against our deferred tax assets (which primarily relate to net operating loss carryforwards) when determining the required valuation allowance. Doing so would result in the understatement of the valuation allowance and related deferred income tax expense.
 
We have adopted the provisions of the FASB ASC 740-10. FASB ASC 740-10 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken in a tax return. We must determine whether it is “more-likely-than-not” that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. Once it is determined that a position meets the more-likely-than-not recognition threshold, the position is measured to determine the amount of benefit to recognize in the financial statements. Uncertain tax positions require determinations and estimated liabilities to be made based on provisions of the tax law which may be subject to change or varying interpretation. If our determinations and estimates prove to be inaccurate, the resulting adjustments could be material to our future financial statements.
 
In addition, we operate within multiple taxing jurisdictions and may be subject to audits in these jurisdictions. These audits can involve complex issues that may require an extended period of time for resolution. In management’s opinion, adequate provisions for income taxes have been made.
 
Inventories
 
Our policy for valuation of inventory and commitments to purchase inventory, including the determination of obsolete or excess inventory, requires us to perform a detailed assessment of inventory at each balance sheet date, which includes a review of, among other factors, an estimate of future demand for products within specific time horizons, valuation of existing inventory, as well as product lifecycle and product development plans. The estimates of future demand that we use in the valuation of inventory are the basis for our revenue forecast, which is also used for our short-term manufacturing plans. Inventory reserves are also provided to cover risks arising from slow-moving items. 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 on assumptions about future demand and market conditions. We may be required to record additional inventory write-down if actual market conditions are less favorable than those projected by our management. For fiscal 2014, no significant changes were made to the underlying assumptions related to estimates of inventory valuation or the methodology applied.
 
Goodwill
 
As of December 31, 2014, we had recorded goodwill of $45.4 million. We allocate goodwill acquired in a business combination to the appropriate reporting unit as of the acquisition date. Currently our reporting units are also our reportable segments and the associated goodwill was determined when the specific businesses in the reportable segments were purchased. Under FASB ASC 350-10, goodwill and intangible assets deemed to have indefinite lives are no longer amortized but are subject to annual impairment tests, and tests between annual tests in certain circumstances, based on estimated fair value in accordance with FASB ASC 350-10, and written down when impaired.
 
When testing goodwill for impairment we have the option of performing a qualitative assessment before calculating the fair value of a reporting unit. If the Company determines, on the basis of qualitative factors, that it is more likely than not that the fair value of the reporting unit is greater than the carrying amount, the two-step impairment test would not be required. If we cannot determine on the basis of qualitative factors that goodwill is not impaired, goodwill is then tested for impairment by using a discounted cash flow analysis. This type of analysis requires us to make assumptions and estimates regarding industry economic factors and the profitability of future business strategies. Significant estimates used in the methodologies include estimates of future cash flows, future short-term and long-term growth rates, weighted average cost of capital and estimates of market multiples for the reportable units. It is our policy to conduct impairment testing based on our current business strategy in light of present industry and economic conditions, as well as future expectations. In assessing the recoverability of our goodwill, we may be required to make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. This process is subjective and requires judgment at many points throughout the analysis. If our estimates or their related assumptions change in subsequent periods or if actual cash flows are below our estimates, we may be required to record impairment charges for these assets not previously recorded.
 
 
28

 
We completed our annual goodwill impairment review using the financial results as of the quarter ended December 31, 2014 using our forecasted plan developed in the fourth quarter.
 
Under certain circumstances we have the option of performing a qualitative assessment when testing goodwill for impairment. We determined that this qualitative assessment would be appropriate in the case of our Training and Simulation Division, but that with respect to our Power Systems Division, we determined that we were required to perform a quantitative analysis.
 
With respect to our Training and Simulation Division, we determined, using qualitative factors, that no goodwill was impaired.

 Significant judgments inherent in these analyses include assumptions about appropriate sales growth rates, WACC and the amount of expected future net cash flows. The judgments and assumptions used in the estimate of fair value are generally consistent with the projections and assumptions that are used in current operating plans. Such assumptions are subject to change as a result of changing economic and competitive conditions. The determination of fair value is highly sensitive to differences between estimated and actual cash flows and changes in the related discount rate used to evaluate the fair value of the reporting units and trade name.

The goodwill of our Training and Simulation Division equaled $24.4 million and the goodwill of our Power Systems Division equaled $21.0 million at December 31, 2014. Based on the discounted cash flow valuation at December 31, 2014, an increase in the WACC or changes in other significant variables for the Power Systems Division could potentially result in impairment.

With respect to our Power Systems Division, we undertook the first step of the quantitative analysis, in which we computed a fair value of that reporting unit. The valuation for Power Systems Division exceeded the reporting unit’s carrying value by over 6%; we will continue to monitor the actual results of the reporting unit versus the forecast used for the impairment review and reevaluate the goodwill as required. It should be noted that UEC was just acquired so its fair value and carrying value were the same when acquired in April 2014 and since UEC represents over 50% of the revenue of the Power Systems division, the excess of total fair value over carrying value is adversely impacted. Because we determined, with respect to our Power Systems Division, that the fair value was 6% greater than the carrying value of the unit at the measurement date, the second step of the quantitative impairment assessment was not required, and no goodwill was impaired.
 
We also consider our current market capitalization compared to the sum of the estimated fair values of its reporting units in conjunction with each impairment assessment. As part of this consideration, management recognizes that our market capitalization may not be an accurate representation of the sum of the reporting unit fair values for the following reasons:
 
 ·
The long term horizon of the valuation process versus a short term valuation using current market conditions;
 
 ·
The valuation by individual business segments versus the market share value based on our company as a whole including unallocable corporate costs;
 
 ·
The fact that our stock is thinly traded and widely dispersed with minimal institutional ownership, and thus not followed by major market analysts, leading management to conclude that the market in our securities was not acting as an informationally efficient reflection of all known information regarding us; and
 
 ·
Control premiums reflected in the reporting unit fair values but not in our stock price.
 
As of the December 31, 2014 valuation date, our market capitalization was approximately $56.9 million, which did not, in management’s view, suggest that the fair value estimates used in its impairment assessment required any adjustment.
 
Other Intangible Assets
 
Other intangible assets are amortized over the period during which benefits are expected to accrue, currently estimated at one to ten years.
 
The determination of the value of such intangible assets requires us to make assumptions regarding future business conditions and operating results in order to estimate future cash flows and other factors to determine the fair value of the respective assets. If these estimates or the related assumptions change in the future, we could be required to record additional impairment charges.

Impairment analysis triggering events include - A significant decrease in the market price of a long-lived asset, a significant adverse change in the extent or manner in which a long-lived asset is being used or in its physical condition, a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset, a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of the long lived asset, and a current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.
 
Contingencies
 
We are from time to time involved in legal proceedings and other claims. We are required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. We have not made any material changes in the accounting methodology used to establish our self-insured liabilities during the past three fiscal years.
 
 
29

 
A determination of the amount of reserves required, if any, for any contingencies are made after careful analysis of each individual issue. The required reserves may change due to future developments in each matter or changes in approach, such as a change in the settlement strategy in dealing with any contingencies, which may result in higher net loss.
 
If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material.
 
Warranty Reserves
 
We typically offer a one to two year warranty for many of our products. The specific terms and conditions of those warranties vary depending upon the product sold and country in which we do business. We estimate the costs that may be incurred under our basic limited warranty, including parts and labor, and record warranty liability in the amount of such costs at the time product revenue is recognized. Factors that affect our warranty liability include the number of installed units, historical and anticipated rates of warranty claims, and cost per claim. We periodically assesses the adequacy of our reserves and adjust the amounts as necessary.

 Functional Currency
 
We consider the United States dollar to be the currency of the primary economic environment in which we and EFL operate and, therefore, both we and EFL have adopted and are using the United States dollar as our functional currency. Transactions and balances originally denominated in U.S. dollars are presented at the original amounts. Gains and losses arising from non-dollar transactions and balances are included in net income.
 
The majority of financial transactions of Epsilor is in New Israeli Shekels (“NIS”) and a substantial portion of Epsilor’s costs is incurred in NIS. Management believes that the NIS is the functional currency of Epsilor. Accordingly, the financial statements of Epsilor have been translated into U.S. dollars. All balance sheet accounts have been translated using the exchange rates in effect at the balance sheet date. Statement of operations amounts have been translated using the average exchange rate for the period. The resulting translation adjustments are reported as a component of accumulated other comprehensive loss in stockholders’ equity.
 
Executive Summary
 
Overview of Results of Operations
 
We achieved profitability for the years ended December 31, 2014 and 2013. While we expect to continue to derive revenues from the sale of products that we manufacture and the services that we provide, there can be no assurance that we will be able to maintain profitability on a consistent basis.
 
A portion of our expenses during 2014 arose as a result of one-time expenses and non-cash charges. These charges were primarily related to our UEC acquisition, financings and stock-based awards to employees. To the extent that we continue certain of these activities during 2015, we would expect to continue to incur such expenses in the future.
 
Acquisitions
 
In acquisition of subsidiaries, part of the purchase price is allocated to intangible assets and goodwill. Amortization of intangible assets related to acquisition of subsidiaries is recorded based on the estimated expected life of the assets. Accordingly, for a period of time following an acquisition, we incur a non-cash charge related to amortization of intangible assets in the amount of a fraction (based on the useful life of the intangible assets) of the amount recorded as intangible assets. Such amortization charges continued during 2014 and increased due to the UEC acquisition. We are required to review intangible assets for impairment whenever events or changes in circumstances indicate that carrying amount of the assets may not be recoverable. If we determine, through the impairment review process, that an intangible asset has been impaired, we must record the impairment charge in our statement of operations.
 
In the case of goodwill, the assets recorded as goodwill are not amortized; instead, we are required to perform an annual impairment review. If we determine, through the impairment review process, that goodwill has been impaired, we must record the impairment charge in our statement of operations.
 
We incurred non-cash charges for amortization of intangible assets in 2014 and 2013 in the amount of $2.7 million and $1.1 million, respectively.
 
 
30

 
Issuances of Restricted Shares and Restricted Stock Units.
 
During 2014 and 2013, we issued restricted shares and restricted stock units to certain of our employees and to our directors. Each restricted stock unit is equal to one share of Company stock and is redeemable only for stock. These shares were issued as stock bonuses or were the required annual grant to directors, and are restricted for a period of up to three years from the date of issuance. Relevant accounting rules provide that the aggregate amount of the difference between the purchase price of the restricted shares or restricted stock units (in this case, generally zero) and the market price of the shares on the date of grant is taken as a general and administrative expense, amortized over the life of the period of the restriction.
 
We incurred non-cash charges related to stock-based compensation in 2014 and 2013 in the amount of $1.4 million and $437,000, respectively.
 
Transition to Accelerated Filer Status.
 
We became an accelerated filer as of December 31, 2014 and are now subject to an audit of our internal controls. We expect our general and administrative expenses to reflect these new expenses going forward.
 
Overview of Operating Performance and Backlog
 
Overall, our pre-tax profit from continuing operations for 2014 was $4.5 million on revenues of $103.6 million, compared to a pre-tax profit of $3.3 million on revenues of $88.6 million during 2013. As of December 31, 2014, our overall backlog for continuing operations totaled $69.9 million compared to a backlog of $58.0 million as of December 31, 2013.
 
In our Training and Simulation Division, revenues decreased from approximately $63.4 million in 2013 to $56.4 million in 2014. This decrease was primarily due to the wind down of the first phase of our VCTS program (revenue in this program will increase due to the second phase of our VCTS program, which commenced in the third quarter of 2014). As of December 31, 2014, our backlog for our Training and Simulation Division totaled $45.7 million compared to a backlog of $45.9 million as of December 31, 2013.
 
In our Power Systems Division, revenues increased from approximately $25.2 million in 2013 to approximately $47.2 million in 2014. This increase was primarily due to revenue associated with our new UEC subsidiary, offset by the reduced product sales in our other U.S. subsidiary. As of December 31, 2014, our backlog for our Power Systems Division totaled $24.2 million compared to a backlog of $12.1 million as of December 31, 2013.
 
Common Stock Repurchase Program
 
In February of 2009, we authorized the repurchase in the open market or in privately negotiated transactions of up to $1.0 million of our common stock (increased to $2.0 million in August 2014). Pursuant to this plan, through December 31, 2014 we have repurchased an aggregate of 738,611 shares of our common stock for an aggregate purchase price of $1,098,967 ($1,084,060 net of commissions), all of which was purchased after April 1, 2009. At December 31, 2014, we had remaining authorization for the repurchase of up to $915,940 in shares of our common stock. The repurchase program is subject to the discretion of our management.
 
 
31

 
Results of Operations
 
Summary
 
Following is a table summarizing our results of continuing operations for the years ended December 31, 2014 and 2013, after which we present a narrative discussion and analysis. Our results for 2013 and for the first three months of 2014 do not include the results of UEC Electronics, LLC, a South Carolina limited liability company that we purchased on April 1, 2014.
 
   
Year Ended December 31,
 
   
2014
   
2013
 
Revenues:
           
Training and Simulation Division
 
$
56,404,498
   
$
63,425,319
 
Power Systems Division
   
47,157,851
     
25,146,109
 
   
$
103,562,349
   
$
88,571,428
 
Cost of revenues:
               
Training and Simulation Division
 
$
35,322,870
   
$
44,257,129
 
Power Systems Division
   
35,531,867
     
20,223,011
 
   
$
70,854,737
   
$
64,480,140
 
Research and development expenses:
               
Training and Simulation Division
 
$
1,571,295
   
$
1,296,956
 
Power Systems Division
   
1,751,154
     
1,658,927
 
   
$
3,322,449
   
$
2,955,883
 
Selling and marketing expenses:
               
Training and Simulation Division
 
$
4,800,580
   
$
4,448,036
 
Power Systems Division
   
1,120,758
     
1,169,669
 
   
$
5,921,338
   
$
5,617,705
 
General and administrative expenses:
               
Training and Simulation Division
 
$
4,340,145
   
$
3,553,058
 
Power Systems Division
   
3,941,568
     
1,630,641
 
Corporate
   
8,979,645
     
5,703,260
 
   
$
17,261,358
   
$
10,886,959
 
Amortization of intangible assets:
               
Training and Simulation Division
 
$
263,365
   
$
581,886
 
Power Systems Division
   
2,433,375
     
509,240
 
   
$
2,696,740
   
$
1,091,126
 
Operating income:
               
Training and Simulation Division
 
$
10,106,243
   
$
9,288,254
 
Power Systems Division
   
2,379,129
     
(45,379
)
Corporate
   
(8,979,645
)    
(5,703,260
)
   
$
3,505,727
   
$
3,539,615
 
Other income:
               
Training and Simulation Division
 
$
227,360
   
$
4,761
 
Power Systems Division
   
211,676
     
253,600
 
Corporate
   
2,119,557
     
27,896
 
   
$
2,558,593
   
$
286,347
 
Financial (expense) income:
               
Training and Simulation Division
 
$
(50,975
)  
$
(44,146
)
Power Systems Division
   
(215,453
)    
(30,733
)
Corporate
   
(1,287,094
)    
(424,393
)
   
$
(1,553,522
)  
$
(499,272
)
Income tax expense (benefit):
               
Training and Simulation Division
 
$
133,692
   
$
319,225
 
Power Systems Division
   
(61,777
)    
134,995
 
Corporate
   
951,922
     
598,500
 
   
$
1,023,837
   
$
1,052,720
 
Net income – continuing operations:
               
Training and Simulation Division
 
$
10,148,936
   
$
8,929,644
 
Power Systems Division
   
2,437,129
     
42,493
 
Corporate
   
(9,099,104
)    
(6,698,167
)
   
$
3,486,961
   
$
2,273,970
 
 
 
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Fiscal Year 2014 compared to Fiscal Year 2013
 
Revenues. During 2014, we recognized revenues as follows:
 
Ø  
Training and Simulation Division – We recognized revenues from the sale of air warfare simulators and vehicle simulators, interactive use-of-force training systems and from the provision of maintenance services in connection with such systems.
 
Ø  
Power Systems Division – We recognized revenues from sales of electronics engineering products and provision of design services for the military, as well as from the sale of batteries, chargers, adapters and power hub products to the military and commercial customers. We also recognized revenues from the sale of water-activated battery (WAB) lifejacket lights.
 
Revenues for 2014 totaled $103.6 million, compared to $88.6 million in 2013, an increase of $15.0 million, or 16.9%. In 2014, revenues were $56.4 million for the Training and Simulation Division (compared to $63.4 million in 2013, a decrease of $7.0 million, or 11.1%, due primarily to the wind down of the first phase of our VCTS program (revenue in this program will increase due to the second phase of our VCTS program, which commenced in the third quarter of 2014); and $47.2 million for the Power Systems Division (compared to $25.2 million in 2013, an increase of $22.0 million, or 87.5%, due primarily to $27.2 million in revenue generated by our new electronics engineering and design services for the military business, offset by reduced revenue in certain of our other businesses).
 
The table below details the percentage of total recognized revenue by type of arrangement for the years ended December 31, 2014 and 2013:
 
   
Year Ended December 31,
 
Type of Revenue
 
2014
   
2013
 
Sale of products
   
94.7
%
   
95.0
%
Maintenance and support agreements
   
3.8
%
   
3.3
%
Long term research and development contracts
   
1.5
%
   
1.7
%
Total
   
100.0
%
   
100.0
%
 
Cost of revenues. Cost of revenues totaled $70.8 million during 2014, compared to $64.5 million in 2013, an increase of $6.3 million, or 9.9%, due primarily to the product mix of the reporting units, which included products sold at a higher margin. Cost of revenues were $35.3 million for the Training and Simulation Division (compared to $44.3 million in 2013, a decrease of $9.0 million, or 20.2%, due primarily to lower revenue and a higher margin product mix) and $35.5 million for the Power Systems Division (compared to $20.2 million in 2013, an increase of $15.3 million, or 75.7%, due primarily to revenue generated by our electronics engineering and design services for the military business, offset by reduced revenue in certain our other businesses).
 
Research and development expenses. Research and development expenses for 2014 were $3.3 million, compared to $3.0 million during 2013, an increase of $367,000, or 12.4%, due primarily to continuing research on training systems and battery technologies for new products.
 
Selling and marketing expenses. Selling and marketing expenses for 2014 were $5.9 million, compared to $5.6 million in 2013, an increase of $304,000, or 5.4%, due primarily to increased trade show representation and the sales efforts of both divisions, including additional expenses related to our addition of a new line of business.
 
General and administrative expenses. General and administrative expenses for 2014 were $17.3 million, compared to $10.9 million in 2013, an increase of $6.4 million, or 56.9%, due primarily to our acquisition of UEC ($2.6 million) and $813,000 in one-time, acquisition related expenses, along with increased corporate salary and benefit expenses.
 
Amortization of intangible assets. Amortization of intangible assets totaled $2.7 million in 2014, compared to $1.1 million in 2013, an increase of $1.6 million, or 147.2%, due primarily to the additional $2.4 million in amortization expenses relating to our acquisition of UEC, offset by fully amortized acquisition related intangibles relating to other subsidiaries in our Training and Simulation and Power Systems Divisions.
 
Other income. Other income totaled $2.6 million in 2014, compared to other income of $286,000 in 2013, an increase of $2.3 million, or 793.4%, due primarily to a $2.0 million fair value adjustment of the potential 2015 earn-out due the previous owners of UEC. This adjustment was recorded due to reduction of the deemed purchase price of UEC as a result of potential payments to the seller that will not be earned because of changes in the expected timing of forecasted cash flows.
 
 
33

 
Financial expense, net. Financial expense totaled $1.6 million in 2014, compared to financial expense of $449,000 in 2013, an increase of $1.1 million, or 211.2%, due primarily to increased long term interest and bank financing fees relating to our acquisition of UEC, offset by a decrease in corporate interest and bank charges in 2014.
 
Income taxes. We recorded $1.0 million in tax expense in 2014, compared to $1.1 million in tax expense in 2013, a decrease of $30,000, or 2.7%, mainly concerning “naked” credits (“naked” credits occur when deferred tax liabilities that are created by indefinite-lived assets such as goodwill cannot be used as a source of taxable income to support the realization of deferred tax assets). This amount includes the required adjustment of taxes due to the deduction of goodwill “naked” credits for U.S. federal taxes, which totaled $599,000 in non-cash expenses in 2014 and $599,000 in non-cash expenses in 2013. Additionally, overall taxes have increased due to our improved results.
 
Net income. Due to the factors cited above, we went from a net income from continuing operations of $2.3 million in 2013 to a net income of $3.5 million in 2014, an improvement of $1.2 million or 53.3%.
 
Liquidity and Capital Resources
 
As of December 31, 2014, we had $11.3 million in cash and $236,000 in restricted collateral deposits, as compared to December 31, 2013, when we had $5.8 million in cash and $498,000 in restricted collateral deposits. We have experienced fluctuations in available cash in the previous twelve months due to the funding requirements of our larger contracts. These fluctuations have not had a significant impact on our operations, due in part to the increase in our credit facility that was negotiated with our primary bank in 2013. We also had $11.3 million in available, unused bank lines of credit with our main bank as of December 31, 2014, under a $15.0 million credit facility under our FAAC subsidiary, described below. As of December 31, 2014, we had no short-term bank debt with our primary bank.
 
We have a $15.0 million line of credit (the “Line of Credit”) with our primary bank (the “Bank”), secured by the assets and receivables of FAAC and by the assets and receivables of Arotech and of our U.S. subsidiaries. Additionally, Arotech and certain of its subsidiaries are guarantors of the Line of Credit.

On April 1, 2014, pursuant to an Amended and Restated Credit Agreement (the “Amended Credit Agreement”), the parties to the original credit agreement (the “Original Credit Agreement”) agreed to amend the Line of Credit to add two term loans to it: an $18.0 million 61-month senior term loan at an interest rate of 3.75% over LIBOR, and a $4.5 million 61-month B term loan at an interest rate of 5.5% over LIBOR. The interest rate charged as of December 31, 2014 was 3.91% for term loan A and 5.66% for term loan B. Principal payments are made monthly for term loan A and quarterly for term loan B. Interest is paid monthly for both loans. Pursuant to a joinder agreement that took effect upon our acquisition of UEC (the “Joinder Agreement”), UEC became a party to the Amended Credit Agreement as a co-borrower with FAAC, and provided a guaranty and security substantially identical to those granted by us and EFB. We, FAAC, and EFB also entered into a patent and trademark security agreement with the Bank; upon effectiveness of the Joinder Agreement, UEC executed a substantially identical agreement.

Certain covenants contained in the Original Credit Agreement have been modified in the Amended Credit Agreement. Commencing with the fiscal quarter ending September 30, 2014, our “Fixed Charge Coverage Ratio”, determined on a combined basis with UEC and otherwise computed in the same manner as under the Original Credit Agreement, has been raised to 1.25 to 1 from 1.10 to 1. “Net Advances to Affiliates” are now defined with reference to FAAC or UEC, as the case may be, and may not increase by more than $5,500,000 on a combined basis for both borrowers in any calendar year over a “Base Amount” to be determined by mutual agreement of FAAC and the bank.

In addition, two new covenants have been added in the Amended Credit Agreement. First, UEC’s earnings before interest, taxes, depreciation and amortization with certain add-backs (“EBITDA”), computed on a stand-alone basis, may not be less than $4,500,000 for any trailing twelve-month period ending at the end of a fiscal quarter (a “Test Period”) beginning with the Test Period ending September 30, 2014 and each succeeding fiscal quarter thereafter. Second, the ratio of “Combined Funded Indebtedness” (defined as all indebtedness (a) in respect of money borrowed, (b) evidenced by a note, debenture or other like written obligation to pay money, (c) in respect of rent or hire of property under leases or lease arrangements which under GAAP are required to be capitalized or (d) in respect of obligations under conditional sales or other title retention agreements, all as determined on a combined basis for FAAC and UEC) to “Combined Adjusted EBITDA” (defined as EBITDA of FAAC and UEC computed on a combined basis) may not exceed (a) 2.25 to 1.0 for the Test Period ending September 30, 2014 or any Test Period ending as of the end of any fiscal quarter thereafter prior to the fiscal quarter ending March 31, 2015 or (b) 2.00 to 1.0 for the Test Period ending March 31, 2015 or any Test Period ending as of the end of any fiscal quarter thereafter.
 
At the end of 2014 and as of the filing date of this report, we met all required current covenants.
 
 
34

 
We used available funds in 2014 primarily for investment in fixed assets and repayment of short term debt. We purchased approximately $2.1 million of property and equipment during 2014. Our net property and equipment amounted to $6.5 million as of December 31, 2014.
 
Net cash provided by operating activities for 2014 and 2013 was $7.4 million and $10.2 million, respectively, a net change of $2.8 million. This difference was due primarily to the profit from continuing operations and the changes in working capital. The timing of cash inflows and outflows has impacted us due to the substantial purchases of products to fulfill the contracts in the Simulation and Training Division and Power Systems Division.
 
Net cash used in investing activities for 2014 and 2013 was $31.3 million and $1.9 million, a net change of $29.4 million. This difference was due primarily to the $29.1 million acquisition of our UEC subsidiary.
 
Net cash provided by (used in) financing activities for 2014 and 2013 was $29.9 million and $(4.4 million), respectively, a change of $34.3 million. The increase in 2014 of cash provided by financing activities was due to the $22.5 million in new long term debt associated with the acquisition of UEC and net proceeds from the recent stock offering in the amount of $10.7 million as compared to the stock offering proceeds of $6.3 million in 2013. Additionally, there were repayments of an additional $3.1 million in long term debt in 2014.
 
As of December 31, 2014, we had essentially no short-term bank debt and $21.3 million in long-term debt outstanding, as compared to December 31, 2013, when we had no short-term bank debt and $1.9 million in long-term debt outstanding for continuing operations, including current maturities.
 
Subject to all of the reservations regarding “forward-looking statements” set forth above, we believe that our present cash position, anticipated cash flows from operations and availability under our lines of credit should be sufficient to satisfy our current estimated cash requirements through the next twelve months. In this connection, we note that from time to time our working capital needs are partially dependent on our subsidiaries’ lines of credit.
 
Effective Corporate Tax Rate
 
Certain of our subsidiaries incurred net operating losses during the years ended December 31, 2014 and 2013. With respect to some of our U.S. subsidiaries that operated at a net profit during 2014, we were able to offset federal taxes against our net operating loss carryforward. These subsidiaries are, however, subject to state taxes that cannot be offset against our net operating loss carryforward. We also set up a tax liability for the impact of the deductions taken for goodwill.
 
As of December 31, 2014, we had a U.S. net operating loss carryforward of approximately $35.0 million that is available to offset future taxable income under certain circumstances, expiring primarily from 2021 through 2032, and foreign net operating and loss carryforwards of approximately $85.1 million, which are available indefinitely to offset future taxable income under certain circumstances.
 
ITEM 8.                      FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
 
Page
Consolidated Financial Statements
 
F-1
F-2
F-4
F-5
F-7
F-9
 
ITEM 9.                      CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
Not applicable.
 
 
35

 
ITEM 9A.                   CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures
 
As of December 31, 2014, our management, including the principal executive officer and principal financial officer, evaluated our disclosure controls and procedures related to the recording, processing, summarization, and reporting of information in our periodic reports that we file with the SEC. These disclosure controls and procedures are intended to ensure that material information relating to us, including our subsidiaries, is made known to our management, including these officers, by other of our employees, and that this information is recorded, processed, summarized, evaluated, and reported, as applicable, within the time periods specified in the SEC’s rules and forms. Due to the inherent limitations of control systems, not all misstatements may be detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Any system of controls and procedures, no matter how well designed and operated, can at best provide only reasonable assurance that the objectives of the system are met and management necessarily is required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. Our controls and procedures are intended to provide only reasonable, not absolute, assurance that the above objectives have been met.
 
Based on their evaluation as of December 31, 2014, our principal executive officer and principal financial officer were able to conclude that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) were effective.
 
We will continue to review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis and to improve our controls and procedures over time and correct any deficiencies that we may discover in the future. Our goal is to ensure that our senior management has timely access to all material financial and non-financial information concerning our business. While we believe the present design of our disclosure controls and procedures is effective to achieve our goal, future events affecting our business may cause us to modify our disclosure controls and procedures.
 
Management’s Report on Internal Control Over Financial Reporting
 
Our management, including our principal executive and financial officers, is responsible for establishing and maintaining adequate internal control over our financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our management has evaluated the effectiveness of our internal controls as of the end of the period covered by this Annual Report on Form 10-K for the year ended December 31, 2014. In making our assessment of internal control over financial reporting, management used the criteria set forth by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission in the 2013 Internal Control – Integrated Framework.
 
Our management concluded that our internal control over financial reporting was effective as of December 31, 2014.
 
Our internal control over financial reporting as of December 31, 2014 has been audited by BDO USA, LLP, an independent registered public accounting firm, as stated in their attestation report which appears herein.
 
Changes in Internal Controls Over Financial Reporting
 
There have been no changes in our internal control over financial reporting that occurred during our last fiscal quarter to which this Annual Report on Form 10-K relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
 
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Report of Independent Registered Public Accounting Firm
 
To the Board of Directors and Shareholders of Arotech Corporation
Ann Arbor, Michigan
 
We have audited Arotech Corporation’s internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Arotech Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in this Item 9A, Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
In our opinion, Arotech Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on the COSO criteria.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Arotech Corporation as of December 31, 2014 and 2013, and the related consolidated statements of comprehensive income, changes in stockholders’ equity and cash flows for the years then ended and our report dated March 20, 2015 expressed an unqualified opinion thereon.
 
/s/ BDO USA, LLP
Grand Rapids, Michigan
March 20, 2015
 
ITEM 9B.                   OTHER INFORMATION
 
None.
 
 
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PART III
 
ITEM 10.                    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
  
Executive Officers, Directors and Significant Employees
 
Executive Officers and Directors
 
Our executive officers and directors and their ages as of February 28, 2015 were as follows:
 
Name
 
Age
 
Position
Steven Esses
  51  
President, Chief Executive Officer and Director
Robert S. Ehrlich
  77  
Executive Chairman of the Board
Dr. Jay M. Eastman
  66  
Director
Seymour Jones
  83  
Director
Michael E. Marrus
  51  
Director
Richard Rudy
  56  
Director
Thomas J. Paup
  66  
Senior Vice President – Finance and Chief Financial Officer
 
Our by-laws provide for a board of directors of one or more directors. There are currently seven directors. Under the terms of our certificate of incorporation, the board of directors is composed of three classes of similar size, each elected in a different year, so that only one-third of the board of directors is elected in any single year. Dr. Eastman and Mr. Marrus are designated Class I directors and have been elected for a term expiring in 2015 or until their successors are elected and qualified; Prof. Jones and Mr. Rudy are designated Class II directors elected for a term expiring in 2017 or until their successors are elected and qualified; and Messrs. Esses and Ehrlich are designated Class III directors elected for a term that expires in 2016 or until their successors are elected and qualified. A majority of the Board is “independent” under relevant SEC and Nasdaq regulations.
 
Steven Esses has been our President and Chief Executive Officer since October 2014. He has been a director since July 2002, our Executive Vice President since January 2003, our Chief Operating Officer from February 2003 until February 2012 and our President since December 2005. From 2000 until 2002, Mr. Esses was a principal with Stillwater Capital Partners, Inc. (“Stillwater”), a New York-based investment research and advisory company specializing in alternative investment strategies. During this time, Mr. Esses also acted as an independent consultant to new and existing businesses in the areas of finance and business development. In 1995, Mr. Esses founded the Dunkin’ Donuts franchise in Israel and was its Managing Director and CEO until 2005. Before founding Dunkin’ Donuts Israel, Mr. Esses was the Director of Retail Jewelry Franchises with Hamilton Jewelry, and before that he served as Executive Director of Operations for the Conway Organization, a major off-price retailer with 17 locations.
 
Mr. Esses has been actively involved in the day-to-day management of companies since he was 22, when he co-founded a company that eventually went public. He has worked in retail and wholesale, in high-tech and low-tech, in a variety of industries. Throughout his career, he has been highly numbers-oriented, focusing on budgetary and fiscal matters and on building business value. We believe that Mr. Esses’s background and experience make him appropriate to serve as one of our directors in light of our business and structure.
 
Robert S. Ehrlich has been our Executive Chairman of the Board since October 2014 and was our Chairman of the Board from January 1993. From October 2002 until September 2014, Mr. Ehrlich was our Chief Executive Officer. From May 1991 until January 1993, Mr. Ehrlich was our Vice Chairman of the Board, from May 1991 until October 2002 he was our Chief Financial Officer, and from October 2002 until December 2005, Mr. Ehrlich also held the title of President. From 1981 to 1991, Mr. Ehrlich served as Chairman of the Board and CEO of Fresenius USA, Inc. (NYSE: FRN), a manufacturer of medical devices. From 1987 to June 2003, Mr. Ehrlich served as a director of PSC Inc. (Nasdaq: PSCX), a manufacturer and marketer of laser diode bar code scanners, and, between April 1997 and June 2003, Mr. Ehrlich was the chairman of the board of PSCX. Mr. Ehrlich received a B.S. and J.D. from Columbia University in New York, New York.
 
 
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Mr. Ehrlich has experience as an accountant, an attorney and as an investment banker. He has been involved with public companies since the late 1960s, both as an investment banker and as the chief financial officer and a director of Mattel (Nasdaq: MAT), where he was instrumental in helping to uncover fraudulent practices in the preparation of certain of that company’s financial statements, and he continued to serve as a director of Mattel through the late 1980s. After leaving Mattel, Mr. Ehrlich founded his own boutique investment banking company and became a director of certain of the companies involved in his investment banking business. Mr. Ehrlich ultimately became the Chairman and CEO of Fresenius USA and of PSCX, prior to becoming our Chief Financial Officer in 1991 and our Chief Executive Officer in 2002. We believe that Mr. Ehrlich’s background and experience make him appropriate to serve as one of our directors in light of our business and structure.
 
Dr. Jay M. Eastman has been one of our directors since October 1993. From November 1991 to December 2011, Dr. Eastman served as President and Chief Executive Officer of Lucid, Inc. (OTCQB: LCDX), a public company that is developing laser technology applications for medical diagnosis and treatment; since December 2011, Dr. Eastman has served as a director and Chief Science Officer of Lucid. Dr. Eastman served as Senior Vice President of Strategic Planning of PSCX from December 1995 through October 1997. Dr. Eastman is also a director of Dimension Technologies, Inc., a developer and manufacturer of 3D displays for computer and video displays, and of Chapman Instruments, Inc., a private manufacturer of precision surface metrology instruments. From 1981 until 1983, Dr. Eastman was the Director of the University of Rochester’s Laboratory for Laser Energetics, where he was a member of the staff from 1975 to 1981. He holds, as inventor or co-inventor, 44 patents, and is a fellow of the Optical Society of America and the Society of Photo-Optical Instrumentation Engineers, as well as an honorary member of the Rochester Engineering Society. Dr. Eastman holds a B.S. and a Ph.D. in Optics from the University of Rochester in New York.
 
Dr. Eastman brings to our Board the unique perspective of a trained scientist who has also been deeply involved in the business world. Since many of our company’s products are of a “high-tech” nature, Dr. Eastman’s scientific background is extremely valuable to the Board. Additionally, Dr. Eastman brings to the Board his experiences as President and Chief Executive Officer of a high-tech company, as well as his experience as a director of other public companies. We believe that Dr. Eastman’s background and experience make him appropriate to serve as one of our directors in light of our business and structure.
 
Seymour Jones has been one of our directors since August 2005. Mr. Jones has been a clinical professor of accounting at New York University Stern School of Business since September 1993. Professor Jones teaches courses in accounting, tax, forensic accounting and legal aspects of entrepreneurism. He is also the Associate Director of Ross Institute of Accounting Research at Stern School of Business. His primary research areas include audit committees, auditing, entrepreneurship, financial reporting, and fraud. Professor Jones is the principal author of numerous books including Conflict of Interest, The Coopers & Lybrand Guide to Growing Your Business, The Emerging Business and The Bankers Guide to Audit Reports and Financial Statements. From April 1974 to September 1995, Mr. Jones was a senior partner of the accounting firm of Coopers & Lybrand, a legacy firm of PricewaterhouseCoopers LLP (“PwC”). Professor Jones is a certified public accountant in New York State. Professor Jones received a B.A. in economics from City College, City University of New York, and an M.B.A. from NYU Stern.
 
Prof. Jones brings many years of experience as an audit partner at PwC with extensive financial accounting knowledge that is critical to our board of directors. Prof. Jones’s experience with accounting principles, financial reporting rules and regulations, evaluating financial results and generally overseeing the financial reporting process of large public companies from an independent auditor’s perspective and as a professor of accounting makes him an invaluable asset to our board of directors. We believe that Prof. Jones’s background and experience make him appropriate to serve as one of our directors in light of our business and structure.
 
Michael E. Marrus has been one of our directors since October 2007. With 25 years of experience as an investment banker, Mr. Marrus has most recently been a Senior Managing Director at Dominick and Dominick, a wealth management and investment services firm, and a Managing Director of Merriman Capital, Inc., a financial services firm focused on growth companies. From 1998 to 2009, he was a Managing Director of C.E. Unterberg, Towbin & Co., an investment banking firm that was acquired by Collins Stewart plc. Prior to joining Unterberg, Towbin, Mr. Marrus was a Principal and founding member of Fieldstone Private Capital Group, an investment banking firm specializing in corporate, project and structured finance. Previously, he was employed at Bankers Trust Company, initially in the Private Equity and Merchant Banking Groups and subsequently in BT Securities, the securities affiliate of Bankers Trust. Mr. Marrus has an A.B. from Brown University and an M.B.A. from the Graduate School of Business, University of Chicago.
 
Mr. Marrus has been involved in mergers and acquisitions as an investment banker and has experience in company valuation in a wide range of industries, a critical skill set for us. We believe that Mr. Marrus’s background and experience make him appropriate to serve as one of our directors in light of our business and structure.
 
Richard I. Rudy has been one of our directors since August 2014. Since January of 2012, Mr. Rudy has been a founder and partner of Advanced Energy Capital, LLC, a private investment management concern with a focus on energy-related investments. Prior to that, beginning in 1997, Mr. Rudy was a principal of Stillwater; before that, he was Chief Financial Officer and general counsel of the Conway Stores, a New York-based chain of discount apparel stores. Mr. Rudy received a B.S. (summa cum laude) in accounting from Brooklyn College and a J.D. from New York University School of Law.
 
 
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Mr. Rudy has experience as a CFO, an attorney and a hedge fund principal, which positions him for all aspects of credit analysis and management. He spent several years at EF Hutton, a stock brokerage firm, and Drexel, Burnham & Lambert, formerly an investment banking firm focused on leveraged buyouts, advising high net worth clients with regard to alternatives to traditional equity and credit investments, including energy and real estate-related investments. Mr. Rudy spent several years in a variety of corporate financial/managerial capacities and was jointly responsible for founding and running a $1.3 billion investment advisor whose primary focus was credit and asset based lending. Over the last years he has spearheaded several energy-related transactions and has through Advanced Energy Capital and other vehicles, financed over $400 million in energy-related sales transactions. He has co-managed many investment funds and vehicles and has been featured at several alternative investment conferences around the world. He has served on the boards of directors of several privately held companies and charitable institutions. We believe that Mr. Rudy’s background and experience make him appropriate to serve as one of our directors in light of our business and structure.
 
Thomas J. Paup has been our Vice President – Finance since December 2005 and our Chief Financial Officer since February 2006; in May 2013, Mr. Paup was promoted to Senior Vice President. Mr. Paup is currently also a Finance Lecturer at Eastern Michigan University. Mr. Paup was an Affiliated Partner with McMillan|Doolittle LLP, a retail consulting firm, from March 2002 until accepting this position with us, and prior thereto, he was an Executive in Residence and Finance Instructor at DePaul University’s Kellstadt Graduate School of Business. Prior to his teaching experience, Mr. Paup spent over 25 years in the retail industry. Most recently, between 1997 and 2000, Mr. Paup was the Executive Vice President and Chief Financial Officer and member of the Board of Directors of Montgomery Ward and Company, formerly a private mail order and department store retailer. Mr. Paup brings a broad background of strategic and operational management experiences from the department store industry, where he served as CFO of Lord & Taylor, an upscale, specialty-retail department store chain, and Kaufmann’s, a department store that merged into Macy’s, Inc. (“Macy’s”), and Controller of Bloomingdale’s, an upscale chain of department stores owned by Macy’s, and Robinson-May, formerly a chain of department stores. Mr. Paup holds an MBA in Finance and a BBS from Eastern Michigan University.
 
Board Leadership Structure
 
From October 2002 until October 2014, we operated under the traditional U.S. board leadership structure with our chief executive officer serving as chairman of the board. However, upon the retirement of Mr. Ehrlich as our CEO after thirteen years in that position, our board re-evaluated its leadership structure. Beginning in October 2014 with the appointment of Mr. Esses as our new CEO, the board determined that it would be preferable for Mr. Ehrlich to continue to head our Board of Directors as its Executive Chairman. We believe this board leadership structure is best for our company and our shareholders as Mr. Esses begins his service as CEO of our company.
 
We believe it is the chief executive officer’s responsibility to run the company and the chairman’s responsibility to run the board. As directors continue to have more oversight responsibilities than ever before, we believe it is beneficial to have a chairman whose sole job is leading the board. In making its decision to change the leadership structure and appoint a separate chairman, the board considered Mr. Ehrlich’s long experience as our Chairman and as chairman of the board of other public companies, and the time that Mr. Esses will be required to devote to the CEO position in the current economic environment. By having Mr. Ehrlich serve as Executive Chairman of the Board, Mr. Esses will be able to focus his entire energy on running the company.
 
We believe our chief executive officer and our chairman have an excellent working relationship that has allowed Mr. Esses to make a good transition into the role of chief executive officer and will allow him to focus on growing our company in a difficult business environment. We believe this provides strong leadership for our board, while also positioning our CEO as the leader of the company in the eyes of our customers, employees and stockholders.
 
As part of our periodic board self-evaluation process, we evaluate our leadership structure to ensure that the board continues to believe that it provides the optimal structure for our company and stockholders. We recognize that different board leadership structures may be appropriate for companies in different situations. We believe our current leadership structure, with Mr. Esses serving as President and Chief Executive Officer and Mr. Ehrlich serving as Executive Chairman of the Board, is the optimal structure for our company at this time.
 
Our independent directors have not chosen to formally designate a lead independent director.
 
 
40

 
Committees of the Board of Directors
 
Our board of directors has an Audit Committee, a Compensation Committee, a Nominating Committee and an Executive and Finance Committee. The current composition of the various committees of the Board of Directors is as follows (the name of the chairman of each committee appears in italics):
 
Audit Committee
 
Compensation Committee
 
Nominating Committee
 
Executive and Finance Committee
Seymour Jones
Michael E. Marrus
Richard I. Rudy
 
Jay M. Eastman
Seymour Jones
Richard I. Rudy
 
Michael Marrus
Jay M. Eastman
Richard I. Rudy
 
Robert S. Ehrlich
Steven Esses
Michael E. Marrus
 
Audit Committee
 
The purpose of the Audit Committee is to review with management and our independent auditors the scope and results of the annual audit, the nature of any other services provided by the independent auditors, changes in the accounting principles applied to the presentation of our financial statements, and any comments by the independent auditors on our policies and procedures with respect to internal accounting, auditing and financial controls. The Audit Committee was established in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934, as amended. In addition, the Audit Committee is charged with the responsibility for making decisions on the engagement, compensation, retention and oversight of the work of our independent auditors. The Audit Committee consists of Prof. Jones (Chair) and Messrs. Marrus and Rudy. Each member of the Audit Committee is an “independent director,” as that term is defined in Rule 4200(a)(15) of the listing standards and Marketplace Rules of the National Association of Securities Dealers (the “NASD”) and the SEC’s Rule 10A-3. All Audit Committee members possess the required by law, the level of financial literacy. We have determined that Prof. Jones qualifies as an “audit committee financial expert” under applicable SEC and Nasdaq regulations. As required by law, the Audit Committee operates pursuant to a charter, available through a hyperlink located on the investor relations page of our website, at http://content.stockpr.com/arotech/media/b7c6b7bc3ea4b17ef9af28aab2221d6d.pdf.
 
Compensation Committee
 
The duties of the Compensa­tion Committee are to recommend compensation arrangements for our executive officers and review annual compensation arrangements for all other officers and significant employees.
 
The Compensation Committee consists of Dr. Eastman (Chair), Prof. Jones and Mr. Rudy. Each member of the Compensation Committee is an independent director as that term is defined in the NASD listing standards. The Compensation Committee operates under a formal charter that governs its duties, which charter is publicly available through a hyperlink located on the investor relations page of our website, at http://content.stockpr.com/arotech/media/249a9ac7cc90aa315f94037d49d2246e.pdf.
 
The Compensation Committee maintains compensation and incentive programs designed to motivate, retain and attract management and utilize various combinations of base salary, bonuses payable upon the achievement of specified goals, discretionary bonuses and grants of restricted stock. Our President and Chief Executive Officer, Mr. Steven Esses, our Executive Chairman, Mr. Robert S. Ehrlich, and our Chief Financial Officer, Mr. Thomas J. Paup, are all parties to employment agreements with us. The Compensa­tion Committee reviews the compensation, both cash and stock, of our executive officers on an annual basis, while taking into account as well changes in compensation during previous years. Some of these components, such as salary, are generally fixed and do not vary based on our financial and other performance; some components, such as bonus, are in whole or in part dependent upon the achievement of certain goals jointly agreed upon by our management and the Compensation Committee; and some components, such as stock options and restricted stock, have a value that is dependent upon our stock price at the time of award and going forward. The Compensation Committee reviews the compensation, both cash and stock, of our executive officers on an annual basis, while taking into account as well changes in compensation during previous years.
 
The Compensation Committee performs an annual review of our executive officers’ cash compensation and share and option holdings to determine whether they provide adequate compensation for the services they perform, as well as adequate incentives and motivation to our executive officers and whether they adequately compensate our executive officers relative to comparable officers in other companies.
 
Compensation Committee meetings typically have included, for all or a portion of some of the meetings, a representative of The Burke Group, Inc., a well-known consulting firm specializing in executive officer compensation, as well as preliminary discussion with our senior officers prior to our Compensation Committee deliberating without any members of management present. For compensation decisions, including decisions regarding the grant of equity compensation relating to executive officers (other than our Chairman and Chief Executive Officer), the Compensation Committee typically considers the recommendations of our Chairman and Chief Executive Officer.
 
 
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Nominating Committee
 
The Nominating Committee identifies and proposes candidates to serve as members of the Board of Directors. Proposed nominees for membership on the Board of Directors submitted in writing by stockholders to Arotech’s Secretary will be brought to the attention of the Nominating Committee. The Nominating Committee consists of Mr. Marrus (Chair), Dr. Eastman and Mr. Rudy. Each member of the Nominating Committee is an independent director as that term is defined in the NASD listing standards. The Nominating Committee makes recommendations to the Board of Directors regarding new directors to be selected for membership on the Board of Directors and its various committees. The Nominating Committee operates under a formal charter that governs its duties. The Nominating Committee’s charter is publicly available through a hyperlink located on the investor relations page of our website, at http://content.stockpr.com/arotech/media/9db8a8bd53ecd3f2d895b23986e237c8.pdf.
 
Executive and Finance Committee
 
The Executive and Finance Committee exercises the powers of the Board during the intervals between meetings of the Board, in the management of our property, business and affairs (except with respect to certain extraordinary transactions). The Executive and Finance Committee consists of Messrs. Ehrlich (Chair), Esses and Marrus.
 
Code of Ethics
 
We have adopted a Code of Ethics, as required by Nasdaq listing standards and the rules of the SEC, that applies to our principal executive officer, our principal financial officer and our principal accounting officer. The Code of Ethics is publicly available through a hyperlink located on the investor relations page of our website, at http://content.stockpr.com/arotech/media/df40a6c92bcbf0b776162586acce0841.pdf. If we make substantive amendments to the Code of Ethics or grant any waiver, including any implicit waiver, that applies to anyone subject to the Code of Ethics, we will disclose the nature of such amendment or waiver on the website or in a report on Form 8-K in accordance with applicable Nasdaq and SEC rules.
 
Code of Conduct
 
We have adopted a general Code of Conduct, as required by Nasdaq listing standards and the rules of the SEC, that applies to all of our employees. The Code of Conduct is publicly available through a hyperlink located on the investor relations page of our website, at http://content.stockpr.com/arotech/media/5c5e3b052edfcf1e78084a414a4c37c1.pdf.
 
Whistleblower Policy
 
We have adopted a Whistleblower Policy, as required by Nasdaq listing standards, in order to ensure compliance with the provisions of the Sarbanes-Oxley Act of 2002. The Whistleblower Policy is publicly available through a hyperlink located on the investor relations page of our website, at http://content.stockpr.com/arotech/media/6a9edfc8a5cd8b55aa0c9f4a6aef0363.pdf. Employees with complaints about our compliance with applicable legal and regulatory requirements relating to accounting, auditing and internal control matters may submit their complaints in person, by mail or other written communication or by telephone to our Complaint Administrator. The Complaint Administrator can be contacted anonymously, by submitting the form located on our corporate website at http://www.arotech.com/contact/ethics-compliance. Complaints sent in this manner will automatically be stripped of all computer-encoded information identifying the originating e-mail address, and will then automatically be forwarded to the Complaint Administrator’s regular e-mail address at Arotech.
 
Director Compensation
 
Non-employee members of our Board of Directors are entitled to a cash retainer of $8,000 (plus expenses) per quarter, plus $500 per quarter for each committee on which such outside directors serve ($1,000 per quarter for members of the Executive and Finance Committee). The Chairman of the Audit Committee receives an additional retainer of $1,500 per quarter, and the Chairman of the Compensation Committee receives an additional retainer of $1,000 per quarter. No per-meeting fees are paid. In addition, we have adopted a Non-Employee Director Equity Compensation Plan, pursuant to which non-employee directors receive an initial grant of a number of restricted shares having a fair market value on the date of grant equal to $25,000 upon their election as a director, and an annual grant on March 31 of each year of a number of restricted shares having a fair market value on the date of grant equal to $35,000. Each grant of restricted stock shall become free of restrictions in three equal installments on each of the first, second and third anniversaries of the grant, unless the director is removed from the Board of Directors for cause prior to such vesting. Restrictions lapse automatically in the event of a director being removed for service other than for cause, or being nominated as a director but failing to be elected, or death, disability or mandatory retirement. Furthermore, all restrictions lapse prior to the consummation of a merger or consolidation involving us, our liquidation or dissolution, any sale of substantially all of our assets or any other transaction or series of related transactions as a result of which a single person or several persons acting in concert own a majority of our then-outstanding common stock.
 
 
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The following table shows the compensation earned or received by each of our non-officer directors for the year ended December 31, 2014:
 
DIRECTOR COMPENSATION
 
Name
 
Fees
Earned or
Paid in
Cash
   
Stock
Awards
Granted
2014
   
Total
   
Stock
Awards
Vested(1)
2014
 
Dr. Jay M. Eastman
 
$
33,000
   
$
25,000
   
$
58,000
   
$
75,239
(2)
Seymour Jones
 
$
36,000
   
$
25,000
   
$
61,000
   
$
75,239
(3)
Michael E. Marrus
 
$
31,500
   
$
25,000
   
$
56,500
   
$
75,239
(4)
Arthur S. Leibowitz(7)
 
$
29,000
   
$
25,000
   
$
54,000
   
$
75,239
(5)
Richard I. Rudy
 
$
9,500
   
$
25,000
   
$
34,500
   
$
(6)
                     
(1)
This column reflects the 2014 compensation expense for stock based awards for the year ended December 31, 2014.
 
(2)
As of December 31, 2014, Dr. Eastman held 20,820 unvested restricted shares of our common stock that were awarded in 2014.
 
(3)
As of December 31, 2014, Prof. Jones held 20,820 unvested restricted shares of our common stock that were awarded in 2014.
 
(4)
As of December 31, 2014, Mr. Marrus held 20,820 unvested restricted shares of our common stock that were awarded in 2014.
 
(5)
As of December 31, 2014, Mr. Leibowitz held 20,820 unvested restricted shares of our common stock that were awarded in 2014.
 
(6)
As of December 31, 2014, Mr. Rudy held 6,983 unvested restricted shares of our common stock that were awarded in 2014.
 
(7)
This individual retired as a director effective August 11, 2014.
 
 
Significant Employees
 
Our significant employees as of February 28, 2015, and their ages as of December 31, 2014, are as follows:
 
Name
 
Age
 
Position
Dean Krutty
  49  
Senior Vice President, Operations – North America
Ronen Badichi
  49  
General Manager, Power Systems Division – Europe and Asia
Yaakov Har-Oz
  57  
Senior Vice President, General Counsel and Secretary
Norman E. Johnson
  62  
Corporate Controller, Chief Accounting Officer
 
Dean Krutty became President of the Simulation Division in January 2005, after having spent the prior thirteen years as a member of the FAAC management team, and was promoted to Arotech’s Senior Vice President, Operations – North America in January 2015. He began his career at FAAC as an electrical engineer in FAAC’s part task trainer division and served as FAAC’s Director of Operations prior to becoming its President. He also has significant experience managing programs in the training and simulation industry. Mr. Krutty holds a B.S. in electrical engineering from the Michigan State University.
 
Ronen Badichi became the General Manager of Epsilor Electronic Industries in May 2005 and the General Manager of our Power Systems Division – Europe and Asia in December 2007. Prior to joining Epsilor, Mr. Badichi served since 1999 as the General Manager of Maoz Industries, a high end supplier of displays to the aviation industry. Prior thereto, Mr. Badichi was a project manager at BAE Systems (LON: BA) and served as the F-16 Avionics Integration manager in the Israeli Air Force, with the rank of Captain. Mr. Badichi holds a B.Sc. in Physics and Electro-Optic Engineering from the Lev Institute of Technology in Jerusalem.
 
Yaakov Har-Oz has served as our Vice President and General Counsel since October 2000 and as our corporate Secretary since December 2000; in December 2005 Mr. Har-Oz was promoted to Senior Vice President. From 1994 until October 2000, Mr. Har-Oz was a partner in the Jerusalem law firm of Ben-Ze’ev, Hacohen & Co. Prior to moving to Israel in 1993, he was an administrative law judge and in private law practice in New York. Mr. Har-Oz holds a B.A. from Brandeis University in Waltham, Massachusetts and a J.D. from Vanderbilt Law School (where he was an editor of the law review) in Nashville, Tennessee. He is a member of the New York bar and the Israel Chamber of Advocates.
 
 
43

 
Norman E. Johnson has served as our Controller and as our Chief Accounting Officer since August 2006. Prior to joining Arotech, Mr. Johnson was the Corporate Controller with Catuity Inc., a provider of loyalty and gift card solutions. Prior to Catuity, he was with the McCoig Group, a Detroit based holding company, and from March 2000 to August 2004 he was the Corporate Controller of Learning Care Group Inc., a provider of child care and educational services recently acquired by the private equity firm American Securities LLC. Mr. Johnson holds a B.S. in Accounting from Central Michigan University in Mt. Pleasant, Michigan.
 
Section 16(a) Beneficial Ownership Reporting Compliance
 
Under the securities laws of the United States, our directors, certain of our officers and any persons holding more than ten percent of our common stock are required to report their ownership of our common stock and any changes in that ownership to the Securities and Exchange Commission. Specific due dates for these reports have been established and we are required to report any failure to file by these dates during 2014. We are not aware of any instances during 2014, not previously disclosed by us, where such “reporting persons” failed to file the required reports on or before the specified dates.
 
ITEM 11.                    EXECUTIVE COMPENSATION
 
Cash and Other Compensation
 
Summary Compensation Table
 
The following table, which should be read in conjunction with the explanations provided below, shows the compensation that we paid (or accrued) to our executive officers during the fiscal years ended December 31, 2014 and 2013:
 
SUMMARY COMPENSATION TABLE(1)
 
                   
Stock
             
                   
Awards
   
All Other
       
Name and Principal Position
 
Year
 
Salary
   
Bonus(2)
   
Granted(3)
   
Compensation
   
Total
 
Steven Esses
 
2014
 
$
330,946
(4)
 
$
374,600
   
$
223,000
   
$
516,356
(5)
 
$
1,444,902
 
President, Chief Executive
Officer and a director
 
2013
 
$
273,437
(6)
 
$
205,400
   
$
273,750
   
$
398,878
(7)
 
$
1,151,465
 
Robert S. Ehrlich (8)
 
2014
 
$
482,808
   
$
361,250
   
$
111,500
   
$
64,385
(9)
 
$
1,019,943
 
Executive Chairman of
the Board and a director
 
2013
 
$
444,356
   
$
379,900
   
$
365,000
   
$
135,423
(10)
 
$
1,324,679
 
Thomas J. Paup
 
2014
 
$
225,000
   
$
187,250
   
$
133,800
   
$
1,436
(11)
 
$
547,486
 
Senior Vice President –
Finance and Chief
Financial Officer
 
2013
 
$
201,400
   
$
100,500
   
$
273,750
   
$
(11)
 
$
575,650
 
 
(1)
We paid the amounts reported for each named executive officer in U.S. dollars and/or New Israeli Shekels (NIS). We have translated amounts paid in NIS into U.S. dollars at the exchange rate of NIS into U.S. dollars at the time of payment or accrual, except that certain items are pursuant to corporate policy paid at a set exchange rate that may be higher than the actual exchange rate on the date of payment. The difference, which was a positive number in 2014 and 2013, has been reported under “Salary.” The exchange rate differences for Mr. Ehrlich were $97,330 and $88,797 for 2014 and 2013, respectively. The exchange rate differences for Mr. Esses were $66,716 and $54,642 for 2014 and 2013, respectively.
(2)
Bonuses are performance-based, against criteria established by the Compensation Committee of the Board of Directors and approved by the full Board of Directors. See “Employment Contracts,” below.
(3)
Reflects the value of awards of restricted stock or restricted stock units granted to our executive officers based on the compensation cost of their stock-based awards; see Note 13.b. of the Notes to Consolidated Financial Statements. The number of shares of restricted stock or restricted stock units received by our executive officers pursuant to such awards in 2014, vesting entirely after one year (dependent 33% on tenure and 67% on performance), was as follows: Mr. Esses, 100,000; Mr. Ehrlich, 50,000; and Mr. Paup, 60,000. The number of shares of restricted stock or restricted stock units received by our executive officers pursuant to such awards in 2013, vesting entirely after one year (dependent 33% on tenure and 67% on performance), was as follows: Mr. Esses, 75,000; Mr. Ehrlich, 100,000; and Mr. Paup, 75,000. All of these shares vested in 2014.
 
 
44

 
(4)
Does not include approximately $124,723 that we paid in consulting fees to Sampen Corporation, a New York corporation owned by members of Steven Esses’s immediate family, from which Mr. Esses receives a salary. See “Item 13. Certain Relationships and Related Transactions – Consulting Agreement with Sampen Corporation,” below.
(5)
Of this amount, $119,570 represents payments to Israeli pension and education funds; $378,207 represents the change in our accrual for severance pay that will be payable to Mr. Esses upon his leaving our employ other than if he is terminated for cause, such as a breach of trust; $37,460 represents sick pay redemption; $4,544 represents the change in sick pay accruals; $(18,460) represents the change of our accrual for vacation pay; $825 represents tax reimbursements; and $3,298 represents other normal or mandated Israeli benefits.
(6)
Does not include approximately $148,723 that we paid in consulting fees to Sampen Corporation, a New York corporation owned by members of Steven Esses’s immediate family, from which Mr. Esses receives a salary. See “Item 13. Certain Relationships and Related Transactions – Consulting Agreement with Sampen Corporation,” below.
(7)
Of this amount, $38,745represents payments to Israeli pension and education funds; $38,856 represents the change in our accrual for severance pay that will be payable to Mr. Esses upon his leaving our employ other than if he is terminated for cause, such as a breach of trust; $28,680 represents sick pay redemption; $214,559 represents the change in sick pay accruals; $8,687 represents the change of our accrual for vacation pay; $750 represents tax reimbursements; and $68,601 represents other normal or mandated Israeli benefits.
(8)
Mr. Ehrlich was serving as our Chief Executive Officer until October 2014, at which time he became our Executive Chairman of the Board.
(9)
Of this amount, $31,013 represents the change in our accrual for severance pay that will be payable to Mr. Ehrlich upon his leaving our employ other than if he is terminated for cause, such as a breach of trust; $29,112 represents the change of our accrual for vacation pay; $857 represents tax reimbursements, $44,609 represents vacation days redemption and $17,018 represents other normal or mandated Israeli benefits.
(10)
Of this amount, $91,834 represents the change in our accrual for severance pay that will be payable to Mr. Ehrlich upon his leaving our employ other than if he is terminated for cause, such as a breach of trust; $32,205 represents the change of our accrual for vacation pay; $3,578 represents tax reimbursements and $7,806 represents other normal or mandated Israeli benefits.
(11)
Represents the increase (decrease) in our accrual for Mr. Paup for accrued but unused vacation days.
 
Executive Loans
 
In 2000, we extended a loan to one of our Named Executive Officers. This loan is summarized in the following table, and is further described under “Item 13. Certain Relationships and Related Transactions – Officer Loan,” below.
 
Name of Borrower
 
Date of Loan
 
Original
 Principal
Amount of Loan
   
Amount
Outstanding
as of
12/31/2014
 
Terms of Loan
Robert S. Ehrlich
 
02/09/2000
 
$
329,163
   
$
452,995
 
Twenty-five-year non-recourse loan to purchase our stock, secured by the shares of stock purchased.
 
Plan-Based Awards
 
Grants of Restricted Stock or Restricted Stock Units
 
During 2014, the Compensation Committee approved the grant of a total of 210,000 shares of restricted stock or restricted stock units to our executive officers (in connection with their amended and restated employment agreements). The table below sets forth each equity award granted to our executive officers during the year ended December 31, 2014.
 
GRANTS OF PLAN-BASED AWARDS
 
Name
 
Grant Date
 
All Other Stock
Awards: Number of
Shares of Stocks
   
Grant Date Fair Value of
Stock Awards (1)
 
Steven Esses(2)
 
12/15/2014
   
225,000
   
$
560,500
 
Robert S. Ehrlich(2)
 
12/15/2014
   
50,000
   
$
111,500
 
Thomas J. Paup(2)
 
12/15/2014
   
60,000
   
$
133,800
 
       
(1)
Reflects the aggregate market value of the shares of restricted stock or restricted stock units determined based on the closing price of our common stock on the Nasdaq Global Market on the date of grant.
 
(2)
The restricted shares or restricted stock units vest on December 31, 2015 (dependent 33% on tenure and 67% on performance).
 
 
 
45

 
Stock Option Exercises and Vesting of Restricted Stock Awards
 
Our executive officers did not exercise any stock options during 2014. The following table presents awards of restricted stock or restricted stock units that vested during the year ended December 31, 2014.
 
STOCK VESTED
 
Name
 
Number of Shares
Acquired on Vesting
(#)
   
Value Realized
on Vesting(1)
($)
 
Steven Esses
   
75,000
   
$
227,500
 
Robert S. Ehrlich
   
33,333
   
$
148,665
 
   
(1)
Reflects the aggregate market value of the shares of restricted stock or restricted stock units determined based on a per share price at vesting based on the closing price of our common stock on the Nasdaq Global Market.
 
Outstanding Equity Awards at Fiscal Year-End
 
The table below sets forth information for our executive officers with respect to option, restricted stock and restricted stock unit values at the end of the fiscal year ended December 31, 2014.
 
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END
 
   
Stock Awards
 
               
Equity Incentive Plan Awards
 
               
Number of
   
Market Value
 
   
Number of
   
Market Value
   
Unearned
   
of Unearned
 
   
Shares that
   
of Shares that
   
Shares that
   
Shares that
 
   
Have Not
   
Have Not
   
Have Not
   
Have Not
 
   
Vested
   
Vested(1)
   
Vested
   
Vested(1)
 
Name
   
(#)
   
($)
     
(#)
   
($)
 
Steven Esses
   
208,333
(2)
 
$
483,333
     
116,667
(3)
 
$
270,667
 
Robert S. Ehrlich
   
83,333
(4)
 
$
193,333
     
100,000
(5)
 
$
232,000
 
Thomas J. Paup
   
45,000
(6)
 
$
104,400
     
90,000
(7)
 
$
208,800
 
   
 (1)
Reflects the aggregate market value of the shares of restricted stock or restricted stock units determined based on a per share price at grant based on the closing price of our common stock on that day on the Nasdaq Global Market.
(2)
25,000 of these shares vest on January 1, 2015, 25,000 of these shares vest on June 30, 2015, 100,000 of these shares vest on December 31, 2015, 41,667 of these shares vest on December 31, 2016, and 41,666 of these shares vest on December 31, 2017, based solely on continued employment through such dates.
(3)
50,000 of these shares vest on January 1, 2015and 66,667 of these shares vest on December 31, 2016, based on continued employment through such dates and on achievement by us of certain performance criteria.
(4)
33,333 of these shares vest on January 1, 2015, 33,333 of these shares vest on June 30, 2015, and 16,667 of these shares vest on December 31, 2015, based solely on continued employment through such dates.
(5)
66,667 of these shares vest on January 1, 2015 and 33,333 of these shares vest on December 31, 2016, based on continued employment through such dates and on achievement by us of certain performance criteria.
(6)
25,000 of these shares vest on January 1, 2015, and 20,000 of these shares vest on December 31, 2015, based solely on continued employment through such dates.
(7)
50,000 of these shares vest on January 1, 2015, and 40,000 of these shares vest on December 31, 2016, based on continued employment through such dates and on achievement by us of certain performance criteria.
 
 
46

 
Employment Contracts
 
Steven Esses
 
Mr. Esses is party to an amended and restated employment agreement with us effective October 1, 2014. The term of this employment agreement expires on December 31, 2017. The employment agreement provides that Mr. Esses will serve as our President and Chief Executive Officer.
 
The employment agreement provides for a monthly base salary of NIS 105,000 (approximately $27,666 per month at the rate of exchange in effect on November 10, 2014), as adjusted for Israeli inflation (but with no retroactive inflation adjustment for 2015 in respect of inflation during 2014) in an amount of not less than 3.5%. Additionally, the board may, at its discretion, raise Mr. Esses’s base salary. Mr. Esses also receives a retention bonus in the amount of 125,000 shares of restricted stock, vesting (contingent on continued employment) in three equal tranches on each of December 31, 2015, 2016 and 2017.
 
The employment agreement provides that if the results we actually attain in a given year are at least 100% of the amount we budgeted at the beginning of the year, we will pay a bonus, on a sliding scale, in an amount equal to a minimum of 25% of Mr. Esses’s annual base salary then in effect, up to a maximum of 75% of his annual base salary then in effect if the results we actually attain for the year in question are 110% or more of the amount we budgeted at the beginning of the year. For 2013 and 2014, the Compensation Committee choose financial targets for determining eligibility for the above-referenced cash incentive bonus that are determined in part on the achievement of set budgetary forecast targets for adjusted EBITDA, a non-GAAP measurement, and in part on the achievement of other targets – in the case of 2013, targets for revenues and adjusted EBITDA, and in the case of 2014, targets for adjusted EBITDA. Bonus targets will be chosen for 2015 based upon future budgetary forecasts.
 
The employment agreement also contains various benefits customary in Israel for senior executives, tax and financial planning expenses, and contains confidentiality and non-competition covenants.
 
We can terminate Mr. Esses’s employment agreement in the event of death or disability or for “Cause” (defined as conviction of certain crimes, willful failure to carry out directives of our board of directors or gross negligence or willful misconduct). Mr. Esses has the right to terminate his employment upon a change in our control or for “Good Reason,” which is defined to include adverse changes in employment status or compensation, our insolvency, material breaches and certain other events. Additionally, Mr. Esses may retire (after age 65), retire early (after age 55) or terminate his agreement for any reason upon 150 days’ notice.
 
Upon termination of employment, the employment agreement provides for payment of all accrued and unpaid compensation (including under most circumstances Israeli statutory severance), and (unless we have terminated the agreement for Cause or Mr. Esses has terminated the agreement without Good Reason and without giving us 150 days’ notice of termination) bonuses (to the extent earned) due for the year in which employment is terminated and severance pay equal to the greater of (i) twenty-four (24) times monthly salary, and (ii) NIS 4,430,250 (approximately $1,167,296 at the rate of exchange in effect on November 10, 2014). In addition, upon retirement or early retirement, Mr. Esses receives a further payment of up to $250,000. Furthermore, Mr. Esses will receive, in respect of all benefits, an additional sum in the amount of (i) $75,000, in the case of termination due to disability, Good Reason, death, or non-renewal, or (ii) $150,000, in the case of termination due to early retirement, retirement, change of control or change of location. Additionally, in respect of any termination due to a change of control or a change in the primary location from which Mr. Esses shall have conducted his business activities during the 60 days prior to such change or in the event of his death or disability, all outstanding options and all restricted shares will be fully vested. Restricted shares that have vested prior to the date of termination are not forfeited under any circumstances, including termination for Cause.
 
A table describing the payments that would have been due to Mr. Esses under his employment agreement had Mr. Esses’s employment with us been terminated at the end of 2014 under various circumstances appears under “Potential Payments and Benefits upon Termination of Employment – Steven Esses,” below.
 
In April 2009, we, with the agreement of Mr. Esses, funded a portion of his severance security by means of issuing to him, in trust, restricted stock having a value (based on the closing price of our stock on the Nasdaq Stock Market on the date on which Mr. Esses and our board of directors agreed on this arrangement) of $200,000, a total of 273,973 shares. In Mr. Esses’s new employment agreement, we agreed with him that these shares would still be restricted, but that the issuance of these shares to him would not reduce our severance obligations referred to above.
 
See also “Item 13. Certain Relationships and Related Transactions – Consulting Agreement with Sampen Corporation,” below.
 
 
47

 
Robert S. Ehrlich
 
Mr. Ehrlich is party to an amended and restated employment agreement with us effective in January 2015. The term of this employment agreement expires on December 31, 2017. The employment agreement provides that Mr. Ehrlich will serve as our Executive Chairman of the Board.
 
The employment agreement provides for a monthly base salary of NIS 98,822 (approximately $25,236 at the rate of exchange in effect on December 24, 2014), as adjusted for Israeli inflation (but with no retroactive inflation adjustment for 2015 in respect of inflation during 2014). Additionally, the board may, at its discretion, raise Mr. Ehrlich’s base salary.
 
The employment agreement also provides for an annual bonus divided into three tranches. The first tranche of the bonus is in an amount equaling between 20% and 50% of one-third of Mr. Ehrlich’s gross annual Base Salary, and is awarded based on the achievement of acquisition and finance objectives during the previous fiscal year, such objectives to be set by the Compensation Committee after consultation with management. The second and third tranches are based on the results we actually attain in a given year, and are paid on a sliding scale, in an amount equal to a minimum of 20% of two-thirds of Mr. Ehrlich’s annual base salary then in effect if the results we actually attain for the year in question are 100% of the amount we budgeted at the beginning of the year, up to a maximum of 50% of two-thirds of his annual base salary then in effect if the results we actually attain for the year in question are 110% or more of the amount we budgeted at the beginning of the year. Budget targets in the past have included combinations of revenues, EBITDA, backlog, and/or other factors. Mr. Ehrlich’s previous employment agreement had a similar bonus provision (but with a lower (20%) threshold bonus). For 2013 and 2014, the Compensation Committee choose financial targets for determining eligibility for the above-referenced cash incentive bonus that are determined in part on the achievement of set budgetary forecast targets for adjusted EBITDA, a non-GAAP measurement, and in part on the achievement of other targets – in the case of 2013, targets for revenues and adjusted EBITDA, and in the case of 2014, targets for adjusted EBITDA. Bonus targets will be chosen for 2015 based upon future budgetary forecasts.
 
The employment agreement also contains various benefits customary in Israel for senior executives, tax and financial planning expenses, and contains confidentiality and non-competition covenants.
 
We can terminate Mr. Ehrlich’s employment agreement in the event of death or disability or for “Cause” (defined as conviction of certain crimes, willful failure to carry out directives of our board of directors or gross negligence or willful misconduct). Mr. Ehrlich has the right to terminate his employment upon a change in our control or for “Good Reason,” which is defined to include adverse changes in employment status or compensation, our insolvency, material breaches and certain other events.
 
Upon termination of employment, the employment agreement provides for payment of all accrued and unpaid compensation and benefits (including under most circumstances Israeli statutory severance), and (unless we have terminated the agreement for Cause or Mr. Ehrlich has terminated the agreement without Good Reason) bonuses (to the extent earned) due for the year in which employment is terminated. Furthermore, in respect of any termination by us other than termination for Cause, all outstanding options and all restricted shares will be fully vested. Restricted shares that have vested prior to the date of termination are not forfeited under any circumstances, including termination for Cause.
 
The employment agreement further notes that Mr. Ehrlich’s severance payment of $1,625,400 under his prior agreement, which has been fully earned, has been paid to him (or that bank standing instructions have been issued with respect to such payment).
 
A table describing the payments that would have been due to Mr. Ehrlich under his employment agreement had Mr. Ehrlich’s employment with us been terminated at the end of 2014 under various circumstances (pursuant to the terms of his then-current employment agreement) appears under “Potential Payments and Benefits upon Termination of Employment – Robert S. Ehrlich,” below.
 
Thomas J. Paup
 
Mr. Paup is party to an amended and restated employment agreement with us executed in May 2013 and amended in January 2014, having a term running until December 31, 2015. The employment agreement provides that Mr. Paup will serve as our Senior Vice President – Finance and Chief Financial Officer. In January 2015, Mr. Paup’s employment agreement was amended to, among other things, extend the term through March 31, 2017 and to increase the number of vacation days Mr. Paup receives annually from 20 to 40.
 
Under the terms of his employment agreement as amended, Mr. Paup is entitled to receive a base salary of $250,000, as adjusted annually for inflation (but with no retroactive inflation adjustment for 2013 in respect of inflation during 2012).
 
 
48

 
The employment agreement provides that if the results we actually attain in a given year are at least 90% of the amount we budgeted at the beginning of the year, we will pay a bonus, on a sliding scale, in an amount equal to a minimum of 16.5% of Mr. Paup’s annual base salary then in effect, up to a maximum of 50% of his annual base salary then in effect if the results we actually attain for the year in question are 110% or more of the amount we budgeted at the beginning of the year. Mr. Paup’s previous employment agreement had a similar bonus provision (but with a higher (20%) threshold bonus). For 2013 and 2014, the Compensation Committee choose financial targets for determining eligibility for the above-referenced cash incentive bonus that are determined in part on the achievement of set budgetary forecast targets for adjusted EBITDA, a non-GAAP measurement, and in part on the achievement of other targets – in the case of 2013, targets for revenues and adjusted EBITDA, and in the case of 2014, targets for adjusted EBITDA. Bonus targets will be chosen for 2015 based upon future budgetary forecasts.
 
Mr. Paup’s employment agreement provides that if we terminate his agreement other than for cause (defined as conviction of certain crimes, willful failure to carry out directives of our board of directors or gross negligence or willful misconduct), we must pay Mr. Paup severance in an amount of twelve times his monthly salary. Restricted shares that have vested prior to the date of termination are not forfeited under any circumstances, including termination for Cause.
 
A table describing the payments that would have been due to Mr. Paup under his employment agreement had Mr. Paup’s employment with us been terminated at the end of 2014 under various circumstances (pursuant to the terms of his then-current employment agreement) appears under “Potential Payments and Benefits upon Termination of Employment – Thomas J. Paup,” below.
 
Others
 
Other employees have entered into individual employment agreements with us. These agreements govern the basic terms of the individual’s employment, such as salary, vacation, overtime pay, severance arrangements and pension plans. Subject to Israeli law, which restricts a company’s right to relocate an employee to a work site farther than sixty kilometers from his or her regular work site, we have retained the right to transfer certain employees to other locations and/or positions provided that such transfers do not result in a decrease in salary or benefits. All of these agreements also contain provisions governing the confidentiality of information and ownership of intellectual property learned or created during the course of the employee’s tenure with us. Under the terms of these provisions, employees must keep confidential all information regarding our operations (other than information which is already publicly available) received or learned by the employee during the course of employment. This provision remains in force for five years after the employee has left our service. Further, intellectual property created during the course of the employment relationship belongs to us.
 
A number of the individual employment agreements, but not all, contain non-competition provisions which restrict the employee’s rights to compete against us or work for an enterprise which competes against us. Such provisions generally remain in force for a period of two years after the employee has left our service.
 
Under the laws of Israel, an employee of ours who has been dismissed from service, died in service, retired from service upon attaining retirement age, or left due to poor health, maternity or certain other reasons, is entitled to severance pay at the rate of one month’s salary for each year of service, pro rata for partial years of service. We currently fund this obligation by making monthly payments to approved private provident funds and by its accrual for severance pay in the consolidated financial statements. See Note 2.q. of the Notes to the Consolidated Financial Statements.
 
Potential Payments and Benefits upon Termination of Employment
 
This section sets forth in tabular form quantitative disclosure regarding estimated payments and other benefits that would have been received by certain of our executive officers if their employment had terminated on December 31, 2014 (the last business day of the fiscal year), pursuant to the terms of their then-current employment agreements.
 
For a narrative description of the severance and change in control arrangements in the current employment contracts of Messrs. Esses, Ehrlich and Paup, see “– Employment Contracts,” above. Each of Messrs. Esses and Ehrlich will be eligible to receive severance payments in excess of accrued but unpaid items only if he signs a general release of claims.
 
Steven Esses
 
The following table describes the potential payments and benefits upon employment termination for Steven Esses, our President and Chief Executive Officer, pursuant to applicable law and the terms of his then-current employment agreement with us, as if his employment had terminated on December 31, 2014 (the last business day of the fiscal year) under the various scenarios described in the column headings as explained in the footnotes below.
 
 
49

 
See also “Item 13. Certain Relationships and Related Transactions – Consulting Agreement with Sampen Corporation,” below.
 
STEVEN ESSES
 
Payments
and Benefits
 
Non-
 Renewal(1)
   
Death or
 Disability(2)
   
Cause(3)
   
Good
 Reason(4)
   
Change of
 Control(5)
   
Retirement(6)
   
Early 
Retirement(7)
   
Other 
Employee 
Termination(8)
 
Accrued but unpaid(9):
                                               
Base salary
 
$
23,333
   
$
23,333
   
$
23,333
   
$
23,333
   
$
23,333
   
$
23,333
   
$
23,333
   
$
23,333
 
Vacation
   
78,441
     
78,441
     
78,441
     
78,441
     
78,441
     
78,441
     
78,441
     
78,441
 
Sick leave(10)
   
218,197
     
218,197
     
218,197
     
218,197
     
218,197
     
218,197
     
218,197
     
218,197
 
Recuperation pay(11)
   
324
     
324
     
324
     
324
     
324
     
324
     
324
     
324
 
Benefits:
                                                               
Manager’s insurance(12)
   
3,695
     
3,695
     
3,695
     
3,695
     
3,695
     
3,695
     
3,695
     
3,695
 
Continuing education fund(13)
   
1,750
     
1,750
     
1,750
     
1,750
     
1,750
     
1,750
     
1,750
     
1,750
 
Contractual severance
   
1,135,962
     
1,135,962
             
1,135,962
     
1,135,962
     
1,135,962
     
1,135,962
         
Statutory severance(14)
   
430,779
     
430,779
             
430,779
     
430,779
     
430,779
     
430,779
         
Benefits
                           
75,000
     
150,000
     
150,000
     
150,000
         
TOTAL:
 
$
1,892,481
   
$
1,892,481
   
$
325,740
   
$
1,967,481
   
$
2,042,481
   
$
2,042,481
   
$
2,042,481
   
$
325,740
 
   
 (1)
“Non-renewal” is defined in Mr. Esses’s employment agreement as a decision, made with written notice of at least 90 days in advance of the effective date of such decision, by either us or Mr. Esses not to renew Mr. Esses’s employment for an additional two-year term. Pursuant to the terms of Mr. Esses’s employment agreement, in the absence of such notice, Mr. Esses’s employment agreement automatically renews.
(2)
“Disability” is defined in Mr. Esses’s employment agreement as a physical or mental infirmity which impairs Mr. Esses’s ability to substantially perform his duties and which continues for a period of at least 180 consecutive days.
(3)
“Cause” is defined in Mr. Esses’s employment agreement as (i) conviction for fraud, crimes of moral turpitude or other conduct which reflects on us in a material and adverse manner; (ii) a willful failure to carry out a material directive of our Chief Executive Officer, provided that such directive concerned matters within the scope of Mr. Esses’s duties, would not give Mr. Esses “Good Reason” to terminate his agreement (see footnote 4 below) and was capable of being reasonably and lawfully performed; (iii) conviction in a court of competent jurisdiction for embezzlement of our funds; or (iv) reckless or willful misconduct that is materially harmful to us.
(4)
“Good Reason” is defined in Mr. Esses’s employment agreement as (i) (a) a change in Mr. Esses’s status, title, position or responsibilities which, in Mr. Esses’s reasonable judgment, represents a reduction or demotion in his status, title, position or responsibilities as in effect immediately prior thereto, (b) a change in the primary location from which Mr. Esses shall have conducted his business activities during the 60 days prior to such change, or (c) a change in the composition of a majority of the Board of Directors; or (ii) a reduction in Mr. Esses’s base salary; (iii) the failure by us to continue in effect any material compensation or benefit plan in which Mr. Esses is participating; (iv) our insolvency or the filing (by any party, including us) of a petition for our winding-up; (v) any material breach by us of any provision of Mr. Esses’s employment agreement; or (vi) any purported termination of Mr. Esses’s employment for cause by us which does not comply with the terms of Mr. Esses’s employment agreement.
(5)
Represents additional payment due to Mr. Esses should he terminate his employment under the circumstances set forth in clause (i)(c) of footnote 4 above.
(6)
“Retirement” is defined as Mr. Esses terminating his employment with us at age 65 or older on at least 150 days’ prior notice.
(7)
“Early Retirement” is defined as Mr. Esses terminating his employment with us at age 55 or older (up to age 65) on at least 150 days’ prior notice.
 
(8)
Any termination by Mr. Esses of his employment with us that does not fit into any of the prior categories, including but not limited to Mr. Esses terminating his employment with us, with or without notice, other than at the end of an employment term or renewal thereof, in circumstances that do not fit into any of the prior categories.
 
(9)
Does not include a total of $9,000 in accrued but unpaid consulting fees due at December 31, 2014 to Sampen Corporation, a New York corporation owned by members of Steven Esses’s immediate family, from which Mr. Esses receives a salary. See “Item 13. Certain Relationships and Related Transactions – Consulting Agreement with Sampen Corporation,” below.
 
(10)
Limited to an aggregate of 30 days.
 
(11)
Pursuant to Israeli law and our customary practice, we pay Mr. Esses in July of each year the equivalent of six days’ “recuperation pay” at the statutory rate of NIS 378 (approximately $97) per day.
 
(12)
Payments to managers’ insurance, a benefit customarily given to senior executives in Israel, come to a total of 15.83% of base salary, consisting of 8.33% for payments to a fund to secure payment of statutory severance obligations, 5% for pension and 2.5% for disability. The managers’ insurance funds reflected in the table do not include the 8.33% payments to a fund to secure payment of statutory severance obligations with respect to amounts paid prior to December 31, 2013, which funds are reflected in the table under the “Statutory severance” heading.
 
(13)
Pursuant to Israeli law, we must contribute an amount equal to 7.5% of Mr. Esses’s base salary to a continuing education fund, up to the permissible tax-exempt salary ceiling according to the income tax regulations in effect from time to time. At December 31, 2014, the ceiling then in effect was NIS 15,712 (approximately $4,040). In Mr. Esses’s case, we have customarily contributed to his continuing education fund in excess of the tax-exempt ceiling, and then reimbursed Mr. Esses for the tax. The sums in the table reflect this additional contribution and the resultant tax reimbursement.
 
(14)
Under Israeli law, employees terminated other than for cause receive severance in the amount of one month’s base salary for each year of work, at their salary rate at the date of termination.
 
 
 
50

 
Robert S. Ehrlich
 
The following table describes the potential payments and benefits upon employment termination for Robert S. Ehrlich, our Executive Chairman of the Board, pursuant to applicable law and the terms of his then-current employment agreement with us, as if his employment had terminated on December 31, 2014 (the last business day of the fiscal year) under the various scenarios described in the column headings as explained in the footnotes below.
 
ROBERT S. EHRLICH
 
Payments and Benefits
 
Death or
 Disability(1)
   
Cause(2)
   
Good
 Reason(3)
   
Other 
Employee 
Termination(4)
 
Accrued but unpaid:
                       
Base salary
 
$
32,123
   
$
32,123
   
$
32,123
   
$
32,123
 
Vacation
   
112,975
     
112,975
     
112,975
     
112,975
 
Recuperation pay(5)
   
405
     
405
     
405
     
405
 
Benefits:
                               
Continuing education fund(6)
   
2,409
     
2,409
     
2,409
     
2,409
 
Contractual severance
   
1,625,400
     
1,625,400
     
1,625,400
     
1,625,400
 
Statutory severance(7)
   
976,278
             
976,278
         
TOTAL:
 
$
2,749,590
   
$
1,773,312
   
$
2,749,590
   
$
1,773,312
 
   
(1)
“Disability” is defined in Mr. Ehrlich’s employment agreement as a physical or mental infirmity which impairs Mr. Ehrlich’s ability to substantially perform his duties and which continues for a period of at least 180 consecutive days.
(2)
“Cause” is defined in Mr. Ehrlich’s employment agreement as (i) conviction for fraud, crimes of moral turpitude or other conduct which reflects on us in a material and adverse manner; (ii) a willful failure to carry out a material directive of our Board of Directors, provided that such directive concerned matters within the scope of Mr. Ehrlich’s duties, would not give Mr. Ehrlich “Good Reason” to terminate his agreement (see footnote 4 below) and was capable of being reasonably and lawfully performed; (iii) conviction in a court of competent jurisdiction for embezzlement of our funds; or (iv) reckless or willful misconduct that is materially harmful to us.
(3)
“Good Reason” is defined in Mr. Ehrlich’s employment agreement as (i) a change in Mr. Ehrlich’s status, title, position or responsibilities which, in Mr. Ehrlich’s reasonable judgment, represents a reduction or demotion in his status, title, position or responsibilities as in effect immediately prior thereto; (ii) a reduction in Mr. Ehrlich’s base salary; (iii) the failure by us to continue in effect any material compensation or benefit plan in which Mr. Ehrlich is participating; (iv) our insolvency or the filing (by any party, including us) of a petition for our winding-up; (v) any material breach by us of any provision of Mr. Ehrlich’s employment agreement; (vi) any purported termination of Mr. Ehrlich’s employment for cause by us which does not comply with the terms of Mr. Ehrlich’s employment agreement; or (vii) any movement of the location where Mr. Ehrlich is generally to render his services to us from the Jerusalem/Tel Aviv area of Israel.
(4)
“Other Employee Termination” means a termination by Mr. Ehrlich of his employment other than for Good Reason.
(5)
Pursuant to Israeli law and our customary practice, we pay Mr. Ehrlich in July of each year the equivalent of ten days’ “recuperation pay” at the statutory rate of NIS 378 (approximately $97) per day.
(6)
Pursuant to Israeli law, we must contribute an amount equal to 7.5% of Mr. Ehrlich’s base salary to a continuing education fund, up to the permissible tax-exempt salary ceiling according to the income tax regulations in effect from time to time. At December 31, 2014, the ceiling then in effect was NIS 15,712 (approximately $4,040).
(7)
Under Israeli law, employees terminated other than for cause receive severance in the amount of one month’s base salary for each year of work, at their salary rate at the date of termination.
 
 
51

 
Thomas J. Paup
 
The following table describes the potential payments and benefits upon employment termination for Thomas J. Paup, our Senior Vice President – Finance and Chief Financial Officer, pursuant to applicable law and the terms of his then-current employment agreement with us, as if his employment had terminated on December 31, 2014 (the last business day of the fiscal year) under the various scenarios described in the column headings as explained in the footnotes below.
 
THOMAS J. PAUP
 
Payments and Benefits
 
Death or
 Disability(1)
   
Cause(2)
   
Non-Renewal(3)
   
Termination 
 at Will(4)
 
Accrued but unpaid:
                       
Base salary
 
$
225,000
   
$
225,000
   
$
225,000
   
$
225,000
 
Vacation
   
12,500
     
12,500
     
12,500
     
12,500
 
Contractual severance
   
250,000
             
250,000
     
250,000
 
TOTAL:
 
$
487,500
   
$
237,500
   
$
487,500
   
$
487,500
 
   
(1)
“Disability” is defined in Mr. Paup’s employment agreement as a physical or mental infirmity which impairs Mr. Paup’s ability to substantially perform his duties and which continues for a period of at least 180 consecutive days.
(2)
“Cause” is defined in Mr. Paup’s employment agreement as (i) a breach of trust by Mr. Paup, including, for example, but without limitation, commission of an act of moral turpitude, theft, embezzlement, self-dealing or insider trading; (ii) the unauthorized disclosure by Mr. Paup of confidential information of or relating to us; (iii) a material breach by Mr. Paup of his employment agreement; or (iv) any act of, or omission by, Mr. Paup which, in our reasonable judgment, amounts to a serious failure by Mr. Paup to perform his responsibilities or functions or in the exercise of his authority, which failure, in our reasonable judgment, rises to a level of gross nonfeasance, misfeasance or malfeasance.
(3)
“Non-Renewal” is defined in Mr. Paup’s employment agreement as the agreement coming to the end of the Term and not being extended or immediately succeeded by a new substantially similar employment agreement.
(4)
“Termination at Will” is defined in Mr. Paup’s employment agreement as Mr. Paup terminating his employment with us on written notice of at least 120 days in advance of the effective date of such termination.
 
ITEM 12.                    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
Security Ownership of Certain Beneficial Owners and Management
 
The following table sets forth information regarding the security ownership, as of March 18, 2015, of those persons owning of record or known by us to own beneficially more than 5% of our common stock and of each of our Named Executive Officers and directors, and the shares of common stock held by all of our directors and executive officers as a group.
 
Name and Address of Beneficial Owner(1)
 
Shares Beneficially
Owned(2)(3)
   
Percentage of Total
Shares Outstanding(3)
 
Robert S. Ehrlich
   
1,225,643
(4)
   
5.0
%
Steven Esses
   
1,171,480
(5)
   
4.8
%
Thomas J. Paup
   
316,896
(6)
   
1.3
%
Dr. Jay M. Eastman
   
79,329
(7)
   
*
 
Prof. Seymour Jones
   
79,329
(8)
   
*
 
Michael E. Marrus
   
82,619
(9)
   
*
 
Richard I. Rudy
   
6,983
(10)
   
*
 
All of our directors and executive officers as a group (7 persons)
   
2,962,279
(11)
   
12.0
%
   
*
Less than one percent.
(1)
The address of each named beneficial owner is in care of Arotech Corporation, 1229 Oak Valley Drive, Ann Arbor, Michigan 48108.