**Table of Contents**

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**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-K**

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**x****     ****ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For the fiscal year ended December 31, 2009**

 

**OR**

 

**o****        ****TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For the transition periodfrom              to    **

 

**Commission File No. 000-51995**

 

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**ETELOS****, INC.**

(Exact name of registrant as specified in itscharter)

 

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| **Delaware**                                                    | ** ** | **77-0407364**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |       | (I.R.S.  Employer Identification No.) |
| ** **                                                      | ** ** | ** **                            |
| **26828  Maple Valley Highway-#297**                            |       |                                  |
| **Maple  Valley, WA**                                           | ** ** | **98038**                             |
| (Address of principal  executive offices)                       |       | (Zip Code)                            |

 

**(425)458-4510**

Registrant’s telephone number

 

Securities registeredpursuant to Section 12(b) of the Exchange Act:

 
| **Title of Each Class** | ** ** | **Name of Each Exchange on Which Registered** |
|----------------------------------------|------------|-----------------------------------------------------------------------------|
| **None**                               | ** ** | **None**                                                                    |

 

Securities registered pursuantto Section 12(g) of the Exchange Act: **CommonStock, Par Value $0.01**

 

Indicate by check mark if the registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act...    Yes o No x

 

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o No x

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. x  Yes    o  No

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of 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 postsuch files).  o  Yes   o   No

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See definition of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

| Large accelerated filer o                                  |   | Accelerated filer o         |
|------------------------------------------------------------|--------|-----------------------------|
| Non-accelerated filer o(Do not check if a smaller company) |   | Smaller reporting company x |

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act). Yes o No x

 

The aggregate market value of the shares of common stock held bynon-affiliates of the issuer, based upon the closing price of the common stockas of the last business day of the registrant’s most recently completed secondfiscal quarter as reported on the OTC Bulletin Board ($0.36 per share), wasapproximately $2.16 million.  Shares ofcommon stock held by each executive officer and director and by each person whoowned 10% or more of the outstanding common stock have been excluded in thatsuch persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusivedetermination for other purposes.  Thedetermination of who was a 10% stockholder and the number of shares held bysuch person is based on Schedule 13D, Schedule 13G, and Form 4 filingswith the Securities and Exchange Commission as of June 30, 2009.

 

As of March 16, 2010, there were 23,939,810 shares of the issuer’scommon stock outstanding and 743,333 shares of the issuer’s New Series A Preferred stock outstanding.

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**EXPLANATORY NOTE**

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On February 8, 2007, TripathTechnology Inc., a Delaware corporation (“Tripath”)filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code.On February 1, 2008, the bankruptcy court issued an order confirmingapproval of the Plan of Reorganization, including the merger and the transferof all of Tripath’s existing assets into a separatebankruptcy estate and the discharge of all of Tripath’sliabilities.  The Plan of Reorganizationalso contemplated the merger of Etelos, Incorporated,a Washington corporation (“Etelos-WA”) with Tripath.   Theoverall impact of the confirmed Plan of Reorganization was for Tripath to emerge from the bankruptcy proceeding with noassets and no liabilities as a shell corporation and for all issued andoutstanding securities of and interests in Tripath,including debentures, stock options (including, but not limited to, all stockoptions granted to employees), warrants, and other shares of common stock to becanceled and extinguished.

 

On April 23, 2008, Tripathfiled a Current Report on Form 8-K announcing, among other things, that Etelos-WA merged with and into Tripath,and that the surviving corporation changed its name to Etelos, Inc.and its fiscal year end to December 31. The effective date of the merger was April 22, 2008, and Etelos, Inc., as the surviving corporation, willconduct the business and operations previously conducted by Etelos-WA.  In connection with the merger, alloutstanding shares of Etelos-WA common stock wereconverted into shares of Etelos, Inc. commonstock on a three for one ratio: one share of Etelos, Inc.common stock for every three shares of common stock of Etelos-WA.  Also in connection with the merger, (i) all outstanding shares of preferred stock of Etelos-WA were converted into shares of common stock of Etelos, Inc., (ii) Etelos, Inc.issued an aggregate of 5,010,000 shares of its common stock to the secured andunsecured creditors of Tripath and (iii) all theshares of Tripath were cancelled.  Prior to the merger, Tripathwas a shell corporation and in accordance with the Plan of Reorganization hadno assets or liabilities.  While Tripath acquired all the outstanding preferred and commonstock of Etelos-WA, for accounting purposes, theacquisition has been treated as a recapitalization of Etelos-WAwith Etelos-WA as the acquirer (a reverseacquisition).  The historical financialstatements prior to April 22, 2008, are those of Etelos-WAand the description of the business contained in this report as well as the onecontained in the financial statements reflect the operations of Etelos-WA for the quarterly and twelve month periods ended December 31,2008 and 2007.

 

Also, on April 23, 2008, Etelos, Inc.,formerly Tripath, amended its certificate ofincorporation with the state of Delaware to change its total authorized sharesof stock to 300,000,000 shares, of which 250,000,000 shares are designated “commonstock” with a par value of $0.01 per share and 50,000,000 shares are designated“preferred stock” with a par value of $0.01 per share.  The preferred stock may be issued from timeto time in one or more series, each of such series to consist of such number ofshares and to have such terms, rights, powers and preferences, and thequalifications and limitations with respect thereto, as stated in theresolutions providing for the issue of such series adopted by the board ofdirectors.

 

Information concerning number of shares outstandingfor Etelos, Inc. including the conversion pricesand number of shares issuable upon conversion ofconvertible securities and exercise prices of warrants and stock options andthe number of shares issuable upon exercise of suchoptions and warrants, has been adjusted to reflect the three for one conversionratio effected in connection with the merger as if it had occurred for allperiods presented.

 

In this report, unless the context indicatesotherwise, the terms “Etelos,” “Company,” “we,” “us,”and “our” refer to Etelos, Inc., a Delawarecorporation.

 

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**Etelos, Inc.**

 

**AnnualReport on Form 10-K**

 

**For theYear Ended December 31, 2009**

 

**TABLE OF CONTENTS**

 
| ** **        | ** **                                                                                                         | **Page** |
|-------------------|--------------------------------------------------------------------------------------------------------------------|----------|
|              |                                                                                                               |     |
| **PART I**   |                                                                                                               |
|              |                                                                                                               |     |
| ITEM 1.           | BUSINESS                                                                                                           | **1**    |
|              |                                                                                                               |     |
| ITEM 1A.          | RISK FACTORS                                                                                                       | **8**    |
|              |                                                                                                               |     |
| ITEM 1B.          | UNRESOLVED  STAFF COMMENTS                                                                                         | **19**   |
|              |                                                                                                               |     |
| ITEM 2.           | PROPERTIES                                                                                                         | **19**   |
|              |                                                                                                               |     |
| ITEM 3.           | LEGAL PROCEEDINGS                                                                                                  | **19**   |
|              |                                                                                                               |     |
| ITEM 4.           | REMOVED AND RESERVED                                                                                               | **20**   |
|              |                                                                                                               |     |
| **PART II**  |                                                                                                               |
|              |                                                                                                               |     |
| ITEM 5.           | MARKET FOR REGISTRANT’S COMMON EQUITY,  RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES | **20**   |
|              |                                                                                                               |     |
| ITEM 6.           | SELECTED  FINANCIAL DATA                                                                                           | **22**   |
|              |                                                                                                               |     |
| ITEM 7.           | MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                        | **22**   |
|              |                                                                                                               |     |
| ITEM  7A.         | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                        | **33**   |
|              |                                                                                                               |     |
| ITEM  8.          | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                                       | **33**   |
|              |                                                                                                               |     |
| ITEM 9.           | CHANGES IN AND DISAGREEMENTS  WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                              | **33**   |
|              |                                                                                                               |     |
| ITEM  9A.         | CONTROLS  AND PROCEDURES                                                                                           | **33**   |
|              |                                                                                                               |     |
| ITEM 9B.          | OTHER  INFORMATION                                                                                                 | **35**   |
|              |                                                                                                               |     |
| **PART III** |                                                                                                               |
|              |                                                                                                               |     |
| ITEM  10.         | DIRECTORS,  EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE                                                            | **35**   |
|              |                                                                                                               |     |
| ITEM  11.         | EXECUTIVE  COMPENSATION                                                                                            | **37**   |
|              |                                                                                                               |     |
| ITEM 12.          | SECURITY OWNERSHIP OF  CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS                    | **38**   |
|              |                                                                                                               |     |
| ITEM  13.         | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTION, AND DIRECTOR INDEPENDENCE                                          | **39**   |
|              |                                                                                                               |     |
| ITEM  14.         | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                            | **40**   |
|              |                                                                                                               |     |
| **PART IV**  |                                                                                                               |
|              |                                                                                                               |     |
| ITEM  15.         | EXHIBITS,  FINANCIAL STATEMENT SCHEDULES                                                                           | **40**   |
|              |                                                                                                               |     |
|              | SIGNATURES                                                                                                         | **43**   |
|              |                                                                                                               |     |
|              | FINANCIAL STATEMENTS                                                                                               | **44**   |

 

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**FORWARD LOOKING STATEMENTS**

 

This Annual Report on Form 10-K containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, or the “Securities Act,” and Section 21E of theSecurities Exchange Act of 1934 or the “Exchange Act.”  These forward-looking statements are subjectto certain risks and uncertainties that could cause actual results to differmaterially from historical results or anticipated results, including those setforth under the heading “Risk Factors” and elsewhere in, or incorporated byreference into, this report.

 

In some cases, you can identify forward lookingstatements by terms such as “may,” “intend,” “might,” “will,” “should,” “could,”“would,” “expect,” “believe,” “anticipate,” “estimate,” “predict,” “potential,”or the negative of these terms.  Theseterms and similar expressions are intended to identify forward-lookingstatements.  The forward-lookingstatements in this report are based upon management’s current expectations andbelief, which management believes are reasonable.  In addition, we cannot assess the impact ofeach factor on our business or the extent to which any factor or combination offactors, or factors we are aware of, may cause actual results to differmaterially from those contained in any forward looking statements.  You are cautioned not to place undue relianceon any forward-looking statements.  Thesestatements represent our estimates and assumptions only as of the date of thisreport.  Except to the extent required byfederal securities laws, we undertake no obligation to update any forward-lookingstatement to reflect events or circumstances after the date hereof or toreflect the occurrence of unanticipated events.

 

You should be aware that our actual results coulddiffer materially from those contained in the forward-looking statements due toa number of factors, including:

 

·                                          our abilityto obtain future financing or funds when needed;

·                                          marketacceptance and market demand for our products and services;

·                                          newcompetitors are likely to emerge and new technologies may further increase competition;

·                                          our operatingcosts may increase beyond our current expectations and we may be unable tofully implement our current business plan;

·                                          our abilityto successfully obtain a diverse customer base;

·                                          our abilityto protect our intellectual property through patents, trademarks, copyrightsand confidentiality agreements;

·                                          our abilityto attract and retain a qualified employee base;

·                                          our abilityto respond to new developments in technology and new applications of existingtechnology before our competitors;

·                                          acquisitions,business combinations, strategic partnerships, divestures, and othersignificant transactions may involve additional uncertainties; and

·                                          our abilityto maintain and execute a successful business strategy.

 

Other risks and uncertainties include those outlinedin risk factors detailed in this report and our other SEC filings.  You should consider carefully the statementsunder “Item 1A. Risk Factors” in Part I and other sections of this report,which address additional factors that could cause our actual results to differfrom those set forth in the forward-looking statements and could materially andadversely affect our business, operating results and financial condition.  All subsequent written and oralforward-looking statements attributable to us or persons acting on our behalfare expressly qualified in their entirety by the applicable cautionarystatements.

 

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**PART I**

 

**ITEM 1.                  BUSINESS**

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***Business***

 

We have a Web Applicationdistribution platform delivering Web Applications for businesses.  We provide a Software-as-a-Service (SaaS)ecosystem for building, distributing, and using Web Applications, including amarketplace to deploy and support them. Unlike other cloud computing and Platform-as-a-Service (PaaS) solutions,we enable software manufacturers to migrate existing applications or create newapplications, then package, distribute, host, bill, market and support theirSaaS enabled applications through multiple private label applicationsmarketplaces.

 

We have developedproducts for Web Applications, which include open standards-based tools for Webdevelopers, businesses and individual users such as the Etelos ApplicationServerTM (EASTM)and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support many common programminglanguages and also support our English Application Scripting Engine (EASETM), a simple-to-use open standards-based scriptinglanguage we developed.  In order tosupport broader adoption of our products, EASE and other components of the EDEare made available to developers at market appropriate pricing.  This is done to support the development ofnew Web Applications and the migration of existing Web Applications into theEtelos ecosystem where there are tools and other support mechanisms for themarketing, distribution, and support of these applications.

 

Our business model focuses on the sales and operationof private-label Web application marketplaces, including provision of theprofessional services required to develop, deploy and operate suchmarketplaces, and the launch of offerings of the Etelos Platform SuiteTM.   The EtelosPlatform Suite is designed to allow Independent Software Vendors (ISVs) toimplement a SaaS delivery version of their existing applications, whether ornot those applications are already Web Applications, and to syndicate theoffering of those applications through multiple private label marketplaces. Inthese difficult economic times, we believe that a variety of ISVs will haveapplications that they need to move to the Web for lower cost implementation,easier, simpler scalability, and broader distribution.  The EtelosPlatform Suite also enables Marketplace Partners, including non-technologybusinesses, to have their own private label marketplaces and tools to offerSaaS Web Applications to better serve their customers in multiple distributionchannels.

 

Although we have long enabled applications to bedistributed via the Web, we believe that our shift away from a direct marketingfocus to providing professional services and tools to ISVs will have four majorbenefits for our business.  First, thisoffering will expose the core platform to more ISVs for greater benefit totheir end users and the creation of a larger pool of applications forsyndication. Second, the development and operation of third party-brandedmarketplaces shifts the financial expense and operational burdens of sales andmarketing to end users to Marketplace Partners that better know their customersand are better capitalized to support necessary sales and marketing activities. Third, because this two-pronged go-to-market strategy is offered on arevenue-sharing basis, it fundamentally reduces barriers to acceptance byeliminating up front costs for Syndication Partners to offer their productsthrough multiple Marketplace Partners, and by charging Marketplace Partnersonly for sales success.   Finally, thisshift allows us to focus on our core competency in development and operation ofonline marketplaces, while better managing limited financial and otherresources.

 

In addition to revenuesfrom consulting services, we receive a transaction fee or subscription fee fortransactions that occur within these private-label Web applicationmarketplaces.  Most customers in thesemarketplaces pay a subscription fee, which we share with Syndication Partnersand Marketplace Partners; this revenue share is calculated as a percentage of grossrevenues from the sale of subscriptions to Syndication Partner offerings inprivate-label Web application marketplaces operating on the Etelos PlatformSuite.

 

***History***

 

We were originally organized as Etelos, Incorporated,a Washington corporation on May 5, 1999. We have been engaged in thebusiness of web application development and services since our inception.

 

On February 8, 2007, Tripath Technology Inc., aDelaware corporation (“Tripath”) filed a voluntary petition for relief underChapter 11 of the Bankruptcy Code. On February 1, 2008, the bankruptcycourt issued an order confirming approval of the Plan of Reorganization,including the merger and the transfer of all of Tripath’s existing assets intoa separate bankruptcy estate and the discharge of all of Tripath’sliabilities.  The Plan of Reorganizationalso contemplated the merger of Etelos, Incorporated with and into Tripath.

 

On April 22, 2008, we completed the merger withand into Tripath, changed the name of the surviving entity to Etelos, Inc.,and changed our fiscal year end to December 31.

 

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***Recent Developments***

 

On June 30, 2009, we restructured our January 2008and April 2008 Convertible 6% Secured Debentures in the principal amountof $5.5 million. Under the terms of the agreement, the terms of the debenturesare extended to December 31, 2012, interest accrues at 0% from the date ofthe agreement until October 1, 2010, and at 6% thereafter. All accrued butunpaid interest as of June 30, 2009, and interest due to be earned to September 30,2010 under the original terms of the January 2008 and April 2008Debentures was added to the principal amount and will be payable on the date ofmaturity.  Our obligation to make monthlyamortizing redemption payments has been terminated; we will make semi-annualinterest payments only. We also agreed to terminate the registration rightsagreement entered into in conjunction with the debentures and to exchange thewarrants issued in conjunction with the debentures for Etelos common stock on a1:1 basis.

 

On September 29, 2009, we entered into asecurities purchase agreement with three accredited investors for the sale of10% senior secured convertible debentures in the principal amount of $2.0million. We refer to these debentures as our September 2009Debentures.  In this transaction, inaddition to the debentures, we issued to the investors warrants topurchase 3,000,000 shares of our common stock with an exercise price of $0.60per share, or the “September 2009 warrants,” a warrant to purchase2,250,000 shares of our common stock with an exercise price of $0.01 per share,or the “ September 2009 par value warrant,” and 750,000 shares of ourrestricted common stock, or the “closing shares.”  One of the investorspaid part of its subscription amount through the cancellation of approximately$1.2 million worth of short-term indebtedness we owed to such investor.  The securities purchase agreement furtherprovided that we had the right, subject to certain conditions, to require theinvestors to purchase an aggregate of $1.0 million in additional principalamount of debentures.  We exercised thatright on December 15, 2009, and issued an additional $1.0 million ofdebentures to the investors on that date.

 

Subsequently,on January 25, 2010, we entered into a securities purchase agreement withan entity affiliated with Donald W. Morissette, who, together with his affiliates,beneficially owns more than 10% of our outstanding common stock, for the saleof 10% senior secured convertible debentures, identical to the September 2009Debentures, in the principal amount of $250,000. In this transaction, inaddition to the debentures, we issued a warrant to purchase 375,000 shares ofour common stock with an exercise price of $0.60 per share and 375,000 sharesof our restricted common stock, or the “closing shares.”  We refer to thisfinancing as our January 2010 financing in this report. The securitiespurchase agreement further provided that we had the right, subject to certainconditions, to require the investor to purchase an aggregate of $125,000 inadditional principal amount of debentures between March 15 and 31, 2010.We exercised that right on March 15, 2010, and issued $125 thousand inadditional debentures to an entity affiliated with Mr. Morissette.  See “MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS — Liquidity and Capital Resources”below for a description of the terms of all of our outstanding debentures.

 

In the quarter ended December 31, 2009, andsubsequently, we resolved a number of significant litigation items in a mannerthat we believe was generally favorable to the Company.  These matters asserted claims against theCompany in the aggregate amount of approximately $2.5 million, and were settledfor cash and note payments in the aggregate amount of approximately $400thousand, payable over the next 6-12 months, and the issuance of 346,667 sharesof common stock of the Company, valued at approximately $218 thousand.  In one of these matters, we repurchased andretired 2.4 million shares of our common stock - approximately 10% of the issuedand outstanding shares for $175,000.  See“LEGAL PROCEEDINGS” below.

 

In addition, payment schedules for approximately $300thousand in long overdue accounts payable have been negotiated for payment overthe next 6-12 months.

 

On December 22,2009, the board of directors, with Mr. Kolke and Mr. Rudy abstainingin the matters affecting them or their affiliates, authorized the issuance of (a) 434,754shares of Common Stock to Selma and Daniel Kolke, for payment of 45% of theprincipal and 100% of the accrued interest on the promissory note dated December 30,2007, which has been in default since September 2008; (b) 28,939 shares ofCommon Stock to Paul Stuit, for payment in full of principal and accruedinterest on the promissory note dated February 24, 2009, which was indefault; and (c) 143,379 shares of Common Stock to Ronald Rudy, forpayment in full of principal and accrued interest on the promissory note dated March 312009, which also was in default.  Thetransactions were effective on December 31, 2009, and the Common Stock wasissued at an effective price of $0.75 per share and the amount of notes payableto related parties converted to common stock by these issuances was $455,304.

 

In partial settlement ofapproximately $292 thousand of an aggregate $575 thousand in unpaid salariesdue and owing to current employees of the Company as of December 31, 2009,the board of directors has authorized the registration of 500,000 shares ofCommon Stock previously reserved under the Company’s 2009 Equity Incentive Planas partial payment of up to 50% of the amount of unpaid salary due and owing toeach current employee.  369,078 of thoseshares are to be issued upon completion of the registration process at aneffective price of $0.79 per share.

 

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***Industry Background***

 

The 1990s saw thewidespread adoption among large enterprises of packaged business managementapplications that automated a variety of departmental functions, such asaccounting, finance, order and inventory management, human resources, sales,and customer support. These sophisticated applications required significantcash outlays for the initial purchase and for ongoing maintenance and support. Inaddition, these applications were internally managed and maintained byenterprise customers, requiring increasingly large staffs to support complexinformation technology infrastructures. Most importantly, the applicationsgenerally were provided by multiple vendors, with each application providingonly a departmental view of the enterprise. To gain an enterprise-wide view,organizations attempted to tie together their various incompatible packagedapplications through long, complex, and costly integration efforts. Many ofthese attempts failed, in whole or in part, often after significant delay andexpense. As a consequence, many large enterprises have transitioned frommultiple point products to comprehensive, integrated business managementsuites, such as those offered by Oracle and SAP, as their core businessmanagement platforms.

 

Small-to-Medium sizedBusinesses (SMBs), which we define as businesses with up to 1,000 employees,have application software requirements that are similar, in many respects, tolarge enterprises because their core business processes are substantially thesame. These requirements include the integration of back-office activities,such as managing payroll and tracking inventory; front-office activities,including order management and customer support; and, increasingly,sophisticated e-commerce capabilities. According to a 2006 forecast for the CRMmarket and 2007 forecasts for the ERP and supply chain management, or SCM,markets from Gartner, Inc., companies in North America spent approximately$13.7 billion on ERP, CRM, and SCM software applications in 2006, of which SMBsaccounted for $4.4 billion, or 32 percent. Gartner projects that SMB spendingon these applications will grow 8.7 percent annually from 2006 to 2010,compared to 5.7 percent for large businesses.

 

SMBs are generally lesscapable than large enterprises of performing the costly, complex, andtime-consuming integration of multiple point products from one or more vendors.As a result, a comprehensive business suite may provide comparatively greaterbenefits and value for the SMB customer. Suites designed for, and broadlyadopted by, large enterprises to provide a comprehensive, integrated platformfor managing these core business processes generally are not well suited toSMBs due to the complexity and cost of such applications.

 

Recently, SMBs have begunto benefit from the development of the on-demand SaaS model. SaaS uses theInternet to provide users with access to software applications from a centrallyhosted computing facility through a web browser. SaaS eliminates the costsassociated with installing and maintaining applications within the customer’sinformation technology infrastructure. On-demand applications are generallylicensed for a monthly, quarterly or annual subscription fee, as opposed toon-premise enterprise applications that typically require the payment of a muchlarger, upfront license fee. As a result, on-demand applications requiresubstantially less initial and ongoing investment in software, hardware andimplementation services and lower ongoing support and maintenance, making themmore affordable for SMBs.

 

To date, the on-demandsoftware model has been applied to a variety of types of business softwareapplications, including CRM, security, accounting, human resources management,messaging, and others, and it has been broadly adopted by a wide variety ofbusinesses. IDC estimates worldwide on-demand enterprise software vendorrevenues were approximately $3.7 billion in 2006 and that they will grow 32percent annually through 2011 to $14.8 billion.

 

While SaaS applications have enabled SMBs to benefitfrom enterprise-class capabilities, most are still products that requireextensive, costly, and time-consuming integration to work with other applications.SMBs generally have been unable to implement a comprehensive set of businessmanagement products at an affordable level of cost that will enable them to runtheir businesses using a single system of records, provide real-time views oftheir operations, and be readily customizable and rapidly deployed andimplemented, especially in a geographically dispersed organization.

 

***EtelosTM Products and Services***

 

We have developed andoffer a range of products and services for developers and for consumers of WebApplications.  Our product offerings aregrouped into two basic programs: the Etelos EcosystemTM and the Etelos Platform SuiteTM.

 

The Etelos Ecosystem. The Etelos Ecosystem is a dynamicdevelopment, distribution, and consumption environment for scaling applicationsand providing business solutions to common business problems.  Ourecosystem is constantly being improved and expanded to contain the tools andsupport programs that help foster continued development of a network of addedvalue development and distribution partners.

 

Our products for WebApplications include open standards-based tools for Web developers, businessand individual users such as the Etelos Application ServerTM (EASTM) and theEtelos Development EnvironmentTM (EDETM).  EAS and EDE support manycommon application languages and also support the English Application ScriptingEngine (EASETM),our simple-to-use open standards scripting language.  In order to supportbroader adoption of our products, EASE and other components of our platform areprovided to developers and users at market appropriate pricing.  This isdone to support the development of new Web Applications and the migration ofexisting Web Applications into the Etelos ecosystem where there are tools andother support mechanisms for the marketing, distribution, sales and support ofthese applications.  We generally receive a transaction fee, arevenue-share based subscription fee or a license fee for transactions thatoccur within the Etelos Ecosystem via an Etelos Marketplace.

 

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Web Applications builtwith or brought to the Etelos Ecosystem are made available for distribution inan Etelos Marketplace as a subscription service using the Software-as-a-Service(SaaS) or software-on-demand business model. The Etelos Ecosystem givesdevelopers of Web Applications, including us, an easy place to distribute andsupport Web Applications.  Web Applications delivered through the EtelosMarketplace or through third-party branded Marketplaces operated by us can beeasily and conveniently billed, distributed and configured to provide updatesand support to users exactly in accordance with the developer’s desires,without requiring the developer to perform development unrelated to theunderlying Web Application or to operate a robust licensing and deliveryinfrastructure.  An Etelos Marketplace relieves the burdens to developersof delivery and support to the users of their Web Applications.  We alsoprovide additional paid professional services and support on behalf of ourSyndication and Marketplace Partners.

 

An Etelos Marketplace enablesrapid adoption of Web Applications by giving customers freedom of choice toselect from a wide array of fully customizable, on-demand businessapplications.  These applications may be deployed in the hostingenvironment of the customer’s choice, including hosting services providedthrough us. Web Applications built on our platform may be integrated with otherWeb Applications through the use of Etelos App SyncTM, hosted anywhere, and customized tocreate highly flexible business solutions.  Not only can businesses easilychoose from a range of Web Applications, but they can instantly “try or buy”them. The flexibility of the Etelos Ecosystem enables businesses to assemble aWeb Applications suite.  The Build-a-SuiteTM concept is ideally tailored for particularbusiness needs and building scalable solutions.

 

Etelos Platform Suite

 

The Etelos Platform Suite allows third parties touse our software platforms and our services to develop and operate privatelabel applications and marketplaces.  Webegan working with third parties on private label solutions in November 2008and our first customers launched their private label marketplaces in mid-fiscal2009.

 

There are four components to the Etelos PlatformSuite:

 

·                                          The SaaSApplication Platform enables technology providers to move their non-WebApplication or service to web-based SaaS distribution;

·                                          The SaaSMarketplace Platform enables third parties to offer a variety of syndicated WebApplications and services in a third party-branded SaaS marketplace;

·                                          The SaaSDistribution Platform allows technology companies and service providers todistribute additional Web Applications and services to customers on a SaaSplatform; and

·                                          The SaaSSyndication Platform lets SaaS providers distribute their Web Applications andservices through a network of third party-branded marketplaces.

 

The Etelos Platform Suite allowsour customers to take advantage of our tools and experience in the SaaS marketto move their existing applications to the Web for lower costimplementation, easier, simpler scalability, and broader distribution. Our Etelos Platform Suite enables Marketplace Partners, includingnon-technology businesses, to have their own private label marketplaces andtools to offer SaaS Web Applications to better serve their customers inmultiple distribution channels.

 

Etelos Web ApplicationHosting. By usingalmost any programming language a developer chooses, including our own EASElanguage, and by hosting Web Applications wherever users want, utilizing ourEtelos Application Server, the Etelos Development Environment allows ourpartners to extend solutions using our platform.  Our customers rely on our products and theproducts of our Syndication Partners to run their businesses, and, as a result,it is our responsibility to ensure the availability of our service. We continueto improve our infrastructure with the goal of maximizing the availability ofour Web Applications and those of our developers, distributors and users. We host on a highly-scalable network located in secure third-partyfacilities.  We have facility space, power, and Internet connectivityprovided by Network OS, a third party co-location and hosting provider, locatedin the Seattle, WA area. In anticipation of future growth, we may engageadditional providers and/or expand the number of data centers utilized withexisting vendors. Our hosting operations incorporate industry-standard hardwareand our EAS operating system and databases and application servers provide aflexible, scalable architecture. Elements of our products’ infrastructure canbe replaced or added with no interruption in service, helping to ensure thatthe failure of any single device will not cause a broad service outage.

 

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Professional Services.

 

We are developingrepeatable, cost-effective consulting and implementation services to assist ourcustomers with integrating Web Applications, using them on and off-line andimporting data from other systems. We provide support services to aid inchanging their business processes to take advantage of the enhanced flexibilityenabled by our Build-a-Suite concept. Build-a-Suite enables ourcustomers to implement cost reducing, scalable business processes within theirorganization and identifying, configuring, and customizing our products andthose of our partners for each unique business process and requirement, with agoal of entering data once and using it across the organization and across theapplications used by the business.

 

Our consulting andimplementation methodology leverages the nature of our on-demand WebApplication software architecture, the industry-specific expertise of ourprofessional services employees, and the design of the Etelos Ecosystem and private-labelWeb application marketplaces operating on the Etelos Platform Suite. They areused to simplify, reduce costs and expedite the implementation of scalable WebApplications to aid in better business operations. We generally employ a jointstaffing model for implementation projects in which we involve the customermore actively in the implementation process than traditional software companies.We believe this better prepares our customers to support their own applicationset.  In addition, because our Web Applications are on-demand, ourProfessional Services employees can remotely configure many applications formost situations. Our consulting and implementation services are generallyoffered on a fixed price basis. Our network of partners also providesprofessional services to our customers.

 

Customer Support andManagement.

 

Our technical supportorganization, with personnel in the United States, offers support via the Web24 hours a day, seven days a week. Our system allows for skills-based and timezone-based routing to address general and technical inquiries across allaspects of our services. For our direct customers and development partners, weoffer tiered customer support programs depending upon the service needs of bothour and their customers’ Web Applications. Support contracts typically have aone-year term. For customers who purchase Web Applications through distributionpartners, we attempt to assure a quality customer experience by providingprimary product support, instead of permitting the distribution partner toprovide that support.

 

***Etelos Benefits***

 

The advantages of our products and services are:

 

Open Standards.  Products distributed in an EtelosMarketplace are developed on open standards.  This foundation makes theproducts easy to develop, easy to adopt and integrate with other WebApplications, and easy to swap or modify to meet specific customer needs. The use of open standards for business applications distinguishes the productsin an Etelos Marketplace not only from comprehensive product suites from suchvendors of proprietary software as Microsoft, Oracle, and SAP, but also fromproducts offered by other SaaS vendors such as salesforce.com or NetSuite, thatrequire developers of Web Applications to adopt a high-cost proprietaryfoundation for their products, resulting in higher costs to both developers andtheir customers.

 

On-Demand Delivery Model. We deliver our products over theInternet as a license-based or subscription based service using a SaaS model,making adoption easy and scalability simple.  The SaaS delivery model alsoeliminates the need for customers to buy and maintain on-premise hardware andsoftware. Our products are designed to be reliable, scalable and secure. Ourarchitecture enables businesses to maintain very high levels of availability,scale easily as their business and customers grow while providing a safe andsecure environment for business-critical data and applications.

 

Low Total Cost ofOwnership. OurSaaS delivery model and each different Web Application’s ease of use andconfigurability aids in helping to significantly reduce implementation andmaintenance costs of hardware, software and services. The Etelos ecosystemvirtually eliminates the need for dedicated software development or informationtechnology support personnel. Customers subscribe to products through an EtelosMarketplace for a monthly fee based on the number of users and the productsthey select.  Subscription fees paid to us periodically, typicallymonthly, tend to be significantly less than typical upfront costs paid bybusinesses to purchase product licenses from other providers. Our on-demanddelivery model virtually eliminates ongoing maintenance and upgrade costsassociated with a typical distributed infrastructure. Because Web Applicationsdistributed in an Etelos Marketplace are developed on open standards anddelivered over the Internet, any desired customization can be highly targeted,and therefore usually performed at lower cost to the business customer.

 

Rapid Implementation. The Internet-based on-demand deliverymodel implemented by an Etelos Marketplace enables remote deployment andeliminates many of the steps and costs typically associated with on-premiseinstallations. Syndication Partners and their customers can implement ourofferings themselves, or work with our development partners or our professionalservices organization to meet their specific needs.

 

Security, Control andChoice.  Thecombination of open standards and Internet-based on-demand delivery and supportenabled using an Etelos Marketplace provides customers with security for theirimportant business data, control over the use and portability of that data, andflexibility and freedom of choice in Web Applications that provide built-inquality and scalability as solutions to specific business needs.

 

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***Sales and Marketing***

 

We generate sales throughboth indirect and direct approaches. Most selling of subscriptions for WebApplications and Hosting is done over the Internet.  Sales of customproducts and Professional Services tend to be direct. Our direct sales teamconsists of professionals in various locations in the United States, includingresellers, with additional development, distribution, and businessrelationships being developed in North America, South America, Europe, and theAsia-Pacific region.

 

Our Web Applications andHosting sales activities generally are the result of word of mouth, marketingprograms, or user referrals.  Our sales and support personnel provide webbased seminars, forums, and direct support services to ensure continuedsubscription sales.  The sales cycle typically ranges from days to months,and can vary based on the Web Application, the scope of any customizationdesired, and the scope of any professional services required to meet specificcustomer requirements.

 

Our sales process forCustom Products and Professional Services typically begins with the generationof a sales lead from a marketing program or customer referral. After the leadis qualified, our sales personnel conduct focused web-based demonstrationsalong with initial price discussions. Members of our professional services teamare engaged, as needed, to offer insight around aspects of the implementation.Our sales cycle typically ranges from days to months, but can vary based on thespecific application, the size and complexity of the potential customer’sinformation technology environment, and many other factors.

 

We tailor our marketingefforts around relevant application categories, customer sizes, and customerindustries. As part of our marketing strategy, we have established a number ofkey programs and initiatives, including online and search engine advertising,email campaigns, web based seminars, product launch events, trade show andindustry event sponsorship and participation, and marketing support fordevelopment and distribution partners.

 

***Customers***

 

As of December 31,2009, we had limited revenues, primarily from consulting projects for a verylimited number of customers in projects of varying sizes and duration.  During 2009, three customers comprised 77% ofour total revenues and each of these customers accounted for more than 10percent of our revenue during the year ended December 31, 2009. There were no accounts receivable from those three customers as of December 31,2009; one other customer accounts for 100% of the Company’s accountsreceivables as of December 31, 2009.

 

***Competition***

 

We compete with a broadarray of Enterprise Software, On-line Advertising and SaaS companies. Thesemarkets are highly competitive, fragmented, and subject to rapid changes intechnology. Many of our potential customers are seeking their first businessWeb Application and, as such, evaluate a wide range of alternatives duringtheir purchase process. We face significant competition within each of ourmarkets from companies with broad product suites and greater name recognitionand resources than us.  We also face competition from smaller companiesfocused on specialized solutions. To a lesser extent, we compete with internallydeveloped and maintained solutions.  Current competitors includeNetSuite,Inc., Epicor Software Corporation, Jamcracker, Intuit Inc., MicrosoftCorporation, SAP, The Sage Group plc, Amazon, salesforce.com, inc., and othersnot listed here, both public and private.

 

We believe that the principal competitive factors inour markets include:

 

·                                          freedom of choice in Web Applications;

·                                          service breadth and functionality;

·                                          performance, security, and reliability;

·                                          “Try and Buy”: the ability to tailor andcustomize services for a specific company, vertical or industry;

·                                          ease of use and replacement;

·                                          speed and ease of deployment, integrationand configuration;

·                                          total cost of ownership, includingsubscription, implementation and support costs;

·                                          sales and marketing approach; and

·                                          financial resources and reputation.

 

We believe that wecompete favorably with most of our competitors on the basis of each of thefactors listed above.  We further note, however, that certain of ourcompetitors have greater sales, marketing, and financial resources, moreextensive geographic presence, and greater name recognition than us. Inaddition, although we have extended the number of applications we haveintroduced for specific vertical markets, we may be at a disadvantage in certainother vertical markets compared to certain of our competitors. We may facefuture competition in our markets from other large, established companies, aswell as from emerging companies. In addition, we expect that there is likely tobe continued consolidation in the industry that could lead to increasedtechnology, price, and other forms of competition.

 

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***Intellectual Property***

 

Our success depends inpart upon our ability to protect our core technology and intellectual property.To accomplish this, we rely on a combination of intellectual property rights,including trade secrets, patents, copyrights and trademarks, as well ascustomary contractual protections. We view our patents, trade secrets, andknow-how as a significant component of our intellectual property assets, as wehave spent years designing and developing our products, which we believedifferentiates us from our competitors.

 

As of December 31,2009, we had multiple U.S. and foreign patent applications pending. We may fileadditional patent applications in the U.S. and elsewhere.  We do not knowwhether our pending or future patent applications will result in the issuanceof patents in the U.S. or elsewhere, or whether the examination process willrequire us to narrow our claims. Even if granted, there can be no assurancethat the pending patent applications will provide us with significantcompetitive protection.

 

We use a number ofunregistered trademarks.  We have not registered any trademarks or servicemarks.

 

We maintain a policyrequiring our employees, consultants and other third parties to enter intoconfidentiality and proprietary rights agreements and to control access tosoftware, documentation and other proprietary information.

 

We do not analyze thesoftware that we distribute from our ISV Syndication Partners to determine theadequacy of their intellectual property rights. We have not maintained operating controls or logs, or initiated orconducted any forensic, code history, ‘genealogy’ or other form of audit,analysis, processes, training, or code review of software code incorporatedinto any of our products or in other products offered by our ISV SyndicationPartners in any Etelos Marketplace.  These products may include codesubject to various forms of ‘open source’, ‘copyleft’ or similar licenses thatrequire as a condition of modification or distribution of software subject tosuch license(s) that [a] such software or other software combined ordistributed with such software be disclosed or distributed in source code form,or [b] such software or other software combined or distributed with suchsoftware, and any related intellectual property, be licensed on aroyalty-free basis, including for the purposes of making additional copies orderivative works of such software.  This may adversely affect our abilityto patent certain inventions or to license or distribute certain products —whether by open source license or other form of license or right — and mayresult in liability to unknown parties for infringement of their patents orother intellectual property rights.

 

The steps we have takento protect our intellectual property rights may not be adequate. Third partiesmay infringe or misappropriate our proprietary rights. Competitors may alsoindependently develop technologies that are substantially equivalent orsuperior to the technologies we employ in our services. Failure to protect ourproprietary rights adequately could significantly harm our competitive positionand operating results.

 

In addition, we licensethird-party technologies that are incorporated into some elements of ourservice offerings. Licenses of third-party technologies may not continue to beavailable to us at a reasonable cost, or at all.

 

The software andtechnology industries are characterized by the existence of a large number ofpatents, copyrights, trademarks, and trade secrets and by frequent litigationbased on allegations of infringement or other violations of intellectualproperty rights. As we face increasing competition, the possibility ofintellectual property rights claims against us grows. Many of our commercialagreements require us to indemnify our customers for third-party intellectualproperty infringement claims, which would increase our costs as a result ofdefending those claims and might require that we pay damages if there were anadverse ruling in any such claims.

 

With respect to anyintellectual property rights claim against us or our customers, we may have topay damages or stop using technology found to be in violation of a third party’srights. We may have to seek a license for the technology, which may not beavailable on reasonable terms, may significantly increase our operatingexpenses, or may require us to restrict our business activities in one or morerespects. The technology also may not be available for license to us at all. Asa result, we may be required to develop alternative non-infringing technology,which could require significant effort and expense.

 

***Research and Development***

 

During the years ended December 31,2009, and 2008, research and development expenses were $1.3 million and $2.6million, respectively, and consisted primarily of employee and employee-relatedexpenses.  To date, we have expensed allof our product development costs as incurred; we do not capitalize softwaredevelopment costs.

 

***Employees***

 

As of December 31, 2009, we had 12 full-timeemployees and one part-time employee. From time to time, we also engage temporary employees and consultants.None of our employees are represented by a labor union with respect to his orher employment with us.  We consider ourrelationships with our employees to be satisfactory.  However, we have experienced significantoperating issues which have caused us to reduce employment and reducecompensation paid to our employees.  See “RISKFACTORS - *We have reduced our employment force and havechallenges meeting our operating demands”* below.

 

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***Additional Information***

 

Our annual and quarterly reports, along with all otherreports and amendments filed with or furnished to the SEC are publiclyavailable free of charge on the Investor section of our website atwww.etelos.com as soon as reasonably practicable after these materials arefiled with or furnished to the SEC. Our corporate governance policies, ethicscode and board of directors’ committee charters are also posted within thissection of the website. The information on our website is not part of this orany other report we file with, or furnish to, the SEC. The SEC also maintainsan Internet site that contains reports, proxy and information statements, andother information regarding issuers that file electronically with the SEC. Theaddress of that site is www.sec.gov.

 

**ITEM1A.**                                            RISK FACTORS

** **

Investment in our common stock involves a high degreeof risk. You should carefully consider the risks described below together withall of the other information included in this report before making aninvestment decision. If any of the following risks actually occur, ourbusiness, financial condition or results of operations could suffer. In thatcase, the market price of our common stock could decline, and you may lose allor part of your investment.

 

***Our current cash will fund ourbusiness as currently planned only through early-mid 2010. We need additionalfunding or we will be forced to curtail or cease operations.***

 

We need immediate and substantial cash to continue ouroperations. Management has projected that cash on hand will be sufficient onlyto allow us to continue our operations through early-mid 2010.  We are presently engaged in activediscussions for additional investments by existing and prospective investorsbut we currently have no funding commitments. We have not made required payments under our outstanding debt securitiesand the holders of our outstanding debt securities have the right to demandpayment of the amounts currently due under such securities or exercise theirother remedies, such as foreclosing on our assets.  We also need to make payments and negotiatepayment plans for certain notes payable and other payables and there is a riskthat trade creditors will not accept deferred payment and may exercise otherremedies to collect balances due and owing. We therefore will need additionalfunding, either through equity or debt financings, or we will be forced tocurtail or cease operations or consider other strategic alternatives such asbankruptcy.

 

***We have a substantially reducedemployment force and have challenges meeting our operating demands.***

 

We have decreased our number of full-time employeesfrom 46 at June 30, 2008, to 12 as of December 31, 2009.  All except the three lowest paid currentemployees are being paid less than full salary, ranging from 97% to 74% of netsalary, and there is no assurance that any of these personnel will be able tocontinue to work on this payment arrangement. Our operating plan has placed,and our anticipated growth plan is expected to continue to place, a significantstrain on our very limited managerial, administrative, operational, financial,and other resources, compounded by these recent reductions in headcount.Although we will be required to continue to improve our operational, financial,and management controls and our reporting procedures it is clear that we maynot be able to do so effectively and may not be able to recruit or retainadequate, qualified personnel to meet our operating demands. As such, we may beunable to manage our expenses effectively in the future, which may negativelyimpact our gross margins or operating expenses in any particular quarter.

 

***We have a history of losses andare currently carrying a net loss.  Ifour business model is not successful, or if we are unable to generatesufficient revenue to offset our expenditures, then we may not become profitableand you may lose your entire investment in our company.***

 

We have not been profitable on an annual or quarterlybasis since our formation.  We incurrednet losses of $6.8 million and $19.3 million for the years ended December 31,2009, and 2008, respectively, and have an accumulated deficit of $36.6 millionat December 31, 2009.  Although ourrevenue has slightly increased and our costs of sales and expenses havedecreased, our growth has been insignificant and future revenue growth may notbe sustainable and we may not achieve sufficient revenue to achieve or maintainprofitability.  We have incurred and maycontinue to incur significant losses in the future, for a number of reasonsincluding the other risks described in this report, and we may encounter unforeseenexpenses, difficulties, complications, delays, and other unknown factors.  Accordingly we may not be able to achieve ormaintain profitability and we may continue to incur significant losses in theforeseeable future. These losses may require us to scale back our business,sell or license some or all of our technology or assets, or curtail or ceaseoperations.

 

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***Our limited operating history maynot serve as an adequate basis to judge our future prospects and results ofoperations.***

 

We began our operations in 1999 but we did not adoptthe SaaS on-demand Web Application delivery model until 2005, and we haverecently changed our basic business model. Our limited operating history in theSaaS industry may not provide a meaningful basis on which to evaluate ourbusiness. Since our inception our revenues have not always grown from year toyear.  We cannot assure you that we willachieve our growth targets, or that we will achieve positive cash-flow orprofitability, or that we will not incur negative cash flow or net losses in thefuture. We expect that our operating expenses will increase as we expand. Anysignificant failure to realize anticipated revenue growth could result insignificant operating losses beyond our forecasts. We will continue toencounter risks and difficulties frequently experienced by companies at asimilar stage of development, including our potential failure to:

 

·                                          maintain andimprove our technology;

·                                          expand ourproduct and service offerings and maintain the high quality of products andservices offered;

·                                          sell ourproducts and services to sufficient, quality customers to produce revenuesadequate to meet our operating needs;

·                                          manage ourexpanding operations, including the integration of any future acquisitions;

·                                          obtainsufficient working capital to support our expansion and to fill customers’orders in time;

·                                          maintainadequate control of our expenses;

·                                          implement ourproduct development, marketing, sales, and acquisition strategies and adapt andmodify them as needed; and/or

·                                          anticipateand adapt to changing conditions in the markets in which we operate as well asthe impact of any changes in government regulation, mergers and acquisitionsinvolving our competitors, technological developments, and other significantcompetitive and market dynamics.

 

If we are not successful in addressing any or all ofthese risks, then our business may be materially and adversely affected.

 

***We may encounter substantialcompetition in our business and our failure to compete effectively mayadversely affect our ability to generate revenue.***

 

We face competition from both traditional softwarevendors and other SaaS providers. Many of our actual and potential competitorsenjoy substantial competitive advantages over us, such as greater namerecognition, longer operating histories, more varied products and services, andlarger marketing budgets, as well as substantially greater financial,technical, and other resources. In addition, many of our competitors haveestablished marketing relationships and access to larger customer bases, andhave major distribution agreements with consultants, system integrators, andresellers. If we are not able to compete effectively, then our operatingresults will be harmed.

 

We believe that existing and new competitors willcontinue to improve the design and performance of their products and tointroduce new products with competitive price and performance characteristics.We expect that we will be required to continue to invest in product developmentand productivity improvements to compete effectively in our markets. Ourcompetitors could develop better technology or more efficient products orundertake more aggressive and costly marketing campaigns than ours, which mayadversely affect our marketing strategies and could have a material adverse effecton our business, results of operations, and financial condition.

 

Our major competitors may be better able than us tosuccessfully endure downturns in our markets. In periods of reduced demand forour products, we can either choose to maintain market share by reducing oursubscription prices to meet competition or maintain subscription prices, whichlikely would result in sacrifice of our market share. Sales and overallprofitability would be reduced and sustained losses may continue in eithercase. In addition, we cannot be assured that additional competitors will notenter our existing markets, or that we will be able to compete successfullyagainst existing or new competition.

 

***The market for on-demand WebApplications may develop more slowly than we expect.***

 

Our success will depend, to a large extent, on thewillingness of individuals and SMBs to accept on-demand services for WebApplications that they view as critical to the success of their business. Manybusinesses have invested substantial effort and financial resources tointegrate traditional enterprise software into their businesses and may bereluctant or unwilling to switch to a different application or to migrate theseapplications to on-demand Web Applications.

 

Other factors that may affect market acceptance of ourWeb Applications include our ability to:

 

·                                          minimize thetime and resources required to implement products distributed through an EtelosMarketplace;

·                                          maintain highlevels of customer satisfaction;

·                                          implementupgrades and other changes to our products without disrupting our service;and/or

·                                          provide rapidresponse time during periods of intense activity on customer websites.

 

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In addition, market acceptance of our Web Applicationsmay be affected by:

 

·                                          the securitycapabilities, reliability, and availability of on-demand services;

·                                          customerconcerns with entrusting a third party to store and manage their data,especially confidential or sensitive data;

·                                          the level ofcustomization or configuration we offer; and/or

·                                          the price,performance, and availability of competing products and services.

 

***Our inability to fund our capitalto meet our expenditure requirements may adversely affect our growth andprofitability.***

 

Our continued growth is dependent upon our ability toraise capital from outside sources. Our ability to obtain financing will dependupon a number of factors, including our financial condition and results ofoperations, the condition of the economy, and conditions in relevant financialmarkets.  If we are unable to obtainfinancing, as needed, on a timely basis and on acceptable terms, our financialposition, competitive position, growth, and profitability may be adverselyaffected.  The current state of the USand global economy raises substantial doubts, especially about our ability toraise the additional capital that we will need to sustain our businessoperations.

 

***Our customers are individuals,small and medium-sized businesses, and divisions of large companies, which mayincrease our costs to reach, acquire and retain customers.***

 

We market and distribute our products and services andother offerings in Private-label Web application marketplaces operating on theEtelos Platform Suite to individuals, SMBs, and divisions of largecompanies. To grow our revenue quickly, we must add new customers, selladditional services to existing customers, and encourage existing customers torenew their subscriptions. However, selling to and retaining individuals andSMBs can be more difficult than selling to and retaining large enterprisesbecause SMB customers tend to be more price sensitive and more difficult toreach with broad marketing campaigns.  Inaddition, individuals and SMBs have high churn rates in part because of thenature of their businesses and often lack the staffing to benefit fully fromour products.  Further, individuals andSMBs often require higher sales, marketing, and support expenditures by vendorsthat sell to them per revenue dollar generated for those vendors.

 

***Many of our customers are pricesensitive, and if the prices that we or our Syndication Partners charge forsubscriptions to products or services offered in an Etelos Marketplace areunacceptable to our customers, then our operating results will be harmed.***

 

Many of our customers are price sensitive, and we havelimited experience with respect to determining the appropriate prices for ourproducts or services. In addition, we have no control over prices charged byour Syndication Partners for their products or services offered in an EtelosMarketplace. As the market for our products or services matures, or as newcompetitors introduce new products or services that compete with ours, we maybe unable to renew agreements with existing customers or attract new customersat the same price or based on the same pricing model as previously used. As aresult, it is possible that competitive dynamics in our market may require usto change pricing models or reduce prices, which could harm our revenue, grossmargin, and operating results.

 

***We may not be able to preventothers from unauthorized use of our patents and other intellectual property,which could harm our business and competitive position.***

 

Our success depends, in part, on our ability toprotect our proprietary technologies. We rely on a combination of patent,copyright, trademark, and trade secret laws, as well as confidentialityprocedures and contractual restrictions, to establish and protect ourintellectual property rights on a global basis, all of which provide onlylimited protection.

 

We own multiple filed United States and foreign patentapplications covering our technology and we expect to file more U.S. andforeign patent applications in the future. We have filed to protect most ofthose patents in many foreign countries. But the process of seeking patentprotection can be lengthy and expensive. We cannot assure you that any patent will issue from our currentlypending patent applications in a manner that gives us the protection that weseek, if at all, or that any future patents issued to us will not bechallenged, invalidated, or circumvented. Since the filing of some of thesepatent applications may have been, or will be, made after the date of firstsale or disclosure of the subject inventions, patent protection may not beavailable for these inventions outside the United States.  Any patents that may issue in the future maynot provide sufficiently broad protection or they may not prove to beenforceable in actions against alleged infringers. Also, we cannot assure youthat any future service mark or trademark registrations will be issued forpending or future applications or that any registered service marks ortrademarks will be enforceable or provide adequate protection of our domesticand foreign proprietary rights.

 

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We do not analyze the software that we distribute fromour ISV Syndication Partners to determine the adequacy of their intellectualproperty rights.  We have not maintainedoperating controls or logs, or initiated or conducted any forensic, codehistory, ‘genealogy’ or other forms of audit, analysis, processes, training, orcode review of software code incorporated into any Etelos product or in otherproducts offered by our ISV Syndication Partners in any Etelos Marketplace.These products may include code subject to various forms of ‘open source’, ‘copyleft’,or similar licenses that require as a condition of modification or distributionof software subject to such license(s) that (i) such software orother software combined or distributed with such software be disclosed ordistributed in source code form, or (ii) such software or other softwarecombined or distributed with such software, and any related intellectualproperty, be licensed on a royalty-free basis, including for the purposes ofmaking additional copies or derivative works of such software.  This may adversely affect our ability topatent certain inventions or to license or distribute certain products -whether by open source license or other form of license or right - and mayresult in liability to unknown parties for infringement of their patents orother intellectual property rights.

 

***We require our SyndicationPartners to indemnify us for intellectual property claims but we cannot assurethat these agreements will be enforceable.***

 

We endeavor to enter into agreements with ouremployees and contractors and agreements with parties with whom we do businessto limit access to and disclosure of our proprietary information. The steps wehave taken, however, may not prevent unauthorized use or the reverseengineering of our technology. Moreover, others may independently developtechnologies that are competitive to ours or infringe our intellectualproperty. Enforcement of our intellectual property rights also depends on oursuccessful legal actions against these infringers, but these actions may not besuccessful, even when our rights have been infringed.  In addition, the legal standards relating tothe validity, enforceability, and scope of protection of intellectual propertyrights in Internet-related industries are uncertain and still evolving.

 

***Assertions by third parties thatwe infringe their intellectual property, whether successful or not, couldsubject us to costly and time-consuming litigation or expensive licenses.***

 

The software and technology industries arecharacterized by the existence of a large number of patents, copyrights,trademarks, and trade secrets and by frequent litigation based on allegationsof infringement or other violations of intellectual property rights. As we faceincreasing competition, the possibility of intellectual property rights claimsagainst us may grow; the costs of defending against such claims can be verylarge. Our technologies may not be able to withstand any third-party claims orrights against their use. Additionally, many of our partner and productagreements require us to indemnify our customers for certain third-partyintellectual property infringement claims, which could increase our costs as aresult of defending such claims and may require that we pay damages or purchaseexpensive licenses, if there were an adverse ruling related to any such claims.These types of claims could harm our relationships with our customers, maydeter future customers from subscribing to our services, or could expose us tolitigation for these claims. Even if we are not a party to any litigationbetween a customer and a third party, an adverse outcome in any such litigationcould make it more difficult for us to defend our intellectual property in anysubsequent litigation in which we are a named party.

 

Any intellectual property rights claim against ourcustomers, or us, with or without merit, could be time-consuming, expensive tolitigate or settle, and could divert management attention and financialresources. An adverse determination also could prevent us from offering ourproducts to our customers and may require that we procure or develop substituteservices that do not infringe.

 

For any intellectual property rights claim against usor against our Marketplace Partners or customers, we may have substantialdirect and indirect costs.  Direct costscan include a requirement to pay damages or stop using technology found to bein violation of a third party’s rights. We may have to purchase a license forthe technology, which may not be available on reasonable terms, if at all, maysignificantly increase our operating expenses, or may require us to restrictour business activities in one or more respects. As a result, we may also berequired to develop alternative non-infringing technology, which could requiresignificant effort and expense. Substantial indirect costs also may be expected in the form of diversionof development and management resources in strategic planning for legal,technology, and business defenses to such claims.

 

***We rely on our management teamand need additional personnel to grow our business, and the loss of one or morekey employees or our inability to attract and retain qualified personnel couldharm our business.***

 

Our success and future growth depends to a significantdegree on the skills and continued services of our management team, especiallyDaniel J.A. Kolke, our interim Chief Executive Officer, Acting Chief FinancialOfficer, and Chairman of the Board. The loss of the services of any member ofour management team for any reason may have a material adverse effect on ourbusiness and prospects.  We do notmaintain key man insurance on any members of our management team, including Mr. Kolke.

 

We significantly and materially reduced our managementteam and have not hired replacements for the management team in the positionsof Vice President and Chief Financial Officer, Vice President — Marketing, VicePresident Corporate Development, and Vice President — Human Resources, as wellas several other Director-level positions, primarily in non-technical positionsthroughout the Company.  We did not fillthese positions in the period ending December 31, 2009, and we have notfilled any of these positions to the date of this report.

 

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Our future success also depends on our ability toattract, retain and motivate highly skilled technical, managerial, sales,marketing and service and support personnel, including members of ourmanagement team. Competition for sales, marketing, and technology developmentpersonnel is particularly intense in the software and technology industries. Asa result, we may be unable to successfully attract or retain qualifiedpersonnel. Our inability to attract and retain the necessary personnel couldharm our business.

 

***If we do not effectively expandand train our sales force and our services and support teams, then we may beunable to add new customers and retain existing customers.***

 

We plan to expand our sales force and our services andsupport teams to increase our customer base and revenue. We believe that thereis significant competition for sales, service, and support personnel with theskills and technical knowledge that we require. Our ability to achievesignificant revenue growth will depend, in part, on our success in recruiting,training, and retaining sufficient numbers of personnel to support our growth.New hires require significant training and, in most cases, take significanttime before they achieve full productivity. Our recent hires and planned hiresmay not become as productive as we expect and we may be unable to hire orretain sufficient numbers of qualified individuals in the markets where we dobusiness. If these expansion efforts are not successful or do not generate acorresponding increase in revenue, then our business will be harmed.

 

***We do not have a dedicatedsales team and our revenues and operating results are substantially dependenton third-party resellers.***

** **

We do not have a dedicatedsales team.  Our chief executive officerand other employees attempt to identify sales opportunities and, when suchopportunities materialize, attempt to market and sell our products.  We are substantially dependent uponthird-party resellers to market and sell our products and to generate end-usercustomers.  We have one agreement inplace at this time with a third-party reseller to market and sell our products,and that reseller has several additional reseller agreements in place.  We have no control over the amount of timeand resources these third-party resellers dedicate to marketing and selling ourproducts.  The loss of any third-partyreseller may significantly reduce our revenues. There is no assurance that we can add additional resellers or replaceour current reseller with other resellers or an in-house sales team in theevent we lose our reseller or the reseller devotes inadequate time andresources to selling our products.  Tothe extent we distribute or license our products or services directly toend-user customers, we may be in competition with our resellers. In response tofuture direct sales strategies or for other business reasons, our resellers mayfrom time to time choose to resell our competitors’ products in addition to, orin place of, our products. Our revenues and financial condition may beadversely affected if our reseller stops marketing and selling our products orif the reseller is not able to generate end-user customers to purchase ourproducts.

 

***Our operating results may besubject to fluctuations that could increase the volatility of the price of ourCommon Stock. .***

 

Our operating results may fluctuate in the future. Asa result, we may fail to meet or exceed the expectations of research analystsor investors, which could cause our stock price to decline. Alsoperiod-to-period comparisons of our operating results may not be meaningful.You should not rely on the results of one quarter as an indication of futureperformance.

 

Fluctuations in our quarterly operating results may bedue to a number of factors, including the risks and uncertainties discussedelsewhere in this report. Fluctuations in our quarterly operating results couldcause our stock price to decline rapidly, may lead analysts to change theirlong-term model for valuing our common stock, could cause us to face short-termliquidity issues, may impact our ability to retain or attract key personnel, orcause other unanticipated issues. If our quarterly operating results fall belowthe expectations of research analysts or investors, then the price of ourcommon stock could decline substantially.

 

***We use third-party data centersto support our services. Any disruption of service at these facilities couldinterrupt or delay our ability to deliver our service to our customers.***

 

We host many of our services and serve a significantnumber of our customers from third-party data center facilities with NetworkOS, located in the greater Seattle Washington area. We do not control theoperation of these facilities. These facilities may be vulnerable to damage orinterruption from earthquakes, hurricanes, floods, fires, terrorist attacks,power losses, telecommunications failures, and similar events. These facilitiesalso could be subject to break-ins, computer viruses, sabotage, intentionalacts of vandalism and other misconduct. The occurrence of a natural disaster oran act of terrorism, a decision to close the facilities without adequatenotice, or other unanticipated problems could result in lengthy interruptionsin our services.

 

Our data center facility providers have no obligationto renew their agreements with us on commercially reasonable terms, or at all.If we are unable to renew our agreements with any facility provider oncommercially reasonable terms, then we may experience increased costs ordowntime in connection with the transfer to a new data center facility.

 

Any errors, defects, disruptions, or other performanceproblems with our services could harm our reputation and may damage ourcustomers’ businesses. Interruptions in our services might reduce our revenue,cause us to issue credits to customers, subject us to potential liability,cause customers to terminate their subscriptions, and harm our renewal rates.

 

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***Any significant fluctuation inprice of servers or related support may have a material adverse effect on thecost of our products and services.***

 

The prices of servers and related support are subjectto market conditions and generally we do not, and do not expect to, havelong-term contracts with our suppliers for those items. While these items aregenerally available and we have not experienced any shortage in the past, wecannot assure you that the necessary servers or support will continue to beavailable to us at prices currently in effect or acceptable to us. The pricesfor these items have varied significantly in the past and may varysignificantly in the future. Numerous factors, most of which are beyond ourcontrol, influence prices of servers and related support. These factors includegeneral economic conditions, industry capacity utilization, vendor backlogs anddelays and other uncertainties.

 

We may not be able to adjust our product prices,especially in the short-term, to recover cost increases in these items. Ourfuture profitability may be adversely affected to the extent we are unable topass on higher server and support related costs to our customers.

 

***We may become liable to ourcustomers and lose customers if we have defects or disruptions in our productsand services or if we provide poor service.***

 

Because we deliver products as a service through anEtelos Marketplace, errors or defects in the Web Applications underlying theservice, or a failure of our hosting infrastructure may make the serviceunavailable to our customers. Because our customers use the products to managecritical aspects of their business, any errors, defects, disruptions inservice, or other performance problems with the products, whether in connectionwith the day-to-day operation of the products, upgrades or otherwise, coulddamage our customers’ businesses. If we have any errors, defects, disruptionsin service, or other performance problems with the products, then customerscould elect not to renew their subscriptions or delay or withhold payment tous. As a result, we could lose future sales or customers may make warrantyclaims against us or our Syndication Partners, which could result in anincrease in our provision for doubtful accounts, an increase in collectioncycles for accounts receivable, or costly litigation.

 

***Material defects or errors in thesoftware we use to deliver our products and services and the offerings by ourMarketplace and Syndication Partners could harm our reputation, result insignificant costs to us, and impair our ability to distribute our services.***

 

The Web Applications offered in an Etelos Marketplaceare inherently complex and may contain material defects or errors, particularlywhen first introduced or when new versions or enhancements are released. Wehave, from time to time, found defects in our products and services, and new errorsin our existing software and services may be detected in the future. We have noactual knowledge, but we reasonably expect that the products and servicesoffered by our Syndication Partners may have similar errors and/or defects. Anyerrors or defects that cause interruptions to the availability of our servicesand the services for our Marketplace Partners could result in:

 

·                  a reduction in sales or delay inmarket acceptance of services from us or our Marketplace Partners;

·                  sales credits or refunds to ourcustomers and customers of our Marketplace Partners;

·                  loss of existing customers anddifficulty in attracting new customers;

·                  diversion of development resources;

·                  harm to our reputation, or thereputation of our Marketplace Partners; and/or

·                  increased warranty and insurancecosts.

 

After the release of our services, defects or errorsmay also be identified from time to time by our internal team, our Marketplaceand Syndication Partners, and by our customers. The costs incurred incorrecting any material defects or errors in such products or services may besubstantial and could harm our operating results.

 

***If our security measures arebreached and unauthorized access is obtained to a customer’s data, then we mayincur significant liabilities, our service may be perceived as not beingsecure, and customers may curtail or stop using our products.***

 

The products and services we offer in an EtelosMarketplace involve the storage of large amounts of our customers’ sensitiveand proprietary business information. If our security measures are breached asa result of third-party action, employee error, malfeasance, or otherwise, andsomeone obtains unauthorized access to our customers’ data, then we could incursignificant liability to our Syndication and Marketplace Partners, ourcustomers, and to individuals or businesses whose information was being storedby our customers, our business may suffer and our reputation may be damaged.Because techniques used to obtain unauthorized access to, or to sabotage,systems change frequently and generally are not recognized until launchedagainst a target, we may be unable to anticipate these techniques or toimplement adequate preventive measures. If an actual or perceived breach of oursecurity occurs, then the market perception of the effectiveness of oursecurity measures could be harmed and we could lose sales and customers.

 

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***If we are unable to develop newproducts or services, distribute our products or services into new markets, oradd Syndication Partners to offer their products or services for distributionin an Etelos Marketplace, then our revenue growth will be harmed and we may notbe able to achieve profitability.***

 

Our ability to attract new customers and to increaserevenue from existing customers will depend in large part on our ability toenhance and improve our existing products and to add new Marketplace Partnersand new Syndication Partners to offer their products and services anddistribute into new markets. The success of any enhancement or new SyndicationPartner offering depends on several factors, including the timely completion,introduction, and market acceptance of the enhancement, product or service. Anynew product or service offered by a Syndication Partner or that we develop oracquire may not be introduced in a timely or cost-effective manner and may notachieve the broad market acceptance necessary to generate significant revenue.Any new markets into which we attempt to distribute our products or servicesmay not be receptive. If we are unable to successfully develop or acquire newproducts or services, enhance our existing products and services to meetcustomer requirements, or distribute our products and services into newmarkets, then our revenue will not grow as expected and we may not be able toachieve profitability.

 

***If we fail to maintain proper andeffective internal controls or are unable to remediate the material weakness inour internal controls, then our ability to produce accurate and timelyfinancial statements could be impaired and investors’ views of us could beharmed.***

 

Ensuring that we have adequate internal financial andaccounting controls and procedures in place so that we can produce accuratefinancial statements on a timely basis is a costly and time-consuming effortthat needs to be re-evaluated frequently. Our internal control over financialreporting is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsin accordance with generally accepted accounting principles.

 

During our audit for the year ended December 31,2008, we identified material weaknesses in our internal controls. The materialweaknesses relate to the absence of specific policies and procedures for someaccounting functions and the need for accounting personnel who possess theskill sets necessary to operate and report as a public company, andspecifically the skills necessary to ensure that adequate review of criticalaccount reconciliations is performed and that supporting documentation iscomplete, accurate, and in accordance with generally accepted accountingprinciples. Our financial position and limited resources make it difficult forus to address these weaknesses and we continue to have these materialweaknesses as of December 31, 2009. If we fail to address these material weaknesses or if additionalmaterial weaknesses in our internal controls are discovered in the future, thenwe may fail to meet our future reporting obligations, our financial statementsmay contain material misstatements and the price of our common stock maydecline.

 

Implementing any appropriate changes to our internalcontrols may distract our officers and employees, entail substantial costs tomodify our existing processes, and add personnel and take significant time tocomplete. These changes may not, however, be effective in maintaining theadequacy of our internal controls, and any failure to maintain that adequacy,or consequent inability to produce accurate financial statements on a timelybasis, could increase our operating costs and harm our business. In addition,investors’ perceptions that our internal controls are inadequate or that we areunable to produce accurate financial statements on a timely basis may harm ourstock price and make it more difficult for us to effectively market anddistribute our products and services to new and existing customers.

 

***Government regulation of theInternet and e-commerce is evolving, and unfavorable changes or our failure tocomply with regulations could harm our operating results.***

 

As Internet commerce continues to evolve, increasingregulation by super-national, federal, state or local government agenciesbecomes more likely. Increased regulation in the area of data privacy, and lawsand regulations applying to the solicitation, collection, processing, or use ofpersonal or consumer information could affect our customers’ ability to use andshare data, potentially reducing demand for Web-based applications andrestricting our ability to store, process, and share our customers’ data. Inaddition, taxation of services provided over the Internet or other chargesimposed by government agencies or by private organizations for accessing theInternet may also be imposed. Any regulation imposing greater fees for Internetaccess or use or restricting information exchange over the Internet couldresult in a decline in the use of the Internet and the viability of Web-basedservices, which could harm our business and operating results.

 

***Privacy concerns and laws orother regulations may reduce the effectiveness of our products and services andharm our business.***

 

Our customers can use the products and servicesoffered in an Etelos Marketplace to store personal or identifying informationregarding their customers and contacts. Super-national, federal, state andother government bodies and agencies have adopted or are considering adoptionof laws and regulations regarding the collection, use, and disclosure ofpersonal information obtained from consumers and other individuals. The costsof compliance with, and other burdens imposed by, such laws and regulationsthat are applicable to the businesses of our customers may limit the use andadoption of our products and services and reduce overall demand.

 

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In addition to government activity, privacy advocacygroups and the technology and other industries are considering various new,additional, or different self-regulatory standards that may place additionalburdens on us and our Marketplace and Syndication Partners. If the gathering ofpersonal information were to be curtailed, then Web-based applications would beless effective, which may reduce demand for the products and services offeredin an Etelos Marketplace and harm our business.

 

***Our operating results may beharmed if we are required to collect taxes for our subscription services injurisdictions where we have not historically done so.***

 

We have not collected any sales or other taxes fromour customers or remitted any such taxes to any taxing jurisdiction where wemay be required to do so. We have begun an analysis of this issue but to datehave not made any accrual for any potential liability.  In addition, additional taxing jurisdictionsat various local, national and super-national levels may seek to impose salesor other tax collection obligations on us. We have not recorded sales or other tax liabilities for the years ended December 31,2009 or 2008, in respect of sales or other tax liabilities in any jurisdiction.Any determination that we should be collecting sales or other taxes on ourservice could result in substantial tax liabilities for past sales, discouragecustomers from purchasing our products, or otherwise harm our business andoperating results.

 

***Changes in financial accountingstandards or practices may cause adverse, unexpected financial reportingfluctuations, and harm our operating results.***

 

A change in accounting standards or practices couldharm our operating results and may even affect our reporting of transactionscompleted before the change is effective. New accounting pronouncements andvarying interpretations of accounting pronouncements have occurred and mayoccur in the future. Changes to existing rules or the questioning ofcurrent practices may harm our operating results or the way we conduct ourbusiness.

 

***We may expand by acquiring orinvesting in other companies, which may divert management’s attention, resultin additional dilution to our stockholders, and consume resources that arenecessary to operate and sustain our business.***

 

Although we have no ongoing negotiations or currentagreements or commitments for any acquisitions, our business strategy mayinclude acquiring complementary products, services, technologies, orbusinesses. We also may enter into relationships with other businesses toexpand our product or service offerings or our ability to provide service in foreignjurisdictions, which could involve preferred or exclusive licenses, additionalchannels of distribution, discount pricing, investments in other companies, orother strategies. Negotiating these transactions can be time-consuming,difficult, and expensive, and our ability to close these transactions may oftenbe subject to approvals that are beyond our control. Consequently, thesetransactions, even if undertaken and announced, may not close.

 

An acquisition, investment, or business relationshipmay result in unforeseen operating difficulties and expenditures. Inparticular, we may encounter difficulties assimilating or integrating thebusinesses, technologies, products, services offerings, personnel, oroperations of the acquired companies, particularly if the key personnel of theacquired company choose not to work for us, the target’s software is not easilyadapted to work with ours, or we are unable to retain the customers of anyacquired business due to changes in management or otherwise. Acquisitions mayalso disrupt our business, divert our resources, and require significantmanagement attention that would otherwise be available for operation anddevelopment of our business. Moreover, the anticipated benefits of anyacquisition, investment, or business relationship may not be realized or we maybe exposed to unknown liabilities. For one or more of those transactions, wemay:

 

·                  issue additional equity securitiesthat would dilute our stockholders;

·                  use cash that we may need in thefuture to operate our business;

·                  incur debt on terms unfavorable to usor that we are unable to repay;

·                  incur large charges or substantialliabilities;

·                  encounter difficulties retaining keyemployees of the acquired company or integrating diverse software codes orbusiness cultures; and/or

·                  become subject to adverse taxconsequences, substantial depreciation, or deferred compensation charges.

 

Any of these risks could harm our business andoperating results.

 

***We may be subject to other legalclaims.***

 

In the quarter ended December 31, 2009, andsubsequently, we resolved a number of significant litigation items in a mannerthat we believe was generally favorable to the Company.  See “LEGAL PROCEEDINGS” below.   The settlements in several of these matterscontained unsecured promissory notes and there is no assurance that we will beable to perform the payment obligations under those notes as and when theybecome due and payable.  If we default onthese payment obligations then other claims may be asserted against us tocollect on those promissory notes.

 

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**On December 31, 2009, we settleda judgment in the matter of Kaufman Bros., L.P. v. Etelos, Inc. in theSupreme Court of the State of New York, New York County, in the approximateamount of $186,000, for $93,000 in cash, payable in 5 installments with thefinal installment due June 1, 2010, and the issuance of 200,000 shares ofrestricted common stock. The settlement permits Kaufman Bros. to sell up to180,000 shares from July 1, 2010, through March 2011 to recover theremaining $93,373 of the settlement; the additional 20,000 shares aredesignated for payment of attorneys’ fees in the event of a default in the notepayments.  After payment in full of the note payments, if there is nodefault giving rise to a claim for attorneys’ fees, those 20,000 shares will bereturned to the Company and cancelled. After Kaufman Bros. recovers the remaining $93,373 from the sale of someor all of the 180,000 shares, any remaining shares will be repurchased by theCompany for $0.01 and cancelled; after March 2011, any balance due on theremaining amount of the settlement will be discharged and any unsold shareswill be repurchased by the Company at $0.01 per share and cancelled.**

** **

On October 31, 2008,the Company closed its offices in San Mateo, California.  The landlord for these premises filed acomplaint in the Superior Court of San Mateo County, California (Case No. CIV479535) and trial was set for February 8, 2010.  The parties went to mediation in January 2010and subsequently entered into a settlement agreement including, *inter alia*, a $200,000 promissory note, with 6% interest,payable in 12 monthly payments beginning in July 2010.  The settlement agreement and note wereexecuted and delivered on February 8, 2010.

 

On October 31, 2008, we relocated our Washingtonoffices and abandoned the sub-leased premises of our former offices in Renton,Washington. The sublease for these premises runs through June 2010.  Subsequently, on March 5, 2010, theprime landlord filed a complaint against us for breach of contract andsuccessor liability.  This matter wasjust served and we have not yet evaluated the claims made in this case.  We will need to evaluate and defend theseclaims.

 

As part of our reduction of monthly cash operatingexpenses during the quarter ended December 31, 2008, and continuing afterthe end of the quarter, we placed all employees in Washington and California onpartial deferrals of salary, ranging from 10% to 100% of base salary. At theend of that quarter, until the filing date of this report, a major portion ofthis deferral amount remains unpaid, including amounts due to employees who subsequentlywere terminated.

 

Since August 22,2008, we have terminated 33 employees employed in both our California andWashington offices.  Except as noted,none of these terminated employees have asserted any claims against us at thistime but no assurances can be given that such employees will not assert suchclaims in the future.

 

On March 19,2009, the Company issued an unsecured note of $88 thousand for an accountpayable balance. The note bears interest of 11% and is due on April 1,2010, with payment terms of $15 thousand on issuance of the note, and monthlypayments of $6 thousand beginning May 1, 2009 with a final payment on March 20,2010.  All payments have been made inaccordance with the note to the date of this report.

 

In connection with our operations, reverse merger,multiple financings, and protection of our intellectual property, we haveincurred substantial accounts payable to a small number of vendors that remainunpaid and overdue.  We have been incommunication with these vendors and have entered into payment plans with someof these vendors and expect to enter into negotiated payment plans with othervendors, but there is no assurance that we will be successful in thesenegotiations, or that we will be able to make payments under such plans.  Therefore the assertion of claims by thesevendors for these amounts due and owing could become the subject of claims inlitigation.

 

***Our officers, directors, andaffiliates control us through their positions and stock ownership and theirinterests may differ from other stockholders.***

 

As of December 31, 2009, our officers, directors,and affiliates beneficially own approximately 70 percent of our common stockand 63 percent of our preferred stock. As a result, if they act together, theyare able to influence the outcome of stockholder votes on various matters,including the election of directors and extraordinary corporate transactions,including business combinations. This concentration could also have the effectof delaying or preventing a change in control that could otherwise bebeneficial to our stockholders. The interests of our officers, directors, andaffiliates may differ from other stockholders. Furthermore, the current ratiosof ownership of our common stock reduce the public float and liquidity of ourcommon stock, which can in turn affect the market price of our common stock.

 

***We are responsible for theindemnification of our officers and directors.***

 

Our articles of incorporation and bylaws provide forthe indemnification of our directors, officers, employees, and agents, and,under certain circumstances, against costs and expenses incurred by them in anylitigation to which they become a party arising from their association with oractivities on our behalf. Consequently, we may be required to expendsubstantial funds to satisfy these indemnity obligations.

 

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***The sale of the shares of ourcommon stock acquired in private placements could cause the price of our commonstock to decline.***

 

The purchasers of our outstanding convertiblepromissory notes, debentures, and related warrants, as well as the holders ofour other outstanding convertible notes, may, subject to compliance with Rule 144,rely on the provisions of Rule 144 to resell the shares of our commonstock acquired upon the conversion and exercise of such securities.  We have no way of knowing whether or whensuch shares may be sold.  Depending uponmarket liquidity at the time, a sale of shares by such investors at any giventime could cause the trading price of our common stock to decline.  The sale of substantial number of shares ofour common stock, or anticipation of such sales, could make it more difficultfor us to sell equity or equity-related securities in the future at a time andat a price that we might otherwise wish to effect sales.

 

In connection with our January 2008 and April 2008Debentures, in the aggregate, we issued a total of $6.3 million principalamount of convertible debentures, convertible into 4,690,695 shares of ourcommon stock, and warrants to purchase an additional 611,111 shares of ourcommon stock.  In connection with our September 2009Debentures and our January 2010 Debentures, we issued a total of $3.4million principal amount of convertible debentures, convertible into 6,500,000shares of our Common Stock and warrants to purchase an additional 5,625,000shares of our Common Stock. The conversion or exercise into our common stockcould result in a substantial increase in the number of shares in our publicfloat.  Depending upon market liquidityat the time a resale of our common stock is made by the investors in suchprivate placements, such sale could cause the trading price of our common stockto decline.  In addition, the sale of asubstantial number of shares of our common stock, or anticipation of suchsales, could make it more difficult for us to sell equity or equity-relatedsecurities in the future at a time and at a price that we might otherwise wishto effect sales.

 

***We have significant indebtedness.***

 

We have incurred $9.7 million in principal amount ofindebtedness as a result of the issuance of our September 2009, January 2008and April 2008 Debentures.  Thedebentures impose significant requirements on us, including, among others,requirements that we pay interest and other charges on the debentures.  Our ability to comply with these provisionsmay be affected by changes in our business condition or results of ouroperations, or other events beyond our control. We have breached certain of these covenants and are in a default underthe debentures, which permits the holders thereof to accelerate the maturity ofthe debentures and demand repayment in full.  Such actions by such holders could impair ourability to operate or cause us to seek bankruptcy protection.

 

***Certain covenants we agreed to inconnection with the debentures may impair our ability to issue additional debtor equity.***

 

Our September 2009, January 2008 and April 2008Debentures impose significant covenants on us, including restrictions againstincurring additional indebtedness, creating any liens on our property, amendingour certificate of incorporation or bylaws, redeeming or paying dividends onshares of our outstanding common stock, and entering into certain related partytransactions. These covenants and restrictions may impair our ability to issueadditional debt or equity, if necessary.

 

***If we need additional financingin the future and are required to issue securities which are priced at lessthan the conversion price of our debentures or the exercise price of warrantssold in our recent private placements, it will result in additional dilution.***

 

Our September 2009, January 2008 and April 2008Debentures and the related warrants contain provisions that will require us toreduce the conversion price and exercise price, as the case may be, if we issueadditional securities while such debentures or warrants are outstanding whichcontain purchase prices, conversion prices or exercise prices less than theconversion price of our September 2009, January 2008 or April 2008Debentures or the exercise price of the warrants.  If this were to occur, current investors,other than the investors in our recent private placements, would sustainmaterial dilution in their ownership interest.

 

***Anti-takeover provisionscontained in our amended and restated certificate of incorporation and amendedand restated bylaws, as well as provisions of Delaware law, could impair atakeover attempt.***

 

Our amended and restated certificate of incorporation,amended and restated bylaws and Delaware law contain provisions that could havethe effect of rendering more difficult or discouraging an acquisition deemedundesirable by our board of directors. Our corporate governance documentsinclude provisions:

 

·                  authorizing blank check preferredstock, which could be issued with voting, liquidation, dividend, and otherrights superior to our common stock;

·                  limiting the liability of, andproviding indemnification to, our directors and officers;

·                  limiting the ability of ourstockholders to call and bring business before special meetings;

·                  requiring advance notice ofstockholder proposals for business to be conducted at meetings of ourstockholders and for nominations of candidates for election to our board ofdirectors;

·                  controlling the procedures for theconduct and scheduling of board and stockholder meetings; and

·                  limiting, generally, the filling ofvacancies or newly created seats on the board to our board of directors then inoffice.

 

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These provisions, alone or together, could delay hostiletakeovers and changes in control or changes in our management.

 

Any provision of our amended and restated certificateof incorporation or bylaws or Delaware law that has the effect of delaying ordeterring a change in control could limit the opportunity for our stockholdersto receive a premium for their shares of our common stock, and could alsoaffect the price that some investors are willing to pay for our common stock.

 

***We may issue additional shares ofour capital stock, including through convertible debt securities, to financefuture operations or complete a business combination, which would reduce theequity interest of our stockholders and could cause a change in control of ourownership.***

 

Although we have no commitments as of the date of thisreport to issue any additional securities, we may issue a substantial number ofadditional shares of our common stock or preferred stock, or a combination ofboth, including through convertible debt securities, to finance futureoperations.  We may not be able to obtainadditional debt or equity financing on favorable terms, if at all.  If we engage in debt financing, then we maybe required to accept terms that restrict our ability to incur additionalindebtedness and force us to maintain specified liquidity or other ratios.

 

Further, the issuance of additional shares of ourcommon stock or any number of shares of preferred stock, including uponconversion of any debt securities, may:

 

·                  significantlyreduce the equity interest of our current stockholders;

·                  causea change in control if a substantial number of our shares of common stock orvoting preferred stock are issued, which may affect, among other things, ourability to use our net operating loss carry-forwards, if any, and could alsoresult in a change in management; and/or

·                  adversely affect prevailing marketprices for our common stock.

 

If we need additional capital and cannot raise it onacceptable terms, we may not be able to, among other things:

 

·                  develop or enhance our products andservices;

·                  continue to expand our development,sales and marketing organizations;

·                  acquire complementary technologies,products or businesses;

·                  expand operations;

·                  hire, train and retain employees;and/or

·                  respond to competitive pressures orunanticipated working capital requirements.

 

Although we have no commitments as of the date hereofto issue any additional securities, we may issue a substantial number ofadditional shares of our common stock or preferred stock, or a combination ofboth, including through convertible debt securities, to finance futureoperations or complete a business combination. The issuance of additional shares of our common stock or any number ofshares of preferred stock, including upon conversion of any debt securities:

 

·                  may significantly reduce the equityinterest of our current stockholders;

·                  will likely cause a change in controlif a substantial number of our shares of common stock or voting preferred stockare issued and could also result in a change in management; and/or

·                  may adversely affect prevailingmarket prices for our common stock.

 

The 2009 Equity Incentive Plan and the 2007 StockIncentive Plan and all options currently issued pursuant to these plans andoptions granted outside such plans provides for accelerated vesting of allunvested options in the event of a change of control.  This may be regarded as both a disincentiveto acquisition of the Company as a liquidation strategy and a barrier toretention of key employees following a change-of-control acquisition andtherefore make such an acquisition more costly or difficult, and therefore anunattractive strategic option, for a prospective acquirer.

 

***We have never paid dividends onour capital stock and we do not anticipate paying any cash dividends in theforeseeable future.***

 

We have paid no cash dividends on any of our classesof capital stock to date and we currently intend to retain our future earnings,if any, to fund the development and growth of our business.  In addition, the terms of the various Debenturesprohibit us from making any dividend payment or distribution to holders of ourcommon stock while any portion of the Debentures remain outstanding.  As a result, capital appreciation, if any, ofour common stock will be your sole source of gain for the foreseeable future.

 

***Our securities may be thinlytraded on the Over-the-Counter Bulletin Board, which may not provide liquidityfor our investors.***

 

Our common stock is quoted on the Over-the-CounterBulletin Board. The Over-the-Counter Bulletin Board is an inter-dealer,over-the-counter market that provides significantly less liquidity than theNASDAQ Stock Market or other national or regional exchanges. Securities tradedon the Over-the-Counter Bulletin Board are usually thinly traded, highly volatile,have fewer market makers, and are not followed by analysts.

 

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The SEC’s order handling rules, which apply toNASDAQ-listed securities, do not apply to securities quoted on theOver-the-Counter Bulletin Board. Quotes for stocks included on theOver-the-Counter Bulletin Board may not be listed in newspapers. Therefore,prices for securities traded solely on the Over-the-Counter Bulletin Board maybe difficult to obtain and holders of our securities may be unable to reselltheir securities at or near their original acquisition price, or at any price.

 

***Investors must contact abroker-dealer to trade Over-the-Counter Bulletin Board securities. As a result,you may not be able to buy or sell our common stock at the times that you maywish.***

 

Even though our common stock is quoted on theOver-the-Counter Bulletin Board, the Over-the-Counter Bulletin Board may notpermit our investors to sell securities when and in the manner that they wish.Because there are no automated systems for negotiating trades on theOver-the-Counter Bulletin Board, they are conducted via telephone. In times ofheavy market volume, the limitations of this process may result in asignificant increase in the time it takes to execute investor orders.Therefore, when investors place market orders to buy or sell a specific numberof shares at the current market price it is possible for the price of a stockto go up or down significantly during the lapse of time between placing amarket order and its execution.

 

***Our stock price may be volatileand you may not be able to sell your shares for more than what you paid.***

 

Our stock price is likely to be subject to significantvolatility and you may not be able to sell shares of common stock at or abovethe price you paid for them. The market price of the common stock couldcontinue to fluctuate in the future in response to various factors including,but not limited to: quarterly variations in operating results; our ability tocontrol costs and improve cash flow; announcements of technological innovationsor new products by us or our competitors; changes in investor perceptions; andnew products or produce enhancements by us or our competitors. The stock marketin general has continued to experience volatility, which may further affect ourstock price. As such, you may not be able to resell your shares of common stockat or above the price you paid for them.

 

***Our common stock is likely to besubject to penny stock rules.***

 

Our common stock is subject to Rule 15g-1 through15g-9 under the Exchange Act, which imposes certain sales practice requirementson broker-dealers which sell our common stock to persons other than establishedcustomers and “accredited investors” (generally, individuals with net worth inexcess of $1 million or annual incomes exceeding $200 thousand (or $300thousand together with their spouses). For transactions covered by this rule, a broker-dealer must make aspecial suitability determination for the purchaser and have received thepurchaser’s written consent to the transaction prior to the sale.  This rule adversely affects the abilityof broker-dealers to sell our common stock and purchasers of our common stockto sell their shares of such common stock. Additionally, our common stock is likely to be subject to the SECregulations for “penny stock.”  Pennystock includes any equity security that is not listed on a national exchangeand has a market price of less than $5.00 per share, subject to certainexceptions.  The regulations require thatprior to any non-exempt buy/sell transaction in a penny stock, a disclosureschedule set forth by the SEC relating to the penny stock market must bedelivered to the purchaser of such penny stock. This disclosure must include the amount of commissions payable to boththe broker-dealer and the registered representative and current pricequotations for the common stock.  Theregulations also require that monthly statements be sent to holders of pennystock which disclose recent price information for the penny stock and informationof the limited market for penny stocks. These requirements adversely affect the market liquidity of our commonstock.

 

**ITEM IB.                UNRESOLVEDSTAFF COMMENTS**

** **

**None.**

** **

**ITEM 2.                  PROPERTIES**

** **

Ourcorporate headquarters is located in Maple Valley, Washington, but we do notown or lease any real property and conduct the major portion of our businessactivities virtually: using the Internet and other telecommunications toolslike those distributed in Marketplaces based upon the Etelos Platform Suite forSaaS distribution. In the future we may be required to lease workspaces toenhance productivity and collaboration. Our requirements for property are notunique or specialized; if and when the need arises, we believe that suitablespace will be available to us on commercially reasonable terms.

 

**ITEM 3.                  LEGALPROCEEDINGS**

** **

From time to time, we become subject to various legalproceedings and claims, both asserted and unasserted, that arise in theordinary course of business. Litigation in general, and securities litigationin particular, can be expensive and disruptive to normal business operations.Moreover, the results of legal proceedings are difficult to predict. Anunfavorable resolution of one or more of these lawsuits would materiallyadversely affect our business, results of operations, or financial condition.We accrue legal costs when incurred.  Theneed to defend any such claims could require payments of legal fees and ourlimited financial resources could severely impact our ability to defend anysuch claims.

 

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During the quarter ended December 31, 2009, theCompany entered into a Settlement Agreement with Jeffrey L. Garon, our formerCEO; see the Company’s Form 8-K filed with the SEC on December 18,2009.  Subsequent to the end of thequarter, all payments required by the settlement agreement were made, wherebythe Company has repurchased 2,356,655 shares of common stock previously issuedto Garon at the original purchase price of approximately $175,000, and all therepurchased shares have been cancelled.

 

In June 2008, Kaufman Bros. L.P.initiated litigation against us for breach of contract under an advisory servicesagreement and, effective on December 5, 2008, we entered into a settlementagreement with Kaufman Bros., pursuant to which (i) we agreed to pay toKaufman Bros. $210,000, in twelve monthly installments of $17,500; (ii) weissued to Kaufman Bros. a warrant to purchase 500,000 shares of our commonstock at an exercise price of $0.75 per share exercisable for a period of fiveyears; (iii) we agreed with Kaufman Bros. to immediately terminate allprovisions, terms and conditions of the advisory services agreement andexchanged mutual releases; and (iv) Kaufman Bros. agreed to dismiss thepending lawsuit in the Supreme Court of New York, without prejudice.  Subsequent to entering into the settlementagreement, we did not fully comply with our payment obligations under thesettlement agreement and we received a notice of default and confession ofjudgment against us. On December 31, 2009, we settled the judgmentin the approximate amount of $186,000, for $93,000 in cash, payable in 5installments with the final installment due June 1, 2010, and the issuanceof 200,000 shares of restricted common stock. The terms of the settlementagreement permit Kaufman Bros. to sell up to 180,000 shares from July 1,2010, through March 2011 to recover the remaining $93,373 of thesettlement; the additional 20,000 shares are designated for payment ofattorneys’ fees in the event of a default in the note payments.  Afterpayment in full of the note payments, if there is no default giving rise to aclaim for attorneys’ fees, those 20,000 shares will be returned to us andcancelled.  After Kaufman Bros. recoversthe remaining $93,373 from the sale of some or all of the 180,000 shares, wehave a right to repurchase any remaining shares for $0.01 and cancel suchshares, after March 2011, any balance due on the remaining amount of thesettlement will be discharged and we will repurchase any unsold shares at $0.01per share and cancel them.

** **

On October 31, 2008, weclosed our offices in San Mateo, California. On or about December 19, 2008, the landlord for these premisesfiled a complaint claiming damages of $659 thousand and other amounts againstthe Company’s predecessor Etelos, Incorporated, a Washington corporation (“Etelos—WA”) in the Superior Court of San Mateo County, California (Case No. CIV479535).  A default judgment was setaside because the landlord failed to properly serve either the Company orEtelos-WA. The Company was subsequently served properly and trial was set for February 8,2010.  The parties went to mediation in January 2010and subsequently entered into a settlement agreement, including a release ofclaims, in which we agreed: (a) to pay $66,000 in cash within 30 days, (b) toissue a $200,000 promissory note, with 6% interest, payable in 12 monthlypayments beginning in July 2010, and (c) to issue shares of Common Stockof the Company equal to $125,000 in value, based upon the closing price of theCompany’s stock on January 6, 2010. The settlement agreement and note were executed and delivered on February 8,2010, and 166,667 shares were subsequently were delivered on March 1,2010.

 

As part of our reduction of monthly cash operatingexpenses during the quarter ended December 31, 2008, and continuing afterthe end of the quarter, we placed all employees in Washington and California onpartial deferrals of salary, ranging from 10% to 100% of base salary. At theend of that quarter, until the filing date of this report, a major portion ofthis deferral amount remains unpaid, including amounts due to employees who subsequentlywere terminated.

 

**ITEM 4.**                  REMOVED ANDRESERVED

** **

**PART II**

 

**ITEM 5.****                 ****MARKET FOR REGISTRANT’S COMMONEQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES**

** **

**Marketfor Registrant’s Common Equity**

 

Effective April 29,2008, shares of our common stock began being quoted on the OTC Bulletin Boardunder the symbol “ETLO.”  The OTC Bulletin Board is a regulated quotationservice that displays real-time quotes, last-sale prices and volume informationin over-the-counter equity securities.  The OTC Bulletin Board securitiesare traded by a community of market makers that enter quotes and trade reports.

 

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The followingtable sets forth the high and low bid prices per share of our common stock bythe OTC Bulletin Board for the periods indicated as reported on the OTCBulletin Board.

 
| **For  the year ended December 31, 2009** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------------------|------------|----------|------------|---------|------------|
| Fourth Quarter                                 |       | $        | 1.00       |    | $          | 0.31 |   |
| Third Quarter                                  |       | $        | 0.79       |    | $          | 0.25 |   |
| Second Quarter                                 |       | $        | 1.20       |    | $          | 0.36 |   |
| First Quarter                                  |       | $        | 2.75       |    | $          | 0.10 |   |

 
| **For  the year ended December 31, 2008**  | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------------------------------------|------------|----------|------------|---------|------------|
| Fourth Quarter                                  |       | $        | 1.25       |    | $          | 0.10 |   |
| Third Quarter                                   |       | $        | 14.00      |    | $          | 1.05 |   |
| Second Quarter (Commencing April 29, 2008) |       | $        | 4.99       |    | $          | 0.50 |   |

 

The quotesrepresent inter-dealer prices, without adjustment for retail mark-up, markdownor commission and may not represent actual transactions.  The trading volume of our securitiesfluctuates and may be limited during certain periods.  As a result of these volume fluctuations, theliquidity of an investment in our securities may be adversely affected.

 

**Holdersof Record**

 

As of March 16,2010, there were 23,939,810 shares of our common stock outstanding held by approximately62 holders of record.

 

**TransferAgent**

 

Our transfer agent is BNYMellon Shareowner Services, P.O. Box 358016, Pittsburgh, PA 15252.

 

**Dividends**

 

We have never declared or paid any cash dividends onour common stock.  For the foreseeable future, we intend to retain anyearnings to finance the development and expansion of our business, and we donot anticipate paying any cash dividends on our common stock.  Inaddition, we are restricted from paying any dividends on our common stock underthe terms of our January debentures and April debentures.  Anyfuture determination to pay dividends will be at the discretion of our board ofdirectors.

 

**SecuritiesAuthorized for Issuance under Equity Compensation Plans**

 

The table below setsforth information as of December 31, 2009, with respect to compensationplans under which our common stock is authorized for issuance.  Thefigures related to securities authorized for issuance under equity compensationplans relate to options granted under the 1999 Stock Option Plan, the 2007Stock Incentive Plan, and the 2009 Equity Incentive Plan.  The 1999 StockOption Plan, and the 2007 Stock Incentive Plan were approved by ourshareholders.  Our shareholders have notapproved the 2009 Equity Incentive Plan.

 

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| **Plan Category**                                      | ** ** | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights  (a)** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights  (b)** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  column a)  (c)** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity compensation plans approved by security holders      |       | 1,089,665                                                                                                                                                 |       | $                                                                                                                | 0.31       |                                                                                                                                                                                                            | 264,542    |   |
| Equity compensation plans not approved by security  holders |       | 5,025,000                                                                                                                                                 |       | $                                                                                                                | 0.51       |                                                                                                                                                                                                            | 3,975,000  |   |

 

DanielJ.A. Kolke received a grant of 3,433,333 options under his employment agreementthat was not issued under the terms of these equity compensation plans.

 

**ITEM 6.****                 ****SELECTED FINANCIAL DATA**

 

As a smaller reportingcompany we are not required to provide the information required by this item.

 

**ITEM7.**                  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

** **

The following discussion of our financial conditionand results of operations should be read in conjunction with our financialstatements and the related notes and other financial information appearingelsewhere in this report. Readers are also urged to carefully review andconsider the various disclosures made by us which attempt to advise interestedparties of the factors which affect our business, including without limitation,the disclosures made under “Item 1A. Risk Factors” included in Part I ofthis report.

 

**Overview**

** **

We are a provider of tools and services for thedevelopment and distribution of Web Applications.  We generate revenues from a share of revenuesgenerated by the sales of subscriptions to use Web Applications developed by usand by our Syndication Partners, which are offered through Marketplaces basedon the Etelos Platform Suite for SaaS distribution, that we develop andoperate.  We also are engaged innegotiations for the licensing of the Etelos Platform Suite for thedevelopment and operation of marketplaces by third parties.  Our principal cost of revenue is hardware,software, and network connectivity used in connection with the delivery of ourproducts and services.  Our primaryoperating expenses are for personnel costs, especially in technology researchand development.

 

During the quarter ended December 31, 2008, wetook significant steps intended to improve our operating results, ranging fromchanging the focus of our business model from an end-user-focused model to afocus on enterprise customer sales to reducing monthly cash operating expensesby aggregate workforce reductions of over 70% and relocating our corporateheadquarters to lower cost facilities. The shift in business focus was a fundamental change, and the reductionof operating expenses was a one-time exercise in survival that has thus farbeen successful, but this exercise is not completed and has created, andcontinues to create, a substantial working capital deficit that must beaddressed and resolved.

 

As a major part of our reduction of monthly cashoperating expenses during the six quarters ending December 31, 2009, andcontinuing to the date of this report, we placed all remaining employees onpartial payment of salary; all except the three lowest paid employees arereceiving payment ranging from 97% to 74% of net pay.   At the end of the quarter, and as of thefiling date of this report, the amount of this deferral, which has beenaccrued, remains substantially unpaid, including amounts due to employees inour California office who subsequently were terminated during the quarterending December 31, 2008.

 

Similar to other companies, we have suffered theeffects of the current adverse economic conditions.  We restructured a major portion of our debtsecurities on June 30, 2009, and entered into an additional long-term debtfinancing on September 30, 2009, which converted a series of bridge loansentered into in the first three quarters of calendar 2009, and provided foradditional cash in September 2009 and in December 2009.   That cash was originally intended to carryus to June 2010 but we incurred substantial unexpected expenses inconnection with resolving certain litigation matters and other major creditorclaims.  See “LEGAL PROCEEDINGS” above.

 

Our survival plan has continued and we continue to need immediate andsubstantial cash to continue our operations. Management has projected that thecombination of cash on hand will be sufficient to allow us to continue ouroperations only through early-mid 2010. If cash reserves are notsufficient to sustain operations, then we plan to raise additional capital byselling shares of our capital stock or other securities.  We are presently engaged in activediscussions for additional investments by existing and prospective investorsbut we have no funding commitments in place at this time and we can give noassurance that such capital will be available on favorable terms, or atall.  If we cannot obtain financing, thenwe may be forced to further curtail our operations, cease voluntarily filingreports with the SEC, or possibly be forced to evaluate a sale or liquidationof our assets, or consider strategic alternatives such as bankruptcy.  Even if we are successful in raising additionalfunds, there is no assurance regarding the terms of any additional investmentand any such investment or other strategic alternative would likelysubstantially dilute or eliminate the interests of our stockholders.

 

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***Recent Financings***

 

*January 2010 Debentures*

 

On January 25, 2010, we entered into a securitiespurchase agreement with an entity affiliated with Donald W. Morissette for thesale of 10% senior secured convertible debentures, identical to the September 2009Debentures, in the principal amount of $250,000. In this transaction, inaddition to the debentures, we issued a warrant to purchase 375,000 shares ofour common stock with an exercise price of $0.60 per share and 375,000 sharesof our restricted common stock, or the “closing shares.”  We refer to thisfinancing as our January 2010 financing in this report. The securitiespurchase agreement further provided that we had the right, subject to certainconditions, to require the investor to purchase an aggregate of $125,000 inadditional principal amount of debentures between March 15 and 31, 2010.We exercised that right on March 15, 2010, and issued $125 thousand inadditional debentures to the investor.  Mr. Morissette,who, together with his affiliates, beneficially owns more than 10% of ouroutstanding common stock.

 

*September 2009 Debentures*

 

On September 29, 2009,we entered into a securities purchase agreement with three accredited investorsfor the sale of 10% senior secured convertible debentures in the principalamount of $2.0 million. Oneof the investors in our September 2009 financing is an affiliate of EnableCapital Management LLC, who, together with its affiliates, beneficially ownsmore than 10% of our outstanding common stock and holds $7.7 million inprincipal amount of our outstanding debentures, excluding the principal amountof the debentures purchased in our September 2009 financing.

 

The following summarizesthe terms of the debentures we agreed to issue:

 
| *Term:*                  |   | Due and payable on the  second anniversary of the date of issuance.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|--------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| *Interest:*              |   | Interest is payable  quarterly in cash at the rate of 10% per annum beginning on January 1,  2010.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| *Principal  Payment:*    |   | The principal amount,  if not paid earlier, is due and payable on the second anniversary of the date  of issuance.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|                     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| *Early  Redemption:*     |   | We have the right to  redeem the debenture before maturity by payment in cash of 100% of the then  outstanding principal amount plus (i) accrued but unpaid interest,  (ii) an amount equal to all interest that would have accrued if the  principal amount subject to such redemption had remained outstanding through  the maturity date and (iv) all liquidated damages and other amounts due  in respect of the debenture. To redeem the debenture we must meet certain  equity conditions. The payment of the debenture would occur on the 20th trading day following the date we  gave the holder notice of our intent to redeem the debenture. We agreed to  honor any notices of conversion that we receive from the holder before the  date we pay off the debenture.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|                     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| *Voluntary  Conversion:* |   | The debenture is  convertible at anytime at the discretion of the holder at a conversion price  per share of $0.50, subject to adjustment including anti-dilution protection.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|                     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| *Covenants:*             |   | The debenture imposes  certain covenants on us, including restrictions against incurring additional  indebtedness, creating any liens on our property, amending our certificate of  incorporation or bylaws, redeeming or paying dividends on shares of our  outstanding common stock, and entering into certain related party  transactions. The debentures define certain events of default, including  without limitation failure to make a payment obligation, failure to observe  other covenants of the debenture or related agreements (subject to applicable  cure periods), breach of representation or warranty, bankruptcy, default  under another significant contract or credit obligation, delisting of our  common stock, a change in control, or failure to deliver share certificates  in a timely manner. In the event of default, generally, the holder has the  right to accelerate all amounts outstanding under the debenture and demand  payment of a mandatory default amount equal to the greater of (i) the  outstanding principal plus accrued and unpaid interest divided by the  conversion price multiplied by the volume weighted average price of our  common stock and other amounts due in respect of the debenture and (ii) 120%  of the amount outstanding plus accrued interest, the amount equal to all  interest that would have accrued if the principal amount of the debenture had  remained outstanding through the maturity date and all liquidated damages and  other amounts due in respect of the debenture. |

 

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| *Security:* |   | The debenture is  secured by all of our assets under the terms of the security agreement we  entered into with the investors dated September 29, 2009. |
|-------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

We refer to these debentures as our September 2009Debentures. The summary of the financing transaction, and of the terms of thesecurities and agreements related to such transaction, is qualified in itsentirety by reference to the form of securities purchase agreement, debenture,warrant, and security agreement, each of which is filed as an exhibit to thisreport and incorporated herein by this reference.

 

In thistransaction, in addition to the debentures, we issued warrants to purchase3,000,000 shares of our common stock with an exercise price of $0.60 per share,or the “September 2009 warrants,” a warrant to purchase 2,250,000 sharesof our common stock with an exercise price of $0.01 per share, or the “ September 2009par value warrant,” and 750,000 shares of our restricted common stock, orthe “closing shares.”  One of the investors paid part of its subscriptionamount through the cancellation of approximately $1.2 million worth of indebtednesswe owed to such investor in principal amount and accrued interest of variousshort-term promissory notes previously issued throughout 2009.  The securities purchase agreement furtherprovided that we had the right, subject to certain conditions, to require theinvestors to purchase an aggregate of $1.0 million in additional principalamount of debentures.  We exercised thatright on December 15, 2009, and issued $1.0 million of additionaldebentures at that time.

 

For a moredetailed discussion of our September 2009 Debentures, please see thediscussion under the caption “September 2009 Debentures” under “Note 6.Convertible Notes and Debentures and embedded Derivative and Warrant Liability”to our financial statements contained in this report.

 

*June 2009 Amendment Agreement*

 

On June 30, 2009, weentered into an amendment agreement with the holder of our outstanding 6%secured convertible debentures in an aggregate principal amount of $5.5 millionissued in January 2008 and April 2008 and our outstanding warrants topurchase up to 666,666 shares of our common stock issued in January 2008and April 2008.

 

With respect to thedebentures, under the terms of the amendment agreement, the parties agreed to:

 

·                                          extend the date of maturity to December 31,2012 (with respect to the debentures issued in January 2008, the maturitydate was previously January 31, 2010 and with respect to the debenturesissued in April 2008, the maturity date was April 30, 2010);

·                                          eliminate the monthly redemptionrequirement;

·                                          require that all future interest paymentsbe made in cash (previously, we could make payments in shares of our commonstock);

·                                          reduce the interest rate to 0% per annumuntil September 30, 2010;

·                                          defer interest payments until January 1,2011;

·                                          require all accrued but unpaid interestas of June 30, 2009 and interest that would have been earned under theoriginal terms to September 30, 2010 be added to the principal amount andbe payable on the date of maturity;

·                                          waive any event of default arising out ofthe nonpayment of any accrued interest as of the date of the amendmentagreement; and

·                                          modify the anti-dilution protectionprovisions such that the conversion price will not be reduced to less than$0.10 as a result of any subsequent equity sales.

 

The reduction in interestrate, deferment of interest payments, and elimination of the right to makeinterest payments in shares of common stock significantly reduce the short termcash requirements for our company and the potential for future dilution to ourstockholders that could have occurred as a result of the issuance of shares ofour common stock to meet interest and monthly redemption payment obligations.

 

In addition, under theterms of the amendment agreement, the holder of the warrants was granted the rightto exchange such outstanding warrants for shares of our common stock at therate of one share of common stock underlying such warrants for one share ofcommon stock.  In exchange, the anti-dilution protection under thewarrants was eliminated.  Previously the exercise price of the warrantswould decrease, and the number of shares issuable upon exercise would increase,generally, each time we issued common stock or common stock equivalents at aprice less than the exercise price of the warrants.  The amendmentagreement eliminates the potential for future dilution from the warrants.

 

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Under the terms of theamendment agreement, the parties also agreed to terminate the registrationrights agreement dated January 31, 2008, as amended on April 22,2008, and each agreed to waive any and all defaults that may have occurredunder such agreement. We further agreed to provide an additional remedy to theholder if we fail to satisfy, for any reason, the current public informationrequirement under Rule 144(c).

 

For a more detaileddiscussion of our April 2008 Debentures, please see the discussion underthe caption “April 2008 Debentures” under “Note 6. Convertible Notes andDebentures and Embedded Derivative and Warrant Liability” to our financialstatements contained in this report.

 

For a more detailed discussion of our January 2008Debentures, please see the discussion under the caption “January 2008Debentures” under “Note 6. Convertible Notes and Debentures and EmbeddedDerivative and Warrant Liability” to our financial statements contained in thisreport.

 

*Series A Preferred Financing*

 

In December 2008 and February 2009, weclosed a round of financing for the sale of 843,333 shares of our Series APreferred Stock at $0.75 per share, for an aggregate purchase price of $632.5thousand, and warrants to purchase 843,333 shares of common stock of theCompany, at an exercise price of $0.75 per share, and a three year term.  This financing was led by Daniel J.A. Kolke,our founder, chairman, chief executive officer, acting chief financial officer,and chief technology officer, with participation from two of our directors andother prior investors. The holders of the January 2008 Debentures and the April 2008Debentures consented to this financing, but did not participate.

 

During the quarter ended December 31, 2009,holders of 100,000 shares of our Series A Preferred Stock converted theshares into common stock at the conversion price of $0.75 per share.  At December 31, 2009 we had 743,333shares of Series A Preferred Stock issued and outstanding.

 

***Critical Accounting Policies Involving ManagementEstimates and Assumptions***

 

Ourdiscussion and analysis of our financial condition and results of operations isbased on our financial statements.  Inpreparing our financial statements in conformity with accounting principlesgenerally accepted in the United States, we must make a variety of estimatesand assumptions that affect the reported amounts of assets and liabilities, thedisclosure of contingent assets and liabilities, and the reported amounts ofrevenues and expenses.  We haveidentified the following accounting policies that we believe requireapplication of management’s most subjective judgments, often requiring the needto make estimates about the effect of matters that are inherently uncertain andmay change in subsequent periods.

 

***Allowance for Doubtful Accounts***

 

Weprovide, when appropriate, an allowance for doubtful accounts to ensure thatour trade receivables are not overstated due to un-collectability. Thecollectability of our accounts receivables is evaluated based on a variety offactors, including the length of time receivables are past due, indication ofthe customer’s willingness to pay, significant one-time events and historicalexperience.  We have not recorded anallowance for doubtful accounts at this time as we believe all our accountsreceivable will be collected.

 

***Revenue Recognition***

 

Weprovide Web Applications as a subscription service using theSoftware-as-a-Service (SaaS) or software-on-demand business model and allowthird parties to offer their products and services through Storefronts in anEtelos Marketplace, and to advertise on our web site or in our annual magazinefor a fee.  We also license our softwareunder perpetual and term licenses. Revenues are recognized on these service and licensing transactionsusing the criteria in ASC 605-10, “Revenue Recognition” (ASC 605-10) and ASC985-605, “Software Revenue Recognition”, (ASC 985-605) respectively, which bothprovide that revenue may be recognized when all of the following criteria aremet:

 

·                  Persuasive evidence of anarrangement exists,

·                  The product or service hasbeen delivered,

·                  The fee is fixed ordeterminable, and

·                  Collection of the resultingreceivable is reasonably assured or probable.

 

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Wemust first determine whether ASC 605-10 or ASC 985-605 applies to our revenuetransactions.  We than determine if thecriteria above have been met by assessing the ASC 605-10 and ASC 985-605 andtheir various interpretations in view of the agreements and other documentationrelated to the revenue transactions.  Theinterpretation of the agreements often requires considerable judgment as wellas determining what accounting literature is appropriate and how that literatureshould be applied.  If our standardagreements are used to establish evidence of the arrangement, then our revenueis generally recognized as follows:

 

ForSaaS revenue transactions, persuasive evidence of an arrangement exists uponacceptance by the customer of a binding agreement and authorization by thecustomer to charge a credit card; delivery generally occurs over the term ofthe subscription agreement related to the SaaS; and the fee is fixed andcollection reasonably assured when the customer’s credit card is charged.  Accordingly, revenue is recognized over theperiod the SaaS is provided.

 

Forsoftware licensed under term or perpetual agreements, persuasive evidence ofthe arrangement is evidenced by a binding agreement signed by the customer anddelivery generally occurs upon delivery of the software to a common carrier. Ifa significant portion of a fee is due after our normal payment terms oftypically 30 days, we recognize revenue as the fees become due. If we determinethat collection of a fee is not reasonably assured, we defer the fees andrecognize revenue upon cash receipt, provided that all other revenuerecognition criteria are met.

 

However,if the terms and conditions of an agreement are nonstandard, then significantcontract interpretation is sometimes required to determine the appropriateaccounting for these transactions including: (1) whether an arrangementexists; (2) how the arrangement consideration should be allocated amongpotential multiple elements; (3) when to recognize revenue on thedeliverables; (4) whether all elements of the arrangement have beendelivered; (5) whether the arrangement should be reported gross as aprincipal versus net as an agent; (6) whether we receive a separatelyidentifiable benefit from the purchase arrangements with our customer for whichwe can reasonably estimate fair value; and (7) whether the arrangementshould be characterized as revenue or a reimbursement of costs incurred. Inaddition, our revenue recognition policy requires an assessment as to whethercollection is reasonably assured, which inherently requires us to evaluate thecreditworthiness of our customers. Changes in judgments on these assumptionsand estimates could materially impact the timing or amount of revenuerecognition.

 

***Internal Use Software***

 

UnderASC 985-20 “Costs of Software to be Sold, Leased, or Marketed” (ASC 985-20),costs incurred in the research and development of new software products areexpensed as incurred until technological feasibility is established.  Alternatively, ASC 350-40 “Internal UseSoftware” (ASC 350-40), applies to software development costs that are notrelated to software to be sold, licensed, leased or otherwise marketed as aseparate product or as part of a product or process and are within the scope ofASC 985-20.  Under ASC 350-40, softwaredevelopment costs incurred for software that is only used internally, includingcosts incurred to purchase third party software, are capitalized beginning whenthe Company has determined certain factors are present, including among others,that technology exists to achieve the performance requirements, buy versusinternal development decisions have been made, and the Company’s management hasauthorized the funding for the project. We must determine whether ASC 985-20 or ASC 350-40 is applicable to oursoftware development costs.  We then mustdetermine when software capitalization should begin and cease and what costsunder the applicable standard can be capitalized.  Both of these tasks involves considerablejudgment and can result in material different amounts of software beingcapitalized and have a significant impact on our reported results ofoperations.  To date, because we plan tolicense all our software products, we have determined that the provisions ofASC 985-20 should be applied to the cost of our product development.  As products and enhancements have generallyreached technological feasibility and have been released for sale atsubstantially the same time, all research and development costs have beenexpensed.

 

***Stock-Based Compensation Expense***

 

Wehave adopted ASC 718-10 using the modified prospective method andtherefore have not restated prior periods’ results. Under the fair valuerecognition provisions of ASC 718-10, we recognize stock-based compensationexpense net of an estimated forfeiture rate and therefore only recognizecompensation cost for those shares expected to vest over the service period ofthe award.  Calculating stock-basedcompensation expense requires the input of highly subjective assumptions,including the expected term of the stock-based awards, stock price volatility,and the pre-vesting option forfeiture rate. We estimate the expected life ofoptions granted based on historical exercise patterns, which we believe are representativeof future behavior. We estimate the volatility of our common stock on the dateof grant based on the historical volatility of other publicly traded companiesin our industry. The assumptions used in calculating the fair value ofstock-based awards represent our best estimates, but these estimates involveinherent uncertainties and the application of management judgment. As a result,if factors change and we use different assumptions, our stock-basedcompensation expense could be materially different in the future. In addition,we are required to estimate the expected forfeiture rate, as well as theprobability that performance conditions that affect the vesting of certainawards will be achieved, and only recognize expense for those shares expectedto vest. We estimate the forfeiture rate based on historical experience of ourstock-based awards that are granted, exercised, and cancelled. If our actualforfeiture rate is materially different from our estimate, the stock-basedcompensation expense could be significantly different from what we haverecorded in the current period. Beginning in the quarter ended December 31,2008, and continuing in the year ended December 31, 2009, the globaleconomy has been highly volatile and, during this period, the Company found itnecessary to take drastic measures to reduce operating expenses, but thelikelihood of success of these efforts cannot be predicted.  Therefore the forfeiture rate in the quarterended December 31, 2008, was very high. The forfeiture rate declined substantially during the year ended December 31,2009, but it is not known whether this forfeiture rate will be maintained inthe future; management will continue to monitor its estimates.

 

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***Accounting for Convertible Notes and Debentures,Embedded Derivatives and Warrants***

 

Weevaluate the embedded derivatives included in the debt instruments we issueunder the guidance in ASC 815-10 “Derivatives and Hedging” (ASC 815-10) on theissuance date of the debt and on each subsequent reporting date to determinewhether such embedded derivatives are clearly and closely related to the debthost.  The purpose of the evaluation isto determine whether the embedded derivatives, which are not clearly andclosely related to the debt host, need to be bifurcated from the debt host andaccounted for as a derivative at their estimated fair value as a liability orasset at the date of issuance and thereafter, adjusted to estimated fair valuewith a charge or credit to our statement of operations. ASC 815-10 generallyindicates that if the conversion features are (i) indexed to the Company’scapital stock under the guidance in ASC 815-40-15 “Derivatives and Hedging —Contracts in Entity’s Own Equity — Scope and Scope Exceptions” (ASC 815-40-15)and (ii) would be classified as equity if a freestanding derivative underthe guidance in ASC 815-40-25 “Derivatives and Hedging — Contracts in Entity’sOwn Equity — Recognition” (ASC 815-40-25), then the embedded derivatives neednot be bifurcated from the debt host.  Wealso evaluate the warrants issued with the debt under ASC 815-40-25 todetermine whether the proceeds allocated to the warrants or the fair value ofthe warrants should be recorded as equity or a liability, respectively, and ifa liability adjusted to fair value with a charge or credit to our statement ofoperations. ASC 815-40-25 generally requires, among other factors, that (i) theCompany can settle the derivative in cash or its own stock, at its option, (ii) settlementcan be made in unregistered shares, and (iii) the Company has sufficientauthorized shares to issue shares of its common stock for all equityinstruments convertible to or which can be exercised for its capital stock. ASC815-10 also provides guidance on when put and call features included in a debthost agreement are not clearly and closely related to the debt host and must bebifurcated and recorded as liability. The guidance in ASC 815-10 is complex and it has manyinterpretations.  Accordingly, we mustuse judgment to apply and interpret this guidance as well as ensure we have appliedthe correct guidance.

 

Ifthe embedded derivatives or warrants must be recorded as a liability, then wemust make certain assumptions to value the embedded derivative.  This includes computing the discounted netpresent value of the debt and making assumptions about interest rates, probabilitiesof outcomes, volatility, fair value of the Company’s stock prior to its mergerwith Tripath, and discount rates.  Thediscount factor is the Company’s estimate of the appropriate rate of returnthat an investor would expect from a similar debenture not taking intoconsideration the conversion feature or warrants.  All of these assumptions have a materialimpact on the value attributed to the derivative or warrant.

 

Our analysis and judgmentmay vary from quarter to quarter and changes in estimates may result insignificant increases or decreases in expenses. Moreover, because of the relative size of our operations and the numberof stock options and derivative instruments we have issued, income and expensesassociated with changes in the value of outstanding derivative securities historicallyhave had an overshadowing impact on our financial results.  Consequently, our net income or loss for anyparticular period may not be indicative of the Company’s performance for thatperiod as a result of the application of such accounting rules, and thereforeshould not be relied upon by any person as an accurate depiction of the truefinancial condition of the Company.

 

**Results of Operations**

 

***Year Ended December 31, 2009, Compared with Year Ended December 31,2008***

 

***Revenues***

 

Revenueswere $150 thousand and $123 thousand for the years ended December 31, 2009and 2008, respectively. Revenues increased by $27 thousand, or 22 percent, inthe year ended December 31, 2009, compared to the same period in2008.   The increase was due to a fewadditional ad hoc projects undertaken concurrently with the transition in ourbusiness model.

 

***Cost of Revenue***

 

Costof revenue includes our costs of network hardware, software and other resourcesused in delivery of our products and services. Cost of revenue was $268 thousandand $542 thousand for the years ended December 31, 2009 and 2008,respectively. Cost of revenue for the year of 2009 decreased by $274 thousand,or by 51 percent.  The decrease in costof revenue from 2008 to 2009 was primarily attributable to the decreased costsof hosting and Internet bandwidth associated with the transition in ourbusiness model. Stated as a percentage of revenues, cost of revenue for theyear ending December 31, 2009, was 179 percent and for the correspondingperiod of 2008 was 440 percent.

 

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***Operating Expenses***

 

*Generaland Administrative*.  General andadministrative expenses include payroll and related employee benefits, andother headcount-related costs associated with finance, facilities, legal andother administrative expenses. General and administrative expenses were $3.1million and $3.2 million for the years ended December 31, 2009 and 2008,respectively. The $102 thousand, or 3 percent, decrease in general andadministrative expense was primarily attributable to due to decreased salaryand benefits expense of all administrative personnel, offset by increased useof consultants to support being a public company.

 

*Salesand Marketing Expenses*. Sales and marketing expenses include payroll, employee benefits, andother headcount-related costs associated with sales and marketing personnel andtravel, advertising, promotions, trade shows, seminars, and other programs.Sales and marketing expenses were $0.8 million and $1.7 million for the yearsended December 31, 2009 and 2008, respectively. The $831 thousand, or 50percent, decrease in sales and marketing expense was due to decreased activitiesin direct sales and marketing.

 

*Researchand Development*.  Researchand development expenses include primarily employee and employee relatedexpenses. Research and development expenses were $1.3 million and $2.6 millionfor the years ended December 31, 2009 and 2008, respectively. Research anddevelopment expenses decreased by $1,325 thousand or by 50 percent, in the yearending December 31, 2009, compared to the same period in 2008.  This decrease was primarily due to decreasedsalary and benefits expenses for engineers engaged in research and development.

 

*Restructuring*

 

Restructuringcosts of $92 thousand for the year ended December 31, 2009, consistedprimarily of an increase in the estimated closing costs of the San Mateo officerent obligations of $244 thousand based on the settlement reached with thelandlord in January 2010, offset by a decrease in the estimated employeerelated costs of $175 thousand based on the settlement reached with our formerCEO in December 2009.  There werecosts of $632 thousand in 2008, consisting primarily of employee related costsand office rent obligations.

 

*OtherIncome (Expense)*

 

Netother expense for the year ended December 31, 2009, is $572 thousand,consisting of loss on extinguishment of debt in connection with the amendmentof the January 2008 and April 2008 Debentures, and conversion ofoutstanding promissory notes into part of the September 2009 Debentures.

 

*InterestExpense*

 

Netinterest expense was $1.1 million for the year ended December 31, 2009,compared to interest income of $2.6 million for the comparable period of 2008.The increase in interest expense from 2008 to 2009 of $3,689 thousand was dueto the reduction in the marked-to-market valuation of liabilities relating toembedded derivatives and warrants because of the stability in the Company’sshare price between December 31, 2009 and 2008 and due to thereclassification of warrants from liabilities to equity upon the restructuringof the January 2008 and April 2008 Debentures, offset by a reductionin the amortization of debt discount on the January 2008 and April 2008Debentures due to the acceleration in 2008 of the unamortized debt discountbecause of the default events related to those Debentures.

 

*NetLoss*

 

Ournet loss was $6.8 million and $19.3 million for the years ended December 31,2009 and 2008, respectively, a decrease of $12.5 million, or 65 percent.  The decrease in net loss from 2008 to 2009was due primarily to the Merger costs in 2008 of $13.4 million, decreasedsalaries and general and administrative expenses and other operating expensesof $3.0 million, offset by the increase in interest expense, discussed above.

 

*Liquidityand Capital Resources*

 

OnDecember 31, 2009, we had $445 thousand in cash and cash equivalents, andnet accounts receivable of $10 thousand, and prepaid expenses and other currentassets of $16 thousand. Our working capital deficit at December 31, 2009,was $5 million, which included $315 thousand of warrant and derivativeliability, compared to a deficit of $10.4 million, including $108 thousand inwarrant and derivative liability at December 31, 2008.  The decrease in working capital deficit ismainly attributable to the reclassification of the January 2008 and April 2008Debentures to long-term liabilities upon the amendment of those instruments on June 30,2009.

 

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Netcash used by operating activities during the year ended December 31, 2009,was $2.4 million, compared to $7 million during the year ended December 31,2008. The reduction in the primary use of cash from operating activities from2008 to 2009 was due mainly to a reduction in payment of salaries and generaland administrative expenses and other operating expenses of $3.0 million, and adelay in payment of accounts payable, accrued payroll, and accrued expenses ofapproximately $1.3 million.

 

Netcash provided by financing activities for year ended December 31, 2009,was $2.8 million, primarily from the issuance of our September 2009Debentures, further discussed in “Note 6 — Convertible Notes and Debentures andEmbedded Derivative and Warrant Liability” in our financial statements includedin this report.

 

Netcash provided by financing activities for the year ended December 31,2008, was $6.2 million, primarily from the issuance of our January 2008Debentures and our April 2008 Debentures and the sale of the New Series APreferred shares, further discussed in “Note 6 — Convertible Notes andDebentures and Embedded Derivative and Warrant Liability” in our financialstatements included in this report.

 

Similar to other companies, we have suffered theeffects of the current adverse economic conditions. We are in default of our September 2007notes for failure to make payments when due. The aggregate principal and accrued interest currently due under thesedebt securities as of the year ended December 31, 2009, is $2million.  We restructured a major portionof our debt securities on June 30, 2009, and entered into an additionallong-term debt financing on September 30, 2009, which converted a seriesof bridge loans entered into in the first three quarters of calendar 2009, andprovided for additional cash in September 2009 and in December 2009.   That cash was originally intended to carryus to June 2010 but we incurred substantial unexpected expenses inconnection with resolving certain litigation matters and other major creditorclaims.

 

Our survival plan has continued and we continue to need immediate andsubstantial cash to continue our operations. Management has projected that thecombination of cash on hand will be sufficient to allow us to continue ouroperations only through early-mid 2010. If cash reserves are notsufficient to sustain operations, then we plan to raise additional capital byselling shares of our capital stock or other securities.  We are presently engaged in activediscussions for additional investments by existing and prospective investors butwe have no funding commitments in place at this time and we can give noassurance that such capital will be available on favorable terms, or atall.  If we cannot obtain financing, thenwe may be forced to further curtail our operations, cease voluntarily filingreports with the SEC, or possibly be forced to evaluate a sale or liquidationof our assets, or consider strategic alternatives such as bankruptcy.  Even if we are successful in raisingadditional funds, there is no assurance regarding the terms of any additionalinvestment and any such investment or other strategic alternative would likelysubstantially dilute or eliminate the interests of our stockholders.

 

***Subsequent Events***

 

Subsequently, on January 25, 2010, we enteredinto a securities purchase agreement with an entity affiliated with Donald W.Morissette for the sale of 10% senior secured convertible debentures, identicalto the September 2009 Debentures, in the principal amount of $250,000. Inthis transaction, in addition to the debentures, we issued a warrant topurchase 375,000 shares of our common stock with an exercise price of $0.60 pershare and 375,000 shares of our restricted common stock, or the “closingshares.”  We refer to this financing as our January 2010 financing inthis report. The securities purchase agreement further provided that we had theright, subject to certain conditions, to require the investor to purchase anaggregate of $125,000 in additional principal amount of debentures between March 15and 31, 2010.  We exercised that right onMarch 15, 2010, and issued $125 thousand in additional debentures to anentity affiliated with Mr. Morissette. Mr. Morissette, who, together with his affiliates, beneficiallyowns more than 10% of our outstanding common stock.

 

During the quarter ended December 31, 2009, weentered into a Settlement Agreement with our former CEO Jeffrey L. Garon; seethe Company’s Form 8-K filed with the SEC on December 18, 2009.  Subsequent to the end of the quarter, allpayments required by the settlement agreement were made, whereby we repurchased2,356,655 shares of common stock previously issued to Garon at the originalpurchase price of approximately $175,000, and those shares were cancelled.

 

On October 31, 2008, weclosed our offices in San Mateo, California. On or about December 19, 2008, the landlord for these premisesfiled a complaint claiming damages of $659 thousand and other amounts againstthe Company’s predecessor Etelos, Incorporated, a Washington corporation (“Etelos—WA”) in the Superior Court of San Mateo County, California (Case No. CIV479535).  A default judgment was setaside because the landlord failed to properly serve either the Company orEtelos-WA. The Company was subsequently served properly and trial was set for February 8,2010.  The parties went to mediation in January 2010and subsequently entered into a settlement agreement, including a release ofclaims, in which we agreed: (a) to pay $66,000 in cash within 30 days, (b) toissue a $200,000 promissory note, with 6% interest, payable in 12 monthlypayments beginning in July, 2010, and (c) to issue shares of Common Stockof the Company equal to $125,000 in value, based upon the closing price of theCompany’s stock on January 6, 2010. The settlement agreement and note were executed and delivered on February 8,2010, and 166,667 shares subsequently were delivered on March 1, 2010.

 

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In partial settlement ofapproximately $292 thousand of an aggregate $575 thousand in unpaid salariesdue and owing to current employees of the Company as of December 31, 2009,the board of directors has authorized the registration of 500,000 shares ofCommon Stock previously reserved under the Company’s 2009 Equity Incentive Planas partial payment of up to 50% of the amount of unpaid salary due and owing toeach current employee.  369,078 of thoseshares are to be issued upon completion of the registration process at aneffective price of $0.79 per share.

 

***Commitments and Contingencies***

 

At December 31, 2009, we had the followingfinancing obligations:

 

**September 2007 Notes**

 

Our September 2007 notes were issued as part of aprivate placement that was completed during August and September 2007.  In that private placement we issued a totalof approximately $3.3 million of 6% convertible notes at an original issuediscount of 10% with warrants to purchase 1,080,000 shares of common stock withan exercise price of $1.20 per share. In connection with the Merger that closedon April 22, 2008, $1.5 million of these notes were converted at $0.75 pershare. At the time of the Merger, 974,667 of the warrants had been exercisedand the remaining 33,333 warrants expired by their terms upon closing theMerger.

 

Under the terms of the remaining $1.8 million of thenotes that were not converted, principal payments began being payable on September 1,2008, and continued to be payable on the last day of each calendar quarter, andinterest payments began being payable beginning February 1, 2008.

 

All principal and interest payments under the September 2007notes is due and payable at December 31, 2009, in the approximateaggregate amount of $2 million.

 

**January 2008 and April 2008 Debentures**

 

In January 2008,we issued our January 2008 Debentures with an aggregate principal amountof $2.0 million. In April 2008, we issued our April 2008 Debenturesin the aggregate principal amount of $3.5 million. On June 30, 2009, weentered into an amendment agreement that modified the terms of thesedebentures.  As modified, the debenturesmature on December 31, 2012.  Nointerest accrues under the debentures until September 30, 2010, at whichtime interest will accrue at 6% per annum. Semi-annual payments of interest only, in the approximate amount of $95thousand, begin January 1, 2011, and continue until maturity.

 

**September 2009 Debentures**

 

On September 29,2009, we entered into a securities purchase agreement with three accreditedinvestors for the sale of 10% senior secured convertible debentures in theprincipal amount of $2.0 million. We refer to these debentures as our September 2009Debentures.  In this transaction, inaddition to the debentures, we issued to the investors warrants topurchase 3,000,000 shares of our common stock with an exercise price of $0.60per share, or the “September 2009 warrants,” a warrant to purchase2,250,000 shares of our common stock with an exercise price of $0.01 per share,or the “September 2009 par value warrant,” and 750,000 shares of ourrestricted common stock, or the “closing shares.”  One of the investorspaid part of its subscription amount through the cancellation of approximately$1.2 million worth of short-term indebtedness we owed to such investor.  The securities purchase agreement furtherprovided that we had the right, subject to certain conditions, to require theinvestors to purchase an aggregate of $1.0 million in additional principalamount of debentures.  We exercised thatright on December 15, 2009, and issued an additional $1.0 million ofdebentures to the investors on that date.

 

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The following is a summary of our convertible notesand debentures obligations as of December 31, 2009:

 
| ** **                             | ** ** | **Convertible Notes   and Debentures** | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|
|                                   |       |                                   |       |
| 2010                                   |       | $                                      | 1,764      |   |
| 2011                                   |       | 3,000                                  |       |
| 2012                                   |       | 6,332                                  |       |
| 2013                                   |       | 0                                      |       |
| 2014                                   |       | 0                                      |       |
| Total convertible notes and debentures |       | $                                      | 11,096     |   |

 

**Operating and Capital Leases**

 

Rent expense under leases totaled ($13) thousand and$254 thousand for the periods ended December 31, 2009 and 2008, respectively.  We have no future minimum rental paymentsrequired under non-cancelable leases as these have been recorded asrestructuring costs and are included in other accrued expenses as at December 31,2009. All capital leases were paid off in full during the year ended December 31,2009.

 

On October 31, 2008, we relocated our Washingtonoffices and abandoned the sub-leased premises of our former offices in Renton,Washington. The sublease for these premises runs through June 2010.  Subsequently, on March 5, 2010, theprime landlord filed a complaint against us for breach of contract andsuccessor liability.  This matter wasjust served and we have not yet evaluated the claims made in this case.  We will need to evaluate and defend theseclaims.

 

On or about December 19,2008, the landlord for the San Mateo premises filed a complaint claimingdamages of $659 thousand and other amounts against the Company’s predecessorEtelos, Incorporated, a Washington corporation (“Etelos —WA”) in the SuperiorCourt of San Mateo County, California (Case No. CIV 479535).  A default judgment was set aside because thelandlord failed to properly serve either the Company or Etelos-WA. The Companywas subsequently served properly and trial was set for February 8,2010.  The parties went to mediation in January 2010and subsequently entered into a settlement agreement, including a release ofclaims, in which we agreed: (a) to pay $66,000 in cash within 30 days, (b) toissue a $200,000 promissory note, with 6% interest, payable in 12 monthlypayments beginning in July, 2010, and (c) to issue shares of Common Stockof the Company equal to $125,000 in value, based upon the closing price of theCompany’s stock on January 6, 2010. The settlement agreement and note were executed and delivered on February 8,2010, and 166,667 shares subsequently were delivered on March 1, 2010.

 

**Off Balance Sheet Arrangements**

 

We did not have any off-balance sheetarrangements as of the period ended December 31, 2009.

 

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**Going Concern Issue**

 

Duringthe year ended December 31, 2009, we have been unable to generate cashflows sufficient to support our operations and have been dependent on debtraised from qualified investors.  Weremain dependent on outside sources of funding until our results of operationsprovide positive cash flows.  Our independentauditors issued a going concern explanatory paragraph in their report dated March 17,2010. With our current level of funding, substantial doubt exists about ourability to continue as a going concern.

 

Thefinancial statements contained in this report do not include any adjustmentsrelating to the recoverability and classification of recorded asset amounts oramounts and classification of liabilities that might be necessary should we beunable to continue in existence.  Ourability to continue as a going concern is dependent upon our ability togenerate sufficient cash flows to meet our obligations on a timely basis, toobtain additional financing as may be required, and ultimately to attainprofitable operations.  However, there isno assurance that profitable operations or sufficient cash flows will occur inthe future.

 

Wehave supported current operations by raising additional operating cash throughbridge loans and the private sale of our convertible debentures and preferredstock.  This has provided us with thecash inflows to continue our business plan, but has not resulted in significantimprovement in our financial position. We are considering alternatives toaddress our cash flow situation that include raising capital through additionalsale of our common stock and/or debentures.

 

Thiscould result in substantial dilution of existing stockholders. There can be noassurance that our current financial position can be improved, that we canraise additional working capital, or that we can achieve positive cash flowsfrom operations. Our long-term viability as a going concern is dependent uponour ability to (i) locate sources of debt or equity funding to meetcurrent commitments and near-term future requirements and (ii) achieveprofitability and ultimately generate sufficient cash flow from operations tosustain our continuing operations.

 

**Recent Accounting Pronouncements**

 

During the third quarter of2009, the Company adopted the new Accounting Standards Codification (“ASC”) asissued by the Financial Accounting Standards Board (FASB).  The ASC hasbecome the authoritative source of US GAAP recognized by FASB to be applied bynon-governmental entities.  The ASC is not intended to amend or change USGAAP.  The adoption of the ASC did not have a material impact on theCompany’s financial statements.

 

In June 2009, the FASB issuednew standards for the accounting for transfers of financial assets. These newstandards eliminate the concept of a qualifying special-purpose entity; removethe scope exception from applying the accounting standards that address theconsolidation of variable interest entities to qualifying special-purposeentities; change the standards for de-recognizing financial assets; and requireenhanced disclosure. These new standards are effective beginning in the firstquarter of 2010, and are not expected to have a significant impact on thefinancial statements.

 

In June 2009, the FASBissued amended standards for determining whether to consolidate a variableinterest entity. These amended standards eliminate a mandatory quantitativeapproach to determine whether a variable interest gives the entity acontrolling financial interest in a variable interest entity in favor of aqualitatively focused analysis, and require an ongoing reassessment of whetheran entity is the primary beneficiary. These amended standards are effectivebeginning in the first quarter of 2010 and are not expected to have asignificant impact on the financial statements.

 

In October 2009, theFASB issued new standards for revenue recognition with multiple deliverables.These new standards impact the determination of when the individualdeliverables included in a multiple-element arrangement may be treated asseparate units of accounting. Additionally, these new standards modify themanner in which the transaction consideration is allocated across theseparately identified deliverables by no longer permitting the residual methodof allocating arrangement consideration. These new standards are required to beadopted in the first quarter of 2011; however, early adoption is permitted. TheCompany does not expect these new standards to significantly impact thefinancial statements.

 

In October 2009, theFASB issued new standards for the accounting for certain revenue arrangementsthat include software elements. These new standards amend the scope ofpre-existing software revenue guidance by removing from the guidancenon-software components of tangible products and certain software components oftangible products. These new standards are required to be adopted in the firstquarter of 2011; however, early adoption is permitted. The Company does notexpect these new standards to significantly impact the financial statements.

 

InJanuary 2010, the FASB issued amended standards that require additionalfair value disclosures. These amended standards require disclosures aboutinputs and valuation techniques used to measure fair value as well asdisclosures about significant transfers, beginning in the first quarter of2010. Additionally, these amended standards require presentation ofdisaggregated activity within the reconciliation for fair value measurementsusing significant unobservable inputs (Level 3), beginning in the first quarterof 2011. The Company does not expect these new standards to significantlyimpact the financial statements.

 

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**ITEM 7A.****                ****QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Intentionally omittedpursuant to Item 305(e) of Regulation S-K.

** **

**ITEM 8.****                   ****FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

The following financialstatements are included beginning on page F-1 of this report:

 
| ** **                                                                                    | **Page** |
|-----------------------------------------------------------------------------------------------|----------|
| Report of Independent Registered Public Accounting  Firm                                      | F-1      |
| Balance Sheets as of December 31, 2009 and 2008                                          | F-2      |
| Statements of Operations for the years ended  December 31, 2009 and 2008                 | F-3      |
| Statements of Stockholders’ Deficit for the years  ended December 31, 2009 and 2008 | F-4      |
| Statements of Cash Flows for the years ended  December 31, 2009 and 2008                 | F-5      |
| Notes to Financial Statements                                                                 | F-6      |

** **

**ITEM 9.****                   ****CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

** **

**None.**

** **

**ITEM 9A.****                ****CONTROLS AND PROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

Our disclosure controls and procedures are designed toprovide reasonable assurances that material information related to our companyis recorded, processed, summarized, and reported within the time periodsspecified in the SEC rules and forms, and that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure. Our Chief Executive Officer and Chief FinancialOfficer evaluated our disclosure controls as of December 31, 2009.

 

Based on this evaluation, our Chief Executive Officerand Chief Financial Officer have concluded that our disclosure controls andprocedures were not effective as of December 31, 2009, at the reasonableassurance level for the reasons discussed below related to material weaknessesin our internal control over financial reporting.

 

**Management’sAnnual Report on Internal Control Over Financial Reporting**

 

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act.  Our internal controls are intendedto provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with accounting principles generally accepted in the United Statesof America (“GAAP”).  Our internal controls include policies andprocedures that:

 
| 1.     |   | pertain to the  maintenance of records that in reasonable detail accurately and fairly  reflect the transactions and dispositions of our assets;                                                                                                                                         |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                     |
| 2.     |   | provide reasonable  assurance that transactions are recorded as necessary to permit preparation  of financial statements in accordance with GAAP, and that our receipts and  expenditures are being made only in accordance with the authorization of our  management and directors; and |
|   |   |                                                                                                                                                                                                                                                                                     |
| 3.     |   | provide reasonable  assurance regarding prevention or timely detection of unauthorized  acquisition, use or disposition of our assets that could have a material  effect on the financial statements.                                                                                    |

 

Our management is responsible for establishing andmaintaining adequate internal control over our financial reporting.  Under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, we conducted an evaluation of the effectiveness of ourinternal control over financial reporting based on the framework in InternalControl-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).  Based on our evaluation under that framework,our management concluded that our internal control over financial reporting wasnot effective as of December 31, 2009 as a result of several materialweaknesses in our internal controls.

 

A material weakness is a deficiency, or a combinationof deficiencies, in internal control over financial reporting, such that thereis reasonable possibility that a material misstatement of the Company’s annualor interim financial statements will not be prevented or detected on a timelybasis.  We had previously concluded thatour internal control over financial reporting as of December 31, 2008, wasnot effective because of a lack of resources to obtain sufficient in-housepersonnel, as described below. Therefore, we have identified the followingmaterial weaknesses:

 
| 1. |   | we have not completed  the design and implementation of effective internal control policies and procedures  necessary to provide reasonable assurances regarding accurate and timely  financial accounting, recording and reporting of routine and non-routine  commitments and transactions and effective management oversight of the  accounting for routine and non-routine transactions, or to monitor the  effectiveness of our internal controls; |
|----|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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| 2.     |   | we have not completed  the design and implementation of effective internal control policies and  procedures necessary to provide reasonable assurance regarding accurate and  timely period end financial closing and reporting;                                                                                                        |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 3.     |   | we have not completed  the design and implementation of effective internal control policies and  procedures related to risk assessment and fraud prevention and detection  activities;                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 4.     |   | we have not completed  the design and implementation of effective internal control policies and  procedures necessary to provide reasonable assurance regarding the accuracy  and integrity of spreadsheets and other “off system” work papers that are  used in the financial accounting process;                            |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 5.     |   | we have not completed  the design and implementation of internal control policies and procedures  necessary to provide reasonable assurance with respect to the accuracy and  completeness of assertions and disclosures related to significant financial  statement accounts, and with respect to IT general and application controls; |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 6.     |   | we did not maintain  sufficient in-house personnel resources with the technical accounting  knowledge, expertise and training in the selection, application and  implementation of GAAP to certain complex or non-routine transactions; and                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 7.     |   | we did not maintain  adequate segregation of duties for staff members responsible for certain  financial accounting and reporting functions.                                                                                                                                                                                            |

 

It is possible that we may have additional materialweaknesses that we have not yet identified. We are in the process of attemptingto remediate the above noted material weaknesses, but that remediation was notcomplete as of December 31, 2009, or the filing date of this report.

 

Our plans to remediate the identified materialweaknesses include: developing action plans to complete the implementation ofinternal controls necessary to correct each such weakness; assessing the needto take additional actions including, but not limited, to the following:evaluate accounting and control systems to identify opportunities for enhancedcontrols; recruit and hire additional staff to provide greater segregationof duties; evaluate the need for other employee changes; and evaluate suchother actions as our advisors may recommend. During 2009, we engaged outside consultants with technical accountingknowledge and expertise to advise and ensure the preparation of our financialstatements in accordance with GAAP, with particular emphasis on certain complexor non-routine transactions. Nevertheless, our ability to remediate all weaknesses is substantiallyimpaired by our limited financial resources.

 

Management does not believe that any of the Company’sannual or interim financial statements issued to date contain a materialmisstatement as a result of the aforementioned weaknesses in our internal controlover financial reporting.

 

This annual report does not include an attestationreport of our registered public accounting firm regarding internal control overfinancial reporting.  Management’s reportwas not subject to attestation by our registered public accounting firmpursuant to temporary rules of the SEC that permit the company to provideonly management’s report in this annual report.

 

Our management, including our Chief Executive Officerand Chief Financial Officer, does not expect that our disclosure controls orinternal controls over financial reporting will prevent all errors or allinstances of fraud.  A control system, nomatter how well designed and operated, can provide only reasonable, not absolute,assurance that the control system’s objectives will be met.  Further, the design of a control system mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs.  Because of the inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance thatall control issues and instances of fraud, if any, within our company have beendetected.  These inherent limitationsinclude the realities that judgments in decision-making can be faulty, and thatbreakdowns can occur because of simple error or mistake.  Controls can also be circumvented by theindividual acts of some persons, by collusion of two or more people, or bymanagement override of the controls.  Thedesign of any system of controls is based in part upon certain assumptionsabout the likelihood of future events, and any design may not succeed inachieving its stated goals under all potential future conditions.  Over time, controls may become inadequatebecause of changes in conditions or deterioration in the degree of compliancewith policies or procedures.  Because ofthe inherent limitation of a cost-effective control system, misstatements dueto error or fraud may occur and not be detected.

 

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**ChangesIn Internal Controls over Financial Reporting.**

 

We did not make any changes in our internal controlover financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) ofthe Exchange Act) during our most recent fiscal quarter that has materiallyaffected, or is likely to materially affect, our internal control overfinancial reporting.

 

**ITEM 9B.****                ****OTHERINFORMATION**

** **

**None.**

** **

**PART III**

 

**ITEM 10.****                 ****DIRECTORS, EXECUTIVE OFFICERS ANDCORPORATE GOVERNANCE**

** **

Our directors are electedby our stockholders to a term of one year and to serve until his or hersuccessor is duly elected and qualified, or until his death, resignation orremoval.  Each of our officers is appointed by our board of directors to aterm of one year and serves until his successor is duly elected and qualified,or until his death, resignation or removal from office.

 

Our bylaws provide thatthe number of directors that shall constitute our whole board of directorsshall not be less than one or more than nine.  The number of directors isdetermined by resolution of our board of directors or by our stockholders atour annual meeting.  Our current board of directors consists of four directors.

 

The following table setsforth certain information regarding our executive officers and directors as of December 31,2009:

 
| **Name**             | ** ** | **Position**                                                   | ** ** | **Age** |
|----------------------|------------|----------------------------------------------------------------|------------|---------|
| Daniel J. A. Kolke   |       | Chairman, Chief  Executive Officer and Chief Financial Officer |       | 39      |
| Ronald A. Rudy       |       | Director                                                       |       | 67      |
| Andy Liu             |       | Director                                                       |       | 33      |
| Robert L. Thordarson |       | Director                                                       |       | 43      |

 

***Daniel J. A. Kolke***

 

Danny Kolke foundedEtelos, Incorporated in May 1999.  It is his vision and energy as thekey architect that has driven development of the Etelos Ecosystem.  Mr. Kolkehas served as a member of our board of directors and as various executiveofficers since our inception in 1999.  Hehas served as chairman of our board of directors since April 4, 2000. Mr. Kolkeis widely respected as an industry-leading pioneer in SaaS and cloud computingand makes significant contributions to the Company and our board of directorsas the key architect of the Etelos Ecosystem and as a lecturer and evangelistfor SaaS and cloud computing.  He wasappointed our chief executive officer in September 2008 and as our actingchief financial officer in December 2008. He attended the Stanford Law School Directors College in 2008.

 

***Ronald A. Rudy***

 

Ronald A. Rudy has servedas a director since March 1, 2006. He has been an independent investor and consultant to the mortgageindustry since September 2005. He founded Portland Mortgage Company in1983 and served as its president and chief executive officer until it wasacquired in 2004, until September 2005. Portland Mortgage Company was thelargest independent Mortgage Banking Company in Oregon and Southwest Washingtonwith over $1 billion in loan volume.  Mr. Rudywas responsible for managing all financial and regulatory reporting, and themanagement of a $39 million warehouse line of credit and the hedging operationsin connection with $100-$150 million of loans in process.  His expertise in financial matters andexperience in management of financial and regulatory matters make a majorcontribution to our board of directors.  Mr. Rudy served as president of theOregon Mortgage Bankers Association in 1989 and as president of OregonExecutives in 2003.  Mr. Rudy servedon the Board of Governors for The Mortgage Bankers Association from 1996-2003and on the National Board of Directors of The Mortgage Bankers Association in2003-2004. He also was president of the Portland Guadalajara SistersAssociation in 2000 and a member of its board of directors from 1996-2001. Mr. Rudy isa graduate of the University of Portland and attended the Stanford Law SchoolDirectors College in 2008.

 

***AndyLiu***

 

Andy Liu has served as adirector since his appointment by the Board on August 8, 2008.  He is CEO of BuddyTV, the largestindependently held TV site on the Internet. Prior to BuddyTV, Mr. Liuserved as President and CEO of NetConversions from 1999-2004 prior to its saleto aQuantive and served as VP and GM of its Site Optimization unit from2004-2005. He is also a founder of a non-profit that is focused on technologyin developing countries and is very passionate about entrepreneurship. Mr. Liubrings deep experience in building companies, site optimization, viralmarketing, SEO, community building and product development. In 2003, he wasnamed to Puget Sound Business Journal’s “40 Under 40.” Mr. Liu earned hisMBA from Wharton.

 

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***RobertL. Thordarson***

 

Bob Thordarson has servedas a director since his appointment by the Board on October 20, 2008.  He brings 15 years of direct entrepreneurialexperience to Etelos, most in the ideation, funding, launch and growth ofstartups within the Telecommunications and Web Services marketplace. He isfounder and CEO of BluCapp, a Web services startup, and co-founder of Cequint, Inc.,a software company revolutionizing mobile Caller ID services. He was formerlyPresident of TechFaith America, a mobile handset ODM headquartered in Beijing(CNTF), and formerly CEO and Co-Founder of Consumerware, a telecommunicationsdevice design and manufacturing company focused on developing consumer productsfor North America’s largest telecommunications carriers. Mr. Thordarsonbrings hands-on operational and development experience to building companies,business and partner development, managing diverse and distributed teams andchannel marketing. Mr. Thordarson studied Economics at the University ofWashington.

 

There are no familyrelationships among our directors or executive officers.  There are no arrangements between any of ourdirectors and any other person pursuant to which they have been appointed tothe Board.

 

***Audit Committee***

*** ***

We have a separately designated audit committee of ourboard of directors, established in accordance with Section 3(a)(58)(A) ofthe Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Our audit committee is comprised of Messrs. Rudyand Thordarson.  The audit committee isresponsible for the appointment, compensation, retention and oversight of ourindependent registered public accounting firm.  In addition, the committeereviews with our management and its independent auditors financial informationthat will be provided to stockholders and others, the systems of internalcontrols which management and our board have established and our audit andfinancial reporting processes. The committee operates under a written AuditCommittee Charter adopted by our board, a copy of which can be found under the “InvestorInformation — Corporate Governance — Board Committee Charters” section of ourwebsite at www.etelos.com. Our audit committee met in April 2009 inconnection with the audit of our 2008 financial statements, and met three timesin 2009.   Our board of directors has chosen to use the independencestandards of the Nasdaq Stock Market to evaluate the independence of its auditcommittee members.  Our board of directors has determined that all currentmembers of the audit committee are “independent” as that term is defined in thecurrent applicable rules of the Nasdaq Stock Market and also meet theadditional criteria for independence of audit committee members under theapplicable rules of the Exchange Act.  In addition, our board ofdirectors believes that Mr. Rudy is an “audit committee financial expert”as defined in Item 407(d) of Regulation S-B.   Mr. Rudy has served as President &Chief Executive Officer of a major regional mortgage company, where he wasresponsible for managing all financial and regulatory reporting, and themanagement of $1 billion in loan volume, a $39 million warehouse line ofcredit, and the hedging operations in connection with over $100-$150 million ofloans in process.  As a result of thesuccessful management of these responsibilities, Mr. Rudy has extensiveexperience analyzing and evaluating financial statements, an understanding ofgenerally accepted accounting principles, an understanding of internal controlover financial reporting and an understanding of audit committee functions. Mr. Rudyis a graduate of the University of Portland and attended the Stanford LawSchool Directors College in 2008.

 

***Code of Ethics***

*** ***

Our board of directors adopted a “Code of Conduct andPolicy for Reporting Possible Violations” that applies to our directors and allemployees, including our executive officers. Our code of ethics can be viewedby visiting our website at www.etelos.com and clicking on “Investors.” In theevent we make any amendments to, or grant any waivers of, a provision of ourcode of ethics that applies to our principal executive officer, principal financialofficer, or principal accounting officer that requires disclosure underapplicable SEC rules, we intend to disclose such amendment or waiver and thereasons therefore on a Form 8-K or on our next periodic report inaccordance with SEC rules.

 

***Section 16(a) Beneficial Ownership ReportingCompliance***

*** ***

Section 16(a) of the Securities Exchange Actof 1934 requires our officers and directors, and persons who own more than tenpercent of a registered class of our securities, to file with the SEC reports ofownership of our securities and changes in reported ownership. Officers,directors and greater than ten percent stockholders are required by SEC rules tofurnish us with copies of all Section 16(a) reports they file.

 

Based solely on a review of the reports furnished tous, or written representations from reporting persons that all reportabletransaction were reported, we believe that during the fiscal year ended December 31,2009, our officers, directors and greater than ten percent stockholders timely filedall reports they were required to file under Section 16(a).

 

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**ITEM 11.****                 ****EXECUTIVE COMPENSATION**

 

**SummaryCompensation**

 

The Summary CompensationTable below summarizes the total compensation paid or earned by each of ournamed executive officers during the years ended December 31, 2009 and2008.  Throughout this prospectus, the individuals included in the SummaryCompensation Table set forth below are referred to as the “named executiveofficers.”

 

**SummaryCompensation Table**

 
| **Name and Principal Position** | ** ** | **Year** | ** ** | **Salary  ($)** | ** ** | **Bonus  ($)** | ** ** | **Stock  Awards  ($)** | ** ** | **Option  Awards  (2)  ($)** | ** ** | **All Other  Compensation  ($)** | ** ** | **Total  ($)** | ** ** |
|------------------------------------------------|------------|----------|------------|-----------------|------------|----------------|------------|------------------------|------------|------------------------------|------------|---------------------------------------|------------|----------------|------------|
| Daniel J.A. Kolke (1)                          |       | 2009     |       | 200,489         |       | —         |       | —                 |       | 518,874                      |       | —                                |       | 719,363        |       |
| Chief Executive Officer                        |       | 2008     |       | 130,594         |       | —         |       | —                 |       | —                       |       | —                                |       | 130,594        |       |

 

----

(1) Mr. Kolke was appointed Chief ExecutiveOfficer in September 2008 and Chief Financial Officer in November 2008;prior to that time he served as our Chief Technology Officer.

(2)  Represents theamount recognized for financial statement reporting purposes in respect ofoutstanding option awards in accordance with ASC 718. The assumptions made invaluing option awards reported in this column are discussed in Note 3, “Summaryof Significant Accounting Policies” under “Stock-Based Compensation” and Note12, “Accounting for Share-Based Compensation” to our financial statementsincluded in this report.

 

**EmploymentAgreement**

 

Under the terms of theagreement between us and Mr. Kolke regarding his employment, Mr. Kolkeis entitled to receive base salary in the amount of $175,000 payable inaccordance with our payroll policies. In addition, in connection with hisemployment, on August 11, 2007, we granted Mr. Kolke an option topurchase up to 3,433,333 shares of common stock at an exercise price of $0.051per share, of which 858,833 vested on the date of grant, 858,833 vested on theone year anniversary of August 11, 2008, and the balance vest ratablyduring the 24 months following August 11, 2008. If not exercised, theoption expires on August 11, 2017. On October 2, 2009, Mr. Kolke was granted an additional optionto purchase 1,700,000 shares of common stock at an exercise price of $0.51 pershare, of which  425,000 vested upongrant, 425,000 will vest on October 2, 2010, and the balance will vestratably during the 24 months following October 2, 2010.  If not exercised, then these options expireon October 2, 2019.

 

**OutstandingEquity Awards at Fiscal Year End**

 

The following table setsforth information concerning unexercised options, stock that has not vested andequity incentive plan awards for each named executive officer outstanding as ofDecember 31, 2009:

 

**OutstandingEquity Awards at Fiscal Year-End**

 
| ** **         | ** ** | **Option  Awards**                                                                 | ** ** | **Stock  Awards**                                                                    | ** ** |
|--------------------|------------|------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| **Name**           | ** ** | **Number of  Securities  Underlying  Unexercised  Options  exercisable  (1)** | ** ** | **Number of  Securities  Underlying  Unexercised  Options  unexercisable  (2)** | ** ** | **Equity  Incentive  Plan  Awards:  Number of  Securities  Underlying  Unexercised  Unearned  Options** | ** ** | **Option  Exercise  Price  ($)** | ** ** | **Option  Expiration  Date** | ** ** | **Number  of  Shares  or  Units of  Stock  That  Have Not  Vested** | ** ** | **Market  Value of  Shares  or  Units of  Stock  That  Have Not  Vested  ($)** | ** ** | **Equity  Incentive  Plan  Awards:  Number  of  Unearned  Shares,  Units  or Other  Rights  That  Have Not  Vested** | ** ** | **Equity  Incentive  Plan  Awards:  Market  or  Payout  Value  of  Unearned  Shares,  Units  or Other  Rights  That  Have Not  Vested  ($)** | ** ** |
| Daniel  J.A. Kolke |       | 2,861,111                                                                          |       | 572,222                                                                              |       | — |   | 0.051 |   | 08-11-2017 |   | — |   | — |   | — |   | — |   |
| Daniel  J.A. Kolke |       | 425,000                                                                            |       | 1,275,000                                                                            |       | — |   | 0.51 |   | 10-02-2019 |   | — |   | — |   | — |   | — |   |

 

----

(1) Consists of thevested portion of options granted to Mr. Kolke pursuant to his August 2007and October 2009 stock option grants.

(2) Consists of theunvested portion of options granted to Mr. Kolke, pursuant to his August 2007or October 2009 stock option grants. The unvested options granted in August 2007 vest monthly at therate of 71,528 options per month, until August 2010.  The unvested options granted in October 2009vest (a) 425,000 options on October 2, 2010, and (b) thereafterat 35,417 shares per month until October 2012.

 

**DirectorCompensation**

 

On March 5, 2008,our board of directors adopted a board compensation plan providing for (a) existingnon-executive board members to receive options to acquire up to 10,000 sharesof our common stock at an exercise price of $1.20 per share, which vest as to50 percent on the 12 month anniversary of the date of grant and the remaining50 percent on the 24 month anniversary of the date of grant; (b) newnon-executive board members to receive options to acquire up to 10,000 sharesof our common stock at an exercise price equal to the fair market value of ourcommon stock on the date of grant, which vest as to 50 percent on the 12 month anniversaryof the date of grant and the remaining 50 percent on the 24 month anniversaryof the date of grant; (c) all re-elected board members to receive, upontheir re-election, options to acquire up to 10,000 shares of our common stockat an exercise price equal to the fair market value of our common stock on thedate of grant, which vest as to 100 percent on the 12 month anniversary of thedate of grant; and (d) a quarterly payment of $1.5 thousand to eachnon-executive member of the board for their expenses in connection withattendance at quarterly board meetings and periodic board committeemeetings.  In September 2009, ourboard of directors increased the annual grant size for non-executive directorsto 100,000 options.

 

The table below sets forththe compensation the member of our board of directors received during thefiscal year ended December 31, 2009.

 

**DirectorCompensation**

 
| **Name**             | ** ** | **Fees Earned or  Paid in Cash  ($)** | ** ** | **Option Awards  ($)(1)** | ** ** | **All Other  Compensation  ($)** | ** ** | **Total  ($)** | ** ** |
|----------------------|------------|------------------------------------------------------|------------|--------------------------------|------------|---------------------------------------|------------|----------------|------------|
| Ronald A. Rudy       |       | 6,000                                                |       | 30,522                         |       | 0                                     |       | 36,522         |       |
| Andy Liu             |       | 6,000                                                |       | 30,522                         |       | 0                                     |       | 36,522         |       |
| Robert L. Thordarson |       | 6,000                                                |       | 30,522                         |       | 0                                     |       | 36,522         |       |

 

----

(1)           Represents the amount recognized forfinancial statement reporting purposes in respect of outstanding option awardsin accordance with ASC 718. The assumptions made in valuing option awardsreported in this column are discussed in Note 3, “Summary of SignificantAccounting Policies” under “Stock-Based Compensation” and Note 12, “Accountingfor Share-Based Compensation” to our financial statements included in thisreport. At December 31, 2009, the following option awards wereoutstanding: (a) Ronald Rudy 120,000 options, of which 10,000 have vestedas of the date of this report; (b) Andy Liu 110,000 options, 5,000 ofwhich have vested; and (c) Robert L. Thordarson 110,000 options, 5,000 ofwhich have vested.

 

10,000of the options issued to Mr. Liu were amended by action of the board ofdirectors, Mr. Liu abstaining, on October 2, 2009, which amended allunexpired or forfeited options previously granted on August 8, 2008, torevise the exercise price from $5.93 to $0.51, the closing price of theCompany’s common stock on October 2, 2009.

 

We plan to enter into indemnificationagreements with each of our directors (and our executive officers) on termsthat we believe are reasonable, customary, and comparable to those entered intoby other publicly traded companies in the United States.

 

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**ITEM 12.****                 ****SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

 

The following table setsforth certain information with respect to the beneficial ownership of ourcommon stock as of March 16, 2010, by (i) any person or group owningmore than 5 percent of our common stock, (ii) each director, (iii) eachof our named executive officers, and (iv) all named executive officers anddirectors as a group.  As of March 16, 2010, we had 23,939,810 shares of common stock issued andoutstanding and 743,333 shares of Series A Preferred stock issued andoutstanding.   Beneficial ownership is determined in accordance with Rule 13d-3(d) promulgatedby the SEC under the Exchange Act and includes shares that can be acquiredwithin 60 days through exercise or conversion of a security.  Unless otherwise stated, each beneficialowner has sole power to vote and dispose of the shares and the address of suchperson is c/o Etelos, Inc., 26828 Maple Valley Highway #297, Maple Valley,Washington 93038.

 
| **Name and Address of Beneficial Owner** | ** ** | **Amount and********Nature of  Beneficial Ownership** | ** ** | **Percentage of********Class  Beneficially********Owned** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| **Officers and Directors**                                        |       |                                                                 |       |                                                           |       |
| Daniel J. A. Kolke                                                |       | 6,134,213                                                            | (1)        | 20.63                                                          | %          |
| Ronald A. Rudy                                                    |       | 1,390,272                                                            | (2)        | 5.71                                                           | %          |
| Andy Liu                                                          |       | 110,000                                                              | (3)        | 0.46                                                           | %          |
| Robert L. Thordarson                                              |       | 176,667                                                              | (4)        | 0.73                                                           | %          |
| Directors and Officers as a group                                 |       | 7,811,152                                                            | (5)        | 25.69                                                          | %          |
| **5% Stockholders (other than officers or directors)**            |       |                                                                 |       |                                                           |       |
| Don Morissette                                                    |       | 10,853,650                                                           | (6)        | 43.30                                                          | %          |
| Enable Capital Management LLC                                     |       | 3,703,217                                                            | (7)        | 15.47                                                          | %          |
| Salzwedel Financial Communications, Inc.                     |       | 3,000,000                                                            | (8)        | 11.57                                                          | %          |

 

----

(1)               Consists of (i) 260,629 shares ofcommon stock, (ii) 5,133,333 shares of common stock issuable upon exerciseof options, (iii) 333,333 shares of common stock issuable upon conversionof Series A Preferred Stock, (iv) 333,333 shares of common stockissuable upon exercise of warrants, and (v) 73,585 shares of common stockheld by Mr. Kolke’s spouse.

(2)               Consists of (i) 980,273 shares ofcommon stock, (ii) 110,000 shares of common stock issuable upon exerciseof options, (iii) 133,333 shares of common stock issuable upon conversionof Series A Preferred Stock, and (iv) 166,666 shares of common stockissuable upon exercise of warrants.

(3)               Consists of 110,000 shares of commonstock issuable upon exercise of options.

(4)               Consists of (i) 33,334 shares ofcommon stock, (ii) 110,000 shares of common stock issuable upon exerciseof options, and (iii) 33,333 shares of common stock issuable upon exerciseof warrants.

(5)               Consists of (i) 1,373,603 shares ofcommon stock, (ii) 6,495,999 shares of common stock issuable upon exerciseof options, (iii) 466,666 shares of common stock issuable upon conversionof Series A Preferred Stock, and (iv) 533,332 shares of common stockissuable upon conversion of warrants.

(6)               Don Morissette and Don Morissette, LLCcollectively hold (i) 9,728,650 shares of common stock, (ii) 375,000shares of common stock issuable upon exercise of warrants and (iii) 750,000shares of common stock issuable upon conversion of a debenture.  Mr. Morissette may be contacted at 4230Galewood, Suite 100, Lake Oswego, Oregon 97035.

(7)               Based solely upon information filed bythis stockholder in a Form 4 filed with the SEC on January 12,2010.  Enable Growth Partners, L.P., aDelaware limited partnership (“EGP”), Enable Opportunity Partners, L.P., aDelaware limited partnership (“EOP”), and Pierce Diversified Strategy MasterFund, LLC, a Delaware limited liability company (“Pierce”, and together withEOP and EGP, the “Investors”), collectively hold (i) 3,707,084 shares ofour common stock, (ii) warrants to purchase 444,444 shares of our commonstock at an exercise price of $0.75 per share, subject to certain adjustments(the “Enable Warrants”), (iii) a 6% convertible note (“Note 1”) in theaggregate principal amount of $924,000, which is convertible into shares of ourcommon stock at a conversion rate of $0.75 per share, (iv) a 6%convertible note (“Note 2”) in the aggregate principal amount of $440,000,which is convertible into shares of our common stock at a conversion rate of$0.75 per share, (v) a 6% convertible note (“Note 3”) in the principalamount of $1,000,000, which is convertible into shares of our common stock at aconversion rate of $0.75 per share, and (vi) a 6% convertible note (“Note4”, and together with Note 1, Note 2, and Note 3, the “Notes”) in the principalamount of $3,000,000, which is convertible into shares of our common stock at aconversion rate of $0.75 per share. Note 3, Note 4, and the Enable Warrantseach contain an issuance limitation prohibiting the Investors from exercisingor converting those securities to the extent that such exercise would result inbeneficial ownership by the Investors of more than 4.99% of the Shares thenissued and outstanding.  Enable CapitalManagement, LLC (“ECM”) is the investment manager and general partner of EOPand EGP. ECM also serves as the investment manager of Pierce. Mitchell S. Levineis the Managing Member of ECM and has voting and investment power over thesecurities held by the Investors. Thus, for the purposes of Reg. Section 240.13d-3,EGP, EOP, Pierce, ECM and/or Mr. Levine may be deemed to be beneficialowners of more than 10% of the shares. Mr. Levine holds 73,333 shares inhis individual capacity. Accordingly, this table reflects the aggregateholdings of EGP, EOP, Pierce and Mr. Levine. Other than the shares held byMr. Levine in his individual capacity, ECM and Mr. Levine do not holddirectly any of the securities or derivative securities with respect thereto,and disclaim any beneficial ownership of any of the securities or derivativesecurities reported or excluded herein for purposes of Rule 16a-1(a) underthe Exchange Act, except for their pecuniary interest therein.  ECM may be contacted at One Ferry BuildingSte. 225, San Francisco, California 94111.

(8)              Consistsof (i) 1,000,000 shares of common stock and (ii) 2,000,000 shares ofcommon stock issuable upon exercise of options.

 

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**ITEM 13.****                 ****CERTAIN RELATIONSHIPS AND RELATEDTRANSACTION, AND DIRECTOR INDEPENDENCE**

 

**Related Transactions****.**

 

We previously enteredinto a series of loan transactions with the parents and two brothers of ourchairman and chief executive officer, Mr. Daniel J.A. Kolke.  Inconnection with the settlement of these loans on December 30, 2007, weissued three unsecured promissory notes in the aggregate principal amount of$815.8 thousand which will become secured by certain of our presentlyunidentified assets if and when Mr. Kolke is no longer neither an employeenor a member of our****board ofdirectors. The unsecured promissory notes bearinterest at 7.5 percent.  On December 22,2009, our board of directors, with Daniel J.A. Kolke abstaining, approved theissuance of 434,754 shares of common stock of the company to Daniel & Selma Kolke, as payment of 45% of principal and100% of accrued interest due on their note, as of December 31, 2009, at avalue of $0.75 per share, or approximately $326 thousand.  The balance due on the note to Daniel &Selma Kolke as of December 31, 2009, was $324 thousand, and the principalamount outstanding under the other two promissory notes, in the aggregate, asof December 31, 2009, was $30 thousand.

 

In March 2009, we entered into apromissory note with Ronald A. Rudy, a member of our Board of Directors, in theprincipal amount of $100 thousand, bearing interest of 10% per annum.  On December 22, 2009, our board ofdirectors, with Mr. Rudy abstaining, approved the issuance of 143,379shares of our common stock to Mr. Rudy as payment in full of all principaland accrued interest due on the promissory note as of December 31, 2009,at a value of $0.75 per share.

 

On December 18, 2009, we entered into apromissory note with Daniel J.A. Kolke, our chairman, in the principal amountof $40 thousand, bearing interest at 6% per annum.  All principal on the note was paid in full onJanuary 4, 2010.

 

**Parent Companies****.**

 

We do not have a parentcompany.

 

**Director Independence****.**

 

Ourboard of directors currently consists of four members, Daniel J. A. Kolke,Ronald A. Rudy, Andy Liu and Robert L. Thordarson.  Messrs. Rudy,Liu, and Thordarson are considered independent under the definition ofindependence established by The Nasdaq Stock Market.

 

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**ITEM 14.****                 ****PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

** **

We have selected Stonefield Josephson, Inc. asour independent registered public accounting firm for 2009. The audit committeeof our board of directors intends to meet with the auditor in June 2010 todiscuss the terms of the audit engagement for fiscal 2010. Stonefield Josephsonwas our principal accountant for the fiscal year ended December 31, 2008.Representatives from Stonefield Josephson have been invited to attend theannual meeting. If they attend, they will be provided the opportunity to make astatement if they desire to do so, and are expected to be available to answerappropriate questions.

 

Forpurposes of the tables below:

 
| Audit Fees         |   | include fees and expenses  for professional services rendered for the audits of our annual financial  statements for the applicable year and for the review of the financial  statements included in our quarterly reports on Form 10-Q for the  applicable year.  |
|--------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Audit-Related Fees |   | consist of fees billed for  assurance and related services that are related to the performance of the  audit or review of our financial statements and registration filings with the  SEC and are not reported as audit fees.                                           |
| Tax Fees           |   | consist of preparation of  our federal and state tax returns, review of quarterly estimated payments,  and consultation concerning tax compliance issues.                                                                                                               |
| All Other Fees     |   | includes any fees for  services not covered above. Fees noted for both annual periods primarily  represent fees associated with communications and attendance at meetings with  management, the board of directors, and the audit committee of the board of  directors. |

 

The following table sets forth the aggregate feesbilled for services from January 1, 2009, to December 31, 2009, byStonefield Josephson:

 
| Audit Fees         |   | $      | 247,000 |   |
|--------------------|--------|--------|---------|--------|
| Audit Related Fees |   | $      | —  |   |
| Tax Fees           |   | $      | 10,000  |   |
| All Other Fees     |   | $      | 4,000   |   |
|               |   |   |    |
| Total              |   | $      | 261,000 |   |

 

The following table sets forth the aggregate feesbilled for services from January 1, 2008, to December 31, 2008, byStonefield Josephson:

 
| Audit Fees         |   | $      | 330,000 |   |
|--------------------|--------|--------|---------|--------|
| Audit Related Fees |   | $      | 218,000 |   |
| Tax Fees           |   | $      | 41,000  |   |
| All Other Fees     |   | $      | 13,000  |   |
|               |   |   |    |
| Total              |   | $      | 602,000 |   |

 

**Audit Committee Pre-Approval Policies andProcedures**

 

The policy of the audit committee of our board ofdirectors is to pre-approve all audit and permissible non-audit servicesprovided by our independent auditors. These services may include auditservices, audit-related services, tax services and other services. Pre-approvalis generally provided for up to one year and any pre-approval is detailed as tothe particular service or category of services. The independent auditor andmanagement are required to periodically report to the audit committee regardingthe extent of services provided by the independent auditor in accordance withthis pre-approval.  All of our auditexpenses incurred in 2008 were pre-approved by our Audit Committee.

 

**PART IV**

 

**ITEM 15.****                 ****EXHIBITS, FINANCIAL STATEMENTSCHEDULES**

** **

(a)    Documents filed as part of this Report:

 

(1) Financial Statements—all financial statementsof the Company as set forth under Item 8, on page F-1 of this Report.

 

(2) Financial Statement Schedules—as a smallerreporting company we are not required to provide the information required bythis item.

 

(3) Exhibits

 

40

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**EXHIBITINDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                             |
|----------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  |       | Plan  Proponents’ Third Amended Plan of Reorganization for the Debtor dated  December 20, 2007 (incorporated by reference to the registrant’s Current  Report on Form 8-K filed on April 23, 2008)                                                                                                                                                                                 |
| 2.2                  |       | Agreement  and Plan of Merger dated April 22, 2008 between Tripath Technology Inc.  and Etelos, Incorporated (incorporated by reference to the registrant’s  Current Report on Form 8-K filed on April 23, 2008)                                                                                                                                                                        |
| 3.1                  |       | Amended  and Restated Certificate of Incorporation (incorporated by reference to the  registrant’s Current Report on Form 8-K filed on April 23, 2008)                                                                                                                                                                                                                                       |
| 3.2                  |       | Bylaws  (incorporated by reference to the registrant’s Current Report on  Form 8-K filed on April 23, 2008)                                                                                                                                                                                                                                                                                  |
| 3.3                  |       | Certificate  of Designation For Series A Preferred Stock (incorporated by reference  to the registrant’s Current Report on Form 8-K filed on December 5,  2008)                                                                                                                                                                                                                         |
| 4.1                  |       | Form of  common stock purchase warrant issued in connection with the January 2008  financing (incorporated by reference to the registrant’s Current Report on  Form 8-K filed on April 23, 2008)                                                                                                                                                                                   |
| 4.2                  |       | Form of  original issue discount 6.0% senior secured convertible debenture issued in  connection with the January 2008 financing (incorporated by reference to  the registrant’s Current Report on Form 8-K filed on April 23,  2008)                                                                                                                                              |
| 4.3                  |       | Form of  common stock purchase warrant issued in connection with the April 2008  financing (incorporated by reference to the registrant’s Registration  Statement on Form S-1 filed on May 8, 2008)                                                                                                                                                                                |
| 4.4                  |       | Form of  original issue discount 6.0% senior secured convertible debenture issued in  connection with the April 2008 financing (incorporated by reference to  the registrant’s Registration Statement on Form S-1 filed on May 8,  2008)                                                                                                                                           |
| 4.5                  |       | Form of  convertible promissory note issued by Etelos, Incorporated in August and  September 2007 (incorporated by reference to the registrant’s Registration  Statement on Form S-1 filed on May 8, 2008)                                                                                                                                                                    |
| 4.6                  |       | Form of  three year Common Stock Purchase Warrant dated December 3, 2008  (incorporated by reference to the registrant’s Current Report on  Form 8-K filed on December 5, 2008)                                                                                                                                                                                                    |
| 4.7                  |       | Form of  10% Senior Secured Convertible Debenture issued in connection with  September 2009 financing (incorporated by reference to the registrant’s  Current Report on Form 8-K filed on September 30, 2009)                                                                                                                                                                      |
| 4.8                  |       | Form of  warrant issued in connection with September 2009 financing with an  exercise price of $0.60 per share (incorporated by reference to the  registrant’s Current Report on Form 8-K filed on September 30,  2009)                                                                                                                                                            |
| 4.9                  |       | Form of  Warrant issued in connection with September 2009 financing with an  exercise price of $0.01 per share (incorporated by reference to the  registrant’s Current Report on Form 8-K filed on September 30,  2009)                                                                                                                                                            |
| 4.10                 |       | Form of  10% Senior Secured Convertible Debenture issued in connection with  January 2010 financing (incorporated by reference to the registrant’s  Current Report on Form 8-K filed on January 26, 2010)                                                                                                                                                                          |
| 4.11                 |       | Form of  warrant issued in connection with the January 2010 financing with an  exercise price of $0.60 per share (incorporated by reference to the  registrant’s Current Report on Form 8-K filed on January 26, 2010)                                                                                                                                                             |
| 10.1                 |       | Loan  and Security Agreement by and among Etelos, Incorporated and Bridge Bank,  National Association dated October 5, 2007 (incorporated by reference to  the registrant’s Current Report on Form 8-K filed on April 23,  2008)                                                                                                                                                        |
| 10.2                 |       | The  anti-dilution agreement entered between Etelos, Incorporated and each of Don  Morissette and Ronald A. Rudy, as amended, dated March 6, 2008  (incorporated by reference to the registrant’s Current Report on  Form 8-K filed on April 23, 2008)                                                                                                                                  |
| 10.3                 |       | Settlement  Agreement and General Release of Claims dated December 30, 2007, among  (i) Etelos, Incorporated, (ii) Robyn and Daniel J.A. Kolke,  (iii) Selma and Daniel A. Kolke, (iv) Kristin and Desmond D. Kolke,  and (v) Crystal and Raymond D. Kolke (incorporated by reference to the  registrant’s Current Report on Form 8-K filed on April 23, 2008) |
| 10.4                 |       | Promissory  Note dated December 30, 2007 issued to Selma and Daniel A. Kolke  (incorporated by reference to the registrant’s Current Report on  Form 8-K filed on April 23, 2008)                                                                                                                                                                                                       |
| 10.5                 |       | Promissory  Note dated December 30, 2007 issued to Daniel J.A. Kolke (incorporated  by reference to the registrant’s Current Report on Form 8-K filed on  April 23, 2008)                                                                                                                                                                                                               |
| 10.6                 |       | Promissory  Note dated December 30, 2007 issued to Desmond D. Kolke (incorporated by  reference to the registrant’s Current Report on Form 8-K filed on  April 23, 2008)                                                                                                                                                                                                                |
| 10.7                 |       | Securities  Purchase Agreement by and among Etelos, Incorporated and the purchasers  identified therein dated as of January 31, 2008 (incorporated by  reference to the registrant’s Current Report on Form 8-K filed on  April 23, 2008)                                                                                                                                               |
| 10.8                 |       | Registration  Rights Agreement by and among Etelos, Incorporated and the purchasers  identified therein dated as of January 31, 2008 (incorporated by  reference to the registrant’s Current Report on Form 8-K filed on  April 23, 2008)                                                                                                                                               |
| 10.9                 |       | Security  Agreement dated as of January 31, 2008 by and among Etelos, Incorporated  and the holders of the original issue discount 6.0% senior secured  convertible debentures issued in connection with the January 2008  financing (incorporated by reference to the registrant’s Current Report on  Form 8-K filed on April 23, 2008)                                           |
| 10.10                |       | Securities  Purchase Agreement by and among Etelos, Incorporated and the purchasers  identified therein dated as of                                                                                                                                                                                                                                                                                         |

 

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|   |   | April 22,  2008 (incorporated by reference to the registrant’s Registration Statement on  Form S-1 filed on May 8, 2008)                                                                                                                                                                  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.11  |   | Amendment  to Registration Rights Agreement by and among Etelos, Incorporated and the  purchasers identified therein dated as of April 22, 2008 (incorporated  by reference to the registrant’s Registration Statement on Form S-1  filed on May 8, 2008)                                 |
| 10.12# |   | Employment  Agreement dated August 11, 2007 with Jeffrey L. Garon (incorporated by  reference to the registrant’s Registration Statement on Form S-1 filed  on May 8, 2008)                                                                                                               |
| 10.13# |   | Employment  Agreement dated August 11, 2007 with Daniel J.A. Kolke (incorporated by  reference to the registrant’s Registration Statement on Form S-1 filed  on May 8, 2008)                                                                                                              |
| 10.14  |   | Securities  Purchase Agreement by and among Etelos, Incorporated and the purchasers  identified therein related to the August and September 2007  convertible note offering (incorporated by reference to the registrant’s  Registration Statement on Form S-1 filed on May 8, 2008) |
| 10.15  |   | Letter  Agreement dated May 2, 2008 (incorporated by reference to the  registrant’s Registration Statement on Form S-1 filed on May 8,  2008)                                                                                                                                             |
| 10.16  |   | Form of  Securities Purchase Agreement for Series A Preferred Stock dated  December 3, 2008 (incorporated by reference to the registrant’s Current  Report on Form 8-K filed on December 5, 2008)                                                                               |
| 10.17  |   | Promissory  Note dated April 17, 2009 issued to Enable Growth Partners LP  (incorporated by reference to the registrant’s Current Report on  Form 8-K filed on April 23, 2009)                                                                                                            |
| 10.18  |   | Amendment  Agreement dated June 30, 2009 (incorporated by reference to the  registrant’s Current Report on Form 8-K filed on July 1, 2009)                                                                                                                                                |
| 10.19  |   | Form of  Securities Purchase Agreement dated September 29, 2009 (incorporated by  reference to the registrant’s Current Report on Form 8-K filed on  September 30, 2009)                                                                                                             |
| 10.20  |   | Form of  Security Agreement dated September 29, 2009 (incorporated by reference  to the registrant’s Current Report on Form 8-K filed on  September 30, 2009)                                                                                                                        |
| 10.21  |   | Form of  Securities Purchase Agreement dated January 25, 2010 (incorporated by  reference to the registrant’s Current Report on January 26, 2010)                                                                                                                                         |
| 10.22  |   | Form of  Amendment to Security Agreement dated January 25, 2010 (incorporated by  reference to the registrant’s Current Report on January 26, 2010)                                                                                                                                       |
| 10.23* |   | Form of  Settlement Agreement dated December 3, 2009 with Jeffrey L. Garon                                                                                                                                                                                                                          |
| 10.24  |   | Promissory  Note dated July 9, 2009, issued to Enable Growth Partners LP  (incorporated by reference to the registrant’s Quarterly Report on  August 19, 2009)                                                                                                                                 |
| 10.25  |   | Promissory  Note dated August 10, 2009, issued to Enable Growth Partners LP (incorporated  by reference to the registrant’s Quarterly Report on August 19, 2009)                                                                                                                               |
| 11.1*  |   | Statement  re Computation of Per Share Earnings (included within the financial  statements filed in this registration statement)                                                                                                                                                                              |
| 21.1   |   | Listing  of Subsidiaries (incorporated by reference to the registrant’s Current Report  on Form 8-K filed on April 23, 2008)                                                                                                                                                                   |
| 23.1*  |   | Consent  of Stonefield Josephson, Inc., Independent Registered Public Accounting  Firm                                                                                                                                                                                                                   |
| 24.1*  |   | Power  of attorney (See signature page of this Report)                                                                                                                                                                                                                                                   |
| 31.1*  |   | Certification  of Principal Executive Officer pursuant to Rule 13a-14(a) or  15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002                                                                                      |
| 31.2*  |   | Certification  of Principal Financial Officer pursuant to Rule 13a-14(a) or  15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002                                                                                      |
| 32.1*  |   | Certification  of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                             |
| 32.2*  |   | Certification  of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                             |

 

----

*     Filedwith this report

#     Managementcontract or compensatory plan or arrangement

 

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**SIGNATURES**

** **

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 
| ** **                 | **Etelos, Inc.** |
|----------------------------|-----------------------|
|                       | (Registrant)          |
|                       |                  |
| Date:  March 17, 2010 | /s/ Daniel J.A. Kolke |
|                       | By:                   | Daniel J.A. Kolke |
|                       | Title:                | Chief Executive Officer |

 

**POWER OF ATTORNEY**

 

KNOW ALL MEN BY THESE PRESENTS, that each of theundersigned, being a director or officer of Etelos, Inc., a Delawarecorporation, hereby constitutes and appoints Daniel J.A. Kolke and KennedyBrooks, or each of them individually, as his true and lawful attorney-in-factand agent, with full power of substitution and re-substitution, for him and inhis name, place and stead in any and all capacities, to sign any and allamendments to this annual report on Form 10-K and to file the same, withall exhibits thereto and all other documents in connection therewith, with theSecurities and Exchange Commission, granting unto said attorney-in-fact andagents, and each of them, full power and authority to do and perform each andevery act and thing requisite and necessary to be done that such annual reportand its amendments shall comply with the Securities Act, and the applicable rules andregulations adopted or issued pursuant thereto, as fully and to all intents andpurposes as he or she might or could do in person, hereby ratifying andconfirming all that said attorneys-in-fact and agents, or any of them or theirsubstitute or re-substitute, may lawfully do or cause to be done by virtuehereof.

 

In accordance with the Exchange Act, this report hasbeen signed below by the following persons on behalf of the registrant in thecapacities and on the dates indicated.

 
| **Signature**             | ** ** | **Title**                                                                                           | ** ** | **Date**             |
|---------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|----------------------|
| ** **                | ** ** | ** **                                                                                          | ** ** | ** **           |
| /s/ DANIEL J.A. KOLKE     |       | Chief Executive Officer and Director (Principal  Executive Officer and Principal Financial Officer) |       | March 17, 2010  |
| Daniel J.A. Kolke         |       |
|                      |       |                                                                                                |       |                 |
| /s/ RONALD A. RUDY        |       | Director                                                                                            |       | March 17, 2010  |
| Ronald A. Rudy            |       |                                                                                                |       |                 |
|                      |       |                                                                                                |       |                 |
| /s/ ANDY LIU              |       | Director                                                                                            |       | March 17,  2010 |
| Andy Liu                  |       |                                                                                                |       |                 |
|                      |       |                                                                                                |       |                 |
| /s/ ROBERT L.  THORDARSON |       | Director                                                                                            |       | March 17,  2010 |
| Robert L.  Thordarson     |       |                                                                                                |       |                 |

 

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**ETELOS,INC.**

** **

**FINANCIAL STATEMENTS**

** **

**FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008**

 

**TABLE OF CONTENTS**

 
| ** **                                                                                    | **Page** |
|-----------------------------------------------------------------------------------------------|----------|
| Report of Independent Registered Public Accounting  Firm                                      | F-1      |
| Balance  Sheets as of December 31, 2009 and 2008                                         | F-2      |
| Statements  of Operations for the years ended December 31, 2009 and 2008                 | F-3      |
| Statements of Stockholders’ Deficit for the years ended  December 31, 2009 and 2008 | F-4      |
| Statements of Cash Flows for the years ended  December 31, 2009 and 2008                 | F-5      |
| Notes to Financial Statements                                                                 | F-6      |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

To the Board of Directorsand Stockholders of Etelos, Inc.:

 

We have audited theaccompanying balance sheets of Etelos, Inc. as of December 31, 2009and 2008, and the related statements of operations, stockholders’ deficit, andcash flows for each of the years in the two-year period ended December 31,2009. Etelos, Inc.’s management is responsible for these financialstatements. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free of materialmisstatement. The company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of thecompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the financial position of Etelos, Inc. as of December 31,2009 and 2008, and the results of its operations and its cash flows for each ofthe years in the two-year period ended December 31, 2009 in conformitywith accounting principles generally accepted in the United States of America.

 

As described in Note 4 tothe financial statements, the accompanying financial statements have beenprepared assuming that the Company will continue as a going concern. TheCompany’s recurring net losses and accumulated deficit raise substantial doubtabout its ability to continue as a going concern. Management’s plans to addressthese matters are discussed in Note 4 to the financial statements. Thefinancial statements do not include any adjustments that might result from theoutcome of this uncertainty.

 

/s/ Stonefield Josephson, Inc.

 

San Francisco, California

March 17, 2010

 

F-1

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**ETELOS, INC.BALANCE SHEETS**

(in thousands, except share data)

 
| ** **                                                                                                                                                                           | ** ** | **December 31,   2009** | ** ** | **December 31,   2008** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                           | ** ** | ** **                   | ** ** | ** **                   | ** ** |
| ASSETS                                                                                                                                                                               |       |                         |       |                         |       |
| Current  assets:                                                                                                                                                                     |       |                         |       |                         |       |
| Cash  and cash equivalents                                                                                                                                                           |       | $                            | 445        |                         | $          | 7 |   |
| Accounts  receivable                                                                                                                                                                 |       | 10                           |       | 60                           |       |
| Prepaid  expenses and other current assets                                                                                                                                           |       | 16                           |       | 46                           |       |
| Accretion  of interest on convertible notes payable                                                                                                                                  |       | 250                          |       | —                       |       |
| Total  current assets                                                                                                                                                                |       | 721                          |       | 113                          |       |
|                                                                                                                                                                                 |       |                         |       |                         |       |
| Property  and equipment, net                                                                                                                                                         |       | 46                           |       | 82                           |       |
| Debt  issuance costs                                                                                                                                                                 |       | 30                           |       | —                       |       |
| Other  assets                                                                                                                                                                        |       | 2                            |       | 10                           |       |
|                                                                                                                                                                                 |       |                         |       |                         |       |
| **Total assets**                                                                                                                                                                     | ** ** | **$**                        | **799**    | ** **                   | **$**      | **205** | ** ** |
|                                                                                                                                                                                 |       |                         |       |                         |       |
| LIABILITIES  AND STOCKHOLDERS’ DEFICIT                                                                                                                                          |       |                         |       |                         |       |
| Current  liabilities:                                                                                                                                                                |       |                         |       |                         |       |
| Accounts  payable                                                                                                                                                                    |       | $                            | 1,120      |                         | $          | 983 |   |
| Accounts  payable related parties                                                                                                                                                    |       | 27                           |       | 42                           |       |
| Accrued  payroll and related expenses                                                                                                                                                |       | 1,029                        |       | 399                          |       |
| Other  accrued expenses                                                                                                                                                              |       | 1,229                        |       | 1,381                        |       |
| Deferred  revenue                                                                                                                                                                    |       | 8                            |       | 64                           |       |
| Current  portion convertible notes payable, net of discounts                                                                                                                         |       | 1,764                        |       | 7,264                        |       |
| Current  portion notes payable                                                                                                                                                       |       | 110                          |       | 89                           |       |
| Current  portion notes payable to related parties                                                                                                                                    |       | 108                          |       | 132                          |       |
| Current  portion capital leases                                                                                                                                                      |       | —                       |       | 9                            |       |
| Warrant  and derivative liability                                                                                                                                                    |       | 315                          |       | 108                          |       |
| Total  current liabilities                                                                                                                                                           |       | 5,710                        |       | 10,471                       |       |
|                                                                                                                                                                                 |       |                         |       |                         |       |
| Long-term  convertible notes payable, net of premiums and discounts, less current  portion                                                                                           |       | 7,214                        |       | —                       |       |
| Long-term  notes payable to related parties, less current portion                                                                                                                    |       | 286                          |       | 552                          |       |
| Long-term  capital leases, less current portion                                                                                                                                      |       | —                       |       | 24                           |       |
|                                                                                                                                                                                 |       |                         |       |                         |       |
| Total  liabilities                                                                                                                                                                   |       | 13,210                       |       | 11,047                       |       |
|                                                                                                                                                                                 |       |                         |       |                         |       |
| Commitments  and contingencies                                                                                                                                                       |       |                         |       |                         |       |
|                                                                                                                                                                                 |       |                         |       |                         |       |
| Stockholders’  deficit:                                                                                                                                                         |       |                         |       |                         |       |
| Preferred  stock, $0.01 par value: 50,000,000 shares authorized with liquidation  preferences:                                                                                       |       |                         |       |                         |       |
| New  Series A: 3,333,333 shares authorized; issued and outstanding: 743,333  shares at December 31, 2009 and 833,333 shares at December 31, 2008                      |       | 7                            |       | 8                            |       |
| Series A:  4,166,667 shares authorized; issued and outstanding - no shares at  December 31, 2009 and 2008                                                                  |       | —                       |       | —                       |       |
| Series B:  7,500,000 shares authorized; issued and outstanding - no shares at December 31,  2009 and 2008                                                                  |       | —                       |       | —                       |       |
| Series C:  20,000,000 shares authrorized; issued and outstanding - no shares at  December 31, 2009 and 2008                                                                |       | —                       |       | —                       |       |
| Common  stock, $0.01 par value: 250,000,000 shares authorized; issued and outstanding  -23,398,143 shares at December 31, 2009 and 23,027,624 shares at  December 31, 2008 |       | 234                          |       | 231                          |       |
| Additional  paid-in capital                                                                                                                                                          |       | 23,903                       |       | 18,722                       |       |
| Accumulated  deficit                                                                                                                                                                 |       | (36,555                      | )          | (29,803                      | )          |
| Total stockholders’  deficit                                                                                                                                                    |       | (12,411                      | )          | (10,842                      | )          |
|                                                                                                                                                                                 |       |                         |       |                         |       |
| **Total liabilities and stockholders’ deficit**                                                                                                                                 | ** ** | **$**                        | **799**    | ** **                   | **$**      | **205** | ** ** |

 

Theaccompanying notes are an integral part of these financial statements. 

 

F-2

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Table of Contents

 

**ETELOS, INC.**

**STATEMENTS OF OPERATIONS**

(in thousands,except per share data)

 
| ** **                                                                                                 | ** ** | **Year Ended**   | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                 | ** ** | **December 31,** | ** ** |
| ** **                                                                                                 | ** ** | **2009**              | ** ** | **2008** | ** ** |
| ** **                                                                                                 | ** ** | ** **            | ** ** | ** ** | ** ** |
| Revenue                                                                                                    |       | 150                   |       | 123 |   |
| Cost  of revenue                                                                                           |       | 268                   |       | 542 |   |
| Gross  loss                                                                                                |       | (118                  | )          | (419 | ) |
|                                                                                                       |       |                  |       |   |   |
| Operating  expenses:                                                                                       |       |                  |       |   |   |
| Research  and development                                                                                  |       | 1,315                 |       | 2,640 |   |
| Sales  and marketing                                                                                       |       | 826                   |       | 1,657 |   |
| General  and administrative                                                                                |       | 3,062                 |       | 3,164 |   |
| Restructuring  Costs                                                                                       |       | 92                    |       | 632 |   |
| Change  in valuation of liability related to warrants from settlement, financing, and  consulting services |       | (299                  | )          | — |   |
| Total  operating expenses                                                                                  |       | 4,996                 |       | 8,093 |   |
|                                                                                                       |       |                  |       |   |   |
| Loss  from operations                                                                                      |       | (5,114                | )          | (8,512 | ) |
|                                                                                                       |       |                  |       |   |   |
| Other  income (expense):                                                                                   |       |                  |       |   |   |
| Merger  costs                                                                                              |       | —                |       | (13,444 | ) |
| Other  income (expense)                                                                                    |       | 15                    |       | (14 | ) |
| Loss  on extinguishment of debt                                                                            |       | (587                  | )          | — |   |
| Total  other income (expense)                                                                              |       | (572                  | )          | (13,458 | ) |
|                                                                                                       |       |                  |       |   |   |
| Interest  income (expense):                                                                                |       |                  |       |   |   |
| Interest  expense, net                                                                                     |       | (561                  | )          | (479 | ) |
| Amortization  of notes discount and debt issuance costs and accretion of notes premium, net                |       | (386                  | )          | (2,872 | ) |
| Change  in valuation of liability relating to embedded derivatives and warrants                            |       | (119                  | )          | 6,965 |   |
| Beneficial  conversion of interest conversion                                                              |       | —                |       | (991 | ) |
| Total  interest income (expense)                                                                           |       | (1,066                | )          | 2,623 |   |
|                                                                                                       |       |                  |       |   |   |
| Loss  before taxes                                                                                         |       | (6,752                | )          | (19,347 | ) |
|                                                                                                       |       |                  |       |   |   |
| Provision  for income taxes                                                                                |       | —                |       | — |   |
|                                                                                                       |       |                  |       |   |   |
| **Net loss**                                                                                               | ** ** | **$**                 | **(6,752** | **)** | **$** | **(19,347** | **)** |
|                                                                                                       |       |                  |       |   |   |
| Beneficial  conversion upon issuance of preferred stock                                                    |       | —                |       | (22 | ) |
|                                                                                                       |       |                  |       |   |   |
| Net  loss available to common stockholders                                                                 |       | **$**                 | **(6,752** | **)** | **$** | **(19,369** | **)** |
|                                                                                                       |       |                  |       |   |   |
| Basic  and diluted net loss per share available to common stock holders                                    |       | $                     | (0.29      | ) | $ | (1.07 | ) |
|                                                                                                       |       |                  |       |   |   |
| Weighted  average number of common shares used in computing basic and diluted net loss  per share          |       | 22,940                |       | 18,173 |   |

 

Theaccompanying notes are an integral part of these financial statements. 

 

F-3

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Table ofContents

 

**ETELOS, INC.**

**STATEMENTSOF STOCKHOLDERS’ DEFICIT**

(in thousands, except share data)

 
| ** **                                                                                           | ** ** | **Preferred Stock**   | ** ** | ** **                   | ** ** | ** **        | ** ** | ** **          | ** ** | ** **        | ** ** | ** **             | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------------|------------|-------------------|------------|---------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                           | ** ** | ** **            | ** ** | ** **                   | ** ** | **Series A** | ** ** | **Series B**   | ** ** | **Series C** | ** ** | ** **             | ** ** | ** ** | ** ** | **Total** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                           | ** ** | **New Series A** | ** ** | **(Adjusted for par value)** | ** ** | **Common Stock**  | ** ** | **Additional Paid** | ** ** | **Accumulated**   | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                           | ** ** | **Shares**            | ** ** | **Amount**                   | ** ** | **Shares**        | ** ** | **Amount**          | ** ** | **Shares**        | ** ** | **Amount**             | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **in Capital** | ** ** | **Deficit** | ** ** | **Deficit** | ** ** |
|                                                                                                 |       |                  |       |                         |       |              |       |                |       |              |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Balance at December 31, 2007**                                                                | ** ** | **—**            | ** ** | **$**                        | **—** | ** **        | **22,167** | ** **          | **$**      | **665**           | ** ** | **40,000**             | ** ** | **$** | **2,400** | ** ** | **1,482,604** | ** ** | **$** | **568** | ** ** | **6,791,313** | ** ** | **$** | **68** | ** ** | **$** | **1,787** | ** ** | **$** | **(10,434** | **)** | **$** | **(4,946** | **)** |
| ** **                                                                                           | ** ** | ** **            | ** ** | ** **                   | ** ** | ** **        | ** ** | ** **          | ** ** | ** **        | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Issuance  of common stock for conversion of preferred stock                                          |       | —                |       | —                       |       | (22,167           | )          | (665                | )          | (40,000           | )          | (2,400                 | )          | (1,482,604 | ) | (568 | ) | 1,544,771 |   | 16 |   | 3,617 |   | — |   | — |   |
| Issuance  of common stock for convertible debt                                                       |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 3,283,200 |   | 33 |   | 2,361 |   | — |   | 2,394 |   |
| Issuance  of common stock for merger consideration                                                   |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 5,010,000 |   | 50 |   | 13,127 |   | — |   | 13,177 |   |
| Issuance  of common stock for interest conversion                                                    |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 147,990 |   | 2 |   | 197 |   | — |   | 199 |   |
| Issuance  of common stock under anti-dilution provisions                                             |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 5,526,250 |   | 55 |   | (55 | ) | — |   | — |   |
| Issuance  of common stock for warrants exercised                                                     |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 745,350 |   | 7 |   | 453 |   | — |   | 460 |   |
| Issuance  of common stock for stock options exercised                                                |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 3,750 |   | — |   | — |   | — |   | — |   |
| Repurchase  of common stock                                                                          |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | (25,000 | ) | — |   | (36 | ) | — |   | (36 | ) |
| Issuance  of warrants with convertible debt                                                          |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 73 |   | — |   | 73 |   |
| Reclassify  fair value of embedded derivative and warrant to liabilities                             |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | (4,392 | ) | — |   | (4,392 | ) |
| Beneficial  conversion of interest conversion                                                        |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 991 |   | — |   | 991 |   |
| Issuance  of preferred stock, net of proceeds allocated to detachable warrants                       |       | 833,333               |       | 8                            |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 470 |   | — |   | 478 |   |
| Beneficial  Conversion upon issuance of converted stock                                              |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 22 |   | (22 | ) | — |   |
| Stock  based compensation                                                                            |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 107 |   | — |   | 107 |   |
| Net  Loss                                                                                            |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   |   |   | (19,347 | ) | (19,347 | ) |
| **Balance at December 31, 2008**                                                                | ** ** | **833,333**           | ** ** | **8**                        | ** ** | **—**        | ** ** | **—**          | ** ** | **—**        | ** ** | **—**             | ** ** | **—** | ** ** | **—** | ** ** | **23,027,624** | ** ** | **231** | ** ** | **18,722** | ** ** | **(29,803** | **)** | **(10,842** | **)** |
|                                                                                                 | ** ** | ** **            | ** ** | ** **                   | ** ** | ** **        | ** ** | ** **          | ** ** | ** **        | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Issuance  of Preferred New Series A Stock                                                       |       | 10,000                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 6 |   | — | ** ** | **6** | ** ** |
| Issuance  of common stock to consultant                                                              |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 1,000,000 |   | 10 |   | 500 |   | — | ** ** | **510** | ** ** |
| Reclass  warrant and derivative liability                                                            |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 931 |   | — | ** ** | **931** | ** ** |
| Issuance  of warrants with promissory notes                                                          |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 110 |   | — | ** ** | **110** | ** ** |
| Issuance  of common stock wtih Senior Secured Debentures                                             |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 750,000 |   | 8 |   | 183 |   | — | ** ** | **191** | ** ** |
| Issuance  of Series I Warrants with Senior Secured Debentures                                   |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 424 |   | — | ** ** | **424** | ** ** |
| Issuance  of Series II Warrants with Senior Secured Debentures                                  |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 565 |   | — | ** ** | **565** | ** ** |
| Beneficial  conversion feature on issuance of Senior Secured Debentures                              |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 1,399 |   | — | ** ** | **1,399** | ** ** |
| Issuance  of common stock upon conversion of Preferred New Series A Stock                       |       | (100,000              | )          | (1                           | )          | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 100,000 |   | 1 |   | — |   | — | ** ** | **—** | ** ** |
| Issuance  of common stock for accounts payable                                                       |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 180,000 |   | 2 |   | 91 |   | — | ** ** | **93** | ** ** |
| Issuance  of common stock for notes payable, notes payable to related parties, and  accrued interest |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 607,072 |   | 6 |   | 449 |   | — | ** ** | **455** | ** ** |
| Repurchase  of common stock                                                                          |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | (2,356,655 | ) | (24 | ) | (151 | ) | — | ** ** | **(175** | **)** |
| Issuance  of common stock for stock options exercised                                                |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | 90,102 |   | — |   | 19 |   | — | ** ** | **19** | ** ** |
| Stock  based compensation                                                                            |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | 655 |   | — | ** ** | **655** | ** ** |
| Net  loss                                                                                            |       | —                |       | —                       |       | —            |       | —              |       | —            |       | —                 |       | — |   | — |   | — |   | — |   | — |   | (6,752 | ) | **(6,752** | **)** |
| **Balance at December 31, 2009**                                                                | ** ** | **743,333**           | ** ** | **$**                        | **7**      | ** **        | **—** | ** **          | **$**      | **—**        | ** ** | **—**             | ** ** | **$** | **—** | ** ** | **—** | ** ** | **$** | **—** | ** ** | **23,398,143** | ** ** | **$** | **234** | ** ** | **$** | **23,903** | ** ** | **$** | **(36,555** | **)** | **$** | **(12,411** | **)** |

 

Theaccompanying notes are an integral part of these financial statements. 

 

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Table ofContents

 

**ETELOS,INCORPORATED**

**STATEMENTS OF CASH FLOWS**

(in thousands)

 
| ** **                                                                                                             | ** ** | **Year Ended**        | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                             | ** ** | **December 31,** | ** ** |
| ** **                                                                                                             | ** ** | **2009**              | ** ** | **2008** | ** ** |
|                                                                                                                   |       |                  |       |   |   |
| **Cash flows from operating activities:**                                                                              | ** ** | ** **            | ** ** | ** ** | ** ** |
| Net  loss                                                                                                              | ** ** | $                     | (6,752     | ) | $ | (19,347 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:                                           | ** ** |                  |       |   |   |
| Depreciation  and amortization                                                                                         | ** ** | 36                    |       | 32 |   |
| Amortization  (accretion) of notes discount (premium)                                                                  | ** ** | 305                   |       | 2,872 |   |
| Amortization  of financing fees                                                                                        | ** ** | —                |       | 323 |   |
| Accretion  of interest                                                                                                 | ** ** | 163                   |       | — |   |
| Stock  based compensation                                                                                              | ** ** | 655                   |       | 107 |   |
| Consulting  expenses paid through issuance of common stock and warrants                                                | ** ** | 1,511                 |       | — |   |
| BCF  on interest payments                                                                                              | ** ** | —                |       | 991 |   |
| Change  in valuation of embedded derivatives and warrant liability                                                     | ** ** | (181                  | )          | (7,156 | ) |
| Settlement  expenses paid through issuance of warrants                                                                 | ** ** | —                |       | 130 |   |
| Loss  on extinguishment of restructured debentures                                                                     | ** ** | 587                   |       | — |   |
| Merger  costs paid in common stock                                                                                     | ** ** | —                |       | 13,177 |   |
| Changes  in operating assets and liabilities:                                                                          | ** ** |                  |       |   |   |
| Accounts  receivable, net                                                                                              | ** ** | 50                    |       | (60 | ) |
| Prepaid  expenses and other current assets                                                                             | ** ** | 30                    |       | (25 | ) |
| Other  assets                                                                                                          | ** ** | 8                     |       | (58 | ) |
| Debt  issuance costs                                                                                                   | ** ** | (35                   | )          | — |   |
| Accounts  payable                                                                                                      | ** ** | 224                   |       | 734 |   |
| Accounts  payables related parties                                                                                     | ** ** | (15                   | )          | (14 | ) |
| Accrued  payroll and related expenses                                                                                  | ** ** | 647                   |       | (115 | ) |
| Other  accrued expenses                                                                                                | ** ** | 463                   |       | 1,308 |   |
| Deferred  revenues                                                                                                     | ** ** | (56                   | )          | 56 |   |
| **Net cash used in operating activities**                                                                              | ** ** | (2,360                | )          | (7,045 | ) |
| **Cash flows from investing activities:**                                                                              | ** ** |                  |       |   |   |
| Purchases  of property and equipment                                                                                   | ** ** | —                |       | (64 | ) |
| **Net cash used in investing activities**                                                                              | ** ** | —                |       | (64 | ) |
| **Cash flows from financing activities:**                                                                              | ** ** |                  |       |   |   |
| Proceeds  from notes payable                                                                                           | ** ** | 2,985                 |       | 6,442 |   |
| Payments  of notes payable                                                                                             | ** ** | (63                   | )          | (954 | ) |
| Proceeds  from issuance of common stock                                                                                | ** ** | 2                     |       | 460 |   |
| Proceeds  from issuance of preferred stock                                                                             | ** ** | 6                     |       | 625 |   |
| Payments  to repurchase common stock                                                                                   | ** ** | (175                  | )          | — |   |
| Payment  of fees for financing transactions                                                                            | ** ** | —                |       | (234 | ) |
| Proceeds  from notes payable to related parties                                                                        | ** ** | 140                   |       | — |   |
| Payments  of notes payable to related parties                                                                          | ** ** | (64                   | )          | (132 | ) |
| Payment  on capital lease                                                                                              | ** ** | (33                   | )          | (19 | ) |
| **Net cash provided by financing activities**                                                                          | ** ** | 2,798                 |       | 6,188 |   |
| ** **                                                                                                             | ** ** |                  |       |   |   |
| **Net increase (decrease) in cash and cash equivalents**                                                               | ** ** | 438                   |       | (921 | ) |
| ** **                                                                                                             | ** ** |                  |       |   |   |
| **Cash and cash equivalents at beginning of year**                                                                     | ** ** | 7                     |       | 928 |   |
| ** **                                                                                                             | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Cash and cash equivalents at end of period**                                                                         | ** ** | **$**                 | **445**    | ** ** | **$** | **7** | ** ** |
| ** **                                                                                                             | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Supplemental disclosures of cash flow information:**                                                                 | ** ** | ** **            | ** ** | ** ** | ** ** |
| Cash  paid for interest                                                                                                | ** ** | 16                    |       | 126 |   |
| ** **                                                                                                             | ** ** |                  |       |   |   |
| **Supplemental disclosures of non-cash financing activities:**                                                         | ** ** |                  |       |   |   |
| Beneficial  conversion feature on issuance of Senior Secured Debentures                                                | ** ** | 1,399                 |       | — |   |
| Issuance  of warrants with promissory notes, Series I and Series II warrants  with Senior Secured Debentures | ** ** | 1,099                 |       | 73 |   |
| Reclass  warrant and derivative liability                                                                              | ** ** | 931                   |       | — |   |
| Issuance  of common stock for notes payable, notes payable to related parties, and  accrued interest                   | ** ** | 455                   |       | 199 |   |
| Issuance  of common stock for convertible notes and debentures                                                         | ** ** | 191                   |       | 2,394 |   |
| Increase  in convertible notes principal                                                                               | ** ** | 413                   |       | — |   |
| Issuance  of warrants and embedded derivatives as liabilities                                                          | ** ** | 255                   |       | — |   |
| Repurchase  of common stock                                                                                            | ** ** | —                |       | (36 | ) |
| Issuance  of common stock for accounts payable                                                                         | ** ** | 93                    |       | — |   |
| Issuance  of common stock for stock options exercised in partial settlement of accrued  payroll                        | ** ** | 17                    |       | — |   |
| Issuance  of common stock under anti-dilution provisions                                                               | ** ** | —                |       | 55 |   |
| Issuance  of common stock upon conversion of preferred stock                                                           | ** ** | 1                     |       | 15 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

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**NOTES TO FINANCIAL STATEMENTS**

 

***1. Organization***

 

On February 8, 2007, Tripath Technology Inc., aDelaware corporation (“Tripath”), filed a voluntary petition for relief underChapter 11 of the Bankruptcy Code. On February 1, 2008, the bankruptcycourt issued an order confirming approval of the Plan of Reorganization,including the merger and the transfer of all of Tripath’s existing assets intoa separate bankruptcy estate and the discharge of all of Tripath’sliabilities.  The Plan of Reorganization also contemplated the merger ofEtelos, Incorporated, a Washington corporation (“Etelos-WA”) withTripath.  The overall impact of the confirmed Plan of Reorganizationwas for Tripath to emerge from the bankruptcy proceeding with no assets and noliabilities as a shell corporation and for all issued and outstandingsecurities of and interests in Tripath, including debentures, stock options(including, but not limited to, all stock options granted to employees),warrants, and other shares of common stock to be canceled and extinguished.

 

On April 23, 2008, Tripath filed a Current Reporton Form 8-K announcing, among other things, that Etelos-WA, merged withand into Tripath (the “Merger”), and that the surviving corporation changed itsname to Etelos, Inc. and its fiscal year end to December 31. The effective date of the Merger was April 22, 2008, and Etelos, Inc.,as the surviving corporation, will conduct the business and operationspreviously conducted by Etelos-WA.  In connection with the Merger, alloutstanding shares of Etelos-WA common stock were converted into shares ofEtelos, Inc. common stock on a three for one ratio: one share of EtelosInc. common stock for every three shares of common stock of Etelos-WA. Also in connection with the Merger, (i) all outstanding shares ofpreferred stock of Etelos-WA were converted into shares of common stock ofEtelos, Inc., (ii) Etelos, Inc. issued an aggregate of 5,010,000shares of its common stock to the secured and unsecured creditors of Tripathand (iii) all the shares of Tripath Technology were cancelled. Also on April 23,2008, Etelos, Inc., formerly Tripath, amended its articles ofincorporation with the state of Delaware to change its total authorized sharesof stock to 300,000,000 shares, of which 250,000,000 shares are designated “CommonStock” with a par value of $0.01 per share and 50,000,000 shares are designated“Preferred Stock” with a par value of $0.01 per share.  The PreferredStock may be issued from time to time in one or more series, each of such seriesto consist of such number of shares and to have such terms, rights, powers andpreferences, and the qualifications and limitations with respect thereto, asstated in the resolutions providing for the issue of such series adopted by theboard of directors.

 

Prior to the Merger, Tripath was a shell corporationand in accordance with the Plan of Reorganization had no assets orliabilities.  While Tripath acquired all the outstanding preferred andcommon stock of Etelos-WA, for accounting purposes, the acquisition has beentreated as a recapitalization of Etelos-WA with Etelos-WA as the acquirer (areverse acquisition).  Proforma financial information giving effect to theacquisition as if the acquisition took place on January 1, 2007, have notbeen presented because Etelos-WA acquired no tangible or intangible assets,liabilities or any of the business operations of Tripath prior to its emergencefrom bankruptcy and therefore, the historical operations of Tripath are not anindicator of the future operations of Etelos, Inc.  The operations ofEtelos, Inc. subsequent to the Merger include only those of Etelos-WA.

 

The 5,010,000 shares of Etelos, Inc. common stockwere valued at $2.63 per share, the estimated fair value of the common stock onthe date of the Merger, which resulted in a charge to operations of $13.2million included in the caption Merger Related Costs in the accompanyingStatement of Operations.  Etelos, Inc. believes that these shareswere issued primarily for past services provided to Etelos-WA by the securedcreditors and the release of the secured and unsecured creditors claims againstTripath.

 

Information concerning number of shares outstandingfor Etelos, Inc. including the conversion prices and number of sharesissuable upon conversion of convertible securities and exercise prices ofwarrants and stock options and the number of shares issuable upon exercise ofthe options and warrants has been adjusted to reflect this stock split for allperiods presented.  Also, the Shareholders’ Deficit section of theaccompanying Balance Sheet has been adjusted to reflect the legal capitalstructure of Tripath adjusted for the change in authorized shares of common andpreferred stock.

 

***2.  The Company and Risks and Uncertainties***

 

As used herein, unless the context requires otherwise,the terms the “Company,” “it,” “its,” or “Etelos” refers to Etelos, Inc.,the corporation that survived the Merger.

 

Etelos has a Web Application distribution platformdelivering Web Applications for businesses. Etelos provides a Software-as-a-Service (SaaS) ecosystem for building,distributing, and using Web Applications, including a marketplace to deploy andsupport them.  Unlike other cloudcomputing and Platform-as-a-Service (PaaS) solutions, Etelos enables softwaremanufacturers to migrate existing applications or create new applications, thenpackage, distribute, host, bill, market and support their SaaS enabledapplications through multiple private label Web application marketplaces.

 

Etelos has developedproducts for Web Applications, which include open standards-based tools for Webdevelopers, businesses and individual users such as the Etelos ApplicationServerTM (EASTM)and the Etelos Development EnvironmentTM (EDETM).  EAS and

 

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EDE support many commonprogramming languages and also support the English Application Scripting Engine(EASETM), a simple-to-use open standards-basedscripting language developed by us.  Inorder to support broader adoption of our products, EASE and other components ofthe EDE are made available to developers at market appropriate pricing.  This is done to support the development ofnew Web Applications and the migration of existing Web Applications into theEtelos ecosystem where there are tools and other support mechanisms for themarketing, distribution, and support of these applications.

 

The Company’s business model focuses on the sales andoperation of private-label Web application marketplaces, including provision ofthe professional services required to develop, deploy and operate suchmarketplaces, and the launch of offerings of the Etelos Platform SuiteTM.   The EtelosPlatform Suite is designed to allow Independent Software Vendors (ISVs) toimplement a SaaS delivery version of their existing applications, whether ornot those applications are already Web Applications, and to syndicate theoffering of those applications through multiple private label marketplaces. Inthese difficult economic times, the Company believes that a variety of ISVswill have applications that they need to move to the Web for lower costimplementation, easier, simpler scalability, and broader distribution. The Etelos Platform Suite also enables Marketplace Partners,including non-technology businesses, to have their own private labelmarketplaces and tools to offer SaaS Web Applications to better serve theircustomers in multiple distribution channels.

 

***3. Summary of Significant Accounting Policies***

 

***Basis of Presentation***

** **

**These financial statements have been prepared by Etelos, Inc.(the “Company”), in accordance with accounting principles generally accepted inthe United States of America and reflect all adjustments, consisting of normalrecurring adjustments, which in the opinion of management are necessary tostate fairly the Company’s financial position, results of operations, and cashflows for the periods presented.**

** **

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and reported amounts of revenues andexpenses during the reporting period. Actual results could differ from thoseestimates, and such differences could affect the results of operations reportedin future periods and such differences could be material.

 

*Cash andCash Equivalents*

 

Cash consists primarily of cash on deposit atfederally-insured banks in the United States of America. Investmentsecurities with maturity of ninety days or less at the time of purchase are considered cashequivalents. The Company’s investments are primarily comprised of money marketfunds and certificates of deposit, the fair market value of which approximatescost.

 

*AccountsReceivable*

 

Accounts receivable arerecorded at the invoiced amount and generally do not bear interest. Amountscollected on trade accounts receivable are included in net cash provided byoperating activities in the statements of cash flows.

 

*Concentrationof Credit Risk*

 

Financialinstruments that potentially subject the Company to concentration of creditrisk consist primarily of cash, cash equivalents, and accounts receivable.  Cash and cash equivalents are maintained in federally insured banks in theUnited States of America.  Deposits insuch banks may exceed US federally insured limits and be subject to the currentrisks and uncertainties of dealing with such US banks.

 

TheCompany’s accounts receivables are derived primarily from customers.  For the year ended December 31, 2009, tothe date of this report, the Company had limited revenues, primarily from consulting projectsfor a very limited number of customers in projects of varying sizes andduration.  During 2009, three customerscomprised 77% of total revenues and each of these customers accounted for morethan 10 percent of revenue during the year ended December 31, 2009. There were no accounts receivable from those three customers as of December 31,2009; one other customer accounted for 100% of the Company’s accountsreceivable as of December 31, 2009. In the year ended December 31, 2008, no single customer accountedfor 10% or more of the Company’s revenue, nor for 10% or more of the Company’saccounts receivable in the year ended December 31, 2008.

 

*Allowancefor Doubtful Accounts*

 

The Company provides, whenappropriate, an allowance for doubtful accounts to ensure trade receivables arenot overstated due to uncollectability. The collectability of the Company’sreceivables is evaluated based on a variety of factors, including the length oftime receivables are past due, indication of the customer’s willingness to pay,significant one-time events, and historical experience. As of December 31,2009 and 2008, the Company determined that an allowance for doubtful accountswas not necessary orwarranted.

 

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*DeferredRevenue*

 

Deferred revenue representsmoney received or promised but not recognized as revenue because the work hasnot been completed or the software subscription has not been fully delivered,and therefore is deferred until the work is completed or the softwaresubscription is fully delivered when it is then transferred to the appropriaterevenue account. The Company does not have a concentration of risk in any oneaccount as subscriptions tend to be subscribed to by many individualsubscribers as compared to a small number of large enterprises.

 

*Propertyand Equipment*

 

Property, furniture, andequipment are stated at historical cost less accumulated depreciation andamortization. Depreciation and amortization are computed on a straight-linebasis over the estimated useful lives of the assets, which the Companycurrently believes are three to five years. Fixed assets are composed ofcomputer equipment under capital leases with cost of $39 thousand in both yearsand with accumulated depreciation of approximately $23 thousand and $14thousand as of December 31, 2009 and 2008, respectively. Depreciationexpense for the years ended December 31, 2009 and 2008 was approximately$36 thousand and $32.5 thousand, respectively.

 
| ** **                                        | ** ** | **December 31,**   | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|
| ** **                                        | ** ** | **2009**                | ** ** | **2008** | ** ** |
| ** **                                        | ** ** | **(In thousands)** | ** ** |
| Details of property and equipment are as follows: |       |                    |       |   |   |
| Computer equipment                                |       | $                       | 88         |   | $ | 88 |   |
| Furniture and fixtures                            |       | 2                       |       | 2 |   |
| Leased equipment                                  |       | 39                      |       | 39 |   |
| Software                                          |       | 4                       |       | 4 |   |
|                                              |       | 133                     |       | 133 |   |
| Less: accumulated depreciation and amortization   |       | (87                     | )          | (51 | ) |
|                                              |       | $                       | 46         |   | $ | 82 |   |

 

*Fair Valueof Financial Instruments*

 

The Company’s balance sheetincludes the following financial instruments: cash, accounts receivable,accounts payable, and accrued liabilities. The Company considers the carryingamount of working capital items to approximate the fair value for thesefinancial instruments because of the relatively short period of time betweenorigination of the instruments and their expected realization.

 

*Research and Development andSoftware Development Costs*

 

Researchand development expenses consist primarily of salaries, payroll taxes,benefits, and related expenditures for technology, software development,project management, and support personnel. Costs related to the research anddevelopment of new products, services and enhancements to existing products areexpensed as provided for by ASC 985-20 “Costs of Software to be Sold, Leased, orMarketed” (ASC 985-20). Under ASC 985-20, costs incurred in the research anddevelopment of new software products are expensed as incurred untiltechnological feasibility is established. Research and development costs arecapitalized beginning when a product’s technological feasibility has beenestablished and ending when the product is available for general release tocustomers. Technological feasibility is reached when the product reaches theworking model stage. To date, products and enhancements have generally reachedtechnological feasibility and have been released for sale at substantially thesame time and all research and development costs have been expensed.

 

ASC350-40 “Internal-Use Software” (ASC 350-40), which applies to SaaS businessmodel, are met for the capitalization of software development cost.  UnderASC 350-40, software development costs, including costs incurred to purchasethird party software, are capitalized beginning when the Company has determinedcertain factors are present, including, among others, that technology exists toachieve the performance requirements, buy versus internal development decisionshave been made, and the Company’s management has authorized the funding for theproject. Capitalization of software development costs ceases when the softwareis substantially complete and is ready for its intended use.  To date, nosoftware development costs incurred have met the criteria set forth in ASC350-40 for capitalization.

 

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*Revenue Recognition*

 

Etelosdistributes Web Applications and it Marketplace Platform as a subscriptionservice using the SaaS or software-on-demand business model and allow thirdparties to offer their products or services through storefronts in an EtelosMarketplace, and to advertise on its web site or in its magazine for afee.  It also licenses certain of its software products under perpetualand term licenses.  Revenues are recognized on these service and licensingtransactions using the criteria in ASC 605-10, “Revenue Recognition” (ASC605-10), and ASC 985-605, “Software Revenue Recognition” (ASC 985-605),respectively, which both provide that revenue may be recognized when all of thefollowing are met:

 

·                                          persuasive evidence of anarrangement exists,

·                                          the product or service hasbeen delivered,

·                                          the fee is fixed ordeterminable, and

·                                          collection of the resultingreceivable is reasonably assured or probable.

 

Forthe SaaS business model, persuasive evidence is generally an acceptance by thecustomer of a binding agreement and authorization by the customer to charge acredit card; delivery generally occurs over the term of the subscriptionagreement related to the SaaS; and the fee is fixed and collection reasonablyassured when the customer’s credit card is charged.  Accordingly, revenueis recognized over the period the SaaS is provided.

 

For software licensed under term or perpetualagreements, persuasive evidence of an arrangement is evidenced by a bindingagreement signed by the customer and delivery generally occurs upon delivery ofthe software to a common carrier. If a significant portion of a fee is dueafter normal payment terms of typically 30 days, then revenue is recognized asthe fees become due. If the Company determines that collection of a fee is notreasonably assured, then it defers the fees and recognizes revenue upon cashreceipt, provided that all other revenue recognition criteria are met.

 

Advertisingon the Company’s web site is recognized as revenue over the period theadvertisement appears on its web site and advertising presented in its magazineis recognized upon publication of the magazine provided the other criteria forrevenue recognition set forth above have been met.

 

Arrangementsfor which the fees are not deemed reasonably assured for collection arerecognized upon cash collection.

 

*Stock Based Compensation*

 

TheCompany accounts for its stock-based compensation in accordance with ASC718-10, “Compensation — Stock Compensation” (ASC 718-10) using theBlack-Scholes Merton model to value all stock based compensation awards. The Company has recorded compensation cost in the statement of operations basedon the fair value of the award for the requisite service period.  The Company also estimates forfeitures incalculating the expense relating to share-based compensation as opposed to onlyrecognizing these forfeitures and the corresponding reduction in expense asthey occur.  The Company recognized $655thousand and $107 thousand of expense for the years ended December 31,2009 and 2008, respectively.

 

ASC718-10 requires the cash flows resulting from the tax benefits resultingfrom tax deductions in excess of the compensation cost recognized for thoseoptions to be classified as financing cash flows. Due to its loss position,there were no such tax benefits during the year ended December 31, 2009and 2008. Prior to the adoption of ASC 718-10, those benefits would have beenreported as operating cash flows had we received any tax benefits related tostock option exercises.

 

*Advertising*

 

Advertisingand other promotional costs, which consist primarily of public relationsactivities, are expensed as incurred, and were approximately $7 thousand and$21 thousand, for the years ended December 31, 2009 and 2008,respectively.

 

*Income Taxes*

 

TheCompany accounts for income taxes in accordance with ASC 740-10, “Income Taxes”(ASC 740-10) which utilizes the liability method of accounting for incometaxes. Deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying amount of existing assets and liabilities and their respective taxbases. Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. Valuation allowances areestablished when necessary to reduce deferred tax assets to the amountsexpected to be realized.

 

TheCompany has adopted the provisions of ASC 740-10-25, “Income Taxes — Overall —Recognition” (ASC 740-10-25). The Company did not have any unrecognized taxbenefits and there was no effect on its financial condition or results ofoperations as a result of implementing ASC 740-10-25.

 

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TheCompany files income tax returns in the United States of America federal jurisdictionand various state jurisdictions in the United States of America.  The Company does not believe that there willbe any material changes in its unrecognized tax positions over the next twelvemonths.  The Company believes that itsincome tax filing positions and deductions would be sustained on audit and doesnot anticipate any adjustments that will result in a material adverse effect onthe Company’s financial position, results of operations, or cash flow.  Therefore, no reserves for uncertain incometax positions have been recorded pursuant to ASC 740-10-25.  In addition, the Company did not record acumulative effect adjustment related to the adoption of ASC 740-10-25.

 

TheCompany’s policy is to recognize interest and penalties accrued on any unrecognizedtax benefits as a component of income tax expense.  As of the date of the adoption of ASC740-10-25, the Company did not have any accrued interest or penaltiesassociated with any unrecognized tax benefits, nor was any such interestexpense recognized during the years ended December 31, 2009 and 2008. TheCompany’s effective tax rate differs from the federal statutory rate primarilydue to increases in its deferred income tax valuation allowance.

 

*Net Loss per Share*

 

Basic net loss per share is computed by dividing thenet loss available to common stockholders for the period by the weightedaverage number of shares of common stock outstanding during the period,excluding any unvested restricted stock that is subject to repurchase. Dilutednet income per share is computed using the weighted average number of commonshares and, if dilutive, potential common shares outstanding during the period.Potential common shares consist of unvested restricted stock (using thetreasury stock method), the incremental common shares issuable upon theexercise of stock options and warrants (using the treasury stock method) andthe conversion of the Company’s convertible notes and debentures (using theif-converted method).  As their effect is antidilutive, 9,547,998 and4,086,497 shares of common stock exercisable under outstanding employee stockoptions, 9,864,444 and 2,091,000 shares of common stock exercisable underoutstanding warrants, 13,246,027 and 6,535,963 shares of common stock issuableupon conversion of the outstanding convertible notes payable and debentures andaccrued interest, as of December 31, 2009 and 2008, respectively, havebeen excluded from this calculation.  The average exercise price ofoutstanding employee stock options and warrants to purchase the Company’scommon stock is $0.32 and $0.26, and $0.45 and $1.41, respectively, at December 31,2009 and 2008.

 

The following table, which has been adjusted toreflect the three for one conversion ratio effected in connection with theMerger, sets forth the computation of basic and diluted net loss per share forthe periods presented (in thousands, except per share amounts):

 
| ** **                                              | ** ** | **For the Year**      | ** ** |
|---------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **Ended December 31** | ** ** |
| ** **                                              | ** ** | **2009**                        | ** ** | **2008** | ** ** |
| ** **                                              | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Numerator:                                              |       |                            |       |   |   |
| Net (loss)                                              |       | $                               | (6,752     | ) | $ | (19,347 | ) |
|                                                    |       |                            |       |   |   |
| Beneficial conversion upon issuance of preferred  stock |       | —                          |       | (22 | ) |
|                                                    |       |                            |       |   |   |
| Net (loss) available to common stockholders             |       | $                               | (6,752     | ) | $ | (19,369 | ) |
|                                                    |       |                            |       |   |   |
| Denominator:                                            |       |                            |       |   |   |
| Weighted average common stock                           |       | 22,940                          |       | 18,173 |   |
|                                                    |       |                            |       |   |   |
| Net loss per share:                                     |       |                            |       |   |   |
| Basic and Diluted                                       |       | $                               | (0.29      | ) | $ | (1.07 | ) |

 

*Use ofEstimates*

 

The preparation of thefinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities, thedisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

 

*SubsequentEvents*

 

Eteloshas evaluated subsequent events and transactions for potential recognition ordisclosure in the financial statements.

 

*Reclassification*

 

Certainoperating expenses have been reclassified in 2008 to be consistent with andcomparable to the classification in 2009.

 

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*SegmentReporting*

 

The Company has oneoperating segment because the Company is not organized into multiple segmentsfor the purpose of making operating decisions or for assessing performance. Thechief operating decision maker evaluates performance, makes operatingdecisions, and allocates resources based on financial data consistent with thepresentation in the accompanying financial statements.

 

***4. Going Concern***

 

The financial statementshave been prepared with the assumption that the Company will continue as agoing concern.  The Company has experienced net losses of $6.8 million and$19.3 million for the years ended December 31, 2009 and 2008,respectively, and has a total stockholders’ deficit of $12.4 million as of December 31,2009.  The Company’s recurring net lossesand accumulated deficit raise substantial doubt about its ability to continueas a going concern. The financial statements do not include any adjustmentsrelating to the recoverability and classification of asset carrying amounts orthe amount and classification of liabilities that might arise should it be unableto continue as a going concern.

 

Managementhas supported current operations by raising additional operating cash throughthe private sale of convertible debentures and notes payable and preferredstock. This has provided the cash inflows to continue the Company’s businessplan, but has not resulted in significant improvement in its financial positionor results of operations.  Managementalso has substantially reduced operating expenses by termination of employeesand other reductions in operating expenses. Alternatives being pursued to improve the Company’s cash flow used inoperations include (1) raising additional working capital throughadditional sale of preferred stock, common stock and/or debt and (2) reducingcash operating expenses to levels that are in line with current revenues. The first alternative could result in substantial dilution to existingshareholders. There can be no assurance that the Company’s current financialposition can be improved, that it can raise additional working capital, or thatit can achieve positive cash flows from operations. The Company’s long-termviability as a going concern is dependent upon its ability to (1) locatesources of debt or equity funding to meet current commitments and near-termfuture working capital requirements and (2) achieve profitability andultimately generate sufficient cash flow from operations to sustain itscontinuing operations.

 

TheCompany’s cash balance including proceeds from its recent debt financings andpreferred stock financing may not be sufficient to fund operations beyondearly-mid 2010.  If cash reserves are not sufficient to sustainoperations, then management plans to further reduce operating expenses and/orraise additional capital by selling shares of capital stock or other securitiesthat could result in substantial dilution to existing shareholders. However, there are no commitments or arrangements for future financingsin place at this time and the Company can give no assurance that such capitalwill be available on favorable terms, or at all.  The Company may needadditional financing thereafter until it can achieve profitability.  If itcannot, then it will be forced to further curtail operations or possibly beforced to evaluate a sale or liquidation of assets.  Even if it issuccessful in raising additional funds, there is no assurance regarding theterms of any additional investment.

 

On January 25, 2010, the Company entered into asecurities purchase agreement with an entity affiliated with Donald W.Morissette, who, together with his affiliates, beneficially owns more than 10%of the Company’s outstanding common stock, for the sale of 10% senior securedconvertible debentures, identical to the September 2009 Debentures, in theprincipal amount of $250,000. In this transaction, in addition to thedebentures, the Company issued a warrant to purchase 375,000 shares of itscommon stock with an exercise price of $0.60 per share and 375,000 shares ofits restricted common stock, or the “closing shares.”  This transaction isreferred to as the January 2010 financing in this report. The securitiespurchase agreement further provided that the Company had the right, subject tocertain conditions, to require the investor to purchase an aggregate of$125,000 in additional principal amount of debentures between March 15 and31, 2010. The Company exercised that right on March 15, 2010, and issued$125 thousand in additional debentures on that date.

 

***5***.  ***Recently Issued AccountingStandards***

 

During the third quarter of2009, the Company adopted the new Accounting Standards Codification (“ASC”) asissued by the

 

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Financial Accounting StandardsBoard (FASB).  The ASC has become the authoritative source of US GAAPrecognized by FASB to be applied by non-governmental entities.  The ASC isnot intended to amend or change US GAAP.  The adoption of the ASC did nothave a material impact on the Company’s financial statements.

 

In June 2009, the FASBissued new standards for the accounting for transfers of financial assets.These new standards eliminate the concept of a qualifying special-purposeentity; remove the scope exception from applying the accounting standards thataddress the consolidation of variable interest entities to qualifyingspecial-purpose entities; change the standards for de-recognizing financialassets; and require enhanced disclosure. These new standards are effectivebeginning in the first quarter of 2010, and are not expected to have asignificant impact on the financial statements.

 

In June 2009, the FASBissued amended standards for determining whether to consolidate a variableinterest entity. These amended standards eliminate a mandatory quantitativeapproach to determine whether a variable interest gives the entity acontrolling financial interest in a variable interest entity in favor of aqualitatively focused analysis, and require an ongoing reassessment of whetheran entity is the primary beneficiary. These amended standards are effectivebeginning in the first quarter of 2010 and are not expected to have asignificant impact on the financial statements.

 

In October 2009, theFASB issued new standards for revenue recognition with multiple deliverables.These new standards impact the determination of when the individualdeliverables included in a multiple-element arrangement may be treated asseparate units of accounting. Additionally, these new standards modify themanner in which the transaction consideration is allocated across theseparately identified deliverables by no longer permitting the residual methodof allocating arrangement consideration. These new standards are required to beadopted in the first quarter of 2011; however, early adoption is permitted. TheCompany does not expect these new standards to significantly impact thefinancial statements.

 

In October 2009, theFASB issued new standards for the accounting for certain revenue arrangementsthat include software elements. These new standards amend the scope ofpre-existing software revenue guidance by removing from the guidancenon-software components of tangible products and certain software components oftangible products. These new standards are required to be adopted in the firstquarter of 2011; however, early adoption is permitted. The Company does notexpect these new standards to significantly impact the financial statements.

 

InJanuary 2010, the FASB issued amended standards that require additional fairvalue disclosures. These amended standards require disclosures about inputs andvaluation techniques used to measure fair value as well as disclosures aboutsignificant transfers, beginning in the first quarter of 2010. Additionally,these amended standards require presentation of disaggregated activity withinthe reconciliation for fair value measurements using significant unobservableinputs (Level 3), beginning in the first quarter of 2011. The Company does notexpect these new standards to significantly impact the financial statements.

 

***6. Convertible Notes and Debentures and Embedded Derivativeand Warrant Liability***

 

Convertible notes anddebentures comprise (in thousands):

 
| ** **                                                                            | ** ** | **December 31,  2009** | ** ** | **December 31,  2008** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| 6% convertible notes                                                                  |       | $                           | 1,764      |                        | $          | 1,764 |   |
| January 2008 Debentures                                                          |       | 2,320                       |       | 2,000                       |       |
| April 2008 Debentures                                                            |       | 4,012                       |       | 3,500                       |       |
| September 2009 Debentures                                                        |       | 3,000                       |       | —                      |       |
|                                                                                  |       | 11,096                      |       | 7,264                       |       |
| Plus (less) premium (discount) on notes payable                                       |       | (2,118                      | )          | —                      |       |
|                                                                                  |       |                        |       |                        |       |
|                                                                                  |       | 8,978                       |       | 7,264                       |       |
| Less current portion of convertible notes payable                                     |       | (1,764                      | )          | (7,264                      | )          |
|                                                                                  |       |                        |       |                        |       |
| Long term convertible notes payable, net of  premium (discount), less current portion |       | $                           | 7,214      |                        | $          | — |   |

 

*6%Convertible Notes*

 

During the period August 2007to October 2007, the Company issued 6 percent convertible notes with aface value of $3,326 thousand at an original issue discount of 10 percent withdetachable warrants to purchase shares of its common stock in exchange for$3,024 thousand.  These notes mature on March 31, 2009, with interestdue and payable on February 1, 2008, and on the last day of each calendarquarter thereafter. The Company was required to make payments on theoutstanding principal balance beginning September 1, 2008, and on the 1st day of each calendar quarter thereafter. Thedefault interest rate is 8 percent. The notes and unpaid interest areconvertible into shares of the Company’s common stock at the option of theholder or involuntarily upon the occurrence of

 

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certain financing events.As of December 31, 2009, $1,562 thousand of the face value of the 6%convertible notes have been converted to 2,083 thousand shares of the Company’scommon stock and $1,764 thousand remain outstanding. The Company failed to makethe required interest and principal payments on the 6 percent convertible notesduring the year ended December 31, 2009, and through the date of thesefinancial statements. Accordingly, the Company is in default under the terms ofthe 6 percent convertible notes, which results in all principal and interestrelated to the 6 percent convertible notes becoming due and payable to theholders. As a result, the Company has accrued interest on the 6 percentconvertible notes at the default rate of 8 percent and classified all amountsdue related to the 6 percent convertible notes as current liabilities.

 

In addition, thepurchasers of the 6 percent convertible notes received warrants, which arefully exercisable, to purchase 1,080,000 shares of the Company’s common stockat an exercise price of $1.20. The warrants expire August through October 2013,unless they are earlier automatically terminated upon (i) a publicoffering of the Company’s common stock, (ii) sale of the Company, or (iii) achange in control. At December 31, 2009, all of these warrants had beenexercised or expired and none are outstanding.

 

*January 2008Debentures — Prior to Amendment on June 30, 2009 (see below)*

 

On January 31, 2008,the Company issued convertible debentures (the “January 2008 Debentures”)with a principal amount of $2 million and detachable warrants to purchase222,222 shares of its common stock in exchange for $1.9 million.  The January 2008Debentures are all held by Enable Capital. Enable Capital beneficially ownsmore than 10% of the Company’s common stock. The January 2008 Debentures are due on January 31, 2010, andbear interest at 6 percent per annum payable semiannually on January 1 andJuly 1, commencing July 1, 2008.  Monthly principal paymentsequal to 1/18th of the principal amount were to begin on September 1,2008.  The Company had the right to pay interest and monthly principalpayments in cash, or upon notice to the holders and compliance with certainequity conditions, it can pay all or a portion of any such payment in commonstock valued at a price equal to the lesser of the then effective conversionprice or 85 percent of the average of the volume weighted average price pershare for its common stock for the 10 consecutive trading days immediatelyprior to the applicable payment date.  The equity conditions that it mustmeet include having a currently effective registration statement covering theshares of common stock issuable upon conversion of the debenture, and havingthe daily dollar trading volume for its common stock exceed $250,000 for eachof the 20 consecutive trading days before the date in question.  The January 2008Debentures and any accrued interest are convertible at anytime at thediscretion of the holder at a conversion price per share of $1.35, subject to acap on the beneficial ownership of its shares of common stock by the holder andits affiliates following such conversion. The conversion price is adjusted upona stock split, reverse stock split, or upon issuance of stock dividends,whereby the conversion price would be adjusted to ensure that the holder wouldbe receiving the same number of shares, as though the conversion right had beenexercised prior to the triggering event.  Further, the conversion price isadjusted if common stock or equivalents are subsequently sold or re-priced at aprice below the conversion price or rights, options or warrants are issued toholders of its common stock entitling them to purchase common stock at priceslower than the volume weighted average price on the date issued.

 

The Company has theoption to redeem the January 2008 Debentures before their maturity bypayment in cash of an amount equal to 120 percent of the then outstandingprincipal amount, plus accrued interest and other charges, and the right toforce conversion of the debentures if the average of the volume weightedaverage price of its common stock exceeds $3.39 for 20 trading days out of aconsecutive 30 trading day period.  This redemption option and forcedconversion right are subject to the Company meeting certain equity conditions,including having the daily dollar trading volume for its common stock exceed$250 thousand for each of the 20 consecutive trading days before the date inquestion and having a currently effective registration statement covering theshares of common stock issuable upon conversion of the debentures and theforced conversion option, subject to the applicable cap on the beneficialownership of its shares of common stock by the holder and its affiliatesfollowing such conversion.  The January 2008 Debentures arecollateralized by substantially all the assets of the Company.

 

The January 2008Debentures impose certain covenants on the Company, including restrictionsagainst incurring additionalindebtedness, creating any liens on its property,amending its certificate of incorporation or bylaws, redeeming or payingdividends on shares of our outstanding common stock, and entering into certainrelated party transactions.  The January 2008 Debentures also definecertain events of default, including, without limitation, failure to make apayment obligation, failure to observe other covenants of the debenture orrelated agreements (subject to applicable cure periods), breach ofrepresentation or warranty, bankruptcy, default under another significantcontract or credit obligation, delisting of its common stock, a change incontrol, failure to secure and maintain an effective registration statementcovering the resale of the common stock underlying the debentures and thewarrants, or failure to deliver share certificates in a timely manner.  Inthe event of default, the holders of the January 2008 Debentures have theright to accelerate all amounts outstanding under the debentures and demandpayment of a mandatory default amount equal to 130 percent of the amountoutstanding plus accrued interest and expenses. The Company failed to makerequired interest and principal payments on the January 2008 Debenturesbeginning with the payment due on September 30, 2008 and through June 30,2009. Accordingly, the Company is in default under the terms of the January 2008Debentures, and the holders have the right to demand that the default amountequal to 130% of the amount outstanding plus accrued interest be paid to theholders. As of December 31, 2008 and June 30, 2009, the Companyclassified all amounts due related to the January 2008 Debentures ascurrent liabilities, and the holders had not elected to exercise their rightsarising from the Company’s default.

 

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The detachable warrants,which are fully exercisable, to purchase 222,222 shares of our common stock,expire in January 2011 and are exercisable at a price of $1.80 per share,subject to adjustment.  As of December 31, 2009, none of thesewarrants had been exercised.

 

*Amendmentof January 2008 Debentures*

 

On June 30, 2009,the Company executed an amendment agreement to restructure the January 2008Debentures. Under the terms of the agreement, the maturity of the debentureswas extended to December 31, 2012; the outstanding interest as of June 30,2009, and interest that would have been earned under the original terms of theDebentures was added to principal as of June 30, 2009; the interest ratewas reduced to 0% until September 30, 2010; the monthly amortizingredemption payment schedule was eliminated and replaced with a requirement topay interest only on a semi-annual basis beginning January 1, 2011, and topay principal at maturity; the option to make principal and interest paymentsin shares of common stock instead of cash was removed; the anti-dilutionprovisions were modified so that the conversion price cannot be reduced below$0.10 as a result of subsequent equity sales; the registration rights agreemententered into in conjunction with the debentures was terminated; the optionalredemption amount was reduced to 100% of the then outstanding principal amountplus accrued but unpaid interest and plus all liquidated damages and otheramounts due; and all past defaults were waived. Additionally, the warrantsissued in conjunction with the debentures were modified so that the warrant maybe exchanged for a share of common stock on a 1:1 basis, and were modified to eliminatethe anti-dilution provisions afforded for subsequent equity sales at a pricelower than the original conversion price. No direct fees were either charged byor received from the debenture holders for the restructuring.

 

The Company evaluated therestructuring of the January 2008 Debentures under the guidance inASC 470-50 “Debt — Modifications and Extinguishments” (ASC 470-50) as of June 30,2009. The Company concluded that the restructuring of the January 2008Debentures met the definition of an extinguishment of debt as the terms of themodified debentures were substantially different from the original terms.Accordingly, the Company recorded the difference between the fair value andcarrying value of the January 2008 Debentures as a loss on extinguishmentof debt of $299 thousand in earnings for the year ended December 31, 2009.

 

Additionally, as part ofthe restructuring of the January 2008 Debentures, the outstanding accruedinterest of $170 thousand as of June 30, 2009, was reclassified to outstandingprincipal, and the interest that was to have been earned under the originalterms of the debentures from July 1, 2009, through September 30,2010, of $150 thousand was recorded as an increase to outstanding principalwith the corresponding debit amount being recorded as Accreting Interest onConvertible Notes Payable. This interest amount will be accreted to earningsover the revised maturity date of the January 2008 Debentures using theeffective interest method.

 

The Company recorded adebt premium of $299 thousand related to the difference between the fair valueand the revised principal amount of the January 2008 Debentures, alongwith the increase in the fair value of the embedded conversion option of $50thousand as a debt discount, and debt issuance costs related to fees incurredby the Company from service providers related to the restructuring of the January 2008Debentures of $9 thousand were capitalized as Debt Issuance Costs. These itemswill be accreted or amortized to earnings over the revised maturity date of theJanuary 2008 Debentures using the effective interest method.

 

*April 2008Debentures — Prior to Amendment on June 30, 2009 (see below)*

 

On April 22, 2008,the Company issued convertible debentures (the “April 2008 Debentures”) witha principal amount of $3.5 million and detachable warrants to purchase 388,889shares of our common stock in exchange for $3.4 million.  The April 2008Debentures are all held by Enable Capital. Enable Capital beneficially owns more than 10% of the Company’s commonstock.  The April 2008 Debenturesare due on April 30, 2010, and have identical terms and conditions to the January 2008Debentures described above. The Company failed to make required interest andprincipal payments on the April 2008 Debentures beginning with the paymentdue on September 30, 2008, and through June 30, 2009. Accordingly,the Company is in default under the terms of the April 2008 Debentures,and the holders have the right to demand that the default amount equal to 130%of the amount outstanding plus accrued interest be paid to the holders. As of December 31,2008 and June 30, 2009, the Company classified all amounts due related tothe April 2008 Debentures as current liabilities, and the holders had notelected to exercise their rights arising from the Company’s default.

 

The detachable warrants, which are fully exercisable, to purchase388,889 shares of our common stock, expire in April 2011 and areexercisable at a price of $1.80 per share, subject to adjustment.  As of December 31,2009, none of these warrants had been exercised.

 

In connection with the January 2008Debentures and the April 2008 Debentures, the Company also entered into aregistration rights agreement with the investors, pursuant to which it agreedto file a registration statement covering the resale of the shares of commonstock that may be issued to such investors upon the conversion of thedebentures, payment in kind, and the exercise of the related warrants. The Company agreed to maintain the effectiveness of the registration statement(subject to certain limitations) for a period of time until the holders cansell the underlying common stock without volume restrictions under Rule 144of the Securities Act of 

 

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1933, or the SecuritiesAct. If the registration statement is not declared effective by an agreed todate, or if the Company fails to maintain the effectiveness of the registrationstatement, then the Company is required to pay to each investor, as partialliquidated damages, cash equal to 1.0 percent of the aggregate purchase pricepaid by such investor for the securities purchased in the financing and thenheld by such investor, and must pay to such investor 1 percent for eachsubsequent 30-day period that the default remains uncured, up to a maximumaggregate liquidated damages amount of 10 percent of the aggregate purchaseprice paid by the holders of the debentures.

 

The Company’sregistration statement was effective July 31, 2008, which was eight daysafter the deadline in the registration rights agreements. However, thepenalties for this delay were waived in the agreement to restructure the January 2008and April 2008 Debentures on June 30, 2009.

 

*Amendmentof April 2008 Debentures*

 

On June 30, 2009,the Company executed an amendment agreement to restructure the April 2008Debentures in the same manner described above for the January 2008Debentures.

 

The Company evaluated therestructuring of these debentures under the guidance of ASC 470-50 andconcluded that the restructuring of the April 2008 Debentures did not meetthe definition of an extinguishment of debt, as the terms of the modified debentureswere not substantially different from the original terms. However, as the April 2008Debentures included an embedded conversion feature, the Company was required toaccount for any increase in the fair value of the embedded conversion optionimmediately prior to and immediately after the transaction as a debt discountwith the credit being recorded as additional paid in capital. Accordingly, theCompany recorded the increase in the fair value of the embedded conversionoption of $80 thousand as a debt discount that will be amortized over therevised maturity date of the April 2008 Debentures using the effectiveinterest method.

 

As part of therestructuring of the April 2008 Debentures, the outstanding accruedinterest of $249 thousand as of June 30, 2009, was reclassified tooutstanding principal, and the aggregate interest that would have accrued underthe original terms of the debentures from July 1, 2009, through September 30,2010, of $263 thousand was recorded as an increase to outstanding principalwith the corresponding debit amount being recorded as Accreting Interest onConvertible Notes Payable. This interest amount will be accreted to earningsover the revised maturity date of these Debentures using the effective interestmethod.

 

*September 2009 Debentures*

 

On September 30,2009, the Company issued 10% Senior Secured Debentures (the “September 2009Debentures”) with a principal amount of $2.0 million, warrants to purchase5,250,000 shares of our common stock, and 750,000 shares of our common stock inexchange for $0.8 million in cash and the cancellation of $1.2 million inpromissory notes and accrued interest.  Seventy-five percent of the September 2009Debentures are held by Enable Capital. Enable Capital beneficially owns more than 10% of the Company’s commonstock.  The September 2009Debentures are due on September 30, 2011, and bear interest at 10 percentper annum payable quarterly on January 1, April 1, July 1, and October 1,commencing January 1, 2010.  The principal amount is due on maturity.  The September 2009 Debentures areconvertible at anytime at the discretion of the holder at a conversion priceper share of $0.50, subject to a cap on the beneficial ownership of its sharesof common stock by the holders and their affiliates following such conversion.The conversion price is adjusted upon a stock split, reverse stock split, orupon issuance of stock dividends, whereby the conversion price would beadjusted to ensure that the holder would be receiving the same number ofshares, as though the conversion right had been exercised prior to thetriggering event.  Further, the conversion price is adjusted if commonstock or equivalents are subsequently sold or re-priced at a price below theconversion price, or rights, options or warrants are issued to holders of itscommon stock entitling them to purchase common stock at prices lower than thevolume weighted average price on the date issued, with a floor for theconversion price of $0.10 per share.

 

The Company has theoption to redeem the September 2009 Debentures before their maturity bypayment in cash of an amount equal to 100 percent of the then outstandingprincipal amount, plus outstanding accrued interest and other charges, and allinterest that would have accrued if the outstanding principal amount hadremained outstanding through maturity.  This redemption option is subjectto the Company meeting certain equity conditions, including having the dailydollar trading volume for its common stock exceed $250 thousand for each of the20 consecutive trading days before the date in question and having a currentlyeffective registration statement covering the shares of common stock issuableupon conversion of the debentures, subject to the applicable cap on thebeneficial ownership of its shares of common stock by the holders and theiraffiliates following such conversion.  The September 2009 Debenturesare collateralized by substantially all the assets of the Company.

 

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The September 2009Debentures impose certain covenants on the Company, including restrictionsagainst incurring additional indebtedness, creating any liens on its property,amending its certificate of incorporation or bylaws, redeeming or payingdividends on shares of our outstanding common stock, and entering into certainrelated party transactions.  The September 2009 Debentures alsodefine certain events of default, including, without limitation, failure tomake a payment obligation, failure to observe other covenants of the debentureor related agreements (subject to applicable cure periods), breach ofrepresentation or warranty, bankruptcy, default under another significant contractor credit obligation, delisting of its common stock, a change in control,failure to secure and maintain an effective registration statement covering theresale of the common stock underlying the debentures and the warrants, orfailure to deliver share certificates in a timely manner.  In the event ofdefault, the holders of the September 2009 Debentures have the right toaccelerate all amounts outstanding under the debentures and demand payment of amandatory default amount equal to the greater of (i) the outstandingprincipal amount plus all accrued and unpaid interest divided by the conversionprice multiplied by the volume weighted average price or (ii) 120 percentof the amount outstanding, plus accrued interest and expenses, and all interestthat would have accrued if the then outstanding principal amount had remainedoutstanding through maturity. Additionally the mandatory default amount wouldalso include all other amounts, costs, expenses and liquidated damages due inrespect of the debentures.

 

The detachable warrants,which are fully exercisable, to purchase 3,000,000 and 2,250,000 shares of ourcommon stock, expire in September 2014 and September 2016,respectively, and are exercisable at a price of $0.60 and $0.01 per share,respectively, subject to adjustment.  The warrants may be exchanged for ashare of common stock on a 1:1 basis, and the warrants that expire in September 2014include a floor on the exercise price of $0.10 per share.  As of December 31, 2009, none of thesewarrants had been exercised.

 

As part of the issuanceof the September 2009 Debentures, the Company exchanged existingpromissory notes with an aggregate principal amount of $1,150 thousand for alike portion of the September 2009 Debentures. The Company evaluated therestructuring of these promissory notes under ASC 470-50 as of September 30,2009 and concluded that the restructuring of the various promissory notes metthe definition of an extinguishment of debt as the terms of the September 2009Debentures were substantially different from the original terms of thepromissory notes due to the insertion of a conversion feature. Accordingly, theCompany recorded the difference between the fair value of the September 2009Debentures and carrying value of the promissory notes as a loss onextinguishment of debt of $288 thousand in earnings for the year ended December 31,2009, including the remaining unamortized debt discount recorded on the July 2009promissory note of $68 thousand.

 

The Company recorded a debt premium of $220 thousand related to thedifference between the fair value and the principal amount of the September 2009Debentures, and debt issuance costs related to fees incurred by the Company of$25 thousand were capitalized as Debt Issuance Costs. Additionally, the Companyrecognized a further debt discount due to a beneficial conversion feature onthe issuance of the September 2009 Debentures of $776 thousand.  These items will be accreted or amortized toearnings over the maturity date of the September 2009 Debentures using theinterest method.

 

At December 15,2009, the purchasers of the September 2009 Debentures executed and delivered alldocuments and payments to purchase an aggregate of $1.0 million in additionalprincipal amount of September 2009 Debentures.  The Company recognized a debt discount due toa beneficial conversion feature on the issuance of these September 2009Debentures of $623 thousand, which will be amortized to earnings over thematurity date of the September 2009 Debentures using the interest method.

 

*EmbeddedDerivatives*

 

The Company has evaluatedthe embedded derivatives included in the 6% Convertible Notes, and the January 2008,April 2008, and the September 2009 Debentures, consisting of theconversion features and certain put and call features described above, underthe guidance in ASC 815-10 “Derivatives and Hedging” (ASC 815-10) on theissuance date of the Convertible Notes and the January 2008, April 2008,and September 2009 Debentures, and on each subsequent reportingdate.  The purpose of the evaluation is to determine whether the embeddedderivatives need to be bifurcated from the debt host and accounted for as aderivative at their estimated fair value as a liability at the date of issuanceand thereafter, adjusted to estimated fair value with a charge or credit to theCompany’s statement of operations.  ASC 815-10 generally indicates that ifthe conversion features are (i) indexed to the Company’s capital stock under theguidance in ASC 815-40-15, “Derivatives and Hedging — Contractsin Entity’s Own Equity — Scope and Scope Exceptions” (ASC 815-40-15), and (ii) would be classified asequity if a freestanding derivative under the guidance in ASC 815-40-25 “Derivativesand Hedging — Contracts in Entity’s Own Equity — Recognition” (ASC 815-40-25)then the embedded derivatives need not be bifurcated from the debt host. ASC 815-40-25 generally requires, among other factors, that (i) theCompany can settle the derivative in cash or its own stock, at its option, (ii) settlementcan be made in unregistered shares, and (iii) the Company has sufficientauthorized shares to issue shares of its common stock for all equityinstruments convertible to or which can be exercised for its capitalstock.  ASC 815-10 also provides guidance on when put and call featuresincluded in a debt host agreement are not clearly and closely related to thedebt host must be bifurcated and recorded as a liability.  The January 2008,April 2008 and September 2009 Debentures include put and callfeatures.

 

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*EmbeddedDerivatives — 6% Convertible Notes*

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the conversion features embedded in the 6%Convertible Notes met the criteria in ASC 815-10 at issuance and through April 21,2008, the day prior to the merger with Tripath, because the conversion to theCompany’s common stock could only be settled in its capital stock, the capitalstock could be unregistered and the sufficiency of the authorized shares wasunder the Company’s control as it could control the outcome of a shareholdervote to increase the authorized shares.  However, on the date of themerger with Tripath, April 22, 2008, the Company concluded it no longerhad control to ensure the sufficiency of its authorized shares of common stockand recorded the conversion features embedded in the 6% Convertible Notes withan estimated fair value of $3,674 thousand and recorded the amount as Warrantand Derivative Liability. At December 31, 2008, and June 30, 2009,the estimated fair value of the conversion features was subsequently revaluedto $2 thousand and $0 thousand, respectively, with the related credit of $3,672and $2 thousand included in the Company’s statement of operations in interestexpense for the year ended December 31, 2008, and the six months ended June 30,2009, respectively. The Company determined the estimated fair value of theconversion features on April 22 and December 31, 2008, and June 30,2009, by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $2.91, $0.33, and$0.36, respectively, per share; terms of 0.95, 0.25, and 0 years, respectively;risk free interest rates of 1.82%, 0.11% and 0.0%, respectively; and volatilityof 47.16%, 73.59%, and 0.0%, respectively. Probabilities were then applied tothe outputs using the Matlab Monte Carlo Simulation of the Company’s stockprices to arrive at a value for the conversion options.

 

Upon the restructuring ofthe Company’s January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the conversion features embedded in the 6%Convertible Notes met the criteria in ASC 815-10 to be accounted for as anequity instrument because the Company had control to ensure the sufficiency ofits authorized shares of common stock, as the modified anti-dilution provisionsrelating to the January 2008 and April 2008 Debentures include afloor on the conversion price adjustment as a result of any subsequent equitysales. Due to the change in classification from liability to equity, theCompany recorded a reclassification of the fair value as of June 30, 2009to additional paid in capital of $0 thousand. As of December 31, 2009, theCompany continues to conclude that the conversion features embedded in the 6%Convertible Notes meet the criteria in ASC 815-10 to be accounted for as anequity instrument.

 

*EmbeddedDerivatives — January 2008 and April 2008 Debentures*

 

Prior to the restructuring of the January 2008and April 2008 Debentures on June 30, 2009, the Company concludedthat the conversion features embedded in the January 2008 Debentures metthe criteria in ASC 815-10 at issuance and through April 21, 2008, the dayprior to the merger with Tripath, and therefore, were not bifurcated from thedebt host because the conversion to the Company’s common stock could only besettled in its common stock, the common stock could be unregistered and thesufficiency of the authorized shares was under the Company’s control as itcould control the outcome of a shareholder vote to increase the authorizedshares.  However, on the date of the merger with Tripath, April 22,2008, the Company concluded it no longer had control to ensure the sufficiencyof its authorized shares of common stock nor could it settle the conversionfeature in unregistered shares. Therefore, the Company recorded the conversionfeatures embedded in the January 2008 Debentures with an estimated fairvalue of $896 thousand and recorded the amount as Warrant and DerivativeLiability.  At December 31, 2008, and June 30, 2009, theestimated fair value of the conversion feature was subsequently revalued to $5thousand and $2 thousand, respectively, with the related credit of $891thousand and $3 thousand included in the Company’s statement of operations ininterest expense for the year ended December 31, 2008, and the six monthsended June 30, 2009. The Company determined the estimated fair value ofthe conversion options on April 22 and December 31, 2008, and June 30,2009, using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $2.91, $0.33, and$0.36, respectively, per share; terms of 1.75 years, 1.08 years, and 0.58years, respectively; risk free interest rates of 1.84%, 0.40%, and 0.39%,respectively; and volatility of 47.16% 65.48%, and 48.84%, respectively. Probabilities were then applied to the outputs using the Matlab Monte CarloSimulation of the Company’s stock prices to arrive at a value for theconversion options.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the conversion features embedded in the April 2008Debentures should be bifurcated from the debt host and recorded as liabilitiesbecause the conversion features must be settled in registered shares and thatdue to the Merger with Tripath the Company no longer had control over ashareholder vote to ensure the sufficiency of its authorized shares of commonstock. The estimated fair value of the embedded conversion features was $1,507thousand at April 22, 2008, and recorded in the line entitled “Warrant andderivative liability” in the accompanying Balance Sheet. At December 31,2008, and June 30, 2009, the estimated fair value of the embeddedconversion features was subsequently revalued to $10 thousand and $2 thousand,respectively, with the related credit of $1,497 thousand and $8 thousandincluded in the Company’s statement of operations in interest expense for theyear ended December 31, 2008, and the six months ended June 30, 2009,respectively. The Company determined the estimated fair value of the conversionoptions on April 22 and December 31, 2008, and June 30, 2009,using the Black-Scholes Merton valuation model and the following assumptions:fair value of the Company’s common stock of $2.91, $0.33, and $0.36,respectively, per share; terms of 2, 1.33, and 0.83 years, respectively; riskfree interest rates of 1.87%, 2.24%, and 0.49%, respectively; and volatility of49.00%, 61.48%, and 58.72%, respectively.  Probabilities were then appliedto the outputs using the Matlab Monte Carlo Simulation of the Company’s stockprices to arrive at a value for the conversion options.

 

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Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the conversion features embedded in the January 2008and April 2008 Debentures met the criteria in ASC 815-10 to be accountedfor as an equity instrument because the Company had control to ensure thesufficiency of its authorized shares of common stock, as the modifiedanti-dilution provisions relating to the January 2008 and April 2008Debentures include a floor on the conversion price adjustment as a result ofany subsequent equity sales, and because the conversion features no longer arerequired to be settled in registered shares. Due to the change inclassification from liability to equity, the Company recorded areclassification of the fair value of the conversion features embedded in the January 2008and April 2008 Debentures as of June 30, 2009, to additional paid incapital of $0 thousand and $2 thousand, respectively. As of December 31,2009, the Company continues to conclude that the conversion features embeddedin the January 2008 and April 2008 Debentures meet the criteria inASC 815-10 to be accounted for as an equity instrument.

 

The Company alsoconcluded that the put and call in the January 2008 and April 2008Debentures were embedded derivatives that were not clearly and closely relatedto the debt host and therefore should be bifurcated from the debt host alongwith the conversion features and recorded as a liability at their estimatedfair value at issuance.  The Company determined the net fair value of theput and call embedded in the January 2008 and April 2008 Debentureson April 22 and December 31, 2008, to be *de minimus*.

 

As of December 31,2009, the Company concluded that the put and call features embedded in the January 2008and April 2008 Debentures continue to be not clearly and closely relatedto the debt host and therefore should be bifurcated from the debt host andrecorded as a liability at their estimated fair value. The Company determinedthe net fair value of the put and call to be $93 thousand and $161 thousand forthe January 2008 and April 2008 Debentures, respectively, with therelated debit of $93 thousand and $161 thousand, respectively, included in theCompany’s statement of operations in interest expense for the year ended December 31,2009. The Company determined the estimated fair value of the put on December 31,2009, using the Black-Scholes Merton valuation model and the followingassumptions: fair value and exercise price of the put embedded in the January 2008and April 2008 Debentures equivalent to 130% of the outstanding principaland accrued interest of $3,015,858 and $5,216,312, respectively; term of 3years to the maturity date of December 31, 2012; risk free interest rateof 1.7%; and volatility of 15.96% which was determined using the volatility ofthe Bank Prime Lending Rate. The Company determined the estimated fair value ofthe call on December 31, 2009, using the Black-Scholes Merton valuationmodel and the following assumptions: fair value and exercise price of the callembedded in the January 2008 and April 2008 Debentures equivalent to100% of the outstanding principal and accrued interest of $2,319,890 and$4,012,548, respectively; term of 3 years to the maturity date of December 31,2012; risk free interest rate of 1.7%; and volatility of 15.96% which wasdetermined using the volatility of the Bank Prime Lending Rate.

 

*EmbeddedDerivatives — September 2009 Debentures*

 

Upon the issuance of the September 2009Debentures on September 30, 2009, the Company concluded that theconversion features embedded in the September 2009 Debentures met thecriteria in ASC 815-10 to be accounted for as an equity instrument even thoughthe September 2009 Debentures include a reset provision on the conversionprice and is considered non-conventional debt, because the Company has controlto ensure the sufficiency of its authorized shares of common stock, as thedebentures include a floor on the conversion price adjustment, and because theconversion features are not required to be settled in registered shares.  The Company also concluded that the put andcall in the September 2009 Debentures were embedded derivatives that werenot clearly and closely related to the debt host and therefore should bebifurcated from the debt host and recorded as a liability at their estimatedfair value at issuance.  The Company determined the net fair value of theput and call embedded in the September 2009 Debentures on September 30,2009, to be $45 thousand, and recorded a discount on the debentures that willbe amortized as interest expense over the life of the debentures using theinterest method.  The Company determinedthe estimated fair value of the put on September 30, 2009, using theBlack-Scholes Merton valuation model and the following assumptions: fair valueand exercise price of the put embedded in the September 2009 Debenturesequivalent to 120% of the outstanding principal and accrued interest expectedto be earned to maturity of $2,800,000; term of 2.0 years to the maturity dateof September 30, 2011; risk free interest rate of 0.95%; and volatility of18.31% which was determined using the volatility of the Bank Prime LendingRate. The Company determined the estimated fair value of the call on September 30,2009, using the Black-Scholes Merton valuation model and the followingassumptions: fair value and exercise price of the call embedded in the September 2009Debentures equivalent to 100% of the outstanding principal and accrued interestexpected to be earned to maturity of $2,400,000; term of 2.0 years to thematurity date of September 30, 2011; risk free interest rate of 0.95%; andvolatility of 18.31% which was determined using the volatility of the BankPrime Lending Rate.

 

Upon the issuance of the September 2009Debentures on December 17, 2009, the Company concluded that the conversionfeatures embedded in the September 2009 Debentures met the criteria in ASC815-10 to be accounted for as an equity instrument even though the September 2009Debentures include a reset provision on the conversion price and is considerednon-conventional debt, because the Company has control to ensure thesufficiency of its authorized shares of common stock, as the debentures includea floor on the conversion price adjustment, and because the conversion featuresare not required to be settled in registered shares.  The Company also concluded that the put andcall in the September 2009 Debentures were embedded derivatives that werenot clearly and closely related to the debt host and therefore should bebifurcated from the debt host and recorded as a liability at their estimatedfair value at 

 

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issuance.  TheCompany determined the net fair value of the put and call embedded in the September 2009Debentures on December 17, 2009 to be $23 thousand, and recorded adiscount on the debentures that will be amortized as interest expense over thelife of the debentures using the interest method.  The Company determined the estimated fairvalue of the put on December 17, 2009, using the Black-Scholes Mertonvaluation model and the following assumptions: fair value and exercise price ofthe put embedded in the September 2009 Debentures equivalent to 120% ofthe outstanding principal and accrued interest expected to be earned tomaturity of $1,400,000; term of 1.8 years to the maturity date of September 30,2011; risk free interest rate of 0.77%; and volatility of 19.21% which wasdetermined using the volatility of the Bank Prime Lending Rate. The Companydetermined the estimated fair value of the call on December 17, 2009,using the Black-Scholes Merton valuation model and the following assumptions:fair value and exercise price of the call embedded in the September 2009Debentures equivalent to 100% of the outstanding principal and accrued interestexpected to be earned to maturity of $1,200,000; term of 1.8 years to thematurity date of September 30, 2011; risk free interest rate of 0.77%; andvolatility of 19.21% which was determined using the volatility of the BankPrime Lending Rate.

 

As of December 31,2009, the Company concluded that the put and call features embedded in the September 2009Debentures continue to be not clearly and closely related to the debt host andtherefore should be bifurcated from the debt host and recorded as a liabilityat their estimated fair value. The Company determined the net fair value of theput and call to be $61 thousand for the September 2009 Debentures, withthe related credit of $7 thousand included in the Company’s statement ofoperations in interest expense for the year ended December 31, 2009. TheCompany determined the estimated fair value of the put on December 31,2009, using the Black-Scholes Merton valuation model and the followingassumptions: fair value and exercise price of the put embedded in the September 2009Debentures equivalent to 120% of the outstanding principal and accrued interestof $4,200,000; term of 1.75 years to the maturity date of September 30,2011; risk free interest rate of 0.97%; and volatility of 16.12% which wasdetermined using the volatility of the Bank Prime Lending Rate. The Companydetermined the estimated fair value of the call on December 31, 2009,using the Black-Scholes Merton valuation model and the following assumptions:fair value and exercise price of the call embedded in the September 2009Debentures equivalent to 100% of the outstanding principal and accrued interestof $3,600,000; term of 1.75 years to the maturity date of September 30,2011; risk free interest rate of 0.97%; and volatility of 16.21% which wasdetermined using the volatility of the Bank Prime Lending Rate.

 

*WarrantsIssued in Connection with January 2008 and April 2008 Debentures*

 

Effective with theissuance of the January 2008 and April 2008 Debentures, the Companyissued warrants to purchase 222,222 and 388,889 shares, respectively, of theCompany’s common stock at an exercise price of $1.80 per share, subject toadjustment, which warrants have a term of three years.

 

The Company evaluated theterms and conditions of the warrants issued with the January 2008 and April 2008Debentures under the guidance in ASC 815-40-25 and ASC 815-40-15 to determinewhether the warrants should be accounted for as equity or a liability andthereafter adjusted to their respective estimated fair value at each reportingdate.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrants issued with the January 2008Debentures met the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance andthrough April 22, 2008, and therefore, were accounted for as equitybecause the warrants could only be settled by issuance of the Company’s commonstock, the common stock could be unregistered, and the sufficiency of theauthorized shares was under the Company’s control as it could control theoutcome of a shareholder vote to increase the authorized shares.  However,on the date of the merger with Tripath, April 22, 2008, the Companyconcluded it no longer had control to ensure the sufficiency of its authorizedshares of common stock nor could it settle the warrants in unregistered sharesand therefore, recorded the estimated value fair value of the warrants of $320thousand as Warrant and Derivative Liability.  At December 31, 2008,and June 30, 2009, the estimated fair value of the warrants was revaluedto $1 thousand and $1 thousand, respectively, with the related credit of $319thousand and $0 thousand included in the Company’s statement of operations ininterest expense for the year ended December 31, 2008, and the six monthsended June 30, 2009, respectively. The Company determined the estimatedfair value of the warrants on April 22 and December 31, 2008, and June 30,2009, by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $2.91, $0.33, and$0.36, respectively, per share; terms of 2.5, 2.08 and 1.58 years, respectively;risk free interest rates of 2.54%, 0.78%, and 0.88%, respectively; andvolatility of 47.81%, 56.98%, and 59.34%, respectively.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrants issued with the April 2008Debentures did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 atissuance because it no longer had control to ensure the sufficiency of itsauthorized shares of common stock nor could it settle the warrants inunregistered shares and therefore, recorded the estimated value fair value ofthe warrants of $590 thousand as Warrant and Derivative Liability.  At December 31,2008, and June 30, 2009, the estimated fair value of the warrants wasrevalued to $4 thousand and $2 thousand with the related credit of $586thousand and $2 thousand included in the Company’s statement of operations ininterest expense for the year ended December 31, 2008, and the six monthsended June 30, 2009, respectively. The Company determined the estimatedfair value of the warrants on April 22 and December 31, 2008, and June 30,2009, by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $2.91, $0.33, and$0.36, respectively, per share; terms of 3, 2.33, and 1.83 years, respectively;risk free interest rates of 2.43%, 0.84%, and 1.02%, respectively; andvolatility of 49.17%, 62.44%, and 57.08%, respectively.

 

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Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued with the January 2008 and April 2008Debentures met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accountedfor as equity because the Company had control to ensure the sufficiency of itsauthorized shares of common stock.  TheCompany reached this conclusion because the conversion price of the January 2008and April 2008 Debentures that was subject to adjustment due toprice-based anti-dilution provisions was modified to include a floor on theconversion price adjustment as a result of any subsequent equity sales, andtherefore the Company was able to conclude that has a sufficient authorized butunissued number of shares to settle all outstanding contracts requiringsettlement in shares. Due to the change in classification from liability toequity, the Company recorded a reclassification of the fair value as of June 30,2009, to additional paid in capital of $1 thousand and $2 thousand,respectively. As of December 31, 2009, the Company continues to concludethat the warrants issued with the January 2008 and April 2008Debentures meet the criteria in ASC 815-10 to be accounted for as an equityinstrument.

 

*WarrantsIssued in Connection with September 2009 Debentures*

 

Effective with theissuance of the September 2009**Debentures, the Company issued Series Iand Series II warrants to purchase 3,000,000 and 2,250,000 shares,respectively, of the Company’s common stock at exercise prices of $0.60 and$0.01 per share, respectively, subject to adjustment, and with terms of fiveand seven years, respectively.

 

The Company evaluated theterms and conditions of the warrants issued with the September 2009**Debenturesunder the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether thedetachable warrants should be accounted for as equity or a liability andthereafter adjusted to their respective estimated fair value at each reportingdate and concludedthat the Series I and Series II warrants issued with the September 2009**Debentures met the criteria in ASC815-40-25 and ASC 815-40-15 at issuance, and therefore, were accounted for asequity because the warrants could only be settled by issuance of the Company’scommon stock, the common stock could be unregistered, and the sufficiency ofthe authorized shares was under the Company’s control. The Company determinedthe fair value of the Series I and Series II warrants on September 30,2009, to be $424 thousand and $565 thousand, respectively, and recorded adiscount on the debentures that will be amortized as interest expense over thelife of the debentures using the interest method.

 

The Company determinedthe estimated fair value of the Series I warrants on September 30,2009, using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $0.78; exercise priceof $0.60; term of 5.0 years; risk free interest rate of 2.31%; and volatilityof 54.11%. The Company determined the estimated fair value of the Series IIwarrants on September 30, 2009, using the Black-Scholes Merton valuationmodel and the following assumptions: fair value of the Company’s common stockof $0.78; exercise price of $0.01; term of 7.0 years; risk free interest rateof 2.93%; and volatility of 57.83%.  Asof December 31, 2009, the Company continues to conclude that the warrantsissued in connection with the September 2009 Debentures meet the criteriain ASC 815-10 to be accounted for as an equity instrument.

 

*WarrantsIssued in Connection with Other Notes Payable and Notes Payable to RelatedParties*

 

Effective with theissuance of promissory notes on February 23, March 31, and July 9,2009, the Company issued warrants to purchase 26,667, 133,333, and 500,000shares, respectively, of the Company’s common stock at an exercise price of$0.75 per share, which warrants have a term of three, three, and five years,respectively.

 

The Company evaluated theterms and conditions of these warrants under the guidance in ASC 815-40-25 andASC 815-40-15 to determine whether the warrants should be accounted for asequity or a liability and thereafter adjusted to their respective estimatedfair value at each reporting date.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrant issued with the promissory note inFebruary 2009 did not meet the criteria in ASC 815-10 at issuance becausethe Company did not have control to ensure the sufficiency of its authorizedshares of common stock and therefore, recorded the estimated value fair valueof the warrant of $36 thousand as Warrant and Derivative Liability.  At June 30,2009, the estimated fair value of the warrant was revalued to $1 thousand withthe related credit of $35 thousand included in the Company’s statement ofoperations in interest expense for the six months ended June 30, 2009. TheCompany determined the estimated fair value of the warrant on February 23and June 30, 2009, by using the Black-Scholes Merton valuation model andthe following assumptions: fair value of the Company’s common stock of $2.01and $0.36, respectively, per share; terms of 3 and 2.67 years, respectively;risk free interest rates of 1.34% and 1.46%, respectively; and volatility of53.63% and 52.58%, respectively.

 

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Thefair value of the warrant recorded upon issuance was treated as a discount onother notes payable, and was amortized over the life of the promissory note,which matured on May 31, 2009, using the interest method. During the yearended December 31, 2009, $36 thousand of the discount was amortized tointerest expense. TheFebruary 2009 promissory note was cancelled on September 30, 2009 inexchange for September 2009 Debentures.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued with the promissory note in February 2009met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for asequity because the Company had control to ensure the sufficiency of itsauthorized shares of common stock. The Company reached this conclusion becausethe conversion price of the January 2008 and April 2008 Debenturesthat was subject to adjustment due to price-based anti-dilution provisions wasmodified to include a floor on the conversion price adjustment as a result ofany subsequent equity sales, and therefore the Company was able to concludethat it has a sufficient authorized but unissued number of shares to settle alloutstanding contracts requiring settlement in shares. Due to the change inclassification from liability to equity, the Company recorded areclassification of the fair value as of June 30, 2009 to additional paidin capital of $1 thousand. As of December 31, 2009, the Company continuesto conclude that the warrants issued with the promissory note in February 2009should be accounted for as equity.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrant issued with the promissory note inMarch 2009, did not meet the criteria in ASC 815-10 at issuance becausethe Company did not have control to ensure the sufficiency of its authorizedshares of common stock and therefore, recorded the estimated value fair valueof the warrant of $83 thousand as Warrant and Derivative Liability.  At June 30,2009, the estimated fair value of the warrant was revalued to $7 thousand withthe related credit of $76 thousand included in the Company’s statement ofoperations in interest expense for the six months ended June 30,2009.  The Company determined the estimated fair value of the warrant on March 31and June 30, 2009, by using the Black-Scholes Merton valuation model andthe following assumptions: fair value of the Company’s common stock of $1.20and $0.36 per share, respectively; term of 3 and 2.75 years, respectively; riskfree interest rate of 1.15% and 1.51%, respectively; and volatility of 53.28%and 51.87%, respectively.

 

The fair value of thewarrant recorded upon issuance was treated as a discount on notes payable torelated parties, and was being amortized over the life of the promissory note,which was due to mature on October 31, 2009, using the interest method.During the year ended December 31, 2009, $35 thousand of the discount wasamortized to interest expense. The March 2009 promissory note wascancelled on September 30, 2009 in exchange for September 2009Debentures.  As a result, the remainingunamortized debt discount of $48 thousand was written off as part of the losson extinguishment of debt.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued with the promissory note in March 2009met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as anequity instrument because the Company had control to ensure the sufficiency ofits authorized shares of common stock. The Company reached this conclusionbecause the conversion price of the January 2008 and April 2008Debentures that was subject to adjustment due to price-based anti-dilutionprovisions was modified to include a floor on the conversion price adjustmentas a result of any subsequent equity sales, and therefore the Company was ableto conclude that it has a sufficient authorized but unissued number of sharesto settle all outstanding contracts requiring settlement in shares.  Due to the change in classification fromliability to equity, the Company recorded a reclassification of the fair valueas of June 30, 2009 to additional paid in capital of $7 thousand. As of December 31,2009, the Company continues to conclude that the warrants issued with thepromissory note in March 2009 should be accounted for as equity.

 

The Company concludedthat the warrant issued with the promissory note in July 2009 met thecriteria in ASC 815-40-25 and ASC 815-40-15 at issuance, and therefore, wasaccounted for as equity because the warrants could only be settled by issuanceof the Company’s common stock, the common stock could be unregistered, and thesufficiency of the authorized shares was under the Company’s control. TheCompany determined the fair value of the warrant on issuance to be $110thousand and recorded a discount on the promissory note that will be amortizedas interest expense over the life of the promissory note using the interestmethod. During the year ended December 31, 2009, the Company amortized $42thousand in the Company’s statement of operations as interest expense. The July 2009promissory note was cancelled on September 30, 2009, in exchange for September 2009Debentures. As a result, the remaining unamortized debt discount of $68thousand was written off as part of the loss on extinguishment of debt.

 

The Company determinedthe estimated fair value of the warrant on issuance, using the Black-ScholesMerton valuation model and the following assumptions: fair value of the Company’scommon stock of $0.55; exercise price of $0.75; term of 5.0 years; risk freeinterest rate of 2.34%; and volatility of 53.68%.  As of December 31, 2009, the Companycontinues to conclude that the warrants issued in connection with thepromissory note in July 2009 should be accounted for as an equityinstrument.

 

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*Warrantsissued with New Series A Preferred Stock*

 

In October 2008 andas amended in December 2008, the Board of Directors authorized thedesignation and issuance of up to 3,333,333 shares of New Series AConvertible Preferred Stock (the “New Series A Preferred Stock”), and theoffering of up to $2,500,000 of New Series A Preferred Stock and a numberof warrants with an exercise price of $0.75 equal to 100% of the number ofshares purchased by each purchaser. Through the year ended December 31,2009 and 2008, the Company closed a round of financing for the sale of 10,000and 833,333 shares, respectively, of its New Series A Preferred Stock at$0.75 per share, for an aggregate purchase price of $7.5 thousand and $625thousand, respectively, and warrants to purchase 10,000 and 833,333 shares ofcommon stock of the Company, respectively, at an exercise price of $0.75 pershare, and a three year term. The lead investor of this financing was DanielJ.A. Kolke, the Company’s founder, chairman, chief executive officer, actingchief financial officer, and chief technology officer, with participation fromtwo of the Company’s directors and other prior investors. The holders of the January 2008Debentures and the April 2008 Debentures consented to this financing, butdid not participate.

 

The Company concluded atthe date of issuance and through the reporting date that the embeddedconversion features in the New Series A Preferred Stock should not bebifurcated from the equity host as they were clearly and closely related to theequity host. Also during the year ended December 31, 2008, the Companyrecorded a beneficial conversion feature related to the New Series APreferred Stock, which could have been converted to the Company’s common stock,through the date the conversion feature was recorded, as a dividend expense of$22 thousand.

 

The Company evaluated theterms and conditions of the warrants issued with the New Series APreferred Stock under the guidance in ASC 815-40-25 and ASC 815-40-15 todetermine whether the warrants should be accounted for as equity or a liabilityand thereafter adjusted to their respective estimated fair value at eachreporting date.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrants issued with the New Series APreferred Stock did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 atissuance because the Company did not have control to ensure the sufficiency ofits authorized shares of common stock. Therefore, the Company recorded theestimated value fair value of the warrants of $148 thousand as Warrant andDerivative Liability.  At December 31, 2008, and June 30, 2009,respectively, the estimated fair value of the warrants was revalued to $40thousand and $40 thousand, respectively, with the related credit of $108thousand and $0 thousand included in the Company’s statement of operations infinancing expense for the year ended December 31, 2008, and the six monthsended June 30, 2009, respectively. The Company determined the estimatedfair value of the warrants on December 3 and 31, 2008 and June 30,2009, and February 27 and June 30, 2009, by using the Black-ScholesMerton valuation model and the following assumptions: fair value of the Company’scommon stock of $0.60, $0.33 and $0.36, and $0.51 and $0.36, respectively, pershare; terms of 3, 2.92 and 2.42, and 3.0 and 2.67 years, respectively; riskfree interest rates of 1.07%, 0.98% and 1.33%, and 1.4% and 1.46%,respectively; and volatility of 53.07%, 54.96% and 54.25%, and 53.63% and52.58%, respectively.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued in relation to the New Series APreferred Stock met the criteria in ASC 815-40-25 and ASC 815-40-15 to beaccounted for as an equity instrument because the Company had control to ensurethe sufficiency of its authorized shares of common stock. The Company reachedthis conclusion because the conversion price of the January 2008 and April 2008Debentures that was subject to adjustment due to price-based anti-dilutionprovisions was modified to include a floor on the conversion price adjustmentas a result of any subsequent equity sales, and therefore the Company was ableto conclude that it has a sufficient authorized but unissued number of sharesto settle all outstanding contracts requiring settlement in shares.  Due to the change in classification fromliability to equity, the Company recorded a reclassification of the fair valueas of June 30, 2009 to additional paid in capital of $40 thousand. As of December 31,2009, the Company continues to conclude that the warrants issued with the New Series APreferred Stock should be accounted for as equity.

 

*WarrantsIssued in Connection with Litigation Settlement*

 

Effective December 5,2008, the Company entered into a settlement agreement with Kaufman Bros.,pursuant to which the Company issued to Kaufman Bros. a warrant to purchase500,000 shares of the Company’s common stock at an exercise price of $0.75 pershare, which warrant has a term of five years. See discussion *infra* Note 15.

 

The Company evaluated theterms and conditions of the warrants issued in the settlement under theguidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrantsshould be accounted for as equity or a liability and thereafter adjusted to itsrespective estimated fair value at each reporting date.

 

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Prior to the restructuring of the January 2008 and April 2008Debentures on June 30, 2009, the Company concluded that the warrantsissued in the settlement did not meet the criteria in ASC 815-40-25 and ASC815-40-15 at issuance because the Company did not have control to ensure thesufficiency of its authorized shares of common stock and therefore, recordedthe estimated value fair value of the warrants of $130 thousand as Warrant andDerivative Liability.  At December 31, 2008, and June 30, 2009,respectively, the estimated fair value of the warrants was revalued to $46thousand and $47 thousand with the related (credit) debit of ($84) thousand and$1 thousand included in the Company’s statement of operations in settlementexpense for the year ended December 31, 2008, and the six months ended June 30,2009, respectively. The Company determined the estimated fair value of thewarrants on December 5 and December 31, 2008, and June 30, 2009,by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $0.60, $0.33, and$0.36, respectively, per share; terms of 5 years, 4.92, and 4.42 years, respectively;risk free interest rates of 1.67%, 1.53%, and 2.28%, respectively; andvolatility of 56.16%, 56.74%, and 54.68%, respectively.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued in relation to the litigationsettlement met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accountedfor as an equity instrument because the Company had control to ensure thesufficiency of its authorized shares of common stock. The Company reached thisconclusion because the conversion price of the January 2008 and April 2008Debentures that was subject to adjustment due to price-based anti-dilutionprovisions was modified to include a floor on the conversion price adjustmentas a result of any subsequent equity sales, and therefore the Company was ableto conclude that it has a sufficient authorized but unissued number of sharesto settle all outstanding contracts requiring settlement in shares.  Due to the change in classification fromliability to equity, the Company recorded a reclassification of the fair valueas of June 30, 2009, to additional paid in capital of $47 thousand. As of December 31,2009, the Company continues to conclude that the warrants issued with thelitigation settlement should be accounted for as equity.

 

*WarrantsIssued in Connection with Consulting Agreement*

 

Effective March 2,2009, the Company entered into a consulting agreement with Salzwedel FinancialCommunications, Inc., pursuant to which the Company issued a warrant topurchase 2,000,000 shares of the Company’s common stock at an exercise price of$0.01 per share, which warrant has a term of five years.

 

The Company evaluated theterms and conditions of the warrants issued in relation to the consultingagreement under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants shouldbe accounted for as equity or a liability and thereafter adjusted to itsrespective estimated fair value at each reporting date.

 

Prior to the restructuringof the January 2008 and April 2008 Debentures on June 30, 2009,the Company concluded that the warrant issued in relation to the consultingagreement did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 atissuance because the Company did not have control to ensure the sufficiency ofits authorized shares of common stock and, therefore, recorded the estimatedvalue fair value of the warrants of $1,001 thousand as Warrant and DerivativeLiability.  At June 30, 2009, the estimated fair value of thewarrants was revalued to $702 thousand with the related credit of $299 thousandincluded in the Company’s statement of operations in investor relations expensefor the six months ended June 30, 2009. The Company determined theestimated fair value of the warrants on March 2 and June 30, 2009, byusing the Black-Scholes Merton valuation model and the following assumptions:fair value of the Company’s common stock of $0.51 and $0.36, respectively, pershare; terms of 5 years and 4.67 years, respectively; risk free interest ratesof 1.86% and 2.39%, respectively; and volatility of 56.68% and 54.64%,respectively.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued in relation to the consultingagreement met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accountedfor as an equity instrument because the Company had control to ensure thesufficiency of its authorized shares of common stock. The Company reached this conclusionbecause the conversion price of the January 2008 and April 2008Debentures that was subject to adjustment due to price-based anti-dilutionprovisions was modified to include a floor on the conversion price adjustmentas a result of any subsequent equity sales, and therefore the Company was ableto conclude that it has a sufficient authorized but unissued number of sharesto settle all outstanding contracts requiring settlement in shares.  Due to the change in classification fromliability to equity, the Company recorded a reclassification of the fair valueas of June 30, 2009 to additional paid in capital of $702 thousand. As of December 31,2009, the Company continues to conclude that the warrants issued with theconsulting agreement should be accounted for as equity.

 

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The following is asummary of the movement related to embedded derivatives and warrant liabilitiesduring the year ended December 31, 2009 (in thousands):

 
| ** **                                                                                                   | ** ** | **Embedded  derivatives** | ** ** | **Warrant  liabilities** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|--------------------------|------------|-----------|------------|
|                                                                                                         |       |                      |       |                     |       |      |       |
| Balance as of  December 31, 2008                                                                        |       | $                         | 16         |                     | $          | 92        |       | $ | 108 |   |
|                                                                                                         |       |                      |       |                     |       |      |       |
| Fair value of  warrant liabilities issued with Other Notes Payable and Notes Payable to  Related Parties     |       |                      |       | 120                      |       | 120       |       |
| Fair value of  warrant liabilities issued with New Series A Preferred warrants                          |       |                      |       | 1                        |       | 1         |       |
| Fair value of  warrant liabilities issued with consulting agreement                                          |       |                      |       | 1,001                    |       | 1,001     |       |
| Fair value of embedded derivatives issued with  September 2009 Debentures                               |       | 68                        |       |                     |       | 68        |       |
| Change in marked-to-market value of 6% convertible  notes payable                                            |       | (2                        | )          |                     |       | (2        | )          |
| Change in marked-to-market value of  January 2008 Debentures                                            |       | 88                        |       |                     |       | 88        |       |
| Change in marked-to-market value of April 2008  Debentures                                              |       | 154                       |       |                     |       | 154       |       |
| Change in marked-to-market value of  September 2009 Debentures                                          |       | (7                        | )          |                     |       | (7        | )          |
| Change in marked-to-market value of  January 2008 warrants                                              |       |                      |       | (—                  | )          | (—   | )          |
| Change in marked-to-market value of April 2008  warrants                                                |       |                      |       | (3                       | )          | (3        | )          |
| Change in marked-to-market value of Other  Notes Payable and Notes Payable to Related Parties warrants       |       |                      |       | (112                     | )          | (112      | )          |
| Change in marked-to-market value of New  Series A Preferred warrants                                    |       |                      |       | (2                       | )          | (2        | )          |
| Change in marked-to-market value of litigation  settlement warrants                                          |       |                      |       | 1                        |       | 1         |       |
| Change in marked-to-market value of consulting  agreement warrants                                           |       |                      |       | (299                     | )          | (299      | )          |
| Reclassification to additional paid in capital upon  restructuring of January and April Debentures |       | (2                        | )          | (799                     | )          | (801      | )          |
|                                                                                                         |       |                      |       |                     |       |      |       |
| Balance as of December 31, 2009                                                                         |       | $                         | 315        |                     | $          | —    |       | $ | 315 |   |

 

***7. Notes Payable to RelatedParties***

 

The Company previouslyentered into a series of loan transactions with the parents and two brothers ofour chairman and chief executive officer, Mr. Daniel J.A. Kolke.  Inconnection with settlement of these loans, we issued three unsecured promissorynotes in the aggregate principal amount of $815.8 thousand which will becomesecured by certain of our presently unidentified assets if and when Mr. Kolkeis no longer neither an employee nor a member of our****board of directors. Theunsecured promissory notes bear interest at 7.5 percent.  On December 22, 2009, the board ofdirectors, with Daniel J.A. Kolke abstaining, approved the issuance of 434,754 sharesof common stock of the company toDaniel & Selma Kolke, as payment of 45% of principal and 100% ofaccrued interest due on their note, as of December 31, 2009, at a value of$0.75 per share, or approximately $326 thousand.  The balance due on the note to Daniel &Selma Kolke, as of December 31, 2009, was $324 thousand and theprincipal amount outstanding on the other two promissory notes, in theaggregate, as of December 31, 2009, was $30 thousand.

 

In March 2009, Etelos entered into apromissory note with Ronald A. Rudy, a member of our Board of Directors, in theprincipal amount of $100 thousand, bearing interest of 10% per annum.  On December 22, 2009, our board ofdirectors, with Mr. Rudy abstaining, approved the issuance of 143,379shares of our common stock to Mr. Rudy as payment in full of all principaland accrued interest due on the promissory note as of December 31, 2009,at a value of $0.75 per share.

 

On December 18, 2009, Etelos entered intoa promissory note with Daniel J.A. Kolke, our chairman, in the principal amountof $40 thousand, bearing interest at 6% per annum.  All principal on the note subsequently waspaid in full on January 4, 2010.

 

***8.  Notes Payable***

 

On March 19, 2009,the Company issued an unsecured note of $88 thousand for an accounts payablebalance. The note bears interest of 11% and is due on April 1, 2010, withpayment terms of $15 thousand on issuance of the note, and monthly payments of$6 thousand beginning May 1, 2009 with a final payment on March 20,2010. Interest expense on this note was $4 thousand for the year ended December 31,2009.

 

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**9. *Taxes***

 

TheCompany accounts for income taxes in accordance with ASC 740 “Income Taxes”which utilizes the liability method of accounting for income taxes. Deferredtax assets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amount ofexisting assets and liabilities and their respective tax bases. Deferred taxassets and liabilities are measured using enacted tax rates expected to applyto taxable income in the years in which those temporary differences areexpected to be recovered or settled. Valuation allowances are established whennecessary to reduce deferred tax assets to the amounts expected to be realized.

 

TheCompany has adopted the provisions of ASC 740-10-25, “Income Taxes — Overall —Recognition” (ASC 740-10-25). The Company did not have any unrecognized taxbenefits and there was no effect on its financial condition or results ofoperations as a result of implementing ASC 740-10-25.

 

TheCompany files income tax returns in the United States of America federaljurisdiction and various state jurisdictions in the United States of America.  The statute of limitations has expired forthe tax years prior to 2006 for federal tax purposes and for tax years prior to2005 for state tax purposes.  The Companydoes not believe that there will be any material changes in its unrecognizedtax positions over the next twelve months. The Company believes that its income tax filing positions and deductionswould be sustained on audit and does not anticipate any adjustments that willresult in a material adverse effect on the Company’s financial position,results of operations, or cash flow. Therefore, no reserves for uncertain income tax positions have beenrecorded pursuant to ASC 740-10-25.  Inaddition, the Company did not record a cumulative effect adjustment related tothe adoption of ASC 740-10-25.

 

TheCompany’s policy is to recognize interest and penalties accrued on anyunrecognized tax benefits as a component of income tax expense.  As of the date of the adoption of ASC740-10-25, the Company did not have any accrued interest or penalties associatedwith any unrecognized tax benefits, nor was any such interest expenserecognized during the years ended December 31, 2009 and 2008.  The Company’s effective tax rate differs fromthe federal statutory rate primarily due to increases in its deferred incometax valuation allowance.

 

The components of the incometax benefit for the years ended December 31, 2009 and 2008, respectively,are set forth in the following table (in thousands):

 
| ** **                          | ** ** | **December 31,  2009** | ** ** | **December 31,  2008** | ** ** |
|-------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Federal (expense) benefit:          |       |                        |       |                        |       |
| Current                             |       | $                           | —     |                        | $          | — |   |
| Deferred                            |       | 2,895                       |       | 8,153                       |       |
| Valuation allowance                 |       | (2,895                      | )          | (8,153                      | )          |
| State (expense) benefit:            |       |                        |       |                        |       |
| Current                             |       | —                      |       | —                      |       |
| Deferred                            |       | —                      |       | —                      |       |
| Valuation allowance                 |       | —                      |       | —                      |       |
| Total income tax (expense)  benefit |       | $                           | —     |                        | $          | — |   |

 

Theincome tax (expense) benefit differs from the federal statutory rate because ofthe effects of the following items for the fiscal years ended December 31,2009 and 2008.

 
| ** **                                  | ** ** | **December 31,  2009** | ** ** | **December 31,  2008** | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Statutory rate                              |       | 34.0                        | %          | 34.0                        | %          |
| State income taxes, net of  federal benefit |       | 0.0                         | %          | 0.0                         | %          |
| Change in valuation  allowance              |       | (34.0                       | )%         | (34.0                       | )%         |
| Effective tax (expense)  benefit rate       |       | 0.0                         | %          | 0.0                         | %          |

 

Deferredincome taxes are provided to reflect temporary differences in the basis of netassets for income tax and financial reporting purposes, as well as available netoperating losses. The tax effected temporary differences comprising the Company’sdeferred income taxes as of December 31, 2009 and 2008, all non-current,are as follows (in thousands):

 
| ** **                     | ** ** | **December 31,  2009** | ** ** | **December 31,  2008** | ** ** |
|--------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Net operating losses           |       | $                           | 61,248     |                        | $          | 66,367 |   |
| Valuation allowance            |       | (61,248                     | )          | (66,367                     | )          |
| Net deferred income tax  asset |       | $                           | 0          |                        | $          | 0 |   |

 

TheCompany has recorded a valuation allowance in the amount set forth above fordeferred tax assets where it is more likely than not the Company will notrealize future tax benefits relatedto these items. The netchange in the valuation allowance for the year ended December 31, 2009, was a decreaseof $5.1 million with the decrease primarily due to the Company’s reverse mergerin April 2008. The Company has not performed an IRC §382 study.

 

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As of December 31,2009, the Company has federal net operating loss carryforwardsavailable tooffset future taxable income of approximately $161 million. The federal netoperating loss carryforwards expire through the year 2030. The Company hasstated net operating loss carryforwards of $75 million primarily due to thereverse merger in April 2008.

 

The Tax Reform Act of 1986 imposed substantialrestrictions on the utilization of NOLs in the event of an “ownership change” of acorporation (as defined in the Internal Revenue Code).  Utilization of the Company’s net operating losses may belimited by these restrictions.  Itis likely at least one “ownership change” occurred prior to December 31,2009,therefore the net operating losses may be limited in the utilization againstfuture income and could result in theirexpiration prior to utilization.

 

***10. Equity***

 

Common Stock

 

The Company has issued 23,398,143 shares of common stock from a totalof 250,000,000 authorized shares with a par value of $0.01 per share.

 

Preferred Stock

 

The Company had issued 1,544,771 shares of preferred stock — in Series A,Series B, and Series C — from a total of 50,000,000 authorized shareswith a par value of $0.01 per share.  In connectionwith the Merger, all issued and outstanding shares of Series A, Series B,and Series C preferred stock were converted into shares of common stock ona one-for-one basis.

 

In October 2008 and as amended in December 2008,the Company’s Board of Directors authorized the designation and issuance of upto 3,333,333 shares of a New Series A Convertible Preferred Stock (the “NewSeries A Preferred Stock”), and the offering of a December 2008Preferred Stock Financing of up to $2,500,000 of New Series A PreferredStock with a Stated Value of $0.75 per share and a number of warrants with anexercise price of $0.75 equal to 100% of the number of shares purchased by eachpurchaser. Through the period ending December 31, 2008, the Company closeda round of financing for the sale of 833,333 shares of this New Series APreferred Stock at $0.75 per share, for an aggregate purchase price of $625thousand, and warrants to purchase 833,333 shares of common stock of theCompany, at an exercise price of $0.75 per share, and a three year term. Thisfinancing was led by related parties and other prior investors. The holders ofthe January 2008 Debentures and the April 2008 Debentures consentedto this financing, but did not participate. During the year ended December 31, 2009, 100,000 shares of New Series APreferred converted to Common Stock.

 

The rights, preferences, and privileges of the New Series APreferred stock are as follows:

 

*VotingRights. *Holders of New Series A Preferred Stock andcommon stock vote as a single class upon any matter submitted to thestockholders for a vote and the holder of each share of Series A PreferredStock has the right to one vote for each share of common stock into which suchshare of Series A Preferred Stock could then be converted.

 

*Liquidation. *Holders of New Series A Preferred Stock areentitled to a liquidation preference to the holders of common stock, on a prorata basis, of 120% of the Stated Value. All remaining assets of the Company, if any, shall be distributed to theholders of common stock.

 

*Conversion. *Each share of New Series A Preferred Stock isconvertible, at the option of the holder of such share, into the number offully paid and nonassessable shares of common stock determined by dividing theStated Value by the then applicable conversion price.

 

*Registration Rights. *Holders of New Series APreferred Stock have no registration rights.

 

Warrants

 

As of December 31, 2009, warrants representing 9,864,444 shares ofour common stock were exercisable as set forth in the following table:

 
| **Issue Date** | ** ** | **# of Warrants** | ** ** | **Exercise price** | ** ** | **Expiration date** | ** ** |
|---------------------|------------|-----------------------------|------------|-------------------------|------------|--------------------------|------------|
| ** **          | ** ** | ** **                  |       |                    |       |                     |       |
| Jan-08              |       | 222,222                     |       | $                       | 1.80       |                     | Jan-11     |   |
| Apr-08              |       | 388,889                     |       | $                       | 1.80       |                     | Apr-11     |   |
| Dec-08              |       | 833,333                     |       | $                       | 0.75       |                     | Dec-11     |   |
| Dec-08              |       | 500,000                     |       | $                       | 0.75       |                     | Dec-13     |   |
| Feb-09              |       | 36,667                      |       | $                       | 0.75       |                     | Feb-12     |   |
| Mar-09              |       | 2,000,000                   |       | $                       | 0.01       |                     | Mar-12     |   |
| Mar-09              |       | 133,333                     |       | $                       | 0.75       |                     | Mar-12     |   |
| Jul-09              |       | 500,000                     |       | $                       | 0.75       |                     | Jul-14     |   |
| Sep-09              |       | 3,000,000                   |       | $                       | 0.60       |                     | Sep-14     |   |
| Sep-09              |       | 2,250,000                   |       | $                       | 0.01       |                     | Sep-16     |   |
| Total               |       | 9,864,444                   |       |                    |       |                     |       |

 

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The Company determined the estimated fair value of warrants issued byusing the Black-Scholes Merton model. See discussion, *supra*,Note 6.

 

Shares reserved

 

As of December 31, 2009, the Company has the following sharesreserved:

 
| Options Issued                 |   | 9,547,998  |   |
|--------------------------------|--------|------------|--------|
| Option Plan Available          |   | 4,239,542  |   |
| Debenture Conversion(s)        |   | 13,042,695 |   |
| Debenture Interest  Conversion |   | 203,332    |   |
| Warrants Issued                |   | 9,864,444  |   |
| Total                          |   | 36,898,011 |   |

 

***11. Stock Option Plans***

** **

On November 1, 1999, the Company adopted the 1999 Stock OptionPlan (the “1999 Plan”), on November 11, 2007, adopted the 2007 StockIncentive Plan (the “2007 Plan”) and on October 2, 2009, adopted the 2009Equity Incentive Plan (the “2009 Plan”). Each are incentive plans for employees, directors, consultants, agentsand independent contractors and are administered by the Board of Directors,which was authorized to grant incentive stock options (“ISOs”) andnon-statutory stock options (“NSOs”) to employees, directors and consultantsfor up to 5,000,000 shares of common stock under the 1999 Plan, 4,843,250 underthe 2007 Plan, and 9,000,000 under the 2009 Plan.  ISOs may be granted only to employees of theCompany (including officers and directors who are also employees). NSOs may begranted to employees, non-employee directors and consultants of the Company.  Under the 2007 Plan, upon the first date thatthe Company is publicly held, no employee of the Company will be eligible to begranted options covering more than 500,000 shares of common stock during anycalendar year.

 

Upon adoption of the 2007 Plan, 165,000 options which had been grantedunder the 1999 Plan and remaining shares reserved for issuance under the 1999Stock Option Plan relating to un-granted options were cancelled.  Under the 2007 Plan, ISOs and NSOs aregranted at a price that is not to be less than 100 percent of the fair marketvalue of the common stock on the date of grant, as determined by the Board ofDirectors. Generally, the options granted to new employees under this plan vestover a period of 4 years with 25 percent vesting on the first anniversary datefrom the date of grant and then monthly thereafter over the remaining 36months. Options granted to shareholders who own more than 10 percent of theoutstanding stock of the Company at the time of grant must be issued at prices notless than 110 percent of the estimated fair value of the stock on the date ofgrant. Options under the 2007 Plan may be granted for exercise periods up to 10years.

 

Upon adoption of the 2009 Plan, 1,113,249 options which had beengranted under the 1999 Plan and 2007 Plan continued in effect and remainingshares reserved for issuance under the 2007 Stock Option Plan relating toun-granted options were cancelled.  Underthe 2009 Plan, ISOs and NSOs are granted at a price that is not to be less than100 percent of the fair market value of the common stock on the date of grant,as determined by the Board of Directors. Generally, the options granted to newemployees under this plan vest over a period of 4 years with 25 percent vestingon the first anniversary date from the date of grant and then monthlythereafter over the remaining 36 months. The options granted in October 2009vest 25 percent on the date of grant, 25 percent vesting on the firstanniversary date from the date of grant and then monthly thereafter over theremaining 24 months.  Options granted toshareholders who own more than 10 percent of the outstanding stock of theCompany at the time of grant must be issued at prices not less than 110 percentof the estimated fair value of the stock on the date of grant. Options underthe 2009 Plan may be granted for exercise periods up to 10 years.

 

***12. Accounting forShare-Based Compensation***

** **

The following table summarizes stock option activity under the Company’sstock option plans (in thousands, except share and per share data):

 
| **Options**                            | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price Per  Share** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at  December 31, 2008 |       | 4,086,497  |       | $                                                              | 0.26       |                                                        | 8.6        |                                | $          | 1,053 |   |
| Granted                                |       | 5,805,000  |       | $                                                              | 0.47       |                                                        |       |                                |       |   |
| Exercised                              |       | (90,102    | )          | $                                                              | 0.22       |                                                        |       |                                |       |   |
| Canceled/Forfeited                     |       | (253,397   | )          | $                                                              | 0.89       |                                                        |       |                                |       |   |
| Outstanding at  December 31, 2009 |       | 9,547,998  |       | $                                                              | 0.32       |                                                        | 8.9        |                                | $          | 4,175 |   |
| Exercisable at  December 31, 2009 |       | 4,291,488  |       | $                                                              | 0.21       |                                                        | 8.2        |                                | $          | 2,384 |   |
| Unvested at  December 31, 2008    |       | 5,256,510  |       | $                                                              | 0.42       |                                                        | 9.4        |                                | $          | 1,791 |   |

 

AggregateIntrinsic Value wasdetermined based upon the closing price of the Company’s publicly listed commonstock price on December 31, 2009.

 

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Share based compensation expense attributable to individuals thatworked in the following functions is as follows (in thousands):

 
| ** **                      | ** ** | **Fiscal Year  Ended December 31,  2009** | ** ** | **Fiscal Year  Ended December 31,  2008** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| Research and development        |       | $                                                        | 282        |                                                     | $          | 46 |   |
| Selling and marketing           |       | 177                                                      |       | 29                                                       |       |
| General and administrative      |       | 196                                                      |       | 32                                                       |       |
| Total share-based  compensation |       | $                                                        | 655        |                                                     | $          | 107 |   |

 

The weighted-average fairvalue of stock-based compensation is based on the single option valuationapproach and is estimated on the date of grant using a Black-Scholes Mertonbased option valuation model. The fair value of forfeitures has been adjustedto actual and no dividends have been declared. The fair value of options grantedduring the year ended December 31, 2009 and 2008, were calculated based onthe following average assumptions:

 
| ** **              | ** ** | **For the Year**      | ** ** |
|-------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **Ended December 31** | ** ** |
| ** **              | ** ** | **2009**                        | ** ** | **2008** | ** ** |
| Estimate fair value     |       | $                               | 0.28       |   | $ | 1.41 |   |
| Expected lives in years |       | 7                               |       | 7 |   |
| Volatility              |       | 58.0                            | %          | 59.0 | % |
| Risk free interest rate |       | 2.74                            | %          | 3.26 | % |
| Dividend yield          |       | 0                               | %          | 0 | % |
|                         |            |                                 |            |  |  |  |  |

 

The Company usedestimated volatility of comparable public companies to estimate the expectedvolatility used for the Black-Scholes Merton model. The risk-free interest rateassumption is based upon the US Treasury yield. The Company historically hasnot declared dividends and therefore the dividend yield was assumed to be zeroin the model.

 

On October 2, 2009, theboard of directors, with Mr. Liu abstaining, approved an amendment of allunexpired or forfeited options previously granted on August 8, 2008, torevise the exercise price from $5.93 to $0.51, the closing price of the Company’scommon stock on October 2, 2009.  Inthe aggregate, 86,000 options were amended pursuant to this action.  In accordance with ASC 718-20-35-3, theCompany determined incremental compensation cost of $21 thousand related to themodification of the exercise price of these options, of which $7 thousand wasrecognized as share-based compensation in the year ended December 31,2009. The remaining $14 thousand of share-based compensation will be recognizedover a period of 2.67 years.

 

Totalcash received as a result of options exercised during the fiscal year ended December 31,2009, was $2 thousand. There were no equity instruments granted undershare-based payment arrangements and therefore there was no cash used to settleany equity instrument. The Company does not plan to repurchase any sharesduring the upcoming annual period.

 

***13. Restructuring***

 

On October 1, 2008,the Company relocated its headquarters from San Mateo, California to Renton,Washington and terminated eight employees based in California.  On October 31, 2008, the Company closedits offices in San Mateo, California and abandoned the leased premises of itsformer offices there.  Effective on October 31,2008, David S.G. MacKenzie resigned his position as vice president and chieffinancial officer and the Company has not yet appointed any person to serveseparately as its chief financial officer. On October 31, 2008, the Company relocated its headquarters andabandoned the subleased premises of its former offices in Renton,Washington.  In October 2008, theCompany terminated eight more employees employed in both its California andWashington offices.  In connection withthis restructuring plan, the Company has accrued or incurred one-timerestructuring costs in the amount of $632 thousand during the quarter and yearended December 31, 2008.  In 2009,the Company revised these restructuring costs based on updated information fromsettlements entered into with the landlord of the San Mateo office and theCompany’s former Chief Executive Officer.

 

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The following summarizesour restructuring charges:

 
| ** **                                       | ** ** | **Office &  Equipment  Leases** | ** ** | **Employee  Termination  Costs** | ** ** | **Other** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|------------------------------------------|------------|----------------------------------|------------|-----------|------------|-----------|------------|
|                                             |       |                                     |       |                             |       |      |       |      |       |
| Restructuring liability:  October 1, 2008   |       | $                                        | —     |                             | $          | —    |       | $         | —     |   | $ | — |   |
| Reclassification of  previously accrued expenses |       | 65                                       |       | —                           |       | —    |       | 65        |       |
| Restructuring costs                              |       | 367                                      |       | 188                              |       | 77        |       | 632       |       |
| Less: Payments                                   |       | (41                                      | )          | —                           |       | (4        | )          | (45       | )          |
|                                             |       |                                     |       |                             |       |      |       |      |       |
| Balance: December 31,  2008                 |       | 391                                      |       | 188                              |       | 73        |       | 652       |       |
|                                             |       |                                     |       |                             |       |      |       |      |       |
| Change in restructuring  costs                   |       | 251                                      |       | (159                             | )          | —    |       | 92        |       |
| Less: Payments                                   |       | (9                                       | )          | (29                              | )          | —    |       | (38       | )          |
|                                             |       |                                     |       |                             |       |      |       |      |       |
| Balance: December 31,  2009                 |       | $                                        | 633        |                             | $          | —    |       | $         | 73         |   | $ | 706 |   |

 

Theabove restructuring cost liabilities as of December 31, 2009 and 2008 areincluded in Other Accrued Expenses in the Company’s balance sheet.

 

As part of its reductionof monthly cash operating expenses during the quarter ended September 30,2008, and continuing during the quarter and year ended December 31, 2008,through the date of these financial statements, the Company placed allemployees on partial deferrals of salary, ranging from 10% to 100% of basesalary, and accrued these deferrals.  Atthe end of the period, and as of the date of these financial statements, thisdeferral amount remains unpaid, including amounts due to employees in itsCalifornia office who were terminated during the period.

 

***14. Commitments and contingencies***

** **

**FinancingObligations**

 

The following is asummary of the maturity schedule of our convertible notes and debenturesobligations as of December 31, 2009:

 
| ** ** | ** ** | **Convertible  Notes and  Debentures** | ** ** | **Notes Payable** | ** ** | **Total** | ** ** |
|------------|------------|----------------------------------------|------------|-------------------|------------|-----------|------------|
| 2010       |       | $                                      | 1,764      |              | $          | 218       |       | $ | 1,982 |   |
| 2011       |       | 3,000                                  |       | —            |       | 3,000     |       |
| 2012       |       | 6,332                                  |       | —            |       | 6,332     |       |
| 2013       |       | —                                 |       | —            |       | —    |       |
| 2014       |       | —                                 |       | —            |       | —    |       |
| Thereafter |       | —                                 |       | 286               |       | 286       |       |
| Total      |       | $                                      | 11,096     |              | $          | 504       |       | $ | 11,600 |   |

 

**Operatingand Capital Leases**

 

Rent expense under leasestotaled ($13) thousand and $254 thousand for the periods ended December 31,2009 and 2008, respectively.  We have nofuture minimum rental payments required under non-cancelable leases as thesehave been recorded as restructuring costs and are included in other accruedexpenses as at December 31, 2009. All capital leases were paid off in fullduring the year ended December 31, 2009.

 

On October 31, 2008,the Company relocated it Washington offices and abandoned the sub-leasedpremises of its former offices in Renton, Washington. The sublease for thesepremises runs through June 2010. Subsequently, on March 5, 2010, the prime landlord filed acomplaint for breach of contract and successor liability  This matter was just served and the Companyhas not yet evaluated the claims made in this case.

 

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On October 31, 2008,the Company closed our offices in San Mateo, California.  On or about December 19, 2008, thelandlord for these premises filed a complaint claiming damages of $659 thousandand other amounts against the Company’s predecessor Etelos, Incorporated, aWashington corporation (“Etelos —WA”), in the Superior Court of San MateoCounty, California (Case No. CIV 479535). A default judgment was set aside because the landlord failed to properlyserve either the Company or Etelos-WA. The Company was subsequently servedproperly and trial was set for February 8, 2010.  The parties went to mediation in January 2010and subsequently entered into a settlement agreement, including a release ofclaims, in which the Company agreed: (a) to pay $66,000 in cash within 30days, (b) to issue a $200,000 promissory note, with 6% interest, payablein 12 monthly payments beginning in July, 2010, and (c) to issue shares ofCommon Stock of the Company equal to $125,000 in value, based upon the closingprice of the Company’s stock on January 6, 2010.  The settlement agreement and note wereexecuted and delivered on February 8, 2010, and 166,667 sharessubsequently were delivered on March 1, 2010.

 

***15.          Litigation and Claims***

 

During the quarter ended December 31,2009, the Company entered into a Settlement Agreement with its former CEOJeffrey L. Garon.  Subsequent to the endof the quarter, all payments required by the settlement agreement were made,whereby the Company repurchased 2,356,655 shares of common stock previouslyissued to Garon at the original purchase price of approximately $175,000, andthose shares were cancelled.

 

In June 2008, KaufmanBros. L.P. initiated litigation and, effective on December 5, 2008, theCompany entered into a settlement agreement with Kaufman Bros., pursuant towhich (i) the Company agreed to pay to Kaufman Bros. $210,000, in twelvemonthly installments of $17,500; (ii) the Company issued to Kaufman Bros.a warrant to purchase 500,000 shares of the Company’s common stock at anexercise price of $0.75 per share exercisable for a period of five years;(iii) the Company and Kaufman Bros. agreed immediately to terminate allprovisions, terms and conditions of the advisory services agreement andexchanged mutual releases; and (iv) Kaufman Bros. agreed to dismiss thepending lawsuit in the Supreme Court of New York, without prejudice.  Subsequent to entering into the settlementagreement, the Company did not fully comply with its payment obligations underthe settlement agreement and the Company received a notice of default andconfession of judgment.  OnDecember 31, 2009, the Company and Kaufman Bros. settled the judgment inthe approximate amount of $186,000, for $93,000 in cash, payable in 5installments with the final installment due June 1, 2010, and the issuanceof 200,000 shares of restricted common stock. The terms of the settlementprovide that Kaufman Bros. will be permitted to sell up to 180,000 shares fromJuly 1, 2010 through March 2011 to recover the remaining $93,373 ofthe settlement; the additional 20,000 shares are designated for payment ofattorneys’ fees in the event of a default in the note payments.  Afterpayment in full of the note payments, if there is no default giving rise to aclaim for attorneys fees, those 20,000 shares will be returned to the Companyand cancelled.  After Kaufman Bros.recovers the remaining $93,373 from the sale of some or all of the 180,000shares, any remaining shares will be repurchased by the Company for $0.01 andcancelled; after March 2011, any balance due on the remaining amount ofthe settlement will be discharged and any unsold shares will be repurchased bythe Company at $0.01 per share and cancelled.

 

On February 8, 2010,the Company entered into a settlement agreement in the San Mateo County,California litigation; see discussion at Note 14, above.

 

OnOctober 31, 2008, the Company relocated the Washington offices and abandonedthe sub-leased premises of the former offices in Renton, Washington. Thesublease for these premises runs through June 2010. Subsequently, on March 5,2010, the prime landlord filed a complaint against the Company for breach ofcontract and successor liability. The Company has accrued the rent expenseaccording to the sublease agreement as restructuring charges since 2008 and theliability balance remain unpaid and accrued as of December 31, 2009. TheCompany has only recently been served in this matter and will need to evaluateand defend these claims.

 

***16.          Subsequent Events***

 

On January 25, 2010,the Company entered into a securities purchase agreement with an entityaffiliated with Donald W. Morissette, who, together with his affiliates,beneficially owns more than 10% of the Company’s outstanding common stock, forthe sale of 10% senior secured convertible debentures, identical to the September 2009Debentures, in the principal amount of $250,000. In this transaction, inaddition to the debentures, the Company issued a warrant to purchase 375,000shares of its common stock with an exercise price of $0.60 per share and375,000 shares of its restricted common stock, or the “closing shares.” This transaction is referred to as the January 2010 financing in thisreport. The securities purchase agreement further provided that the Company hadthe right, subject to certain conditions, to require the investor to purchasean aggregate of $125,000 in additional principal amount of debentures between March 15and 31, 2010. The Company exercised that right on March 15, 2010, andissued $125 thousand in additional debentures on that date.

 

During the quarter ended December 31,2009, the Company entered into a Settlement Agreement with its former CEOJeffrey L. Garon.  Subsequent to the endof the year, all payments required by the settlement agreement were made,whereby the Company repurchased 2,356,655 shares of common stock previouslyissued to Garon at the original purchase price of approximately $175,000, andthose shares were cancelled.

 

On February 8, 2010,the Company entered into a settlement agreement in the San Mateo County,California litigation; see discussion at Note 14, above.

 

OnMarch 5, 2010, the prime landlord for the Company’s sub-leased space in Renton,Washington filed a complaint against the Company for breach of contract andsuccessor liability. See discussion at Note 15, above.

 

In partialsettlement of approximately $292 thousand of an aggregate $575 thousand inunpaid salaries due and owing to current employees of the Company as of December 31,2009, the board of directors has authorized the registration of 500,000 sharesof Common Stock previously reserved under the Company’s 2009 Equity IncentivePlan as partial payment of up to 50% of the amount of unpaid salary due andowing to each current employee.  369,078of those shares are to be issued upon completion of the registration process atan effective price of $0.79 per share.

 

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