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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 SECURITIES EXCHANGE ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------|

 

**For the fiscal year ended December 31, 2008**

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**OR**

 

| **o** | **TRANSITION REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|---------------------------------------------------------------------------------------------------|

 

**For the transition period from              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 registered pursuant toSection 12(b) of the Exchange Act:

 

| **Title of Each Class**           | ** ** | **Name of Each Exchange on Which Registered** |
|-----------------------------------|------------|-----------------------------------------------|
| **Common Stock, Par Value $0.01** | ** ** | **None**                                      |

 

Securities registeredpursuant to Section 12(g) of the Exchange Act: **None**

 

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

 

Indicate by check mark if the registrant is not required to file reportspursuant to Section 13 or Section 15(d) of the Act. Yes o No x

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. x  Yes    o  No

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definition of “large accelerated filer,” “accelerated filer” and “smallerreporting 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 a shell company (asdefined 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 ($4.00 per share), wasapproximately $27.6 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 13G filings with the Securities and ExchangeCommission as of June 30, 2008.

 

As of March 20, 2009, there were 23,022,027 shares of the issuer’scommon stock outstanding and 833,333 shares of the issuer’s New Series APreferred stock outstanding.

 

 

 

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**EXPLANATORY NOTE**

** **

On February 8, 2007, Tripath Technology Inc., a Delawarecorporation (“Tripath”) filed a voluntary petition for relief under Chapter 11of the Bankruptcy Code. On February 1, 2008, the bankruptcy court issuedan order confirming approval of the Plan of Reorganization, including themerger and the transfer of all of Tripath’s existing assets into a separatebankruptcy estate and the discharge of all of Tripath’s liabilities.  The Plan of Reorganization also contemplatedthe merger of Etelos, Incorporated, a Washington corporation (“Etelos-WA”) withTripath.   The overall impact of theconfirmed Plan of Reorganization was for Tripath to emerge from the bankruptcyproceeding with no assets and no liabilities as a shell corporation and for allissued and outstanding securities of and interests in Tripath, includingdebentures, stock options (including, but not limited to, all stock optionsgranted to employees), warrants, and other shares of common stock to becanceled and extinguished.

 

On April 23, 2008, Tripath filed a Current Report on Form 8-Kannouncing, among other things, that Etelos-WA, merged with and into Tripath,and that the surviving corporation changed its name to Etelos, Inc. andits 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.  Inconnection with the merger, all outstanding shares of Etelos-WA common stockwere converted into shares of Etelos, Inc. common stock on a three for oneratio: one share of Etelos, Inc. common stock for every three shares of commonstock of Etelos-WA.  Also in connectionwith the merger, (i) all outstanding shares of preferred stock ofEtelos-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 the shares of Tripath werecancelled.  Prior to the merger, Tripathwas a shell corporation and in accordance with the Plan of Reorganization hadno assets or liabilities.  While Tripathacquired all the outstanding preferred and common stock of Etelos-WA, foraccounting purposes, the acquisition has been treated as a recapitalization ofEtelos-WA with Etelos-WA as the acquirer (a reverse acquisition).  The historical financial statements prior to April 22,2008, are those of Etelos-WA and the description of the business contained inthis report as well as the one contained in the financial statements reflectthe 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 of incorporation with the state of Delaware to changeits total authorized shares of stock to 300,000,000 shares, of which 250,000,000shares are designated “common stock” with a par value of $0.01 per share and50,000,000 shares are designated “preferred stock” with a par value of $0.01per share.  The preferred stock may beissued from time to time in one or more series, each of such series to consistof 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.

 

Information concerning number of shares outstanding for Etelos, Inc.including the conversion prices and number of shares issuable upon conversionof convertible securities and exercise prices of warrants and stock options andthe number of shares issuable upon exercise of such options and warrants, hasbeen adjusted to reflect the three for one conversion ratio effected inconnection with the merger as if it had occurred for all periods presented.

 

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**Etelos, Inc.**

 

**AnnualReport on Form 10-K**

 

**For theYear Ended December 31, 2008**

 

**TABLEOF CONTENTS**

 
| ** **        | ** **                                                                                                             | **Page**   |
|-------------------|------------------------------------------------------------------------------------------------------------------------|------------|
| ** **        | ** **                                                                                                             | ** ** |
| **PART I**   |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 1.**       | **BUSINESS**                                                                                                           | **1**      |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 1A.**      | **RISK FACTORS**                                                                                                       | **7**      |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 1B.**      | **UNRESOLVED  STAFF COMMENTS**                                                                                         | **21**     |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 2.**       | **PROPERTIES**                                                                                                         | **21**     |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 3.**       | **LEGAL PROCEEDINGS**                                                                                                  | **21**     |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 4.**       | **SUBMISSION OF MATTERS TO A VOTE OF  SECURITY HOLDERS**                                                               | **22**     |
| ** **        | ** **                                                                                                             | ** ** |
| **PART II**  |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 5.**       | **MARKET FOR REGISTRANT’S COMMON EQUITY,  RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES** | **22**     |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 6.**       | **SELECTED FINANCIAL  DATA**                                                                                           | **23**     |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 7.**       | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**                        | **23**     |
| ** **        | ** **                                                                                                             | ** ** |
| **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**                    | **39**     |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 13.**      | **CERTAIN RELATIONSHIPS AND RELATED  TRANSACTION, AND DIRECTOR INDEPENDENCE**                                          | **40**     |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 14.**      | **PRINCIPAL ACCOUNTANT FEES AND SERVICES**                                                                             | **41**     |
| ** **        | ** **                                                                                                             | ** ** |
| **PART IV**  |
| ** **        | ** **                                                                                                             | ** ** |
| **ITEM 15.**      | **EXHIBITS, FINANCIAL STATEMENT  SCHEDULES**                                                                           | **42**     |
| ** **        | ** **                                                                                                             | ** ** |
| ** **        | **SIGNATURES**                                                                                                         | **44**     |
| ** **        | ** **                                                                                                             | ** ** |
| ** **        | **FINANCIAL  STATEMENTS**                                                                                              | **45**     |

 

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**FORWARDLOOKING STATEMENTS**

 

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

 

This Annual Report on Form 10-K contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, or the “Securities Act,” and Section 21E of the Securities ExchangeAct of 1934 or the “Exchange Act.”  Theseforward-looking statements are subject to certain risks and uncertainties thatcould cause actual results to differ materially from historical results oranticipated results, including those set forth under the heading “Risk Factors”and elsewhere in, or incorporated by reference into, this report.

 

In some cases, you can identify forward looking statements by termssuch as “may,” “intend,” “might,” “will,” “should,” “could,” “would,” “expect,”“believe,” “anticipate,” “estimate,” “predict,” “potential,” or the negative ofthese terms.  These terms and similarexpressions are intended to identify forward-looking statements.  Such statements are subject to certain risksand uncertainties, which could cause actual results to differ materially fromthose projected.  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 of eachfactor 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 anyforward-looking statement to reflect events or circumstances after the datehereof or to reflect the occurrence of unanticipated events.

 

You should be aware that our actual results could differ materiallyfrom those contained in the forward-looking statements due to a number offactors, including:

 

·                                          our abilityto obtain future financing or funds when needed;

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

·                                          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;

·                                          our abilityto maintain and execute a successful business strategy; and

·                                          we face otherrisks described from time to time in periodic and current reports we file withthe United States Securities and Exchange Commission, or the “SEC.”

 

Other risks and uncertainties include such factors asmarket acceptance and market demand for our products and services, pricing, thechanging regulatory environment, the effect of our accounting policies,potential seasonality, industry trends, adequacy of our financial resources toexecute our business plan, our ability to attract, retain and motivate keytechnical, marketing and management personnel, possible disruption incommercial activities occasioned by terrorist activity and armed conflict, andother 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 oral forward-lookingstatements attributable to us or persons acting on our behalf are expresslyqualified in their entirety by the applicable cautionary statements.

 

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**PART I**

 

| **ITEM 1.** | ** ** | **BUSINESS** |
|-------------|------------|--------------|

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***Business***

 

We have a Web Application distribution platform delivering WebApplications for businesses.  We providea Software-as-a-Service (SaaS) ecosystem for building, distributing, and usingWeb Applications, including a marketplace to deploy and support them.  Unlike other cloud computing andPlatform-as-a-Service (PaaS) solutions, we enable software manufacturers tomigrate existing applications or create new applications, then package,distribute, host, bill, market and support their SaaS enabled applicationsthrough multiple private label applications marketplaces.

 

We have developed products for Web Applications, which include openstandards-based tools for Web developers, businesses and individual users suchas the Etelos Application ServerTM (EASTM)and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support many common programminglanguages and also support the English Application Scripting Engine (EASETM), a simple-to-use openstandards-based scripting language developed by us.  In order to support broader adoption of ourproducts, EASE and other components of the EDE are made available to developersat 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, and support of theseapplications.  We generally receive atransaction fee or subscription fee for transactions that occur within theEtelos ecosystem either via the Etelos MarketplaceTM pursuant to StorefrontOperating Agreements, or in third-party branded Marketplaces operated by uspursuant to Marketplace Partner Agreements (sometimes referred to as “an EtelosMarketplace” or, collectively, as “the Etelos Marketplaces”).  Most customers in Etelos Marketplaces pay asubscription fee, which we share with Syndication Partners and MarketplacePartners; this revenue share is calculated as a percentage of gross revenuesfrom the sale of subscriptions to Syndication Partner offerings in the EtelosMarketplaces.

 

Etelos Marketplaces support and encourage communities of developers,distributors, and consumers to expand their offerings, collaborate on new ideasand improvements, and provide scalable solutions using Web Applicationsavailable to others.

 

***History***

 

We were originally organized as Etelos, Incorporated, a Washingtoncorporation on May 5, 1999. We have been engaged in the business of webapplication development and services since our inception.

 

On February 8, 2007, Tripath Technology Inc., a Delawarecorporation (“Tripath”) filed a voluntary petition for relief under Chapter 11of the Bankruptcy Code. On February 1, 2008, the bankruptcy court issuedan order confirming approval of the Plan of Reorganization, including themerger and the transfer of all of Tripath’s existing assets into a separatebankruptcy estate and the discharge of all of Tripath’s liabilities.  The Plan of Reorganization also contemplatedthe merger of Etelos, Incorporated with and into Tripath.

 

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

 

***Recent Developments***

 

On November 6, 2008, we announced changes to our business model tofocus on the sales and operation of private label Web application marketplaces,including provision of the professional services required to develop, deployand operate such marketplaces, and the launch of offerings of the Etelos PlatformSuiteTM.   The Etelos Platform Suite focuses onenabling Independent Software Vendors (ISVs) to implement SaaS delivery oftheir existing applications, whether or not those applications are already WebApplications, and syndicating the offering of those applications throughmultiple private label marketplaces. In these difficult economic times, webelieve that a variety of ISVs will have applications that they need to move tothe Web for lower cost implementation, easier, simpler scalability, and broaderdistribution.  The Etelos Platform Suite also enables MarketplacePartners, 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.

 

Although we have long enabled applications to be distributed via theWeb, we believe this shift away from a core direct marketing focus of offeringmultiple products through a single portal in the Etelos Marketplace will havefour major benefits for our business.  First, this offering will exposethe core platform to more ISVs for greater benefit to their end users and thecreation of a larger pool of applications for syndication. Second, thedevelopment and operation of third party-branded marketplaces shifts thefinancial expense and operational burdens of sales and marketing to end usersto Marketplace Partners that better know their 

 

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customers and are better capitalized to supportnecessary sales and marketing activities.  Third, because this two-prongedgo-to-market strategy is offered on a revenue-sharing basis, it fundamentallyreduces barriers to acceptance by eliminating up front costs for SyndicationPartners to offer their products through multiple Marketplace Partners, and bycharging Marketplace Partners only for sales success.   Finally, this shift allows us to focus onour core competency in development and operation of online marketplaces, whilebetter managing limited financial and other resources.

 

During the quarter ended December 31, 2008, we began to implementthis shift and, during the period up to the date of this report, we have announcednew Syndication Partner agreements with ISVs to deliver SaaS-enabled versionsof their products and to syndicate those apps for distribution through a numberof third party-branded SaaS marketplaces, and we have announced agreements tolaunch third party private label marketplaces, including third parties nottraditionally regarded as technology providers.  We expect to make furthersuch announcements reflecting this shift during the coming months but we do nothave an estimate or projection of how, or when, or if, the benefits, if any, ofthis shift will be reflected in our operating results.

 

In the period after the year ended December 31, 2008, we enteredinto a series of bridge loans with certain purchasers of our New Series APreferred stock and with the holders of our January 2008 and April 2008Debentures.  In the aggregate thesebridge loans were for the principal amount of $655 thousand, which is estimatedto cover our operating expenses through June 2009.  These notes bear interest at ten percent perannum, and have maturities ranging from May 31, 2009, through October 17,2009.  The notes payable to the holdersof our New Series A Preferred stock were accompanied by 146,667 warrantsto purchase shares of our Common Stock at $0.75 per share, with a term of fiveyears.  The notes payable to the holderof our January 2008 and April 2008 Debentures are subject to thesecurity interest granted to those holders in connection with those debentures.

 

***Industry Background***

 

The 1990s saw the widespread adoption among large enterprises ofpackaged business management applications that automated a variety ofdepartmental functions, such as accounting, finance, order and inventorymanagement, human resources, sales, and customer support. These sophisticatedapplications required significant cash outlays for the initial purchase and forongoing maintenance and support. In addition, these applications wereinternally managed and maintained by enterprise customers, requiringincreasingly large staffs to support complex information technologyinfrastructures. Most importantly, the applications generally were provided bymultiple vendors, with each application providing only a departmental view ofthe enterprise. To gain an enterprise-wide view, organizations attempted to tietogether their various incompatible packaged applications through long,complex, and costly integration efforts. Many of these attempts failed, inwhole or in part, often after significant delay and expense. As a consequence,many large enterprises have transitioned from multiple point products tocomprehensive, integrated business management suites, such as those offered byOracle and SAP, as their core business management platforms.

 

Small-to-Medium sized Businesses (SMBs), which we define as businesseswith up to 1,000 employees, have application software requirements that aresimilar, in many respects, to large enterprises because their core businessprocesses are substantially the same. These requirements include theintegration of back-office activities, such as managing payroll and trackinginventory; front-office activities, including order management and customersupport; and, increasingly, sophisticated e-commerce capabilities. According toa 2006 forecast for the CRM market and 2007 forecasts for the ERP and supplychain management, or SCM, markets from Gartner, Inc., companies in NorthAmerica spent approximately $13.7 billion on ERP, CRM, and SCM softwareapplications in 2006, of which SMBs accounted for $4.4 billion, or 32 percent. Gartnerprojects that SMB spending on these applications will grow 8.7 percent annuallyfrom 2006 to 2010, compared to 5.7 percent for large businesses.

 

SMBs are generally less capable than large enterprises of performingthe costly, complex, and time-consuming integration of multiple point productsfrom one or more vendors. As a result, SMBs can frequently derive greaterbenefits from a comprehensive business suite. 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 begun to benefit from the development of theon-demand SaaS model. SaaS uses the Internet to deliver access to softwareapplications from a centrally hosted computing facility by users through a webbrowser. SaaS eliminates the costs associated with installing and maintainingapplications within the customer’s information technology infrastructure.On-demand applications are generally licensed for a monthly, quarterly orannual subscription fee, as opposed to on-premise enterprise applications thattypically require the payment of a much larger, upfront license fee. As aresult, on-demand applications require substantially less initial and ongoinginvestment in software, hardware and implementation services and lower ongoingsupport and maintenance, making them more affordable for SMBs.

 

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To date, the on-demand software model has been applied to a variety oftypes of business software applications, including CRM, security, accounting,human resources management, messaging, and others, and it has been broadlyadopted by a wide variety of businesses. IDC estimates worldwide on-demandenterprise software vendor revenues were approximately $3.7 billion in 2006 andthat they will grow 32 percent annually through 2011 to $14.8 billion.

 

While SaaS applications have enabled SMBs to benefit fromenterprise-class capabilities, most are still products that require extensive,costly, and time-consuming integration to work with other applications. SMBsgenerally 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 Productsand Services***

 

We have developed and offer a range of products and services fordevelopers and for consumers of Web Applications.  Our product offerings are grouped into twobasic programs: the Etelos EcosystemTM and the Etelos Platform Suite.

 

The Etelos Ecosystem. The Etelos Ecosystem is a dynamic development,distribution, and consumption environment for scaling applications and providingbusiness solutions to common business problems.  Our ecosystem isconstantly being improved and expanded to contain the tools and supportprograms that help foster continued development of a network of added valuedevelopment and distribution partners.

 

Our products for Web Applications include open standards-based toolsfor Web developers, business and individual users such as the EtelosApplication ServerTM (EASTM) and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support manycommon application languages and also support the English Application ScriptingEngine (EASETM),a simple-to-use open standards scripting language developed by us.  Inorder to support broader adoption of our products, EASE and other components ofour platform are provided to developers and users at market appropriatepricing.  This is done to support the development of new Web Applicationsand the migration of existing Web Applications into the Etelos ecosystem wherethere are tools and other support mechanisms for the marketing, distribution,sales and support of these applications.  We generally receive atransaction fee, a revenue-share based subscription fee or a license fee fortransactions that occur within the Etelos ecosystem via an Etelos Marketplace.

 

Web Applications built with or brought to the Etelos ecosystem are madeavailable for distribution in an Etelos Marketplace as a subscription serviceusing the Software-as-a-Service (SaaS) or software-on-demand business model.The Etelos ecosystem gives developers of Web Applications, including us, aneasy place to distribute and support Web Applications.  Web Applicationsdelivered through the Etelos Marketplace or through third-party brandedMarketplaces operated by us can be easily and conveniently billed, distributedand configured to provide updates and support to users exactly in accordancewith the developer’s desires, without requiring the developer to perform developmentunrelated to the underlying Web Application or to operate a robust licensingand delivery infrastructure.  An Etelos Marketplace relieves the burdensto developers of delivery and support to the users of their WebApplications.  We also provide additional paid professional services andsupport on behalf of our Syndication and Marketplace Partners.

 

We also offer Etelos Ad ServeTM, an on-demand system for purchasing orpublishing advertising in the Etelos ecosystem. Etelos Ad Serve allows acustomer to purchase ads to be displayed in our applications (i.e. in EtelosCRMTMor Etelos ProjectsTM), or in an Etelos Marketplace. Etelos Ad Serve also allows ourpartners to become advertising publishers in their own web site or on theirapplications hosted in an Etelos Marketplace.  Etelos Ad Serve is animportant tool for us and our Syndication Partners to receive revenue whiledelivering trial or “free” ad-supported subscriptions to applications in anEtelos Marketplace.  In addition to the benefits of revenue, this toolenables wider adoption of Web Applications through reduced or no-costsubscriptions, which serves important viral marketing goals.

 

An Etelos Marketplace enables rapid adoption of Web Applications bygiving customers freedom of choice to select from a wide array of fullycustomizable, on-demand business applications.  These applications may bedeployed in the hosting environment of the customer’s choice, including hostingservices provided through us. Web Applications built on our platform may beintegrated with other Web Applications through the use of Etelos App SyncTM, hostedanywhere, and customized to create highly flexible business solutions. Not only can businesses easily choose from a range of Web Applications, butthey can instantly “try or buy” them. The flexibility of the Etelos ecosystemenables businesses to assemble a Web Applications suite.  TheBuild-a-SuiteTMconcept is ideally tailored for particular business needs and building scalablesolutions.

 

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Etelos Platform Suite The Etelos Platform Suite allowsthird parties to use our software platforms and our services to develop aprivate label application and marketplace. We began working with third parties on private label solutions in November 2008and expect that our first customers will launch their private labelmarketplaces beginning in the second quarter of fiscal 2009. There are fourcomponents to the Etelos Platform Suite:

 

·                                          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.

 

Our Etelos Platform Suite allows our customers to take advantageof our tools and experience in the SaaS market to move their existing applications tothe Web for lower cost implementation, easier, simpler scalability, and broaderdistribution.  Our Etelos Platform Suite enables MarketplacePartners, 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.

 

Etelos Web Application Hosting. By using almost any programminglanguage a developer chooses, including our own EASE language, and by hostingWeb Applications wherever users want, utilizing our Etelos Application Server,the Etelos Development Environment allows our partners to extend solutionsusing our platform.  Our customers relyon our products and the products of our Syndication Partners to run their businesses,and, as a result, it is our responsibility to ensure the availability of ourservice. We continue to improve our infrastructure with the goal of maximizingthe availability of our Web Applications and those of our developers,distributors and users.  We host on a highly-scalable network located insecure third-party facilities.  We have facility space, power, andInternet connectivity provided by Network OS in the Seattle, WA area. Inanticipation of future growth, we may engage additional providers and/or expandthe number of data centers utilized with existing vendors. Our hostingoperations incorporate industry-standard hardware and our EAS operating systemand databases and application servers provide a flexible, scalablearchitecture. Elements of our products’ infrastructure can be replaced or addedwith no interruption in service, helping to ensure that the failure of anysingle device will not cause a broad service outage.

 

Professional Services. We are developing repeatable, cost-effective consultingand implementation services to assist our customers with integrating WebApplications, using them on and off-line and importing data from other systems.We provide support services to aid in changing their business processes to takeadvantage of the enhanced flexibility enabled by our Build-a-Suite concept.Build-a-Suite enables our customers to implement cost reducing, scalablebusiness processes within their organization and identifying, configuring, andcustomizing our products and those of our partners for each unique businessprocess and requirement, with a goal of entering data once and using it acrossthe organization and across the applications used by the business.

 

Our consulting and implementation methodology leverages the nature ofour on-demand Web Application software architecture, the industry-specificexpertise of our professional services employees, and the design of the Etelosecosystem and Etelos Marketplaces. They are used to simplify, reduce costs andexpedite the implementation of scalable Web Applications to aid in betterbusiness operations. We generally employ a joint staffing model forimplementation projects in which we involve the customer more actively in theimplementation process than traditional software companies. We believe thisbetter prepares our customers to support their own application set.  Inaddition, because our Web Applications are on-demand, our Professional Servicesemployees can remotely configure many applications for most situations. Ourconsulting and implementation services are generally offered on a fixed pricebasis. Our network of partners also provides professional services to ourcustomers.

 

Customer Support and Management. Our technical support organization,with personnel in the United States, offers support via the Web 24 hours a day,seven days a week. Our system allows for skills-based and time zone-basedrouting to address general and technical inquiries across all aspects of ourservices. For our direct customers and development partners, we offer tieredcustomer support programs depending upon the service needs of both our andtheir customers’ Web Applications. Support contracts typically have a one-yearterm. 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.

 

The advantages of our products and services are:

 

Open Standards.  Products distributed in an Etelos Marketplaceare developed on open standards.  This foundation makes the products easyto develop, easy to adopt and integrate with other Web Applications, and easyto swap or modify to meet specific customer needs.  The use of openstandards for business applications distinguishes the products in an EtelosMarketplace not only from comprehensive product suites from such vendors ofproprietary software as Microsoft, Oracle, and SAP, but also from products offeredby other SaaS vendors such as salesforce.com or NetSuite, that requiredevelopers of Web Applications to adopt a high-cost proprietary foundation fortheir products, resulting in higher costs to both developers and theircustomers.

 

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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 of Ownership. Our SaaS delivery model and eachdifferent Web Application’s ease of use and configurability aids in helping tosignificantly reduce implementation and maintenance costs of hardware, softwareand services. The Etelos ecosystem virtually eliminates the need for dedicatedsoftware development or information technology support personnel. Customerssubscribe to products through an Etelos Marketplace for a monthly fee based onthe number of users and the products they select.  Subscription fees paidto us periodically, typically monthly, tend to be significantly less thantypical upfront costs paid by businesses to purchase product licenses fromother providers. Our on-demand delivery model virtually eliminates ongoingmaintenance and upgrade costs associated with a typical distributedinfrastructure. Because Web Applications distributed in an Etelos Marketplaceare developed on open standards and delivered over the Internet, any desiredcustomization can be highly targeted, and therefore usually performed at lowercost to the business customer.

 

Rapid Implementation. The Internet-based on-demand delivery modelimplemented by an Etelos Marketplace enables remote deployment and eliminatesmany of the steps and costs typically associated with on-premise installations.Syndication Partners and their customers can implement our offeringsthemselves, or work with our development partners or our professional servicesorganization to meet their specific needs.

 

Security, Control and Choice.  The combination of open standardsand Internet-based on-demand delivery and support enabled using an EtelosMarketplace provides customers with security for their important business data,control over the use and portability of that data, and flexibility and freedomof choice in Web Applications that provide built-in quality and scalability assolutions to specific business needs.

 

***Sales and Marketing***

 

Sales.  We generate sales through both indirect anddirect approaches. Most selling of subscriptions for Web Applications andHosting is done over the Internet.  Sales of custom products andProfessional Services tend to be direct. Our direct sales team consists ofprofessionals in various locations in the United States, with additionaldevelopment, distribution, and business relationships being developed in NorthAmerica, South America, Europe, and the Asia-Pacific region.

 

Our Web Applications and Hosting sales activities generally are theresult of word of mouth, marketing programs, or user referrals.  As leadsself qualify and most often use credit cards for payment, our sales and supportpersonnel provide web based seminars, forums, and direct support services toensure continued subscription sales.  The sales cycle typically rangesfrom days to months, and can vary based on the Web Application, the scope ofany customization desired, and the scope of any professional services requiredto meet specific customer requirements.

 

Our sales process for Custom Products and Professional Servicestypically begins with the generation of a sales lead from a marketing programor customer referral. After the lead is qualified, our sales personnel conductfocused web-based demonstrations along with initial price discussions. Membersof our professional services team are engaged, as needed, to offer insightaround aspects of the implementation. Our sales cycle typically ranges fromdays to months, but can vary based on the specific application, the size andcomplexity of the potential customer’s information technology environment, andmany other factors.

 

Marketing.  We tailor our marketing efforts aroundrelevant application categories, customer sizes, and customer industries. Aspart of our marketing strategy, we have established a number of key programsand initiatives, including online and search engine advertising, emailcampaigns, web based seminars, product launch events, trade show and industryevent sponsorship and participation, and marketing support for development anddistribution partners.

 

***Customers***

 

As of December 31, 2008, we served approximately 10,000 activecustomers of diverse sizes and types across a wide variety of industries, witha focus on SMBs, which we define as businesses with fewer than 1,000 employees,and divisions of larger companies. No single customer accounted for more than10 percent of our revenue during the quarter and year ended December 31,2008.  Customers of all types use our products to achieve a wide varietyof business objectives.

 

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***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 our marketsfrom companies with broad product suites and greater name recognition andresources than us.  We also face competition from smaller companiesfocused on specialized solutions. To a lesser extent, we compete withinternally developed and maintained solutions.  Current competitorsinclude NetSuite,Inc., Epicor Software Corporation, Intuit Inc., MicrosoftCorporation, SAP, The Sage Group plc, Amazon, salesforce.com, inc., and othersnot listed here, both public and private.

 

We believe that theprincipal competitive factors in our 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, more extensivegeographic presence, and greater name recognition than us. In addition,although we have extended the number of applications we have introduced forspecific vertical markets, we may be at a disadvantage in certain othervertical markets compared to certain of our competitors. We may face futurecompetition in our markets from other large, established companies, as well asfrom emerging companies. In addition, we expect that there is likely to becontinued consolidation in the industry that could lead to increasedtechnology, price, and other forms of competition.

 

***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 31,2008, we had multiple U.S. and foreign patent applications pending. We plan tofile additional patent applications in the U.S. and elsewhere.  We do notknow whether our pending or future patent applications will result in theissuance of patents in the U.S. or elsewhere, or whether the examinationprocess will require us to narrow our claims. Even if granted, there can be noassurance that the pending patent applications will provide us with 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.

 

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We have not maintainedoperating controls or logs, or initiated or conducted any forensic, codehistory, ‘genealogy’ or other form of audit, analysis, processes, training, orcode review of software code incorporated into any of our products or in otherproducts offered by others in an Etelos Marketplace.  These products mayinclude code subject to various forms of ‘open source’, ‘copyleft’ or similarlicenses that require as a condition of modification or distribution of softwaresubject to such license(s) that [a] such software or other softwarecombined or distributed with such software be disclosed or distributed insource code form, or [b] such software or other software combined ordistributed with such software, and any related intellectual property, belicensed on a royalty-free basis, including for the purposes of makingadditional copies or derivative works of such software.  This mayadversely affect our ability to patent certain inventions or to license ordistribute certain products – whether by open source license or other form oflicense or right – and may result in liability to unknown parties forinfringement of their patents or other 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 thirdparty’s rights. We may have to seek a license for the technology, which may notbe available 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 31,2008, and December 31, 2007, research and development expenses were $2.6million and $2.0 million, respectively, and consisted primarily of employee andemployee-related expenses.

 

***Employees***

 

As of December 31, 2008, we had approximately 13 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.  SeeRisk Factors “*We have reduced our employment force andhave challenges meeting our operating demands”* discussion *infra*.

 

***Additional Information***

*** ***

Our annual and quarterlyreports, along with all other reports and amendments filed with or furnished tothe SEC are publicly available free of charge on the Investor section of ourwebsite at www.etelos.com as soon as reasonably practicable after thesematerials are filed with or furnished to the SEC. Our corporate governancepolicies, ethics code and board of directors’ committee charters are alsoposted within this section of the website. The information on our website isnot part of this or any other report we file with, or furnish to, the SEC. TheSEC also maintains an Internet site that contains reports, proxy andinformation statements, and other information regarding issuers that fileelectronically with the SEC. The address of that site is www.sec.gov.

 

**ITEM1A.**                                            RISK FACTORS

** **

Investment in our common stock involves a high degree of risk. Youshould carefully consider the risks described below together with all of theother information included in this report before making an investment decision.If any of the following risks actually occur, our business, financial conditionor results of operations could suffer. In that case, the market price of ourcommon stock could decline, and you may lose all or part of your investment.

 

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***Our current cash will fund our business as currently planned onlythrough June 2009. We need additional funding or we will be forced tocurtail or cease operations.***

*** ***

We need immediate and substantial cash to continue our operations. Wecurrently have no funding commitments. Management has projected that cash onhand will be sufficient to allow us to continue our operations only through June 2009.  We have not made required payments under ouroutstanding debt securities and the holders of our outstanding debt securitieshave the right to demand payment of the amounts currently due under suchsecurities or exercise their other remedies, such as foreclosing on our assets.  We also need to negotiate payment plans forcertain payables and there is a risk that trade creditors will not acceptdeferred payment and exercise other remedies to collect balances due and owing.We therefore will need additional funding, either through equity or debtfinancings, or we will be forced to curtail or cease operations or considerother strategic alternatives such as bankruptcy.

 

***We have a limited operating history, have experienced significantexpenditures related to funding our initial product development, and arecurrently carrying a net loss.  If ourbusiness model is not successful, or if we are unable to generate sufficientrevenue to offset our start-up expenditures, then we may not become profitableand you may lose your entire investment in our company.***

*** ***

We began our operations in 1999 but we did not adopt the SaaS on-demandWeb Applications delivery model until 2005, and further changed our businessmodel in the quarter ended December 31, 2008. As such, we have a limitedoperating history in the SaaS industry in general, and even more limitedexperience with our new business model, from which to evaluate our business andprospects.  We incurred a net loss of$19.4 million for the year ended December 31, 2008, and $4.0 million forthe year ended December 31, 2007, and have an accumulated deficit of $29.8million at December 31, 2008.  Wecannot assure you that our future planned operations will be implementedsuccessfully or that we will ever have profits. Furthermore, we are experiencing the initial costs and uncertainties ofa young operating company, including start-up expenditures, unforeseen costsand difficulties, complications, and delays, all of which must be resolvedand/or paid without the benefit of a predictable revenue stream.  We cannot be sure that we will be successfulin meeting these challenges and addressing these risks and uncertainties.  If we are unable to do so, then we may berequired to scale back our business, sell or license some or all of ourtechnology or assets, or curtail or cease operations.

 

***We do not have sufficient current cash to pay the principal and accruedinterest amounts due under our outstanding debt securities.***

*** ***

The debentures we issued require monthly principal payments equal to1/18th of the principal amount due under each debenture.  The debentures accrue interest at the rate ofsix percent per annum, payable quarterly and on each monthly principalpayment.  We have not made certainpayments as required by the terms of the debentures, and do not expect to havethe ability to do so in the near future.

 

We are currently in default of our debentures because of our failure tomake certain payments when due.  As aresult the holders of the debentures have the right to accelerate all amountsoutstanding under the debentures and demand payment of a mandatory defaultamount equal to 130 percent of the amount outstanding under the debenture, plusaccrued interest and expenses.  If suchdemand was made, we would be unable to repay the mandatory default amount, andthe holders could commence legal action against us.  Any such action could impose significantcosts on us and require us to curtail or cease operations.

 

In addition, as a result of being in default under our January Debenturesand April Debentures, the holders may have the right to foreclose onsubstantially all of our assets pursuant to the terms of the security agreementwe entered into with such holders and they would have the right to takepossession of our assets and operate our business.  Though we are in regular communication withthe holders of our outstanding debt securities, and none of them have demandedpayment or exercised other remedies due to our current default under suchsecurities, we can give no assurances that the holders will not exercise theirremedies in the future.

 

***Our limited operating history may not serve as an adequate basis tojudge our future prospects and results of operations.***

*** ***

We began our operations in 1999 but we did not adopt the SaaS on-demandWeb Application delivery model until 2005, and we have recently changed ourbasic business model. Our limited operating history in the SaaS industry maynot provide a meaningful basis on which to evaluate our business. Since ourinception our revenues have not always grown from year to year.  We cannot assure you that we will achieve ourgrowth targets, or that we will achieve positive cash-flow or profitability, orthat we will not incur negative cash flow or net losses in the future. Weexpect that our operating expenses will increase as we expand. Any significantfailure to realize anticipated revenue growth could result in significantoperating losses beyond our forecasts. We will continue to encounter risks anddifficulties frequently experienced by companies at a similar stage ofdevelopment, including our potential failure to:

 

·                                          maintain andimprove our technology;

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

 

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·                                          sellsubscriptions to our products and offerings by our Syndication Partners tosufficient, quality customers to produce revenues adequate to meet ouroperating 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 of these risks, thenour business may be materially and adversely affected.

 

***We may encounter substantial competition in our business and ourfailure to compete effectively may adversely affect our ability to generaterevenue.***

*** ***

We believe that existing and new competitors will continue to improvethe design and performance of their products and to introduce new products withcompetitive price and performance characteristics. We expect that we will berequired to continue to invest in product development and productivityimprovements to compete effectively in our markets. Our competitors coulddevelop better technology or more efficient products or undertake moreaggressive and costly marketing campaigns than ours, which may adversely affectour marketing strategies and could have a material adverse effect on ourbusiness, results of operations, and financial condition.

 

Our major competitors may be better able than us to successfully enduredownturns in our markets. In periods of reduced demand for our products, we caneither choose to maintain market share by reducing our subscription prices tomeet competition or maintain subscription prices, which likely would result insacrifice of our market share. Sales and overall profitability would be reducedand sustained losses may continue in either case. In addition, we cannot be assuredthat additional competitors will not enter our existing markets, or that wewill be able to compete successfully against existing or new competition.

 

***We have a history of losses and we may not achieve profitability in thefuture.***

*** ***

We have not been profitable on a quarterly or annual basis since ourformation. Our operations resulted in a net loss of $19.4 million for the yearended December 31, 2008 and $4.0 million for the year ending December 31,2007. As of December 31, 2007, our accumulated deficit was $10.4 millionand at December 31, 2008, our accumulated deficit was $29.8 million. Weexpect to make significant future expenditures related to the development andexpansion of our business. In addition, as a public company, we will incursignificant legal, accounting, and other expenses that we did not incur as aprivate company. As a result of these increased expenditures, we will have togenerate and sustain increased revenue to achieve and maintain futureprofitability. While our revenue has grown somewhat in recent periods, thatgrowth has not been significant and future revenue growth may not besustainable and we may not achieve sufficient revenue to achieve or maintainprofitability. We have incurred and may continue to incur significant losses inthe future for a number of reasons, including due to the other risks describedin this report, and we may encounter unforeseen expenses, difficulties,complications, delays, and other unknown factors. Accordingly, we may not beable to achieve or maintain profitability and we may continue to incursignificant losses for the foreseeable future.

 

***The market for on-demand Web Applications may develop more slowly thanwe expect.***

*** ***

Our success will depend, to a large extent, on the willingness ofindividuals and SMBs to accept on-demand services for Web Applications thatthey view as critical to the success of their business. Many businesses haveinvested substantial effort and financial resources to integrate traditionalenterprise software into their businesses and may be reluctant or unwilling toswitch to a different application or to migrate these applications to on-demandWeb Applications.

 

Other factors that may affect market acceptance of our Web Applicationsinclude 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 Applications may be affectedby:

 

·                                          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.

 

***The market for our products may not develop further, or it may developmore slowly than we expect, either of which would harm our business.***

*** ***

The market in which we participate is intensely competitive, and if wedo not compete effectively, then our operating results may be harmed.  The market for SaaS on-demand WebApplications for business is highly competitive and rapidly changing withrelatively low barriers to entry. With the introduction of new technologies andnew market entrants, we expect competition to intensify in the future. Inaddition, pricing pressures and increased competition generally could result inreduced sales, reduced margins, or the failure of our products to achieve ormaintain more widespread market acceptance. Often we offer products in anEtelos Marketplace that compete against existing systems that our potentialcustomers have already made significant expenditures to install. Competition inour market is based principally upon service breadth and functionality; serviceperformance, security and reliability; ability to tailor and customize servicesfor a specific company, vertical or industry; ease of use of the service, speedand ease of deployment, integration and configuration; total cost of ownership,including price and implementation and support costs; professional servicesimplementation; and financial resources of the vendor.

 

We face competition from both traditional software vendors and otherSaaS providers. Many of our actual and potential competitors enjoy substantialcompetitive advantages over us, such as greater name recognition, longeroperating histories, more varied products and services, and larger marketingbudgets, as well as substantially greater financial, technical, and otherresources. In addition, many of our competitors have established marketingrelationships and access to larger customer bases, and have major distributionagreements with consultants, system integrators, and resellers. If we are notable to compete effectively, then our operating results will be harmed.

 

***Our inability to fund our capital to meet our expenditure requirementsmay adversely affect our growth and profitability.***

*** ***

Our continued growth is dependent upon our ability to raise capitalfrom outside sources. Our ability to obtain financing will depend upon a numberof factors, including our financial condition and results of operations, thecondition of the economy, and conditions in relevant financial markets.  If we are unable to obtain financing, asneeded, on a timely basis and on acceptable terms, our financial position,competitive position, growth, and profitability may be adversely affected.  The current state of the US and globaleconomy raises substantial doubts, especially about our ability to raise theadditional capital that we will need to sustain our business operations.

 

***We have reduced our employment force and have challenges meeting ouroperating demands.***

*** ***

We have decreased our number of full-time employees from 46 at June 30,2008, to 13 as of December 31, 2008. All of these remaining employees are on deferred salary, ranging from10% to 100% of base salary, and there is no assurance that any of thesepersonnel will be able to continue to work on this payment arrangement. Ouroperating plan has placed, and our anticipated growth plan is expected tocontinue to place, a significant strain on our very limited managerial,administrative, operational, financial, and other resources, compounded bythese recent reductions in headcount. Although we will be required to continueto improve our operational, financial, and management controls and ourreporting procedures it is clear that we may not be able to do so effectivelyand may not be able to recruit or retain adequate, qualified personnel to meetour operating demands. As such, we may be unable to manage our expenseseffectively in the future, which may negatively impact our gross margins oroperating expenses in any particular quarter.

 

***Our customers are individuals, small and medium-sized businesses, anddivisions of large companies, which may increase our costs to reach, acquireand retain customers.***

*** ***

We market and distribute our products and services and other offeringsin Etelos Marketplaces to individuals, SMBs, and divisions of large companies.To grow our revenue quickly, we must add new customers, sell additionalservices to existing customers, and encourage existing customers to renew theirsubscriptions. However, selling to and retaining individuals and SMBs can bemore difficult than selling to and retaining large enterprises because SMBcustomers tend to be more price sensitive and more difficult to reach withbroad marketing campaigns.  In addition,individuals and SMBs have high churn rates in part because of the nature oftheir businesses and often lack the staffing to benefit fully from ourproducts.  Further, individuals and SMBsoften require higher sales, marketing, and support expenditures by vendors thatsell to them per revenue dollar generated for those vendors.

 

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***Many of our customers are price sensitive, and if the prices that we orour Syndication Partners charge for subscriptions to products or servicesoffered in an Etelos Marketplace are unacceptable to our customers, then ouroperating results will be harmed.***

*** ***

Many of our customers are price sensitive, and we have limitedexperience with respect to determining the appropriate prices for our productsor services. In addition, we have no control over prices charged by ourSyndication 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 prevent others from unauthorized use of ourpatents and other intellectual property, which could harm our business andcompetitive position.***

*** ***

Our success depends, in part, on our ability to protect our proprietarytechnologies. 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 and we cannot assure that our patentapplications will result in patents being issued, or that our existing orfuture issued patents will be sufficient to provide us with meaningfulprotection or commercial advantages.  Wealso cannot assure that our current or potential competitors do not have, andwill not obtain, patents that will prevent, limit or interfere with our abilityto make, use or sell our technology or operate an Etelos Marketplace.

 

***Our success depends in large part on our ability to protect and enforceour intellectual property rights.***

*** ***

We rely on a combination of patent, copyright, service mark, trademark,and trade secret laws, as well as confidentiality procedures and contractualrestrictions, to establish and protect our proprietary rights on a globalbasis, all of which provide only limited protection. We cannot assure you thatany patent will issue from our currently pending patent applications in amanner that gives us the protection that we seek, if at all, or that any futurepatents issued to us will not be challenged, invalidated, or circumvented.Since the filing of some of these patent applications may have been, or willbe, made after the date of first sale or disclosure of the subject inventions,patent protection may not be available for these inventions outside the UnitedStates.  Any patents that may issue inthe future may not provide sufficiently broad protection or they may not proveto be enforceable in actions against alleged infringers. Also, we cannot assureyou that 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.

 

We have not maintained operating controls or logs, or initiated orconducted any forensic, code history, ‘genealogy’ or other forms of audit,analysis, processes, training, or code review of software code incorporatedinto any Etelos product or in other products offered by Syndication Partners inan Etelos Marketplace. We do not review the intellectual property rightsrelated to products or services offered by Syndication Partners in an EtelosMarketplace. These products may include code subject to various forms of ‘opensource’, ‘copyleft’, or similar licenses that require as a condition ofmodification or distribution of software subject to such license(s) that (i) suchsoftware or other software combined or distributed with such software bedisclosed or distributed in source code form, or (ii) such software orother software combined or distributed with such software, and any relatedintellectual property, be licensed on a royalty-free basis, including for thepurposes of making 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 Syndication Partners to indemnify us for intellectualproperty claims but we cannot assure that these agreements will be enforceable.***

*** ***

We endeavor to enter into agreements with our employees and contractorsand agreements with parties with whom we do business to limit access to anddisclosure of our proprietary information. The steps we have taken, however,may not prevent unauthorized use or the reverse engineering of our technology.Moreover, others may independently develop technologies that are competitive toours or infringe our intellectual property. Enforcement of our intellectualproperty rights also depends on our successful legal actions against these infringers,but these actions may not be successful, even when our rights have beeninfringed.  In addition, the legalstandards relating to the validity, enforceability, and scope of protection ofintellectual property rights in Internet-related industries are uncertain andstill evolving.

 

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***Assertions by third parties that we infringe their intellectualproperty, whether successful or not, could subject us to costly andtime-consuming litigation or expensive licenses.***

 

The software and technology industries are characterized by theexistence of a large number of patents, copyrights, trademarks, and tradesecrets and by frequent litigation based on allegations of infringement orother violations of intellectual property rights. As we face increasingcompetition, the possibility of intellectual property rights claims against usmay grow; the costs of defending against such claims can be very large. Ourtechnologies may not be able to withstand any third-party claims or rightsagainst their use. Additionally, many of our partner and product agreementsrequire us to indemnify our customers for certain third-party intellectualproperty infringement claims, which could increase our costs as a result ofdefending such claims and may require that we pay damages or purchase expensivelicenses, if there were an adverse ruling related to any such claims. Thesetypes of claims could harm our relationships with our customers, may deterfuture 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 our customers, or us,with or without merit, could be time-consuming, expensive to litigate orsettle, and could divert management attention and financial resources. Anadverse determination also could prevent us from offering our products to ourcustomers and may require that we procure or develop substitute services thatdo not infringe.

 

For any intellectual property rights claim against us or against ourMarketplace Partners or customers, we may have substantial direct and indirectcosts.  Direct costs can include arequirement to pay damages or stop using technology found to be in violation ofa third party’s rights. We may have to purchase a license for the technology,which may not be available on reasonable terms, if at all, may significantlyincrease our operating expenses, or may require us to restrict our businessactivities in one or more respects. As a result, we may also be required todevelop alternative non-infringing technology, which could require significanteffort and expense.  Substantial indirectcosts also may be expected in the form of diversion of development andmanagement resources in strategic planning for legal, technology, and businessdefenses to such claims.

 

***We rely on our management team and need additional personnel to growour business, and the loss of one or more key employees or our inability toattract and retain qualified personnel could harm our business.***

*** ***

Our success and future growth depends to a significant degree on theskills and continued services of our management team, especially Daniel J.A.Kolke, our interim Chief Executive Officer, Acting Chief Financial Officer, andChairman of the Board. The loss of the services of any member of our managementteam for any reason may have a material adverse effect on our business andprospects.  We do not maintain key man insuranceon any members of our management team, including Mr. Kolke.

 

Subsequent to the termination of our former Chief Executive Officer, wesignificantly and materially reduced our management team and have not hiredreplacements for the management team in the positions of Vice President andChief Financial Officer, Vice President – Marketing, Vice President CorporateDevelopment, and Vice President – Human Resources, as well as several otherDirector-level positions, primarily in non-technical positions throughout theCompany.  We did not fill these positionsin the period ending December 31, 2008, and we have not filled any ofthese positions to the date of this report.

 

Our future success also depends on our ability to attract, retain andmotivate highly skilled technical, managerial, sales, marketing and service andsupport personnel, including members of our management team. Competition forsales, marketing, and technology development personnel is particularly intensein the software and technology industries. As a result, we may be unable tosuccessfully attract or retain qualified personnel. Our inability to attractand retain the necessary personnel could harm our business.

 

***If we do not effectively expand and train our sales force and ourservices and support teams, then we may be unable to add new customers andretain existing customers.***

*** ***

We plan to expand our sales force and our services and support teams toincrease our customer base and revenue. We believe that there is significantcompetition for sales, service, and support personnel with the skills andtechnical knowledge that we require. Our ability to achieve significant revenuegrowth will depend, in part, on our success in recruiting, training, andretaining sufficient numbers of personnel to support our growth. New hiresrequire significant training and, in most cases, take significant time beforethey achieve full productivity. Our recent hires and planned hires may notbecome as productive as we expect and we may be unable to hire or retainsufficient 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.

 

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***If we are unable to cost-effectively market and distribute our productsto our target customers, then our ability to grow our revenue quickly and becomeprofitable will be harmed.***

 

Our quarterly operating results may fluctuate in the future. As aresult, we may fail to meet or exceed the expectations of research analysts orinvestors, which could cause our stock price to decline. Also period-to-periodcomparisons of our operating results may not be meaningful. You should not relyon the results of one quarter as an indication of future performance.

 

Fluctuations in our quarterly operating results may be due to a numberof factors, including the risks and uncertainties discussed elsewhere in thisreport. Fluctuations in our quarterly operating results could cause our stockprice to decline rapidly, may lead analysts to change their long-term model forvaluing our common stock, could cause us to face short-term liquidity issues,may impact our ability to retain or attract key personnel, or cause otherunanticipated issues. If our quarterly operating results fall below theexpectations of research analysts or investors, then the price of our commonstock could decline substantially.

 

***We use third-party data centers to support our services. Any disruptionof service at these facilities could interrupt or delay our ability to deliverour service to our customers.***

*** ***

We host many of our services and serve a significant number of ourcustomers from third-party data center facilities with Network OS, located inthe greater Seattle Washington area. We do not control the operation of thesefacilities. These facilities may be vulnerable to damage or interruption from earthquakes,hurricanes, floods, fires, terrorist attacks, power losses, telecommunicationsfailures, and similar events. These facilities also could be subject tobreak-ins, computer viruses, sabotage, intentional acts of vandalism and othermisconduct. The occurrence of a natural disaster or an act of terrorism, adecision to close the facilities without adequate notice, or otherunanticipated problems could result in lengthy interruptions in our services.

 

Our data center facility providers have no obligation to renew theiragreements with us on commercially reasonable terms, or at all. If we areunable to renew our agreements with any facility provider on commerciallyreasonable terms, then we may experience increased costs or downtime inconnection with the transfer to a new data center facility.

 

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

 

***Any significant fluctuation in price of servers or related support mayhave a material adverse effect on the cost of our products and services.***

*** ***

The prices of servers and related support are subject to marketconditions and generally we do not, and do not expect to, have long-termcontracts with our suppliers for those items. While these items are generallyavailable and we have not experienced any shortage in the past, we cannotassure you that the necessary servers or support will continue to be availableto us at prices currently in effect or acceptable to us. The prices for theseitems have varied significantly in the past and may vary significantly in thefuture. Numerous factors, most of which are beyond our control, influenceprices of servers and related support. These factors include general economicconditions, industry capacity utilization, vendor backlogs and delays and otheruncertainties.

 

We may not be able to adjust our product prices, especially in theshort-term, to recover cost increases in these items. Our future profitabilitymay be adversely affected to the extent we are unable to pass on higher serverand support related costs to our customers.

 

***We may become liable to our customers and lose customers if we havedefects or disruptions in our products and services or if we provide poorservice.***

*** ***

Because we deliver products as a service through an Etelos Marketplace,errors or defects in the Web Applications underlying the service, or a failureof our hosting infrastructure may make the service unavailable to ourcustomers. Because our customers use the products to manage critical aspects oftheir business, any errors, defects, disruptions in service, or otherperformance problems with the products, whether in connection with theday-to-day operation of the products, upgrades or otherwise, could damage ourcustomers’ businesses. If we have any errors, defects, disruptions in service,or other performance problems with the products, then customers could elect notto renew their subscriptions or delay or withhold payment to us. As a result,we could lose future sales or customers may make warranty claims against us orour Syndication Partners, which could result in an increase in our provisionfor doubtful accounts, an increase in collection cycles for accountsreceivable, or costly litigation.

 

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***If our security measures are breached and unauthorized access isobtained to a customer’s data, then we may incur significant liabilities, ourservice may be perceived as not being secure, and customers may curtail or stopusing our products.***

 

The products and services we offer in an Etelos Marketplace involve thestorage of large amounts of our customers’ sensitive and proprietary businessinformation. If our security measures are breached as a result of third-partyaction, employee error, malfeasance, or otherwise, and someone obtainsunauthorized access to our customers’ data, then we could incur significantliability to our Syndication and Marketplace Partners, our customers, and toindividuals or businesses whose information was being stored by our customers,our business may suffer and our reputation may be damaged. Because techniquesused to obtain unauthorized access to, or to sabotage, systems change frequentlyand generally are not recognized until launched against a target, we may beunable to anticipate these techniques or to implement adequate preventivemeasures. If an actual or perceived breach of our security occurs, then themarket perception of the effectiveness of our security measures could be harmedand we could lose sales and customers.

 

***If we are unable to develop new products or services, distribute ourproducts or services into new markets, or add Syndication Partners to offertheir products or services for distribution in an Etelos Marketplace, then ourrevenue growth will be harmed and we may not be able to achieve profitability.***

*** ***

Our ability to attract new customers and to increase revenue fromexisting customers will depend in large part on our ability to enhance andimprove our existing products and to add new Marketplace Partners and newSyndication Partners to offer their products and services and distribute intonew markets. The success of any enhancement or new Syndication Partner offeringdepends on several factors, including the timely completion, introduction, andmarket acceptance of the enhancement, product or service. Any new product orservice offered by a Syndication Partner or that we develop or acquire may notbe introduced in a timely or cost-effective manner and may not achieve thebroad market acceptance necessary to generate significant revenue. Any newmarkets into which we attempt to distribute our products or services may not bereceptive. If we are unable to successfully develop or acquire new products orservices, enhance our existing products and services to meet customerrequirements, or distribute our products and services into new markets, thenour revenue will not grow as expected and we may not be able to achieve profitability.

 

***If we fail to maintain proper and effective internal controls or areunable to remediate the material weakness in our internal controls, then ourability to produce accurate and timely financial statements could be impairedand investors’ views of us could be harmed.***

 

Ensuring that we have adequate internal financial and accountingcontrols and procedures in place so that we can produce accurate financialstatements on a timely basis is a costly and time-consuming effort that needsto be re-evaluated frequently. Our internal control over financial reporting isa process designed to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements in accordancewith generally accepted accounting principles.

 

During our audit for the year ended December 31, 2008, weidentified 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.  If wefail to address these material weaknesses or if additional material weaknessesin our internal controls are discovered in the future, then we may fail to meetour future reporting obligations, our financial statements may contain materialmisstatements and the price of our common stock may decline.

 

Implementing any appropriate changes to our internal controls maydistract our officers and employees, entail substantial costs to modify ourexisting processes, and add personnel and take significant time to complete.These changes may not, however, be effective in maintaining the adequacy of ourinternal controls, and any failure to maintain that adequacy, or consequentinability to produce accurate financial statements on a timely basis, couldincrease our operating costs and harm our business. In addition, investors’perceptions that our internal controls are inadequate or that we are unable toproduce accurate financial statements on a timely basis may harm our stockprice and make it more difficult for us to effectively market and distributeour products and services to new and existing customers.

 

***Material defects or errors in the software we use to deliver ourproducts and services and the offerings by our Marketplace and SyndicationPartners could harm our reputation, result in significant costs to us, andimpair our ability to distribute our services.***

*** ***

The Web Applications underlying the offerings 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 newerrors in our existing software and services may be detected in the future. Wehave no actual knowledge, but we reasonably expect that the products andservices offered by our Syndication Partners may have similar errors and/ordefects. Any errors or defects that cause interruptions to the availability ofour services and the services for our Marketplace Partners could result in:

 

·                                          a reductionin sales or delay in market acceptance of services from us or our MarketplacePartners;

 

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·                  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 errors may also beidentified from time to time by our internal team, our Marketplace andSyndication Partners, and by our customers. The costs incurred in correctingany material defects or errors in such products or services may be substantialand could harm our operating results.

 

***Government regulation of the Internet and e-commerce is evolving, andunfavorable changes or our failure to comply with regulations could harm ouroperating results.***

 

As Internet commerce continues to evolve, increasing regulation bysuper-national, federal, state or local government agencies becomes morelikely. Increased regulation in the area of data privacy, and laws andregulations 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 or other regulations may reduce theeffectiveness of our products and services and harm our business.***

 

Our customers can use the products and services offered in an EtelosMarketplace to store personal or identifying information regarding theircustomers and contacts. Super-national, federal, state and other governmentbodies and agencies have adopted or are considering adoption of laws and regulationsregarding the collection, use, and disclosure of personal information obtainedfrom consumers and other individuals. The costs of compliance with, and otherburdens imposed by, such laws and regulations that are applicable to thebusinesses of our customers may limit the use and adoption of our products andservices and reduce overall demand.

 

In addition to government activity, privacy advocacy groups and thetechnology and other industries are considering various new, additional, ordifferent self-regulatory standards that may place additional burdens on us andour Marketplace and Syndication Partners. If the gathering of personalinformation were to be curtailed, then Web-based applications would be lesseffective, which may reduce demand for the products and services offered in anEtelos Marketplace and harm our business.

 

***Our operating results may be harmed if we are required to collect taxesfor our subscription services in jurisdictions where we have not historicallydone so.***

 

We have not collected any sales or other taxes from our customers orremitted any such taxes to any taxing jurisdiction where we may be required todo so. We have begun an analysis of this issue but to date have not made anyaccrual for any potential liability.  Inaddition, additional taxing jurisdictions at various local, national andsuper-national levels may seek to impose sales or other tax collectionobligations on us.  We have not recordedsales or other tax liabilities for the years ended December 31, 2008 or2007, in respect of sales or other tax liabilities in any jurisdiction. Asuccessful assertion 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 accounting standards or practices may causeadverse, unexpected financial reporting fluctuations, and harm our operatingresults.***

 

A change in accounting standards or practices could harm our operatingresults and may even affect our reporting of transactions completed before thechange is effective. New accounting pronouncements and varying interpretationsof accounting pronouncements have occurred and may occur in the future. Changesto existing rules or the questioning of current practices may harm ouroperating results or the way we conduct our business.

 

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***We may expand by acquiring or investing in other companies, which maydivert management’s attention, result in additional dilution to ourstockholders, and consume resources that are necessary to operate and sustainour business.***

 

Although we have no ongoing negotiations or current agreements orcommitments for any acquisitions, our business strategy may include acquiringcomplementary products, services, technologies, or businesses. We also mayenter into relationships with other businesses to expand our product or serviceofferings or our ability to provide service in foreign jurisdictions, whichcould involve preferred or exclusive licenses, additional channels ofdistribution, discount pricing, investments in other companies, or otherstrategies. Negotiating these transactions can be time-consuming, difficult,and expensive, and our ability to close these transactions may often be subjectto approvals that are beyond our control. Consequently, these transactions,even if undertaken and announced, may not close.

 

An acquisition, investment, or business relationship may result inunforeseen operating difficulties and expenditures. In particular, we mayencounter difficulties assimilating or integrating the businesses, technologies,products, services offerings, personnel, or operations of the acquiredcompanies, particularly if the key personnel of the acquired company choose notto work for us, the target’s software is not easily adapted to work with ours,or we are unable to retain the customers of any acquired business due tochanges in management or otherwise. Acquisitions may also disrupt our business,divert our resources, and require significant management attention that wouldotherwise be available for operation and development of our business. Moreover,the anticipated benefits of any acquisition, investment, or businessrelationship may not be realized or we may be exposed to unknown liabilities.For one or more of those transactions, we may:

 

·                  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 and operating results.

 

***We may be subject to other legal claims.***

 

In June 2008, Kaufman Bros. L.P. filed suit against us in theUnited States District Court for the Southern District of New York (Case No. 80CV 5716) and sought a temporary restraining order and other extraordinaryrelief.  The complaint arose out of an advisory services agreement,pursuant to which Kaufman Bros. was to provide us with advisory services inconnection with financings and strategic transactions. We notified Kaufman Bros.that we believed it had failed to provide the required services under theagreement, and that we were therefore entitled to terminate the agreement forcause. In the suit, Kaufman Bros. was seeking (i) monetary damages of$400,000 for anticipatory breach of the agreement; (ii) $73,800 in feesallegedly owed in connection with a previously closed financing transaction; (iii) andinjunction prohibiting us from cancelling any shares issued to Kaufman Bros. ascompensation, (iv) a declaration from the court that we are not entitledto a refund of any fees previously paid to Kaufman Bros., and (v) adeclaration that we are obligated to pay Kaufman Bros. a commission on anyfinancing or transaction that we enter into within 18 months following thetermination of the agreement.  On July 15, 2008, Kaufman Bros.voluntarily filed a notice of dismissal without prejudice.  Settlementdiscussions were unsuccessful and, on July 31, 2008, Kaufman Bros.re-filed substantially the same claims in the Supreme Court of New York -County of New York (Index No. 08-602239). Effective on December 5,2008, the Company entered into a settlement agreement with Kaufman Bros.,pursuant to which (i) the Company agreed to pay to Kaufman Bros. $210,000,in twelve monthly installments of $17,500; (ii) the Company issued toKaufman Bros. warrants to purchase 500,000 shares of the Company’s common stockat an exercise price of $0.75 per share, which warrants have a term of fiveyears; (iii) the Company and Kaufman Bros. agreed immediately to terminateall provisions, 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. Subsequentto entering into the settlement agreement, we have not fully complied with ourpayment obligations under the settlement agreement but, through the date offiling of this report, Kaufman Bros. has not exercised any of its remedies fordefault under the settlement agreement.

 

On October 31, 2008, the Company closed its offices in San Mateo,California and abandoned the leased premises of its former offices there.  The landlord for these premises has asserteda claim for $659 thousand for alleged unpaid rent and other amounts and filed aproceeding in the Superior Court of San Mateo County, California (Case No. CIV479535) on December 19, 2008.  Thismatter is pending and the Company intends to defend its position.

 

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On September 18, 2008, the employment of Jeffrey L. Garon aspresident and chief executive officer of the Company was terminated.  On October 19, 2008, Mr. Garonresigned from the Board of Directors.  Mr. Garonand the Company entered into an Employment Agreement dated August 11,2007, which provided certain benefits to Mr. Garon in the event oftermination of his employment, and granted to the Company certain rights to repurchaseshares issued on behalf of Mr. Garon pursuant to his employmentagreement.  The Company and Mr. Garonhave been engaged in discussions about these benefits and rights, and no finalagreement has been reached as of the filing date of this report.

 

On October 1, 2008, we relocated our headquarters from San Mateo,California to Renton, Washington, and terminated eight employees based inCalifornia. In October 2008, we terminated eight more employees employedin both our California and Washington offices. None of these terminated employees have asserted any claims against usat this time but no assurances can be given that such employees will not assertsuch claims in the future.

 

As part of our reduction of monthly cash operating expenses during thequarter ended December 31, 2008, and continuing after the end of thequarter, we placed all employees on partial deferrals of salary, ranging from10% to 100% of base salary.  At the endof the quarter, until the filing date of this report, this deferral amountremains unpaid, including amounts due to employees who subsequently wereterminated.  On December 17, 2008,we received notice that one employee has filed a claim with the CaliforniaLabor Commissioner; that claim has not been resolved. No other employee hasasserted a claim or demand for immediate payment of these unpaid amounts butthe assertion of such claims or demands by such employees, or by othergovernmental authorities, is foreseeable.

 

In connection with our reverse merger, multiple financings, andprotection of our intellectual property, we have incurred substantial accountspayable to law firms that remain unpaid and overdue.  We have been in communication with thesevendors and expect to enter into negotiated payment plans with these vendors,and others, but there is no assurance that we will be successful in thesenegotiations, or that we will be able to make payments under such plans if andwhen negotiated.  Therefore the assertionof claims by these vendors for these amounts due and owing could become thesubject of claims in litigation.

 

***Our officers, directors, and affiliates control us through theirpositions and stock ownership and their interests may differ from otherstockholders.***

 

As of December 31, 2008, our officers, directors, and affiliatesbeneficially own approximately 72 percent of our common stock and 60 percent ofour preferred stock. As a result, if they act together, they are able toinfluence the outcome of stockholder votes on various matters, including theelection of directors and extraordinary corporate transactions, includingbusiness combinations. This concentration could also have the effect ofdelaying or preventing a change in control that could otherwise be beneficialto our stockholders. The interests of our officers, directors, and affiliatesmay differ from other stockholders. Furthermore, the current ratios ofownership 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 the indemnification of our officers anddirectors.***

 

Our articles of incorporation and bylaws provide for theindemnification of our directors, officers, employees, and agents, and, undercertain 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.

 

***The market price of our securities could be adversely affected by salesof registered and restricted securities.***

 

Actual sales or the prospect of future sales of shares of our commonstock pursuant to a prospectus or under Rule 144 may have a depressiveeffect upon the price of, and market for, our common stock.  As of December 31, 2008, 23,027,624shares of our common stock were issued and outstanding, of which 18,017,624 are“restricted securities” and under some circumstances may, in the future, beunder a registration under the Securities Act or in compliance with Rule 144adopted under the Securities Act.  Ingeneral, under Rule 144, subject to the satisfaction of other conditions,a person who has beneficially owned restricted shares of common stock for atleast one year is entitled to sell, within any three month period, a number ofshares that does not exceed the greater of 1 percent of the total number ofoutstanding shares of the same class; or if the common stock is quoted onNASDAQ or a stock exchange, the average weekly trading volume during the fourcalendar weeks immediately preceding the sale. We cannot predict what effect, if any, that sales of shares of commonstock, or the availability of these shares for sale, will have on the marketprices prevailing from time to time. Nevertheless, the possibility that substantial amounts of common stockmay be sold in the public market may adversely effect prevailing prices for ourcommon stock and could impair our ability to raise capital in the futurethrough the sale of equity securities.

 

In addition to the 18,017,624 shares of “restricted securities” thatwere issued and outstanding as of December 31, 2008, we have aregistration statement that registers for resale an aggregate of 1,906,557shares of our common stock. The additional overhang represented by theseregistered securities could also have a depressive effect on the public tradingprice of our common stock.

 

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***The sale of the shares of our common stock acquired in privateplacements could cause the price of our common stock to decline.***

 

The purchasers of our January 2008 and April 2008 Debenturesand related warrants, as well as the holders of our other outstandingconvertible notes, may, subject to compliance with Rule 144, rely on theprovisions of Rule 144 to resell the shares of our common stock acquiredupon 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 addition, in connection with our January 2008 and April 2008Debentures, in the aggregate, we issued a total of $5.5 million principalamount of convertible debentures, convertible into 4,074,074 shares of ourcommon stock, and warrants to purchase an additional 611,111 shares of our commonstock.  We agreed to register for resaleby the investors the shares of common stock issuable upon the conversion of thedebentures and the exercise of the warrants we issued in those privateplacements. The conversion or exercise into our common stock and theregistration of that common stock could result in a substantial increase in thenumber of shares in our public float. Depending upon market liquidity at the time a resale of our common stockis made by the investors in such private placements, such sale could cause thetrading price of our common stock to decline. In addition, the sale of a substantial number of shares of our commonstock, or anticipation of such sales, could make it more difficult for us tosell equity or equity-related securities in the future at a time and at a pricethat we might otherwise wish to effect sales.

 

***We have significant indebtedness and agreed to certain restrictions asa result of our recent private placement of convertible debentures.***

 

We incurred $5.5 million in principal amount of indebtedness as aresult of the issuance of our January 2008 and April 2008Debentures.  The debentures carrysubstantial covenants that impose significant restrictions on us, includingrestrictions against incurring additional indebtedness, creating any liens onour property, amending our certificate of incorporation or bylaws, redeeming orpaying dividends on shares of our outstanding common stock, and entering intocertain related party transactions.  Thedebentures also carry substantial covenants that impose significantrequirements on us, including, among others, requirements that we pay interestand other charges on the debentures;

 

Our ability to comply with these provisions may be affected by changesin our business condition or results of our operations, or other events beyondour control.  We have breached certain ofthese covenants and are in a default under the debentures, which permits theholders thereof to accelerate the maturity of the debentures and demandrepayment in full.  Such actions by suchholders could impair our ability to operate or cause us to seek bankruptcyprotection.

 

***Certain covenants we agreed to in connection with the debentures mayimpair our ability to issue additional debt or equity.***

 

Our January 2008 and April 2008 Debentures impose significantcovenants on us, some of which may impair our ability to issue additional debtor equity, if necessary.  For example,the investors in our April 2008 Debentures have the right to participatein any financing we undertake through the date that is the 12 month anniversaryof the effectiveness of the registration statement we agreed to file for there-sale of our shares of common stock issuable upon conversion and exercise ofour April 2008 Debentures.

 

***Our failure to secure and maintain registration of the common stockcould result in substantial liquidated damages.***

 

Under the terms of the registration rights agreements we entered intowith the investors in connection with our January 2008 and April 2008Debentures, we agreed to file a registration statement covering the resale ofthe shares of common stock underlying the securities we sold in such privateplacements, and to maintain the effectiveness of the registration statements(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.  If theregistration statement is not declared effective within an agreed to timeperiod, or if we fail to maintain the effectiveness of the registrationstatement, we are required to pay to the investors partial liquidated damages.Since the registration statement was effective on July 31, 2008, after thedeadline in the registration rights agreement, we may be liable for liquidateddamages, in the amount of $14.7 thousand, which we have accrued as a liability.

 

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***If we need additional financing in the future and are required to issuesecurities which are priced at less than the conversion price of our debenturesor the exercise price of warrants sold in our recent private placements, itwill result in additional dilution.***

 

Our January 2008 and April 2008 Debentures and the relatedwarrants contain provisions that will require us to reduce the conversion priceand exercise price, as the case may be, if we issue additional securities whilesuch debentures or warrants are outstanding which contain purchase prices,conversion prices or exercise prices less than the conversion price of our January 2008or April 2008 Debentures 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 provisions contained in our amended and restatedcertificate of incorporation and amended and restated bylaws, as well asprovisions of Delaware law, could impair a takeover attempt.***

 

Our amended and restated certificate of incorporation, amended andrestated bylaws and Delaware law contain provisions that could have the effectof rendering more difficult or discouraging an acquisition deemed undesirableby our board of directors. Our corporate governance documents includeprovisions:

 

·                  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.

 

These provisions, alone or together, could delay hostile takeovers andchanges in control or changes in our management.

 

Any provision of our amended and restated certificate of incorporationor bylaws or Delaware law that has the effect of delaying or deterring a changein control could limit the opportunity for our stockholders to receive apremium for their shares of our common stock, and could also affect the pricethat some investors are willing to pay for our common stock.

 

***We may issue additional shares of our capital stock, including throughconvertible debt securities, to finance future operations or complete abusiness combination, which would reduce the equity interest of our stockholdersand could cause a change in control of our ownership.***

 

Although we have no commitments as of the date of this report to issueany additional securities, we may issue a substantial number of additionalshares of our common stock or preferred stock, or a combination of both,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 our common stock or anynumber of shares of preferred stock, including upon conversion of any debtsecurities, may:

 

·                  significantly reduce the equityinterest of our current stockholders;

·                  cause a change in control if asubstantial number of our shares of common stock or voting preferred stock areissued, which may affect, among other things, our ability to use our netoperating loss carry-forwards, if any, and could also result in a change inmanagement; and/or

·                  adversely affect prevailing marketprices for our common stock.

 

If we need additional capital and cannot raise it on acceptable 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.

 

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Although we have no commitments as of the date hereof to issue anyadditional securities, we may issue a substantial number of additional sharesof our common stock or preferred stock, or a combination of both, includingthrough convertible debt securities, to finance future operations or complete abusiness combination.  The issuance ofadditional shares of our common stock or any number of shares of preferredstock, 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 2007 Stock Incentive Plan and all options issued under the 2007Stock Incentive Plan contain provisions for acceleration of all unvestedoptions in the event of a change of control, which might be a disincentive toacquisition of the Company as a liquidation strategy.

 

The 2007 Stock Incentive Plan and all options currently issuedthereunder and options granted outside such plan provides for acceleratedvesting of all unvested options in the event of a change of control, which isdefined as an acquisition by a single person of more than 50 percent of thetotal combined voting power of all of our outstanding securities. This may beregarded as a barrier to retention of key employees following achange-of-control acquisition and therefore make such an acquisition morecostly or difficult, and therefore an unattractive strategic option, for aprospective acquiror.

 

***We have never paid dividends on our capital stock and we do not anticipatepaying any cash dividends in the foreseeable future.***

 

We have paid no cash dividends on any of our classes of capital stockto date and we currently intend to retain our future earnings, if any, to fundthe development and growth of our business. In addition, the terms of the Notes prohibit us from making any dividendpayment or distribution to holders of our common stock while any portion of theNotes remain outstanding.  As a result,capital appreciation, if any, of our common stock will be your sole source ofgain for the foreseeable future.

 

***Our securities may be thinly traded on the Over-the-Counter BulletinBoard, which may not provide liquidity for our investors.***

 

Our common stock is quoted on the Over-the-Counter Bulletin Board. TheOver-the-Counter Bulletin Board is an inter-dealer, over-the-counter marketthat provides significantly less liquidity than the NASDAQ Stock Market orother national or regional exchanges. Securities traded on the Over-the-CounterBulletin Board are usually thinly traded, highly volatile, have fewer marketmakers, and are not followed by analysts.

 

The SEC’s order handling rules, which apply to NASDAQ-listedsecurities, do not apply to securities quoted on the Over-the-Counter BulletinBoard. Quotes for stocks included on the Over-the-Counter Bulletin Board maynot be listed in newspapers. Therefore, prices for securities traded solely onthe Over-the-Counter Bulletin Board may be difficult to obtain and holders ofour securities may be unable to resell their securities at or near theiroriginal acquisition price, or at any price.

 

***Investors must contact a broker-dealer to trade Over-the-CounterBulletin Board securities. As a result, you may not be able to buy or sell ourcommon stock at the times that you may wish.***

 

Even though our common stock is quoted on the Over-the-Counter BulletinBoard, the Over-the-Counter Bulletin Board may not permit our investors to sellsecurities when and in the manner that they wish. Because there are noautomated systems for negotiating trades on the Over-the-Counter BulletinBoard, they are conducted via telephone. In times of heavy market volume, thelimitations of this process may result in a significant increase in the time ittakes to execute investor orders. Therefore, when investors place market ordersto buy or sell a specific number of shares at the current market price it ispossible for the price of a stock to go up or down significantly during thelapse of time between placing a market order and its execution.

 

***Our stock price may be volatile and you may not be able to sell yourshares for more than what you paid.***

 

Our stock price is likely to be subject to significant volatility andyou may not be able to sell shares of common stock at or above the price youpaid for them. The market price of the common stock could continue to fluctuatein the future in response to various factors including, but not limited to:quarterly variations in operating results; our ability to control costs andimprove cash flow; announcements of technological innovations or new productsby us or our competitors; changes in investor perceptions; and new products orproduce enhancements by us or our competitors. The stock market in general hascontinued to experience volatility, which may further affect our stock price.As such, you may not be able to resell your shares of common stock at or abovethe price you paid for them.

 

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***Our common stock is likely to be subject to penny stock rules.***

 

Our common stock is subject to Rule 15g-1 through 15g-9 under theExchange Act, which imposes certain sales practice requirements onbroker-dealers which sell our common stock to persons other than establishedcustomers and “accredited investors” (generally, individuals with net worths 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 price quotationsfor the common stock.  The regulationsalso require that monthly statements be sent to holders of penny stock whichdisclose recent price information for the penny stock and information of thelimited market for penny stocks.  Theserequirements adversely affect the market liquidity of our common stock.

 

**ITEM IB.                UNRESOLVEDSTAFF COMMENTS**

** **

**None.**

** **

**ITEM 2.                  PROPERTIES**

** **

Our corporate headquarters is located inMaple Valley, Washington, but we do not own or lease any real property andconduct the major portion of our business activities virtually: using theInternet and other telecommunications tools like those we offer fordistribution in Etelos Marketplaces. We believe that our existing propertiesare in good condition and are sufficient and suitable for the conduct of ourbusiness. Our requirements for property are not unique or specialized; if andwhen the need arises, we believe that suitable space will be available to us oncommercially reasonable terms.

 

**ITEM 3.                  LEGALPROCEEDINGS**

** **

From time to time, we become subject to various legal proceedings andclaims, both asserted and unasserted, that arise in the ordinary course ofbusiness. Litigation in general, and securities litigation in particular, canbe expensive and disruptive to normal business operations. Moreover, theresults of legal proceedings are difficult to predict. An unfavorableresolution of one or more of these lawsuits would materially adversely affectour business, results of operations, or financial condition. We accrue legalcosts when incurred.  The need to defendany such claims could require payments of legal fees and our limited financialresources could severely impact our ability to defend any such claims.

 

In June 2008, Kaufman Bros. L.P. filed suit against us in theUnited States District Court for the Southern District of New York (Case No. 80CV 5716) and sought a temporary restraining order and other extraordinaryrelief.  The complaint arises out of an advisory services agreement,pursuant to which Kaufman Bros. was to provide us with advisory services inconnection with financings and strategic transactions. We notified KaufmanBros. that we believed it had failed to provide the required services under theagreement, and that we were therefore entitled to terminate the agreement forcause. In the suit, Kaufman Bros. was seeking (i) monetary damages of$400,000 for anticipatory breach of the agreement; (ii) $73,800 in feesallegedly owed in connection with a previously closed financing transaction; (iii) andinjunction prohibiting us from cancelling any shares issued to Kaufman Bros. ascompensation, (iv) a declaration from the court that we are not entitledto a refund of any fees previously paid to Kaufman Bros., and (v) adeclaration that we are obligated to pay Kaufman Bros. a commission on anyfinancing or transaction that we enter into within 18 months following thetermination of the agreement.  On July 15, 2008, Kaufman Bros.voluntarily filed a notice of dismissal without prejudice.  Settlementdiscussions were unsuccessful and, on July 31, 2008, Kaufman Bros. re-filedsubstantially the same claims in the Supreme Court of New York - County of NewYork (Index No. 08-602239). 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.warrants to purchase 500,000 shares of the Company’s common stock at anexercise price of $0.75 per share, which warrants have a term of five years; (iii) theCompany and Kaufman Bros. agreed immediately to terminate all provisions, termsand conditions of the advisory services agreement and exchanged mutualreleases; and (iv) Kaufman Bros. agreed to dismiss the pending lawsuit inthe Supreme Court of New York, without prejudice. Subsequent to entering intothe settlement agreement, we have not fully complied with our paymentobligations under the 

 

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settlement agreement but, through the date of filingof this report, Kaufman Bros. has not exercised any of its remedies for defaultunder the settlement agreement.

 

On October 31, 2008, the Company closed its offices in San Mateo,California and abandoned the leased premises of its former offices there.  The landlord for these premises has asserteda claim for $659 thousand for alleged unpaid rent and other amounts, and fileda proceeding in the Superior Court of San Mateo County, California (Case No. CIV479535) on December 19, 2008.  Thismatter is pending and the Company intends to defend its position.

 
| **ITEM 4.** | **SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS** |
|-------------|----------------------------------------------------------|

** **

There were nomatters submitted to a vote of stockholders during the fourth quarter of fiscalyear 2008.

 

**PART II**

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

** **

**Market for Registrant’s Common Equity**

 

Effective April 29, 2008, shares of our common stock began beingquoted on the OTC Bulletin Board under the symbol “ETLO.”  The OTCBulletin Board is a regulated quotation service that displays real-time quotes,last-sale prices and volume information in over-the-counter equity securities. The OTC Bulletin Board securities are traded by a community of market makersthat enter quotes and trade reports.  This market is extremely limited andany prices quoted may not be a reliable indication of the value of our commonstock.

 

The following table setsforth the high and low bid prices per share of our common stock by the OTCBulletin Board for the periods indicated as reported on the OTC Bulletin Board.

 
| **For the year ended  December 31, 2008**   | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------------------------|------------|----------|------------|---------|------------|
| Fourth Quarter                                   |       | $        | 1.25       |    | $          | 0.10 |   |
| Third Quarter                                    |       | $        | 14.00      |    | $          | 1.15 |   |
| Second Quarter (Commencing  April 29, 2008) |       | $        | 4.99       |    | $          | 0.76 |   |

 

The quotes representinter-dealer prices, without adjustment for retail mark-up, markdown orcommission 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.

 

**Holders of Record**

 

As of December 31, 2008, there were 23,027,624 shares of ourcommon stock outstanding held by approximately 145 holders of record.

 

**Transfer Agent**

 

Our transfer agent is BNY Mellon Shareowner Services, P.O. Box358016, Pittsburgh, PA 15252.

 

**Dividends**

 

We have never declared or paid any cash dividends on our commonstock.  For the foreseeable future, we intend to retain any earnings tofinance the development and expansion of our business, and we do not anticipatepaying any cash dividends on our common stock.  In addition, we are restrictedfrom paying any dividends on our common stock under the terms of our January debenturesand April debentures.  Any future determination to pay dividends willbe at the discretion of our board of directors.

 

**Securities Authorized for Issuanceunder Equity Compensation Plans**

 

The table below sets forth information as of December 31, 2008,with respect to compensation plans under which our common stock is authorizedfor issuance.  The figures related to equity compensation plans approvedby security holders relate to 

 

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options grantedunder the 1999 Stock Option Plan and the 2007 Stock Incentive Plan.  We donot have any equity compensation plans not approved by its security holders.

 
| **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 |       | 4,086,497                                                                                                                                                 |       | $                                                                                                                | 0.26       |                                                                                                                                                                                                            | 791,145    |   |
|                                                         |            |                                                                                                                                                           |            |                                                                                                                  |            |                                                                                                                                                                                                                 |            |  |

 

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

** **

As a smaller reporting company we are not required to provide theinformation required by this item.

 

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

** **

The following discussion of our financial condition and results ofoperations should be read in conjunction with our financial statements and therelated notes and other financial information appearing elsewhere in thisreport. Readers are also urged to carefully review and consider the variousdisclosures made by us which attempt to advise interested parties of thefactors which affect our business, including without limitation, thedisclosures made under “Item 1A. Risk Factors” included in Part I of thisreport.

 

**Overview**

** **

We are a provider of tools and services for the development anddistribution of Web Applications.  Wegenerate revenues from a share of revenues generated by the sales ofsubscriptions to use Web Applications developed by us and by our Syndication Partners,which are offered through Etelos Marketplaces developed and operated byus.  Our principal cost of revenue ishardware, software, and network connectivity used in connection with thedelivery of our products and services. Our primary operating expenses are for personnel costs, especially intechnology research and development.

 

During the quarter ended December 31, 2008, we took significantsteps intended to improve our operating results, ranging from changing thefocus of our business model from an end-user-focused model to a focus onenterprise customer sales to reducing monthly cash operating expenses byaggregate workforce reductions of over 70% and relocating our corporateheadquarters to lower cost facilities. The shift in business focus is a fundamental change, and the reductionof operating expenses is a one-time exercise in survival that has thus far beensuccessful, but this exercise is not completed and has created a substantialworking capital deficit that must be addressed and resolved.

 

Similar to other companies, we have suffered the effects of the currentadverse economic conditions.  For thisreason, as discussed in more detail elsewhere in this report, we have not beenmaking recent payments due and owing on our outstanding debt securities,including our January 2008 Debentures and April 2008 Debentures.  As a result the holders of such securitiesmay declare us in default and demand that all amounts due thereunder beimmediately paid in cash, and with respect to our January Debentures and April Debentures,the holders may demand that we pay 130 percent of the outstanding principalamount and interest.  If such demand wasmade, then we do not currently have the financial resources to make thepayments owed. In addition, the holders of our January Debentures and April Debenturesmay have the right to foreclose on substantially all of our assets pursuant tothe terms of the security agreement we entered into with such holders and theywould have the right to take possession of our assets and operate our business.  Though we are in regular communication withthe holders of our outstanding debt securities, and none of them have demandedpayment or exercised other remedies due to our current default under suchsecurities, we can give no assurances that the holders will not exercise theirremedies in the future.

 

We need immediate and substantial cash to continue ouroperations. Management has projected that the combination of cash on hand willbe sufficient to allow us to continue our operations only through June 2009,and only if the holders of our outstanding debt securities do not demandpayment of such securities or exercise other remedies. If cash reserves are notsufficient to sustain operations, then we plan to raise additional capital byselling shares of our capital stock or other securities.  However, there are no 

 

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commitments or arrangements for future financings in place at this timeand we can give no assurance that such capital will be available on favorableterms, or at all.  If we cannot obtainfinancing, then we may be forced to further curtail our operations, ceasevoluntarily filing reports with the SEC, or possibly be forced to evaluate asale or liquidation of our assets, or consider strategic alternatives such asbankruptcy.  Even if we are successful inraising additional 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.

 

***Corporate Changes***

 

During the last quarter of the year ended December 31, 2008, aswell as after the year ended, we took various steps to reduce monthly cashoperating expenses and bring our expenses closer in line with available workingcapital and anticipated revenues goals, including further reductions in ourworkforce and the relocation of our corporate headquarters from space that we werealready leasing in Renton, Washington to a lower cost space. For moreinformation regarding the reduction in force and the relocation of ourcorporate headquarters, please see “Note 14. Restructuring” to our financialstatements included in this report.

 

As part of our reduction of monthly cash operating expenses during thelast two quarters of the year ended December 31, 2008, and continuing tothe date of this report, we placed all employees on partial deferrals ofsalary, ranging from 10% to 100% of base salary.  At the end of the quarter, and as of thefiling date of this report, the amount of this deferral, which has beenaccrued, remains unpaid, including amounts due to employees in our Californiaoffice who subsequently were terminated during the quarter ending September 30,2008.

 

We also had a number of changes in our executive management team.  On September 18, 2008, Jeffrey L. Garon’semployment as our president and chief executive officer was terminated, and weappointed Daniel J.A. Kolke as our interim chief executive officer.  Mr. Kolke, who founded Etelos in 1999,had been and continues to be the chairman of our board of directors and ourchief technology officer. Mr. Garon subsequently resigned from our boardof directors on October 19, 2008. Effective October 31, 2008, David S.G. MacKenzie resigned as ourvice president and chief financial officer, but he continued to serve as anadvisor and consultant to us through the end of the quarter.  Daniel J.A. Kolke also serves as our interimchief financial officer.

 

On October 20, 2008, the Board elected Robert L. Thordarson to fill avacancy on our board of directors until the next shareholders’ meeting.

 

Certain of the steps we have taken to reduce monthly cash operatingexpenses, including the termination of employment of our employees and theabandonment of office facilities, may result in claims against us from theaffected parties.  See the risk factorentitled, “We may be subject to other legal claims” contained in Item 1A of Part Iof this report.

 

***Recent Financings***

 

*Series A Financing*

 

During the month of December 2008, we closed a round of financingfor the sale of 833,333 shares of our Series A Preferred Stock at $0.75per share, for an aggregate purchase price of $625 thousand, and warrants topurchase 833,333 shares of common stock of the Company, 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 technologyofficer, with participation from two of our directors and other priorinvestors. The holders of the January 2008 Debentures and the April 2008Debentures consented to this financing, but did not participate.

 

*April2008 Debentures*

 

On April 22, 2008,we entered into a securities purchase agreement with two unaffiliatedinstitutional investors for the sale of original issue discount 6 percentconvertible debentures and common stock purchase warrants.  We refer to these debentures as our April2008 Debentures.  In this transaction weissued an aggregate of $3.5 million principal amount of debentures and warrantsto purchase an aggregate of up to 388,889 shares of our common stock.  The warrants have a term of three years andan exercise price of $1.80 per share, subject to adjustment, includingfull-ratchet anti-dilution protection. This transaction resulted in net proceeds to us of $3.4 million.

 

For a moredetailed discussion of our April 2008 Debentures, please see the discussionunder the caption “April 2008 Debentures” under “Note 10. Convertible Notes andDebentures and Embedded Derivative and Warrant Liability” to our financialstatements contained in this report.

 

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*January 2008 Debentures*

 

On January 31, 2008, we entered into a securities purchaseagreement with three unaffiliated institutional investors for the sale of 6 percentsecured convertible debentures and common stock purchase warrants.  We refer to these debentures as our January 2008Debentures.  In this transaction weissued an aggregate of $2.0 million principal amount of debentures and warrantsto purchase an aggregate of 222,222 shares of our common stock.  This transaction resulted in net proceeds tous of $1.9 million.

 

The warrants are three year warrants to purchase shares of our commonstock at a price of $1.80 per share, subject to adjustment, including full-ratchetanti-dilution protection.  As of December 31,2008, none of these warrants had been exercised.

 

For a more detailed discussion of our January 2008 Debentures,please see the discussion under the caption “January 2008 Debentures”under “Note 10. Convertible Notes and Debentures and Embedded Derivative andWarrant Liability” to our financial statements contained in this report.

 

**Critical AccountingPolicies Involving Management Estimates and Assumptions**

** **

Our discussion and analysis of our financial condition and results ofoperations is based on our financial statements.  In preparing our financial statements inconformity with accounting principles generally accepted in the United States,we must make a variety of estimates and assumptions that affect the reportedamounts of assets and liabilities, the disclosure of contingent assets andliabilities, and the reported amounts of revenues and expenses.  We have identified the following accountingpolicies that we believe require application of management’s most subjectivejudgments, often requiring the need to make estimates about the effect ofmatters that are inherently uncertain and may change in subsequent periods.

 

*Allowance for Doubtful Accounts*

 

We provide, when appropriate, an allowance for doubtful accounts toensure that our trade receivables are not overstated due to un-collectability.The collectability of our accounts receivables is evaluated based on a varietyof factors, 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*

 

We provide 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 service 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 Securities and Exchange Commission Staff AccountingBulletin 104, *“Revenue Recognition in Financial Statements”*(SAB 104) and SOP 97-2, *“Software RevenueRecognition”*, (SOP 97-2) respectively, which both provide thatrevenue may be recognized when all of the following criteria are met:

 

·                  Persuasive evidence of an arrangementexists,

·                  The product or service has beendelivered,

·                  The fee is fixed or determinable, and

·                  Collection of the resultingreceivable is reasonably assured or probable.

 

We must first determine whether SAB 104 or SOP 97-2 applies to ourrevenue transactions.  We than determineif the criteria above have been met by assessing the SAB 104 and SOP 97-2 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 thatliterature should be applied.  If ourstandard agreements are used to establish evidence of the arrangement, then ourrevenue is generally recognized as follows:

 

·                  For SaaS revenue transactions,persuasive evidence of an arrangement exists upon acceptance by the customer ofa binding agreement and authorization by the customer to charge a credit card;delivery generally occurs over the term of the subscription agreement relatedto the SaaS; and the fee is fixed and collection reasonably assured when thecustomer’s credit card is charged. Accordingly, revenue is recognized over the period the SaaS is provided.

·                  For software licensed under term orperpetual agreements, persuasive evidence of the arrangement is evidenced by abinding agreement signed by the customer and delivery generally occurs upondelivery of the software to a common carrier. If a significant portion of a feeis due after our normal payment terms of typically 30 days, we recognizerevenue as the fees become due. If we determine that collection of a fee is notreasonably assured, we defer the fees and recognize revenue upon cash receipt,provided that all other revenue recognition criteria are met.

 

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However, if the terms and conditions of an agreement are nonstandard,then significant contract interpretation is sometimes required to determine theappropriate accounting for these transactions including: (1) whether anarrangement exists; (2) how the arrangement consideration should beallocated among potential multiple elements; (3) when to recognize revenueon the deliverables; (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*

 

Under SFAS NO. 86, *“Accounting for Costs ofComputer Software to be Sold, Leased or Otherwise Marketed”* (SFAS86), costs incurred in the research and development of new software productsare expensed as incurred until technological feasibility is established.  Alternatively, Statement of Position 98-1, *“Accounting for Costs of Computer Software Developed or Obtained forInternal Use”* (SOP 98-1), applies to software development costs thatare not related to software to be sold, licensed, leased or otherwise marketedas a separate product or as part of a product or process and are within thescope of SFAS 86.  Under SOP 98-1,software development costs incurred for software that is only used internally,including costs incurred to purchase third party software, are capitalizedbeginning when the Company has determined certain factors are present,including among others, that technology exists to achieve the performancerequirements, buy versus internal development decisions have been made, and theCompany’s management has authorized the funding for the project.  We must determine whether SFAS 86 or SOP 98-1is applicable to our software development costs.  We then must determine when softwarecapitalization should begin and cease and what costs under the applicablestandard can be capitalized.  Both ofthese tasks involves considerable judgment and can result in material differentamounts of software being capitalized and have a significant impact on ourreported results of operations.  To date,because we plan to license all our software products, we have determined thatthe provisions of SFAS 86 should be applied to the cost of our productdevelopment.  As products andenhancements have generally reached technological feasibility and have beenreleased for sale at substantially the same time, all research and developmentcosts have been expensed.

 

*Stock-Based Compensation Expense*

 

Effective January 1, 2006, we adopted SFAS 123R using the modifiedprospective method and therefore have not restated prior periods’ results.Under the fair value recognition provisions of SFAS 123R, we recognizestock-based compensation expense net of an estimated forfeiture rate andtherefore only recognize compensation cost for those shares expected to vestover the service period of the award. Calculating stock-based compensation expense requires the input ofhighly subjective assumptions, including the expected term of the stock-basedawards, stock price volatility, and the pre-vesting option forfeiture rate. Weestimate the expected life of options granted based on historical exercisepatterns, which we believe are representative of future behavior. We estimatethe volatility of our common stock on the date of grant based on the historicalvolatility of other publicly traded companies in our industry. The assumptionsused in calculating the fair value of stock-based awards represent our bestestimates, but these estimates involve inherent uncertainties and theapplication of management judgment. As a result, if factors change and we usedifferent assumptions, our stock-based compensation expense could be materiallydifferent in the future. In addition, we are required to estimate the expectedforfeiture rate, as well as the probability that performance conditions thataffect the vesting of certain awards will be achieved, and only recognizeexpense for those shares expected to vest. We estimate the forfeiture ratebased on historical experience of our stock-based awards that are granted, exercised,and cancelled. If our actual forfeiture rate is materially different from ourestimate, the stock-based compensation expense could be significantly differentfrom what we have recorded in the current period. The quarter ended December 31,2008, was a highly volatile period for the economy on a global basis, duringwhich period the Company found it necessary to take drastic measures to reduceoperating expenses, but the likelihood of success of these efforts cannot bepredicted.  Therefore the forfeiture ratein the quarter ended December 31, 2008, and for the period up to thefiling date of this report, was very high. It is not known whether this forfeiture rate will be maintained in thefuture; management will continue to monitor its estimates.

 

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

 

The Company evaluates the embedded derivatives included in the debtinstruments it issues under the guidance in Statement of Financial AccountingStandard No. 133 *“Accounting for DerivativeInstruments and Hedging Activities”* and its related guidance andinterpretations (SFAS 133) on the issuance date of the debt and on eachsubsequent reporting date to determine whether such embedded derivatives areclearly and closely related to the debt host. The purpose of the evaluation is to determine whether the 

 

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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 value witha charge or credit to the Company’s statement of operations.  SFAS 133 generally indicates that if theconversion features are (i) indexed to the Company’s capital stock and (ii) wouldbe classified as equity if a freestanding derivative under the guidance in EITF00-19, *“Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock”* (EITF00-19), then the embedded derivatives need not be bifurcated from the debthost.  We also evaluate the warrantsissued with the debt under EITF 00-19 to determine whether the proceedsallocated to the warrants or the fair value of the warrants should be recordedas equity or a liability, respectively, and if a liability adjusted to fairvalue with a charge or credit to the Company’s statement of operations.  EITF 00-19 generally requires, among otherfactors, that (i) the Company can settle the derivative in cash or its ownstock, at its option, (ii) settlement can be made in unregistered shares,and (iii) the Company has sufficient authorized shares to issue shares ofits common stock for all equity instruments convertible to or which can beexercised for its capital stock.  SFAS133 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 SFAS 133 is complex and it has manyinterpretations.  Accordingly, we mustuse judgment to apply and interpret this guidance as well as ensure we haveapplied the correct guidance.

 

If the embedded derivatives or warrants must be recorded as aliability, then we must make certain assumptions to value the embeddedderivative.  This includes computing thediscounted net present value (DNPV) of the debt and making assumptions aboutinterest rates, probabilities of outcomes, volatility, fair value of theCompany’s stock prior to its merger with Tripath, and discount rates.  The discount factor is the Company’s estimateof the appropriate rate of return that an investor would expect from a similardebenture not taking into consideration the conversion feature orwarrants.  All of these assumptions havea material impact on the value attributed to the derivative or warrant.

 

**Results of Operations**

 

**Fluctuations in Operating Results**

 

**Year Ended December 31, 2008, Compared withYear Ended December 31, 2007**

 

***Revenues***

 

Revenues were $123 thousand and $304 thousand for the years ended December 31,2008 and 2007, respectively. Revenues decreased by $181 thousand, or 60percent, in the year ended December 31, 2008, compared to the same periodin 2007.  The decrease in revenues is duein part to reductions in revenues generated from the sale of newsletters andrelated hosting services and a one-time sale of software in June 2007.    In the year ended December 31, 2008,and to the date of this report, we also experienced a significant decline insales of our customer resource management product, which had been introduced inmid-2007.

 

***Cost of Revenue***

 

Cost of revenue includes our costs of hardware, software and otherresources used in delivery of our products and services. Cost of revenue was$542 thousand and $315 thousand for the years ended December 31, 2008 and2007, respectively. Cost of revenue for the year of 2008 increased by $227thousand, or by 72 percent.  The increasein cost of revenue from 2007 to 2008 was primarily attributable to theincreased costs of hosting and Internet bandwidth associated with the deploymentof our products and services. Stated as a percentage of revenues, cost ofrevenue for the year ending December 31, 2008, was 440 percent and for thecorresponding period of 2007 was 103 percent.

 

***Operating Expenses***

 

*Research and Development.*  Research and development expenses includeprimarily employee and employee related expenses. Research and developmentexpenses were $2.6 million and $2.0 million for the years ended December 31,2008 and 2007, respectively. Stated as a percentage of revenues, research anddevelopment expense for the corresponding periods was 2,151 percent and 642percent, respectively.  Research anddevelopment expenses increased by $600 thousand or by 30 percent, in the yearending December 31, 2008, compared to the same period in 2007.  This increase was primarily due to increasedsalary and benefits expenses for engineers engaged in research and development.

 

*Sales and Marketing Expenses.*  Sales and marketing expenses include payroll,employee benefits, and other headcount-related costs associated with sales andmarketing personnel and travel, advertising, promotions, trade shows, seminars,and other programs. Sales and marketing expenses were $1,662 thousand and $812thousand for the years ended December 31, 2008 and 2007, respectively. The$850 thousand, or 105 percent, increase in sales and marketing expense was dueto increased activities of sales and marketing. Stated as a percentage ofrevenues, sales and marketing expense for the corresponding periods was 1,351percent and 267 percent, respectively.

 

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*General and Administrative.*  General and administrative expenses includepayroll and related employee benefits, and other headcount-related costsassociated with finance, facilities, legal and other administrative expenses.General and administrative expenses were $3,153 thousand and $923 thousand forthe years ended December 31, 2008 and 2007, respectively. The $2,230thousand, or 341 percent, increase in general and administrative expense wasprimarily attributable to increased hiring of accounting, administrative,legal, and compliance personnel and greater use of consultants and temporarypersonnel to support being a public company. Stated as a percentage of revenues, general and administrative expensefor the corresponding periods was 25,634 percent and 303 percent, respectively.

 

***Restructuring***

 

Restructuring costs of $632 thousand for the year ended December 31,2008, consisted primarily of employee related costs and $339 thousand in officerent obligations.  There were no similiarcosts in 2007.

 

***Other Income (Expense)***

 

Net other expense for the year ended December 31, 2008, is $13.4million, and it is related to the costs associated with completing the mergerwith Tripath. The merger-related costs include the value of 5,010,000 shares ofEtelos common stock paid to Tripath creditors, which were valued on April 22,2008, at $2.63 per share for a total cost of $13.2 million, and legal,accounting and other professional fees paid to complete the Merger. 

 

***Interest Expense***

 

Net interest expense was $(2,623) thousand for the year ended December31, 2008, compared to $362 thousand for the comparable period of 2007. Interestexpense primarily consisted of $2,872 thousand of amortization of notesdiscount, $991 thousand of beneficial conversion of interest conversion, and$479 thousand of interest expense on convertible notes and debentures, offsetby a change in the valuation of liability relating to embedded derivatives andwarrants of $(6,965) thousand for the year ended December 31, 2008, compared to$80 thousand of amortization of notes discount and $282 thousand of interestexpense on convertible notes for the year ended December 31, 2007.

*** ***

***Net Loss***

 

Our net loss was $19.4 million and $4.0 million for the years ended December 31,2008 and 2007, respectively, an increase of $15.4 million, or 385 percent.  The increase in net loss from 2007 to 2008was primarily due to decreased revenue and increased salaries and general andadministrative expenses and other employee-related costs incurred during aperiod of transition in which we were deeply involved in preparations forcompleting the reverse merger process, in addition to the Merger and interestcharges explained above.

 

**Liquidity and Capital Resources**

 

On December 31, 2008, we had $7 thousand in cash and cashequivalents, net accounts receivable of $60 thousand, and prepaid expenses andother current assets of $46 thousand. Our working capital deficit at December 31,2008, was $10.4 million, compared to a deficit of $3.5 million at December 31,2007. The increase in working capital deficit is mainly attributable to thewarrant and derivative liability recorded in prior periods and furtherdiscussed in “Note 6- Convertible Notes and Debentures and Embedded Derivativeand Warrant Liability” in our financial statements included in this report.

 

Net cash used by operating activities during the year ended December 31,2008, was $7 million, compared to $3 million during the period year December 31,2007. The primary use of cash from operating activities during the year ended December 31,2008, was merger-related expenses of $13.2 million.

 

Net cash provided by financing activities for 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.

 

Net cash provided by financing activities for the year ended December31, 2007, was $4.0 million, primarily from the issuance of our 20% ConvertibleNotes and our 6% Convertible Notes, further discussed in “Note 6 — ConvertibleNotes and Debentures and Embedded Derivative and Warrant Liability” in ourfinancial statements included in this report.

 

We are currently in default of our September 2007 notes, January 2008Debentures, and April 2008 Debentures for failure to make payments whendue.  The aggregate principal and accruedinterest currently due under these debt securities as of the year ended December 31,2008, is $7.7 million.  Our January 2008Debentures and April 2008 Debentures are secured by substantially all ofour assets.  If the holders of ouroutstanding debt securities determine to demand payment and we haveinsufficient cash to make the required payments, as is currently the case, theholders could force a sale of our assets for their benefit. Under suchcircumstances, we may need to cease operations or file for protection fromclaims of our creditors under the federal bankruptcy laws.

 

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We need immediate and substantial cash to continue ouroperations. Management has projected that the combination of cash on hand willbe sufficient to allow us to continue our operations only through June 2009,and only if the holders of our outstanding debt securities do not demandpayment of such securities or exercise other remedies. If cash reserves are notsufficient to sustain operations, then we plan to raise additional capital byselling shares of our capital stock or other securities.  However, there are no commitments orarrangements for future financings in place at this time and we can give noassurance that such capital will be available on favorable terms, or at all.  We may need additional financing thereafteruntil we can achieve profitability.  Ifwe cannot obtain additional financing, then we may be forced to curtail ouroperations, cease voluntarily filing reports with the SEC, or possibly beforced to evaluate a sale or liquidation of our assets or consider otherstrategic alternatives such as bankruptcy. Even if we are successful in raising additional funds, there is noassurance regarding the terms of any additional investment and any suchinvestment or other strategic alternative would likely substantially dilute oreliminate the interests of our stockholders.

 

***Subsequent Events***

 

In the period after the end of the quarter ending December 31,2008, we entered into a series of bridge loans with certain purchasers of ourNew Series A Preferred stock and with the holders of our January 2008and April 2008 Debentures.  In theaggregate these bridge loans were for the principal amount of  $655 thousand, which is estimated to coverour operating expenses through June 2009. These notes bear interest at ten percent per annum, and have maturitiesranging from May 31, 2009, through October 17, 2009.  The notes payable to the holders of our New Series APreferred stock were accompanied by 146,667 warrants to purchase shares of ourCommon Stock at $0.75 per share, with a term of five years.  The notes payable to the holder of our January 2008and April 2008 Debentures are subject to the security interest granted tothose holders in connection with those debentures.

 

Following the end of the year ended December 31, 2008, on additional394,414 options were cancelled.

 

***Financing Obligations***

 

At December 31, 2008, we had the following financing obligations:

 

**September 2007 Notes**

 

Our September 2007 notes were issued as part of a privateplacement 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 the notes that werenot converted, principal payments began being payable on September 1,2008, and will continue to be payable on the last day of each calendar quarter,and interest payments began being payable beginning February 1, 2008. On June 15,2008, the holders of these notes agreed to either convert the then-accruedinterest to shares of common stock at a rate of one share for each $1.35 ofinterest owed or to add the then-accrued interest to the principal, and towaive any default arising out of our failure to pay the accrued and unpaidinterest through June 15, 2008.

 

The principal payment amounts remaining on our September 2007notes are scheduled to be paid as follows (in thousands):

 
| **Date**   | ** ** | **September 2007 Notes** | ** ** |
|------------|------------|------------------------------------|------------|
| 9/1/2008   |       | $                                  | 441        |   |
| 9/30/2008  |       | $                                  | 441        |   |
| 12/31/2008 |       | $                                  | 441        |   |
| 3/31/2009  |       | $                                  | 441        |   |
|       |       | $                                  | 1,764      |   |

 

Assuming principal payments are made in accordance with the scheduleset forth above, the amount of interest to be paid through the March 31,2009, maturity date is $55.9 thousand with respect to our September 2007notes, or on average, $3.1 thousand per month.

 

As of the filing date of this report, the September 2008, December 2008,and March 2009 principal payments have not been made and the Company doesnot have, or expect to have, cash on hand to make the payments in the nearfuture; no interest payments have been made for interest accrued since June 15,2008.  We are in regular communicationwith the holders of the September 2007 notes and none of the holders havedemanded payment or exercised other remedies due to our non-payments, but noassurances can be given that the holders will not exercise their remedies inthe future.

 

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**January 2008 Debentures**

 

In January 2008, we issued our January 2008 Debentures withan aggregate principal amount of $2.0 million. Under the terms of thesedebentures, we were to begin making monthly redemption payments on September 1,2008.  The maturity date of thesedebentures is January 31, 2010.  Thetotal monthly principal payment amounts on our January 2008 Debentures arescheduled to be paid as follows:

 

**MonthlyPrincipal Payment Amount (in thousands)**

 
| **Date**  | ** ** | **January 2008  Debentures** | ** ** |
|-----------|------------|-----------------------------------|------------|
| 9/1/2008  |       | $                                 | 111        |   |
| 10/1/2008 |       | $                                 | 111        |   |
| 11/1/2008 |       | $                                 | 111        |   |
| 12/1/2008 |       | $                                 | 111        |   |
| 1/1/2009  |       | $                                 | 111        |   |
| 2/1/2009  |       | $                                 | 111        |   |
| 3/1/2009  |       | $                                 | 111        |   |
| 4/1/2009  |       | $                                 | 111        |   |
| 5/1/2009  |       | $                                 | 111        |   |
| 6/1/2009  |       | $                                 | 111        |   |
| 7/1/2009  |       | $                                 | 111        |   |
| 8/1/2009  |       | $                                 | 111        |   |
| 9/1/2009  |       | $                                 | 111        |   |
| 10/1/2009 |       | $                                 | 111        |   |
| 11/1/2009 |       | $                                 | 111        |   |
| 12/1/09   |       | $                                 | 111        |   |
| 1/1/2010  |       | $                                 | 111        |   |
| 1/31/2010 |       | $                                 | 113        |   |
|      |       | $                                 | 2,000      |   |

 

Assuming monthly principal payments are made in accordance with theschedule set forth above, the amount of interest to be paid through the January 31,2010, maturity date is $240 thousand with respect to our January 2008Debentures, or on average, $13.3 thousand per month.

 

As of the filing date of this report, we have not made any of thepayments due and we do not have, or expect to have, cash on hand to make thepast payments due or any payments due in the near future.  We are in regular communication with theholders of the January 2008 Debentures and none of the holders havedemanded payment or exercised other remedies due to our non-payment, but noassurances can be given that the holders will not exercise their remedies inthe future.

 

**April 2008 Debentures**

 

In April 2008, we issued our April 2008 Debentures with anaggregate principal amount of $3.5 million. Under the terms of thesedebentures, we are to begin making monthly redemption payments on November 1,2008.  The maturity date of thesedebentures is April 30, 2010. The total monthly principal payment amountson our April 2008 Debentures are scheduled to be paid as follows:

 

**MonthlyPrincipal Payment Amount (in thousands)**

 
| **Date**  | ** ** | **April 2008  Debentures** | ** ** |
|-----------|------------|---------------------------------|------------|
| 11/1/2008 |       | $                               | 194        |   |
| 12/1/2008 |       | $                               | 194        |   |
| 1/1/2009  |       | $                               | 194        |   |
| 2/1/2009  |       | $                               | 195        |   |
| 3/1/2009  |       | $                               | 194        |   |
| 4/1/2009  |       | $                               | 195        |   |
| 5/1/2009  |       | $                               | 194        |   |
| 6/1/2009  |       | $                               | 195        |   |
| 7/1/2009  |       | $                               | 194        |   |
| 8/1/2009  |       | $                               | 195        |   |
| 9/1/2009  |       | $                               | 194        |   |
| 10/1/2009 |       | $                               | 195        |   |
| 11/1/2009 |       | $                               | 194        |   |
| 12/1/09   |       | $                               | 195        |   |
| 1/1/2010  |       | $                               | 194        |   |
| 2/1/2010  |       | $                               | 195        |   |
| 3/1/2010  |       | $                               | 194        |   |
| 4/1/2010  |       | $                               | 195        |   |
|      |       | $                               | 3,500      |   |

 

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Assuming monthly principal payments are made in accordance with theschedule set forth above, the amount of interest to be paid through the April 30,2010, maturity date is $420 thousand with respect to our April 2008Debentures, or on average, $23.3 thousand per month.

 

As of the filing date of this report, we have not made any of thepayments due and we do not have, or expect to have, cash on hand to make thepast due payments or any payments due in the near future. We are in regularcommunication with the holders of the April 2008 Debentures and none ofthe holders have demanded payment or exercised other remedies due to ournon-payment, but no assurance can be given that the holders will not exercisetheir remedies in the future.

 

Because we do not meet the equity conditions that would permit us topay interest and monthly principal payments due in respect of our January 2008and April 2008 Debentures in stock, our only option at this time is tomake these payments in cash, which we currently do not have the financialresources to do.  We are evaluating otherequity financing opportunities, the proceeds of which could be used to repaythe debentures, but we have no commitments or arrangements in place for futurefinancing at this time and we can give no assurance that such financing will beavailable on favorable terms, or at all.

 

Because we have failed to make payments when due on our September 2007notes and our January 2008 Debentures and April 2008 Debentures, weare currently in default under such securities. The holders of such securities may demand that all amounts duethereunder be immediately paid in cash, and with respect to our January Debenturesand April Debentures, the holders may demand that we pay 130 percent ofthe outstanding principal amount and the interest rate accrues at a rate equalto the lesser of 18% per annum or the maximum rate permitted under applicablelaw.  If such demand was made, then wewould not currently have the financial resources to make the paymentsowed.  In addition, the holders of our January Debenturesand April Debentures may have the right to foreclose on substantially allof our assets pursuant to the terms of the security agreement we entered intowith such holders and they would have the right to take possession of ourassets and operate our business. Although we are in regular communication with the holders of ouroutstanding debt securities and none of them have demanded payment or exercisedother remedies due to our current default under such securities, we can give noassurance that the holders will not make such demands or exercise theirremedies in the future.

 

**Operating and Capital Leases**

 

We have non-cancelable leases for corporate facilities andequipment.  Rent expense under the leasestotaled $254 thousand and $147 thousand for the periods ended December 31,2008 and 2007, respectively.  Futureminimum rental payments required under non-cancelable leases are as follows forthe twelve months ended December 31:

 
| ** **                                          | ** ** | **Operating  Leases** | ** ** | **Capital  Leases** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|---------------------|------------|
|                                                |       |                  |       |                |       |
| 2009                                                |       | $                     | 241        |                | $          | 21 |   |
| 2010                                                |       | 54                    |       | 13                  |       |
| 2011                                                |       | 6                     |       | 13                  |       |
| 2012                                                |       | 5                     |       | 2                   |       |
| 2013                                                |       | 2                     |       | —              |       |
| Total minimum lease  payments                       |       | $                     | 308        |                | $          | 49 |   |
| Less: amount representing  interest                 |       |                  |       | (16                 | )          |
| Present value of minimum  lease payments            |       |                  |       | 33                  |       |
| Less: current portion of  capital lease obligations |       |                  |       | (9                  | )          |
| Long-term capital lease  obligations                |       |                  |       | $                   | 24         |   |

 

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On October 31, 2008, we closed our offices in San Mateo,California and abandoned the leased premises of our offices there. Also on October 31,2008, we relocated our Washington offices and abandoned the leased premises ofour former offices in Renton, Washington. The landlord for the San Mateo, California leased premises has asserteda claim against us for $659 thousand and other amounts and filed suit againstus in the Superior Court of San Mateo County, California (Case No. CIV479535).  We intend to defend thisclaim.  The landlord for the Renton,Washington location has not yet asserted any claim, but the assertion of suchclaims, and the need for us to defend such claims, is foreseeable.

 

**Off Balance Sheet Arrangements**

 

We did not have any off-balance sheet arrangements as of the periodended December 31, 2008.

 

**Going Concern Issue**

 

We remain dependent on outside sources of funding until our results ofoperations provide positive cash flows. Our independent auditors issued a going concern explanatory paragraph intheir report dated April 24, 2009. With our current level of funding,substantial doubt exists about our ability to continue as a going concern.

 

During the year ended December 31, 2008, we have been unable togenerate cash flows sufficient to support our operations and have beendependent on debt and equity raised from qualified individual investors.

 

These factors raise substantial doubt about our ability to continue asa going concern.  The financialstatements contained herein do not include any adjustments relating to therecoverability and classification of recorded asset amounts or amounts andclassification of liabilities that might be necessary should we be unable tocontinue in existence.  Our ability tocontinue as a going concern is dependent upon our ability to generatesufficient cash flows to meet our obligations on a timely basis, to obtainadditional financing as may be required, and ultimately to attain profitableoperations.  However, there is noassurance that profitable operations or sufficient cash flows will occur in thefuture.

 

We have supported current operations by raising additional operatingcash through 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: (1) raising capital throughadditional sale of our common stock and/or debentures and (2) reducingcash operating expenses to levels that are in line with current revenues.

 

The first alternative could result in substantial dilution of existingstockholders. There can be no assurance that our current financial position canbe improved, that we can raise additional working capital, or that we canachieve positive cash flows from operations. Our long-term viability as a goingconcern is dependent upon our ability to (i) locate sources of debt orequity funding to meet current commitments and near-term future requirementsand (ii) achieve profitability and ultimately generate sufficient cashflow from operations to sustain our continuing operations.

 

**Recent Accounting Pronouncements**

 

In May 2008, the FASBissued SFAS No. 162 (“SFAS 162”), *TheHierarchy of Generally Accepted Accounting Principles*.  SFAS162 identifies the sources of accounting principles and the framework forselecting principles to be used in the preparation of financial statements ofnongovernmental entities that are presented in conformity with generallyaccepted accounting principles in the United States.  SFAS 162 waseffective on November 15, 2008 and upon adoption of SFAS 162 there was nomaterial impact on our financial statements.

 

In March 2008, the FASB issued SFAS No. 161(“SFAS 161”)*, Disclosures about Derivative Instruments and Hedging Activities-anamendment of SFAS No. 133*. This new standard requiresenhanced disclosures for derivative instruments, including those used inhedging activities. SFAS 161 is effective for fiscal years and interim periodsbeginning after November 15, 2008. We have not yet determined the impact,if any, that the adoption of SFAS 161 will have on our financial statements andrelated disclosures.

 

EffectiveJanuary 1, 2008, the Company adopted Statements of Financial AccountingStandards (“SFAS”) No.157, *Fair Value Measurements*,which defines fair value as the price that would be received from selling anasset or paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. SFAS 157 establishes guidelines formeasuring fair value and expands disclosures regarding fair value measurements.The adoption of SFAS 157 did not have an impact on the Company’s financialposition, results of operations, or cash flows.

 

TheCompany also adopted SFAS 159, *The FairValue Option for Financial Assets and Financial Liabilities—including anamendment of FASB Statement No. 115,*during the first quarter offiscal 2009, but we did not elect the fair value measurement option for anyeligible financial instruments as of December 31, 2008. SFAS 159 allows anentity the irrevocable option to elect fair value for the initial andsubsequent measurement for certain financial assets and liabilities under aninstrument-by-instrument election. Subsequent measurements for the financialassets and liabilities an entity elects to fair value will be recognized inearnings. SFAS 159 also establishes additional disclosure requirements. Theadoption of SFAS 159 did not have any impact on the Company’s results ofoperations or the fair values of its financial assets and liabilities. We couldelect this option for new or substantially modified assets and liabilities inthe future.

 

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In December 2007, the FASB issued SFAS No. 141(R),“*Business Combinations”* (FAS141R), which requires an acquirer to measure the identifiable assets acquired,the liabilities assumed, and any noncontrolling interest in the acquiree attheir fair values on the acquisition date, with goodwill being the excess valueover the net identifiable assets acquired. FAS 141R is effective for financialstatements issued for fiscal years beginning after December 15, 2008.Also, in December 2007, the FASB issued SFAS No. 160, “*Noncontrolling Interests in Consolidated FinancialStatements,**an**amendment**ofARB No. 51”*  (FAS 160),which clarifies that a noncontrolling interest in a subsidiary should bereported as equity in the consolidated financial statements. The calculation ofearnings per share will continue to be based on income amounts attributable tothe parent. FAS 160 is effective for financial statements issued for fiscal yearsbeginning after December 15, 2008. We are currently evaluating the impactof adopting SFAS 141R and SFAS 160 on our financial position, cash flows, andresults of operations.

 

In June 2008, the FASB issued FSP No. EITF03-6-1, “*Determining Whether InstrumentsGranted in Share-Based Payment Transactions Are Participating Securities*”(FSP EITF 03-6-1), which requires entities to apply the two-class method ofcomputing basic and diluted earnings per share for participating securitiesthat include awards that accrue cash dividends (whether paid or unpaid) anytime common shareholders receive dividends and those dividends do not need tobe returned to the entity if the employee forfeits the award. FSP EITF 03-6-1will be effective for the Company on January 1, 2009, and will requireretroactive disclosure. The Company is currently evaluating the impact ofadopting FSP EITF 03-6-1 on its financial position, cash flows, and results ofoperations.

 

| **ITEM 7A.** | **QUANTITATIVE AND QUALITATIVE  DISCLOSURES ABOUT MARKET RISK** |
|--------------|-----------------------------------------------------------------|

 

As a smaller reporting company we are not required to provide theinformation required by this item.

 

** **

| **ITEM 8.** | **FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA** |
|-------------|-------------------------------------------------|

** **

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

 
| ** **                                                                                    | **Page** |
|-----------------------------------------------------------------------------------------------|----------|
| Report of Independent Registered Public Accounting  Firm                                      | F-1      |
| Balance Sheets as of December 31, 2008 and 2007                                          | F-2      |
| Statements of Operations for the years ended  December 31, 2008 and 2007                 | F-3      |
| Statements of Stockholders’ Deficit for the years  ended December 31, 2008 and 2007 | F-4      |
| Statements of Cash Flows for the years ended  December 31, 2008 and 2007                 | F-5      |
| Notes to Financial Statements                                                                 | F-6      |

** **

| **ITEM 9.** | **CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND FINANCIAL  DISCLOSURE** |
|-------------|--------------------------------------------------------------------------------------------|

** **

**None.**

** **

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

 

**Evaluation of Disclosure Controls andProcedures**

 

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, 2008.

 

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, 2008, at the reasonableassurance level for the reasons discussed below related to material weaknessesin our internal control over financial reporting.

 

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**Management’s Annual Report onInternal 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, 2008 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 have concluded that ourinternal control over financial reporting as of December 31, 2008, was noteffective because of the 100% turnover in accounting department personnel.Therefore, the following material weaknesses have been identified:

 
| 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; |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 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 additional material weaknesses maynot have been identified. We are in the process of attempting to remediate theabove noted material weaknesses, but that remediation was not complete as of December 31,2008, or the filing date of this report.

 

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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. However, our ability to remediate these 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 internalcontrol over financial reporting.

 

This annual report does not include an attestationreport of the company’s registered public accounting firm regarding internalcontrol over financial reporting. Management’s report was not subject to attestation by the company’sregistered public accounting firm pursuant to temporary rules of the SECthat permit the company to provide only management’s report in this annualreport.

 

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, notabsolute, 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.

 

**Changes In Internal Controls overFinancial Reporting.**

 

We made the following 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.

 

During the year ended December 31, 2008, our vicepresident and chief financial officer resigned, effective October 31,2008.   He remained an advisor andconsultant to us through the end of the quarter.   However, we have not yet appointed anyperson to serve as our dedicated chief financial officer and, due to ourlimited financial resources and the risks related to our ability to continue asa going concern, there is no assurance that such an appointment can be made, ifat all, in the near future.  Our chiefexecutive officer is currently serving as our acting chief financialofficer.  Therefore, we are unable toassure that we have adequate and appropriate controls in place, or that thecontrols that we do have in place are being managed appropriately.  We will attempt to engage additionalappropriate expertise to evaluate and manage our controls as soon as financialresources permit, but there is no assurance when, or if, that will be possiblein the foreseeable future.

 

| **ITEM 9B.** | **OTHER INFORMATION** |
|--------------|-----------------------|

** **

**None.**

** **

**PART III**

 

| **ITEM 10.** | **DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE  GOVERNANCE** |
|--------------|-------------------------------------------------------------|

** **

Our directors are elected by our stockholders to a term of one year andto serve until his or her successor is duly elected and qualified, or until hisdeath, resignation or removal. During the period ending December 31,2008, the Board elected Andy Liu and Robert Thordarson to fill two vacancies onthe Board.  Each of our officers isappointed by our board of directors to a term of one year and serves until hissuccessor is duly elected and qualified, or until his death, resignation orremoval from office.

 

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Our bylaws provide that the number of directors which shall constituteour whole board of directors shall not be less than one or more thannine.  The number of directors is determined by resolution of our board ofdirectors or by our stockholders at our annual meeting.  Our current boardof directors consists of four directors.

 

The following table sets forth certain information regarding ourexecutive officers and directors as of July 28, 2008:

 
| **Name**              | ** ** | **Position**                                                   | ** ** | **Age** |
|-----------------------|------------|----------------------------------------------------------------|------------|---------|
| Daniel J. A.  Kolke   |       | Chairman, Chief  Executive Officer and Chief Financial Officer | ** ** | 38      |
| Ronald A. Rudy        |       | Director                                                       | ** ** | 66      |
| Andy Liu              |       | Director                                                       |       | 32      |
| Robert L.  Thordarson |       | Director                                                       |       | 42      |

 

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

 

Mr. Kolke founded Etelos, Incorporated in May 1999.  Itis his vision and energy as the key architect that has driven development ofthe Etelos Ecosystem.  Mr. Kolke has served as a member of our boardof directors and as various executive officers since our inception in1999.  He has served as chairman of ourboard of directors since April 4, 2000. He was appointed our chief executive officer in September 2008 andas our acting chief financial officer in December 2008.

 

***Ronald A. Rudy.***

 

Ronald A. Rudy has served as a director since March 1, 2006.  He has been an independent investor andconsultant to the mortgage industry since September 2005. He foundedPortland Mortgage Company in 1983 and served as its president and chiefexecutive officer after it was acquired in 2004, until September 2005.Portland Mortgage Company was the largest independent Mortgage Banking Companyin Oregon and Southwest Washington.  Mr. Rudy served as president of the OregonMortgage Bankers Association in 1989 and as president of Oregon Executives in2003. Mr. Rudy served on the Board of Governors for The Mortgage BankersAssociation from 1996-2003 and on the National Board of Directors of TheMortgage Bankers Association in 2003-2004. He also was president of thePortland Guadalajara Sisters Association in 2000 and a member of its board ofdirectors from 1996-2001.

 

***Andy Liu.***

 

Andy Liu has served as a director since his appointment by the Board onAugust 8, 2008.  He is CEO ofBuddyTV, the largest independently held TV site on the Internet. Prior toBuddyTV, Mr. Liu served as President and CEO of NetConversions from1999-2004 prior to its sale to aQuantive and served as VP and GM of its SiteOptimization unit from 2004-2005. He is also a founder of a non-profit that isfocused on technology in developing countries and is very passionate aboutentrepreneurship. Mr. Liu brings deep experience in building companies,site optimization, viral marketing, SEO, community building and productdevelopment. In 2003, he was named to Puget Sound Business Journal’s “40 Under40.” Mr. Liu earned his MBA from Wharton.

 

***Robert L. Thordarson.***

 

Bob Thordarson has served as a director since his appointment by theBoard on September 24, 2008.  Hebrings 15 years of direct entrepreneurial experience to Etelos, most in theideation, funding, launch and growth of startups within the Telecommunicationsand Web Services marketplace. He is founder and CEO of BluCapp, a Web servicesstartup, co-founder of Cequint, Inc., a software company revolutionizingmobile Caller ID services, and President of TechFaith America, a mobile handsetODM headquartered in Beijing (CNTF) and expanding its reach to North America.He was formerly CEO and Co-Founder of Consumerware, a telecommunications devicedesign and manufacturing company focused on developing consumer products forNorth America’s largest telecommunications carriers. Mr. Thordarson bringshands-on operational and development experience to building companies, businessand partner development, managing diverse and distributed teams and channelmarketing. Mr. Thordarson studied Economics at the University ofWashington.

 

There are no family relationships among our directors or executiveofficers.  There are no arrangementsbetween any of our directors and any other person pursuant to which they havebeen appointed to the Board.

 

***Audit Committee***

*** ***

We have a separately designated audit committee of our board ofdirectors.  Our audit committee iscomprised of Messrs. Rudy, and Liu.

 

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***Code Of Ethics***

*** ***

Our board of directors adopted a “Code of Conduct and Policy forReporting Possible Violations” that applies to our directors and all employees,including our executive officers. Our code of ethics can be viewed by visitingour website at www.etelos.com and clicking on “Investors.” In the event we makeany amendments to, or grant any waivers of, a provision of our code of ethicsthat applies to our principal executive officer, principal financial officer,or principal accounting officer that requires disclosure under applicable SECrules, we intend to disclose such amendment or waiver and the reasons thereforon a Form 8-K or on our next periodic report in accordance with SEC rules.

 

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

*** ***

Section 16(a) of the Securities Exchange Act of 1934 requiresour officers and directors, and persons who own more than ten percent of aregistered class of our securities, to file with the SEC reports of ownershipof our securities and changes in reported ownership. Officers, directors andgreater than ten percent stockholders are required by SEC rules to furnishus with copies of all Section 16(a) reports they file.

 

Based solely on a review of the reports furnished to us, or writtenrepresentations from reporting persons that all reportable transaction werereported, we believe that during the fiscal year ended December 31, 2008,our officers, directors and greater than ten percent stockholders timely filedall reports they were required to file under Section 16(a), except asfollows: (i) on August 8, 2008, we appointed Mr. Andy Liu adirector and issued 10,000 stock options to Mr. Liu in connection with hisappointment; no form 3 or form 4 was filed in connection with this transaction;(ii) on September 24, 2008, we appointed Mr. Robert Thordarson adirector and issued 10,000 stock options to Mr. Thordarson in connectionwith his appointment; no form 3 or form 4 was filed in connection with thistransaction; in addition on December 3, 2008, we completed the sale of33,333 shares of our Series A Preferred Stock for $25 thousand and 25,000warrants to purchase common stock to Mr. Robert L. Thordarson; no form 4has been filed with respect to this transaction; (iii) on December 3,2008, we completed the sale of 333,333 shares of our Series A PreferredStock for $250 thousand and 250,000 warrants to purchase common stock to Mr. DanielJ.A. Kolke our Chief Executive Officer and Chairman; no form 4 has been filedwith respect to this transaction; and (iv) on December 3, 2008, wecompleted the sale of 133,333 shares of our Series A Preferred Stock for$100 thousand and 100,000 warrants to purchase common stock to Mr. RonaldA Rudy a director; no form 4 has been filed with respect to this transaction.

 

| **ITEM 11.** | **EXECUTIVE COMPENSATION** |
|--------------|----------------------------|

** **

**Summary Compensation**

 

The Summary Compensation Table below summarizes the total compensationpaid or earned by each of our named executive officers during the years ended December 31,2008 and 2007.  Throughout this prospectus, the individuals included inthe Summary Compensation Table set forth below are referred to as the “namedexecutive officers.”

 

**SummaryCompensation Table**

 
| **Name and Principal Position** | ** ** | **Year** | ** ** | **Salary  ($)** | ** ** | **Bonus  ($)** | ** ** | **Stock  Awards  (4)  ($)** | ** ** | **Option  Awards  (5)  ($)** | ** ** | **All Other  Compensation  ($)** | ** ** | **Total  ($)** | ** ** |
|------------------------------------------------|------------|----------|------------|-----------------|------------|----------------|------------|-----------------------------|------------|------------------------------|------------|---------------------------------------|------------|----------------|------------|
| Daniel J.A. Kolke (1)                          |       | 2008     |       | 130,594         |       | —         |       | —                      |       | —                       |       | —                                |       | 130,594        |       |
| Chief Executive Officer                        |       | 2007     |       | 127,158         |       | —         |       | —                      |       | 182,100                      |       | —                                |       | 309,256        |       |
|                                           |       |     |       |            |       |           |       |                        |       |                         |       |                                  |       |           |       |
| David MacKenzie (2)                            |       | 2008     |       | 84,375          |       | —         |       | —                      |       | 294,880                      |       | —                                |       | 379,255        |       |
| Former Chief Financial  Officer                |       | 2007     |       | —          |       | —         |       | —                      |       | —                       |       | —                                |       | —         |       |
|                                           |       |     |       |            |       |           |       |                        |       |                         |       |                                  |       |           |       |
| Jeffrey L. Garon (3)                           |       | 2008     |       | 117,807         |       | —         |       | —                      |       | —                       |       | —                                |       | 117,807        |       |
| Former Chief Executive  Officer                |       | 2007     |       | 67,813          |       | —         |       | 121,550                     |       | —                       |       | —                                |       | 189,363        |       |

 

----

(1) Mr. Kolke was appointed Chief ExecutiveOfficer in September 2008, prior to that time he served as our ChiefTechnology Officer.

(2) Mr. MacKenzieserved as our Chief Financial Officer from March 2008 until he resigned onOctober 31, 2008; all his options were forfeited.

(3) Mr. Garonserved as our Chief Executive Officer from August 2007 until hisemployment was terminated on September 18, 2008.

(4) Thisrepresents the fair market value, as determined by independent appraisal, of2,383,333 shares issued to Mr. Garon pursuant to his employment agreement.

(5) Representsthe amount recognized for financial statement reporting purposes in respect ofoutstanding option awards in accordance with SFAS 123(R). The assumptions madein valuing option awards reported in this column are discussed in Note 4, “Summaryof Business and Significant Accounting Policies” under “Stock-BasedCompensation” and Note 7, “Accounting for Share-Based Compensation” to ourfinancial statements included in this report.

 

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**Employment Agreements**

 

Under the terms of the agreement between us and Mr. Garonregarding his employment as our chief executive officer, Mr. Garon wasentitled to receive base salary in the amount of $175,000 payable in accordancewith our payroll policies. In addition, in connection with his employment, on August 11,2007, we issued Mr. Garon a restricted stock award of 2,383,333 shares ofcommon stock, of which 595,833 shares vested upon grant, another 595,833 sharesvested on August 11, 2008, and the balance vested ratably during theperiod following August 11, 2008. When Mr. Garon’s employment with uswas terminated, the unvested portion of the restricted stock award wasforfeited.

 

Under the terms of the agreement between us and Mr. Kolkeregarding his employment as our chief technology officer, Mr. Kolke isentitled to receive base salary in the amount of $175,000 payable in accordancewith our payroll policies. In addition, in connection with his employment, on August 11,2007, we granted Mr. Kolke an option to purchase up to 3,433,333 shares ofcommon stock at an exercise price of $0.051 per share, of which 858,333 optionsvested upon grant, 858,333 options vest on August 11, 2008, and thebalance vest ratably during the 24 months following August 11, 2008. Ifnot exercised, the option expires on August 11, 2017.

 

**Outstanding Equity Awards at Fiscal Year End**

 

The following table sets forth information concerning unexercisedoptions, stock that has not vested and equity incentive plan awards for eachnamed executive officer outstanding as of December 31, 2008:

 

**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  ($)** | ** ** | **Option  Expiration  Date** | ** ** | **Number  of  Shares  or  Units of  Stock  That  Have Not  Vested  (3)** | ** ** | **Market  Value of  Shares  or  Units of  Stock  That  Have Not  Vested  ($)(4)** | ** ** | **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 |       | 2,002,778                                                                          |       | 1,430,555                                                                            |       | — |   | 0.051 |   | 08-11-2017 |   | — |   | — |   | — |   | — |   |
| David MacKenzie   |       | 65,972                                                                             |       | —                                                                               |       |   |   | 1.20 |   | 03-18-2018 |   | — |   | — |   | — |   | — |   |
| Jeffrey L. Garon  |       | —                                                                             |       | —                                                                               |       | — |   | — |   | — |   | 1,241,320 |   | 409,636 |   | — |   | — |   |

 

----

(1) Consistsof (i) the vested portion of options granted to Mr. Kolke pursuant tohis employment agreement, and (ii) fully-vested options issued to Mr. MacKenzie.

(2) Consistsof the unvested portion of options issued to Mr. Kolke pursuant to hisemployment agreement, which vest over 36 months from August 2007.  Mr. MacKenzie terminated his employmentwith us on October 31, 2008, and any unvested options were forfeited atthat time.

(3) Consistsof shares issued to Mr. Garon subject to repurchase by us pursuant to hisemployment agreement, which vest over 36 months from August 2007.  Mr. Garon’s employment was terminated onSeptember 18, 2008, at that point in time 1,142,013 of a total of2,383,333 shares had vested.

(4) Based on$0.33 per share—the closing price for our common stock on December 31,2008.

 

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**Director Compensation**

 

On March 5, 2008, our board of directors adopted a boardcompensation plan providing for (a) existing non-executive board membersto receive options to acquire up to 10,000 shares of our common stock at anexercise price of $1.20 per share, which vest as to 50 percent on the 12 monthanniversary of the date of grant and the remaining 50 percent on the 24 monthanniversary of the date of grant; (b) new non-executive board members toreceive options to acquire up to 10,000 shares of our common stock at anexercise price equal to the fair market value of our common stock on the dateof grant, which vest as to 50 percent on the 12 month anniversary of the dateof grant and the remaining 50 percent on the 24 month anniversary of the dateof grant; (c) all re-elected board members to receive, upon theirre-election, options to acquire up to 10,000 shares of our common stock at anexercise price equal to the fair market value of our common stock on the dateof grant, which vest as to 100 percent on the 12 month anniversary of the dateof 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 committee meetings.

 

The table below sets forth the compensation the member of our board ofdirectors received during the fiscal year ended December 31, 2008.

 

**DirectorCompensation**

 
| **Name**                 | ** ** | **Fees Earned or  Paid in Cash  ($)** | ** ** | **Option Awards  ($)(4)** | ** ** | **All Other  Compensation  ($)** | ** ** | **Total  ($)** | ** ** |
|--------------------------|------------|------------------------------------------------------|------------|--------------------------------|------------|---------------------------------------|------------|----------------|------------|
| Ronald A. Rudy           |       | 0                                                    |       | 12,000                         |       | 0                                     |       | 12,000         |       |
| Andy Liu (1)             |       | 0                                                    |       | 62,500                         |       | 0                                     |       | 62,500         |       |
| Robert L. Thordarson (2) |       | 0                                                    |       | 16,500                         |       | 0                                     |       | 16,500         |       |
| Gregory Ruff (3)         |       | 0                                                    |       |                           |       | 0                                     |       | 0              |       |

 

----

(1) Mr. Liuwas appointed a director in August 2008.

(2) Mr. Thordardsonwas appointed a director in September 2008.

(3) Mr. Ruffresigned from our board of directors in August 2008, and his options wereforfeited.

(4) Represents the amount recognized forfinancial statement reporting purposes in respect of outstanding option awardsin accordance with SFAS 123(R). The assumptions made in valuing option awardsreported in this column are discussed in Note 4, “Summary of Business andSignificant Accounting Policies” under “Stock-Based Compensation” and Note [7],“Accounting for Share-Based Compensation” to our financial statements includedin this report. At December 31, 2008, the following option awards wereoutstanding: (a) Ronald Rudy 10,000 options, of which 50% have vested asof the date of this report; (b) Andy Liu 10,000 options, none of which hadvested; (a) Robert L. Thordarson 10,000 options, none of which had vested.

 

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.

 

| **ITEM 12.** | **SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS** |
|--------------|------------------------------------------------------------------------------------------------------|

 

The following table sets forth certain information with respect to thebeneficial ownership of our common stock as of March 31, 2009, by (i) anyperson or group owning more than 5 percent of our common stock, (ii) eachdirector, (iii) each of our named executive officers, and (iv) allnamed executive officers and directors as a group.  As of March 31,2009, we had 23.027,064 shares of common stock issued and outstanding and833,333 shares of New Series A Preferred stock issued and outstanding.  Beneficial ownership is determined in accordance with Rule 13d-3(d) promulgatedby the SEC under the Exchange Act and includes shares which can be acquiredwithin 60 days through exercise or conversion of a security.  Unlessotherwise stated, each beneficial owner has sole power to vote and dispose ofthe shares and the address of such person is c/o Etelos, Inc., 26828 MapleValley Highway #297, Maple Valley, Washington, 93038.

 

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| **Name and Address of Beneficial Owner** | ** ** | **Amount and Nature of  Beneficial Ownership** | ** ** | **Percentage of Class  Beneficially Owned** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| **Officers and Directors**                                        |       |                                                               |       |                                                       |       |
| Daniel J. A. Kolke                                                |       | 3,309,631                                                          | (1)        | 12.8                                                       | %          |
| David S. G. MacKenzie                                             |       | 1,000                                                              |       | 0.00                                                       | %          |
| Jeffrey L. Garon                                                  |       | 2,384,333                                                          |       | 10.4                                                       | %          |
| Ronald A. Rudy                                                    |       | 991,894                                                            | (2)        | 4.3                                                        | %          |
| Andy Liu                                                          |       | —                                                             |       | 0.0                                                        | %          |
| Robert L. Thordarson                                              |       | 37,500                                                             | (3)        | 0.0                                                        | %          |
| Directors and Officers as  a group                                |       | 6,550,773                                                          | (4)        | 25.6                                                       | %          |
| **5% Stockholders (other than  officers or directors)**           |       |                                                               |       |                                                       |       |
| Don Morissette                                                    |       | 9,353,650                                                          |       | 40.6                                                       | %          |
| Enable Capital Management  LLC                                    |       | 5,735,051                                                          | (5)        | 23.1                                                       | %          |

 

----

(1)               Consists of (i) 500,629 shares of common stock, (ii) 2,360,417shares of common stock issuable upon exercise of outstanding options, (iii) 187,500shares issuable upon conversion of outstanding Series A Preferred Stock, (iv) 187,500shares issuable upon exercise of outstanding warrants, and (v) 73,585shares of common stock held by Mr. Kolke’s spouse.

(2)               Consists of (i) 836,894 shares of common stock, (ii) 5,000shares of common stock issuable upon exercise of outstanding options, (iii) 75,000shares issuable upon conversion of outstanding Series A Preferred Stock,and (iv) 75,000 shares issuable upon exercise of outstanding warrants.

(3)               Consists of (i) 18,750 shares issuable uponconversion of outstanding Series A Preferred Stock, and (iv) 18,750issuable upon exercise of outstanding warrants.

(4)               Consists of (i) 3,722,856 shares of common stock,(ii) 2,365,417 shares issuable upon exercise of outstanding options, (iii) 281,250shares issuable upon conversion of outstanding Series A Preferred Stock,and (iv) 281,250 shares issuable upon conversion of outstanding warrants.

(5)               Enable Capital Management, LLC (“ECM”) acts as theinvestment manager of Enable Growth Partners LP (“EGP”), Enable OpportunityPartners LP (“EOP”), and Pierce Diversified Strategy Master Fund LLC, Ena (“Pierce”). By virtue of having the same investment manager, EGP, EOP, and Pierce may bedeemed to be affiliated entities.  Mitchell S. Levine (“Mr. Levine”and together with ECM, EGP, EOP, and Pierce, the “Investors”) is the ManagingMember of ECM and has delegated voting and dispositive power over thesecurities held by EGP, EOP, and Pierce.  Thus for the purposes of Reg. Section 240.13d-3,EGP, EOP, EOM, Pierce, and/or Mr. Levine may be deemed to be beneficialowners of more than 10% of the shares.  Mr. Levineholds 73,333 shares in his individual capacity. Accordingly, this tablereflects the aggregate holdings of EGP, EOP, Pierce and Mr. Levine. Otherthan the shares held by Mr. Levine in his individual capacity, ECM and Mr. Levinedo not hold directly any of the securities or derivative securities withrespect thereto, and disclaim any beneficial ownership of any of the securitiesor derivative securities reported or excluded herein for purposes of Rule 16a-1(a) underthe Exchange Act, except for their pecuniary interest therein.  ECM may becontacted at One Ferry Building Ste. 225, San Francisco, California 94111.

 

ECM, EGP, EOP, and Pierce collectively hold (i) 3,916,384 sharesof the common stock, (ii) warrants to purchase 444,444 shares of commonstock at an exercise price of $0.75 per share, subject to adjustments, (iii) a6% convertible note (“Note 1”) in the aggregate principal amount of $924,000,which is convertible into Shares at a conversion rate of $0.75 per share, (iv) a6% convertible note (“Note 2”) in the aggregate principal amount of $440,000,which is convertible into Shares at a conversion rate of $0.75 per share, (v) a6% convertible note (“Note 3”) in the aggregate principal amount of $1,000,000,which is convertible into Shares at a conversion rate of $0.75 per share, and (vi) aa 6% convertible note (“Note 4”, and together with Note 1, Note 2 and Note 3,collectively the “Notes”) in the aggregate principal amount of $3,000,000, whichis convertible into Shares at a conversion rate of $0.75 per share.  Note 3, Note 4, and the Warrants each containan issuance limitation prohibiting the Investors from exercising or convertingthe securities to the extent that such exercise would result in beneficialownership by the Investors of more than 4.99% of the Shares then issued andoutstanding.  Accordingly, Note 3, Note4, and the Warrants are not included in this table.

 

| **ITEM 13.** | **CERTAIN RELATIONSHIPS AND RELATED TRANSACTION,  AND DIRECTOR INDEPENDENCE** |
|--------------|-------------------------------------------------------------------------------|

 

**Related Transactions****.**

 

40

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On December 3,2008, we entered into a Securities Purchase Agreement in which we sold anaggregate of $575,000 of Series A Preferred Stock (the “Series APreferred Stock”) and warrants to purchase shares of the Company’s Common Stock(the “Warrants”).  Investors in the Series APreferred Stock included Daniel J.A. Kolke, our founder and CEO, who purchased$250,000 of Series A Preferred Stock and Warrants.  Other investors included Ronald A. Rudy andRobert L. Thordarson, members of our Board of Directors who purchased $100,000and $25,000 of Series A Preferred Stock and Warrants, respectively.  The sales to our CEO and Directors were madeon the same terms and conditions as other investors in the offering.

 

We previously entered into a series of loan transactions with theparents and two brothers of our chairman and chief executive officer, Mr. DanielJ.A. Kolke.  In connection with settlement of these loans, we issued threeunsecured promissory notes in the aggregate principal amount of $815.8 thousandwhich will become secured by certain of our presently unidentified assets ifand when Mr. Kolke is no longer neither an employee nor a member of our****board of directors. The unsecured promissory notes bear interest at 7.5 percent.  The amount outstanding as of December 31,2008 under the promissory notes was $685 thousand which was the largestaggregate principal amount outstanding during the year.  No principal or interest was paid on thesepromissory notes during the quarter ended December 31, 2008.

 

**Parent Companies****.**

 

We do not have a parent company.

 

**Director Independence****.**

 

Our board of directors currently consists offour members, Daniel J. A. Kolke, Ronald A. Rudy, Andy Liu and Robert L.Thordarson.  Messrs. Rudy, Liu and Thordarson are consideredindependent under the definition of independence established by The NasdaqStock Market.

 

| **ITEM 14.** | **PRINCIPAL ACCOUNTANT FEES AND SERVICES** |
|--------------|--------------------------------------------|

** **

We have selected Stonefield Josephson, Inc. as our independentregistered public accounting firm for 2009. The audit committee of our board ofdirectors intends to meet with the auditor in June 2009 to discuss theterms of the audit engagement for fiscal 2009. Stonefield Josephson was ourprincipal 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.

 

For purposes 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     |   | include 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 fees billed for servicesfrom January 1, 2008, to December 31, 2008, by Stonefield Josephson:

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

 

41

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The following table sets forth the aggregate fees billed for servicesfrom January 1, 2007, to December 31, 2007, by Stonefield Josephson:

 
| Audit Fees         |   | $      | 0      |   |
|--------------------|--------|--------|--------|--------|
| Audit Related Fees |   | $      | 0      |   |
| Tax Fees           |   | $      | 0      |   |
| All Other Fees     |   | $      | 0      |   |
|               |   |   |   |
| Total              |   | $      | 0      |   |

 

**Audit Committee Pre-Approval Policies andProcedures**

 

The policy of the audit committee of our board of directors is topre-approve all audit and permissible non-audit services provided by ourindependent auditors. These services may include audit services, audit-relatedservices, tax services and other services. Pre-approval is generally providedfor up to one year and any pre-approval is detailed as to the particularservice or category of services. The independent auditor and management arerequired to periodically report to the audit committee regarding the extent ofservices provided by the independent auditor in accordance with thispre-approval.  All of our audit expensesincurred in 2008 were pre-approved by our Audit Committee.

 

**PART IV**

 

| **ITEM 15.** | **EXHIBITS, FINANCIAL STATEMENT SCHEDULES** |
|--------------|---------------------------------------------|

** **

(a)    Documents filed as part ofthis Report:

 

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

 

(2) FinancialStatement Schedules—As a smaller reporting company we are not required toprovide the information required by this item.

 

(3) Exhibits

 

**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                   |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  |       | Plan Proponents’ Third Amended Plan of  Reorganization for the Debtor dated December 20, 2007 (1)                                                                                                                                       |
| 2.2                  |       | Agreement and Plan of Merger dated April 22,  2008 between Tripath Technology Inc. and Etelos, Incorporated (1)                                                                                                                              |
| 3.1                  |       | Amended and Restated Certificate of Incorporation  (1)                                                                                                                                                                                            |
| 3.2                  |       | Bylaws (1)                                                                                                                                                                                                                                        |
| 3.3                  |       | Certificate of Designation For Series A  Preferred Stock (3)                                                                                                                                                                                 |
| 4.1                  |       | Form of common stock purchase warrant issued in  connection with the January 2008 financing (1)                                                                                                                                         |
| 4.2                  |       | Form of original issue discount 6.0% senior  secured convertible debenture issued in connection with the January 2008  financing (1)                                                                                                    |
| 4.3                  |       | Form of common stock purchase warrant issued in  connection with the April 2008 financing (2)                                                                                                                                           |
| 4.4                  |       | Form of original issue discount 6.0% senior  secured convertible debenture issued in connection with the April 2008  financing (2)                                                                                                      |
| 4.5                  |       | Form of convertible promissory note issued by  Etelos, Incorporated in August and September 2007 (2)                                                                                                                               |
| 4.6                  |       | Form of three year Common Stock Purchase  Warrant dated December 3, 2008 (3)                                                                                                                                                            |
| 10.1                 |       | Loan and Security Agreement by and among Etelos,  Incorporated and Bridge Bank, National Association dated October 5, 2007  (1)                                                                                                              |
| 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 (1)                                                                                        |
| 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 |

 

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|   |   | (v) Crystal and Raymond D. Kolke (1)                                                                                                                                                                                                         |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.4   |   | Promissory Note dated December 30, 2007 issued  to Selma and Daniel A. Kolke (1)                                                                                                                                                             |
| 10.5   |   | Promissory Note dated December 30, 2007 issued  to Daniel J.A. Kolke (1)                                                                                                                                                                     |
| 10.6   |   | Promissory Note dated December 30, 2007 issued  to Desmond D. Kolke (1)                                                                                                                                                                      |
| 10.7   |   | Securities Purchase Agreement by and among Etelos,  Incorporated and the purchasers identified therein dated as of  January 31, 2008 (1)                                                                                                     |
| 10.8   |   | Registration Rights Agreement by and among Etelos, Incorporated  and the purchasers identified therein dated as of January 31, 2008 (1)                                                                                                      |
| 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 (1) |
| 10.10  |   | Securities Purchase Agreement by and among Etelos,  Incorporated and the purchasers identified therein dated as of April 22,  2008 (2)                                                                                                       |
| 10.11  |   | Amendment to Registration Rights Agreement by and  among Etelos, Incorporated and the purchasers identified therein dated as of  April 22, 2008 (2)                                                                                          |
| 10.12# |   | Employment Agreement dated August 11, 2007 with  Jeffrey L. Garon (2)                                                                                                                                                                        |
| 10.13# |   | Employment Agreement dated August 11, 2007 with  Daniel J.A. Kolke (2)                                                                                                                                                                       |
| 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 (2)                                                          |
| 10.15  |   | Letter Agreement dated May 2, 2008 (2)                                                                                                                                                                                                       |
| 10.16  |   | Form of Securities Purchase Agreement for  Series A Preferred Stock dated December 3, 2008 (3)                                                                                                                                     |
| 10.17  |   | Promissory Note dated April 17, 2009 issued to  Enable Growth Partners LP (4)                                                                                                                                                                |
| 11.1*  |   | Statement re Computation of Per Share Earnings  (included within the financial statements filed in this registration  statement)                                                                                                                  |
| 21.1   |   | Listing of Subsidiaries (1)                                                                                                                                                                                                                       |
| 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                                                                                 |

 

----

*     Filed with this report

#     Management contract orcompensatory plan or arrangement

(1) Incorporatedby reference to the registrant’s Current Report on Form 8-K filed on April 23,2008.

(2) Incorporatedby reference to the registrant’s Registration Statement on Form S-1 filedon May 8, 2008.

(3) Incorporatedby reference to the registrant’s Current Report on Form 8-K filed on December 5,2008.

(4) Incorporatedby reference to the registrant’s Current Report on Form 8-K filed on April 23,2009.

 

43

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**Tableof Contents**

** **

**SIGNATURES**

** **

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 

|                      | ** ** | **Etelos, Inc.** |
|---------------------------|------------|-----------------------|
|                      |       | (Registrant)          |
|                      |       |                  |
| Date: April 24, 2009 |       | /s/ Daniel J.A. Kolke |
|                      |       | By:                   | Daniel J.A. Kolke |
|                      |       | Title:                | Chief Executive Officer |

 

**POWER OF ATTORNEY**

 

KNOW ALL MEN BYTHESE PRESENTS, that each of the undersigned, being a director or officer ofEtelos, Inc., a Delaware corporation, hereby constitutes and appointsDaniel J.A. Kolke and Kennedy Brooks, or each of them individually, as his trueand lawful attorney-in-fact and agent, with full power of substitution andre-substitution, for him and in his name, place and stead in any and allcapacities, to sign any and all amendments to this annual report on Form 10-Kand to file the same, with all exhibits thereto and all other documents inconnection therewith, with the Securities and Exchange Commission, grantingunto said attorney-in-fact and agents, and each of them, full power andauthority to do and perform each and every act and thing requisite andnecessary to be done that such annual report and its amendments shall complywith the Securities Act, and the applicable rules and regulations adoptedor issued pursuant thereto, as fully and to all intents and purposes as he orshe might or could do in person, hereby ratifying and confirming all that saidattorneys-in-fact and agents, or any of them or their substitute orre-substitute, may lawfully do or cause to be done by virtue hereof.

 

In accordance withthe Exchange Act, this report has been signed below by the following persons onbehalf of the registrant in the capacities and on the dates indicated.

 
| **Signature**            | ** ** | **Title**                                                          | ** ** | **Date**            |
|--------------------------|------------|--------------------------------------------------------------------|------------|---------------------|
| ** **               | ** ** | ** **                                                         | ** ** | ** **          |
| /s/ DANIEL J.A. KOLKE    |       | Chief Executive Officer and Director (Principal  Executive Officer |       | April 24, 2009 |
| Daniel J.A. Kolke        |       | and Principal Financial Officer)                                   |       |                |
|                     |       |                                                               |       |                |
| /s/ RONALD A RUDY        |       | Director                                                           |       | April 24, 2009 |
| Ronald A. Rudy           |       |                                                               |       |                |
|                     |       |                                                               |       |                |
| /s/ ANDY LIU             |       | Director                                                           |       | April 24, 2009 |
| Andy Liu                 |       |                                                               |       |                |
|                     |       |                                                               |       |                |
| /s/ ROBERT L. THORDARSON |       | Director                                                           |       | April 24, 2009 |
| Robert L. Thordarson     |       |                                                               |       |                |

 

44

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**ETELOS,INC.**

** **

**FINANCIAL STATEMENTS**

** **

**FOR THE YEARS ENDED DECEMBER 31, 2008 AND 2007**

** **

**TABLE OF CONTENTS**

 
|                                                                                          |   | **Page** |
|-----------------------------------------------------------------------------------------------|--------|----------|
| Report of Independent Registered Public Accounting  Firm                                      |   | F-1      |
| Balance  Sheets as of December 31, 2008 and 2007                                         |   | F-2      |
| Statements of Operations for the years ended  December 31, 2008 and 2007                 |   | F-3      |
| Statements of Stockholders’ Deficit for the years  ended December 31, 2008 and 2007 |   | F-4      |
| Statements of Cash Flows for the years ended  December 31, 2008 and 2007                 |   | F-5      |
| Notes to Financial Statements                                                                 |   | F-6      |

 

45

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** **

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

To the Board of Directorsand Stockholders of Etelos Inc.:

 

We have audited theaccompanying balance sheets of Etelos, Inc. as of December 31, 2008 and 2007,and the related statements of operations, stockholders’ deficit, and cash flowsfor each of the two years ended December 31, 2008 and 2007.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits. 

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. We were not engaged to perform an audit of theCompany’s internal control over financial reporting. Our audit includedconsideration of internal control over financial reporting as a basis for designingaudit procedures that are appropriate in the circumstances, but not for thepurpose of expressing an opinion on the effectiveness of the Company’s internalcontrol over financial reporting. Accordingly, we express no such opinion. Anaudit also includes examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits 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, 2008 and2007, and the results of their operations and their cash flows for each of thetwo years in the period ended December 31, 2008, in conformity with accountingprinciples generally accepted in the United States of America.

 

As described in Note 4 to the financial statements, the accompanyingfinancial statements have been prepared assuming that the Company will continueas a going concern. The Company’s recurring net losses and accumulated deficitraise substantial doubt about it’s ability to continue as a going concern.Management’s plans to address these matters are discussed in Note 4 to thefinancial statements. The financial statements do not include any adjustmentsthat might result from the outcome of this uncertainty.

 

 

/s/ Stonefield Josephson,Inc. 

 

San Francisco, California

April 24, 2009

 

F-1

----

Table of Contents

** **

**ETELOS, INC.BALANCE SHEETS**

(in thousands, except share data)
| ** **                                                                                                                                                             | ** ** | **December 31,   2008** | ** ** | **December 31,   2007** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
|                                                                                                                                                                   |       |                         |       |                         |       |
| ASSETS                                                                                                                                                                 |       |                         |       |                         |       |
| Current assets:                                                                                                                                                        |       |                         |       |                         |       |
| Cash and cash equivalents                                                                                                                                              |       | $                            | 7          |                         | $          | 928 |   |
| Accounts receivable, net                                                                                                                                               |       | 60                           |       | —                       |       |
| Prepaid expenses and other  current assets                                                                                                                             |       | 46                           |       | 21                           |       |
| Total current assets                                                                                                                                                   |       | 113                          |       | 949                          |       |
|                                                                                                                                                                   |       |                         |       |                         |       |
| Property and equipment,  net                                                                                                                                           |       | 82                           |       | 50                           |       |
| Other assets                                                                                                                                                           |       | 10                           |       | 41                           |       |
|                                                                                                                                                                   |       |                         |       |                         |       |
| **Total assets**                                                                                                                                                       | ** ** | **$**                        | **205**    | ** **                   | **$**      | **1,040** | ** ** |
|                                                                                                                                                                   |       |                         |       |                         |       |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIT                                                                                                                            |       |                         |       |                         |       |
| Current liabilities:                                                                                                                                                   |       |                         |       |                         |       |
| Accounts payable                                                                                                                                                       |       | $                            | 983        |                         | $          | 249 |   |
| Accounts payable related  parties                                                                                                                                      |       | 42                           |       | 56                           |       |
| Accrued payroll and  related expenses                                                                                                                                  |       | 399                          |       | 514                          |       |
| Other accrued expenses                                                                                                                                                 |       | 1,381                        |       | 236                          |       |
| Deferred revenue                                                                                                                                                       |       | 64                           |       | 8                            |       |
| Current portion convertible  notes payable, net of discounts                                                                                                           |       | 7,264                        |       | 3,139                        |       |
| Current portion other notes  payable                                                                                                                                   |       | 89                           |       | 27                           |       |
| Current portion notes  payable to related parties                                                                                                                      |       | 132                          |       | 187                          |       |
| Current portion capital  leases                                                                                                                                        |       | 9                            |       | 16                           |       |
| Warrant and derivative  liability                                                                                                                                      |       | 108                          |       | —                       |       |
| Total current liabilities                                                                                                                                              |       | 10,471                       |       | 4,432                        |       |
|                                                                                                                                                                   |       |                         |       |                         |       |
| Long-term convertible notes  payable, net of discounts, less current portion                                                                                           |       | —                       |       | 816                          |       |
| Long-term other notes  payable, less current portion                                                                                                                   |       | —                       |       | 73                           |       |
| Long-term notes payable to  related parties, less current portion                                                                                                      |       | 552                          |       | 629                          |       |
| Long-term capital leases, less  current portion                                                                                                                        |       | 24                           |       | 36                           |       |
|                                                                                                                                                                   |       |                         |       |                         |       |
| Total liabilities                                                                                                                                                      |       | 11,047                       |       | 5,986                        |       |
|                                                                                                                                                                   |       |                         |       |                         |       |
| Commitments and contingencies                                                                                                                                          |       |                         |       |                         |       |
|                                                                                                                                                                   |       |                         |       |                         |       |
| Stockholders’ deficit:                                                                                                                                            |       |                         |       |                         |       |
|                                                                                                                                                                   |       |                         |       |                         |       |
| Preferred stock, $0.01 par  value: 50,000,000 shares authorized with liquidation preferences:                                                                          |       |                         |       |                         |       |
| Series A: 4,166,667  shares authorized; issued and outstanding -no shares at December 31,  2008, and 22,167 at December 31, 2007                        |       | —                       |       | 665                          |       |
| New Series A: 3,333,333  shares authorized; issued and outstanding: 833,333 at December 31, 2008,  and no shares at December 31, 2007                   |       | 8                            |       | —                       |       |
| Series B: 7,500,000  shares authorized; issued and outstanding - no shares at December 31,  2008, and 40,000 at December 31, 2007                       |       | —                       |       | 2,400                        |       |
| Series C: 20,000,000  shares authorized; issued and outstanding - no shares at December 31,  2008, and 1,482,604 at December 31, 2007                   |       | —                       |       | 568                          |       |
| Common stock, $0.01 par  value: 250,000,000 shares authorized; issued and outstanding - 23,027,624 at  December 31, 2008, and 6,791,313 at December 31, 2007 |       | 231                          |       | 68                           |       |
| Additional paid-in capital                                                                                                                                             |       | 18,722                       |       | 1,787                        |       |
| Accumulated deficit                                                                                                                                                    |       | (29,803                      | )          | (10,434                      | )          |
| Total stockholders’  deficit                                                                                                                                      |       | (10,842                      | )          | (4,946                       | )          |
|                                                                                                                                                                   |       |                         |       |                         |       |
| **Total liabilities and  stockholders’ deficit**                                                                                                                  | ** ** | **$**                        | **205**    | ** **                   | **$**      | **1,040** | ** ** |

 

The accompanying notes are an integral part of these financialstatements

 

F-2

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Tableof Contents

 

**ETELOS,INC.**

**STATEMENTS OF OPERATIONS**

(in thousands,except per share data)

 
| ** **                                                                                       | ** ** | **Year Ended**   | ** **  |
|--------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|
| ** **                                                                                       | ** ** | **December 31,** | ** **  |
| ** **                                                                                       | ** ** | **2008**              | ** **  | **2007** | ** ** |
| ** **                                                                                       | ** ** | ** **            | ** **  | ** ** | ** ** |
| Revenue                                                                                          |       | $                     | 123         |   | $ | 304 |   |
| Cost of revenue                                                                                  |       | 542                   |        | 315 |   |
| Gross (loss)                                                                                     |       | (419                  | )           | (11 | ) |
|                                                                                             |       |                  |        |   |   |
| Operating expenses:                                                                              |       |                  |        |   |   |
| Research and development                                                                         |       | 2,646                 |        | 1,954 |   |
| Sales and marketing                                                                              |       | 1,662                 |        | 812 |   |
| General and administrative                                                                       |       | 3,153                 |        | 923 |   |
| Restructuring costs                                                                              |       | 632                   |        | — |   |
| Total operating expenses                                                                         |       | 8,093                 |        | 3,689 |   |
|                                                                                             |       |                  |        |   |   |
| Loss from operations                                                                             |       | (8,512                | )           | (3,700 | ) |
|                                                                                             |       |                  |        |   |   |
| Other expense                                                                                    |       |                  |        |   |   |
| Merger costs                                                                                     |       | 13,444                |        | — |   |
| Other expense                                                                                    |       | 14                    |        | — |   |
| Total other expense                                                                              |       | 13,458                |        | — |   |
|                                                                                             |       |                  |        |   |   |
| Other Income                                                                                     |       | —                |        | 106 |   |
|                                                                                             |       |                  |        |   |   |
| Interest expense, net                                                                            |       | (479                  | )           | (282 | ) |
| Amortization of notes  discount                                                                  |       | (2,872                | )           | (80 | ) |
| Change in valuation of  liability relating to embedded derivatives and warrants                  |       | 6,965                 |        | — |   |
| Beneficial conversion of  interest conversion                                                    |       | (991                  | )           | — |   |
| Total interest income (expense)                                                                  |       | 2,623                 |        | (362 | ) |
|                                                                                             |       |                  |        |   |   |
| Loss before taxes                                                                                |       | (19,347               | )           | (3,956 | ) |
|                                                                                             |       |                  |        |   |   |
| Provision for income taxes                                                                       |       | —                |        | — |   |
|                                                                                             |       |                  |        |   |   |
| **Net loss**                                                                                     | ** ** | **$**                 | **(19,347** | **)** | **$** | **(3,956** | **)** |
|                                                                                             |       |                  |        |   |   |
| Beneficial conversion upon  issuance of preferred stock                                          |       | (22                   | )           | — |   |
|                                                                                             |       |                  |        |   |   |
| Net loss available to  common stockholders                                                       |       | $                     | (19,369     | ) | $ | (3,956 | ) |
|                                                                                             |       |                  |        |   |   |
| Basic and diluted net loss  per share available to common stockholders                           |       | $                     | (0.81       | ) | $ | (0.73 | ) |
|                                                                                             |       |                  |        |   |   |
| Weighted average number of  common shares used in computing basic and diluted net loss per share |       | 23,861                |        | 5,391 |   |

 

The accompanying notes are an integral part of these financialstatements

 

F-3

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Tableof Contents

 

**ETELOS,INCORPORATED**

**STATEMENTS OF STOCKHOLDERS’ DEFICIT**

**(inthousands, except share data)**

 
| ** **                                                                                                     | ** ** | **Preferred Stock**     | ** ** | ** **                 | ** ** | ** **                   | ** **  | ** **                   | ** ** | ** **            | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|----------------------------|------------|------------------------------|-------------|------------------------------|------------|-----------------------|------------|
| ** **                                                                                                     | ** ** | **Series A**            | ** ** | ** **                 | ** ** | **Series B**            | ** **  | **Series C**            | ** ** | ** **            | ** ** | **Additional** | ** ** | ** ** | ** ** | **Total** | ** ** |
| ** **                                                                                                     | ** ** | **(Adjusted for par value)** | ** ** | **New Series A** | ** ** | **(Adjusted for par value)** | ** **  | **(Adjusted for par value)** | ** ** | **Common Stock** | ** ** | **paid in** | ** ** | **Accumulated** | ** ** | **stockholders’** | ** ** |
| ** **                                                                                                     | ** ** | **Shares**                   | ** ** | **Amount**                 | ** ** | **Shares**                   | ** **  | **Amount**                   | ** ** | **Shares**            | ** ** | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **capital** | ** ** | **deficit** | ** ** | **equity** | ** ** |
| Adjusted to reflect effect of 3:1 stock split, par  value adjustment and reverse merger on April 23, 2008 |       |                         |       |                       |       |                         |        |                         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                           |       |                         |       |                       |       |                         |        |                         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Balance at December 31, 2006**                                                                          | ** ** | **22,167**                   | ** ** | **$**                      | **665**    | ** **                   | **—**  |                         | **$**      | **—**            | ** ** | **40,000** | ** ** | **$** | **2,400** | ** ** | **1,482,604** | ** ** | **$** | **568** |   | **3,501,647** | ** ** | **$** | **35** | ** ** | **$** | **719** | ** ** | **$** | **(6,478** | **)** | **$** | **(2,091** | **)** |
|                                                                                                           |       |                         |       |                       |       |                         |        |                         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of common stock for investment bank fees                                                              |       | —                       |       | —                     |       | —                       |        | —                       |       | —                |       | — |   | — |   | — |   | 30,000 |   | — |   | 90 |   | — |   | 90 |   |
|                                                                                                           |       |                         |       |                       |       |                         |        |                         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of common stock for warrants exercised                                                                |       | —                       |       | —                     |       | —                       |        | —                       |       | —                |       | — |   | — |   | — |   | 876,333 |   | 9 |   | 784 |   | — |   | 793 |   |
|                                                                                                           |       |                         |       |                       |       |                         |        |                         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of common stock for officer’s service                                                            |       | —                       |       | —                     |       | —                       |        | —                       |       | —                |       | — |   | — |   | — |   | 2,383,333 |   | 24 |   | 97 |   | — |   | 121 |   |
|                                                                                                           |       |                         |       |                       |       |                         |        |                         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Stock based compensation                                                                                       |       | —                       |       | —                     |       | —                       |        | —                       |       | —                |       | — |   | — |   | — |   | — |   | — |   | 27 |   | — |   | 27 |   |
|                                                                                                           |       |                         |       |                       |       |                         |        |                         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of options for note settlement                                                                        |       | —                       |       | —                     |       | —                       |        | —                       |       | —                |       | — |   | — |   | — |   | — |   | — |   | 65 |   | — |   | 65 |   |
|                                                                                                           |       |                         |       |                       |       |                         |        |                         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of warrants for financing agreement                                                                   |       | —                       |       | —                     |       | —                       |        | —                       |       | —                |       | — |   | — |   | — |   | — |   | — |   | 5 |   | — |   | 5 |   |
|                                                                                                           |       |                         |       |                       |       |                         |        |                         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                                       |       | —                       |       | —                     |       | —                       |        | —                       |       | —                |       | — |   | — |   | — |   | — |   | — |   | — |   | (3,956 | ) | (3,956 | ) |
|                                                                                                           |       |                         |       |                       |       |                         |        |                         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **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 to creditors in connection  with merger                                               |       | —                       |       | —                     |       | —                       |        | —                       |       | —                |       | — |   | — |   | — |   | 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 on 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 preferred  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** | **)** |
|                                                                                                                |            |                              |            |                            |            |                              |             |                              |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes form an integral part of these financialstatements

 

F-4

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Tableof Contents

 

**ETELOS,INC.**

**STATEMENTS OF CASH FLOWS**

(in thousands)

 
| ** **                                                                                 | ** ** | **Year Ended**   | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                 | ** ** | **December 31,** | ** ** |
| ** **                                                                                 | ** ** | **2008**              | ** ** | **2007** | ** ** |
| ** **                                                                                 | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Cash flows from operating  activities:**                                                 |       |                  |       |   |   |
| Net loss                                                                                   |       | $                     | (19,347    | ) | $ | (3,956 | ) |
| Adjustments to reconcile  net loss to net cash provided by (used in) operating activities: |       |                  |       |   |   |
| Depreciation and  amortization                                                             |       | 32                    |       | 16 |   |
| Amortization of notes  discount                                                            |       | 2,872                 |       | 80 |   |
| Amortization of financing  fees                                                            |       | 323                   |       | — |   |
| Stock based compensation                                                                   |       | 107                   |       | 27 |   |
| Beneficial conversion  feature                                                             |       | 991                   |       | — |   |
| Change in valuation of  liability relating to embedded derivatives and warrants            |       | (7,156                | )          | — |   |
| Settlement Expenses paid  through issuance of warrants                                     |       | 130                   |       | — |   |
| Merger costs paid in  common stock                                                         |       | 13,177                |       | — |   |
| Gain on settlement of debt                                                                 |       | —                |       | (106 | ) |
| Issuance of stock for bank  fees                                                           |       | —                |       | 90 |   |
| Issuance of warrants for  financing arrangement                                            |       | —                |       | 5 |   |
| Changes in operating  assets and liabilities:                                              |       |                  |       |   |   |
| Accounts receivable, net                                                                   |       | (60                   | )          | 11 |   |
| Prepaid expenses and other  current assets                                                 |       | (25                   | )          | 49 |   |
| Other assets                                                                               |       | (58                   | )          | (41 | ) |
| Accounts payable                                                                           |       | 734                   |       | 35 |   |
| Accounts payable related  parties                                                          |       | (14                   | )          | 47 |   |
| Accrued payroll and  related expenses                                                      |       | (115                  | )          | 381 |   |
| Other accrued expenses                                                                     |       | 1,308                 |       | 304 |   |
| Deferred revenue                                                                           |       | 56                    |       | (2 | ) |
|                                                                                       |       |                  |       |   |   |
| **Net cash used in operating  activities -**                                               | ** ** | **(7,045**            | **)**      | (3,060 | ) |
|                                                                                       |       |                  |       |   |   |
| **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                                                               |       | 6,442                 |       | 3,624 |   |
| Payments of note payable                                                                   |       | (954                  | )          | (30 | ) |
| Proceeds from issuance of  common stock                                                    |       | 460                   |       | 793 |   |
| Proceeds from issuance of  preferred stock                                                 |       | 625                   |       | — |   |
| Payment of fees on  financing transactions                                                 |       | (234                  | )          | — |   |
| Proceeds from notes  payable to related parties                                            |       | —                |       | 6,443 |   |
| Payments of notes payable  to related parties                                              |       | (132                  | )          | — |   |
| Payment of capital leases                                                                  |       | (19                   | )          | (14 | ) |
| Net change in line of  credit                                                              |       | —                |       | (450 | ) |
|                                                                                       |       |                  |       |   |   |
| **Net cash provided by financing  activities**                                             | ** ** | **6,188**             |       | 3,973 |   |
| ** **                                                                                 | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Net increase (decrease) in cash  and cash equivalents**                                  | ** ** | **(921**              | **)**      | 913 |   |
| ** **                                                                                 | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Cash, and cash equivalents,  beginning of period**                                       | ** ** | **928**               |       | 15 |   |
| ** **                                                                                 | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Cash, and cash equivalents, end  of period**                                             | ** ** | **$**                 | **7**      | ** ** | **$** | **928** | ** ** |
|                                                                                       |       |                  |       |   |   |
| **Supplemental disclosure of cash  flow information:**                                     |       |                  |       |   |   |
| Cash paid for interest                                                                     |       | $                     | 126        |   | $ | — |   |
|                                                                                       |       |                  |       |   |   |
| **Supplemental disclosure of  non-cash financing activities:**                             |       |                  |       |   |   |
| Issuance of common stock  for convertible debt                                             |       | $                     | 2,394      |   | $ | — |   |
| Issuance of common stock  for interest conversion                                          |       | $                     | 199        |   | $ | — |   |
| Issuance of detachable  warrants                                                           |       | $                     | 73         |   | $ | — |   |
| Issuance of common stock  for anti-dilution                                                |       | $                     | 55         |   | $ | 42 |   |
| Repurchase of common stock                                                                 |       | $                     | (36        | ) | $ | — |   |
| Conversion of preferred  stock to common stock                                             |       | $                     | 15         |   | $ | — |   |
| Settlement of notes  payable for warrants                                                  |       | $                     | —     |   | $ | 65 |   |
| Issuance of notes for a  discount                                                          |       | $                     | —     |   | $ | 302 |   |

 

The accompanying notes are an integral part of these financialstatements

 

F-5

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Tableof Contents

 

**NOTES TO FINANCIAL STATEMENTS**

***1. Organization***

 

On February 8, 2007, Tripath Technology Inc., a Delawarecorporation (“Tripath”) filed a voluntary petition for relief under Chapter 11of the Bankruptcy Code. On February 1, 2008, the bankruptcy court issuedan order confirming approval of the Plan of Reorganization, including themerger and the transfer of all of Tripath’s existing assets into a separatebankruptcy estate and the discharge of all of Tripath’s liabilities.  ThePlan of Reorganization also contemplated the merger of Etelos, Incorporated, aWashington corporation (“Etelos-WA”) with Tripath.  The overallimpact of the confirmed Plan of Reorganization was for Tripath to emerge fromthe bankruptcy proceeding with no assets and no liabilities as a shellcorporation and for all issued and outstanding securities of and interests inTripath, including debentures, stock options (including, but not limited to, allstock options granted to employees), warrants, and other shares of common stockto be canceled and extinguished.

 

On April 23, 2008, Tripath filed a Current Report on Form 8-Kannouncing, among other things, that Etelos-WA, merged with and into Tripath (the“Merger”), and that the surviving corporation changed its name to Etelos, Inc.and its fiscal year end to December 31.  The effective date of theMerger was April 22, 2008, and Etelos, Inc., as the survivingcorporation, will conduct the business and operations previously conducted byEtelos-WA.  In connection with the Merger, all outstanding shares ofEtelos-WA common stock were converted into shares of Etelos, Inc. commonstock on a three for one ratio: one share of Etelos Inc. common stock for everythree shares of common stock of Etelos-WA.  Also in connection with theMerger, (i) all outstanding shares of preferred stock of Etelos-WA wereconverted 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 the shares of TripathTechnology were cancelled. Also on April 23, 2008, Etelos, Inc.,formerly Tripath, amended its articles of incorporation with the state ofDelaware to change its total authorized shares of stock to 300,000,000 shares,of which 250,000,000 shares are designated “Common Stock” with a par value of$0.01 per share and 50,000,000 shares are designated “Preferred Stock” with apar 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.

 

Prior to the Merger, Tripath was a shell corporation and in accordancewith the Plan of Reorganization had no assets or liabilities.  WhileTripath acquired all the outstanding preferred and common stock of Etelos-WA,for accounting purposes, the acquisition has been treated as a recapitalizationof Etelos-WA with Etelos-WA as the acquirer (a reverse acquisition).  Thehistorical financial statements prior to April 22, 2008, are those ofEtelos-WA and reflect the operations of Etelos-WA for the year ended December31, 2007.  Proforma financial information giving effect to the acquisitionas if the acquisition took place on January 1, 2007, have not beenpresented 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 stock were valued at$2.63 per share, the estimated fair value of the common stock on the date ofthe Merger, which resulted in a charge to operations of $13.2 million includedin the caption Merger Related Costs in the accompanying Statement ofOperations.  Etelos, Inc. believes that these shares were issuedprimarily for past services provided to Etelos-WA by the secured creditors andthe release of the secured and unsecured creditors claims against Tripath.

 

Information concerning number of shares outstanding for Etelos, Inc.including the conversion prices and number of shares issuable upon conversionof convertible securities and exercise prices of warrants and stock options andthe number of shares issuable upon exercise of the options and warrants, hasbeen adjusted to reflect this stock split for all periods presented. Also, the Shareholders’ Deficit section of the accompanying Balance Sheet hasbeen adjusted to reflect the legal capital structure of Tripath adjusted forthe change in authorized shares of common and preferred stock.

 

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***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 thatsurvived the Merger.

 

Etelos has a Web Application distribution platform delivering WebApplications for businesses.  Etelosprovides a Software-as-a-Service (SaaS) ecosystem for building, distributing,and using Web Applications, including a marketplace to deploy and supportthem.  Unlike other cloud computing andPlatform-as-a-Service (PaaS) solutions, Etelos enables software manufacturersto migrate existing applications or create new applications, then package,distribute, host, bill, market and support their SaaS enabled applicationsthrough multiple private label applications marketplaces.

 

Etelos has developed products for Web Applications, which include openstandards-based tools for Web developers, businesses and individual users suchas the Etelos Application ServerTM (EASTM)and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support many common programminglanguages and also support the English Application Scripting Engine (EASETM), a simple-to-use openstandards-based scripting language developed by the Company.  In order to support broader adoption of itsproducts, EASE and other components of the EDE are made available to developersat 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, and support of theseapplications.  Etelos generally receivesa transaction fee or subscription fee for transactions that occur within theEtelos ecosystem either via the Etelos MarketplaceTM pursuant to StorefrontOperating Agreements, or in third-party branded Marketplaces operated by Etelospursuant to Marketplace Partner Agreements (sometimes referred to as “an EtelosMarketplace” or, collectively, as “the Etelos Marketplaces”).  Most customers in Etelos Marketplaces pay asubscription fee, which revenue Etelos shares with Syndication Partners andMarketplace Partners; this revenue share is calculated as a percentage of grossrevenues from the sale of subscriptions to customers of Syndication Partnerproducts and service in the Etelos Marketplaces.

 

Etelos maintains the majority of cashbalances and all short-term investments with one financial institution. 

 

***3. Summary of Significant AccountingPolicies***

 

***Basisof Presentation***

 

**These financial statements have been prepared by Etelos,Inc. (the “Company”), in accordance with accounting principles generallyaccepted in the United States of America and reflect all adjustments,consisting of normal recurring adjustments, which in the opinion of managementare necessary to state fairly the Company’s financial position, results ofoperations, and cash flows for the periods presented.**

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andreported amounts of revenues and expenses during the reporting period. Actualresults could differ from those estimates, and such differences could affectthe results of operations reported in future periods and such differences couldbe material.

 

*Cash and Cash Equivalents*

 

Cashconsists primarily of cash on deposit at federally-insured banks in the UnitedStates of America. Investment securities with maturity of ninety days or less at the time ofpurchase are considered cash equivalents. The Company’s investments areprimarily comprised of money market funds and certificate of deposit, the fairmarket value of which approximates cost.

 

*Accounts Receivable*

 

Accounts receivable are recorded at the invoicedamount and generally do not bear interest. Amounts collected on trade accountsreceivable are included in net cash provided by operating activities in thestatements of cash flows.

 

*Concentration of Credit Risk*

* *

Financial instruments that potentiallysubject the Company to concentration of credit risk consist primarily of cash,cash equivalents, and accounts receivable. Cash and cash equivalents are maintained in federally-insured banks in the United States of America.  Deposits in such banks may exceed USfederally-insured limits and be subject to the current risks and uncertaintiesof dealing with such US banks.

 

The Company’s accounts receivables arederived primarily from customers.  Forthe year ended December 31, 2008, to the date of this report, no singlecustomer accounted for 10% or more of the Company’s revenue in the years endedDecember 31, 2008 and 2007, nor for 10% or more of the Company’s accountsreceivable  in the years ended December31, 2008 and 2007.

 

*Allowance for Doubtful Accounts*

 

                The Companyprovides, when appropriate, an allowance for doubtful accounts to ensure tradereceivables are not overstated due to un-collectability. The collectability ofthe Company’s receivables is evaluated based on a variety of factors, includingthe length of time receivables are past due, indication of the customer’swillingness to pay, significant one-time events, and historical experience. Asof December 31, 2008 and 2007, the Company determined that an allowancefor doubtful accounts was not necessary or warranted.

 

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* *

*Deferred Revenue*

 

Deferred revenue represents money received orpromised but not recognized as revenue because the work has not been completedor the software subscription has been fully delivered, and therefore isdeferred until the work is completed or the software subscription is fullydelivered when it is then transferred to the appropriate revenue account. TheCompany does not have a concentration of risk in any one account assubscriptions tend to be subscribed to by many individual subscribers ascompared to a small number of large enterprises.

 

*Property and Equipment*

 

Property, furniture, and equipment are stated athistorical cost less accumulated depreciation and amortization. Depreciationand amortization are computed on a straight-line basis over the estimateduseful lives of the assets, which the Company currently believes are three tofive years. Fixed assets are composed of computer equipment under capitalleases with cost of $39 thousand in both years and with accumulateddepreciation of approximately $14 thousand and $7 thousand as of December 31,2008 and 2007, respectively. Depreciation expense for the years ended December31, 2008 and 2007 was approximately $32.5 thousand and $16.5 thousand,respectively.

 
| ** **                                         | ** ** | **December 31,**   | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|
| ** **                                         | ** ** | **2008**                | ** ** | **2007** | ** ** |
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| Details of property and  equipment are as follows: |       |                    |       |   |   |
| Computer equipment                                 |       | $                       | 88         |   | $ | 30 |   |
| Furniture and fixtures                             |       | 2                       |       | — |   |
| Leased equipment                                   |       | 39                      |       | 39 |   |
| Software                                           |       | 4                       |       | — |   |
|                                               |       | 133                     |       | 69 |   |
| Less: accumulated  depreciation and amortization   |       | (51                     | )          | (19 | ) |
|                                               |       | $                       | 82         |   | $ | 50 |   |

 

*Fair Value of Financial Instruments*

 

The Company’s balance sheet includes the followingfinancial instruments: cash, accounts receivable, accounts payable, and accruedliabilities. The Company considers the carrying amount of working capital itemsto approximate the fair value for these financial instruments because of therelatively short period of time between origination of the instruments andtheir expected realization.

 

*Research and Development andSoftware Development Costs*

 

Research and development expenses consist primarily of salaries,payroll taxes, benefits, and related expenditures for technology, softwaredevelopment, project management, and support personnel. Costs related to theresearch and development of new products, services and enhancements to existingproducts are expensed as provided for by SFAS NO. 86, “*Accounting for Costs of Computer Software to be Sold,Leased or Otherwise Marketed”* (SFAS 86).  Under SFAS 86, costsincurred in the research and development of new software products are expensedas incurred until technological feasibility is established. Research anddevelopment costs are capitalized beginning when a product’s technologicalfeasibility has been established and ending when the product is available forgeneral release to customers. Technological feasibility is reached when theproduct reaches the working model stage. To date, products and enhancementshave generally reached technological feasibility and have been released forsale at substantially the same time and all research and development costs havebeen expensed.

 

Statement of Position 98-1, “*Accountingfor Costs of Computer Software Developed or Obtained for Internal Use”*(SOP 98-1), which applies to SaaS business model, are met for thecapitalization of software development cost.  Under SOP 98-1, softwaredevelopment costs, including costs incurred to purchase third party software,are capitalized beginning when the Company has determined certain factors arepresent, including, among others, that technology exists to achieve theperformance requirements, buy versus internal development decisions have beenmade, and the Company’s management has authorized the funding for the project.Capitalization of software development costs ceases when the software issubstantially complete and is ready for its intended use.  To date, nosoftware development costs incurred have met the criteria set forth in SOP 98-1for capitalization.

 

*Revenue Recognition*

 

Etelos distributes Web Applications and it Marketplace Platform as asubscription service using the SaaS or software-on-demand business model andallow third parties to offer their products or services through storefronts inan Etelos Marketplace, and to advertise on its web site or in its magazine fora fee.  It also license certain of its software products under perpetualand term licenses.  Revenues are recognized on these service and licensingtransactions using the criteria in SEC Staff Accounting Bulletin 104, “*Revenue Recognition in Financial Statements”,*and SOP 97-2, “*Software Revenue Recognition*”,respectively, which both provide that revenue may be recognized when all of thefollowing are met:

 

·                  persuasive evidence of an arrangementexists,

·                  the product or service has beendelivered,

·                  the fee is fixed or determinable, and

·                  collection of the resultingreceivable is reasonably assured or probable.

 

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For the SaaS business model, persuasive evidence is generally anacceptance 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 the period the SaaS is provided.

 

For software licensed under term or perpetual agreements, persuasiveevidence of an arrangement is evidenced by a binding agreement signed by thecustomer and delivery generally occurs upon delivery of the software to acommon carrier. If a significant portion of a fee is due after our normalpayment terms of typically 30 days, then we recognize revenue as the feesbecome 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.

 

Advertising on the Company’s web site is recognized as revenue over theperiod the advertisement appears on its web site and advertising presented in itsmagazine is recognized upon publication of the magazine provided the othercriteria for revenue recognition set forth above have been met.

 

Arrangements for which the fees are not deemed reasonably assured forcollection are recognized upon cash collection.

 

*Stock Based Compensation*

 

The Company, under SFAS No. 123 (revised 2004), “*Share-Based Payment*”**(FAS 123R), is applying the “modifiedprospective method” and used the Black-Scholes Merton model to value all newstock based compensation awards granted starting January 1, 2007, and forany modification, cancellation, or repurchase of awards granted prior to January 1,2007.  As a result, the Company has recorded compensation cost in thestatement of operations based on the fair value of the award for the requisiteservice period. FAS 123(R) also requires the Company to estimateforfeitures in calculating the expense relating to share-based compensation asopposed to only recognizing these forfeitures and the corresponding reductionin expense as they occur. This resulted in $107 thousand and $27 thousand ofexpense for the years ended December 31, 2008 and 2007, respectively.

 

FAS 123(R) requires the cash flows resulting from the tax benefitsresulting from tax deductions in excess of the compensation cost recognized forthose options to be classified as financing cash flows. Due to its lossposition, there were no such tax benefits during year ended December 31, 2008.Prior to the adoption of FAS 123(R), those benefits would have been reported asoperating cash flows had we received any tax benefits related to stock optionexercises.

 

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*Income Taxes*

* *

The Company accountsfor income taxes in accordance with SFAS No. 109, “*Accounting for Income Taxes*” which utilizes the liabilitymethod of accounting for income taxes. Deferred tax assets and liabilities arerecognized for the future tax consequences attributable to differences betweenthe financial statement carrying amount of existing assets and liabilities andtheir respective tax bases. Deferred tax assets and liabilities are measuredusing enacted tax rates expected to apply to taxable income in the years inwhich those temporary differences are expected to be recovered or settled.Valuation allowances are established when necessary to reduce deferred taxassets to the amounts expected to be realized.

 

The Companyadopted the provisions of Financial Accounting Standards Board (“FASB”)Interpretation No. 48, “*Accounting for Uncertaintyin Income Taxes – an Interpretation of FASB Statement No. 109*” (“FIN48”) on January 1, 2007. The Company did not have any unrecognized tax benefitsand there was no effect on its financial condition or results of operations asa result of implementing FIN 48.

 

The Company filesincome tax returns in the United States of America federal jurisdiction andvarious state jurisdictions in the United States of America.  The Company does not believe that there wilbe 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 FIN 48.  In addition, the Company did not record acumulative effect adjustment related to the adoption of FIN 48.  

 

The Company’spolicy is to recognize interest and penalties accrued on any unrecognized taxbenefits as a component of income tax expense. As of the date of the adoption of FIN 48, the Company did not have anyaccrued interest or penalties associated with any unrecognized tax benefits,nor was any such interest expense recognized during the year ended December 31,2008, or December 31, 2007.  The Company’seffective tax rate differs from the federal statutory rate primarily due toincreases in its deferred income tax vauation allowance.

 

*Net Loss per Share*

 

Basic net loss per share is computed by dividing the net loss availableto common stockholders for the period by the weighted average number of sharesof common stock outstanding during the period, excluding any unvestedrestricted stock that is subject to repurchase. Diluted net income per share iscomputed using the weighted average number of common shares and, if dilutive,potential common shares outstanding during the period. Potential common sharesconsist of unvested restricted stock (using the treasury stock method), theincremental common shares issuable upon the exercise of stock options andwarrants (using the treasury stock method) and the conversion of the Company’sconvertible notes and debentures (using the if-converted method).  Astheir effect is antidilutive, 4,086,497 and 4,215,995 shares of common stockexercisable under outstanding employee stock options, 2,091,000 and 222,222shares of common stock exercisable under outstanding warrants, 6,426,074 and4,033,481 shares of common stock issuable upon conversion of the outstandingconvertible notes payable and debentures, as of December 31, 2008 and 2007,respectively, have been excluded from this calculation.  The averageexercise price of outstanding employee stock options and warrants to purchasethe Company’s common stock is $0.26 and $1.08, and $1.41 and $1.80, respectively,at December 31, 2008 and 2007. 

 

The following table, which has been adjusted to reflect the three forone conversion ratio effected in connection with the Merger, sets forth thecomputation of basic and diluted net loss per share for the periods presented(in thousands, except per share amounts):

 
| ** **                                              | ** ** | **For the Year**      | ** ** |
|---------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **Ended December 31** | ** ** |
| ** **                                              | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| ** **                                              | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Numerator:                                              |       |                            |       |   |   |
| Net income (loss)                                       |       | $                               | (19,347    | ) | $ | (3,956 | ) |
|                                                    |       |                            |       |   |   |
| Beneficial conversion upon  issuance of preferred stock |       | (22                             | )          | — |   |
|                                                    |       |                            |       |   |   |
| Net income (loss)  available to common stockholders     |       | (19,396                         | )          | (3,956 | ) |
|                                                    |       |                            |       |   |   |
| Denominator:                                            |       |                            |       |   |   |
| Weighted average common  stock                          |       | 23,860,957                      |       | 5,391,000 |   |
|                                                    |       |                            |       |   |   |
| Net loss per share:                                     |       |                            |       |   |   |
| Basic and Diluted                                       |       | $                               | (0.81      | ) | $ | (0.73 | ) |

 

*Use of Estimates*

 

The preparation of the financial statements inconformity with accounting principles generally accepted in the United States ofAmerica requires management to make estimates and assumptions that affect thereported amounts of assets and liabilities, the disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from those estimates.

 

*Segment Reporting*

 

The Company has one operating segment because theCompany is not organized into multiple segments for the purpose of makingoperating decisions or for assessing performance. The chief operating decisionmaker evaluates performance, makes operating decisions, and allocates resourcesbased on financial data consistent with the presentation in the accompanyingfinancial statements.

 

***4. Going Concern***

 

                The financial statements have been prepared with theassumption that the Company will continue as a going concern.  The Companyhas experienced net losses of $19.4 million and $4.0 million for the years endedDecember 31, 2008 and 2007, respectively, and has a total stockholders’ deficitof $29.8 million, as of December 31, 2008, all of which raise substantialdoubt about its ability to continue as a going concern. The financialstatements do not include any adjustments relating to the recoverability andclassification of asset carrying amounts or the amount and classification ofliabilities that might arise should it be unable to continue as a goingconcern.

 

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Management has supported current operations by raising additionaloperating cash through the private sale of convertible debentures and notespayable and preferred stock. This has provided the cash inflows to continue theCompany’s business plan, but has not resulted in significant improvement in itsfinancial position or results of operations. Management also has substantially reduced operating expenses by terminationof employees and other reductions in operating expenses.  Alternatives being pursued to improve theCompany’s cash flow used in operations include (1) raising additionalworking capital through additional sale of preferred stock, common stock and/ordebt and (2) reducing cash operating expenses to levels that are in linewith current revenues.  The first alternative could result in substantialdilution to existing shareholders. There can be no assurance that the Company’scurrent financial position can be improved, that it can raise additionalworking capital, or that it can achieve positive cash flows from operations. TheCompany’s long-term viability as a going concern is dependent upon its abilityto (1) locate sources of debt or equity funding to meet currentcommitments and near-term future working capital requirements and (2) achieveprofitability and ultimately generate sufficient cash flow from operations tosustain its continuing operations.

 

The Company’s cash balance including proceeds from its recent debtfinancings and preferred stock financing may not be sufficient to fundoperations beyond June 2009.  If cash reserves are not sufficient tosustain operations, then management plans to further reduce operating expensesand/or raise additional capital by selling shares of capital stock or othersecurities which 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. 

 

In the period after the end of the year endedDecember 31, 2008, the Company entered into a series of bridge loans withcertain purchasers of its New Series A Preferred stock and with theholders of its January 2008 and April 2008 Debentures.  In the aggregate these bridge loans were forthe principal amount of $655 thousand, which is estimated to cover itsoperating expenses through June 2009. These notes bear interest at ten percent per annum, and have maturitiesranging from May 31, 2009, through October 17, 2009.  The notes payable to the holders of its New Series APreferred stock were accompanied by 146,667 warrants to purchase shares of itsCommon Stock at $0.75 per share, with a term of five years.  The notes payable to the holder of its January 2008and April 2008 Debentures are subject to the security interest granted tothose holders in connection with those debentures.

 

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

 

In May 2008, the FASBissued SFAS No. 162 (“SFAS 162”), *TheHierarchy of Generally Accepted Accounting Principles*.  SFAS162 identifies the sources of accounting principles and the framework forselecting principles to be used in the preparation of financial statements ofnongovernmental entities that are presented in conformity with generallyaccepted accounting principles in the United States.  SFAS 162 was effectiveon November 15, 2008 and upon adoption of SFAS 162 there was no materialimpact on the Company’s financial statements.

 

In March 2008, the FASB issued SFAS No. 161(“SFAS 161*”), Disclosures about DerivativeInstruments and Hedging Activities-an amendment of SFAS No. 133*.This new standard requires enhanced disclosures for derivative instruments,including those used in hedging activities. SFAS 161 is effective for fiscalyears and interim periods beginning after November 15, 2008. The Company’shave not yet determined the impact, if any, that the adoption of SFAS 161 willhave on its financial statements and related disclosures.

 

Effective January1, 2008, the Company adopted Statements of Financial Accounting Standards(“SFAS”) No.157, *Fair Value Measurements*, whichdefines fair value as the price that would be received from selling an asset orpaid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. SFAS 157 establishes guidelines formeasuring fair value and expands disclosures regarding fair value measurements.The adoption of SFAS 157 did not have an impact on the Company’s financialposition, results of operations, or cash flows.

 

The Company alsoadopted SFAS 159, *The Fair Value Option forFinancial Assets and Financial Liabilities—including an amendment of FASBStatement No. 115,*during the first quarter of fiscal 2009, but theCompany did not elect the fair value measurement option for any eligiblefinancial instruments as of December 31, 2008. SFAS 159 allows an entity theirrevocable option to elect fair value for the initial and subsequentmeasurement for certain financial assets and liabilities under aninstrument-by-instrument election. Subsequent measurements for the financialassets and liabilities an entity elects to fair value will be recognized inearnings. SFAS 159 also establishes additional disclosure requirements. Theadoption of SFAS 159 did not have any impact on the Company’s results ofoperations or the fair values of its financial assets and liabilities. TheCompany could elect this option for new or substantially modified assets andliabilities in the future.

 

In December 2007, the FASB issued SFAS No. 141(R), *Business Combinations* (“FAS 141R”), whichrequires an acquirer to measure the identifiable assets acquired, theliabilities assumed, and any noncontrolling interest in the acquiree at theirfair values on the acquisition date, with goodwill being the excess value overthe net identifiable assets acquired. FAS 141R is effective for financialstatements issued for fiscal years beginning after December 15, 2008.Also, in December 2007, the FASB issued SFAS No. 160, *Noncontrolling Interests in Consolidated FinancialStatements,**an**amendment**ofARB No. 51*  (“FAS 160”), which clarifies that anoncontrolling interest in a subsidiary should be reported as equity in theconsolidated financial statements. The calculation of earnings per share willcontinue to be based on income amounts attributable to the parent. FAS 160 iseffective for financial statements issued for fiscal years beginning after December 15,2008. The Company is currently evaluating the impact of adopting SFAS 141Rand SFAS 160 on its financial position, cash flows, and results ofoperations.

 

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In June 2008, the FASB issued FSP No. EITF 03-6-1, *Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities* (“FSPEITF 03-6-1”), which requires entities to apply the two-class method ofcomputing basic and diluted earnings per share for participating securitiesthat include awards that accrue cash dividends (whether paid or unpaid) any timecommon shareholders receive dividends and those dividends do not need to bereturned to the entity if the employee forfeits the award. FSP EITF 03-6-1will be effective for the Company on January 1, 2009, and will requireretroactive disclosure. The Company is currently evaluating the impact ofadopting FSP EITF 03-6-1 on its financial position, cash flows, andresults of operations.

 

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

 

Convertible notes and debentures comprise (in thousands):

 
| ** **                                                       | ** ** | **December 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------|------------|------------------------|------------|
| 20% convertible notes                                            |       | $                           | —     |                   | $          | 850 |   |
| 6% convertible notes                                             |       | 1,764                       |       | 3,326                  |       |
| January 2008  Debentures                                    |       | 2,000                       |       | —                 |       |
| April 2008 Debentures                                       |       | 3,500                       |       | —                 |       |
|                                                             |       | 7,264                       |       | 4,176                  |       |
| Less discount on long term  notes payable                        |       | (—                     | )          | (221                   | )          |
|                                                             |       |                        |       |                   |       |
|                                                             |       | 7,264                       |       | 3,955                  |       |
| Less classified as current  portion of convertible notes payable |       | (—                     | )          | (816                   | )          |
|                                                             |       |                        |       |                   |       |
| Long term convertible  notes payable                             |       | $                           | 7,264      |                   | $          | 3,139 |   |

 

*20%Convertible Notes*

 

During the period October 2006 to June 2007, the Companyissued 20 percent convertible notes with a face value of $850 thousand anddetachable warrants to purchase shares of its common stock in exchange for $850thousand.  As of December 31 2008, $750 thousand of the 20 percentconvertible notes had been converted into 1,000,000 shares of the Company’scommon stock and the balance of $100 thousand had been paid in cash.

 

The detachable warrants allowed the holders to purchase up to 283,333shares of the Company’s common stock at an exercise price of $0.09 per share.As of December 31, 2008, all of the warrants had been exercised. Thewarrants were determined to have*de minimus*value at the issuance date.

 

*6%Convertible Notes*

 

During the period August 2007 to October 2007, the Companyissued 6 percent convertible notes with a face value of $3,326 thousand at anoriginal issue discount of 10 percent with detachable warrants to purchaseshares of its common stock in exchange for $3,024 thousand.  These notesmature on March 31, 2009, with interest due and payable on February 1,2008, and on the last day of each calendar quarter thereafter. The Company isrequired to make payments on the outstanding 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 certain financing events. As of December 31,2008, $1,562 thousand of the face value of the 6% convertible notes have beenconverted to 2,352 thousand shares of the Company’s common stock and $1,764thousand remain outstanding. The Company failed to make the required interestand principal payments on the 6 percent convertible notes during the year endedDecember 31, 2008, and through the date of these financial statements.Accordingly, the Company is in default under the terms of the 6 percentconvertible notes, which results in all principal and interest related to the 6percent convertible notes becoming due and payable to the holders. As a result,the Company has accrued interest on the 6 percent convertible notes at thedefault rate of 8 percent and classified all amounts due related to the 6percent convertible notes as current liabilities.

 

In addition, the purchasers of the 6 percent convertible notes receivedwarrants, which are fully exercisable, to purchase 1,080,000 shares of theCompany’s common stock at an exercise price of $0.12. The warrants expire August throughOctober 2013, unless they are earlier automatically terminated upon (i) apublic offering of the Company’s common stock, (ii) sale of the Company,or (iii) a change in control. At December 31, 2008, all of thesewarrants had been exercised or expired and none are outstanding.

 

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*January 2008Debentures*

 

On January 31, 2008, the Company issued convertible debentures (“theJanuary 2008 Debentures”) with a principal amount of $2 million anddetachable warrants to purchase 222,222 shares of its common stock in exchangefor $1.9 million.  The January 2008 Debentures are due on January 31,2010, and bear interest at 6 percent per annum, which is payable semiannuallyon January 1 and July 1, commencing on July 1, 2008. Monthly principal payments equal to 1/18th of the principal amount were tobegin on September 1, 2008.  The Company has the right to payinterest and monthly principal payments in cash, or upon notice to the holdersand compliance with certain equity conditions, it can pay all or a portion ofany such payment in common stock valued at a price equal to the lesser of thethen effective conversion price (currently $1.35) or 85 percent of the averageof the volume weighted average price per share for its common stock for the 10consecutive trading days immediately prior to the applicable paymentdate.  The equity conditions that it must meet include having a currentlyeffective registration statement covering the shares of common stock issuableupon conversion of the debenture, and having the daily dollar trading volumefor its common stock exceed $250,000 for each of the 20 consecutive tradingdays before the date in question.  The January 2008 Debentures andany accrued interest are convertible at anytime at the discretion of the holderat a conversion price per share of $1.35, subject to a cap on the beneficialownership of its shares of common stock by the holder and its affiliatesfollowing such conversion. The conversion price is adjusted upon a stock split,reverse stock split, or upon issuance of stock dividends, whereby theconversion price would be adjusted to ensure that the holder would be receivingthe same number of shares, as though the conversion right had been exercisedprior to the triggering event.  Further, the conversion price is adjustedif common stock or equivalents are subsequently sold or re-priced at a pricebelow the conversion price or rights, options or warrants are issued to holdersof its common stock entitling them to purchase common stock at prices lowerthan the volume weighted average price on the date issued.

 

The Company has the option to redeem the January 2008 Debenturesbefore their maturity by payment in cash of an amount equal to 120 percent ofthe then-outstanding principal amount, plus accrued interest and other charges,and the right to force conversion of the debentures if the average of thevolume weighted average price of its common stock exceeds $3.39 for 20 tradingdays out of a consecutive 30 trading day period.  This redemption optionand forced conversion right are subject to the Company meeting certain equityconditions, including having the daily dollar trading volume for its commonstock exceed $250 thousand for each of the 20 consecutive trading days beforethe date in question and having a currently effective registration statementcovering the shares of common stock issuable upon conversion of the debenturesand the forced conversion option, subject to the applicable cap on thebeneficial ownership of its shares of common stock by the holder and itsaffiliates following such conversion.  The January 2008 Debenturesare collateralized by substantially all the assets of the Company.

 

The January 2008 Debentures impose certain covenants on theCompany, including restrictions against incurring additional indebtedness,creating any liens on its property, amending its certificate of incorporationor bylaws, redeeming or paying dividends on shares of our outstanding commonstock, and entering into certain related party transactions.  The January 2008Debentures also define certain events of default, including, withoutlimitation, failure to make a payment obligation, failure to observe othercovenants of the debenture or related agreements (subject to applicable cureperiods), breach of representation or warranty, bankruptcy, default underanother significant contract or credit obligation, delisting of its commonstock, a change in control, failure to secure and maintain an effectiveregistration statement covering the resale of the common stock underlying thedebentures and the warrants, or failure to deliver share certificates in atimely manner.  In the event of default, the holders of the January 2008Debentures have the right to accelerate all amounts outstanding under thedebentures and demand payment of a mandatory default amount equal to 130percent of the amount outstanding plus accrued interest and expenses. TheCompany has failed to make the required interest and principal payments on the January 2008Debentures due on September 30, and December 31, 2008, and throughthe filing date of this report. Accordingly, the Company is in default underthe terms of the January 2008 Debentures, and the holders have the rightto demand that the default amount equal to 130% of the amount outstanding plusaccrued interest be paid to the holders. As of the date of these financialstatements, the Company has classified all amounts due related to the January2008 Debentures as current liabilities, and the holders have not elected toexercise their rights arising from the Company’s default.

 

Debt issuance costs of $85.2 thousand were incurred in conjunction withthe issuance of the January 2008 Debentures, which have been capitalizedas Other Assets and are amortized using the effective interest method.  As the January 2008 Debentures were indefault and are deemed currently payable, the debt issuance costs have beenfully amortized for the year ended December 31, 2008.

 

The detachable warrants, which are fully exercisable, to purchase222,222 shares of our common stock, expire in January 2011 and areexercisable at a price of $1.80 per share, subject to adjustment.  As of December 31,2008, and through the date of these financial statements, none of thesewarrants had been exercised.

 

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* *

*April 2008Debentures*

 

On April 22, 2008, the Company issued convertible debentures (“theApril 2008 Debentures”) with a principal amount of $3.5 million anddetachable warrants to purchase 388,889 shares of our common stock in exchangefor $3.4 million.  The April 2008 Debentures are due on April 30,2010, and have the identical terms and conditions to the January 2008Debentures described above. The Company has failed to make the requiredinterest and principal payments on the April 2008 Debentures due on September 30and December 31, 2008, and through the date of these financial statements.Accordingly, the Company is in default under the terms of the April 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 the date of this report, the holders have not elected toexercise their rights arising from the Company’s default.

 

Debt issuance costs of $149 thousand were incurred in conjunction withthe issuance of the April 2008 Debentures, which have been capitalized asOther Assets and are amortized using the effective interest method.  As the April 2008 Debentures were in defaultand are deemed currently payable, the debt issuance costs have been fullyamortized for the year ended December 31, 2008.

 

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, for theevents described above, which adjust the conversion price of the January 2008Debentures.  As of December 31, 2008, and through the filing date ofthis report, none of these warrants had been exercised.

 

In connection with the January 2008 Debentures and the April 2008Debentures, the Company also entered into a registration rights agreement withthe investors, pursuant to which it agreed to file a registration statementcovering the resale of the shares of common stock that may be issued to suchinvestors upon the conversion of the debentures, payment in kind, and theexercise of the related warrants.  The Company agreed to maintain theeffectiveness of the registration statement (subject to certain limitations)for a period of time until the holders can sell the underlying common stockwithout volume restrictions under Rule 144 of the Securities Act of 1933,or the Securities Act. If the registration statement is not declared effectiveby an agreed to date, or if the Company fail to maintain the effectiveness ofthe registration statement, then the Company is required to pay to eachinvestor, as partial liquidated damages, cash equal to 1.0 percent of theaggregate purchase price paid by such investor for the securities purchased inthe financing and then held by such investor, and must pay to such investor 1percent for each subsequent 30-day period that the default remains uncured, upto a maximum aggregate liquidated damages amount of 10 percent of the aggregatepurchase price paid by the holders of the debentures.

 

The Company’s registration statement was effective July 31, 2008,which was eight days after the deadline in the registration rights agreements.Accordingly, the Company may be liable for penalties in the amount of $14.7thousand, which it has accrued.

 

*Accountingfor Convertible Notes and Debentures, Embedded Derivatives and Warrants*

 

The Company has evaluated the embedded derivatives included in the 20%and 6% Convertible Notes (the “Convertible Notes”) and the January 2008and April 2008 Debentures, consisting of the conversion features andcertain put and call features described above, under the guidance in Statementof Financial Accounting Standard No. 133 A*ccountingfor Derivative Instruments and Hedging Activities* and its relatedguidance and interpretations (“SFAS 133”) on the issuance date of theConvertible Notes and January 2008 and April 2008 Debentures and oneach subsequent reporting date.  The purpose of the evaluation is todetermine whether the embedded derivatives need to be bifurcated from the debthost and accounted for as a derivative at their estimated fair value as aliability at the date of issuance and thereafter, adjusted to estimated fairvalue with a charge or credit to the Company’s statement of operations. SFAS 133 generally indicates that if the conversion features are (i) indexedto the Company’s capital stock and (ii) would be classified as equity if afreestanding derivative under the guidance in EITF 00-19, *Accounting for Derivative Financial Instruments Indexedto, and Potentially Settled in, a Company’s Own Stock* (“EITF 00-19”),the embedded derivatives need not be bifurcated from the debt host.  EITF00-19 generally requires, among other factors, that (i) the Company cansettle 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. SFAS 133 also provides guidance on when put and call features included in adebt host agreement are not clearly and closely related to the debt host mustbe bifurcated and recorded as a liability.  Only the January 2008 andApril 2008 Debentures include put and call features.

 

The Company concluded that the conversion features embedded in the 6%Convertible Notes met the criteria in SFAS 133 at issuance and through April 23,2008, 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 embedded conversion feature in the 6% Convertible Notes withan estimated fair value of $3,674 thousand and recorded the amount in the lineentitled “Warrant and derivative liability” in the accompanying balancesheets.  At December 31, 2008, theestimated fair value of the conversion feature was subsequently revalued to $2thousand, with the related credit of $3,672 thousand included in the Company’sstatement of operations in interest expense for the year ended December 31,2008. The Company determined the estimated fair value of the conversion featureon April 22, 2008, and December 31, 2008, by using the Black-Scholes Mertonvaluation model and the following assumptions: fair value of the Company’scommon stock of $2.91, and $0.33, respectively, per share; terms of 0.95 years,and 0.25 years, respectively; risk free interest rates of 1.82%, and 0.11%,respectively; and volatility of 47.16%, and 73.59%, respectively. Probabilitieswere then applied to the outputs using the Matlab Monte Carlo Simulation of theCompany’s stock prices to arrive at a value for the conversion options.  

 

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The Company concluded thatthe conversion features embedded in the January 2008 Debentures met thecriteria in SFAS 133 at issuance and through March 31, 2008, andtherefore, were not bifurcated from the debt host because the conversion to theCompany’s common stock could only be settled in its common stock, the commonstock 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.  While the Company concluded thatthe put and call embedded in the January 2008 Debentures was not clearlyand closely related to the debt host, the estimated fair value of the put andcall was determined to be *de minimus* andtherefore was not bifurcated from the debt host.  However, on the date ofthe merger with Tripath, April 22, 2008, the Company concluded it nolonger had control to ensure the sufficiency of its authorized shares of commonstock nor could it settle the conversion feature in unregistered shares. Therefore,the Company recorded the embedded conversion feature and put and call in the January 2008Debentures with an estimated fair value of $896 thousand and recorded theamount in the line entitled “Warrant and derivative liability” in theaccompanying balance sheet.  At December 31, 2008, the estimated fairvalue of the conversion feature was subsequently revalued to $5 thousand, withthe related credit of $891 thousand included in the Company’s statement ofoperations in interest expense for the year ended December 31, 2008. TheCompany determined the estimated fair value of the conversion options on April 22,2008, and December 31, 2008, using the Black-Scholes Merton valuationmodel and the following assumptions: fair value of the Company’s common stockof $2.91, and $0.33, respectively, per share; terms of 1 year and 1.75 years,and 1.08 years, respectively; risk free interest rates of 1.84% and 2.14%, and0.40%, respectively; and volatility of 47.16% and 48.48%, and 65.48%,respectively.  Probabilities were then applied to the outputs using theMatlab Monte Carlo Simulation of the Company’s stock prices to arrive at avalue for the conversion options.

 

The Company concluded thatthe embedded conversion features in the April 2008 Debentures should bebifurcated from the debt host and recorded as liabilities because theconversion features must be settled in registered shares and that due to the Mergerwith Tripath the Company no longer had control over a shareholder vote toensure the sufficiency of our authorized shares of common stock. The Companyalso concluded that the put and call in the April 2008 Debentures wereembedded derivatives and were not clearly and closely related to the debt hostand therefore should be bifurcated from the debt host along with the conversionfeatures and recorded as a liability at their estimated fair value atissuance.  The estimated fair value of the embedded conversion featuresand put and call was $1,507 thousand at April 22, 2008, and recorded inthe line entitled “Warrant and derivative liability” in the accompanyingBalance Sheet. At December 31, 2008, the estimated fair value of theconversion feature was subsequently revalued to $10 thousand, with the relatedcredit of $1,047 thousand included in the Company’s statement of operations ininterest expense for the year ended December 31, 2008. The Companydetermined the estimated fair value of the conversion options on April 22and December 31, 2008, using the Black-Scholes Merton valuation model andthe following assumptions: fair value of the Company’s common stock of $2.91,and $0.33, respectively, per share; terms of 1 year and 2 years, and 1.33years, respectively; risk free interest rates of 1.87% and 2.24%, and 0.50%,respectively; and volatility of 45.76% and 49.00%,and 61.48%,respectively.  Probabilities were then applied to the outputs using theMatlab Monte Carlo Simulation of the Company’s stock prices to arrive at avalue for the conversion options.

 

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The Company evaluated theterms and conditions of the detachable warrants issued with the January 2008and April 2008 Debentures under the guidance in EITF 00-19 to determinewhether the detachable warrants should be accounted for as equity or aliability and thereafter adjusted to their respective estimated fair value ateach reporting date.

 

The Company concluded thatthe detachable warrants issued with the January 2008 Debentures met thecriteria in SFAS 133 at issuance and through March 31, 2008, andtherefore, were accounted for as equity because the warrants could only besettled by issuance of the Company’s common stock, the common stock could beunregistered, and the sufficiency of the authorized shares was under theCompany’s control as it could control the outcome of a shareholder vote toincrease the authorized shares.  However, on the date of the merger withTripath, April 22, 2008, the Company concluded it no longer had control toensure the sufficiency of its authorized shares of common stock nor could itsettle the warrants in unregistered shares and therefore, recorded theestimated value fair value of the warrants of $320 thousand in the lineentitled “Warrant and embedded derivative liability” in the accompanyingBalance Sheets.  At December 31, 2008, the estimated fair value ofthe warrants was revalued to $1 thousand with the related credit of $319thousand included in the Company’s statement of operations in interest expensefor the year ended December 31, 2008. The Company determined the estimatedfair value of the warrants on April 22 and December 31, 2008, byusing the Black-Scholes Merton valuation model and the following assumptions:fair value of the Company’s common stock of $2.91, and $0.33, respectively, pershare; terms of 2.5 years, 2.08 years, respectively; risk free interest ratesof 2.54%, and 0.78%, respectively; and volatility of 47.81%, and 56.98%,respectively.

 

The Company concluded thatthe detachable warrants issued with the April 2008 Debentures did not meetthe criteria in SFAS 133 at issuance because it no longer had control to ensurethe sufficiency of its authorized shares of common stock nor could it settlethe warrants in unregistered shares and therefore, recorded the estimated valuefair value of the warrants of $590 thousand in the line entitled “Warrant andembedded derivative liability” in the accompanying Balance Sheet.  At December 31,2008, the estimated fair value of the warrants was revalued to $4 thousand withthe related credit of $586 thousand included in the Company’s statement ofoperations in interest expense for the year ended December 31, 2008. TheCompany determined the estimated fair value of the warrants on April 22,and December 31, 2008, by using the Black-Scholes Merton valuation modeland the following assumptions: fair value of the Company’s common stock of$2.91, and $0.33, respectively, per share; terms of 3 years, and 2.33 years,respectively; risk free interest rates of 2.43%, and 0.84%, respectively; andvolatility of 49.17%, and 62.44%, respectively.

 

Debt discountsrecorded on the issuance of the Convertible Notes, the January 2008 Debentures,and the April 2008 Debentures, were recorded on the convertible notes anddebentures due to the principal discount between the nominal value and theamount of principal received, the discounts due to the embedded conversionfeatures, and the detachable warrants, and are being amortized using theeffective interest method. As the January 2008 Debentures and the April 2008Debentures were in default and are deemed currently payable, the debt discountshave been fully amortized for the year ended December 31, 2008. Total accretioncharged to interest expense for the year ended December 31, 2008, related tothe convertible notes and debentures was $2,872 thousand.

 

*New Series A PreferredWarrants–Warrant Liability*

 

In October 2008 andas amended in December 2008, the Board of Directors authorized thedesignation and issuance of up to 3,333,333 shares of a New Series AConvertible Preferred Stock (the “New Series A Preferred Stock”), and theoffering of a December 2008 Preferred Stock Financing of up to $2,500,000of New Series A Preferred Stock and a number of warrants with an exerciseprice 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 its 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 Daniel J.A. Kolke, the Company’s founder, chairman, chiefexecutive officer, acting chief financial officer, and chief technologyofficer, with participation from two of its directors and other priorinvestors. The holders of the January 2008 Debentures and the April 2008Debentures consented to this financing, but did not participate.

 

The Company concluded at thedate of issuance and the reporting date that the embedded conversion featuresin the New Series A Preferred Stock should not be bifurcated from theequity host as they were clearly and closely related to the equity host. Alsoduring the year ended December 31, 2008, the Company recorded a beneficialconversion feature related to the New Series A Preferred Stock, whichcould have been converted to the Company’s common stock, through the date theconversion feature was recorded, as a dividend expense of $22 thousand.

 

The Company evaluated theterms and conditions of the detachable warrants issued with the New Series APreferred Stock under the guidance in EITF 00-19 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.

 

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The Company concluded thatthe detachable warrants issued with the New Series A Preferred Stock didnot meet the criteria in SFAS 133 at issuance because the Company did not havecontrol to ensure the sufficiency of its authorized shares of common stock. Therefore,the Company recorded the estimated value fair value of the warrants of $147thousand in the line entitled “Warrant and embedded derivative liability” inthe accompanying Balance Sheet.  At December 31, 2008, the estimatedfair value of the warrants was revalued to $40 thousand with the related creditof $107 thousand included in the Company’s statement of operations in financingexpense for the year ended December 31, 2008. The Company determined theestimated fair value of the warrants on December 3, and December 31,2008, by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $0.60, and $0.33,respectively, per share; terms of 3 years, and 2.92 years, respectively; riskfree interest rates of 1.07%, and 0.98%, respectively; and volatility of53.07%, and 54.96%, respectively.

 

*Warrants Issued in Connectionwith Litigation Settlement*

 

Effective on December 5,2008, the Company entered into a settlement agreement with Kaufman Bros.,pursuant to which the Company issued to Kaufman Bros. warrants to purchase500,000 shares of the Company’s common stock at an exercise price of $0.75 pershare, which warrants have 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 EITF 00-19 to determine whether the warrants should be accountedfor as equity or a liability and thereafter adjusted to their respectiveestimated fair value at each reporting date.

 

The Company concluded thatthe warrants issued in the settlement did not meet the criteria in SFAS 133 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 $130 thousand in the line entitled “Warrantand embedded derivative liability” in the accompanying Balance Sheet.  At December 31,2008, the estimated fair value of the warrants was revalued to $46 thousandwith the related credit of $84 thousand included in the Company’s statement ofoperations in settlement expense for the year ended December 31, 2008. TheCompany determined the estimated fair value of the warrants on December 5and December 31, 2008, by using the Black-Scholes Merton valuation modeland the following assumptions: fair value of the Company’s common stock of$0.60, and $0.33, respectively, per share; terms of 5 years, and 4.92 years,respectively; risk free interest rates of 1.67%, and 1.53%, respectively; andvolatility of 56.16%, and 56.74%, respectively.

 

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

 

The Company previously entered into a series ofunsecured loan transactions with relatives of Daniel J.A. Kolke, its executivechairman, chief executive officer, acting chief financial officer, and chieftechnology officer.  On December 30, 2007, in connection withsettlement of these loans, the Company entered into three unsecured promissorynotes with an aggregate original principal amount of $816 thousand, each ofwhich will become collateralized by certain presently unidentified assets ofthe Company if and when Daniel J.A. Kolke is no longer an employee nor a memberof its board of directors.  Such security interest, if granted, would besubordinated to any and all bank debt or convertible corporate debt. These three notes are outstanding and in default in an aggregate balance of $685thousand as of December 31, 2008. No demands for payment have been made as of the date of this report andthe default has been waived through the year ended December 31, 2008, to thedate of this report.

 

***8. Credit Facility***

 

In October 2007, the Company entered into aone-year credit facility with Bridge Bank which provided for borrowing of up to$250 thousand at an annual interest rate equal to the bank’s prime rate plus2.5 percent. The credit facility was collateralized by substantially all of theCompany’s assets. The Company issued warrants to Bridge Bank to purchase up to10,417 shares of its common stock at an exercise price of $1.20 per share inconnection with this facility, all of which have expired unexercised.  Thecredit facility expired in October 2008, in accordance with its terms, andwas not renewed. There was no borrowing under the facility as of December 31,2008 and 2007.

 

**9. *Taxes***

 

The Company accounts for income taxes in accordance with SFAS No. 109,“*Accounting for 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.

 

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The components of the income tax benefit for the years ended December 31,2008 and 2007, respectively, are set forth in the following table (inthousands):

 
| ** **                         | ** ** | **December 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Federal (expense) benefit:         |       |                        |       |                        |       |
| Current                            |       | $                           | —     |                        | $          | — |   |
| Deferred                           |       | 8,153                       |       | 1,316                       |       |
| Valuation allowance                |       | (8,153                      | )          | (1,316                      | )          |
| 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 31,2008 and 2007.

 
| ** **                                 | ** ** | **December 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| 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 availablenet operating losses. The tax effected temporary differences comprising theCompany’s deferred income taxes as of December 31, 2008 and 2007, allnon-current, are as follows(in thousands):

 
| ** **                    | ** ** | **December 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|-------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Net operating losses          |       | $                           | 66,367     |                        | $          | 3,506 |   |
| Valuation allowance           |       | (66,367                     | )          | (3,506                      | )          |
| Net deferred income tax asset |       | $                           | 0          |                        | $          | 0 |   |

 

The Company has recorded a valuation allowance in the amount set forthabove for deferred tax assets where it is more likely than not the Company willnot realize future tax benefits related to these items. The net change in thevaluation allowance for the year ended December 31, 2008, was an increase of $62.9 millionwith the increase primarily due to the Company’s reverse merger in April 2008.The Company has not performed an IRC §382 study.

 

As of December 31,2008, the Company has federal net operating loss carryforwards available to offset future taxableincome of approximately $172 million. The federal net operating losscarryforwards expire through the year 2029. The Company has stated netoperating loss carryforwards of $89 million primarily due to the reverse mergerin April 2008.

 

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The Tax Reform Act of1986 imposed substantial restrictions on the utilization of NOLs in the event of an “ownership change” of a corporation (as defined in the Internal Revenue Code).  Utilization of the Company’s netoperating losses may be limited by these restrictions.  It is likely at least one “ownership change” occurredprior to December 31,2008, therefore the net operating losses may belimited in the utilization against future income and could result in their expiration prior to utilization.

 

***10. Equity***

 

Common Stock

 

The Company has issued 23,027,624 shares of commonstock from a total of 250,000,000 authorized shares with a par value of $0.01per share.

 

Preferred Stock

 

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

 

In October 2008 andas amended in December 2008, the Company’s Board of Directors authorizedthe designation and issuance of up to 3,333,333 shares of a New Series AConvertible Preferred Stock (the “New Series A Preferred Stock”), and theoffering of a December 2008 Preferred Stock Financing of up to $2,500,000of New Series A Preferred Stock with a Stated Value of $0.75 per share anda number of warrants with an exercise price of $0.75 equal to 100% of thenumber of shares purchased by each purchaser. Through the period endingDecember 31, 2008, the Company closed a round of financing for the sale of833,333 shares of this New Series A Preferred Stock at $0.75 per share,for an aggregate purchase price of $625 thousand, and warrants to purchase833,333 shares of common stock of the Company, at an exercise price of $0.75per share, and a three year term. This financing was led by related parties andother prior investors. The holders of the January 2008 Debentures and the April 2008Debentures consented to this financing, but did not participate.

 

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

 

*Voting Rights. *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. *Eachshare of New Series A Preferred Stock is convertible, at the option of theholder of such share, into the number of fully paid and nonassessable shares ofcommon stock determined by dividing the Stated Value by the then applicableconversion price.

 

*Registration Rights. *Holders of New Series A Preferred Stock have no registrationrights.

 

Warrants

 

As of December 31, 2008, warrants representing1,944,444 shares of our common stock were exercisable as set forth in thefollowing table:

 
| **Issue Date** | ** ** | **# of Warrants** | ** ** | **Exercise price** | ** ** | **Expiration date** | ** ** |
|---------------------|------------|-----------------------------|------------|-------------------------|------------|--------------------------|------------|
|                |       |                        |       |                    |       |                     |       |
| Jan-08              |       | 222,222                     |       | $                       | 1.80       |                     | Jan-09     |   |
| Apr-08              |       | 388,889                     |       | $                       | 1.80       |                     | Apr-09     |   |
| Dec-08              |       | 833,333                     |       | $                       | 0.75       |                     | Dec-09     |   |
| Dec-08              |       | 500,000                     |       | $                       | 0.75       |                     | Dec-12     |   |
| TOTAL               |       | 1,944,444                   |       |                    |       |                     |       |

 

The Company determined the estimated fair value of thewarrants issued during the year ended December 31, 2008, by using theBlack-Scholes Merton model. See discussion, *supra*, Note 6.

 

Shares reserved

 

As of December 31, 2008, the Company has thefollowing shares reserved:

 
| Options Issued                |   | 4,086,497  |   |
|-------------------------------|--------|------------|--------|
| Option Plan Available         |   | 791,145    |   |
| Debenture Conversion(s)       |   | 6,426,074  |   |
| Debenture Interest Conversion |   | 109,889    |   |
| Warrants Issued               |   | 1,944,444  |   |
| Total                         |   | 13,358,049 |   |

 

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***11.Stock Option Plans***

** **

On November 1, 1999, the Company adopted the 1999Stock Option Plan (the “1999 Plan”) and on November 11, 2007, adopted the2007 Stock Incentive Plan (the “2007 Plan”). Both 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 and 4,843,250under the 2007 Plan.  ISOs may be grantedonly to employees of the Company (including officers and directors who are alsoemployees). NSOs may be granted to employees, non-employee directors andconsultants of the Company.  Under the2007 Plan, upon the first date that the Company is publicly held, no employeeof the Company will be eligible to be granted options covering more than500,000 shares of common stock during any calendar year.

 

Upon adoption of the 2007 Plan, 165,000 options whichhad been granted under the 1999 Plan and shares reserved for issuance under the1999 Stock 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 pricesnot less than 110 percent of the estimated fair value of the stock on the dateof grant. Options under the 2007 Plan may be granted for exercise periods up to10 years.

 

***12.Accounting for Share-Based Compensation***

** **

The following table summarizes stock option activityunder the Company’s stock option plans (in thousands, except share and pershare data):

 
| **Options**                           | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price Per  Share** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|---------------------------------------|------------|------------|------------|----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at December 31, 2007 |       | 4,215,995  |       | $                                                              | 1.14       |                                                        | 9.5        |                                | $          | 3,971 |   |
| Granted                               |       | 947,997    |       | $                                                              | 2.51       |                                                        | 8.6        |                                |       |   |
| Exercised                             |       | (3,750     | )          | $                                                              | 0.02       |                                                        | 8.6        |                                |       |   |
| Canceled                              |       | (1,073,745 | )          | $                                                              | 1.40       |                                                        | 8.6        |                                |       |   |
| Outstanding at December 31, 2008 |       | 4,086,497  |       | $                                                              | 0.26       |                                                        | 8.6        |                                | $          | 1,053 |   |
| Exercisable at December 31, 2008 |       | 997,264    |       | $                                                              | 0.12       |                                                        | 8.5        |                                | $          | 275 |   |
| Unvested at December 31, 2008         |       | 3,089,233  |       | $                                                              | 0.31       |                                                        | 8.7        |                                | $          | 778 |   |

 

Aggregate IntrinsicValue was determined based upon the closing price of the Company’s publicly listedcommon stock price on December 31, 2008.

 

Share based compensation expense attributable toindividuals that worked in the following functions is as follows (inthousands):

 
| ** **                     | ** ** | **Fiscal Year  Ended December 31,  2008** | ** ** | **Fiscal Year  Ended December 31,  2007** | ** ** |
|--------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| Research and development       |       | $                                                   | 46         |                                                | $          | 14 |   |
| Selling and marketing          |       | 29                                                  |       | 6                                                   |       |
| General and administrative     |       | 32                                                  |       | 7                                                   |       |
| Total share-based compensation |       | $                                                   | 107        |                                                | $          | 27 |   |

 

The weighted-average fair value of stock-based compensation is based onthe single option valuation approach and is estimated on the date of grantusing a Black-Scholes Merton based option valuation model. The fair value offorfeitures is an estimate and no dividends have been declared. The fair valueof options granted during the three months and year ended December 31,2008 and 2007, were calculated based on the following average assumptions:

 
| ** **              | ** ** | **For the Year**      | ** ** |
|-------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **Ended December 31** | ** ** |
| ** **              | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| Estimate fair value     |       | $                               | 1.41       |   | $ | 0.017 |   |
| Expected lives in years |       | 7                               |       | 7 |   |
| Volatility              |       | 59.00                           | %          | 55 | % |
| Risk free interest rate |       | 3.26                            | %          | 4.2 | % |
| Dividend yield          |       |                            | 0          | % |   | 0 | % |

 

The Company used estimated volatility of comparable public companies toestimate the expected volatility used for the Black-Scholes Merton model. Therisk-free interest rate assumption is based upon the US Treasury yield. TheCompany historically has not declared dividends and therefore the dividendyield was assumed to be zero in the model.

 

Total cash received as a result of options exercisedduring the fiscal year ended December 31, 2008, was $2 thousand. Therewere no equity instruments granted under share-based payment arrangements andtherefore there was no cash used to settle any equity instrument. The Companydoes not plan to repurchase any shares during the upcoming annual period.

 

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***13. Restructuring***

 

On October 1, 2008, the Company relocated itsheadquarters from San Mateo, California to Renton, Washington and terminatedeight employees based in California.  On October 31,2008, the Company closed its offices in San Mateo, California and abandoned theleased premises of its former offices there. Effective on October 31, 2008, David S.G. MacKenzie resigned hisposition as our vice president and chief financial officer and we have not yetappointed any person to serve as our chief financial officer.  On October 31, 2008, the Companyrelocated its headquarters and abandoned the leased premises of its formeroffices in Renton, Washington.  In October 2008,the Company 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.

 

As part of its reduction of monthly cash operatingexpenses during the quarter ended September 30, 2008, and continuingduring the quarter and year ended December 31, 2008, through the date of thesefinancial statements, the Company placed all employees on partial deferrals ofsalary, ranging from 10% to 100% of base salary and accrued these deferrals.  At the end of the period, and as of the dateof these financial statements, this deferral amount remains unpaid, includingamounts due to employees in its California office who were terminated duringthe period.

 

***14. Commitments and contingencies***

** **

**Operatingand Capital Leases**

 

The Company has non-cancelable leases for corporatefacilities and equipment.  Rent expenseunder the leases totaled $254 thousand and $147 thousand for the periods ended December 31,2008 and 2007, respectively.  Futureminimum rental payments required under non-cancelable leases are as follows forthe twelve months ended December 31:

 
| ** **                                          | ** ** | **Operating  Leases** | ** ** | **Capital  Leases** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|---------------------|------------|
|                                                |       |                  |       |                |       |
|                                                | 2009       |                  | $          | 241                 |       | $ | 21 |   |
|                                                | 2010       |                  | 54         |                | 13         |   |
|                                                | 2011       |                  | 6          |                | 13         |   |
|                                                | 2012       |                  | 5          |                | 2          |   |
|                                                | 2013       |                  | 2          |                | —     |   |
| Total minimum lease payments                        |       | $                     | 308        |                | $          | 49 |   |
| Less: amount representing interest                  |       |                  |       | (16                 | )          |
| Present value of minimum lease payments             |       |                  |       | 33                  |       |
| Less: current portion of capital lease  obligations |       |                  |       | (9                  | )          |
| Long-term capital lease obligations                 |       |                  |       | $                   | 24         |   |

 

On October 31, 2008, the Company closed itsoffices in San Mateo, California and abandoned the leased premises of itsoffices there. Also on October 31, 2008, the Company relocated itsWashington offices and abandoned the leased premises of its former offices inRenton, Washington.  The landlord for theSan Mateo, California leased premises has asserted a claim against the Companyfor $659 thousand and other amounts and filed suit against it in the SuperiorCourt of San Mateo County, California (Case No. CIV 479535).  The Company intends to defend this claim asit had previously accrued all rents due under this lease and believes that theclaim should not exceed that amount.  Thelandlord for the Renton, Washington location has not yet asserted any claim,but the assertion of such claims, and the need for the Company to defend suchclaims, is foreseeable.

 

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***15.          Litigation and Claims***

 

In June 2008, Kaufman Bros. L.P. filed suitagainst the Company in the United States District Court for the SouthernDistrict of New York (Case No. 80 CV 5716) and sought a temporaryrestraining order and other extraordinary relief.  The complaint arisesout of an advisory services agreement, pursuant to which Kaufman Bros. was toprovide to the Company advisory services in connection with financings andstrategic transactions. The Company notified Kaufman Bros. that it believed KaufmanBros. had failed to provide the required services under the agreement, and thatit were therefore entitled to terminate the agreement for cause. In the suit,Kaufman Bros. was seeking (i) monetary damages of $400,000 foranticipatory breach of the agreement; (ii) $73,800 in fees allegedly owedin connection with a previously closed financing transaction; (iii) andinjunction prohibiting us from cancelling any shares issued to Kaufman Bros. ascompensation, (iv) a declaration from the court that the Company are notentitled to a refund of any fees previously paid to Kaufman Bros., and (v) adeclaration that the Company are obligated to pay Kaufman Bros. a commission onany financing or transaction that we enter into within 18 months following thetermination of the agreement.  On July 15, 2008, Kaufman Bros.voluntarily filed a notice of dismissal without prejudice.  Settlementdiscussions were unsuccessful and, on July 31, 2008, Kaufman Bros.re-filed substantially the same claims in the Supreme Court of New York -County of New York (Index No. 08-602239). Effective on December 5,2008, the Company entered into a settlement agreement with Kaufman Bros.,pursuant to which (i) the Company agreed to pay to Kaufman Bros. $210,000,in twelve monthly installments of $17,500; (ii) the Company issued toKaufman Bros. warrants to purchase 500,000 shares of the Company’s common stockat an exercise price of $0.75 per share, which warrants have a term of fiveyears; (iii) the Company and Kaufman Bros. agreed immediately to terminateall provisions, 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. Subsequentto entering into the settlement agreement, the Company has not fully compliedwith its payment obligations under the settlement agreement but, through thedate of filing of these financial statements, Kaufman Bros. has not exercisedany of its remedies for default under the settlement agreement.

 

On October 31, 2008, the Company closed itsoffices in San Mateo, California and abandoned the leased premises of itsformer offices there.  The landlord for thesepremises has asserted a claim for $659 thousand and other amounts and filed aproceeding in the Superior Court of San Mateo County, California (Case No. CIV479535).  This matter is pending and theCompany intends to defend its position.

 

On September 18, 2008, the employment of JeffreyL. Garon as president and chief executive officer of the Company wasterminated.  On October 19, 2008, Mr. Garonresigned from the Board of Directors.  Mr. Garonand the Company entered into an Employment Agreement dated August 11,2007, which provided certain benefits to Mr. Garon in the event oftermination of his employment, and granted to the Company certain rights torepurchase shares issued on behalf of Mr. Garon pursuant to his employmentagreement.  The Company and Mr. Garonhave been engaged in discussions about these benefits and rights, and no finalagreement has been reached as of the filing date of these financial statements.

 

***16.          Subsequent Events***

 

In the period after the end of the year ended December 31,2008, the Company entered into a series of bridge loans with certain purchasersof its New Series A Preferred stock and with the holders of its January 2008and April 2008 Debentures.  In theaggregate these bridge loans were for the principal amount of $655 thousand,which is estimated to cover its operating expenses through June 2009.  These notes bear interest at ten percent perannum, and have maturities ranging from May 31, 2009, through October 17,2009.  The notes payable to the holdersof its New Series A Preferred stock were accompanied by 146,667 warrantsto purchase shares of its Common Stock at $0.75 per share, with a term of fiveyears.  The notes payable to the holderof its January 2008 and April 2008 Debentures are subject to thesecurity interest granted to those holders in connection with those debentures.

 

Followingthe end of the year ended December 31, 2008, an additional 394,414 optionswere cancelled.

 

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