**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

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x                              ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934

**For the fiscal year ended December 31, 2004**

**OR**

**o**                                 TRANSITION REPORT PURSUANT TO SECTION 13 OF15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the transition period from                        to                        .**

**Commission File Number: 000-31121**

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AVISTARCOMMUNICATIONS CORPORATION

(Exactname of registrant as specified in its charter)
| **Delaware**                                                            | **88-0463156**                           |
|-------------------------------------------------------------------------|------------------------------------------|
| (State or other jurisdiction of  incorporation or organization)         | (I.R.S. Employer  Identification Number) |
| **555 Twin Dolphin Drive,  Suite 360  Redwood Shores, California** | **94065**                                |
| (Address of Principal Executive Offices)                                | (Zip Code)                               |

 

**Registrant’s telephone number, including area code:(650) 610-2900**

**Securities registered pursuant to Section 12(b) ofthe Act:**
|      | **Title of each class** | ** ** | ** ** | ** ** | **Name of each exchange on which  registered** | ** ** |
|------|-------------------------|------------|------------|------------|------------------------------------------------|------------|
| None |                    | None       |

 

**Securities registered pursuant to Section 12(g) ofthe Act:Common Stock, $0.001 par value**

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Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes x  No o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof the registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. x

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act). Yes o  No x

Aggregatemarket value of the voting and non-voting common equity held by non-affiliatescomputed by reference to the price at which the common equity was last sold on June 30,2004 was $7,592,893. Shares of Common Stock held by each executive officer anddirector and by each person who owns 5% or more of the outstanding Common Stockhave been excluded in that such persons may be deemed to be affiliates. Thisdetermination of affiliate status is not necessarily a conclusive determinationfor other purposes.

As ofDecember 31, 2004, the registrant had outstanding 33,360,709 shares ofCommon Stock.

**DOCUMENTS INCORPORATED BY REFERENCE**

TheRegistrant incorporates by reference into Part III of this Annual Reporton Form 10-K specific portions of its Proxy Statement for its 2005Annual Meeting of Stockholders.

 

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**AVISTAR COMMUNICATIONSCORPORATIONANNUAL REPORT ON FORM 10-KYEAR ENDED DECEMBER 31, 2004**

**TABLEOF CONTENTS**
| ** **                                                                                            | ** ** | Page   | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|--------|------------|
| PART I                                                                                           |       |   |       |
| *Item 1. Business*                                                                                    | * *   | *3*    | * *   |
| *Item 2. Properties*                                                                                  | * *   | *21*   | * *   |
| *Item 3. Legal Proceedings*                                                                           | * *   | *21*   | * *   |
| *Item 4. Submission of Matters to a Vote of Security  Holders*                                        | * *   | *21*   | * *   |
| *PART II*                                                                                        |       |   |       |
| *Item 5. Market for Registrant’s Common Equity and  Related Stockholder Matters*                 | * *   | *22*   | * *   |
| *Item 6. Selected Financial Data*                                                                     | * *   | *22*   | * *   |
| *Item 7. Management’s Discussion and Analysis of Financial Condition  and Results of Operations* | * *   | *24*   | * *   |
| *Item 7a.  Quantitative and Qualitative Disclosures About Market Risk*                                | * *   | *42*   | * *   |
| *Item 8. Financial  Statements and Supplementary Data*                                                | * *   | *43*   | * *   |
| *Item 9. Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure*       | * *   | *43*   | * *   |
| *Item 9a. Controls and  Procedures*                                                                   | * *   | *43*   | * *   |
| *PART III*                                                                                       |       |   |       |
| *Item 10.  Directors and Executive Officers of the Registrant*                                        | * *   | *44*   | * *   |
| *Item 11. Executive  Compensation*                                                                    | * *   | *44*   | * *   |
| *Item 12. Security  Ownership of Certain Beneficial Owners and Management*                            | * *   | *44*   | * *   |
| *Item 13. Certain  Relationships and Related Transactions*                                            | * *   | *44*   | * *   |
| *Item 14.  Principal Accoounting Fees and Services*                                                   | * *   | *44*   | * *   |
| *PART IV*                                                                                        |       |   |       |
| *Item 15.  Exhibits, Financial Statement Schedules*                                                   | * *   | *45*   | * *   |
| *Index to Financial Statements*                                                                       | * *   | *F-1*  | * *   |

 

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**Forward Looking Statements**

*This Annual Report on Form 10-K, theexhibits hereto and the information incorporated by reference herein contain “forwardlooking statements” within the meaning of Section 27A of the SecuritiesAct of 1933, as amended (the “Securities Act”) and Section 21E of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”), and suchforward looking statements involve risks and uncertainties. When used in thisReport, the words “expects,” “anticipates,” “believes,” “plans,” “intends” and “estimates”and similar expressions are intended to identify forward looking statements.These forward-looking statements include predictions regarding our futurerevenues and profits, gross margin, customer concentration, customer buyingpatterns, research and development expenses, sales and marketing expenses,general and administrative expenses ,income tax provision and effective taxrate, realization of deferred tax assets, liquidity and sufficiency of existingcash, cash equivalents, and investments for near-term requirements, sufficiencyof leased facilities, purchase commitments, product development andtransitions, expansion and licensing of our patent portfolio, competition andcompeting technology, and financial condition and results of operations as aresult of recent accounting pronouncements. Such statements are subject torisks and uncertainties that could cause actual results to differ materiallyfrom those projected. These risks and uncertainties include those discussedbelow and those discussed in “Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Factors Affecting Future Operating Results”or incorporated by reference herein. Avistar Communications Corporation (the “Company,”“we,” or “us”) undertakes no obligation to publicly release any revisions tothese forward looking statements to reflect events or circumstances after thedate this Annual Report is filed with the Securities and Exchange Commission orto reflect the occurrence of unanticipated events.*

**PART I**

**Item 1.   *Business***

Wewere founded as a Nevada limited partnership in 1993. We filed our articles ofincorporation in Nevada in December 1997 under the name Avistar SystemsCorporation. We reincorporated in Delaware in March 2000 and changed ourname to Avistar Communications Corporation in April 2000. The operatingassets and liabilities of the business were then contributed to our whollyowned subsidiary, Avistar Systems Corporation, a Delaware corporation. In July 2001,our Board of Directors and the Board of Directors of Avistar Systems approvedthe merger of Avistar Systems with and into Avistar Communications Corporation.The merger was completed in July 2001.

Ourprincipal executive offices are located at 555 Twin Dolphin Drive, Suite 360,Redwood Shores, California, 94065. Our telephone number is (650) 610-2900.Our trademarks include Avistar and the Avistar logo, AvistarVOS, Shareboard,vBrief and The Enterprise Video Company. This Annual Report on Form 10-Kalso includes our and other organizations’ product names, trade names andtrademarks. Our corporate website is www.avistar.com.

TheCompany’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q,Current Reports on Form 8-K, and amendments to reports filedpursuant to Sections 13(a) and 15(d) of the Securities ExchangeAct of 1934, as amended, are available free of charge on our website when suchreports are available on the U.S. Securities and Exchange Commission(SEC) website (see “Company—Investor Relations—SEC Information”). Thepublic may read and copy any materials filed by the Company with the SEC at theSEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC20549. The public may obtain information on the operation of the PublicReference Room by calling the SEC at 1-800-SEC-0330. TheSEC maintains an Internet site that contains reports, proxy and informationstatements and other information regarding issuers that file electronicallywith the SEC at http://www.sec.gov. The contents of these websites are not incorporatedinto this filing.

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**Overview**

We develop, market andsupport an integrated suite of vBusiness—video-enabled eBusiness—applications,all powered by the AvistarVOSTM software. From the desktop, we deliverTV-quality interactive video calling, content creation and publishing,broadcast origination and distribution, video-on-demand, and integrated datasharing. The Avistar video and data collaboration applications are all managedby the AvistarVOS video operating system. By integrating video tightly into theway they work, our customers can use our system to save costs and improveproductivity and communications within the enterprise and between enterprisesto enhance relationships with customers, suppliers and partners. Using AvistarVOS software and leveraging video, telephony and Internetnetworking standards, Avistar applications are designed to be scalable,reliable, cost effective, easy to use, and capable of evolving with communications networks as bandwidth increasesand as new standards and protocols emerge. We currently sell our systemdirectly to enterprises in selected strategic vertical markets, and havefocused initially on the financial services industry. Our objective is toestablish our technology as the standard for networked video through directsales, indirect channel sales/partnerships and the licensing of our technologyto others.

We operate in two segments.Avistar Communications Corporation engages in the design, development,manufacture, sale and marketing of networked video communications products andassociated support services. Collaboration Properties, Inc., or CPI, ourwholly owned subsidiary, engages in the prosecution, maintenance, support andlicensing of the intellectual property that we have developed, some of which isused in our products.

Since inception, we haverecognized the innovative value of our research and development efforts, andhave invested in securing protection for these innovations through domestic andforeign patent application and issuance. As of December 31, 2004, we hold66 U.S. and foreign patents, which we look to license to others in thecollaboration technology marketplace.

**Industry Background**

Globalization, supportedby the near ubiquity of communications networks such as the Internet, hasallowed companies to lower costs, reach new markets, change business processes(e.g., eBusiness) and distribute and outsource operations. It also has meantincreased competition, a faster business pace and less differentiation. Thesefactors, coupled with the difficulty and cost of travel, are causing businessesto look for new tools that will help them increase productivity, take advantageof revenue opportunities and differentiate themselves. Enterprises of all sizes stand to benefit from new and advancedcommunication and collaboration tools that enable their employees, partners,suppliers and customers to collaborate more effectively and form tighterrelationships within and across buildings and over disparate geographies andtime zones, recognizing that speed in decision-making and trust-basedrelationships are becoming even more critical in today’s increasingly complexbusiness environment.

For years, enterpriseshave relied on communication tools used principally in a point-to-point manner,such as telephone and fax. More recently, businesses have also embracednetwork-based collaboration applications, such as teleconferencing, voicemailand email. The emergence of the Internet has accelerated the adoption of thesenetwork-based collaboration applications. The increasing availability andaffordability of bandwidth on communication networks is further drivingbusinesses to utilize new tools of communication, such as web conferencing, toenhance collaboration among users.

As technology advances andbecomes more affordable and modes of communication expand, enterprises areseeking widely deployable and cost effective technology to replicate, at thedesktop, the integration of audio and visual communication and document orproject collaboration that occurs in a face-to-face meeting. Individualsgenerally prefer face-to-face encounters to less personal forms ofcommunication because they can see one another and benefit from the non-verbalcues that speed 

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communicationand deepen understanding. This is particularly true for more complexinteractions such as negotiations, sales, product development, projectmanagement and decision making across geography/functions. However, in today’sglobalized, fast-paced business environment, face-to-face interactions areoften forgone due to the difficulty and time required for travel and the needto act quickly. These time and distance challenges become increasinglydifficult to deal with as the number of potential participants increases.Beyond traditional teleconferencing and data sharing communications, attemptsto conduct virtual meetings as an alternative to face-to-face meetings havegenerally been limited to conference room-based video conferencing andweb-based data teleconferences. Most individuals do not have immediate accessto these video technologies, and the reservation and set-up time make themunlikely to be used on a spontaneous basis.

**Limitations of Current Means of Collaboration**

Toaddress the growing need for collaboration across distance and time,organizations have resorted to using a patchwork of discrete technologies,including video conferencing and teleconferencing, fax, email, Internet audioand video delivery and data sharing applications. Many of these technologieshave been widely adopted, and collectively indicate the need for collaborationtools including networked video. However, these discrete technologies are notgood substitutes by themselves for face-to-face meetings and presentationsbecause they do not provide an integrated communications solution that fostersteam interaction and delivers critical, time-sensitive informationquickly and reliably. By providingface-to-face collaboration in an integrated communications solution, video canspeed problem resolution and motivate action, trust and understanding. Additionally,users want to leverage knowledge and expertise by being able to create andpublish video content from their desktops either spontaneously, as with emailor voicemail, or in a more formal manner for broader distribution through theInternet or corporate data network.

Althoughlimited video technologies are already in use at many enterprises, businessesand other organizations require increasingly comprehensive, integrated andscalable video-enabled communication capabilities. For example, videoconferencing is often limited to point-to-point communication from designatedrooms or through the use of “roll-about” products, where call set-upprocedures, lack of networking, bandwidth requirements and room availabilitygreatly constrain functionality, usability, reliability and efficiency, as wellas access by individuals.

Similarly,broadcasting of stored video or television programming at a desktop or in aconference room is of highly varying quality and generally cannot be added on areal-time basis to a live videoconference. Some products are limited toexclusively using the enterprise data network or the Internet to carry two-waydesktop video conferencing or to transmit video one-way. As a result, they areunable to deliver television quality video in normal corporate settings, andare limited in their ability to create, publish and broadcast thesevideoconferences. In addition, it is difficult to expand these existingproducts within an enterprise, and even more difficult to do so amongenterprises because of bandwidth, security, functionality and qualitylimitations of current enterprise networks.

**Elements of a Complete Collaboration Solution**

Tobecome a critical tool in the enterprise, a communications solution must firstand foremost provide application functionality that boosts worker productivity.It also has to provide high quality at scale, high reliability, low total costof ownership and be available to people where and when they do most of their 

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work, which typically means attheir desks. It must also effectively utilize existing and evolving networkinfrastructure. We believe a complete collaboration solution must provide thefollowing:

Applicationsand functionality

·        supportthe applications people use, in the way they use them, to deliver real-time andnon real-time personal collaboration and data communication

·        do so in an intuitive, “easy”manner in order to foster expanding usage

Quality

·        approximatethe video and audio quality of television for natural and easy interaction

·        makeinteractions as realistic as possible by minimizing visual artifacts whentransmitting and receiving video calls such as latency, jitter, freeze-frame,stutter and small frame size

·        seamlessly integrate all forms of audio, video and data communicationincluding interactive video calling, content creation and publishing, broadcastvideo and video-on-demand retrieval

Scalability

·        like the Internet and public telephone networks, the communicationssolution must be designed for size independence and should scalecost-effectively to support a very large numbers of users

Reliability

·        operatedependably and reliably to avoid user frustration, while minimizing supportcosts

·        provide to video communications the ease of use, speed, quality,functionality, flexibility and global access of the telephone, while easilysupporting more complex applications and situations

Adaptability

·        offer anupgradeable architecture that can evolve as bandwidth availability, protocols,standards and compression technologies change

·        includepowerful software to manage an integrated suite of collaborativeapplications, relying on networked infrastructure

·        leverage current and future business investments in local and wide areanetworks, Internet protocol and standards-based infrastructures

Affordability

·        operate andscale cost effectively

·        utilizestandard, low cost and widely available hardware components

·        becost-effective compared to other pervasive forms of enterprise communicationsuch as email

·        delivercost savings through innovations in support, network and resource management

Webelieve high quality networked video communication allows businesses to improvecollaboration and thereby offers them the opportunity to increase productivity,enhance customer service and revenue generation, and facilitatebusiness-to-business interactions that reduce costs, all on an acceleratedbasis. We also believe that, just as every organization now relies on atelephone network and most businesses increasingly rely on the Internet, amarket is emerging in which businesses and other organizations will choose torely on fully integrated video, audio and data collaboration, regardless ofnetworks, to make their business applications more effective.

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**The Avistar Solution**

Avistar’sgoal is to video-enable enterprises—a concept we term vBusiness—by delivering asuite of video applications which support users where and how they work. It isthrough a tight coupling of various forms of video into daily work processesthat we believe the benefits described above can be realized. To fulfill this,we deliver a video collaboration platform enabled by a unique architecture andpowerful software—theAvistarVOS video operating system. This software provides a comprehensive,integrated suite of video applications that include on-demand access tointeractive video calling and conferencing, content creation and publishing,broadcast origination and video distribution, and video-on-demand, as well asdata sharing, presence-based directory services and network management. Theseapplications support users within and amongst enterprises and over data networks,telephony networks and the Internet. Our system architecture is open andflexible in order to embrace continued technological innovation andstandardization. It is designed to use existing and emerging communication andvideo standards such as session initiation protocol, or SIP. It also providescustomers choice and flexibility in network topologies to best deliverhigh-quality video applications to desktops across the enterprise.

Avistar has built a complete video collaboration solution thattoday is delivering TV-quality videoto thousands of desktops across hundreds of buildings. Each of our applicationscan be used, integrated and managed in conjunction with one another. Peopleoften conceive of video in the enterprise only as two-way, real-time conferencing.Our system allows broadcast video to be included in a video call and allows theentire session to be recorded simultaneously, and made available as storedvideo. Our system joins users in a high-quality video network to improve theirability to solve complex problems, connect to co-workers, customers andsuppliers, manage large projects and quickly act together on opportunities. Oursystem does this cost effectively and reliably and is designed to be able toserve a wide range of businesses from a single office operation to globalcorporations with branch offices and/or widely dispersed operations.

*Interactivevideo calling.  *Oursystem allows users to participate in spontaneous interactive videocollaborations from their desktops. Users can simultaneously see and hearmultiple participants in windows on their workstations. Additionally, oursystem provides full duplex audio, which allows multiple users to speak andhear each other clearly at the same time. The desktop window can be dividedinto four quadrants, to permit up to three other video sources. These sourcescan include other participants in real-time, broadcast content or recordedvideo. The participants can include individual users or conference-room groupslocated at multiple sites and/or various enterprises, all without requiringadvance reservations or conferencing services. Each participant has the fullability to utilize all the call functions of the system, such as adding orremoving participants. The system supports the communications needs of users byallowing them to add a third or fourth participant into a call spontaneouslyfor a quick conference, and then revert back to a two party call. This abilityhelps speed decision-making and leverages the knowledge of experts. Asan example, a sales trader can be on a video call with a client portfoliomanager and spontaneously add a research analyst to the call for added insighton a particular security, then drop the analyst and add a trader to reviewexecution strategy.

*Videocontent creation and publishing.  *With our solution, users can create and publishvideo content from their desktops by recording themselves, recording amulti-point conference or adding commentary to a broadcast and recording theentire session. Recorded content can be played back on demand and can bepublished in various forms inside and outside the enterprise. This includesvideo emails, called vBriefs, which allow users to easily create video messageswhich recipients, with common mail clients and browsers, can watch. This helpsdifferentiate and highly personalize the sender’s email. As an example,research analysts can record introductory commentary and distribute theirresearch reports in a way that cuts through the email clutter of theiraudiences’ inbox. Similarly, video can be simply and quickly be published toweb sites from a user’s desk.

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*Broadcastvideo.  *Salesmeetings, training seminars, analyst reports, management presentations and livenews broadcasts can be delivered real-time to every user’s workstation andstreamed to browser-based users. For example, a customer employed its Avistarvideo network to maximize the reach and impact of an educational seminar. Thecustomer broadcast the seminar to an estimated 300 desktops and meeting roomswith more than 2,000 employees and clients watching in the United States andEurope. As another example, one customer has shifted its international salesmeetings to broadcasts and recorded presentations on its Avistar system,thereby saving travel time and costs, while expanding the broadcast to a wideraudience.

*Video-on-demand.  *Users anywhere on the Avistar network can easilyretrieve stored videos. For example, a corporation uses our system to recordits sales training seminars. Salespeople who are unable to attend theseface-to-face presentations are now able to watch the seminars by retrieving andplaying the stored videos on their desktops when it is convenient for them. Anothercustomer uses our system to record and broadcast their daily morning meetingsso colleagues in other time zones around the world can be updated on the issuesof the day when they report to work. The ability to both archive and retrievestored content can facilitate the establishment of a visual “institutionalmemory” and support training efforts.

*Integrateddata sharing.  *Inaddition to viewing the four quadrants of our video window, multiple users cansimultaneously create and annotate a shared document using text or drawingtools color-coded specifically for each user. All participants can access thecontents of any shared window and save the marked changes for later reference. Oursystem can also be utilized in conjunction with other application sharingprograms that utilize data networks or the Internet. While participating in aninteractive video call, users can access Microsoft NetMeeting’s applicationsharing capabilities through a button on our tool bar and jointly view and edita document. As an example, multiple design engineers can share a technicaldrawing in order to resolve an issue with a defective part.

Oursystem has the following key features necessary to make integrated videocollaboration effective:

*Easy to use interface.  *Our applications bring the rich interaction of a face-to-face meeting andthe quality and ease of use of the telephone to our systems through:

·        *Click-to-connectsimplicity.*To initiate calls oradd another user to a session already underway, a user simply clicks on eithera “direct connect” button or a name in the directory. Standard telephone-likefeatures such as hold, hang-up, forward, leave message or begin another callare all completed with the click of a mouse, or keyboard shortcuts. Additionally,anyone on an Avistar network can initiate a video call to the desktop ofcolleagues, customers, suppliers and others on other Avistar networks. If theperson being called is logged-in but unavailable, users can leave apersonalized call back message that allows the person to automatically returnthe video call without having to look up the address. A portion of thisfunctionality is protected under certain patents held by CPI.

·        “*Find Me, Follow Me.”*Avistar video calling is built on directories andpresence-based features referred to as “Find Me, Follow Me.” Using this feature, our system is able todetermine the presence and location of any user on an Avistar network at anytime. To call any user in the Avistar network, it is not necessary to knowtheir number or current location. As long as the Avistar user is logged intohis or her Avistar application, the Find Me, Follow Me applicationautomatically registers where that user is logged in, regardless of site orgeography, and routes all calls to the user’s location. Using this Find Me, Follow Me technology, Avistar’s system makes video callinga one-click process and enables what we call “Video Instant Messaging.” Aportion of this functionality is protected under certain patents held by CPI.

·        *Comprehensivedirectory*. The Avistar networkdirectory is a comprehensive list of Avistar numbers that can be called with aclick. All users currently logged intoan enterprise’s Avistar network will be 

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shown, providing immediate ‘presence’information as to availability. The global directory can be tailored to includeonly a subset of a more specific business’ community of users. In addition, a privatedirectory feature allows users to create their own directory and reachfrequently called parties with a one-click “direct connect” tool. Both globaland private directories can also include other non-Avistar sites that usestandards-based video conferencing systems. Through the Avistar CommunityExchange and AvistarVOS Proxy products, presence information can be sharedacross participating organizations. The result is one-click, presence-basedcalling which helps form a community of users. A portion of this functionality is protected under certain patents held byCPI.

·        *Consistencyacross locations.*The Avistaruser interface is consistent across desktops and conference rooms. Thus, a userwho is familiar with the functionality at the desktop requires no additionaltraining or set up to utilize an Avistar system in a conference room setting.This allows conference room systems to be “self-service,” thereby avoiding thesupport logistics and expense of traditional room-based systems.

*Seamlessintegration of system applications.  *All of our applications are seamlessly integratedwith one user interface. As a user adds an additional video source during anongoing video call—such as an additional live participant, a one-way broadcastor a stored video clip—there is virtually no delay in launching anotherapplication or downloading data. In addition, each application is synchronizedwith the others so that all participants in a video call see and hear the samecontent simultaneously. Thus, recorded or broadcast video can be added to alive session and shown to all participants. The entire session can also berecorded. Our system enables common network and application management, so thesame directory can be used for two-way calls, one-way broadcasts and data sharingin the same session. Usage can be determined with our integrated call-reportingtool that provides summary data for analysis and cost justification. A portion of this functionality isprotected under certain patents held by CPI.

*Networkmanagement.  *Ournetwork architecture provides system administrators with the ability toflexibly and proactively manage each of the various components of the network. Withinour system, the most costly and complex equipment and software applications areshared as networked resources. This arrangement allows for redundancy anddynamic allocation of these resources to users who need them, and ensures thatusers experience the best video quality possible at the highest reliability andlowest cost of use. Servers and switches can be maintained, installed andrepaired centrally, and many network support functions can be performedremotely over the data network, thereby limiting the disruption of service toan individual user. Similarly, additional desktops and meeting rooms can beeasily and inexpensively added to the Avistar network, with those new usersconcurrently added to the Avistar directory. Additionally, our software makescall routing decisions to minimize communications costs. A portion of thisfunctionality is protected under certain patents held by CPI.

We believe our solution includes the following benefitsto our customers:

·        *Speedbusiness processes.*We provide afully integrated Internet protocol-based video collaboration solution thatseamlessly allows individuals to make video calls, view broadcasts and create,store and access video content or other forms of data from the desktop. Thiscan speed business processes by enhancing collaboration and communication.

·        *Increasedavailability of knowledge within the enterprise.*At many businesses, individuals who possessvaluable knowledge often cannot effectively distribute their knowledge to therest of the organization. Our system enables these businesses to access theseindividuals and disseminate their knowledge more efficiently and effectively byoffering them the ability to call, broadcast or record from their desktops, andoffering other users the ability to receive this information real-time, oraccess video recordings at a convenient time and location. In addition, oursystem gives every desktop the ability to create and publish valuable visualcontent, which can be distributed inside and outside the organization tosupport employee and customer needs worldwide. The ability to 

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spontaneously add additional participants to a call encourages personalcommunications between individuals who otherwise might not enjoy this access.

·        *Improvedproductivity and revenue generation.*Our system helps companies increase the productivity of their employeesand speed up time critical decision-making. By creating a network of Avistarusers, our customers can have face-to-face meetings within the enterprise andwith customers and partners, without the costs and time delays of travel. Negotiations,sales, advisory services, decision-making and other persuasive communicationsare more effective when done face-to-face. Our solution allows interactions tohappen in real-time, speeding up the manner in which business is done, freeingup time for employees, enhancing business-to-business communications, andpotentially increasing revenue generation.

·        *Enhancedcustomer and partner relationships.*Our system helps companies to be more responsive to and develop strongerbusiness relationships with their customers, partners and suppliers. An Avistarcall is generally as easy and reliable as a telephone call, while being morepersonal. One of our customers provides Avistar networks to their clients andbusiness partners, including offshore outsource partners, in order tofacilitate interactions and improve relationships.

·        *Opportunityto leverage existing and future communication infrastructures.*We provide an open architecture that usesexisting standards and is designed to take advantage of emerging standards. Oursystem integrates into our customers’ existing network communicationsinfrastructure, and supports the protocols a company may choose to use forvideo broadcasts, data sharing and transport of information. However, videoquality varies depending on the protocol selected. Our system utilizes existingdata networks for transporting stored video, and is designed to supportreal-time digital networking and video transmission. We have designed oursystem to continue to work with Internet protocol-based technologies asstandards evolve and quality of service improves. We expect this flexibility,together with simplified software and hardware at the desktop, to allowcompanies to make effective use of their existing local area and wide areanetworks, as well as their next generation networks.

·        *Better communication to face new business challengessuch as globalization and distributed locations.*Within globalcorporations, professionals collaborate daily with customers, partners andassociates who are often located in different offices and/or different timezones. This has increasingly become the case as firms, due to economic andsecurity concerns, have restricted travel, begun decentralizing their personnelacross a more distributed set of locations, taking advantage of lower costs ofreal estate, and shifted more operations to outsourcing providers. In thiscontext, critical information must be delivered on a timely basis and withoutconfusion as smoothly as if colleagues were working together in person. Byoffering a combination of conference room and desktop systems, Avistar’s videoproduct suite enables companies that are reducing travel and/or distributingtheir operations to easily and quickly connect small, remote offices to thecentral organization, and still benefit from face-to-face interaction. Based on our experience inhelping existing customers choose their optimal configurations, we are able toadvise new customers on the setups or configurations that will be mosteffective for a large central office, a small branch office, an outsourcingprovider, or other remote locations.

**SystemArchitecture and Technology**

Ournetworked video system is based on our sixth major release of our openarchitecture, which enables users to communicate visually using variousnetworking protocols and transport media, including IP networks and theInternet. We developed our architecture to address the necessary elements of acomplete video-enabled collaboration solution.

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We believe that the following technical factors willtransform and consolidate the existing video collaboration applicationsmarketplace, creating a strong need for a software platform that will supportthis consolidation and evolution:

·        improvedcompression technologies;

·        widespreadproliferation of broadband infrastructure and virtual private networks, or VPNs(with enhanced tools to optimize bandwidth for video transmission (QOS; qualityof service));

·        developingavailability of converged audio, video and data networks;

·        improvedcomputer processing speeds; and

·        adoption ofcritical digital video and multimedia standards.

Oursoftware platform supports this consolidation and evolution by integratingindustry standards for audio, video and data transport, but separating themfrom application functionality and system management. This allows the videooperating system to manage the interoperation and transcoding of variousstandards to seamlessly integrate video, audio and data into complexapplications, and not be limited by the functionality built into oneparticular, application-specific standard. It also allows the system toaccommodate new and evolving standards with minimal disruption. Currentindustry and widely accepted proprietary standards supported include H.320,H.323, SIP, NTSC, PAL, MPEG, Microsoft Windows Media Video and Real NetworksRealMedia.

Webelieve our AvistarVOS video operating system positions us to lead thetransformation described above. Further, we provide a suite of collaborationapplications that seamlessly operate with the AvistarVOS system allowing usersto access this functionality in an easy and intuitive manner. We expect to makethis platform more accessible to developers and to allow integration with otherapplications and network hardware.

Oursystem uses TCP/IP, the standard Internet protocol, for initiating video calls,scheduling and starting broadcast presentations, and managing the creation andaccess of stored video materials. In addition, we use TCP/IP for overallsystems and network management throughout our software platform. This approachallows us to deliver connectivity throughout an enterprise and allows us toleverage existing Internet infrastructure. For delivery of live high-qualityvideo streams in the local area network, we offer a choice of IP or traditionalcircuit switched technologies, including the ability to mix and match networktypes. Thus, with Avistar customers can successfully deploy desktop videoacross the enterprise, even if portions of their network, in older buildingsfor example, aren’t capable of support real-time video on their data networks. Weuse our gateways to translate between the various network technologies used inour system. These gateways are managed and controlled by our systems softwarewith TCP/IP-based protocols.

EachAvistar endpoint functions as a node on the network, like personal computers,printers or file servers on a local area network. Just as color printers andfile servers are often shared network resources on the local area network, themore costly equipment in an Avistar system, such as servers, media servers,switches, and gateways, are centralized and made available to multiple users. Networknodes and resources, like those of a data network, are managed throughcentralized, Internet protocol-based applications and administration tools,such as web-based reports of video call activity.

Because of the tight integration of various videonetwork components, namely, IP or circuit-switched endpoints, the AvistarSwitch, Media Server, Conference Center, Broadcast Podium and gateways, allcontrolled by the AvistarVOS software, our architecture has the following keyfeatures:

·        *Videonetwork choice*: Many IP datanetworks are not capable of reliably supporting real-time video traffic atscale. Avistar provides a choice of using data networks for video traffic insome locations and, through the use of Avistar video switches, circuit-switchednetworks in others. These networks 

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are fully integrated and interoperable, thus ensuring that our system canscale to support large numbers of users.

·        *Networkmanagement:*The AvistarVOSsystem utilizes open protocols for call set-up, call control and directoryservices. It also complies with standards and interfaces and connects withvideo networks through shared Avistar gateways, which are further connected viaprivate or public telephony or TCP/IP networks. Servers communicate through oursignaling system for video protocol, SSV, which is based on TCP/IP, thestandard Internet protocol. Through this signaling system, servers exchangeconfiguration information and allocate call resources during call set-up, andexchange network status information. The signaling system selects the optimalroute for all video calls, helping to minimize call costs and performancedemands on wide area network resources. Most videoconferencing equipment usingindustry standard compression technologies also can communicate with an Avistarnetwork.

·        *Transportstandard independence:* Oursystem selects the appropriate transport standards for transmitting informationover the network to help deliver the highest quality video possible and fullduplex audio in the most efficient manner. For example, the AvistarVOS softwareautomatically exchanges information among servers and switches to determine thebest network route for video calls. For the transport of video over a localarea network, our system uses either data networks with our IP Endpoints orexisting spare Ethernet wires to deliver standards-compliant television qualitysignals with our circuit-switched endpoints. This allows customers to choosethe transport type to best fit their network capabilities in the local area. Ina wide area network, we use industry video compression standards across thepublic telephony network or a customer’s private IP networks or VPN’s. For thetransmission of recorded content on corporate data networks or via theInternet, our system uses standard digital storage formats and transporttechnologies.

·        *Expandableto thousands of users:*Becauseshared resources, such as servers, are attached to the Avistar switch and aremanaged through the data network, new users and new capabilities can be addedwithout replacing existing infrastructure, but rather, by simply adding videosoftware and hardware at each desktop. Just as local area network switches andpublic telephony networks can be linked together without the use of routers,Avistar switches can be similarly linked without the use of video networkgateways. As a result, customers can easily add capacity as their needs grow.

·        *Evolves with digital technology:*Our AvistarVOS software is designed to facilitate utilization ofall-digital, local area networks, including Internet protocol videotransmission, where sufficient bandwidth and quality of service (QOS) areavailable. This all-digital system also maintains compatibility with ourexisting circuit-switched video networks. The AvistarVOS software allowsevolution of the transport of audio and video based on the customer’s localarea data network capabilities. A simple and inexpensive swap of endpointhardware allows customers to migrate to all IP networks while preserving thesame user interface system functionality.

**System Products and Applications**

Oursystem-level products and applications consist of shared resources and anetwork of desktop and conference room endpoints which connect to each otherand these shared resources.

*Shared Resources*

Likethe architecture of most data networks, our system is designed to maximize theuse of shared resources on the network. This configuration results in a desktopthat is not burdened with processor intensive software and hardware. Each usercan access higher quality software, gateways, multi-point conference centers,media servers and video broadcasts with lower per user acquisition andmanagement 

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costs than is possible with non-networked videosolutions. These devices are expected to move to software-only resources overtime. These shared resources consist of the following products andapplications:

*Infrastructure, Server andSoftware Products*

·        *AvistarVOSServer.*All systems requireAvistarVOS Server software. It enables the seamless integration of videoapplications and comprehensive network management and administration. TheAvistarVOS software supports a highly-distributed topology and multipleinstances may be deployed. Digital IP endpoints require network access toservers running AvistarVOS software configured for IP endpoints. Servers in theAvistar Switch also run instances of AvistarVOS Server software as noted below.

·        *AvistarSwitch.*Each Avistar switchincludes server software (the AvistarVOS Server) that provides applicationservices and network management. The Switch hosts shared video services and infrastructure such as Avistar conferencecenters, media servers, gateways, television broadcasts, VCR’s and other videoservices which are accessed by both types of endpoints. It also serves as the video switch for our localarea circuit-switched network, connecting video calls placed among Avistardesktop and conference room users. Each switch supports up to 120 circuit-switcheddesktop users and/or conference rooms and switches can be networked together ina building or campus to scale to many hundreds or even thousands of users. WithIP endpoint deployments, a switch is required only for video services beyondpoint-to-point calling and may be located anywhere with appropriate networkaccess.

·        *AvistarGateways.*Gateways provideconnectivity to the wide area network for circuit-switched endpoints,interoperability with third-party video systems that are H.320 or H.323 compliant,interoperability between IP endpoints and circuit-switched endpoints, andaccess to shared video services for IP endpoints. The gateways support variousprotocol standards, using public telephony, TCP/IP networks or customer’sprivate networks.

·        *AvistarConference Center.*Ourconference center enables multi-point conferences for up to four video sources,with continuous presence that allows all participants to see and hear oneanother continuously and simultaneously. Multiple conference centers can beinstalled on each switch to support a corresponding number of simultaneousmulti-party calls.

·        *AvistarMedia Server.*Our media serverallows users to create, publish and view video content from any desktop orconference room. Any form of video, including a four-way video call, can besaved on the media server in high quality, digital MPEG format. Any user canretrieve and replay video at any time from the media server using the desktopAvistar interface or any industry standard MPEG player. The Avistar MediaServer also has a publishing capability allowing Avistar users to publish videocontent on intranets, extranets or the Internet, including web servers, videoservers or content distribution networks. Publishing to vBriefÔ video email messages is one example. The Media Server software managesformat plug-ins to simplify transcoding to other video standards and formats,such as Real Networks and Microsoft Windows Media Video.

·        *AvistarBroadcast Podium.*Our broadcastpodium allows Avistar desktop or conference room users to broadcast one-way,real-time presentations to an audience of other Avistar users at both local andremote sites. The broadcast podium allows an individual or a conference call tobe broadcast to thousands of users, and, via third party products, to bestreamed simultaneously over the Internet.

·        *AvistarDirectory Software.*Ourdirectories allow a user to place a video call by simply clicking on a name inthe user’s directory of local and remote Avistar users. If the other party islogged-on, our system will route the call to the correct location over thelocal area network or the wide area as appropriate. The user can look upaddresses in private and global address books, utilize browser style type-inboxes, and access speed-dial direct connect buttons. This server-baseddirectory 

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integrates with LDAP directories, simplifies administration and allowsusers to get started quickly without having to manually enter many video phonenumbers into their desktop directory.

·        *AvistarCommunity Exchange and AvistarVOS Proxy*. These products provide secure, cross-enterprise communications betweenindependent Avistar systems. This provides directory and presence informationand system resource reservation for easy and fast connections between firms. Theseproducts facilitate the building of communities of video-enabled users.

·        *Shareboard®Software.*Our Shareboardapplication allows users to collaborate on graphics, data or text during avideo call. By clicking on the “share” button, users are linked to theShareboard data sharing application. Users can share any application window orimage with all conference participants, see all users’ color-keyed pointers andtext and paintbrush annotations, and save or print shared images from anydesktop or conference room.

·        *Avistar Call Reporting System.*With our web-based call reporting system, our customers can track localand wide area network calls logged by our servers. Reports show call details,device usage and calls by user, all viewable from any Web browser. Reports canbe customized and stored for future or specialized analysis.

*Desktop and Conference Room EndpointProducts*

ClientPC’s run the AvistarVOS Client software applications including AvistarConference, the primary user interface to server-based video applications.Endpoints access video services managed by the AvistarVOS Server softwarethrough the AvistarVOS Client software and Client Access Licenses. Endpointsare either IP (digital) or circuit-switched (analog).

*Desktop Endpoints.  *The standard Avistar two-way desktop system consists of the followinghardware components:

·        A highquality camera with built-in directional microphone;

·        A videocodec (with IP endpoints) or video network interface unit (withcircuit-switched endpoints) with ports for camera, microphone, speakers,auxiliary video and audio, headset, built in echo-cancellation circuitry andfull duplex audio, without requiring a headset; and

·        IPendpoints display video either directly on a computer display or externalmonitor. Circuit-switched endpoints include a video overlay card that allowsvideo to be viewed from a computer or an external monitor.

*Avistar Room Systems.  *We deliver complete video systems for a widerange of room sizes and layouts. We believe that one key advantage of oursystem is that the interface used in a conference room system is consistentwith the interface used on individual desktops, allowing for all forms ofvideo-enabled communications: interactive video calling, content creation andpublishing, broadcasting and video-on-demand. Therefore, desktop users arefamiliar with the controls used in Avistar room systems and do not needadditional training to operate the room system, nor do they need an additionaltechnician to set-up and connect conference room calls (as is common withtraditional room systems). In addition, since rooms are simple additional nodeson the network, they can be less expensive than self-contained traditional roomsystems.

*VideoTurrets.  *Through apartnership with a top voice trading platform (turret) providers, Avistarprovides traders with an integrated voice and video turret system. The videoturret combines call-control functionality and turret audio with video. Thisenhances the functionality of the turret while tying audio-only participants onphones and turrets into video calls and broadcasts.

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**Customers**

As of December 31,2004, we have licensed and recognized revenue with respect to over 10,000end-users at approximately 473 customer sites in 150 cities and 43 countries. Becausemany of our customers operate on a decentralized basis, decisions to purchaseour systems are often made independently by individual business units. As such,a single company may represent several separate accounts and multiple customersites may relate to the same company.

For the year ended December 31,2004, Deutsche Bank AG and its affiliates accounted for 50% of our totalrevenue and UBS Warburg LLC and its affiliates accounted for 15% of our totalrevenue. For the year ended December 31, 2003, Deutsche Bank AG and itsaffiliates represented 62% of our total revenue. For the year ended December 31,2002, Deutsche Bank AG and JP Morgan Chase & Company and theiraffiliates each represented greater than ten percent of our total revenue for acombined total of 66% percent of our total revenue. The level of sales toany customer may vary from quarter to quarter, and we expect that significantcustomer concentration will continue for the foreseeable future. The loss of,or a decrease in the level of sales to, or a change in the ordering pattern of,any one of these customers could have a material adverse impact on ourfinancial condition or results of operations.

Internationalrevenue, which consists of sales to customers with operations principally in WesternEurope and Asia  comprised 48%, 58%and 49% of total revenue for 2004, 2003 and 2002, respectively. For 2004, 2003and 2002, revenues to customers in the United Kingdom accounted for 28%, 40%and 26%, respectively, of total revenue.

**Segment Information**

We operate through two segments:

·        AvistarCommunications Corporation engages in the design, development, manufacturing,sale and marketing of networked video communications products.

·        CollaborationProperties, Inc., our wholly owned subsidiary, engages in the development,prosecution, maintenance, support and licensing of the intellectual propertyused in our video communications system.

Financial informationregarding these segments is provided in Note 11 to our consolidated financialstatements included in this Annual Report on Form 10-K. Financialinformation relating to revenues, income and total assets for the three yearsended December 31, 2004, can be found in Item 6 “Selected FinancialData” and also in our Consolidated Financial Statements attached hereto.

**Sales and Marketing**

*Sales.  *We have a direct sales force in the United Statesand Europe consisting of sales managers located in New York, New York andLondon, England. Sales managers have direct responsibility for selling andaccount management, system utilization and expansion at existing customersites.

*Marketing.  *Our marketing efforts are directed towards selectvertical markets, with a current emphasis on financial services. We haveidentified specific collaboration needs for enterprises in each of thesevertical markets. We then help our customers understand how our system cansatisfy these needs, thereby increasing the number of users. We emphasizeinitiatives to develop market awareness of our system and services as well asincreased usage of our installed systems. We also use marketing programs tobuild recognition of our corporate brand, foster partnerships and promote ourtechnology in regards to licensing opportunities.

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**Installation, Maintenance, Training and Support Services**

We provide a wide variety of services forinstallation, design and adoption of our video communications products,including workflow analysis to identify patterns of collaboration betweenworkgroups to determine the best configuration of networked resources for theenterprise. We generally install our systems for new customers. In anincreasing number of cases, our customer’s information technology group orservices partner install follow-on orders. In the future, we expect ourcustomers or their services partners will increasingly perform installation ofadditional systems.

Ourmaintenance services ensure that customers benefit from the latest networkedvideo technology through software upgrades and expedited repair and replacementservices. Our customer support center provides voice and video call assistanceto Avistar users and administrators throughout the world. On-site support isalso available from each of our major regional offices for a separate fee. Inaddition, training for users is available onsite or at an Avistar facility andfor system administrators at an Avistar facility on a for-fee basis.

**Backlog**

Theestimated backlog of product orders believed to be firm was $700,000 at December 31,2004 and $600,000 at December 31, 2003. We expect most of the orders as ofDecember 31, 2004 will be shipped in the first two quarters of 2005. Backlogis not necessarily indicative of past or future operating results.

**Research and Development**

Webelieve that strong system development capabilities are essential to ourstrategy. Our research and development efforts focus on enhancing our coretechnology, developing additional applications, addressing emergingtechnologies, standards and protocols, and engaging in patent and licensingactivities. Our system development team consists of engineers and softwaredevelopers with experience in video and data networking, voice communications,video and data compression, email and Internet technologies. We believe thatour diverse technical expertise contributes to the highly integratedfunctionality of our system. Research and development expenses were $2.6million in 2004, $2.4 million in 2003 and $3.7 million in 2002. We expect todevote a significant amount of our resources to research and development in theforeseeable future.

**Manufacturing**

Weuse contract manufacturers to produce and/or purchase components and performsome material assembly. Our operations staff develops manufacturing strategiesand qualifies and audits manufacturing processes and suppliers. We work withour contract manufacturers to reduce manufacturing costs and to resolve qualitycontrol issues, as well as performing final assembly and testing of ourstandard products. We believe our manufacturing strategy enables us to utilizethe manufacturing capabilities of our contract manufacturers, while allowing usto focus on rapid system development and deployment, software architecture anddevelopment of video communication applications. We use third party,commercially available camera components, microphones, speakers and monitorsfor desktop and room systems, as well as third party compression anddecompression components for our gateways.

**Intellectual Property and Proprietary Rights**

Our ability to compete, andcontinue to provide technological innovation depends substantially uponinternally developed technology. We rely on a combination of patent, copyright,trademark and trade secret laws, as well as licensing, non-disclosure and otheragreements with our consultants, suppliers, customers and employees, to protectour technology. We believe that other factors such as the technological andcreative skills of our personnel, new system developments, frequent system andfeature 

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enhancementsand reliable system support and maintenance are also essential to maintainingour leadership position in technology.

We have pursued registration ofour key trademarks and service marks in the United States, the United Kingdomand certain other European countries, and intend to pursue additionalregistration in additional countries where we plan to establish a significantbusiness presence. We own several United States, Canadian and United Kingdomtrademarks, including Avistar and the Avistar logo, AvistarVOS, Shareboard,vBrief and The Enterprise Video Company.

Through Collaboration Properties, Inc., ourwholly owned subsidiary, as of December 31, 2004, we held 22 United Statespatents and 44 non-United States patents. One additional United States patenthad been allowed. The patents that have been issued expire at varying datesbetween 2013 and 2018. In addition, numerous patent applications are pending inthe United States and several other jurisdictions. Specifically, these patentapplications, most of which relate to and claim priority from an applicationoriginally filed in 1993, include both method and apparatus claims. Thesepatents and pending patent applications disclose and/or claim aspects of ouranalog or digital desktop video conferencing technology, video and multimediastorage technology for messaging and publishing, directory services, and publicwide area networking access, switching and architecture. A portion of thesetechnologies is currently utilized in our system. To date, CPI has focused onexpanding our patent portfolio and expediting patent issuance. We plan tocontinue these efforts and to seek to license our patents to reinforce theadoption of our technology.

On September 23, 2002, CPIcommenced a patent infringement lawsuit against Polycom, Inc. allegingthat several Polycom videoconferencing products infringe four patents held byCPI. The suit was filed in the United States District Court for the NorthernDistrict of California. The four patents involved were U.S. Patent Nos.5,867,654, 5,896,500, 6,212,547 and 6,343,314. These patents cover technologiesrelating to video and data conferencing over unshielded twisted pair (UTP)networks, distributed call-state management, separate monitors for simultaneouscomputer-based data sharing and videoconferencing and remote participant holdand disconnect functions in multi-party conferencing. A trial date for CPI’sclaims against Polycom had been set for January 24, 2005.

On November 12, 2004, Avistar, CPI and Polycom entered into aSettlement Agreement and Patent Cross-License Agreement. Under the terms of theSettlement Agreement:

·        Avistar, on behalf of itself and its subsidiaries, including CPI,provided Polycom and its subsidiaries with specific and general releases ofliability;

·        Polycom, on behalf of itself and its subsidiaries, provided Avistar andits subsidiaries with specific and general releases of liability;

·        Polycom made a lump-sum payment to Avistar in the amount of $27.5 million($21.1 million net of expenses); and

·        Avistar and CPI dismissed with prejudice all claims against Polycom inthe litigation.

Under the terms of the Patent Cross-License Agreement:

·        Avistar and its subsidiaries granted Polycom and its subsidiaries afully-paid up license to Avistar’s patent portfolio, including subsequentpatents that have a priority date within five years of the date of theagreement; and

·        Polycom and its subsidiaries granted Avistar and its subsidiaries afully-paid up license to Polycom’s patent portfolio, including subsequentpatents that have a priority date within five years of the date of theagreement.

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We generally enter intoconfidentiality, license and nondisclosure agreements with our employees,consultants, prospective customers, licensees, and partners that seek to limitthe use and distribution of our proprietary materials and prohibitreverse-engineering of our proprietary technologies. In addition, we controlaccess to and distribution of our software, documentation and other proprietaryinformation. Several of our license agreements with our customers require us toplace our software source code into escrow. In these cases, these agreementsprovide that these customers may be entitled to retain copies of the softwareand will have a limited non-exclusive right to use and/or reproduce, maintain,update, enhance and produce derivative works of the software source code underthe terms of the agreements if we fail to cure a contractual breach by us on atimely basis, or if we become the subject of a bankruptcy or similarproceeding.

Wemaintain a strong working relationship with vendors whom we identify as keysuppliers, and assign preferred provider status to these vendors underagreements that secure ordering and extended warranty rights for us. Theseagreements also generally include marketing provisions under which thesevendors promote our system and development forums under which we have anopportunity to participate in the vendor’s development plans to includefeatures and functions that are favorable to us.

**Competition**

The market for videocollaboration products and systems is highly competitive and fragmented. As aresult of advances in technology, increases in communications capability andreductions in communications costs in the past several years, the market is nowcharacterized by many competitors, rapidly changing technology, evolving userneeds, developing industry standards and protocols and the frequentintroduction of new products and services. Within the market for videocollaboration products and systems, we compete primarily with Polycom Inc.,Tandberg Inc. and VCON Telecommunications Ltd.

We believe we may faceincreasing competition in the future from alternative video communicationssolutions that employ new technologies or new combinations of technologies fromcompanies such as Cisco Systems, Inc., Avaya, Inc., Nortel NetworksCorporation, Microsoft Corporation, and WebEx Communications, Inc., thatenable web-based or network-based video communications with low-cost digitalcamera systems.

We believe that the principal factors affecting competition in ourmarkets include:

·        product features, functionality and scalability;

·        product quality and performance;

·        product reliability and ease of installation;

·        use of open standards;

·        quality of service and support;

·        company reputation, size and financial stability;

·        price and overall cost of ownership;

·        integration with other desktop collaboration products; and

·        document sharing, including internet-based collaboration.

Currently, our principal competitors are companies that provide productsand services in specific areas where we offer our integrated system, such as:

·        room-based point-to-point video communication products;

·        desktop video communications products;

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·        broadcast video products;

·        video retrieval and viewing products;

·        desktop content creation products; and

·        web-based data collaboration products.

While a number of companies havemarketed applications that enable users to use individual features similar toour system, we do not believe that any single competitor currently offers afully integrated system that provides all the features of our system. Webelieve these companies in many cases can also represent complementaryopportunities to extend the reach of our system by potentially expanding themarket for video networking.

Weexpect competition to increase significantly in the future from existingproviders of specialized video communications products, voice over IP solutionproviders and companies that may enter our existing or future markets, possiblyincluding major telephone companies or communications equipment providers. Thesecompanies may develop similar or substitute solutions, which may be less costlyor provide better performance or functionality than our systems. A number ofour existing and potential competitors have longer operating histories,significantly greater financial, marketing, service, support, technical andother resources, significantly greater name recognition and a larger installedbase of customers than we do. In addition, many of our current or potentialcompetitors have well-established relationships with our current and potentialcustomers, and have extensive knowledge of our industry. It is possible thatnew competitors or alliances among competitors may emerge and acquire significantmarket share. To be successful, we must continue to respond promptly andeffectively to the challenges of developing customer requirements,technological change and competitors’ innovations. Accordingly, we cannotpredict what our relative competitive position will be as the market evolvesfor video collaboration products and services.

**Employees**

Asof December 31, 2004, we had 51 employees, including personnel dedicatedto research and development, customer services, including installation andsupport services, sales and marketing and finance and administration. Ourfuture performance depends in significant part upon the continued service ofour key technical, sales and marketing, and senior management personnel, noneof whom is obligated to remain with us by an employment agreement. The loss ofthe services of one or more of our key employees could harm our business.

**Executive Officers**

Our officers and their ages as of December 31, 2004were as follows:
| **Name**             | ** ** | ** ** | ** ** | **Age**                                                    | ** ** | **Position** |
|----------------------|------------|------------|------------|------------------------------------------------------------|------------|--------------|
| Gerald  J. Burnett   |       | 62         |       | Chairman of the Board and  Chief Executive Officer         |
| William  L. Campbell |       | 56         |       | Vice Chairman, and Executive  Vice President and Secretary |
| Robert  J. Habig     |       | 50         |       | Chief Financial Officer                                    |
| J.  Chris Lauwers    |       | 44         |       | Chief Technology and Product Officer                       |
| Anton  F. Rodde      |       | 62         |       | President, Collaboration Properties, Inc.             |
| R.  Jan Afridi       |       | 45         |       | Vice President, Sales                                      |
| Stephen F. Arisco    |       | 46         |       | Vice  President, Operations and Customer Support           |

 

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*Gerald J. Burnett*is one of our founders and has been Chairman ofour Board of Directors and our Chief Executive Officer since March 2000. Heserved as Chief Executive Officer of Avistar Systems from December 1998until March of 2000. From 1993 to 1997, he was a director of AvistarSystems or a principal of its predecessor limited partnership. He is a memberof the Corporation (Board of Trustees) of the Massachusetts Institute ofTechnology. Dr. Burnett holds a B.S. and an M.S. from the MassachusettsInstitute of Technology in electrical engineering and computer science and aPh.D. from Princeton University in computer science and communications.

*William L. Campbell*is one of our founders and has been a member ofour Board of Directors and our Executive Vice President since March 2000. Hehas been our Corporate Secretary since June 2001 and served as our interimChief Financial Officer from April 2001 to May 2001. He has beenPresident and Chief Executive Officer of CPI since December 1997.Mr. Campbell holds a B.S. in general engineering from the U.S. MilitaryAcademy and an M.S. in management from the Sloan School of the MassachusettsInstitute of Technology.

*Robert J. Habig*has been our Chief Financial Officer since May 2001. Previously, he servedas Chief Financial Officer at think3 Corporation, a private computer-aideddesign software company from March 1999 to February 2001, as ChiefFinancial Officer at CrossWorlds Software, Inc., an enterprise softwarecompany from July 1998 to February 1999, as Executive Vice Presidentat First Data Corporation, a financial transactions processing company, from May 1997to June 1998, as a business unit Chief Financial Officer at Allied SignalCorporation, an automotive, aerospace and chemical manufacturing company from1994 to 1997 and held a number of positions with PepsiCo from 1979 to 1994.Mr. Habig holds a B.A. in economics and business from Lafayette Collegeand an M.B.A. from the Simon Graduate School of Business at the University ofRochester.

*J. Chris Lauwers*hasbeen our Chief Technology and Product Officer since February 2000. Heserved as Vice President of Engineering of Avistar Systems from 1994 to 2000. Hepreviously served as Principal Software Architect at Vicor Inc., a private e-business product solutions andengineering consulting company, from 1990 to 1994, and as a researchassociate at Olivetti Research Center from 1987 to 1990. Mr. Lauwers holdsa B.S. in electrical engineering from the Katholieke Universiteit Leuven ofBelgium. Mr. Lauwers also holds an M.S. and a Ph.D. in electricalengineering and computer science from Stanford University.

*Anton F. Rodde*has been the President of CollaborationProperties, Inc., since December 2003. Prior to joining CPI, heserved as President and CEO of Western Data Systems, an ERP software company,from 1991 to 2003, as President and General Manager of several subsidiaries ofTeknekron Corporation, a technology incubator, from 1984 to 1991, as founderand President of Control Automation, a robotics company, from 1980 to 1984 andheld a variety of technical and management positions at AT&T from 1970 to1980. Mr. Rodde holds a B.S. in physics from Benedictine University and anM.S. and Ph.D. in physics from the Illinois Institute of Technology.

*R. Jan Afridi*hasbeen our Vice President of Sales since April 2000. Previously, he servedas Director of Domestic Financial Services Sales from 1998 to March 2000,and as Director of Support Services from 1997 to 1998. Prior to joining Avistarhe was Director of Sales at Cornerstone, a document imaging company, from 1994to 1997. He holds a B.S. in engineering from U.S. Military Academy and anM.B.A. from Golden Gate University.

*Stephen F. Arisco*hasbeen our Vice President of Operations and Customer Service since February 2000.He previously served as Director of Operations and Customer Service of AvistarSystems from December 1997 to January 2000. From 1987 through December 1997,he was Director of Customer Service and Operations at TRW Financial Systems, Inc.,a systems integration company. Mr. Arisco holds a B.S. in Business fromthe University of Phoenix.

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**Item 2**.   *Properties*

Ourcorporate headquarters are located in Redwood Shores, California, where weoccupy approximately 14,000 square feet under a lease that expires in March 2007.We believe that our current leased facilities, together with facilities thatare available to us or are being negotiated, will be sufficient to meet ourneeds for the next twelve months. In addition, we lease a combined total ofapproximately 9,000 square feet of office space in New York, New York, andLondon, England. As of December 31, 2004, approximately 1,000 square feetof our corporate headquarters was being utilized by CPI, our wholly-ownedsubsidiary.

**Item 3**.   *Legal Proceedings*

On September 23, 2002, CPI, our wholly-ownedsubsidiary, commenced a patent infringement lawsuit against Polycom, Inc.alleging that several Polycom videoconferencing products infringe four patentsheld by CPI. The suit was filed in the United States District Court for theNorthern District of California. The four patents involved are U.S. Patent Nos.5,867,654, 5,896,500, 6,212,547 and 6,343,314. These patents cover technologiesrelating to video and data conferencing over unshielded twisted pair (UTP)networks, distributed call-state management, separate monitors for simultaneouscomputer-based data sharing and videoconferencing and remote participant holdand disconnect functions in multi-party conferencing. Briefings on claimsconstruction issues and a hearing before the presiding judge (Markman hearing)took place on March 8, 2004. A trial date for CPI’s claims against Polycomand Polycom’s counterclaims was set for January 24, 2005.

On November 12,2004, Avistar, CPI and Polycom entered into a Settlement Agreement and PatentCross-License Agreement. Under the terms of the Settlement Agreement:

·        Avistar,on behalf of itself and its subsidiaries, including CPI, provided Polycom andits subsidiaries with specific and general releases of liability;

·        Polycom,on behalf of itself and its subsidiaries, provided Avistar and its subsidiarieswith specific and general releases of liability;

·        Polycommade a lump-sum payment to Avistar in the amount of $27.5 million ($21.1million net of expenses); and

·        Avistarand CPI dismissed with prejudice all claims against Polycom in the litigation.

Under the terms ofthe Patent Cross-License Agreement:

·        Avistarand its subsidiaries granted Polycom and its subsidiaries a fully-paid uplicense to Avistar’s patent portfolio, including subsequent patents that have apriority date within five years of the date of the agreement; and

·        Polycom and itssubsidiaries granted Avistar and its subsidiaries a fully-paid up license toPolycom’s patent portfolio, including subsequent patents that have a prioritydate within five years of the date of the agreement.

**Item 4**.   *Submission of Matters to a Vote of Security Holders*

None.

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**PART II**

**Item 5**.   *Market for Registrant’s Common Equity and Related Stockholder Matters*

Ourcommon stock traded on the NASDAQ National Market from August 17, 2000 to October 29,2002 and has traded on the NASDAQ SmallCap Market since October 30, 2002under the symbol “AVSR.”  Prior to August 17,2000, there was no public market for our Common Stock. The following table setsforth for the period indicated the high and low closing sale prices for ourcommon stock, as reported by the NASDAQ Stock Market.
| ** **      | ** ** | **Year Ended**  December 31, 2004 | ** ** | **Year Ended**  December 31, 2003 | ** ** |
|-----------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **      | ** ** | **   High   **     | ** ** | **  Low  **                  | ** ** | **   High   ** | ** ** | **  Low  ** | ** ** |
| First Quarter   |       |                                             | $          | 1.80                                   |       |   | $ | 1.30 |   |   | $ | 1.58 |   |   | $ | 0.23 |   |
| Second Quarter  |       |                                             | $          | 1.35                                             |       |   | $ | 0.76 |   |   | $ | 1.06 |   |   | $ | 0.81 |   |
| Third Quarter   |       |                                             | $          | 1.07                                             |       |   | $ | 0.75 |   |   | $ | 0.85 |   |   | $ | 0.54 |   |
| Fourth  Quarter |       |                                             | $          | 1.85                                             |       |   | $ | 0.89 |   |   | $ | 2.90 |   |   | $ | 0.70 |   |

 

On December 31,2004, the last reported sale price of our common stock on the NASDAQ SmallCapMarket was $1.33 per share. According tothe records of our transfer agent, as of December 31, 2004 there were 81holders of record of our common stock and we believe there are a substantiallygreater number of beneficial holders.

**Recent Sales ofUnregistered Securities**

On March 26, 2004, we completed the private saleof a total of 3,000,000 shares of our common stock to Fuller & ThalerAvalanche Fund, L.P. and Fuller & Thaler Behavioral Finance Fund, Ltd.at a price of $1.20 per share. The net proceeds of this private financing,after deducting expenses of the financing, were approximately $3.6 million.Pursuant to the foregoing sale, we agreed to use our commercially reasonableefforts to register the shares under the Securities Act of 1933, as amended, aswhen requested to do so by Fuller & Thaler during the two yearsfollowing the close date of the transaction, unless Fuller & Thaler isable to sell their holdings under rule 144 during any 90 day period.

The foregoing transaction did not involve any publicoffering, and we believe that the transaction was exempt from the registrationrequirements of the Securities Act by virtue of Section 4(2) thereofor Regulation D promulgated thereunder. The purchasers in the foregoingtransaction represented their intention to acquire the securities forinvestment only and not with a view to or for resale in connection with anydistribution thereof. Appropriate legends were affixed to the sharecertificates and instruments issued in the foregoing transaction. Allpurchasers had adequate access to information about us.

Wehave used and intend to continue to use the remaining net proceeds of thefinancing for working capital purposes.

**Dividend Policy**

We have never paid cashdividends on our common stock, and we do not anticipate paying cash dividendsin the foreseeable future.

**Item 6****.   *Selected Financial Data***

The selected consolidated financial data below shouldbe read in conjunction with “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and our consolidated financial statementsand notes thereto. The selected statements of operations data for the yearsended December 31, 2004, 2003 and 2002 and the selected balance sheet dataas of December 31, 2004 and 2003 are derived from, and are qualified byreference to, the audited financial statements included elsewhere in 

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this Annual Report on Form 10-K.The selected statement of operations data for the year ended December 31,2001 and 2000 and the selected balance sheet data as of December 31, 2002,2001 and 2000 is derived from our financial statements not included in theAnnual Report on Form 10-K. The historical results presented below are notnecessarily indicative of future results.
| ** **                                                                             | ** ** | **Year Ended December 31,**                         | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2004**                                                           | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                             | ** ** | **(In thousands, except per share data)** | ** ** |
| **Statements  of Operations Data**                                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenue:                                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product                                                                                |       | $                                                                  | 3,121      |   | $ | 2,817 |   | $ | 4,430 |   | $ | 11,366 |   | $ | 16,925 |   |
| Services, maintenance and  support                                                     |       | 3,200                                                              |       | 3,775 |   | 4,369 |   | 4,830 |   | 4,489 |   |
| Licensing                                                                              |       | 575                                                                |       | — |   | — |   | — |   | — |   |
| Total revenue                                                                          |       | 6,896                                                              |       | 6,592 |   | 8,799 |   | 16,196 |   | 21,414 |   |
| Cost of revenue:                                                                       |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product                                                                                |       | 1,435                                                              |       | 1,410 |   | 2,129 |   | 4,961 |   | 7,287 |   |
| Services, maintenance and  support                                                     |       | 1,937                                                              |       | 2,119 |   | 2,348 |   | 2,683 |   | 2,167 |   |
| Total cost of revenue                                                                  |       | 3,372                                                              |       | 3,529 |   | 4,477 |   | 7,644 |   | 9,454 |   |
| Gross margin                                                                           |       | 3,524                                                              |       | 3,063 |   | 4,322 |   | 8,552 |   | 11,960 |   |
| Operating expenses:                                                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Research and development                                                               |       | 2,588                                                              |       | 2,420 |   | 3,699 |   | 5,280 |   | 4,123 |   |
| Sales and marketing                                                                    |       | 2,456                                                              |       | 3,598 |   | 3,728 |   | 6,066 |   | 5,627 |   |
| General and administrative                                                             |       | 6,956                                                              |       | 6,034 |   | 4,593 |   | 5,002 |   | 4,283 |   |
| Amortization of deferred stock  compensation                                           |       | —                                                             |       | 135 |   | 358 |   | 898 |   | 2,049 |   |
| Total operating expenses                                                               |       | 12,000                                                             |       | 12,187 |   | 12,378 |   | 17,246 |   | 16,082 |   |
| Loss from operations                                                                   |       | (8,476                                                             | )          | (9,124 | ) | (8,056 | ) | (8,694 | ) | (4,122 | ) |
| Other income (expenses):                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Interest income                                                                        |       | 118                                                                |       | 44 |   | 269 |   | 758 |   | 650 |   |
| Other income (expense), net                                                            |       | 15                                                                 |       | 481 |   | 227 |   | (2 | ) | (1,184 | ) |
| Total other income (expense),  net                                                     |       | 133                                                                |       | 525 |   | 496 |   | 756 |   | (534 | ) |
| Loss before provision for (recovery from) income taxes                                 |       | (8,343                                                             | )          | (8,599 | ) | (7,560 | ) | (7,938 | ) | (4,656 | ) |
| Provision for (recovery from) income taxes                                             |       | 363                                                                |       | 20 |   | 18 |   | (19 | ) | 15 |   |
| Net Loss                                                                               |       | $                                                                  | (8,706     | ) | $ | (8,619 | ) | $ | (7,578 | ) | $ | (7,919 | ) | $ | (4,671 | ) |
| Beneficial conversion related  to convertible preferred stock                          |       |                                                               |       |   |   |   |   |   |   | $ | (37,783 | ) |
| Net loss attributable to  common stockholders                                          |       | $                                                                  | (8,706     | ) | $ | (8,619 | ) | $ | (7,578 | ) | $ | (7,919 | ) | $ | (42,454 | ) |
| Net loss per share—basic and diluted                                              |       | $                                                                  | (0.27      | ) | $ | (0.33 | ) | $ | (0.30 | ) | $ | (0.31 | ) | $ | (4.46 | ) |
| Weighted average shares used in calculating basic and diluted  net loss per share |       | 32,610                                                             |       | 26,368 |   | 25,260 |   | 25,168 |   | 9,510 |   |

 
| ** **                                              | ** ** | **As of December 31,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                              | ** ** | **2004**                              | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                              | ** ** | **(In thousands)**               | ** ** |
| **Balance Sheet Data  Cash  and cash equivalents** |       | $                                     | 21,656     |   | $ | 4,438 |   | $ | 4,783 |   | $ | 7,455 |   | $ | 21,660 |   |
| Short-term investments                                  |       | —                                |       | 1,000 |   | 2,402 |   | 5,831 |   | — |   |
| Working capital                                         |       | 16,367                                |       | 4,848 |   | 7,250 |   | 14,039 |   | 21,423 |   |
| Total assets                                            |       | 24,211                                |       | 8,228 |   | 10,400 |   | 19,265 |   | 28,303 |   |
| Stockholders’  equity                              |       | 514                                   |       | 5,491 |   | 7,948 |   | 15,041 |   | 21,764 |   |
|                                                         |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

** **

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**Item 7**.   *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations*

The following discussion should be read in conjunctionwith the Consolidated Financial Statements and Notes thereto included elsewherein this Annual Report on Form 10-K. Certainstatements in this “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” are forward looking statements. These statementsrelate to future events or our future financial performance and involve knownand unknown risks, uncertainties and other factors that may cause our or ourindustry’s actual results, levels of activity, performance or achievements tobe materially different from any future results, levels of activity,performance or achievements expressed or implied by the forward lookingstatements. These risks and other factors include those listed under “FactorsAffecting Future Operating Results” elsewhere in this Annual Report on Form 10-K.In some cases, you can identify forward looking statements by terminology suchas “may”, “will”, “should”, “expects”, “intends”, “plans”, “anticipates”, “believes”,“estimates”, “predicts”, “potential”, “continue” or the negative of theseterms, or other comparable terminology. These statements are only predictions.Actual events or results may differ materially. In evaluating these statements,you should specifically consider various factors, including the risks outlinedunder “Factors Affecting Future Operating Results.”  These factors may cause our actual results todiffer materially from any forward looking statement.

Although we believe thatthe expectations reflected in the forward looking statements are reasonable, wecannot guarantee future results, levels of activity, performance orachievements. We are under no duty to update any of the forward-lookingstatements after the date of this Annual Report on Form 10-K to conformour prior statements to actual results.

**Overview**

We develop, market and support an integrated suite ofvBusiness—video-enabled eBusiness—applications, all powered by the AvistarVOSTMsoftware. From the desktop, we deliver TV-quality interactive video calling,content creation and publishing, broadcast origination and distribution,video-on-demand, and integrated data sharing. The Avistar video and datacollaboration applications are all managed by the AvistarVOS video operatingsystem. By integrating video tightly into the way they work, our customers canuse our system to help reduce costs and improve productivity and communicationswithin the enterprise and between enterprises, to enhance relationships withcustomers, suppliers and partners. Using AvistarVOSsoftware andleveraging video, telephony and Internet networking standards, Avistarapplications are designed to be scalable, reliable, cost effective, easy touse, and capable of evolving with communicationsnetworks as bandwidth increases and as new standards and protocols emerge. Wecurrently sell our system directly to enterprises in selected strategicvertical markets, and have focused initially on the financial servicesindustry. Our objective is to establish our technology as the standard fornetworked video through direct sales, indirect channel sales/partnerships andthe licensing of our technology to others.

We operate on a 52-week fiscalyear ending December 31. We operate in two segments. AvistarCommunications Corporation engages in the design, development, manufacture,sale and marketing of networked video communications products and associatedsupport services. Collaboration Properties, Inc., or CPI, our wholly ownedsubsidiary, engages in the prosecution, maintenance, support and licensing ofthe intellectual property that we have developed, some of which is used in ourproducts.

Since inception, we have recognized the innovative valueof our research and development efforts, and have invested in securingprotection for these innovations through domestic and foreign patentapplications and issuance. As of December 31, 2004, we hold 66 U.S. andforeign patents, which we look to license to others in the collaborationtechnology marketplace.

On September 23,2002, CPI commenced a patent infringement lawsuit against Polycom, Inc.alleging that several Polycom videoconferencing products infringe four patentsheld by CPI. On November 12, 

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2004,Avistar, CPI and Polycom entered into a Settlement Agreement and PatentCross-License Agreement. Under the terms of the Settlement Agreement andCross-License Agreement, Avistar and CPI provided Polycom and its subsidiarieswith specific and general releases of liability, Polycom, on behalf of itselfand its subsidiaries, provided Avistar and CPI with specific and generalreleases of liability, Polycom made a lump-sum payment to Avistar in the amountof $27.5 million ($21.1 million net of expenses), and Avistar and CPI grantedPolycom a fully-paid up license to Avistar’s patent portfolio, includingsubsequent patents that have a priority date within five years of the date ofthe agreements. As described under Revenue Recognition below, we expect torecognize the payment received from Polycom to licensing revenue ratably over afive year period starting November 12, 2004.

**Critical AccountingPolicies**

The preparation of our Consolidated FinancialStatements in accordance with accounting principles generally accepted in theUnited States requires us to make estimates and judgments that affect thereported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities. We base our estimates onhistorical experience and assumptions that we believe to be reasonable underthe circumstances, the results of which form the basis for making judgmentsabout the carrying values of assets and liabilities that are not readilyapparent from other sources. Actual results may differ from these estimates.

We believe thefollowing critical accounting policies, among others, affect our moresignificant judgments and estimates used in the preparation of our ConsolidatedFinancial Statements:

·        Revenuerecognition;

·        Valuationof accounts receivable; and

·        Valuationof inventories.

**Revenue Recognition**

We derive product revenue principally from the saleand licensing of our video-enabled networked communications system, consistingof a suite of Avistar-designed software and hardware products, including thirdparty components. We also derive revenue from fees for installation,maintenance, support, training services and software development. In addition,we derive revenue from the licensing of our intellectual property portfolio.Product revenue as a percentage of total revenue was 45% for 2004, 43% for 2003and 50% for 2002.

We recognizerevenue in accordance with Statement of Position (“SOP”) 97-2, Software RevenueRecognition (“SOP 97-2”), as amended by SOP 98-9, Modification of SOP 97-2, “SoftwareRevenue Recognition” With Respect to Certain Transactions (“SOP 98-9”). Inconnection with each transaction involving our products, we must evaluatewhether: (i) persuasive evidence of an arrangement exists, (ii) deliveryhas occurred, (iii) our fee is fixed or determinable, and (iv) collectibilityis probable. We apply these criteria as discussed below:

·        *Persuasive evidence of an arrangement exists*.   Werequire a written contract, signed by both the customer and us, or a purchaseorder from those customers that have previously negotiated a standard end-userlicense arrangement or volume purchase agreement with us prior to recognizingrevenue on an arrangement.

·        *Delivery has occurred*.   We deliversoftware and hardware to our customers physically. Our standard delivery termsare FOB shipping point.

·        *The fee is fixed or determinable*.   Ourdetermination that an arrangement fee is fixed or determinable dependsprincipally on the arrangement’s payment terms. Our standard payment 

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terms generally requirethe arrangement fee to be paid within 30 days. Where these terms apply, weregard the fee as fixed or determinable, and we recognize revenue upon delivery(assuming other revenue recognition criteria are met). If the payment terms donot meet this standard, which we refer to as “extended payment terms,” we maynot consider the fee to be fixed or determinable and would then recognizerevenue when customer installments are due and payable.

·        *Collectibility is probable*.   Torecognize revenue, we must judge collectibility of the arrangement fees, whichwe do on a customer-by-customer basis pursuant to our credit review policy. Wetypically sell to customers with whom we have a history of successfulcollection. For new customers, we evaluate the customer’s financial positionand ability to pay. If we determine that collectibility is not probable basedupon our credit review process or the customer’s payment history, we recognizerevenue when cash is collected.

When we provide installationservices, the product and installation revenue is recognized upon completion ofinstallation and receipt of customer confirmation, subject to the satisfactionof the revenue recognition criteria described above. When the customer or athird party provides installation services, the product revenue is recognizedupon shipment, subject to satisfaction of the revenue recognition criteriadescribed above. Payment for product is due upon shipment, subject to specificpayment terms.

The price charged formaintenance and/or support is defined in the product contract, and is based ona fixed price for both hardware and software components as stipulated in thecustomer agreement.  Customers have theoption to renew the maintenance and/or support services in subsequent periodsat the same rate as paid in the initial year. Revenue from maintenance andsupport is recognized pro-rata over the maintenance and/or support term, whichis typically one year in length. Training services are offered together withand independently of the purchase of product. The value of training services isdetermined based on the price charged when such services are sold separately.Training revenue is recognized upon performance of the service. We recognizeservice revenue from software development contracts using the percentage ofcompletion method, when all of the following conditions are met: a contractexists with the customer at a fixed price, we have fulfilled all of ourmaterial contractual obligations to the customer for a deliverable of thecontract, verification of completion of the deliverable has been received, andcollection of the receivable is probable. Reimbursements received forout-of-pocket expenses incurred duringinstallation and support services have not been significant to date. Theseexpenses are recognized as revenue in accordance with Emerging Issues TaskForce (EITF) Issue No. 01-14 (EITF 01-14), “Income StatementCharacterization of Reimbursements Received for “Out of Pocket” ExpensesIncurred.”

We recognize revenue from thelicensing of our intellectual property portfolio based on the terms of theroyalty, partnership and cross-licensing agreements involved. Revenue fromlicensing of our intellectual property, to date, has consisted entirely ofpayment from Polycom, Inc. pursuant to a settlement agreement and across-license agreement dated November 12, 2004, and has been recognizedas revenue in accordance with Section 48 and 49 of Statement of Position97-2, “Software Revenue Recognition” (SOP 97-2), which discussesmultiple-element arrangements and the future delivery of unspecified additionalsoftware products. As part of the settlement and cross-license agreements withPolycom, Inc., we granted to Polycom a non-exclusive, fully paid-up,license to our entire patent portfolio. The cross-license agreement includes afive year capture period from the date of the settlement, adding all our newpatents with a priority date extending up to five years from the date ofexecution of the cross-license agreement. Sections 48 and 49 of SOP 97-2provide that a vendor may agree to deliver software currently and to deliverunspecified additional software products in the future. The software elementsof the kinds of arrangements discussed in paragraph 48 should be accounted foras subscriptions. No allocation of revenue should be made among any of thesoftware products, and all software product-related revenue from thearrangement should be recognized ratably over the term of the arrangementbeginning with delivery of the first product. Accordingly, the net $21.1million license fee paid to us by 

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Polycom, Inc.will be deferred and recognized as licensing revenue ratably over the five yearperiod beginning November 12, 2004.

To date, a significant portion of our revenue hasresulted from sales to a limited number of customers, particularly DeutscheBank AG and UBS Warburg LLC and their affiliates. For 2004, we recorded revenueof approximately $4.5 million, or 65% of total revenue from Deutsche Bank AGand UBS Warburg LLC and their affiliates, each of whom accounted for greaterthan 10% of our total revenue for 2004. For 2003, we recorded revenue ofapproximately $4.1 million, or 62% of total revenue from Deutsche Bank AG andtheir affiliates. No other customers individually accounted for greater than10% of our total revenue for 2003. For 2002, we recorded revenue ofapproximately $5.8 million, or 66% of total revenue from Deutsche Bank AG andJP Morgan Chase & Company and their affiliates, each of whom accountedfor greater than 10% of our total revenue for 2002. We anticipate that ourrevenue, and therefore, our operating results for any given period, willcontinue to depend to a significant extent on a limited number of customers. Asa result, the loss of or a reduction in sales to any one of these customerswould have a significant adverse impact on our operations and financialperformance.

International revenue, whichconsists of sales to customers with operations principally in Western Europeand Asia,  comprised 48% of totalrevenue for 2004, 58% for 2003 and49% for 2002.

Valuation of Accounts Receivable

Estimates are used in determining our allowance fordoubtful accounts and are based on our historical collection experience,historical write-offs, current trends and the credit quality of our customerbase and the characteristics of our accounts receivable by aging category. Ifthe allowance for doubtful accounts was understated, our operating income couldbe significantly reduced. The impact of any such change or deviation may beincreased by our reliance on a relatively small number of customers for a largeportion of our total revenue. As of December 31, 2004, approximately 81%of our accounts receivable balance was concentrated with one customer. As of December 31,2003, approximately 89% of our accounts receivable were concentrated with onecustomer. As of December 31, 2002, approximately 65% of our accountsreceivable were concentrated with one customer.

Valuation of Inventories

We record a provision forobsolete or excess inventory for systems and components that are no longermanufactured or are at risk of being replaced with new versions of our product.In determining the allowance for obsolete or excess inventory, we look at ourforecasted demand versus quantities on hand and commitments. Any significantunanticipated changes in demand or technological developments could have asignificant impact on the value of our inventory and commitments and ourreported results. If actual market conditions are less favorable than thoseprojected, additional inventory write-downs, provision for purchase commitmentsand charges against earnings may be required, which would negatively affect ouroperating income for such period.

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**Results ofOperations**

The following tablesets forth data expressed as a percentage of total revenue for the periodsindicated.
| ** **                                              | ** ** | **Percentage of Total Revenue** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                              | ** ** | **Year Ended December 31,**     | ** ** |
| ** **                                              | ** ** | ** 2004  **                     | ** ** | **  2003  ** | ** ** | **  2002  ** | ** ** |
| Revenue:                                                |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Product                                                 |       |                                           | 45         | % |   |   | 43 | % |   |   | 50 | % |   |
| Services, maintenance and  support                      |       |                                           | 47         |   |   |   | 57 |   |   |   | 50 |   |   |
| License                                                 |       |                                           | 8          |   |   |   | — |   |   |   | — |   |   |
| Total revenue                                           |       |                                           | 100        |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenue:                                        |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Product                                                 |       |                                           | 21         |   |   |   | 21 |   |   |   | 24 |   |   |
| Services, maintenance and  support                      |       |                                           | 28         |   |   |   | 32 |   |   |   | 27 |   |   |
| Total cost of revenue                                   |       |                                           | 49         |   |   |   | 53 |   |   |   | 51 |   |   |
| Gross margin                                            |       |                                           | 51         |   |   |   | 47 |   |   |   | 49 |   |   |
| Operating expenses:                                     |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Research and development                                |       |                                           | 37         |   |   |   | 37 |   |   |   | 42 |   |   |
| Sales and marketing                                     |       |                                           | 36         |   |   |   | 55 |   |   |   | 43 |   |   |
| General and administrative                              |       |                                           | 101        |   |   |   | 92 |   |   |   | 52 |   |   |
| Amortization of deferred stock  compensation            |       |                                           | —     |   |   |   | 2 |   |   |   | 4 |   |   |
| Total operating expenses                                |       |                                           | 174        |   |   |   | 186 |   |   |   | 141 |   |   |
| Loss from operations                                    |       |                                           | (123       | ) |   |   | (139 | ) |   |   | (92 | ) |   |
| Other income (expense):                                 |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Interest income                                         |       |                                           | 2          |   |   |   | 1 |   |   |   | 3 |   |   |
| Other income (expense), net                             |       |                                           | 0          |   |   |   | 7 |   |   |   | 3 |   |   |
| Total other income, net                                 |       |                                           | 2          |   |   |   | 8 |   |   |   | 6 |   |   |
| Loss before provision for  (recovery from) income taxes |       |                                           | (121       | ) |   |   | (131 | ) |   |   | (86 | ) |   |
| Provision for (recovery from)  income taxes             |       |                                           | 5          |   |   |   | 0 |   |   |   | 0 |   |   |
| Net loss                                                |       |                                           | (126       | )% |   |   | (131 | )% |   |   | (86 | )% |   |

 

***COMPARISON OF 2004, 2003 AND 2002***

**Revenue**

Total revenue increased by 5% in 2004 to $6.9 millionfrom $6.6 million for 2003. The increase in total revenue in 2004 relative to2003 was due to the licensing of our intellectual property portfolio for thefirst time in 2004 and increased product sales, offset by reduced softwaredevelopment revenue. The increase in product sales was primarily due to newcustomers added in 2004. The reduction in software development revenue was aresult of software development contracts completed in 2003. For 2004, twocustomers accounted for 65% of our total revenue. For 2003, one customeraccounted for 62% of our total revenue. The level of sales to any customer mayvary from quarter to quarter and year to year. We anticipate that our revenuewill continue to depend on a limited number of major customers for theforeseeable future; although the companies considered to be major customers andthe percentage of revenue represented by each major customer may vary fromperiod to period. The loss of any one of those customers would have a materialadverse impact on our financial condition and operating results.

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Total revenue decreased by25% in 2003 to $6.6 million from $8.8 million for 2002. The decrease in totalrevenue in 2003 relative to 2002 was due to flat product sales and the timingof revenue recognition from 2001 business in 2002. Flat product sales in 2003were due in large part to stagnant demand for enterprise information technologyexperienced in the economy and in the financial services industry inparticular, resulting in constrained budgets and delayed procurement decisionsby existing and potential customers.

**Cost of Revenue**

Cost of revenue declined slightly by 4% in 2004 to$3.4 million from $3.5 million for 2003. The decrease in cost of revenue in2004 relative to 2003 was primarily due to the reduction in softwaredevelopment contract costs associated with the decrease in software developmentcontracts.

Cost of revenue declinedby 21% in 2003 to $3.5 million from $4.5 million for 2002. The decrease in costof revenue in 2003 relative to 2002 was primarily due to the reduction indirect product costs caused by the decreased product volume and, to a lesserextent, due to the reduction in maintenance and support costs caused by theconsolidation of our support center operations at our corporate headquarters.

**Gross Margin**

Gross margin as a percentage of revenue increased in2004 to 51% from 47% for 2003. The increase in gross margin as a percentage ofrevenue for 2004 relative to 2003 was due in large part to the revenueassociated with the licensing of our intellectual property portfolio for thefirst time in 2004. Revenue generated from the licensing of our intellectualproperty portfolio does not have any associated cost of sales. In addition, theincrease in gross margin as a percentage of revenue for 2004 relative to 2003was due to the increase in product sales, which provided greater coverage ofthe fixed component of the cost of product sales, offset by the reducedsoftware development revenue, which resulted in a lower overall revenue base,providing less coverage of the fixed component of the cost of sales.

Gross margin as apercentage of revenue decreased in 2003 to 47% from 49% for 2002. The decreasein gross margin as a percentage of revenue for 2003 relative to 2002 was due inlarge part to the reduced product revenue, which resulted in less coverage ofthe fixed component of the cost of product sales. In addition, the decrease ingross margin as a percentage of revenue for 2003 relative to 2002 was due tohigher service revenue as a percentage of total revenue for 2003, whichgenerally carries a lower margin than product revenue.

**Operating Expenses**

*Research and development.  *Researchand development expenses increased by 7% in 2004 to $2.6 million from $2.4million for 2003. The increase in research and development expenses in 2004relative to 2003 was primarily due to the reduction in software developmentrevenue, which resulted in research and development resources being allocatedto internal projects and recorded as operating expenses. Research anddevelopment projects associated with customer funded development are expensedto cost of sales in the period in which they are incurred. Research anddevelopment expenses decreased by 35% in 2003 to $2.4 million from $3.7 millionfor 2002. The decrease in research and development expenses in 2003 relative to2002 was primarily due to the reduction in personnel and personnel relatedexpense as a result of a 12% decline in average staffing levels and a reductionin outside services and external consulting expenses, as well as reducedcapital expenditures and associated depreciation.

*Sales and marketing.  *Salesand marketing expenses decreased by 32% in 2004 to $2.5 million from $3.6million for 2003. The decrease in sales and marketing expenses in 2004 relativeto 2003 was primarily due to reduction in personnel and personnel related costsas a result of a 25% reduction in staffing levels 

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and a reduction inproperty lease costs.  Sales andmarketing expenses remained relatively flat in 2003 at $3.6 million compared to$3.7 million for 2002.

*General and administrative.  *Generaland administrative expenses increased by 15% in 2004 to $7.0 million from$6.0 million for 2003. The increase in general and administrative expenses in2004 relative to 2003 was due primarily to an increase in legal fees associatedwith our litigation with Polycom, Inc. General and administrative expensesincreased by 31% in 2003 to $6.0 million from $4.6 million for 2002. Theincrease in general and administrative expenses in 2003 relative to 2002 wasdue primarily to an increase in legal fees associated with our litigation withPolycom, Inc.

*Amortization of deferred stockcompensation.  *Amortization of deferred stockcompensation decreased in 2004 to $0 from $135,000 for 2003. The decrease inamortization of deferred stock compensation in 2004 relative to 2003 was due tothe completion of pre-IPO option award amortization and the forfeitures ofstock options by employees no longer with our company. Amortization of deferredstock compensation decreased by 62% in 2003 to $135,000 from $358,000 for 2002.The decrease in amortization of deferred stock compensation in 2003 relative to2002 was due to the partial completion of option amortization, as well asforfeitures of stock options by employees no longer with our company.

*Other income, net.  *Otherincome, net decreased by 75% in 2004 to $133,000 from $525,000 for 2003. Thedecrease in other income, net in 2004 relative to 2003 was due primarily to netinsurance proceeds of $570,000 received in 2003 in satisfaction of a businessinterruption claim for losses incurred by our New York City office followingthe September 11, 2001 terrorist attack on the World Trade Center. Thedecrease in other income, net in 2004 relative to 2003 was offset by increasedinterest income associated with the increased balance of cash, cash equivalentsand short-term investments as a result of payment received under the Settlementand Cross-License agreements reached with Polcyom, Inc. on November 12,2004. Other income, net increased by 6% in 2003 to $525,000 from $496,000 for2002. The increase in other income, net in 2003 relative to 2002 was dueprimarily to net insurance proceeds of $570,000 received in satisfaction of abusiness interruption claim for losses incurred by our New York City officefollowing the September 11, 2001 terrorist attack on the World TradeCenter, offset by lower interest income associated with a declining balance ofcash, cash equivalents and short-term investments and lower interest rates.

*Provisionfor income taxes.  *Provision for income taxes increasedsignificantly in 2004 to $363,000 from $20,000 for 2003. The increase inprovision for income taxes in 2004 relative to 2003 was due primarily tofederal, state and foreign income taxes due as a result of the difference intaxable income versus reported income caused by the settlement and cross-license agreements with Polycom, Inc.signed on November 12, 2004, where we granted to Polycom a non-exclusive,fully paid-up, license to our entire patent portfolio. The net $21.1 millionlicense fee paid to us by Polycom, Inc. was deferred for reportingpurposes and will be recognized as licensing revenue ratably over the five yearperiod beginning November 12, 2004. For tax purposes, the $21.1 millionlicense fee was accounted for as taxable income in 2004, thus generating afederal and state tax liability, net of utilization of our net operating lossesand tax credits.

**Liquidity and Capital Resources**

We have funded our operations since inceptionprimarily from product and services revenue, the net proceeds of $31.3 millionfrom our August 2000 initial public offering of common stock, lines ofcredit with related parties and financial institutions, the proceeds ofapproximately $6.4 million from the sale of Series B preferred stock in December 1999,the proceeds of approximately $5.7 million and $3.6 million from the privatesale of our common stock in October 2003 and March 2004,respectively, and the proceeds of approximately $21.1 million from theSettlement and Cross-license agreements signed with Polycom, Inc. on November 12,2004.

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We had cash and cash equivalents of $21.7 million asof December 31, 2004 and $4.4 million as of December 31, 2003. For2004, we had a net cash inflow of $17.2 million resulting primarily from net cashproceeds from issuance of common stock of $3.7 million and net cash provided byoperations of $12.7 million. The net cash proceeds from issuance of commonstock are primarily due to the private sale of 3,000,000 shares of our commonstock to Fuller & Thaler Avalanche Fund, L.P. and Fuller &Thaler Behavioral Finance Fund, Ltd. in March 2004. The price per share ofthis transaction was $1.20, resulting in net proceeds of this privatefinancing, after deducting expenses of the financing, of $3.6 million. The netcash provided by operations primarily reflected an increase in deferred licenserevenue of $20.6 million as a result of the Settlement and Cross-Licenseagreements signed with Polycom, Inc on November 12, 2004, offset by a netloss of $8.7 million.

For 2003, we had a net cash outflow of $0.3 millionresulting primarily from net cash proceeds from issuance of common stock of$6.0 million and proceeds from net sales of short-term investments of $1.4 million,offset by net cash used in operations of $7.5 million. The net cash proceedsfrom issuance of common stock were primarily due to the private sale of4,615,385 shares of our common stock to Gerald J. Burnett, ourChairman, President and Chief Executive Officer, and other members of hisfamily at a price per share of $1.30 in October 2003, resulting in netproceeds of this private financing, after deducting expenses of the financing,of $5.7 million. The net cash used in operations primarily reflected a net lossof $8.6 million and a decrease in deferred revenue and customer deposits of$0.3 million, but was partially offset by an increase in accounts payable of$0.4 million, an increase in accrued liabilities and other of $0.2 million,a decrease in inventories of $0.2 million and a decrease in prepaid expensesand other current assets of $0.1 million. The cash outflows associated with thenet loss, along with the slight decrease in inventories and prepaid expensesreflect the smaller scale of our business in 2003 relative to 2002. Theincrease in accounts payable and accrued liabilities and other reflect thetiming of disbursements relative to 2002.

For 2002, we had a net cashoutflow of $2.7 million resulting primarily from net cash used in operations of$5.9 million, which was offset by proceeds from net sales of short-terminvestments of $3.4 million. The net cash used in operations primarilyreflected a net loss of $7.6 million, a decrease in accrued liabilities andother of $1.3 million and a decrease in deferred revenue and customer depositsof $0.2 million, partially offset by a decrease in accounts receivable of $2.0million, a decrease in prepaid expenses and other current assets of $0.5million and non-cash stock compensation expense of $0.4 million. The cashoutflows associated with the net loss, reduced accrued liabilities and reducedaccounts receivable reflect the smaller scale of our business in 2002 relativeto 2001.

Expenditures for property and equipment for 2004 wereapproximately $0.2 million. At December 31, 2004, we did not have any materialcommitments for future capital expenditures. We anticipate spendingapproximately $0.5 million in capital expenditures during the next 12 months.

Thefollowing table summarizes our known contractual obligations and commitments asof December 31, 2004 (in thousands) for the periods presented.
| ** **                  | ** ** | **Payments due by period** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|
| ** **                  | ** ** | **Total**                                 | ** ** | **Less than 1  Year** | ** ** | **1 – 3  Years** | ** ** | **3 – 5  Years** | ** ** | **More than   5 Years** | ** ** |
| *Contractual Obligations*   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Long-Term Debt Obligations  |       | $                                         | —     |   |   | $ | — |   |   | $ | — |   |   | $ | — |   |   |   | $ | — |   |   |
| Capital Lease Obligations   |       | —                                    |       |   | — |   |   | — |   |   | — |   |   |   | — |   |   |
| Operating Lease Obligations |       | 1,297                                     |       |   | 785 |   |   | 512 |   |   | — |   |   |   | — |   |   |
| Purchase Obligations        |       | 761                                       |       |   | 329 |   |   | 432 |   |   | — |   |   |   | — |   |   |
| Other Long-Term Liabilities |       | —                                    |       |   | — |   |   | — |   |   | — |   |   |   | — |   |   |
| Total                       |       | $                                         | 2,058      |   |   | $ | 1,114 |   |   | $ | 944 |   |   | $ | — |   |   |   | $ | — |   |   |

 

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On February 27, 2002, we entered into a Loan andSecurity Agreement with a financial institution to borrow up to $4.5 millionunder a revolving line of credit. On December 15, 2002, we entered into anamendment to the Loan and Security Agreement to increase the maximum fundsavailable under the line of credit to $6.0 million and extend the term of theagreement. The amended Loan and Security Agreement, as further amended in March 2003,had an expiration date of February 27, 2004. The agreement, as amended,includes a first priority security interest in all our assets, excludingintellectual property. Gerald Burnett, our Chairman and Chief ExecutiveOfficer, has provided a collateralized guarantee to the financial institution,assuring payment of our obligations under the agreement and as a consequence, anumber of restrictive covenants from the original Loan and Security Agreementwere deleted, except for quick ratio and loan to value covenants, allowing usgreater access to the full amount of the facility. On February 27, 2004,the Loan and Security Agreement was amended to change the maximum borrowingsthereunder to $3.5 million, subject to certain quick ratio and loan to valuecovenants, and to extend the term of the Loan and Security Agreement to February 27,2005. In connection with this amendment, Dr. Burnett’s collateralizedguarantee was amended to reduce the amount of such guarantee to $3.5 million. Inaddition to the guarantee provided to the financial institution, Dr. Burnetthas also provided a personal guarantee to Avistar assuring the provision of upto $2.0 million to Avistar in the event that at least $2.0 million is notavailable to us under the line of credit, or an alternate financingarrangement, for any reason. There were no outstanding borrowings under theline of credit as of December 31, 2004. The Loan and Security Agreementexpired by its terms on February 27, 2005.

On October 15, 2003, we completed the privatesale of 4,615,385 shares of our common stock to Dr. Burnett and othermembers of his family at a price per share of $1.30. The net proceeds of thisprivate financing, after deducting expenses of the financing, wereapproximately $5.7 million. Under the terms of the private placement, Dr. Burnettagreed to certain restrictions on 1,602,847 of the 3,661,539 shares purchasedby him. These restrictions require Dr. Burnett to vote such shares in thesame proportion as our outstanding common stock not beneficially owned by Dr. Burnett.

On March 26, 2004, we completed the private saleof a total of 3,000,000 shares of our common stock to Fuller & ThalerAvalanche Fund, L.P. and Fuller & Thaler Behavioral Finance Fund, Ltd.at a price per share of $1.20. The net proceeds of this private financing afterdeducting expenses of the financing were approximately $3.6 million. Theissuance of these additional shares reduced the number of Dr. Burnett’sshares subject to voting restrictions imposed in connection with his October 15,2003 purchase of common stock from 1,602,847 to 141,152 shares. Also as aresult of this private equity financing, the personal guarantee of Dr. Burnettto provide us with up to $2.0 million in the event that at least $2.0 millionis not available to us under the Loan and Security Agreement was terminated byits terms.

On November 12, 2004, we entered into Settlementand Cross-License agreements with Polycom, Inc. Under these agreements,CPI agreed to dismiss, with prejudice, its infringement suit against Polycomand both companies agreed to cross-license each other’s patent portfolios. Theoriginal litigation was initiated in September 2002, in the FederalDistrict Court for the Northern District of California and involved thefollowing CPI patents: U.S. Patent Nos. 5,867,654; 5,896,500; 6,212,547; and6,343,314. The agreements resulted in a payment, net of legal fees, to us fromPolycom, Inc. in the amount of $21.1 million.

During 2004, we borrowed $750,000 under the Loan andSecurity Agreement. These outstanding borrowings were repaid in November 2004using a portion of the proceeds from the Settlement and Cross-Licenseagreements with Polycom, Inc. As of December 31, 2004, we did nothave any borrowings outstanding under the line of credit.

We currently believe thatexisting cash and cash equivalents balances will provide us with sufficientfunds to finance our operations for the next 12 months. We intend to continueto invest in the development of new products and enhancements to our existingproducts. Our future liquidity and capital requirements will depend uponnumerous factors, including without limitation, general economic 

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conditionsand conditions in the financial services industry in particular, the level andtiming of revenue, the costs and timing of our product development efforts andthe success of these development efforts, the costs and timing of our sales andmarketing activities, the extent to which our existing and new products gainmarket acceptance, competing technological and market developments, the costsinvolved in maintaining and enforcing patent claims and other intellectualproperty rights, all of which may impact our ability to achieve and maintainprofitability.

**Recent Accounting Pronouncements**

In March 2004, the Emerging Issues Task Force(EITF) reached a consensus on Issue No. 03-01, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments.”EITF 03-01 provides guidance on other-than-temporary impairment modelsfor marketable debt and equity securities accounted for under SFAS No. 115,“Accounting for Certain Investments in Debt and Equity Securities,” and SFAS No. 124,“Accounting for Certain Investments Held by Not-for-Profit Organizations,” andnon-marketable equity securities accounted for under the cost method. The EITFdeveloped a basic three-step model to evaluate whether an investment isother-than-temporarily impaired. In September 2004, the FinancialAccounting Standards Board (FASB) issued EITF 03-01-1 which delayedthe effective date of the recognition and measurement provisions of EITF 03-01;however the disclosure requirements remain effective for annual financialstatements for fiscal years ending after December 15, 2004. We willevaluate the effect, if any, of the adoption of EITF Issue No. 03-01when final guidance is released.

In November 2004, the FASB issued SFAS 151,Inventory Costs, which revised ARB 43, relating to inventory costs. Thisrevision is to clarify the accounting for abnormal amounts of idle facilityexpense, freight, handling costs and wasted material (spoilage). This Statementrequires that these items be recognized as a current period charge regardlessof whether they meet the criterion specified in ARB 43. In addition, thisStatement requires the allocation of fixed production overheads to the costs ofconversion be based on normal capacity of the production facilities. SFAS 151is effective for inventory costs incurred during fiscal years beginning after June 15,2005. We do not believe the adoption of SFAS 151 will have a material impact onour financial position, results of operations, or cash flows.

In December 2004, theFASB issued a revision of Statement of Financial Accounting Standards No. 123,“Accounting for Stock-Based Compensation” (SFAS 123R). SFAS 123R supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees,” and its related implementation guidance.SFAS 123R establishes standards for the accounting for transactions inwhich an entity incurs liabilities in exchange for goods or services that arebased on the fair value of the entity’s equity instruments or that may besettled by the issuance of those equity instruments. SFAS 123R does notchange the accounting guidance for share-based payment transactions withparties other than employees provided in SFAS 123 as originally issued andEITF Issue No. 96-18, “Accounting for Equity Instruments That AreIssued to Other Than Employees for Acquiring, or in Conjunction with Selling,Goods or Services.” SFAS 123R is effective for interim reporting periodthat begins after June 15, 2005. The paragraph entitled *Stock Based Compensation* included in Note2 to these consolidated financial statements provides the pro forma net incomeand earnings per share as if we had used a fair-value-based method similar tothe methods required under SFAS 123R to measure the compensation expense foremployee stock awards during fiscal 2004, 2003 and 2002.

**Factors Affecting Future Operating Results**

**Our market is in the early stages of development, and our system may notbe widely accepted.**

Our ability to achieveprofitability depends in part on the widespread adoption of networked videocommunications systems and the adoption of our video operating system inparticular. If the market for our system fails to grow or grows more slowlythan we anticipate, we may not be able to increase revenue 

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orachieve profitability. The market for our system is relatively new and evolving.We have to devote substantial resources to educating prospective customersabout the uses and benefits of our system. Our efforts to educate potentialcustomers may not result in our system achieving broad market acceptance. Inaddition, businesses that have invested or may invest substantial resources inother video products may be reluctant or slow to adopt our system. Similarly,customers using existing information systems in which they have madesignificant investments may refuse to adopt our system if they perceive thatour offerings will not complement their existing systems. Consequently, theconversion from traditional methods of communication to the extensive use ofnetworked video may not occur as rapidly as we wish.

**We have incurred substantial losses in the past and may not be profitablein the future.**

We incurred net losses of $8.7million for 2004, $8.6 million for 2003 and $7.6 million for 2002. As of December 31, 2004, our accumulated deficit was $89.5 million.Our revenue may not increase, or even remain at its current level. In addition,our operating expenses may increase as we continue to develop our business inthe future. As a result, to become profitable, we will need to increase ourrevenue by increasing sales to existing customers and by attracting additionalcustomers. If our expenses increase more rapidly than our revenue, or ifrevenue and expense levels remain the same, we may never become profitable.If we do become profitable, we may not beable to sustain or increase profitability on a quarterly or annual basis. Inaddition, if we fail to reach profitability or to sustain or grow our profitswithin the time frame expected by investors, the market price of our commonstock may be adversely impacted.

**General economicconditions have and may continue to reduce our revenues and harm our business.**

The international economicslowdown and the downturn in the investment banking industry that began in theyear 2000 has negatively affected our business since that time, and maycontinue to do so in the future. During this period, the investment bankingindustry suffered a sharp decline, which caused many of our existing andpotential customers to cancel or delay orders for our products. Although theU.S. economy has improved, our customers and potential customers may continueto delay ordering our products, and we could fall short of our revenueexpectations for 2005 and beyond. Slower growth among our customers, tighteningof customers’ operating budgets, retrenchment in the capital markets and othergeneral economic factors all have had and could in the future have a materiallyadverse effect on our revenue, capital resources, financial condition andresults of operations.

**Our lengthy sales cycle to acquire new customers or large follow-onorders may cause our operating results to vary significantly and make it moredifficult to forecast our revenue.**

We have generally experienced a product sales cycle offour to nine months for new customers or large follow-on orders from existingcustomers due to the time needed to educate customers about the uses andbenefits of our system, and the significant investment decisions that ourprospective customers must make when they decide to buy our system. Many of ourprospective customers have neither budgeted expenses for networked videocommunications systems, or for personnel specifically dedicated to theprocurement, installation or support of these systems. As a result, ourcustomers spend a substantial amount of time before purchasing our system inperforming internal reviews and obtaining capital expenditure approvals.Economic conditions over the last several years have contributed to additionaldeliberation and an associated delay in the sales cycle.

Our lengthy sales cycle is oneof the factors that has caused, and may in the future continue to cause, ouroperating results to vary significantly from quarter to quarter and year toyear. This makes it difficult for us to forecast revenue, and could causevolatility in the market price of our common stock. A lost or delayed ordercould result in lower revenue than expected in a particular quarter or year.

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**Since a majority of our revenuehas come from follow-on orders, our financial performance could be harmed if wefail to obtain follow-on orders in the future.**

Our customers typically placelimited initial orders for our networked video communications system, as theyseek to evaluate its usefulness and value. Our strategy is to pursue additionaland larger follow-on orders after these initial orders. Revenue generated fromfollow-on orders accounted for approximately 78% of our revenue in 2004, 96% in2003 and 95% in 2002. Economic conditions have contributed to decreases in ourclients’ capital spending in the past, and we have experienced a decrease inthe size and number of follow-on orders. Our future financial performancedepends on successful initial installations of our system and successfulgeneration of follow-on orders as the Avistar network expands within a customerorganization. If our system does not meet the needs and expectations ofcustomers, we may not be able to generate follow-on orders.

**Because we depend on a few customers for a majority of our revenue, theloss of one or more of them could cause a significant decrease in our revenue.**

We have historically derived the majority of ourrevenue from a limited number of customers, particularly Deutsche Bank and UBSWarburg LLC and their affiliates. Collectively, these customers accounted for65% of our revenue for 2004. No other customers individually contributedgreater than 10% of our total revenue for 2004. For 2003,Deutsche Bank AG and their affiliates accounted for 62% of our revenue. No other customers individuallyaccounted for greater than 10% of our total revenue for 2003. For 2002,Deutsche Bank and JP Morgan Chase & Company and their affiliatesaccounted for 66% of our revenue, each of whom generated more than 10% of ourtotal revenue. We expect that we will continue to depend upon alimited number of customers for a substantial portion of our revenue. As of December 31,2004, approximately 81% of our accounts receivable were concentrated with onecustomer. As of December 31, 2003, approximately 89% of our accountsreceivable were concentrated with one customer. As of December 31, 2002,approximately 65% of our accounts receivable were concentrated with onecustomer.

The loss of a major customer orthe reduction, delay or cancellation of orders from one or more of oursignificant customers could cause our revenue to decline and our losses toincrease. Because we currently depend on a limited number of customers withlengthy budgeting cycles and unpredictable buying patterns, our revenue fromquarter to quarter or year to year may be volatile. Adverse changes in ourrevenue or operating results as a result of these budgeting cycles or any otherreduction in capital expenditures by our large customers could substantiallyreduce the trading price of our common stock.

**We may not be able to modify and improve our products in a timely andcost effective manner to respond to technological change and customer demands.**

Future hardware and software platforms embodying new technologies and theemergence of new industry standards and customer requirements could render oursystem non-competitive or even obsolete. The market for our system ischaracterized by:

·        rapid technological change;

·        the emergence of new competitors;

·        significant development costs;

·        changes in the requirements of our customers and their communities ofusers;

·        evolving industry standards; and

·        transition to Internet protocol connectivity for video at the desktop,with increasing availability of bandwidth.

Our system is designed to workwith a variety of hardware and software configurations and data networkinginfrastructures used by our customers. The majority of these customer networksrely on 

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MicrosoftWindows servers. However, our software may not operate correctly on otherhardware and software platforms or with other programming languages, databaseenvironments and systems that our customers use. Also, we must constantlymodify and improve our system to keep pace with changes made to our customers’platforms, data networking infrastructures, and their evolving ability totransport video and other applications. This may result in uncertainty relatingto the timing and nature of our new release announcements, introductions ormodifications, which in turn may cause confusion in the market, with a potentiallyharmful effect on our business. If we fail to promptly modify or improve oursystem in response to evolving industry standards or customers’ demands, oursystem could become less competitive, which would harm our financial conditionand reputation.

**Difficulties or delays in installing our products could harm our revenueand margins.**

We recognize revenue upon theinstallation of our system in those cases where we are responsible forinstallation, which often entails working with sophisticated software andcomputing and communications systems. If we experience difficulties withinstallation or do not meet deadlines due to delays caused by our customers orourselves, we could be required to devote more customer support, technical andother resources to a particular installation. If we encounter delays ininstalling our products for new or existing customers or installation requiressignificant amounts of our professional services support, our revenuerecognition could be delayed, our costs could increase and our margins couldsuffer.

**Competition could reduce our market share and decrease our revenue.**

Currently, our competition comesfrom many other kinds of companies, including communication equipment,integrated solution, broadcast video and stand-alone point solution providers.Within the video-enabled network communications market, we compete primarilyagainst Polycom, Tandberg Inc. and VCON Telecommunications Ltd. We believe wemay face increasing competition in the future from alternative video communicationssolutions that employ new technologies or new combinations of technologies fromcompanies such as Cisco Systems, Inc., Avaya, Inc., MicrosoftCorporation, Nortel Networks Corporation and WebEx Communications, Inc.,that enable web-based or network-based video communications with low-costdigital camera systems. The market in which we operate is highly competitive. Inaddition, because our industry is relatively new and one which is characterizedby rapid technological change, evolving user needs, developing industrystandards and protocols and the introduction of new products and services, itis difficult for us to predict whether or when new competing technologies ornew competitors will enter our market.

We expect competition to increase in the future fromexisting competitors and from new market entrants with products that may beless expensive than ours or that may provide better performance or additionalfeatures not currently provided by our products. Many of our current andpotential competitors have substantially greater financial, technical,manufacturing, marketing, distribution and other resources, greater namerecognition and market presence, longer operating histories, lower coststructures and larger customer bases than we do. As a result, they may be ableto adapt more quickly to new or emerging technologies and changes in customerrequirements.

We may be required to reduce prices or increasespending in response to competition in order to retain or attract customers,pursue new market opportunities or invest in additional research anddevelopment efforts. As a result, our revenue, margins and market share may beharmed. We cannot assure you that we will be able to compete successfullyagainst current and future competitors, or that competitive pressures faced byus will not harm our business, financial condition and results of operations.

**Infringement of our proprietary rights could affect our competitiveposition, harm our reputation or cost us money.**

We regard our system as open butproprietary. In an effort to protect our proprietary rights, we rely primarilyon a combination of patent, copyright, trademark and trade secret laws, as wellas licensing, non-

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disclosureand other agreements with our consultants, suppliers, customers and employees. However,these laws and agreements provide only limited protection of our proprietaryrights. In addition, we may not have signed agreements in every case and thecontractual provisions that are in place and the protection they produce maynot provide us with adequate protection in all circumstances. Although CPIholds patents and has filed patent applications covering some of the inventionsembodied in our systems, our means of protecting our proprietary rights may notbe adequate. It may be possible for a third party to copy or otherwise obtainand use our technology without authorization and without our detection. Inthe event that we believe a third party is infringing our intellectual propertyrights, an infringement claim brought by us could, regardless of the outcome,result in substantial cost to us, divert our management’s attention andresources, be time consuming to prosecute and result in unpredictable damageawards. A third party may also developsimilar technology independently, without infringing upon our patents andcopyrights. In addition, the laws of some countries in which we sell our systemmay not protect our software and intellectual property rights to the sameextent as the laws of the United States or other countries where we holdpatents. Unauthorized copying, use or reverse engineering of our system couldharm our business, financial condition or results of operations.

**Others may bring infringement claims against us, which could betime-consuming and expensive to defend.**

In recent years,there has been significant litigation in the United States involving patentsand other intellectual property rights and we have been a party to suchlitigation. We may be a party to litigation in the future, to protect ourintellectual property or as a result of an alleged infringement of theintellectual property of others. These claims and any resulting lawsuit, couldsubject us to significant liability for damages and invalidation of proprietaryrights. These lawsuits, regardless of their success, would likely betime-consuming and expensive to resolve and would divert management’s time andattention. Any potential intellectual property litigation also could force usto do one or more of the following:

·        stopselling, incorporating or using products or services that use the challengedintellectual property;

·        obtainfrom the owner of the infringed intellectual property a license to the relevantintellectual property, which may require us to license our intellectualproperty to such owner, or may not be available on reasonable terms or atall; and

·        redesignthose products or services that use technology that is the subject of aninfringement claim.

If we are forced to take any of the foregoing actions,we may be unable to manufacture, use, sell, import and export our products,which would reduce our revenues.

**Our system could have defects for which we could be held liable for, andwhich could result in lost revenue, increased costs, loss of our credibility ordelay in the further acceptance of our system in the market.**

Our system may contain errors ordefects, especially when new products are introduced or when new versions arereleased. Despite internal system testing, we have in the past discoveredsoftware errors in some of the versions of our system after their introduction.Errors in new systems or versions could be found after commencement ofcommercial shipments, and this could result in additional development costs,diversion of technical and other resources from our other development effortsor the loss of credibility with current or future customers. Any of theseevents could result in a loss of revenue or a delay in market acceptance of oursystem and could harm our reputation.

In addition, we have warrantedto some of our customers that our software is free of viruses. If a virusinfects a customer’s computer software, the customer could assert claimsagainst us, which, regardless of 

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theirmerits, could be costly to defend and could require us to pay damages andpotentially harm our reputation.

Our license agreements with ourcustomers typically contain provisions designed to limit our exposure topotential product liability and certain contract claims. Our license agreementsalso typically limit a customer’s entire remedy to either a refund of the pricepaid or modification of our system to satisfy our warranty. However, theseprovisions vary as to their terms and may not be effective under the laws ofsome jurisdictions. Although we maintain product liability (“errors andomissions”) insurance coverage, we cannot assure you that such coverage will beadequate. A product liability, warranty or other claim could harm our business,financial condition and/or results of operations. Performance interruptions ata customer’s site could negatively affect the demand for our system or giverise to claims against us.

The third party software we license with our systemmay also contain errors or defects for which we do not maintain insurance. Typically,our license agreements transfer any warranty from the third party to ourcustomers to the extent permitted. Product liability, warranty or other claimsbrought against us with respect to such warranties could, regardless of theirmerits, harm our business, financial condition or results of operations.

**The loss of any of our outside contract manufacturers or third partyequipment suppliers that produce key components of our system couldsignificantly disrupt our manufacturing and new product development process.**

We depend on outside contract manufacturers to produce components of oursystems, such as cameras, microphones, gateway, speakers and monitors that weinstall at desktops and in conference rooms. One supplier, Pacific Corporation,is a single source supplier for a key component of our product. Anothersupplier, Equator Technologies Inc., is our only current source of a componentused in our IP gateway product. Our reliance on these third parties involves anumber of risks, including:

·        the possible unavailability of critical services and components on atimely basis, on commercially reasonable terms or at all;

·        if the components necessary for our system were to become unavailable,the need to qualify new or alternative components for our use or reconfigureour system and manufacturing process could be lengthy and expensive;

·        the likelihood that, if particular components were not available, wewould suffer an interruption in the manufacture and shipment of our systemsuntil these components or alternatives become available;

·        reduced control by us over the quality and cost of our system and overour ability to respond to unanticipated changes and increases in customerorders, and conversely, price changes from suppliers if committed volumes arenot met; and

·        the possible unavailability of, or interruption in, access to sometechnologies due to infringement claims, production/supply issues or otherhindrances.

If these manufacturers orsuppliers cease to provide us with the assistance or the components necessaryfor the operation of our business, we may not be able to identify alternatesources in a timely fashion. Any transition to alternate manufacturers orsuppliers would likely result in operational problems and increased expensesand could cause delays in the shipment of or otherwise limit our ability toprovide our products. We cannot assure you that we would be able to enter intoagreements with new manufacturers or suppliers on commercially reasonableterms, or at all. Any disruption in product flow may limit our revenue, delayour product development, seriously harm our competitive position and/or resultin additional costs or cancellation of orders by our customers.

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**If we are unable to expand our direct sales force and/or add distributionchannels, our business will suffer.**

To increase our revenue, we mustincrease the size of our direct sales force and add indirect distributionchannels, such as systems integrators, product partners and/or value-addedresellers, and/or effect sales through our customers. If we are unable tomaintain or increase our direct sales force or add indirect distributionchannels due to our own cost constraints, limited availability of qualifiedpersonnel or other reasons, our future revenue growth may be limited and ourfuture operating results may suffer. We cannot assure you that we will besuccessful in attracting, integrating, motivating and retaining sales personnel.Furthermore, it can take several months before a new hire becomes a productivemember of our sales force. The loss of existing salespeople, or the failure ofnew salespeople and/or indirect sales partners to develop the necessary skillsin a timely manner, could reduce our revenue growth.

**We may not be able to retain our existing key personnel, or hire andretain the additional personnel that we need to sustain and grow our business.**

Our products and technologies are complex, and tosuccessfully implement our business strategy and manage our business, anin-depth understanding of video communication and collaboration technologiesand their potential uses is required. We depend on the continued services ofour executive officers and other key personnel. We do not have long-term employmentagreements with our executive officers or other key personnel and we do notcarry any “key man” life insurance. The loss of the services of any of ourexecutive officers or key personnel could harm our business, financialcondition and results of operations.

We need to attract and retain highly skilled technicaland managerial personnel for whom there is intense competition. If we areunable to attract and retain qualified technical and managerial personnel dueto our own cost constraints, limited availability of qualified personnel orother reasons, our results of operations could suffer and we may never achieveprofitability. The failure of new personnel to develop the necessary skills ina timely manner could harm our business.

**Our plans call for growth in our business, and our inability to achieveor manage growth could harm our business.**

Failure to achieve or managegrowth effectively will harm our business, financial condition and operatingresults. Furthermore, in order to remain competitive or to expand our business,we may find it necessary or desirable in the future to acquire otherbusinesses, products or technologies. If we identify an appropriate acquisitioncandidate, we may not be able to negotiate the terms of the acquisition successfully,to finance the acquisition or to integrate the acquired businesses, products ortechnologies into our existing business and operations. In addition, completinga potential acquisition and integrating an acquired business may strain ourresources and require significant management time.

**Our international operations expose us to potential tariffs and othertrade barriers, unexpected changes in foreign regulatory requirements and lawsand economic and political instability, as well as other risks that couldadversely affect our results of operations.**

International revenue, which consists of sales to customers withoperations principally in Western Europe and Asia,  comprised 48% of total revenue for 2004, 58% for2003 and 49% for 2002. Some of the risks we may encounter in conductinginternational business activities include the following:

·        tariffs and other trade barriers;

·        unexpected changes in foreign regulatory requirements and laws;

·        economic and political instability;

·        increased risk of infringement claims;

39

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·        protection of our intellectual property;

·        restrictions on the repatriation of funds;

·        potentially adverse tax consequences;

·        timing, cost and potential difficulty of adapting our system to the locallanguage standards in those foreign countries that do not use the Englishlanguage;

·        fluctuations in foreign currencies; and

·        limitations in communications infrastructures in some foreign countries.

**International political instability may increase our cost of doingbusiness and disrupt our business.**

Increased international political instability,evidenced by the threat or occurrence of terrorist attacks, enhanced nationalsecurity measures and/or sustained military action may halt or hinder ourability to do business, may increase our costs and may adversely affect ourstock price. This increased instability has had and may continue to havenegative effects on financial markets, including significant price and volumefluctuations in securities markets. If this international political instabilitycontinues or escalates, our business and results of operations could be harmedand the market price of our common stock could decline.

**If our customers do not perceive our system or services to be effectiveor of high quality, our brand and name recognition would suffer.**

We believe that establishing and maintaining brand andname recognition is critical for attracting and expanding our targeted customerbase. We also believe that the importance of reputation and name recognitionwill increase as competition in our market increases. Promotion and enhancementof our name will depend on the success of our marketing efforts, and on ourability to continue to provide high quality systems and services, neither ofwhich can be assured. If our customers do not perceive our system or servicesto be effective or of high quality, our brand and name recognition will suffer,which would harm our business.

**We may not meet the continued listing criteria for the NASDAQ SmallCapMarket, which could materially adversely affect the price and liquidity of ourstock, our business and our financial condition.**

For continued listing of our common stock on TheNASDAQ SmallCap Market, we are required to, among other things (i) maintainstockholders’ equity of at least $2.5 million, or a market value of listedsecurities of at least $35 million or annual net income from continuingoperations of at least $500,000, and (ii) maintain a minimum closing bidprice of our common stock of at least $1.00. If we do not meet the continuedlisting requirements, our common stock could be subject to delisting fromtrading on The NASDAQ SmallCap Market. There can be no assurance that we willcontinue to meet all requirements for continued listing on The NASDAQ SmallCapMarket.

If we are unable to continue to list our common stockfor trading on The NASDAQ SmallCap Market, there may be adverse impact on themarket price and liquidity of our common stock, and our stock may be subject tothe “penny stock rules” contained in Section 15(g) of the SecuritiesExchange Act of 1934, as amended, and the rules promulgated there under. Delistingof our common stock from The NASDAQ SmallCap Market could also materiallyadversely affect our business, including, among other things: our ability toraise additional financing to fund our operations; our ability to attract andretain customers; and our ability to attract and retain personnel, includingmanagement personnel. In addition, if we were unable to list our common stockfor trading on NASDAQ, many institutional investors would no longer be able toretain their interests in and/or make further investments in our common stockbecause of their internal rules and protocols.

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**Our common stock has been and will likely continue to be subject tosubstantial price and volume fluctuations due to a number of factors, many ofwhich will be beyond our control, which may prevent our stockholders fromreselling our common stock at a profit.**

The trading priceof our common stock has in the past been and could in the future be subject tosignificant fluctuations in response to:

·        general trends in the equities market, and/or trends in the technologysector;

·        quarterly variations in our results of operations;

·        announcements regarding our product developments;

·        announcements of technological innovations or new products by us, ourcustomers or competitors;

·        announcements of competitive product introductions by our competitors orour customers;

·        sales or the perception in the market of possible sales of a large numberof shares of our common stock by our directors, officers, employees orprincipal stockholders; and

·        developments or disputes concerning patents or proprietary rights, orother events.

If our revenue and results of operations are below theexpectations of public market securities analysts or investors, thensignificant fluctuations in the market price of our common stock could occur. Inaddition, the securities markets have, from time to time, experiencedsignificant price and volume fluctuations, which have particularly affected themarket prices for high technology companies, and which often are unrelated anddisproportionate to the operating performance of particular companies. Thesebroad market fluctuations, as well as general economic, political and marketconditions, may negatively affect the market price of our common stock.

**If our share price is volatile, we may be the target of securitieslitigation, which is costly and time-consuming to defend.**

In the past, following periodsof market volatility in the price of a company’s securities, security holdershave often instituted class action litigation. Many technology companies havebeen subject to this type of litigation. Our share price has, in the past,experienced price volatility, and may continue to do so in the future. If themarket value of our common stock experiences adverse fluctuations and we becomeinvolved in this type of litigation, regardless of the merits or outcome, wecould incur substantial legal costs and our management’s attention could bediverted, causing our business, financial condition and operating results tosuffer.

**Our expected future working capital needs may require that we seekadditional debt or equity funding which, if not available, could cause ourbusiness to suffer.**

We may need to arrange for the availability ofadditional funding in order to meet our future business requirements. If we areunable to obtain additional funding when needed on acceptable terms, we may notbe able to develop or enhance our products, take advantage of future opportunities,respond to competitive pressures or unanticipated requirements, or finance ourefforts to protect and enforce our intellectual property rights, which couldseriously harm our business, financial condition, results of operations andability to continue operations.

**Provisions of our certificate of incorporation, our bylaws and Delawarelaw may make it difficult for a third party to acquire us, despite the possiblebenefits to our stockholders.**

Our certificate ofincorporation, our bylaws and Delaware law contain provisions that may inhibitchanges in our control that are not approved by our Board of Directors. Forexample, the Board of Directors has the authority to issue up to 10,000,000shares of preferred stock and to determine the terms of this preferred stock,without any further vote or action on the part of the stockholders.

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These provisions may have theeffect of delaying, deferring or preventing a change in our control despitepossible benefits to our stockholders, may discourage bids at a premium overthe market price of our common stock, and may adversely affect the market priceof our common stock and the voting and other rights of our stockholders.

**Our principalstockholders can exercise a controlling influence over our business affairs andthey may make business decisions with which you disagree that will affect thevalue of your investment.**

Our executive officers,directors and entities affiliated with them, in the aggregate, beneficiallyowned approximately 66% of our common stock as of December 31, 2004. If they were to act together, thesestockholders would be able to exercise control over most matters requiringapproval by our stockholders, including the election of directors and approvalof significant corporate transactions. These actions may be taken even if theyare opposed by other investors. This concentration of ownership may also havethe effect of delaying or preventing a change in control of our company, whichcould cause the market price of our common stock to decline.

**Changes in stockoption accounting rules, if enacted as scheduled, will adversely impact ourreported operating results prepared in accordance with generally acceptedaccounting principles, which may in turn adversely impact our stock price andour ability to attract and retain employees.**

In December 2004, the FASBissued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R requiresemployee stock options and rights to purchase shares under stock participationplans to be accounted for under the fair value method, and eliminates theability to account for these instruments under the intrinsic value methodprescribed by APB Opinion No. 25, and allowed under the originalprovisions of SFAS No. 123. SFAS No. 123R requires the use of anoption pricing model for estimating fair value, which is amortized to expenseover the service periods. The requirements of SFAS No. 123R are effectivefor fiscal periods beginning after June 15, 2005. SFAS No. 123Rallows for either prospective recognition of compensation expense orretrospective recognition, which may be back to the original issuance of SFAS No. 123or only to interim periods in the year of adoption. The company is currentlyevaluating these transition methods.

The pro forma impact ofthe adoption of SFAS 123 on our historical financial statements is included inthe condensed notes to the consolidated financial statements presentedelsewhere in this Form 10-K. We expect to continue to grant stock-basedcompensation to employees. The impact of the new standard, when and if issued,may have a material adverse impact on our future results of operations.

**Item 7a.   *Quantitative and Qualitative Disclosures About Market Risk***

We develop products primarily inthe United States and sell those products primarily in North America, Europeand Asia. International revenue, which consists of sales to customers withoperations principally in Western Europe and Asia, comprised 48% of totalrevenue for the year ended December 31, 2004, 58% for the year ended December 31,2003 and 49% for the year ended December 31, 2002. As a result, ourfinancial condition could be affected by factors such as changes in foreigncurrency exchange rates or weak economic conditions in foreign markets. As allof our sales are currently made in United States dollars, a strengthening ofthe United States dollar could make our products less competitive in foreignmarkets. We do not use derivative financial instruments for speculative ortrading purposes, nor do we engage in any foreign currency hedgingtransactions.

Ourinterest income is sensitive to changes in the general level of United Statesinterest rates, particularly since the majority of our investments are inshort-term instruments.

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**Cash and Cash Equivalents and Short-Term Investments**

Cash equivalents consistprimarily of commercial paper and money market funds acquired with remainingmaturity periods of three months or less and are stated at cost, plus accruedinterest that approximates market value. We would not expect our operatingresults or cash flow to be significantly impacted by the effect of suddenchanges in market interest rates given the nature of our short-terminvestments.

The following table provides information about ourinvestment portfolio. For investment securities, the table presents cash andcash equivalents and short-term investments and related weighted averageinterest rates by category at December 31, 2004.
| ** **                                          | ** ** | **Amounts**             | ** ** | **Weighted Average  Interest Rate** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|-----------------------------------------------|------------|
| ** **                                          | ** ** | **(in thousands)** | ** ** | ** **                                    | ** ** |
| ***Description***                                   |       |                    |       |                                          |       |   |   |   |   |
| Cash,  cash equivalents and short-term investments: |       |                    |       |                                          |       |   |   |   |   |
| Cash                                                |       |                    | $          | 834                                           |       |   |   | — |   |   |
| Commercial Paper                                    |       |                    | 10,962     |                                          |       |   | 2.09 | % |   |
| Other cash equivalents                              |       |                    | 9,860      |                                          |       |   | 2.06 | % |   |
| Fair Value at December 31, 2004                |       |                    | $          | 21,656                                        |       |   |   |   |   |   |

 

**Item 8.**   *Financial Statements andSupplementary Data*

Ourconsolidated financial statements and Report of Independent Registered PublicAccounting Firm appear on pages F-1 through F-21 of thisReport.

**Item 9.   *Changes in andDisagreements with Accountants on Accounting and Financial Disclosure***

None

**Item 9a.   *Controls and Procedures***

(a)   Evaluation of disclosure controls and procedures: Our managementevaluated, with the participation of our Chief Executive Officer and ChiefFinancial Officer, the effectiveness of our disclosure controls and proceduresas of the end of the period covered by this Annual Report on Form 10-K.Based on this evaluation, our Chief Executive Officer and Chief FinancialOfficer have concluded that our disclosure controls and procedures (as definedin Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934 (the Exchange Act)) are effective to ensurethat information required to be disclosed by us in reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in Securities and Exchange Commission rules andforms.

(b)   Changes in internal control over financial reporting: There was nochange in our internal control over financial reporting that occurred during theperiod covered by this Annual Report on Form 10-K that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

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**PART III**

**Item 10.   *Directors and Executive Officers of the Registrant***

The information required by thisitem concerning our directors is incorporated by reference to the sectionscaptioned “Election of Directors” and “Section 16(a) BeneficialOwnership Reporting Compliance” contained in the Company’s Proxy Statementrelated to the 2005 Annual Meeting of Stockholders, to be filed by the Companywith the Securities and Exchange Commission within 120 days of the end of 2004pursuant to General Instruction G(3) of Form 10-K (the “ProxyStatement”). Certain information required by this item concerning executiveofficers is set forth in Part I of this Report in “Business—Management”and certain other information required by this item is incorporated byreference from the section captioned “Principal Stockholders” contained in theProxy Statement.

We have adopted a code of ethics that applies to our principal executiveofficers and all members of our finance department, including the principalfinancial officer and principal accounting officer. This code of ethics, whichalso applies to employees generally, is posted on our Internet website. TheInternet address for our website is http://www.avistar.com, and the code ofethics may be found as follows:

*1.     From our main Web page, first click on “Company.”*

*2.     Next, click on “Investor Relations.”*

*3.     Next, click on “Avistar’s Business Conduct and Ethics Policy.”*

Weintend to satisfy the disclosure requirement under Item 10 of Form 8-Kregarding an amendment to, or waiver from, a provision of this code of ethicsby posting such information on our website, at the address and locationspecified above.

**Item 11.   *Executive Compensation***

The information required by thisitem is incorporated by reference to the section captioned “ExecutiveCompensation and Other Matters” contained in the Proxy Statement.

**Item 12.   *Security Ownership of Certain Beneficial Owners and Management***

The information required by thisitem is incorporated by reference to the sections captioned “PrincipalStockholders” and “Record Date and Principal Share Ownership” and the tablecaptioned “Equity Compensation Plan Information” contained in the ProxyStatement.

**Item 13.   *Certain Relationships and Related Transactions***

The information required by thisitem is incorporated by reference to the sections captioned “CompensationCommittee Interlocks and Insider Participation” and “Certain Transactions”contained in the Proxy Statement.

**Item 14.   *Principal Accountant Feesand Services***

Theinformation required by this section is incorporated by reference from theinformation in the section entitled “Ratification of Appointment of IndependentAccountants” in the Proxy Statement.

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**PART IV**

**Item 15.   *Exhibits, Financial Statement Schedules***

(a)(1) *FinancialStatements*

The following financial statements are incorporated byreference in Item 8 of this Report:
|                                                                                                                        | ** ** | **Page** |
|------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent  Registered Public Accounting Firm                                                               |       | F-2      |
| Consolidated Balance Sheets as of  December 31, 2004 and 2003                                                     |       | F-3      |
| Consolidated Statements of  Operations for the years ended December 31, 2004, 2003 and 2002                       |       | F-4      |
| Consolidated Statements of  Stockholders’ Equity for the years ended December 31, 2004, 2003 and  2002  |       | F-5      |
| Consolidated Statements of Cash  Flows for the years ended December 31, 2004, 2003 and 2002                       |       | F-6      |
| Notes to the  Consolidated Financial Statements                                                                        |       | F-7      |

 

(a)(2) *FinancialStatement Schedules*

Schedule II—Valuation andQualifying Accounts and Reserves (see page S-1)

Schedules not listed above havebeen omitted because the information required to be set forth therein is notapplicable or is shown in the financial statements or notes thereto.

(a)(3) *Exhibits*
| 3.2(1)          |   | Restated  Certificate of Incorporation                                                                                                             |
|-----------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.3             |   | Bylaws  of Avistar Communications Corporation                                                                                                      |
| 4.1(1)          |   | Specimen  Certificate evidencing shares of Common Stock                                                                                            |
| 10.1(1)         |   | 1997  Stock Option Plan, as amended*                                                                                                               |
| 10.1.1(1)       |   | 1997  Stock Option Plan Form of Stock Option Agreement*                                                                                       |
| 10.2(1)         |   | 2000  Stock Option Plan, as amended*                                                                                                               |
| 10.3(3)         |   | 2000  Director Option Plan, as amended*                                                                                                            |
| 10.4(1)         |   | Form of  Director Option Agreement*                                                                                                           |
| 10.5(4)         |   | 2000  Employee Stock Purchase Program, as amended*                                                                                                 |
| 10.6(1)         |   | Form of  Indemnification Agreement*                                                                                                           |
| 10.7(1)†   |   | Preferred  Supplier Agreement dated June 24, 1997 by and between Avistar and  Tandberg, Inc., including modifications Nos. 1, 2, 3 and 4 |
| 10.7.1(1)† |   | Modification  No. 5 to the Preferred Supplier Agreement dated June 27, 2000                                                              |
| 10.7.2(2)† |   | Modification  No. 6 to the Preferred Supplier Agreement dated November 27, 2000                                                          |
| 10.8(6)         |   | Settlement  Agreement and Release between the Registrant and R. Stephen Heinrichs dated  April 26, 2001*                                      |
| 10.9(7)         |   | Master  Loan and Security Agreement between the Registrant and Comerica  Bank—California dated February 27, 2002                         |
| 10.9.1(7)† |   | First  Amendment dated December 17, 2002 to Master Loan and Security Agreement  between the Registrant and Comerica Bank—California      |
| 10.9.2(7)† |   | Unconditional  Guaranty of the Gerald J. Burnett and Marjorie J. Burnett Revocable Trust  dated December 17, 2002                             |

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| 10.9.3(7)† |   | Unconditional  Guaranty of Gerald J. Burnett dated December 17, 2002                                                                                                                      |
|-----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.9.4(7)       |   | Second  Amendment dated March 10, 2003 to Master Loan and Security Agreement  between the Registrant and Comerica Bank—California                                                    |
| 10.9.5(9)       |   | Fourth  Amendment dated February 27, 2004 to Master Loan and Security Agreement  between the Registrant and Comerica Bank—California                                                 |
| 10.9.6(9)       |   | Reaffirmation  of Unconditional Guaranty of the Gerald J. Burnett and Marjorie J. Burnett  Revocable Trust dated February 24, 2004                                                        |
| 10.10(8)        |   | Office  Lease Agreement between CA-Twin Dolphin Plaza Limited Partnership and the  Registrant dated July 30, 2003                                                                         |
| 10.11(8)        |   | Common  Stock Purchase Agreement by and among the Registrant and The Gerald J.  Burnett and Marjorie J. Burnett Revocable Trust, Grady Burnett and Wendolyn  Hearn dated October 15, 2003 |
| 10.12(10)       |   | Stock Purchase Agreement  among the Registrant, Fuller & Thaler Behavioral Finance Fund, Ltd.  and Fuller & Thaler Avalanche Fund, L.P. dated March 23, 2004            |
| 10.13           |   | Settlement Agreement  among the Registrant, Collaboration Properties, Inc. and  Polycom, Inc. dated November 12, 2004                                                           |
| 21.1(7)         |   | Subsidiaries  of the Company                                                                                                                                                                   |
| 23.1            |   | Consent  of Independent Registered Public Accounting Firm                                                                                                                                      |
| 24.1            |   | Power  of Attorney (see page 48)                                                                                                                                                          |
| 31.1            |   | Rule 13a-14(a)/15d-14(a) Certification  by the Chief Executive Officer                                                                                                               |
| 31.2            |   | Rule 13a-14(a)/15d-14(a) Certification  by the Chief Financial Officer                                                                                                               |
| 32              |   | Certification  by the Chief Executive Officer and Chief Financial Officer pursuant to 18  U.S.C Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002  |

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*                    Indicates management contract or compensatoryplan or arrangement required to be filed an exhibit pursuant to Item 14(c) ofForm 10-K.

†                    Portionsof the exhibit have been omitted pursuant to a request for confidentialtreatment and the omitted portions have been separately filed with theCommission.

(1)          Filed asan exhibit to the Company’s Registration Statement on Form S-1 (FileNo. 333-39008) as declared effective by the Securities and ExchangeCommission on August 16, 2000.

(2)          Filed asan exhibit to the Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2000 filed with the Securities and ExchangeCommission on March 9, 2001.

(3)          Filed asan exhibit to the Registrant’s Quarterly Report on Form 10-Q for thethree months ended June 30, 2003 filed with the Securities and ExchangeCommission on August 13, 2003.

(4)          Filed asan exhibit to the Registrant’s Registration Statement on Form S-8filed with the Securities and Exchange Commission on August 16, 2000.

(5)          Filed asan exhibit to the Company’s Annual Report on Form 10-K for the yearended December 31, 2001 filed with the Securities and Exchange Commissionon March 21, 2002.

(6)          Filed asan exhibit to the Registrant’s Current Report on Form 8-K filed withthe Securities and Exchange Commission on May 8, 2001.

46

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(7)          Filed asan exhibit to the Company’s Annual Report on Form 10-K for the yearended December 31, 2002 with the Securities and Exchange Commission on March 25,2003.

(8)          Filed asan exhibit to the Registrant’s Quarterly Report on Form 10-Q for thethree months ended September 30, 2003 filed with the Securities andExchange Commission on October 23, 2003.

(9)          Filed asan exhibit to the Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2003 filed with the Securities and ExchangeCommission on March 16, 2004.

(10)   Filed as an exhibit to the Registrant’s QuarterlyReport on Form 10-Q for the quarter ended March 31, 2004 filedwith the Securities and Exchange Commission on May 11, 2004.

47

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, as amended, the Registrant has duly caused this annual report tobe signed on its behalf by the undersigned, thereunto duly authorized.
|                            | AVISTAR COMMUNICATIONS  CORPORATION |
|----------------------------|-------------------------------------|
|                       | By:                                 | /s/   GERALD J. BURNETT |
|                       |                                | Gerald J. Burnett |
| * *                   | * *                            | *Chief Executive* |
| * *                   | * *                            | *Officer and Chairman* |
| Date:  March 28, 2005 | * *                            | * * |

 

**POWEROF ATTORNEY**

KNOW ALL PERSONS BY THESEPRESENTS, that each person whose signature appears below constitutes andappoints Gerald J. Burnett and Robert J. Habig, his true and lawfulattorney-in-fact and agent, with full power of substitution and resubstitution,to sign any and all amendments (including post- effective amendments) to thisAnnual Report on Form 10-K and to file the same, with all exhibits theretoand other documents in connection therewith, with the Securities and ExchangeCommission, granting unto said attorney-in-fact and agent, full power andauthority to do and perform each and every act and thing requisite andnecessary to be done in connection therewith, as fully to all intents andpurposes as he or she might or could do in person, hereby ratifying andconfirming all that said attorney-in-fact and agent, or his substitute orsubstitutes, or any of them, shall do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities ExchangeAct of 1934, as amended, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities and on the datesindicated:
|                                            | **Signature** | ** **                                | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------------------------|---------------|-------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/   GERALD J. BURNETT     |          | Chief  Executive Officer and Chairman     |       | March 28, 2005 |
| Gerald J. Burnett                          |          | (Principal Executive Officer)             |       |                |
| /s/   ROBERT J. HABIG       |          | Chief  Financial Officer  (Principal |       | March 28, 2005 |
| Robert J. Habig                            |          | Financial and Accounting  Officer)        |       |                |
| /s/   WILLIAM L. CAMPBELL   |          | Executive  Vice President and Director    |       | March 28, 2005 |
| William L. Campbell                        |          |                                      |       |                |
| /s/   R.  STEPHEN HEINRICHS |          | Director                                  |       | March 28, 2005 |
| R. Stephen Heinrichs                       |          |                                      |       |                |
| /s/   ROBERT P. LATTA       |          | Director                                  |       | March 28, 2005 |
| Robert P. Latta                            |          |                                      |       |                |
| /s/   ROBERT M. METCALFE    |          | Director                                  |       | March 28, 2005 |
| Robert M. Metcalfe                         |          |                                      |       |                |
| /s/   DAVID M. SOLO         |          | Director                                  |       | March 28, 2005 |
| David M. Solo                              |          |                                      |       |                |
| /s/   JAMES W. ZEIGON       |          | Director                                  |       | March 28, 2005 |
| James W. Zeigon                            |          |                                      |       |                |

 

48

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**INDEX TO FINANCIAL STATEMENTS**
|                                                                                                                       | ** ** | **Page** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent  Registered Public Accounting Firm                                                              |       | F-2      |
| Consolidated Balance Sheets as of  December 31, 2004 and 2003                                                    |       | F-3      |
| Consolidated Statements of  Operations for the years ended December 31, 2004, 2003 and 2002                      |       | F-4      |
| Consolidated Statements of  Stockholders’ Equity for the years ended December 31, 2004, 2003 and  2002 |       | F-5      |
| Consolidated Statements of Cash  Flows for the years ended December 31, 2004, 2003 and 2002                      |       | F-6      |
| Notes to the  Financial Statements                                                                                    |       | F-7      |

 

F-1

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**Report of Independent Registered Public AccountingFirm**

The Board of Directors andStockholdersAvistar Communications Corporation:

We have audited the accompanying consolidated balancesheets of Avistar Communications Corporation and subsidiaries as of December 31,2004 and 2003, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2004. In connection with our audits of theconsolidated financial statements, we also have audited the financial statementschedule. These consolidated financial statements and financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these financial statements and financial statementschedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Avistar Communications Corporationand subsidiaries as of December 31, 2004 and 2003, and the results oftheir operations and their cash flows for each of the years in the three-yearperiod ended December 31, 2004, in conformity with U.S. generally acceptedaccounting principles. Also in our opinion, the related financial statementschedule, when considered in relation to the consolidated financial statementstaken as a whole, presents fairly, in all material respects, the informationset forth therein.

/s/ KPMG LLP

Mountain View, CaliforniaJanuary 28, 2005

F-2

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**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSas of December 31, 2004 and 2003(in thousands, except share and per share data)**
| ** **                                                                                                                                                                                   | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **Assets:**                                                                                                                                                                                  |       |                        |       |                        |       |   |   |   |   |
| Current assets:                                                                                                                                                                              |       |                        |       |                        |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                    |       |                        | $          | 21,656                      |       |   |   | $ | 4,438 |   |   |
| Short-term investments                                                                                                                                                                       |       |                        | —     |                        |       |   | 1,000 |   |   |
| Accounts receivable, net of allowance for doubtful  accounts of $22 and $44 at December 31, 2004 and 2003, respectively                                                                 |       |                        | 963        |                        |       |   | 695 |   |   |
| Inventories, including inventory shipped to  customers’ sites, not yet installed of $34 and $41 at December 31, 2004  and 2003, respectively                                       |       |                        | 737        |                        |       |   | 937 |   |   |
| Prepaid expenses and other current assets                                                                                                                                                    |       |                        | 377        |                        |       |   | 515 |   |   |
| Total current assets                                                                                                                                                                         |       |                        | 23,733     |                        |       |   | 7,585 |   |   |
| Property and equipment, net                                                                                                                                                                  |       |                        | 192        |                        |       |   | 352 |   |   |
| Other assets                                                                                                                                                                                 |       |                        | 286        |                        |       |   | 291 |   |   |
| Total assets                                                                                                                                                                                 |       |                        | $          | 24,211                      |       |   |   | $ | 8,228 |   |   |
| **Liabilities  and Stockholders’ Equity:**                                                                                                                                              |       |                        |       |                        |       |   |   |   |   |
| Current  liabilities:                                                                                                                                                                        |       |                        |       |                        |       |   |   |   |   |
| Accounts payable                                                                                                                                                                             |       |                        | 1,105      |                        |       |   | 941 |   |   |
| Deferred license revenue                                                                                                                                                                     |       |                        | 4,226      |                        |       |   | — |   |   |
| Deferred services revenue and customer deposits                                                                                                                                              |       |                        | 748        |                        |       |   | 671 |   |   |
| Accrued liabilities and other                                                                                                                                                                |       |                        | 1,287      |                        |       |   | 1,125 |   |   |
| Total current liabilities                                                                                                                                                                    |       |                        | 7,366      |                        |       |   | 2,737 |   |   |
| Long-term  liabilities:                                                                                                                                                                      |       |                        |       |                        |       |   |   |   |   |
| Long-term deferred license revenue                                                                                                                                                           |       |                        | 16,331     |                        |       |   | — |   |   |
| Total liabilities                                                                                                                                                                            |       |                        | 23,697     |                        |       |   | 2,737 |   |   |
| Stockholders’  equity:                                                                                                                                                                  |       |                        |       |                        |       |   |   |   |   |
| Common stock, $0.001 par value; 250,000,000 shares  authorized at December 31, 2004 and 2003; 34,542,334 and 31,390,383  shares issued at December 31, 2004 and 2003, respectively |       |                        | 35         |                        |       |   | 31 |   |   |
| Less: treasury common stock, 1,181,625 and 1,179,625  shares at December 31, 2004 and 2003, respectively, at cost                                                                       |       |                        | (53        | )                           |       |   | (51 | ) |   |
| Additional paid-in-capital                                                                                                                                                                   |       |                        | 90,005     |                        |       |   | 86,278 |   |   |
| Accumulated deficit                                                                                                                                                                          |       |                        | (89,473    | )                           |       |   | (80,767 | ) |   |
| Total stockholders’ equity                                                                                                                                                              |       |                        | 514        |                        |       |   | 5,491 |   |   |
| Total liabilities  and stockholders’ equity                                                                                                                                             |       |                        | $          | 24,211                      |       |   |   | $ | 8,228 |   |   |

 

The accompanying notes are an integral part ofthese financial statements.

F-3

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**AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OFOPERATIONSfor the years ended December 31, 2004, 2003 and 2002(in thousands, except per share data)**
| ** **                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                        | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Revenue:                                                                          |       |                                       |       |   |   |   |   |
| Product                                                                           |       | $                                          | 3,121      |   | $ | 2,817 |   | $ | 4,430 |   |
| Services, maintenance and support                                                 |       | 3,200                                      |       | 3,775 |   | 4,369 |   |
| Licensing                                                                         |       | 575                                        |       | — |   | — |   |
| Total revenue                                                                     |       | 6,896                                      |       | 6,592 |   | 8,799 |   |
| Cost of revenue:                                                                  |       |                                       |       |   |   |   |   |
| Product                                                                           |       | 1,435                                      |       | 1,410 |   | 2,129 |   |
| Services, maintenance and support                                                 |       | 1,937                                      |       | 2,119 |   | 2,348 |   |
| Total cost of revenue                                                             |       | 3,372                                      |       | 3,529 |   | 4,477 |   |
| Gross margin                                                                      |       | 3,524                                      |       | 3,063 |   | 4,322 |   |
| Operating Expenses:                                                               |       |                                       |       |   |   |   |   |
| Research and development                                                          |       | 2,588                                      |       | 2,420 |   | 3,699 |   |
| Sales and marketing                                                               |       | 2,456                                      |       | 3,598 |   | 3,728 |   |
| General and administrative                                                        |       | 6,956                                      |       | 6,034 |   | 4,593 |   |
| Amortization of deferred stock compensation*                                      |       | —                                     |       | 135 |   | 358 |   |
| Total operating expenses                                                          |       | 12,000                                     |       | 12,187 |   | 12,378 |   |
| Loss from operations                                                              |       | (8,476                                     | )          | (9,124 | ) | (8,056 | ) |
| Other income:                                                                     |       |                                       |       |   |   |   |   |
| Interest income                                                                   |       | 118                                        |       | 44 |   | 269 |   |
| Other income, net                                                                 |       | 15                                         |       | 481 |   | 227 |   |
| Total other income, net                                                           |       | 133                                        |       | 525 |   | 496 |   |
| Loss before  provision for income taxes                                           |       | (8,343                                     | )          | (8,599 | ) | (7,560 | ) |
| Provision for  income taxes                                                       |       | 363                                        |       | 20 |   | 18 |   |
| Net loss                                                                          |       | (8,706                                     | )          | (8,619 | ) | (7,578 | ) |
| Net loss per  share—basic and diluted                                        |       | $                                          | (0.27      | ) | $ | (0.33 | ) | $ | (0.30 | ) |
| Weighted average  shares used in calculating basic and diluted net loss per share |       | 32,610                                     |       | 26,368 |   | 25,260 |   |

----

 
| * Amortization of  deferred stock compensation excluded from the following expenses: |   |   |   |   |   |   |   |
|--------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|
| Cost of revenue                                                                      |   | $      | — |   | $      | 15     |   | $ | 41 |   |
| Research and development                                                             |   | — |   | 12     |   | 32     |   |
| Sales and marketing                                                                  |   | — |   | 104    |   | 278    |   |
| General and administrative                                                           |   | — |   | 4      |   | 7      |   |
|                                                                                 |   | $      | — |   | $      | 135    |   | $ | 358 |   |

 

The accompanying notes are an integral part ofthese financial statements.

F-4

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**AVISTARCOMMUNICATIONS CORPORATIONCONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITYfor the years ended December 31, 2004, 2003 and 2002(in thousands, except share amounts)**
| ** **                                                                       | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** ** | ** ** | **Additional**    | ** ** | **Deferred**          | ** ** | **Other**              | ** ** | ** **  | ** ** | **Total**  | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-------------|------------|------------|------------|-------------------|------------|-----------------------|------------|------------------------|------------|-------------|------------|------------|------------|
| ** **                                                                       | ** ** | **Common Stock** | ** ** | **Treasury Stock** | ** ** | **Paid-In** | ** ** | **Stock**  | ** ** | **Comprehensive** | ** ** | **Accumulated ** | ** ** | **Stockholders**’ | ** ** |
| ** **                                                                       | ** ** | **shares**            | ** ** | **amount**              | ** ** | **shares**  | ** ** | **amount** | ** ** | **Capital**       | ** ** | **Compensation**      | ** ** | **Income**             | ** ** | **Deficit** | ** ** | **Equity** | ** ** |
| Balance at December 31, 2001                                                     |       | 26,362,603            |       |                    | $          | 26          |       |       | 1,166,125  |              |       | $                     | (40        | )                      |       |        | $          | 80,039     |       |   |   | $ | (493 | ) |   |   | $ | 79 |   |   |   | $ | (64,570 | ) |   |   | $ | 15,041 |   |   |
| Purchase of common stock pursuant to stock repurchase  program                   |       | —                |       |                    | —     |        |       | 13,500     |       |              | (11        | )                     |       |                   | —     |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | (11 | ) |   |
| Issuance of common stock to employees pursuant to  employee stock purchase  plan |       | 98,305                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | 109        |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 109 |   |   |
| Issuance of common stock to employees pursuant to  exercise of options           |       | 4,150                 |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | 4          |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 4 |   |   |
| Amortization of deferred stock compensation, net of  forfeitures                 |       | —                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | —     |        |       |       | 358        |   |   |   | — |   |   |   | — |   |   |   | 358 |   |   |
| Non-employee stock-based compensation                                            |       | —                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | 102        |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 102 |   |   |
| Unrealized loss on short-term investments                                        |       | —                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | —     |        |       |       | —     |   |   |   | (77 | ) |   |   | — |   |   |   | (77 | ) |   |
| Net loss                                                                         |       | —                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | —     |        |       |       | —     |   |   |   | — |   |   |   | (7,578 | ) |   |   | (7,578 | ) |   |
| Balance at December 31, 2002                                                     |       | 26,465,058            |       |                    | 26         |        |       | 1,179,625  |       |              | (51        | )                     |       |                   | 80,254     |        |       |       | (135       | ) |   |   | 2 |   |   |   | (72,148 | ) |   |   | 7,948 |   |   |
| Issuance of common stock to employees pursuant to  employee stock purchase plan  |       | 87,191                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | 64         |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 64 |   |   |
| Issuance of common stock to employees pursuant to  exercise of options           |       | 222,749               |       |                    |       |        |       | —     |       |              | —     |                  |       |                   | 219        |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 219 |   |   |
| Issuance of common stock pursuant to private  placement (net of placement fees)  |       | 4,615,385             |       |                    | 5          |        |       | —     |       |              | —     |                  |       |                   | 5,698      |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 5,703 |   |   |
| Amortization of deferred stock compensation, net of  forfeitures                 |       | —                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | —     |        |       |       | 135        |   |   |   | — |   |   |   | — |   |   |   | 135 |   |   |
| Non-employee stock-based compensation                                            |       | —                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | 43         |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 43 |   |   |
| Unrealized loss on short-term investments                                        |       | —                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | —     |        |       |       | —     |   |   |   | (2 | ) |   |   | — |   |   |   | (2 | ) |   |
| Net loss                                                                         |       | —                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | —     |        |       |       | —     |   |   |   | — |   |   |   | (8,619 | ) |   |   | (8,619 | ) |   |
| Balance at December 31, 2003                                                     |       | 31,390,383            |       |                    | 31         |        |       | 1,179,625  |       |              | (51        | )                     |       |                   | 86,278     |        |       |       | —     |   |   |   | — |   |   |   | (80,767 | ) |   |   | 5,491 |   |   |
| Issuance of common stock to employees pursuant to  employee stock purchase plan  |       | 118,139               |       |                    | 1          |        |       | —     |       |              | —     |                  |       |                   | 85         |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 86 |   |   |
| Issuance of common stock to employees pursuant to  exercise of options           |       | 33,812                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | 43         |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 43 |   |   |
| Issuance of common stock pursuant to private  placement (net of placement fees)  |       | 3,000,000             |       |                    | 3          |        |       | —     |       |              | —     |                  |       |                   | 3,575      |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 3,578 |   |   |
| Non-employee stock-based compensation                                            |       | —                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | 24         |        |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 24 |   |   |
| Purchase of common stock pursuant to stock repurchase  program                   |       | —                |       |                    | —     |        |       | 2,000      |       |              | (2         | )                     |       |                   | —     |        |       |       | —     |   |   |   |   |   |   |   | — |   |   |   | (2 | ) |   |
| Net loss                                                                         |       | —                |       |                    | —     |        |       | —     |       |              | —     |                  |       |                   | —     |        |       |       | —     |   |   |   | — |   |   |   | (8,706 | ) |   |   | (8,706 | ) |   |
| Balance at  December 31, 2004                                                    |       | 34,542,334            |       |                    | $          | 35          |       |       | 1,181,625  |              |       | $                     | (53        | )                      |       |        | $          | 90,005     |       |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | (89,473 | ) |   |   | $ | 514 |   |   |

 

The accompanying notes are an integral part ofthese financial statements.

F-5

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**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSfor the years ended December 31, 2004, 2003 and 2002(in thousands)**
| ** **                                                                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Cash Flows from  Operating Activities:                                                     |       |                                       |       |   |   |   |   |
| Net loss                                                                                   |       | $                                          | (8,706     | ) | $ | (8,619 | ) | $ | (7,578 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                                       |       |   |   |   |   |
| Depreciation                                                                               |       | 339                                        |       | 209 |   | 326 |   |
| Stock-based compensation                                                                   |       | —                                     |       | 135 |   | 358 |   |
| Compensation on options issued to consultants                                              |       | 24                                         |       | 43 |   | 102 |   |
| Provision for doubtful accounts                                                            |       | 77                                         |       | 125 |   | 56 |   |
| Changes in assets  and liabilities:                                                        |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                        |       | (345                                       | )          | (80 | ) | 1,964 |   |
| Inventories                                                                                |       | 200                                        |       | 211 |   | (52 | ) |
| Prepaid expenses and other current assets                                                  |       | 138                                        |       | 114 |   | 492 |   |
| Other assets                                                                               |       | 5                                          |       | 29 |   | 83 |   |
| Accounts payable                                                                           |       | 164                                        |       | 383 |   | (75 | ) |
| Deferred license revenue                                                                   |       | 20,557                                     |       | — |   | — |   |
| Deferred services revenue and customer deposits                                            |       | 77                                         |       | (325 | ) | (209 | ) |
| Accrued liabilities and other                                                              |       | 162                                        |       | 227 |   | (1,339 | ) |
| Net cash provided by (used in) operating activities                                        |       | 12,692                                     |       | (7,548 | ) | (5,872 | ) |
| Cash Flows from  Investing Activities:                                                     |       |                                       |       |   |   |   |   |
| Purchase of short-term investments                                                         |       | —                                     |       | (1,000 | ) | — |   |
| Sale of short-term investments                                                             |       | 1,000                                      |       | 2,400 |   | 3,352 |   |
| Purchase of property and equipment                                                         |       | (179                                       | )          | (183 | ) | (105 | ) |
| Net cash provided by investing activities                                                  |       | 821                                        |       | 1,217 |   | 3,247 |   |
| Cash Flows from  Financing Activities:                                                     |       |                                       |       |   |   |   |   |
| Increase (decrease) in bank overdraft                                                      |       | —                                     |       | — |   | (149 | ) |
| Proceeds from issuance of common stock                                                     |       | 3,707                                      |       | 5,986 |   | 113 |   |
| Repurchases of common stock                                                                |       | (2                                         | )          | — |   | (11 | ) |
| Net cash provided by (used in) financing activities                                        |       | 3,705                                      |       | 5,986 |   | (47 | ) |
| Net increase (decrease) in cash and cash equivalents                                       |       | 17,218                                     |       | (345 | ) | (2,672 | ) |
| Cash and cash equivalents, beginning of year                                               |       | 4,438                                      |       | 4,783 |   | 7,455 |   |
| Cash and cash equivalents, end of year                                                     |       | $                                          | 21,656     |   | $ | 4,438 |   | $ | 4,783 |   |
| Supplemental Cash Flow  Information:                                                       |       |                                       |       |   |   |   |   |
| Cash paid for income taxes                                                                 |       | $                                          | 60         |   | $ | 50 |   | $ | — |   |
| Cash paid for  interest                                                                    |       | $                                          | 6          |   | $ | 8 |   | $ | — |   |

 

The accompanying notes are an integral part ofthese financial statements.

F-6

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**AVISTAR COMMUNICATIONSCORPORATION AND SUBSIDIARIES**

**NOTES** TO FINANCIAL STATEMENTS

**1.   Business, Organization,Reorganization, Initial Public Offering, Basis of Presentation, and Risks andUncertainties**

**Business**

AvistarCommunications Corporation (“Avistar” or the “Company”) provides theAvistar vBusiness integrated suite of video-enabled applications, including networked video communications software andhardware products and services. Avistar’s products include applications forinteractive video calling, content creation and publishing, broadcast video andvideo-on-demand, as well as data sharing, directory services and networkmanagement. Avistar designs, develops, markets, sells, manufactures and/orassembles and installs and supports its products. Avistar’s real-time andnon-real-time products are based upon its architecture and Video OperatingSystem (AvistarVOS) platform, which facilitates distribution over local andwide area networks using telephony or Internet services as appropriate. Avistar’sservices include software development, consulting, implementation, training,maintenance and support. In addition, Avistar seeks to prosecute, maintain,support and license the intellectual property developed by the Company throughits wholly-owned subsidiary, Collaboration Properties, Inc., a Nevadacorporation (CPI).

**Organization**

The business was founded in 1993as a Nevada limited partnership, Avistar Systems, Limited Partnership (“ASLP”).In December 1997, ASLP entered into an acquisition agreement with a newlyformed corporation, Avistar Systems Corporation (“ASC”), to convey all of ASLP’sassets, and transfer all of ASLP’s liabilities, in exchange for 16,000,000shares of ASC’s Series A convertible preferred stock (see Note 6) and2,171,400 shares of common stock. Effective December 31, 1997, alloperations previously conducted by ASLP were thereafter undertaken by ASC.

CollaborationProperties, Inc. (“CPI”) and VCT, Inc. (“VCT”) were founded in 1997and 1998, respectively, to hold certain intellectual property, includingpatents, which underlie certain technology used by ASLP and subsequently by ASC.Three of the stockholders of CPI and VCT owned approximately 95% of CPI and100% of VCT and were also the partners of Collaborative Holdings L.P. (“CHLP”),which owned a controlling interest in ASLP. The remaining 5% ownership of CPIwas held by UBS (USA), Inc. (“UBS”) which also held a 5% ownershipinterest in ASC (see Note 5 and Note 6). Accordingly, the accounts of CPI andVCT have been combined at historical cost with those of ASC for all periodspresented since their inception.

**Reorganization**

Effective March 31, 2000,ASC merged with and into a newly formed Delaware corporation, AvistarCommunications Corporation. The operating assets and liabilities of the businesswere then contributed to a wholly owned subsidiary, Avistar Systems Corporation(“Avistar Systems”), a Delaware corporation. At the same time, the owners ofCPI and VCT transferred all of their stock in those entities to Avistar as acapital contribution. As a result, CPI and VCT are recorded at their historicalcost basis and became wholly owned subsidiaries of Avistar as of March 31,2000. In April 2000, the operations of VCT were merged with and into CPI.

In June 2000, all of the Series Apreferred stock held by ASC was distributed to the Company’s three founders andseveral other individuals based on their respective ownership interests in ASLP.In addition, all of the shares of Avistar’s common stock, held by ASLP weredistributed to the Company’s employees, 

F-7

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formeradvisors and officers. These common shares represent an amount equal to thoseshares of Class B units in ASLP that were owned by the respectiveindividuals before the acquisition.

In July 2001,the Board of Directors of Avistar and the board of directors of Avistar Systemsapproved the merger of Avistar Systems, the wholly owned subsidiary of Avistar,with and into Avistar. The merger was completed in July 2001. The assetsand liabilities of Avistar Systems were transferred to the Company athistorical cost on the date of the merger.

**Initial Public Offering**

In August 2000, the Companycompleted its initial public offering, selling three million shares of commonstock at $12 per share. The initial public offering resulted in net proceeds tothe Company of approximately $31.3 million after the payment of theunderwriters’ commission and deduction of offering expenses.

In August 2000,the Company used a portion of the net proceeds from the initial public offeringto repay the outstanding balances of notes payable and accrued interest duerelated parties of approximately $12.6 million. The remainder of the proceedshas been used to fund the Company’s working capital requirements and investedin securities with varying maturities and is included in cash and cashequivalents, and short-term investments.

**Basis of Presentation**

The accompanying financialstatements as of December 31, 2004 and 2003 present the consolidatedfinancial position of Avistar and its two wholly-owned operating subsidiaries, AvistarSystems U.K. Limited (“ASUK”) and CPI after elimination of all intercompanyaccounts and transactions. The consolidated results are referred to,collectively, as those of Avistar or the Company in these notes.

The functional currency ofASUK is the United States dollar. Accordingly, all gains and losses resultingfrom transactions denominated in currencies other than the United States dollarare included in the statements of operations.

TheCompany’s fiscal year end is December 31.

**Risks and Uncertainties**

The markets for the Company’s products and servicesare in the early stages of development. Some of the Company’s products utilizechanging and emerging technologies. As is typical in industries of this nature,demand and market acceptance are subject to a high level of uncertainty,particularly when there are adverse conditions in the economy. Acceptance ofthe Company’s products, over time, is critical to the Company’s success. TheCompany’s prospects must be evaluated in light of difficulties encountered byit and its competitors in further developing this evolving marketplace. TheCompany has generated losses since inception and had an accumulated deficit of$89.5 million as of December 31, 2004. The Company’s operating results mayfluctuate significantly in the future as a result of a variety of factors,including, but not limited to, the economic environment, the adoption ofdifferent distribution channels, and the timing of new product announcements bythe Company or its competitors.

The Company’s futureliquidity and capital requirements will depend upon numerous factors,including, but not limited to, the costs and timing of its expansion of productdevelopment efforts and the success of these development efforts, the costs andtiming of its expansion of sales and marketing activities, the extent to whichits existing and new products gain market acceptance, competing technologicaland market developments, the costs involved in maintaining, enforcing anddefending patent claims and other intellectual property rights, the level andtiming of revenue and other factors.

F-8

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**2.   Summary of Significant Accounting Policies**

**Use of Estimates**

Thepreparation of financial statements in conformity with generally acceptedaccounting principles 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 andthe reported amounts of revenues and expenses during the period. Actual resultscould differ from those estimates.

**Cash and Cash Equivalents and Short-term Investments**

The Company considers all investment instrumentspurchased with an original maturity of three months or less to be cashequivalents. Investment securities with original or remaining maturities ofmore than three months but less than one year are considered short-terminvestments. Investment securities with original or remaining maturities of oneyear or more are considered long-term investments. The Company classifies itsshort-term investments as available for sale with unrealized gains or lossesreported as a separate component of stockholders’ equity. The fair value of theCompany’s investments was determined based on quoted market prices at thereporting date for those instruments.

TheCompany’s cash equivalents at December 31, 2004 consisted of money marketfunds and short term commercial paper. At December 31, 2004, allinvestments have an original maturity of three months or less and are thereforeclassified as cash and cash equivalents in the accompanying balance sheet. TheCompany’s cash equivalents at December 31, 2003 consisted of short-termauction rate securities. In the fourth quarter of fiscal year 2004, theCompany concluded that it was appropriate to classify its auction ratesecurities as short-term investments. These investments were previouslyclassified as cash and cash equivalents. Accordingly, we have revised our December 31,2003 balance sheet to report these securities as short-term investments in theaccompanying Consolidated Balance Sheets.

**SignificantConcentrations**

Arelatively small number of customers have accounted for a significantpercentage of the Company’s net sales. Sales to major customers as a percentageof sales are as follows for 2004, 2003 and 2002:
| ** **  | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------|------------|----------|------------|----------|------------|----------|------------|
| Customer A  |       |     | 50         | %        |       |     | 62         | % |   |   | 55 | % |   |
| Customer B  |       |     | 15         | %        |       |     | *          |   |   |   | * |   |   |
| Customer  C |       |     | *          |     |       |     | *          |   |   |   | 11 | % |   |

----

*                    Less than 10%

Any change in the relationship with these customerscould have a potentially adverse effect on the Company’s financial position.

Financial instruments thatpotentially subject the Company to concentrations of credit risk consistprimarily of temporary cash investments and trade receivables. The Company hascash and investment policies that limit the amount of credit exposure to anyone financial institution and restrict placement of these investments tofinancial institutions evaluated as highly credit worthy. Concentrations ofcredit risk with respect to trade receivables relate to those trade receivablesfrom both United States and foreign entities, primarily in the financialservices industry. As of December 31, 2004, approximately 81% of accountsreceivable were concentrated with one customer. As of December 31, 2003,approximately 89% of accounts receivable were concentrated with one customer. As of December 31,2004 and 2003, no other customers individually accounted for greater than 10%of total accounts receivable.

F-9

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**Allowance for Doubtful Accounts**

The Company uses estimatesin determining the allowance for doubtful accounts based on historicalcollection experience, historical write-offs, current trends and the creditquality of the Company’s customer base and the characteristics of accountsreceivable by aging category. If the allowance for doubtful accounts wasunderstated, operating income could be significantly reduced. The impact of anysuch change or deviation may be increased by the Company’s reliance on arelatively small number of customers for a large portion of total revenue. Asof December 31, 2004, approximately 81% of the Company’s accountsreceivable balance was concentrated with one customer. As of December 31,2003, approximately 89% of the Company’s accounts receivable was concentratedwith one customer.

**Fair Value ofFinancial Instruments**

Thecarrying amounts of the Company’s financial assets and liabilities, includingcash and cash equivalents, short-term investments, accounts receivable,accounts payable, short-term borrowings and notes payable at December 31,2004 and 2003, approximate fair value because of the short maturity of theseinstruments.

**Inventories**

Inventories are stated at the lower of cost (first-in,first-out method) or market. When required, provisions are made to reduceexcess and obsolete inventories to their estimated net realizable value. Inventoriesconsisted of the following (in thousands):
| ** **                                             | ** ** | **December 31,_** | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|
| ** **                                             | ** ** | **2004**               | ** ** | **2003** | ** ** |
| Raw materials and subassemblies                        |       | $                      | 35         |   | $ | 83 |   |
| Finished goods                                         |       | 668                    |       | 813 |   |
| Inventory shipped to customer sites, not yet installed |       | 34                     |       | 41 |   |
|                                                   |       | $737                   |       | $ | 937 |   |
|                                                        |            |                        |            |  |  |  |  |

 

Inventory shipped tocustomer sites, not yet installed, represents product shipped to customer sitespending completion of the installation process by the Company. As of December 31,2004 and December 31, 2003, the Company had billed approximately $25,000and $160,000, respectively, to customers related to these shipments, but didnot record the revenue, as the installations had not been completed andconfirmed by the customer. Although customers are billed in accordance withcustomer agreements, these deferred revenue amounts are netted against accountsreceivable until the customer confirms installation.

**Property and Equipment**

Property and equipment are stated at cost and aredepreciated using the double declining balance method over the estimated usefullives (three years) of the assets. Repairs and maintenance are expensed asincurred. Property and equipment consisted of the following (in thousands):
| ** **                        | ** ** | **December 31,** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Computer equipment                |       | $                     | 716        |   | $ | 496 |   |
| Computer software                 |       | 216                   |       | 199 |   |
| Furniture, fixtures and equipment |       | 258                   |       | 254 |   |
|                              |       | 1,190                 |       | 949 |   |
| Less: Accumulated depreciation    |       | (998                  | )          | (597 | ) |
|                              |       | $                     | 192        |   | $ | 352 |   |

 

F-10

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**Accrued Liabilities and Other**

Accrued liabilities and other consisted of the following(in thousands):
| ** **                               | ** ** | **December 31,** | ** ** |
|------------------------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Accrued consulting and professional fees |       | $                     | 168        |   | $ | 583 |   |
| Accrued payroll and related benefits     |       | 368                   |       | 216 |   |
| Accrued income taxes                     |       | 301                   |       | — |   |
| Accrued commissions and bonuses          |       | 42                    |       | 43 |   |
| Other                                    |       | 408                   |       | 283 |   |
|                                     |       | $                     | 1,287      |   | $ | 1,125 |   |

 

**Patent Costs**

Dueto uncertainties about the estimated future economic benefits and lives of theCompany’s patents and patent applications, all related outside patent costshave been expensed as incurred. Outside patent costs were approximately $0.1million, $0.1 million and $0.2 million for 2004, 2003 and 2002, respectively,and are reflected in general and administrative expenses in the accompanyingstatements of operations.

**Revenue Recognition and Deferred Revenue**

The Company recognizes revenue in accordance with Statement of Position (“SOP”)97-2, Software Revenue Recognition (“SOP 97-2”), as amended by SOP 98-9,Modification of SOP 97-2, “Software Revenue Recognition” With Respect toCertain Transactions (“SOP 98-9”). In connection with each transactioninvolving product, the Company must evaluate whether: (i) persuasiveevidence of an arrangement exists, (ii) delivery has occurred, (iii) feeis fixed or determinable, and (iv) collectibility is probable. The Companyapplies these criteria as discussed below:

·        *Persuasive evidence of an arrangement exists*.The Company requires a written contract, signed by both the customer and theCompany, or a purchase order from those customers that have previouslynegotiated a standard end-user license arrangement or volume purchase agreementprior to recognizing revenue on an arrangement.

·        *Delivery has occurred*. The Companydelivers software and hardware to customers physically. The standard deliveryterms are FOB shipping point.

·        *The fee is fixed or determinable*. TheCompany’s determination that an arrangement fee is fixed or determinabledepends principally on the arrangement’s payment terms. The Company’s standardpayment terms generally require the arrangement fee to be paid within 30 daysof the date of invoice. Where these terms apply, the Company regards the fee asfixed or determinable, and recognizes revenue upon delivery (assuming otherrevenue recognition criteria are met). If the payment terms do not meet thisstandard, referred to as “extended payment terms,” the fee may not beconsidered to be fixed or determinable and the revenue would then be recognizedwhen customer installments are due and payable.

·        *Collectibility is probable*. To recognizerevenue, the Company judges collectibility of the arrangement fees on acustomer-by-customer basis pursuant to a credit review policy. The Companytypically sells to customers with a history of successful collection. For newcustomers, the Company evaluates the customer’s financial position and abilityto pay. If the Company determines that collectibility is not probable basedupon the credit review process or the customer’s payment history, revenue isrecognized when cash is collected.

F-11

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When the Company providesinstallation services, the product and installation revenue is recognized uponcompletion of the installation process and receipt of customer confirmation,subject to the satisfaction of the revenue recognition criteria described above.When the customer or a third party provides installation services, the productrevenue is recognized upon shipment, subject to satisfaction of the revenuerecognition criteria described above. Payment for product is due upon shipment,subject to specific payment terms. Payment for installation and professionalservices are due upon providing the services, subject to specific payment terms.If payments for systems are made in advance of the completion of installation,such amounts are deferred and recorded as deferred revenue and customerdeposits in the accompanying balance sheets until installation has occurred andthe customer has provided confirmation. Reimbursements received forout-of-pocket expenses incurred duringinstallation and support services, which have not been significant to date, arerecognized as revenue in accordance with Emerging Issues Task Force (EITF)Issue No. 01-14 (EITF 01-14), “Income Statement Characterization ofReimbursements Received for “Out of Pocket” Expenses Incurred.”

The price charged formaintenance and/or support is defined in the contract, and is based on a fixedprice for both hardware and software components as stipulated in the customeragreement. Customers have the option to renew the maintenance and/or supportarrangement in subsequent periods at the same rate as paid in the initial year.Revenue from maintenance and support services is deferred and recognizedpro-rata over the maintenance and/or support term, which is typically one yearin length. Payments for services made in advance of the provision of servicesare recorded as deferred revenue and customer deposits in the accompanyingbalance sheets. Training services are offered independently of the purchase ofproduct. The value of these training services is determined based on the pricecharged when such services are sold separately, and training revenue isrecognized upon performance of the service.

The Company recognizes servicerevenue from software development contracts in accordance with SOP 81-1, “Accountingfor Performance of Construction-Type and Certain Production-Type Contracts.”Revenue related to contracts for software development is recognized using thepercentage of completion method, when all of the following conditions are met:a contract exists with the customer at a fixed price, the Company has fulfilledall of its material contractual obligations to the customer for eachdeliverable of the contract, verification of completion of the deliverable hasbeen received, and collection of the receivable is probable. The amounts billedto customers in excess of revenues recognized to date are deferred and recordedas deferred revenue and customer deposits in the accompanying balance sheets. Assumptionsused for recording revenue and earnings are adjusted in the period of change toreflect revisions in contract value and estimated costs to complete thecontract. Any anticipated losses on contracts in progress are charged toearnings when identified.

TheCompany recognizes revenue from the licensing of its intellectual propertyportfolio based on the terms of the royalty, partnership and cross-licensingagreements involved. Revenue from licensing of intellectual property, to date,has consisted entirely of payment from Polycom, Inc. pursuant to asettlement agreement and a cross-license agreement dated November 12,2004, and has been recognized as revenue in accordance with Section 48 and49 of Statement of Position 97-2, “Software Revenue Recognition” (SOP 97-2),which discusses multiple-element arrangements and the future delivery ofunspecified additional software products. As part of the settlement andcross-license agreements with Polycom, Inc., the Company granted toPolycom a non-exclusive, fully paid-up, license to its entire patent portfolio.The cross-license agreement includes a five year capture period from the dateof the settlement, adding all new patents with a priority date extending up tofive years from the date of execution of the cross-license agreement. Sections48 and 49 of SOP 97-2 provide that a vendor may agree to deliver softwarecurrently and to deliver unspecified additional software products in thefuture. The software elements of the kinds of arrangements discussed inparagraph 48 should be accounted for as subscriptions. No allocation of revenueshould be made among any of the software products, and all softwareproduct-related revenue from the arrangement should be recognized ratably overthe term of the arrangement 

F-12

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beginning with delivery of the first product.Accordingly, the net $21.1 million license fee paid to the Company by Polycom, Inc.,will be deferred and recognized as licensing revenue ratably over the five yearperiod beginning November 12, 2004.

**Warranty**

TheCompany accrues the estimated costs of fulfilling the warranty provisions ofits contracts over the warranty period, which is typically 90 days. Thewarranty accrual was approximately $14,000 as of December 31, 2004 andapproximately $13,000 as of December 31, 2003, and was included in accruedliabilities in the accompanying balance sheets.

**Stock-Based Compensation**

The Company applies theintrinsic-value-based method of accounting prescribed by AccountingPrinciples Board (APB) Opinion No. 25, Accounting for Stock Issued toEmployees, and related interpretations including FASB Interpretation No. 44,Accounting for Certain Transactions involving Stock Compensation, aninterpretation of APB Opinion No. 25, to account for its fixed-planstock options. Under this method, compensation expense is recorded on the dateof grant only if the current market price of the underlying stock exceeded theexercise price. SFAS No. 123, Accounting for Stock-BasedCompensation, established accounting and disclosure requirements using a fair-value-basedmethod of accounting for stock-based employee compensation plans. Asallowed by SFAS No. 123, the Company has elected to continue to apply theintrinsic-value-based method of accounting described above, and hasadopted only the disclosure requirements of SFAS No. 123 (see Note 7). Thefollowing table illustrates the effect on net loss if the fair-value-basedmethod had been applied to all outstanding and unvested awards in each period.
| ** **                                                                                                                   | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net loss, as reported                                                                                                        |       | $                                          | (8,706     | ) | $ | (8,619 | ) | $ | (7,578 | ) |
| Add stock—based employee compensation expense  included in reported net loss, net of tax                           |       | —                                     |       | 135 |   | 358 |   |
| Deduct total stock-based employee compensation expense determined  under fair-value-based method for all  awards, net of tax |       | (2,206                                     | )          | (4,135 | ) | (3,995 | ) |
| Pro forma net loss                                                                                                           |       | $                                          | (10,912    | ) | $ | (12,619 | ) | $ | (11,215 | ) |
| Basic and diluted loss per share                                                                                             |       |                                       |       |   |   |   |   |
| As reported                                                                                                                  |       | $                                          | (0.27      | ) | $ | (0.33 | ) | $ | (0.30 | ) |
| Pro forma                                                                                                                    |       | $                                          | (0.33      | ) | $ | (0.48 | ) | $ | (0.44 | ) |

 

F-13

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TheCompany has adopted SFAS 123 for disclosure purposes. The weighted average fairvalue of options granted during 2004, 2003 and 2002, estimated on the date ofgrant using the Black-Scholes option pricing model was $1.10, $0.82 and $1.15,respectively. The Black-Scholes option-pricing model was developed for use inestimating the fair value of traded options that have vesting restrictions andare fully transferable. In addition, option-pricing models require the input ofhighly subjective assumptions, including a factor to represent expected stockprice volatility. Because the Company’s employee stock options havecharacteristics significantly different from those of traded options, and becausechanges in the subjective input assumptions can materially affect the fairvalue estimate, in management’s opinion, the existing models do not necessarilyprovide a reliable single measure of the fair value of the Company’s options. Thefair value of 2004, 2003 and 2002 options granted is estimated on the date ofgrant using the following assumptions:
| ** **                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|
| ** **                      | ** ** | ** 2004 **                       | ** ** | ** 2003 ** | ** ** | ** 2002 ** | ** ** |
| **Employee Stock Option Plan**  | ** ** |                                       | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Expected dividend               |       |                                       | 0          | **%** |   |   | 0 | **%** |   |   | 0 | **%** |   |
| Average risk-free interest rate |       |                                       | 3.5        | **%** |   |   | 2.9 | **%** |   |   | 3.8 | **%** |   |
| Expected volatility             |       |                                       | 230        | **%** |   |   | 156 | **%** |   |   | 187 | **%** |   |
| Expected term (years)           |       |                                       | 4          | ** ** |   |   | 4 | ** ** |   |   | 4 | ** ** |   |

 
| ** **                       | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | ** 2004 **                       | ** ** | ** 2003 ** | ** ** | ** 2002 ** | ** ** |
| **Employee Stock Purchase Plan** | ** ** |                                       | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Expected dividend                |       |                                       | 0          | **%** |   |   | 0 | **%** |   |   | 0 | **%** |   |
| Average risk-free interest rate  |       |                                       | 3.3        | **%** |   |   | 3.2 | **%** |   |   | 3.8 | **%** |   |
| Expected volatility              |       |                                       | 479        | **%** |   |   | 109 | **%** |   |   | 168 | **%** |   |
| Expected  term (months)          |       |                                       | 6          | ** ** |   |   | 6 | ** ** |   |   | 6 | ** ** |   |

 

**Recent Accounting Pronouncements**

In March 2004, the EmergingIssues Task Force (EITF) reached a consensus on Issue No. 03-01, “TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments.” EITF 03-01 provides guidance on other-than-temporary impairmentmodels for marketable debt and equity securities accounted for under SFAS No. 115,“Accounting for Certain Investments in Debt and Equity Securities,” and SFAS No. 124,“Accounting for Certain Investments Held by Not-for-Profit Organizations,” andnon-marketable equity securities accounted for under the cost method. The EITFdeveloped a basic three-step model to evaluate whether an investment isother-than-temporarily impaired. In September 2004, the FinancialAccounting Standards Board (FASB) issued EITF 03-01-1 which delayed theeffective date of the recognition and measurement provisions of EITF 03-01;however the disclosure requirements remain effective for annual financialstatements for fiscal years ending after December 15, 2004. The Companywill evaluate the effect, if any, of the adoption of EITF Issue No. 03-01when final guidance is released.

In November 2004, the FASBissued SFAS 151, Inventory Costs, which revised ARB 43, relating to inventorycosts. This revision is to clarify the accounting for abnormal amounts of idlefacility expense, freight, handling costs and wasted material (spoilage). ThisStatement requires that these items be recognized as a current period chargeregardless of whether they meet the criterion specified in ARB 43. In addition,this Statement requires the allocation of fixed production overheads to thecosts of conversion be based on normal capacity of the production facilities.SFAS 151 is effective for inventory costs incurred during fiscal yearsbeginning after June 15, 2005. The Company does not believe the adoptionof SFAS 151 will have a material impact on the Company’s financial position,results of operations, or cash flows.

In December 2004,the FASB issued a revision of Statement of Financial Accounting Standards No. 123,“Accounting for Stock-Based Compensation” (SFAS 123R). SFAS 123Rsupersedes 

F-14

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APB Opinion No. 25, “Accounting for StockIssued to Employees,” and its related implementation guidance. SFAS 123Restablishes standards for the accounting for transactions in which an entityincurs liabilities in exchange for goods or services that are based on the fairvalue of the entity’s equity instruments or that may be settled by the issuanceof those equity instruments. SFAS 123R does not change the accountingguidance for share-based payment transactions with parties other than employeesprovided in SFAS 123 as originally issued and EITF Issue No. 96-18, “Accountingfor Equity Instruments That Are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods or Services”. SFAS 123R is effectivefor interim reporting period that begins after June 15, 2005. Theparagraph entitled *Stock Based Compensation*included in Note 2 to these consolidated financial statements provides the proforma net income and earnings per share as if the Company had used afair-value-based method similar to the methods required under SFAS 123R tomeasure the compensation expense for employee stock awards during fiscal 2004,2003 and 2002.

**Other Comprehensive Income**

SFAS No. 130 (“SFAS 130”), “ReportingComprehensive Income,” establishes standards for reporting and display ofcomprehensive income (loss) and its components. This standard definescomprehensive income as the changes in equity of an enterprise, except thoseresulting from stockholder transactions. Accordingly, comprehensive incomeincludes certain changes in equity that are excluded from the net income orloss. For 2004, the net loss and the comprehensive loss were equal. Thecomprehensive loss for 2003 and 2002 was $8.6 million and $7.7 million,respectively.

The components of comprehensive loss are as follows:
| ** **                                                      | ** ** | **Year Ending December 31,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                      | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net loss                                                        |       | $                                           | (8,706     | ) | $ | (8,619 | ) | $ | (7,578 | ) |
| Other comprehensive income (loss):                              |       |                                        |       |   |   |   |   |
| Change in net unrealized gains  and losses on  investments |       | —                                      |       | (2 | ) | (77 | ) |
| Total  comprehensive loss                                       |       | $                                           | (8,706     | ) | $ | (8,621 | ) | $ | (7,655 | ) |

 

**3.   Line of Credit**

On February 27,2002, the Company entered into a Loan and Security Agreement with a financialinstitution to borrow up to $4.5 million under a revolving line of credit. On December 15,2002, the Company entered into an amendment to the Loan and Security Agreementto increase the maximum funds available under the line of credit to $6.0million and extend the term of the agreement. The amended Loan and SecurityAgreement, as further amended in March 2003, had an expiration date of February 27,2004. The agreement, as amended, includes a first priority security interest inall the Company’s assets, excluding intellectual property. Gerald Burnett, theCompany’s Chairman and Chief Executive Officer, has provided a collateralizedguarantee to the financial institution, assuring payment of the Company’sobligations under the agreement and as a consequence, a number of restrictivecovenants from the original Loan and Security Agreement have been deleted,except for quick ratio and loan to value covenants, allowing the Companygreater access to the full amount of the facility. On February 27, 2004,the Loan and Security Agreement was amended to change the maximum borrowingsthereunder to $3.5 million, subject to certain quick ratio and loan to valuecovenants, and to extend the term of the Loan and Security Agreement to February 27,2005. In connection with this amendment, Dr. Burnett’s collateralizedguarantee was amended to reduce the amount of such guarantee to $3.5 million. Inaddition to the guarantee provided to the financial institution, Dr. Burnetthas also provided a personal guarantee to Avistar assuring the provision of upto $2.0 million to Avistar in the event that at least $2.0 million is notavailable to the Company under the line of credit, or an alternate financingarrangement, for any reason. 

F-15

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There were no outstanding borrowings under the line ofcredit as of December 31, 2004. The Loan and Security Agreement expired byits terms on February 27, 2005.

**4.   Commitments and Contingencies**

At December 31, 2004, the Company had openpurchase orders and other contractual obligations of approximately $0.8million, primarily related to inventory purchases. These purchase ordercommitments and contractual obligations are reflected in the Company’sfinancial statements once goods or services have been received or paymentsrelated to the obligations become due.

The Company leases its facilities under operating leasesthat expire through March 2007. As of December 31, 2004, the futureminimum lease commitments under all leases were as follows (in thousands):
| **Year Ending December 31,** | ** ** | ** ** | ** ** | **Amount** | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| 2005                                        |       | $          | 785        |       |
| 2006                                        |       | 432        |       |
| 2007                                        |       | 80         |       |
| 2008                                        |       | —     |       |
| 2009                                        |       | —     |       |
| Thereafter                                  |       | —     |       |
| Total  minimum lease payments               |       | $          | 1,297      |       |

 

Rentexpense under all operating leases for each of 2004, 2003 and 2002 wasapproximately $0.6 million, $1.2 million and $1.4 million, respectively.

**5.   Related Party Transactions**

Certaindirectors with controlling interests in the Company are also the majority ownersof two entities that conducted business with the Company, Vicor Inc. (“Vicor”)and Western Data Systems of Nevada, Inc. (“WDS”). Descriptions of certaintransactions between the Company and these and other related entities follow.

**Revenue from a Related Party**

UBS Warburg LLC, which is anaffiliate of UBS AG, is a stockholder of the Company and is also a customer ofthe Company. As of December 31, 2004 and 2003, UBS Warburg held less than5% of the Company’s stock. Revenue from UBS Warburg LLC and its affiliatesrepresented 15% of total revenue for 2004. Revenue for UBS Warburg LLC and itsaffiliates represented less than 10% of total revenue for 2003 and 2002,respectively. Management believes the transactions with UBS Warburg LLC and itsaffiliates are at terms comparable to those provided to unrelated third parties.As of December 31, 2004 and 2003, the Company had accounts receivableoutstanding from UBS Warburg LLC and its affiliates of approximately $61,000and $23,000, respectively.

Revenuefrom Vicor represented less than 10% of total revenue for 2004. The Company didnot recognize revenue from or contracted for sales made to Vicor during 2003 or2002. Management believes the transactions with Vicor are at terms comparableto those provided to unrelated third parties. As of December 31, 2004 and2003, the Company did not have any accounts receivable outstanding from Vicor.

**Fees to Related Parties**

Robert P. Latta, a member of the law firm WilsonSonsini Goodrich & Rosati, Professional Corporation (“WSGR”), hasserved as a director of the Company since February 2001. Mr. Lattaand 

F-16

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WSGR have represented theCompany and its predecessors as corporate counsel since 1997. During 2004 and2003, payments of approximately $114,000 and $303,000, respectively, were madeto WSGR for legal services provided to the Company.

During2004 and 2003, payments forconsulting fees of approximately $0 and $110,000, respectively, were made to R.Stephen Heinrichs, a former officer of the Company, who is also a member of theBoard of Directors, pursuant to a Separation Agreement between Mr. Heinrichsand the Company dated April 26, 2001.

**Private Placement of Common Stock**

On October 15, 2003,the Company completed the private sale of 4,615,385 shares of common stock to Dr. Burnettand other members of his family at a price per share of $1.30. The net proceedsof this private financing, after deducting expenses of the financing, wereapproximately $5.7 million. Under the terms of the private placement, Dr. Burnettagreed to certain restrictions on 1,602,847 of the 3,661,539 shares purchasedby him. These restrictions require Dr. Burnett to vote such shares in thesame proportion as outstanding common stock not beneficially owned by Dr. Burnett.

**6.   Stockholders’ Equity**

**Private Placement of Common Stock**

On March 26, 2004,the Company completed the private sale of a total of 3,000,000 shares of commonstock to Fuller & Thaler Avalanche Fund, L.P. and Fuller &Thaler Behavioral Finance Fund, Ltd. at a price per share of $1.20. The net proceedsof this private financing after deducting expenses of the financing wereapproximately $3.6 million. The issuance of these additional shares reduced thenumber of Dr. Burnett’s shares subject to voting restrictions imposed inconnection with his October 15, 2003 purchase of common stock from1,602,847 to 141,152 shares. Also as a result of this private equity financing,the personal guarantee of Dr. Burnett to provide the Company with up to$2.0 million in the event that at least $2.0 million is not available to theCompany under the Loan and Security Agreement was terminated by its terms.

**Stock Spilt**

In July 2000,the Company effected a one-for-five reverse stock split. All share and pershare amounts in these financial statements have been adjusted to give effectto the reverse stock split.

**Stock Repurchase Plan**

On March 22,2001, the Company announced that its Board of Directors authorized therepurchase of up to $2.0 million of its common stock in the open market. During2004 and 2002, the Company repurchased 2,000 and 13,500 shares, respectively,at an aggregate cost of approximately $2,000 and $11,000, respectively. Noshares of common stock were repurchased by the Company during 2003.

**Preferred Stock**

In April 2000, thestockholders of the Company authorized 10,000,000 shares of convertiblepreferred stock, effective upon completion of its initial public offering in August 2000.As of December 31, 2003 the Company had 10,000,000 shares of convertiblepreferred stock authorized, at $0.001 per share par value. No shares wereissued or outstanding as of December 31, 2004.

F-17

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In June 2000, theCompany’s Board of Directors (the “Board”) authorized the filing of aregistration statement with the SEC to register shares of its common stock inconnection with its initial public offering. As a result of the initial publicoffering in August 2000, all 16,000,000 of the outstanding shares of Series Aconvertible preferred stock were converted into 19,148,578 shares of commonstock, which represents the sum of (1) 16,000,000 shares of common stockplus (2) an additional 3,148,578 shares of common stock representing abeneficial conversion feature equal to the quotient of (A) the conversionamount, which was $37.8 million at August 16, 2000, and which includes anamount equal to $0.2167 per share per annum, pro rated based on the number ofdays elapsed in the year, divided by (B) the initial offering price of$12.00 per share. The shares of Series A preferred stock had the samevoting rights as the shares of common stock into which they were converted. TheSeries A preferred stock had a liquidation preference of $2.009 per shareplus all declared and unpaid dividends on each share of Series A preferredstock.

**Deferred Stock Compensation**

In connection with thegrant of stock options to purchase shares of common stock to employees during2000, the Company recorded deferred compensation of approximately $1.7 million,representing the difference between the estimated fair value of the commonstock and the aggregate option exercise price of such options at the date ofgrant. This amount is presented as a reduction of stockholders’ equity and isbeing amortized ratably over the service period of the applicable options(generally four years). The Company did not record any amortization of deferredstock compensation in 2004 due to the completion of the pre-IPO option awardamortization and the forfeitures of stock options by employees no longer withour company. Amortization expense, net of forfeitures related to deferred stockcompensation was approximately $0.1 million and $0.4 million in 2003 and 2002,respectively. Compensation expense is decreased in the period of forfeiture forany accrued but unvested compensation arising from the termination of an optionholder’s services.

**7.**   StockOption Plans

**1997 Stock Option Plan**

In December 1997, the Board established the 1997Stock Option Plan (the “1997 Plan”) and authorized the issuance of 1,828,602shares of common stock thereunder. In December 1999 and May 2000,respectively, the Board authorized an additional 1,065,625 shares and 100,000shares to be issued under the Plan. In connection with the initial publicoffering in August 2000, the Board terminated the 1997 Plan as to futuregrants effective August 17, 2000. Under the 1997 Plan, incentive stockoptions to purchase shares of common stock were granted only to employees atnot less than 100% of the fair market value at the grant date as determined bythe Board. Additionally, nonqualified stock options to purchase shares ofcommon stock were granted to employees and consultants at not less than 85% ofthe fair market value at the grant date. Options granted generally had a lifeof ten years.

Optionsgranted under the plan vest over a four-year period, with 25% vesting after oneyear and the remaining vesting 6.25% per quarter. Under the 1997 Plan, theCompany granted options to purchase approximately 1.2 million common shares in2000. In 2003, 2002 and 2001, the Company made no grants under this plan. At December 31,2004, options to purchase a total of 837,150 shares were outstanding under the1997 Plan and no options were available for grant.

**2000 Stock Option Plan**

In April 2000, theBoard established the 2000 Stock Option Plan (the “2000 Plan”). Initially, atotal of 3,000,000 shares of common stock were approved by the Board forissuance under the 2000 Plan, together with annual increases in the number ofshares of common stock reserved under the plan beginning on the first day ofthe Company’s fiscal year, commencing January 1, 2001. In January 2001,the Board approved 

F-18

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anincrease of 1,004,936 shares. In January 2002, the Board approved anincrease of 1,007,858 shares. In January 2003, the Board approved anincrease of 1,011,957 shares. In January 2004, the Board approved anincrease of 1,200,000 shares. As of December 31, 2004, a total of7,045,148 shares had been reserved for issuance under the 2000 Plan. The termof the options granted under this plan may not exceed 10 years and in the caseof the grantees who own more than 10% of the Company’s outstanding stock at thetime of grant, the term of the option may not exceed 5 years. Options grantedunder the 2000 Plan vest and become exercisable as set forth in each optionagreement. In the event of a merger or sale of substantially all assets, theseoptions must be assumed by the successor and if not assumed, will fully vest. The2000 Plan will terminate in 2010. As a result of the increases, a maximum of15,000,000 shares of common stock could be issued under the 2000 Plan. TheCompany granted options to purchase approximately 1.2 million common shares in2000 under this plan. In 2001, the Company granted options to purchaseapproximately 2.3 million common shares under this plan. In 2002, the Companygranted options to purchase approximately 1.3 million common shares under thisplan. In 2003, the Company granted options to purchase approximately 1.8million common shares under this plan. In 2004, the Company granted options topurchase approximately 1.3 million common shares under this plan. At December 31,2004 options to purchase a total of 5,286,913 shares were outstanding under the2000 Plan and 1,758,235 options were available for future grant.

**2000 Director Option Plan**

In April 2000, the Companyadopted the 2000 Director Option Plan (the “Director Plan”). Initially, a totalof 90,000 shares of common stock were approved by the Board for issuance underthe plan, together with an annual increase in the number of shares of commonstock reserved thereunder as provided in the plan beginning on the first day ofthe Company’s fiscal year, commencing January 1, 2001. In January 2001,the Board approved an annual increase of 12,000 shares. In May 2001, theBoard approved an additional 198,000 shares under this plan. In January 2002,the Board approved the annual increase of 30,000 shares. In January 2003,the Board approved the annual increase of 30,000 shares. In April 2003,the Board approved an additional 104,000 shares under this plan. In January 2004,the Board approved the annual increase of 175,000 shares. As of December 31,2004, the Company has authorized a total of 639,000 shares for issuance underthis plan. As a result of the annual increases, a maximum of 1,689,000 sharesof common stock could be issued over the 10-year life of the plan. Options topurchase 12,000 shares were granted in 2000. In 2001, the Company grantedoptions to purchase 270,000 shares under this plan. In 2002, the Companygranted options to purchase 18,000 shares under this plan. In 2003, the Companygranted options to purchase 120,000 shares under this plan. In 2004, the Companygranted options to purchase 170,000 shares under this plan. At December 31,2004 options to purchase a total of 524,000 shares were outstanding under theDirector Plan and 115,000 options were available for future grant.

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A summary of the 1997 Plan, the 2000 Plan, and theDirector Plan activity and related information for the years ended December 31,2004, 2003 and 2002 follows:
| ** **                       | ** ** | ** **             | ** ** | **Options Outstanding** | ** ** |
|----------------------------------|------------|------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **Options  Available** | ** ** | **Shares**                   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Balance, December 31, 2001  |       | 861,986                |       | 4,903,707                    |       |   | $ | 5.05 |   |   |
| Authorized                       |       | 1,235,859              |       | —                       |       |   | — |   |   |
| Granted                          |       | (1,311,000             | )          | 1,311,000                    |       |   | 1.21 |   |   |
| Exercised                        |       | —                 |       | (4,150                       | )          |   | 0.90 |   |   |
| Canceled/repurchased             |       | 844,000                |       | (1,029,827                   | )          |   | 3.41 |   |   |
| Balance, December 31, 2002  |       | 1,630,845              |       | 5,180,730                    |       |   | $ | 4.42 |   |   |
| Authorized                       |       | 1,145,957              |       | —                       |       |   | — |   |   |
| Granted                          |       | (1,956,000             | )          | 1,956,000                    |       |   | 1.13 |   |   |
| Exercised                        |       | —                 |       | (222,749                     | )          |   | 1.01 |   |   |
| Canceled/repurchased             |       | 847,903                |       | (1,383,627                   | )          |   | 3.17 |   |   |
| Balance, December 31, 2003  |       | 1,668,705              |       | 5,530,354                    |       |   | $ | 3.70 |   |   |
| Authorized                       |       | 1,375,000              |       | —                       |       |   | — |   |   |
| Granted                          |       | (1,484,500             | )          | 1,484,500                    |       |   | 1.14 |   |   |
| Exercised                        |       | —                 |       | (33,812                      | )          |   | 1.09 |   |   |
| Canceled/repurchased             |       | 314,030                |       | (332,979                     | )          |   | 2.60 |   |   |
| Balance,  December 31, 2004 |       | 1,873,235              |       | 6,648,063                    |       |   | $ | 3.20 |   |   |

 
| ** **                                | **Options Outstanding**            | ** ** | ** ** | ** **                                                   | **Options Exercisable** | ** **                                |
|-------------------------------------------|-----------------------------------------|------------|------------|--------------------------------------------------------------|------------------------------|-------------------------------------------|
| ** **                                | **Range of  Exercise Prices** | ** ** | ** ** | **Number  Outstanding at  December 31, 2004** | ** **                   | **Weighted-Average  Remaining Life** | ** ** | **Weighted-Average  Exercise Price** | ** ** | **Number  Exercisable at  December 31, 2004** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
| $  0.25 -   0.88 |                                    |       | 489,125    |                                                         |                         |                                      | 7.60 |   |   |   | $ | 0.65 |   |   |   | 175,375 |   |   |   | $ | 0.43 |   |   |
| $  0.90 -   0.90 |                                    |       | 1,212,375  |                                                         |                         |                                      | 8.31 |   |   |   | 0.90 |   |   |   | 458,623 |   |   |   | 0.90 |   |   |
| $  0.92 -   1.04 |                                    |       | 231,900    |                                                         |                         |                                      | 4.69 |   |   |   | 0.95 |   |   |   | 222,400 |   |   |   | 0.95 |   |   |
| $  1.16 -   1.16 |                                    |       | 1,066,000  |                                                         |                         |                                      | 9.30 |   |   |   | 1.16 |   |   |   | — |   |   |   | — |   |   |
| $  1.21 -   1.27 |                                    |       | 699,013    |                                                         |                         |                                      | 7.40 |   |   |   | 1.22 |   |   |   | 432,010 |   |   |   | 1.22 |   |   |
| $  1.30 -   1.52 |                                    |       | 756,950    |                                                         |                         |                                      | 5.58 |   |   |   | 1.47 |   |   |   | 615,524 |   |   |   | 1.48 |   |   |
| $  1.59 -   2.21 |                                    |       | 673,750    |                                                         |                         |                                      | 6.60 |   |   |   | 2.15 |   |   |   | 540,060 |   |   |   | 2.16 |   |   |
| $  2.29 -   8.50 |                                    |       | 874,200    |                                                         |                         |                                      | 6.93 |   |   |   | 5.82 |   |   |   | 627,668 |   |   |   | 7.18 |   |   |
| $  9.35 -   9.35 |                                    |       | 150,000    |                                                         |                         |                                      | 0.72 |   |   |   | 9.35 |   |   |   | 150,000 |   |   |   | 9.35 |   |   |
| $17.25 - 17.25                       |                                    |       | 494,750    |                                                         |                         |                                      | 5.25 |   |   |   | 17.25 |   |   |   | 494,750 |   |   |   | 17.25 |   |   |
|                                      |                                    |       | 6,648,063  |                                                         |                         |                                      | 7.13 |   |   |   | $ | 3.20 |   |   |   | 3,716,410 |   |   |   | $ | 4.78 |   |   |

 

**2000 Employee Stock PurchasePlan**

In April 2000, theCompany adopted the 2000 Employee Stock Purchase Plan (“Employee Stock PurchasePlan”). Initially, a total of 1,500,000 shares of common stock were approved bythe Board for issuance under the plan, together with an annual increase in thenumber of shares of common stock reserved thereunder as provided in the planbeginning on the first day of the Company’s fiscal year, commencing January 1,2001. In January 2001, the Board approved an increase of 753,702 shares. Asof December 31, 2004, the Company has authorized a total of 2,253,702shares for issuance under this plan. As a result of these annual increases, amaximum of 10,500,000 shares could be sold over the 10-year life of the plan. TheEmployee Stock Purchase Plan permits employees to purchase common stock throughpayroll deductions, which may not exceed 15% of an employee’s compensation, at85% of the lower of the fair market value of the Company’s common stock on thefirst or the last day of each offering period. A 

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total of118,139, 87,191 and 98,305 shares were sold under this plan during 2004, 2003and 2002, respectively.

**CommonStock Reserved for Future Issuance**

As of December 31, 2004, the Company had reservedthe following shares of common stock for issuance in connection with:
| Stock options under stock option plans |   | 8,521,298  |   |
|----------------------------------------|--------|------------|--------|
| Employee stock purchase plan           |   | 2,253,702  |   |
| Total                                  |   | 10,775,000 |   |

 

**8.   Legal Proceedings**

On September 23,2002, CPI, the Company’s wholly-owned subsidiary, commenced a patentinfringement lawsuit against Polycom, Inc. alleging that several Polycomvideoconferencing products infringe four patents held by CPI. The suit was filedin the United States District Court for the Northern District of California. Thefour patents involved are U.S. Patent Nos. 5,867,654, 5,896,500, 6,212,547 and6,343,314. These patents cover technologies relating to video and dataconferencing over unshielded twisted pair (UTP) networks, distributedcall-state management, separate monitors for simultaneous computer-based datasharing and videoconferencing and remote participant hold and disconnectfunctions in multi-party conferencing. Briefings on claims construction issuesand a hearing before the presiding judge (Markman hearing) took place on March 8,2004. A trial date for CPI’s claims against Polycom had been set for January 24,2005. On November 12, 2004, the Company, CPI and Polycom entered into aSettlement Agreement and a Patent Cross-License Agreement. Under the terms ofthe agreements:

·        Avistar,on behalf of itself and its subsidiaries, including CPI, provided Polycom andits subsidiaries with specific and general releases of liability;

·        Polycom,on behalf of itself and its subsidiaries, provided Avistar and its subsidiarieswith specific and general releases of liability;

·        Polycommade a lump-sum payment to Avistar in the amount of $27.5 million, or $21.1million net of expenses;

·        Avistarand CPI dismissed with prejudice all claims against Polycom in the litigation;

·        Avistarand its subsidiaries granted Polycom and its subsidiaries a fully-paid uplicense to Avistar’s patent portfolio, including subsequent patents that have apriority date within five years of the date of the agreement; and

·        Polycom and itssubsidiaries granted Avistar and its subsidiaries a fully-paid up license toPolycom’s patent portfolio, including subsequent patents that have a prioritydate within five years of the date of the agreement.

**9.   Income Taxes**

The Company accounts for income taxes in accordancewith SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). SFAS 109provides for an asset and liability approach to account for income taxes underwhich deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities, and their respective taxbases. Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. Deferred tax assets arereduced by a valuation allowance when, in the opinion of management, it is 

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more likely than not thatsome or all of the deferred tax assets will not be recognized. The effect ondeferred tax assets and liabilities of a change in tax rates is recognized inincome in the period of enactment.

The provision for income taxes relates to Federal,State and Foreign tax. The Company provided for income taxes for its subsidiaryin the United Kingdom (ASUK) of approximately $60,000, $20,000 and $18,000 in2004, 2003 and 2002, respectively.

The provision for (recovery from) income taxes consistedof the following (in thousands):
| ** **          | ** ** | **Year Ended December 31,** | ** ** |
|---------------------|------------|--------------------------------------------|------------|
| ** **          | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Current:            |       |                                       |       |   |   |   |   |
| Federal             |       | $                                          | 237        |   | $ | — |   | $ | — |   |
| State               |       | 66                                         |       | — |   | — |   |
| Foreign             |       | 60                                         |       | 20 |   | 18 |   |
|                |       | 363                                        |       | 20 |   | 18 |   |
| Deferred  benefits: |       |                                       |       |   |   |   |   |
| Federal             |       | (2,691                                     | )          | (2,985 | ) | (2,352 | ) |
| State               |       | (335                                       | )          | (490 | ) | (601 | ) |
|                |       | (3,026                                     | )          | (3,475 | ) | (2,953 | ) |
| Valuation allowance |       | 3,026                                      |       | 3,475 |   | 2,953 |   |
|                |       | $                                          | 363        |   | $ | 20 |   | $ | 18 |   |

 

The Company’s effective income tax provision differedfrom the federal statutory rate of 34% due to the following (in thousands):
| ** **                                                                                            | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                            | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Expected  tax benefit at federal statutory rate                                                       |       | $                                          | (2,837     | ) | $ | (2,985 | ) | $ | (2,646 | ) |
| Foreign  and state taxes, net                                                                         |       | 126                                        |       | 20 |   | 18 |   |
| Permanent  non-deductible                                                                             |       |                                       |       | 57 |   | 136 |   |
| Utilization  of net operating losses                                                                  |       | (3,786                                     | )          | — |   | — |   |
| Current  year operating losses and temporary  differences for which no tax benefit is recognized |       | 6,860                                      |       | 2,928 |   | 2,510 |   |
| Provision for income taxes                                                                            |       | $                                          | 363        |   | $ | 20 |   | $ | 18 |   |

 

Permanent and non-deductible isprimarily composed of the non-deductible portion of the deferred stockcompensation expense.

The net deferred income tax asset consisted of thefollowing as of December 31, 2004 and 2003 (in thousands):
| ** **                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Deferred  income tax assets:              |       |     |       |     |       |
| Federal  net operating loss carryforwards |       | $        | 8,244      |     | $          | 12,550 |   |
| State  net operating loss carryforwards   |       | —   |       | 966      |       |
| Tax  credit carry forward                 |       | 2,246    |       | 1,853    |       |
| Deferred  licensing revenue               |       | 8,172    |       | —   |       |
| Reserves                                  |       | 57       |       | 284      |       |
| Property  and Equipment                   |       | 75       |       | 115      |       |
|                                      |       | 18,794   |       | 15,768   |       |
| Valuation  allowance                      |       | (18,794  | )          | (15,768  | )          |
| Net deferred income tax asset             |       | $        | —     |     | $          | — |   |

 

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Net operating loss carryforwardsat December 31, 2004 were approximately $24 million and $0, for Federaland state income tax purposes, respectively. The Federal net operating losscarryforwards expire on various dates through the year 2023.

As of December 31, 2004,unused research and development tax credits of approximately $0.9 million and$1.0 million are available to reduce future Federal and California incometaxes, respectively. Federal credit carryforwards expire beginning in year 2013.California credits will carry forward indefinitely.

TheInternal Revenue Code of 1986, as amended, contains provisions that may limitthe net operating loss carryforwards to be used in any given year upon theoccurrence of certain events, including a significant change in ownershipinterest. The Company believes sufficient uncertainty exists regarding therealizability of the net operating loss and tax credit carryforwards and othertiming differences. Accordingly, a valuation allowance has been provided forthe entire net deferred tax asset.

**10.**   NetLoss Per Share

Basic and diluted net loss pershare of common stock is presented in conformity with SFAS No. 128 (“SFAS128”), “Earnings Per Share,” for all periods presented.

In accordance with SFAS 128,basic net loss per share has been computed using the weighted average number ofshares of common stock outstanding during the period, less shares subject torepurchase. Diluted net loss per share is computed on the basis of the weightedaverage number of shares and potential common shares outstanding during theperiod. Potential common shares result from the assumed exercise of outstandingstock options that have a dilutive effect when applying the treasury stockmethod. The Company has excluded all convertible preferred stock, outstandingstock options and shares subject to repurchase from the calculation of dilutednet loss per share for 2004, 2003 and 2002, because all such securities areantidilutive (owing to the fact that the Company is in a loss position). Accordingly,diluted net loss per share is equal to basic net loss per share for all yearspresented.

The total number of potential common shares excludedfrom the calculations of diluted net loss per share was 1,873,782, 1,556,292and 4,694,564 for 2004, 2003 and 2002, respectively.

The following table presents thecalculation of basic and diluted net loss per share (in thousands, except pershare data):
| ** **                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                          | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net  loss attributable to common stockholders                                       |       | $                                          | (8,706     | ) | $ | (8,619 | ) | $ | (7,578 | ) |
| Weighted  average shares of common stock used in  computing net loss per share |       | 32,610                                     |       | 26,368 |   | 25,260 |   |
| Net  loss per share basic and diluted                                               |       | $                                          | (0.27      | ) | $ | (0.33 | ) | $ | (0.30 | ) |

 

**11.**   SegmentReporting

Disclosureof segments is presented in accordance with SFAS No. 131 (“SFAS 131”), “DisclosuresAbout Segments of an Enterprise and Related Information.”  SFAS 131 establishes standards fordisclosures regarding operating segments, products and services, geographicareas and major customers. The Company isorganized and operates as two operating segments: (1) the design,development, manufacturing, sale and marketing of networked videocommunications products (Avistar) and (2) the prosecution,maintenance, support and licensing of the intellectual property used in theCompany’s products (CPI). Service revenuerelates mainly to the maintenance, support, training, software development andinstallation of products and is included in Avistar for purposes of reportingand decision-making. Avistar also engages in the corporate functions andprovides financing and services to its 

F-23

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subsidiaries. The Company’s chief operating decisionmaker, its Chief Executive Officer, monitors the Company’s operations basedupon the information reflected in the following table (in thousands):
| ** **                            | ** ** | **CPI** | ** ** | **AVISTAR** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|---------|------------|-------------|------------|-----------|------------|
| **Year Ended December 31, 2004** |       |    |       |        |       |      |       |
| Revenue                               |       | $       | 575        |        | $          | 6,321     |       | $ | 6,896 |   |
| Gross margin                          |       | 575     |       | 2,949       |       | 3,524     |       |
| Depreciation expense                  |       | —  |       | (339        | )          | (339      | )          |
| Total operating expenses              |       | (3,898  | )          | (8,102      | )          | (12,000   | )          |
| Interest income                       |       | —  |       | 118         |       | 118       |       |
| Interest expense                      |       | —  |       | 6           |       | 6         |       |
| Net loss                              |       | (3,322  | )          | (5,384      | )          | (8,706    | )          |
| Assets                                |       | 133     |       | 24,078      |       | 24,211    |       |
| **Year Ended December 31, 2003** |       |    |       |        |       |      |       |
| Revenue                               |       | $       | —     |        | $          | 6,592     |       | $ | 6,592 |   |
| Gross margin                          |       | —  |       | 3,063       |       | 3,063     |       |
| Depreciation expense                  |       | (6      | )          | (203        | )          | (209      | )          |
| Total operating expenses              |       | (2,446  | )          | (9,741      | )          | (12,187   | )          |
| Interest income                       |       | —  |       | 44          |       | 44        |       |
| Interest expense                      |       | —  |       | 8           |       | 8         |       |
| Net loss                              |       | (2,446  | )          | (6,173      | )          | (8,619    | )          |
| Assets                                |       | 22      |       | 8,206       |       | 8,228     |       |
| **Year Ended December 31, 2002** |       |    |       |        |       |      |       |
| Revenue                               |       | $       | —     |        | $          | 8,799     |       | $ | 8,799 |   |
| Gross margin                          |       | —  |       | 4,322       |       | 4,322     |       |
| Depreciation expense                  |       | (5      | )          | (321        | )          | (326      | )          |
| Total operating expenses              |       | (1,209  | )          | (11,169     | )          | (12,378   | )          |
| Interest income                       |       | —  |       | 269         |       | 269       |       |
| Interest expense                      |       | —  |       | —      |       | —    |       |
| Net loss                              |       | (1,209  | )          | (6,369      | )          | (7,578    | )          |
| Assets                                |       | 179     |       | 10,221      |       | 10,400    |       |

 

Internationalrevenue, which consists of sales to customers with operations principally inWestern Europe and Asia  comprised48%, 58% and 49% of total revenue for 2004, 2003 and 2002, respectively. For2004, 2003 and 2002, respectively, international revenues to customers in theUnited Kingdom accounted for 28%, 40% and 26%, respectively, of total revenue. TheCompany had no significant long-lived assets in any country other than in theUnited States for any period presented.

F-24

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**12.   Selected Quarterly Results of Operations(unaudited)**

The following tables set forth, for the periodsindicated, the Company’s unaudited financial information for the last eightquarters. The Company believes that the financial statements used to prepare thisinformation include all adjustments, consisting only of normal recurringadjustments, necessary for a fair presentation of this information when read inconjunction with the Company’s financial statements and notes to financialstatements. The operating results for any quarter do not necessarily indicatethe results expected for any future period. As described under RevenueRecognition above, we expect to recognize the payment received from Polycom tolicensing revenue in equal installments over a 5 year period starting November 12,2004. The payment from Polycom and its expected recognition to licensingrevenue may affect the comparability of our financial statements for periodsbefore and after the payment was received.
| ** **                            | ** ** | **Quarter Ended**                                            | ** ** |
|---------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                            | ** ** | **December 31,  2004**                                       | ** ** | **September 30,  2004** | ** ** | **June 30,  2004** | ** ** | **March 31,  2004** | ** ** |
| ** **                            | ** ** | **(In thousands except per share data)** | ** ** |
| Total revenue                         |       |                                                              | $          | 2,304 |   |   |   | $ | 1,512 |   |   | $ | 1,676 |   | $ | 1,404 |   |
| Gross margin                          |       |                                                              | 1,401      |   |   |   | 642 |   |   | 851 |   | 630 |   |
| Total operating expenses              |       |                                                              | 3,243      |   |   |   | 2,925 |   |   | 3,095 |   | 2,737 |   |
| Net loss                              |       |                                                              | $          | (2,096 | ) |   |   | $ | (2,289 | ) |   | $ | (2,233 | ) | $ | (2,088 | ) |
| Net loss per share—Basic/Diluted |       |                                                              | $          | (0.06 | ) |   |   | $ | (0.07 | ) |   | $ | (0.07 | ) | $ | (0.07 | ) |
| Weighted  average shares              |       |                                                              | 33,361     |   |   |   | 33,335 |   |   | 33,277 |   | 30,450 |   |

 
| ** **                            | ** ** | **Quarter Ended**                                            | ** ** |
|---------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                            | ** ** | **December 31,  2003**                                       | ** ** | **September 30,  2003** | ** ** | **June 30,  2003** | ** ** | **March 31,  2003** | ** ** |
| ** **                            | ** ** | **(In thousands except per share data)** | ** ** |
| Total revenue                         |       |                                                              | $          | 1,409 |   |   |   | $ | 2,035 |   |   | $ | 1,485 |   | $ | 1,663 |   |
| Gross margin                          |       |                                                              | 670        |   |   |   | 1,075 |   |   | 609 |   | 709 |   |
| Total operating expenses              |       |                                                              | 2,781      |   |   |   | 2,908 |   |   | 3,084 |   | 3,414 |   |
| Net loss                              |       |                                                              | $          | (2,151 | ) |   |   | $ | (1,307 | ) |   | $ | (2,471 | ) | $ | (2,690 | ) |
| Net loss per share—Basic/Diluted |       |                                                              | $          | (0.07 | ) |   |   | $ | (0.05 | ) |   | $ | (0.10 | ) | $ | (0.11 | ) |
| Weighted  average shares              |       |                                                              | 29,400     |   |   |   | 25,371 |   |   | 25,343 |   | 25,321 |   |

 

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**Item15(a)**

**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIES**

**SCHEDULEII—VALUATION AND QUALIFYING ACCOUNTS**
| ** **                          | ** ** | **Balance at  Beginning of  Year** | ** ** | **Additions  Charged to  Operations** | ** ** | **Write-Offs** | ** ** | **Balance at  End of Year** | ** ** |
|-------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| ** **                          | ** ** | **(In thousands)**                      | ** ** |
| **Allowance for Doubtful Accounts** |       |                                         |       |                                       |       |           |       |                                       |       |   |   |   |   |   |   |   |   |
| Period  Ended:                      |       |                                         |       |                                       |       |           |       |                                       |       |   |   |   |   |   |   |   |   |
| December 31, 2004              |       |                                         | $          | 44                                         |       |           |       | $                                          | 77         |   |   |   | $ | (99 | ) |   |   | $ | 22 |   |   |
| December 31, 2003              |       |                                         | $          | 69                                         |       |           |       | $                                          | 125        |   |   |   | $ | (150 | ) |   |   | $ | 44 |   |   |
| December 31, 2002              |       |                                         | $          | 232                                        |       |           |       | $                                          | 56         |   |   |   | $ | (219 | ) |   |   | $ | 69 |   |   |

 

S-1

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**INDEXTO EXHIBITS**
| Exhibits | ** ** | ** **                                                                                                                                                                                     |
|----------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2      | (1)        | Restated  Certificate of Incorporation                                                                                                                                                         |
| 3.3      |       | Bylaws  of Avistar Communications Corporation                                                                                                                                                  |
| 4.1      | (1)        | Specimen  Certificate evidencing shares of Common Stock                                                                                                                                        |
| 10.1     | (1)        | 1997  Stock Option Plan, as amended*                                                                                                                                                           |
| 10.1.1   | (1)        | 1997  Stock Option Plan Form of Stock Option Agreement*                                                                                                                                   |
| 10.2     | (1)        | 2000  Stock Option Plan, as amended*                                                                                                                                                           |
| 10.3     | (3)        | 2000  Director Option Plan, as amended*                                                                                                                                                        |
| 10.4     | (1)        | Form of  Director Option Agreement*                                                                                                                                                       |
| 10.5     | (4)        | 2000  Employee Stock Purchase Program, as amended*                                                                                                                                             |
| 10.6     | (1)        | Form of  Indemnification Agreement*                                                                                                                                                       |
| 10.7     | (1)†  | Preferred  Supplier Agreement dated June 24, 1997 by and between Avistar and  Tandberg, Inc., including modifications Nos. 1, 2, 3 and 4                                             |
| 10.7.1   | (1)†  | Modification  No. 5 to the Preferred Supplier Agreement dated June 27, 2000                                                                                                          |
| 10.7.2   | (2)†  | Modification  No. 6 to the Preferred Supplier Agreement dated November 27, 2000                                                                                                      |
| 10.8     | (6)        | Settlement  Agreement and Release between the Registrant and R. Stephen Heinrichs dated  April 26, 2001*                                                                                  |
| 10.9     | (7)        | Master  Loan and Security Agreement between the Registrant and Comerica  Bank—California dated February 27, 2002                                                                     |
| 10.9.1   | (7)†  | First  Amendment dated December 17, 2002 to Master Loan and Security Agreement  between the Registrant and Comerica Bank—California                                                  |
| 10.9.2   | (7)†  | Unconditional  Guaranty of the Gerald J. Burnett and Marjorie J. Burnett Revocable Trust  dated December 17, 2002                                                                         |
| 10.9.3   | (7)†  | Unconditional  Guaranty of Gerald J. Burnett dated December 17, 2002                                                                                                                      |
| 10.9.4   | (7)        | Second  Amendment dated March 10, 2003 to Master Loan and Security Agreement  between the Registrant and Comerica Bank—California                                                    |
| 10.9.5   | (9)        | Fourth  Amendment dated February 27, 2004 to Master Loan and Security Agreement  between the Registrant and Comerica Bank—California                                                 |
| 10.9.6   | (9)        | Reaffirmation  of Unconditional Guaranty of the Gerald J. Burnett and Marjorie J. Burnett  Revocable Trust dated February 24, 2004                                                        |
| 10.10    | (8)        | Office  Lease Agreement between CA-Twin Dolphin Plaza Limited Partnership and the  Registrant dated July 30, 2003                                                                         |
| 10.11    | (8)        | Common  Stock Purchase Agreement by and among the Registrant and The Gerald J.  Burnett and Marjorie J. Burnett Revocable Trust, Grady Burnett and Wendolyn  Hearn dated October 15, 2003 |
| 10.12    | (10)       | Stock Purchase Agreement  among the Registrant, Fuller & Thaler Behavioral Finance Fund, Ltd.  and Fuller & Thaler Avalanche Fund, L.P. dated March 23, 2004            |
| 10.13    |       | Settlement Agreement  among the Registrant, Collaboration Properties, Inc. and  Polycom, Inc. dated November 12, 2004                                                           |
| 21.1     | (7)        | Subsidiaries  of the Company                                                                                                                                                                   |
| 23.1     |       | Consent  of Independent Registered Public Accounting Firm                                                                                                                                      |
| 24.1     |       | Power  of Attorney (see page 48)                                                                                                                                                          |

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| 31.1 |   | Rule 13a-14(a)/15d-14(a) Certification  by the Chief Executive Officer                                                                                                              |
|------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Rule 13a-14(a)/15d-14(a) Certification  by the Chief Financial Officer                                                                                                              |
| 32   |   | Certification  by the Chief Executive Officer and Chief Financial Officer pursuant to 18  U.S.C Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |

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*                    Indicates management contract or compensatoryplan or arrangement required to be filed an exhibit pursuant to Item 14(c) ofForm 10-K.

†                    Portionsof the exhibit have been omitted pursuant to a request for confidentialtreatment and the omitted portions have been separately filed with the Commission.

(1)          Filed asan exhibit to the Company’s Registration Statement on Form S-1 (FileNo. 333-39008) as declared effective by the Securities and ExchangeCommission on August 16, 2000.

(2)          Filed asan exhibit to the Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2000 filed with the Securities and ExchangeCommission on March 9, 2001.

(3)          Filed asan exhibit to the Registrant’s Quarterly Report on Form 10-Q for thethree months ended June 30, 2003 filed with the Securities and ExchangeCommission on August 13, 2003.

(4)          Filed asan exhibit to the Registrant’s Registration Statement on Form S-8filed with the Securities and Exchange Commission on August 16, 2000.

(5)          Filed asan exhibit to the Company’s Annual Report on Form 10-K for the yearended December 31, 2001 filed with the Securities and Exchange Commissionon March 21, 2002.

(6)          Filed asan exhibit to the Registrant’s Current Report on Form 8-K filed withthe Securities and Exchange Commission on May 8, 2001.

(7)          Filed asan exhibit to the Company’s Annual Report on Form 10-K for the yearended December 31, 2002 with the Securities and Exchange Commission on March 25,2003.

(8)          Filed asan exhibit to the Registrant’s Quarterly Report on Form 10-Q for thethree months ended September 30, 2003 filed with the Securities andExchange Commission on October 23, 2003.

(9)          Filed asan exhibit to the Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2003 filed with the Securities and ExchangeCommission on March 16, 2004.

(10)   Filed as an exhibit to the Registrant’s QuarterlyReport on Form 10-Q for the quarter ended March 31, 2004 filedwith the Securities and Exchange Commission on May 11, 2004.

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