**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

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**x**                                 ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**For the fiscal year ended December 31, 2006**

**OR**

**o**                                   TRANSITION REPORTPURSUANT TO SECTION 13 OF 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**For the transition period from                       to                       .**

**CommissionFile Number: 000-31121**

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**AVISTARCOMMUNICATIONS CORPORATION**

(Exact nameof 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 areacode: (650) 610-2900**

**Securities registered pursuant to Section 12(b) ofthe Act:**
|                                | **Title of each class** | ** ** | ** ** | **Name of each exchange on which registered** | ** ** |
|--------------------------------|----------------------------------------|------------|------------|-----------------------------------------------------------------------------|------------|
| Common Stock, $0.001 par value | The  NASDAQ Stock Market LLC           |
|                           | (NASDAQ Capital  Market)               |

 

**Securitiesregistered pursuant to Section 12(g) of the Act:**

**None**

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Indicateby check mark if the registrant is a well known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o  No x

Indicateby check mark if the registrant is not required to file the reports pursuant toSection 13 or 15(d) of the Securities Exchange Act of 1934. Yes o  No x

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Exchange Act during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the 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 a large accelerated filer, anaccelerated filer or a non-accelerated filer. (See definition of “acceleratedfiler” and “large accelerated filer” in Rule 12b-2 of the ExchangeAct). (Check One)

Largeaccelerated filer o  Accelerated filer o  Non-accelerated filer x

Indicateby check mark whether the registrant a shell company (as defied in Rule 12b-2of the Exchange 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 30,2006 was $15,013,914. Shares of Common Stock held by each executive officer anddirector and by each person who owns 10% or more of the outstanding CommonStock have been excluded in that such persons may be deemed to be affiliates.This determination of affiliate status is not necessarily a conclusive determinationfor other purposes.

As of March 5, 2007, theregistrant had outstanding 35,317,717 shares of Common Stock.

**DOCUMENTS INCORPORATED BY REFERENCE**

The Registrant incorporatesby reference into Part III of this Annual Report on Form 10-Kspecific portions of its Proxy Statement for its 2007 Annual Meeting ofStockholders.

 

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**AVISTAR COMMUNICATIONSCORPORATIONANNUAL REPORT ON FORM 10-KYEAR ENDED DECEMBER 31, 2006**

**TABLEOF CONTENTS**
|                                                                                                                                                           | ** ** | **Page** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| *PART I*                                                                                                                                             |       |     |       |   |   |
| *Item 1.  Business*                                                                                                                                       | * *   | * * | *3*        |   |   |
| *Item  1a. Risk Factors*                                                                                                                                  | * *   | * * | *22*       |   |   |
| *Item 1b. Unresolved Staff Comments*                                                                                                                      | * *   | * * | *32*       |   |   |
| *Item 2.  Properties*                                                                                                                                     | * *   | * * | *32*       |   |   |
| *Item  3. Legal Proceedings*                                                                                                                              | * *   | * * | *33*       |   |   |
| *Item 4. Submission of Matters to a Vote of Security  Holders*                                                                                            | * *   | * * | *33*       |   |   |
| *PART II*                                                                                                                                            |       |     |       |   |   |
| *Item 5. Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities    * | * *   | * * | *34*       |   |   |
| *Item  6. Selected Financial Data*                                                                                                                        | * *   | * * | *36*       |   |   |
| *Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations*                                                    | * *   | * * | *37*       |   |   |
| *Item 7a.  Quantitative and Qualitative Disclosures About Market Risk*                                                                                    | * *   | * * | *49*       |   |   |
| *Item 8.  Financial Statements and Supplementary Data*                                                                                                    | * *   | * * | *50*       |   |   |
| *Item 9. Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure*                                                           | * *   | * * | *50*       |   |   |
| *Item 9a. Controls  and Procedures*                                                                                                                       | * *   | * * | *50*       |   |   |
| *Item 9b. Other  Information*                                                                                                                             | * *   | * * | *50*       |   |   |
| *PART III*                                                                                                                                           |       |     |       |   |   |
| *Item 10. Directors, Executive Officers of the  Registrant and Corporate Governance Matters*                                                              | * *   | * * | *51*       |   |   |
| *Item 11. Executive Compensation*                                                                                                                         | * *   | * * | *51*       |   |   |
| *Item 12. Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters     *             | * *   | * * | *51*       |   |   |
| *Item 13. Certain Relationships and Related Transactions  and Director Independence*                                                                      | * *   | * * | *52*       |   |   |
| *Item 14. Principal Accountant Fees and Services*                                                                                                         | * *   | * * | *52*       |   |   |
| *PART IV*                                                                                                                                            |       |     |       |   |   |
| *Item 15.  Exhibits, Financial Statement Schedules*                                                                                                       | * *   | * * | *53*       |   |   |
| *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 thisAnnual Report, the words “expects,” “anticipates,” “believes,” “plans,” “intends”and “estimates” and similar expressions are intended to identify forwardlooking statements. These forward looking statements include predictionsregarding our future revenues and profits, income from settlement and patentlicensing, customer concentration, customer buying patterns, research anddevelopment expenses, sales and marketing expenses, general and administrativeexpenses, litigation and legal fees, 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 technologies, 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 “Item 1a. Risk Factors” as well as othersincorporated 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***

We were founded as a Nevadalimited partnership in 1993. We filed our articles of incorporation in Nevadain December 1997 under the name Avistar Systems Corporation. Wereincorporated in Delaware in March 2000 and changed our name to AvistarCommunications Corporation in April 2000. The operating assets andliabilities of the business were then contributed to our wholly ownedsubsidiary, 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(Avistar). The merger was completed in July 2001.

Our principal executive officesare located at 555 Twin Dolphin Drive, Suite 360, Redwood Shores,California, 94065. Our telephone number is (650) 610-2900. Our trademarksinclude Avistar and the Avistar logo, AvistarVOS, Shareboard, vBrief and TheEnterprise Video Company. This Annual Report on Form 10-K alsoincludes our and other organizations’ product names, trade names andtrademarks. Our corporate website is www.avistar.com.

OurAnnual 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 us with the SEC at the SEC’sPublic Reference Room at 450 Fifth Street, NW, Washington, DC 20549.The public may obtain information on the operation of the Public Reference Room bycalling the SEC at 1-800-SEC-0330. The SEC maintains anInternet site that contains reports, proxy and information statements and otherinformation regarding issuers that file electronically with the SEC athttp://www.sec.gov. The contents of these websites are not incorporated intothis filing.

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**Overview**

We develop, market and support an integrated suite ofvBusiness—video-enabled eBusiness—applications, all powered by the AvistarVOSTMsoftware. From the desktop, we deliver business-quality interactive videocalling, content creation and publishing, broadcast origination anddistribution, video-on-demand, and integrated data sharing. The Avistar videoand data collaboration applications are all managed by the AvistarVOS softwareapplication. By integrating video tightly into the way they work, our customerscan use our system to save 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. Additionally, we have licensed our technology and patents tocompanies in the video conferencing market. Our objective is to establish ourtechnology as the standard for networked video through direct sales, indirectchannel sales/partnerships and the licensing of our technology to others.

We operate in two segments. Avistar CommunicationsCorporation engages in the design, development, manufacture, sale and marketingof networked video communications products and associated support services.Collaboration Properties, Inc., or CPI, our wholly owned subsidiary,engages in the prosecution, maintenance, support and licensing of theintellectual property that we have developed, some of which is used in ourproducts.

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, 2006, we held74 U.S. and foreign patents, all of which have been licensed by CPI to thirdparties. We continue to pursue licensing to others in the collaborationtechnology marketplace.

**Industry Background**

Globalization, supported by the near ubiquity ofcommunications networks such as the Internet, has allowed companies to lowercosts, reach new markets, change business processes (e.g., eBusiness) anddistribute and outsource operations. It also has meant increased competition, afaster business pace and less differentiation. These factors, coupled with thedifficulty and cost of travel, increased risks due to socio-politicaluncertainties and pandemic concerns and the desire to reduce carbon emissions,are causing businesses to look for new tools that will help them increaseproductivity, take advantage of revenue opportunities, and minimize businesscontinuity risks. Enterprises of all sizesstand to benefit from new and advanced communication and collaboration toolsthat enable their employees, partners, suppliers and customers to collaboratemore effectively and form tighter relationships within and across buildings andover disparate geographies and time zones. Communications tools that speed indecision-making and build trust-based relationships, especially across cultures,are becoming even more critical in today’s increasingly complex businessenvironment.

The emergence of theInternet has accelerated the adoption of network-based collaborationapplications including email, instant messaging, and web conferencing. Theincreasing availability and affordability of bandwidth on communicationnetworks is further driving businesses to utilize new communication tools, suchas voice and video over IP, and is enabling users to connect from more placesincluding home offices and WiFi hot spots such as airports, and hotels. This isenabling more distributed, mobile and global operations while maintainingcommunications.

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**Limitations ofCurrent Means of Collaboration**

As technology advances and becomes more affordable andmodes of communication expand, enterprises are seeking widely deployable andcost effective technology to replicate, at the desktop, the impact of visualcommunication that occurs in a face-to-face meeting. Individuals generallyprefer face-to-face encounters to less personal forms of communication becausethey can see one another and benefit from the non-verbal cues that speedcommunication and deepen understanding. This is particularly true for morecomplex interactions such as negotiations, sales, product development, projectmanagement and decision making across geography/functions/cultures. However, intoday’s globalized, fast-paced business environment, face-to-face interactionsare often forgone due to the difficulty and time required for travel, and theneed to act quickly. These time and distance challenges become increasinglydifficult to deal with as the number of potential participants increase. Beyondtraditional teleconferencing, attempts to conduct virtual meetings as analternative to face-to-face meetings have generally been limited to conferenceroom-based video conferencing and web-based data teleconferences.

To address the growing need forcollaboration across distance and time, organizations have resorted to using apatchwork of discrete technologies, including video conferencing andteleconferencing, fax, email, instant messaging, Internet audio and videodelivery and data sharing applications. Many of these technologies have beenwidely adopted, and collectively indicate the need for collaboration toolsincluding networked video. However, these discrete technologies are not goodsubstitutes by themselves for face-to-face meetings and presentations becausethey do not provide an integrated communications solution that fosters teaminteraction and deliver critical, time-sensitive information quickly andreliably. By providing face-to-facecollaboration in an integrated communications solution, video can speed problemresolution and motivate action, trust and understanding. Additionally, userswant to leverage knowledge and expertise by being able to create and publishvideo content from their desktop, either spontaneously, as with email orvoicemail, or in a more formal manner for broader distribution through theInternet or corporate data network.

Although video technologies arealready in use at many enterprises, businesses and other organizations requireincreasingly comprehensive, integrated and scalable video-enabled communicationcapabilities. For example, video conferencing is often limited to scheduledpoint-to-point communication from designated rooms or through the use of “roll-about”products, where call set-up procedures, lack of networking, bandwidthrequirements and room availability greatly constrain functionality, usability,reliability and efficiency. Most individuals do not have immediateaccess to these video technologies, and the reservation and set-up time makethem unlikely to be used on a spontaneous basis. Few of these video solutions are deployed widely to individuals tosupport them where and how they normally work—at their desks, integrated intothe business applications they use. Usage and adoption of these systems is thusoften limited.

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 ona real-time basis to a live videoconference. Additionally, the difficulties ofcreating and publishing video content have limited its use to select groups, ifat all.

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**Elements of a Complete Collaboration Solution**

To become a critical tool in the enterprise, acommunications solution must first and foremost provide applicationfunctionality that boosts worker productivity. It also has to be “self service”and provide high quality at scale, high reliability, low total cost ofownership, and be available to people where and when they do most of theirwork, which typically means at their desks but increasingly means from home orwhile traveling. It must also effectively utilize existing and evolving networkinfrastructure. We believe a complete collaboration solution must provide thefollowing:

*Applications and functionality*

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

·       doso 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;

·       leveragecurrent and future business investments in local and wide area networks,Internet protocol and standards-based infrastructures;

·       reduce reliance on hardware components through a shift to software-basedfunctionality;

*Affordability*

·       operate andscale cost effectively;

·       utilizestandard, low cost and widely available hardware components, such as “web-cams”;

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·       becost-effective compared to other pervasive forms of enterprise communication,such as email;

·       deliver costsavings 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.

**The Avistar Solution**

Our goal is to video-enableenterprises—a concept we refer to as vBusiness—by delivering a suite of videoapplications which support users where and how they work with a self-serve,easy-to-use system that fosters usage and adoption. It is through a tightcoupling of various forms of video into daily work processes that we believethe benefits described above can be realized. To fulfill this, we deliver avideo collaboration platform enabled by a unique architecture and powerfulsoftware—the AvistarVOS application software. This software provides acomprehensive, integrated suite of video applications that include on-demandaccess to interactive video calling and conferencing, content creation andpublishing, broadcast origination and video distribution, and video-on-demand,as well as data sharing, presence-based directory services and networkmanagement. These applications support users within and amongst enterprisesover data networks, telephony networks and the Internet. Our systemarchitecture is open and flexible in order to embrace continued technologicalinnovation and standardization. It is designed to use existing and emergingcommunication and video standards such as session initiation protocol, or SIP.It also provides customers choice and flexibility in designing and implementingnetwork topologies to best deliver high-quality video applications to desktopsacross the entire enterprise.

We have built acomplete video collaboration solution that is delivering business-quality video to thousands of desktopsacross hundreds of buildings. Each of our applications can be used, integratedand managed in conjunction with one another. People often conceive of video inthe enterprise only as two-way, real-time conferencing. Our system allowsbroadcast video to be included in a video call, and allows the entire sessionto be recorded simultaneously, and made available as stored video. Our systemjoins users in a high-quality video network to improve their ability to solvecomplex problems, connect to co-workers, customers and suppliers, manage largeprojects and quickly act together on opportunities. Our system does this costeffectively and reliably, and is designed to be able to serve the wide range ofbusinesses from a single office operation to global corporations with branchoffices and/or geographically dispersed operations.

*Interactivevideo calling.**  *Our system allows users to participate inspontaneous interactive video collaborations from their desktops. Users cansimultaneously see multiple participants in windows on their workstations or anexternal monitor. Additionally, our system provides full duplex audio, whichallows multiple users to speak and hear each other clearly at the same time.The desktop window can be divided into four quadrants, to permit up to threeother video sources. These sources can include other participants in real-time,broadcast content or recorded video. The participants can include individualusers or conference-room groups located at multiple sites and/or variousenterprises, all without requiring advance reservations or conferencingservices. Each participant has the full ability to utilize all the callfunctions of the system, such as adding or removing participants, focusing theview on one participant, putting anyone or the entire call on hold, andtransferring the call. Advanced telephony features such as Caller ID, Do NotDisturb, leave message and multiline calling are also provided. The systemsupports the communications needs of users by allowing them to add a third orfourth participant into a call 

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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 oursolution, users can create and publish video content from their desktops byrecording themselves, recording a multi-point conference or adding commentaryto a broadcast and recording the entire session. Recorded content can be playedback on demand, and can be published in various forms inside and outside theenterprise. This includes video emails, called vBriefs, which allow users toeasily create video messages which recipients, with common mail clients andbrowsers, can watch. This helps differentiate and highly personalize the sender’semail. As an example, research analysts can record introductory commentary anddistribute their research reports in a way that cuts through the email clutterof their audiences’ inbox. Similarly, video can simply and quickly be publishedto web sites from a user’s desk.

*Interactivebroadcasts and presentations.**  *Interactivebroadcasts allow moderated presentations to an audience of viewers, who havethe ability to send questions to the presenters. Moderators can dynamicallycontrol who’s presenting, bring audience members into the broadcast, selectwhat views are broadcast, and monitor questions. Sales meetings, trainingseminars, analyst reports, management presentations and live news broadcastscan be delivered real-time to every user’s workstation and streamed tobrowser-based users. For example, a customer employed its Avistar video networkto maximize the reach and impact of an educational seminar. The customerbroadcasted the seminar to an estimated 300 desktops and meeting rooms, withmore than 2,000 employees and clients watching in the United States and Europe.As another example, one customer has shifted its international sales meetingsto broadcasts and recorded presentations on its Avistar system, thereby savingtravel time and costs, while expanding the broadcast to a wider audience.Additionally, video feeds from broadcast TV channels or other video sources canbe distributed to users through the Avistar system.

*Video-on-demand.**  *Users anywhere on the Avistar network can easilyretrieve stored videos. For example, a corporation has used our system torecord its 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.Another customer uses our system to record and broadcast their daily morningmeetings so colleagues in other time zones around the world can be updated onthe issues of the day when they report to work. The ability to both archive andretrieve stored content can facilitate the establishment of a visual “institutionalmemory” and support training efforts.

*Integrateddata sharing.**  *In addition to viewing the four quadrants of ourvideo window, multiple users can simultaneously create and annotate a shareddocument using text or drawing tools color-coded specifically for each user.All participants can access the contents of any shared window and save themarked changes for later reference. Our system can also be utilized inconjunction with other application-sharing programs that utilize data networksor the Internet, including popular web-based data collaboration solutions. Asone example, while participating in an interactive video call, users can accessMicrosoft NetMeeting’s application sharing capabilities through a button on ourtool bar, and jointly view and edit a document. Multiple design engineers, forexample, can share a technical drawing in order to resolve an issue with adefective part.

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Our system has the following key features necessary to make integratedvideo collaboration effective:

*Easy to use interface.**  *Our applications combine the rich interaction ofa face-to-face meeting with a self-service interface that’s intuitive and easyto use. Key features include:

·       *Click-to-connectsimplicity.  *To initiatecalls or add another user to a call already underway, a user simply clicks oneither a “direct connect” button or a name in the directory. Standardtelephone-like features such as hold, hang-up, forward, “leave message” or “beginanother call” are all completed with the click of a mouse, or keyboardshortcuts. Additionally, anyone on an Avistar network can initiate a video callto the desktop of colleagues, customers, suppliers and others on other Avistarnetworks. If the person being called is logged-in but unavailable, users canleave a personalized call back message that allows the person to automaticallyreturn the 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*.   Thepresence-based Avistar network directory is a comprehensive list of Avistarnumbers that can be called with a click. All users currently logged into an enterprise’s Avistarnetwork will be shown, providing immediate ‘presence’ information as toavailability. The global directory can be tailored to include only a subset ofa more specific business’ community of users. In addition, a private directoryfeature allows users to create their own directory and reach frequently calledparties with a one-click “direct connect” tool. Both global and privatedirectories can also include other non-Avistar sites that use standards-basedvideo conferencing systems. Through the Avistar Community Exchange andAvistarVOS Proxy products, presence information can be shared acrossparticipating enterprises. The result is one-click, presence-based,cross-enterprise calling which helps form a community of users. A portionof this functionality is protected under certain patents held by CPI.

·       *Consistencyacross locations.  *TheAvistar user interface is consistent across desktops and conference rooms.Thus, a user who is familiar with the functionality at the desktop requires noadditional training or set up to utilize an Avistar system in a conference roomsetting. This allows conference room systems to be “self-service,” therebyavoiding the support 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 be recorded.Our system enables common network and application management, so the samedirectory can be used for two-way calls, one-way broadcasts and data sharing inthe same session. Usage can be determined with our integrated call-reportingtool that provides summary data for analysis and cost management. A portion of this functionality isprotected under certain patents held by CPI.

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*Officetools integration.**  *Our video application can be tightly linked intocommon collaboration software tools such as Microsoft Office and IBM LotusSametime. As a partner with IBM and Microsoft, we have integrated ourapplications functionality with these products to add video communicationoptions to common applications such as email, instant messaging, contacts, andcalendar events. Thus while in the context of reading an email, responding toan instant message or looking up a contact, the user can initiate a video callto that person.

*Networkmanagement.**  *Our network architecture provides systemadministrators with the ability to flexibly and proactively manage each of thevarious components of the network. Within our system, the most costly andcomplex equipment and software applications are shared as networked resources.This arrangement allows for redundancy and dynamic allocation of theseresources to users who need them, and ensures that users experience the bestvideo quality possible at the highest reliability and lowest cost of use.Servers and switches can be maintained, installed and repaired centrally, andmany network support functions can be performed remotely over the data network,assisted by System Central (our web-based product introduced in 2006), therebylimiting the disruption of service to an individual user. Similarly, additionaldesktops and meeting rooms can be easily and inexpensively added to the Avistarnetwork, with those new users concurrently added to the Avistar directory.Additionally, our software makes call routing decisions to minimizecommunications costs and control bandwidth utilization. A portion of thisfunctionality is protected under certain patents held by CPI.

We believe our solution includes the following benefits to our customers:

·       *Speedbusiness processes.  *Weprovide a fully integrated Internet protocol-based video collaboration solutionthat seamlessly allows individuals to make video calls, view broadcasts andcreate, store and access video content or other forms of data from the desktopmaking visual communications widely and easily available which can speedbusiness 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. The ability tospontaneously add additional participants to a call encourages personal communicationsbetween individuals who otherwise might not enjoy this access. 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.

·       *Improvedproductivity and revenue generation.  *Our system helps companies increase the productivity of their employeesand accelerate 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 persuasivecommunications are more effective when done face-to-face. Our solution allowsinteractions to happen in real-time, speeding up the manner in which businessis done, freeing up time for employees, enhancing business-to-businesscommunications, and potentially 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 or “instant message”,while being more personal. One of our customers has provided Avistar networksto their clients and business 

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partners,including offshore outsource partners, in order to facilitate interactions andimprove 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 the transport of information. However, videoquality varies depending on the protocol selected. Our system utilizes existingdata networks for transporting video, and is designed to support real-timedigital networking and video transmission. We have designed our system tocontinue to work with Internet protocol-based technologies as standards evolveand quality of service improves. We expect this flexibility, together withsimplified software and hardware at the desktop, to allow companies to makeeffective use of their existing local area and wide area networks, as well astheir next generation networks.

·       *Better communication to face new business challenges such asglobalization, business continuity planning, and distributed locations.  *Withinglobal corporations, professionals collaborate daily with customers, partnersand associates 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 increased business resiliency through distributed operations,and shifted more operations to outsourcing providers. In this context, criticalinformation must be delivered on a timely basis and without confusion, assmoothly as if colleagues were working together in person. Avistar’s videoproduct suite enables companies that are reducing travel and/or distributingtheir operations to easily and quickly connect small, remote offices as well asat-home workers to the central organization and still benefit from face-to-faceinteraction. Based on ourexperience in helping existing customers choose their optimal configurations,we are able to advise new customers on setups and configurations that will bemost effective for a large central office, a small branch office, anoutsourcing provider, or other remote locations.

**System Architectureand Technology**

Our networked video system isbased on our ninth major release of our open architecture, which enables usersto communicate visually using various networking protocols and transport media,including IP networks and the Internet. We developed our architecture toaddress the necessary elements of a complete video-enabled collaborationsolution.

We believe that the following technical factors will transform andconsolidate the existing video collaboration applications marketplace, creatinga strong need for a software platform that will support this consolidation andevolution:

·       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.

Our software platform supportsthis consolidation and evolution by integrating industry standards for audio,video and data transport, but separating them from application functionalityand system management. This allows our software application platform to managethe interoperation and transcoding 

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ofvarious standards 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.263,H.264, H.320, H.323, SIP, NTSC, PAL, MPEG, Microsoft Windows Media Video andReal Networks RealMedia.

We believe our AvistarVOS videosoftware platform positions us to lead the transformation described above.Further, we provide a suite of collaboration applications that seamlesslyoperate with the AvistarVOS system allowing users to access this functionalityin an easy and intuitive manner. We expect to make this platform moreaccessible to developers and to allow integration with other applications andnetwork hardware.

Our system uses TCP/IP, thestandard Internet protocol, for initiating video calls, scheduling and startingbroadcast presentations, and managing the creation and access of stored videomaterials. In addition, we use TCP/IP for overall systems and networkmanagement throughout our software platform. This approach allows us to deliverconnectivity throughout an enterprise and allows us to leverage existingInternet infrastructure. For delivery of high-quality video streams in thelocal area network, including wireless, we primarily utilize video over IPtechnology but offer a choice of IP or traditional circuit switched technologies,including the ability to mix and match network types. Thus Avistar customerscan successfully deploy desktop video across the enterprise, even if portionsof their network, in older buildings for example, aren’t capable of supportingreal-time video on their data networks. We use our gateways to translatebetween the various network technologies used in our system. These gateways aremanaged and controlled by our systems software with TCP/IP-based protocols.

Each Avistar endpoint functionsas a node on the network, like personal computers, printers or file servers ona local area network. Just as color printers and file servers are often sharednetwork resources on the local area network, the more costly equipment in anAvistar system, such as servers, media servers, switches, and gateways, arecentralized and made available to multiple users. Network nodes and resources,like those of a data network, are managed through centralized, Internetprotocol-based applications and administration tools, such as web-based reportsof video call activity.

Because of the tight integration of various video network components, theAvistar Switch, Media Server, Conference Center, and gateways, all controlledby the AvistarVOS software, our architecture has the following key features:

·       *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 exchange configurationinformation and allocate call resources during call set-up, and exchangenetwork status information. The signaling system selects the optimal route forall video calls, helping to minimize call costs and performance demands on widearea network resources. Most videoconferencing equipment using industrystandard compression technologies also can communicate with an Avistar network.

·       *Transportstandard independence:  *Oursystem selects the appropriate transport standards for transmitting informationover networks 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 for our legacy product to deliverstandards-compliant high quality signals. This allows customers to choose thetransport type to best fit their 

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networkcapabilities in the local area. In a wide area network, we use industry videocompression standards across a customer’s private IP network, or VPN’s or theInternet or the public telephony network. Product releases during 2006 enhancedour ability to support mobile and home workers who may have lower bandwidthconnections. For the transmission of recorded content on corporate datanetworks or via the Internet, our system uses standard digital storage formatsand transport technologies.

·       *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 a web-camera at each desktop. Just as local area network switchesand public telephony networks can be linked together without the use ofrouters, Avistar switches can be similarly linked without the use of videonetwork gateways. As a result, customers can easily add capacity as their needsgrow.

·       *Evolves with digital technology:  *Our AvistarVOS software is designed to facilitateutilization of all-digital, local area networks, including Internet protocolvideo transmission, where sufficient bandwidth and quality of service (QOS) areavailable. This all-digital system also maintains compatibility with ourexisting legacy 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 endpoint softwareallows customers to migrate to all IP networks, while preserving the same userinterface system functionality.

**System Products and Applications**

Oursystem-level products and applications consist of shared resources and anetwork of desktop, laptop and conference room endpoints which connect to eachother and to shared resources.

*Shared Resources*

Like the architecture of most data networks, our systemis designed to maximize the use of shared resources on the network. Each usercan access higher quality software, gateways, multi-point conference centers,media servers and video broadcasts with lower per user acquisition andmanagement costs than is possible with non-networked video solutions. Thesedevices are expected to move to software-only resources over time. These sharedresources consist of the following products and applications:

*Infrastructure, Server and Software Products*

·       *AvistarVOSServer.  *All systemsrequire AvistarVOS Server software. It enables the seamless integration ofvideo applications, comprehensive network and bandwidth management andadministration. The AvistarVOS software supports a highly-distributed topology,and multiple instances may be deployed. Digital IP endpoints require networkaccess to servers running AvistarVOS software configured for IP endpoints.Servers in the Avistar Switch also run instances of AvistarVOS Server softwareas noted below.

·       *AvistarSwitch.  *Each Avistarswitch runs the AvistarVOS Server software that provides application servicesand 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. Where used, it also serves as the video switch for our localarea circuit-switched network, connecting video calls placed among Avistardesktop and conference room users. With IP endpoint deployments, a switch isrequired only for video services beyond point-to-point calling, and may belocated anywhere with appropriate network access.

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·       *AvistarGateways.  *Gateways provideconnectivity to the wide area network for circuit-switched endpoints,interoperability with third-party video systems that are H.320 or H.323compliant, interoperability between IP endpoints and circuit-switched endpoints,and access to shared video services for IP endpoints. The gateways supportvarious protocol standards, using public telephony, TCP/IP networks or thecustomer’s private 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. Conference centers also support interactive broadcastfunctionality.

·       *AvistarMedia Server.  *Our mediaserver allows users to create, publish and view video content from any desktopor conference 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 publishvideo content on intranets, extranets or the Internet, including web servers,video servers 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.

·       *AvistarInteractive Broadcast.  *Ourinteractive broadcast feature allows Avistar desktop or conference room usersto broadcast one-way, real-time presentations to an audience of other Avistarusers at both local and remote sites. A Moderator UI panel includes an audiencelist, a text-based chat-back channel for viewer questions, broadcast viewcontrol, and the ability to drag and drop presenters and viewers into and outof the broadcast. An individual or a conference call can be broadcast tothousands of users, and, via third party products, be streamed simultaneouslyover the Internet.

·       *AvistarDirectory Software.  *Ourdirectories allow a user to place a video call by simply clicking on a name inthe presence-based, Avistar network directory. Our system will route the callto the correct location over the local area network or the wide area asappropriate. The user doesn’t need to know phone numbers or IP addresses. Theuser can also look up addresses in private and global address books, utilizebrowser style type-in boxes, and access speed-dial ‘direct connect buttons’.This server-based directory integrates with LDAP directories, simplifiesadministration, and allows users to get started quickly, without having tomanually enter many video phone numbers into their desktop directory.

·       *AvistarCommunity Exchange and AvistarVOS Proxy.  *These products provide secure, cross-enterprisecommunications between independent Avistar systems. This provides directory andpresence information and system resource reservation for easy and fastconnections between firms. These products facilitate the building ofcommunities of video-enabled users across enterprises.

·       *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 the Shareboarddata sharing application. Users can share any application window or image withall conference participants, see all users’ color-keyed pointers and text andpaintbrush annotations, and save or print shared images from any desktop orconference room.

·       *Avistar Call Reporting System.  *With our web-based call reporting system, our customers can track allcalls logged by our servers. Reports show call details, device usage and callsby user, all viewable from any Web browser. Reports can be customized andstored for future or specialized analysis.

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*Desktop and Conference Room Endpoint Products*

Client personal computers, orPCs, 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 software only, software plus hardware accelerated IP (digital) orsoftware plus hardware accelerated circuit-switched (analog). Sofware-onlyendpoints have higher processing power minimums on the client PC than endpointswith hardware assist. The AvistarVOS software detects what, if any, additionalhardware is attached and can work in any of three modes. Thus, in the office, auser may have an IP hardware accelerator to minimize processor loading, whileon the road or at home, they use the software-only mode to simplify equipmentrequired.

*Desktop Endpoints.**  *The standard Avistar two-way desktop systemconsists of the following components:

·       AvistarVOS client software, which includes video and audio codecs.

*Optional*

·       Web camera—requiredfor software-only operation;

·       Ahardware-based video codec (used with IP endpoints for signal compression anddecompression) or video network interface unit (with circuit-switchedendpoints), with ports for camera, microphone, speakers, auxiliary video andaudio, headset, built in echo-cancellation circuitry and full duplex audio,without requiring a headset;

·       A highquality camera with built-in directional microphone for hardware assistedendpoints;

·       IP endpointsdisplay video either directly on a computer display or external monitor.Circuit-switched endpoints include a video overlay card that allows video to beviewed from a computer or an external monitor.

*Avistar Room Systems.**  *We deliver complete video systems for a range ofroom sizes and layouts. We believe that one key advantage of our system is thatthe interface used in a conference room system is consistent with the interfaceused on individual desktops, allowing for all forms of video-enabledcommunications: interactive video calling, content creation and publishing,broadcasting and video-on-demand. Therefore, desktop users are familiar withthe controls used in Avistar room systems and do not need additional trainingto operate the room system, nor do they need an additional technician to set-upand connect conference room calls (as is common with traditional room systems).In addition, since rooms are simply additional nodes on the network, they canbe less expensive than self-contained, traditional room systems.

**Patent Licensing**

We derive a significant portionof our annual revenues by licensing our broad portfolio of patents covering,among other areas, video and rich media collaboration technologies, networkedreal-time text and non-text communications and desktop workstation echocancellation. This broad suit of patents enables much of the functionality ofour AvistarVOS application platform. Licenses to third parties may cover partof or all of our patent portfolio. End-to-end rich media collaborativeapplication companies such as Polycom, Inc., Tandberg ASA, SonyCorporation, Emblaze-VCON Ltd., and others have taken licenses to our patentsfor use in their own products. Examples of the many patented innovations in ourportfolio include: the handling of decentralized video call endpoints,unshielded twisted pair video conferencing with data conferencing and desktopworkstation echo cancellation.

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Wemaintain and support an active program to protect our intellectual property,primarily through the filing of patent applications and the defense of issuedpatents against infringement. As of December 31, 2006, we had 74 U.S. andinternational patents on various aspects of our technology, with expirationdates ranging from 2013 to 2018, and have over 25 pending patent applications.In addition, we attempt to protect our trade secrets and other proprietaryinformation through agreements with licensees, proprietary informationagreements with employees and consultants and other security measures. We alsorely on trademarks and trade secret laws to protect our intellectual property.

**Segment Information**

We operate through two segments:

·       AvistarCommunications Corporation engages in the design, development, manufacture,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 12 to our consolidated financialstatements included in this Annual Report on Form 10-K. Financialinformation relating to revenues and other operating income, net loss,operating expenses and total assets for the three years ended December 31,2006, can be found in Item 6 “Selected Financial Data” and also in ourConsolidated Financial Statements attached hereto.

**Customers**

*VideoCommunications Products*

As of December 31, 2006, we have licensed andrecognized revenue with respect to over 14,000 end-users at over 400 customersites in approximately 151 cities in over 40 countries. Because many of ourcustomers operate on a decentralized basis, decisions to purchase our systemsare often made independently by individual business units. As such, a singlecompany may represent several separate accounts and multiple customer sites mayrelate to the same company.

For the year ended December 31, 2006, SonyCorporation, Deutsche Bank AG and its affiliates, and UBS Warburg LLC and itsaffiliates accounted for 38%, 25% and 20% of our total revenues, respectively.For the year ended December 31, 2005, UBS Warburg LLC and its affiliatesaccounted for 45% of our total revenue and Deutsche Bank AG and its affiliatesaccounted for 39% of our total revenue. For the year ended December 31,2004, Deutsche Bank AG and its affiliates accounted for 55% of our totalrevenue and UBS Warburg LLC and its affiliates accounted for 16% of our totalrevenue. The level of sales to any customer may vary from quarter to quarter,and we expect that significant customer concentration will continue for theforeseeable future. The loss of, or a decrease in the level of sales to, or achange in the ordering pattern of, any one of these customers could have amaterial adverse impact on our financial condition or results of operations.

Internationalrevenue, which consists of sales to customers with operations principally inWestern Europe and Asia  comprised75%, 63% and 52% of total revenue for 2006, 2005 and 2004, respectively. For2006, 2005 and 2004, revenues to customers in the United Kingdom accounted for12%, 23% and 31% of total revenue, respectively.

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*Licensing Activities*

Wederived 39%, or $5.2 million, of our annual revenues in 2006 by licensing ourbroad portfolio of patents to third parties covering video and rich mediacollaboration technologies, networked real-time text and non-textcommunications and desktop workstation echo cancellation. Our license revenuein 2006 was primarily due to a license to Sony Corporation and its subsidiaries.Sony Corporation agreed to make an upfront license payment of $5.0 millionand future royalty payments. The $5.0 million upfront payment wasrecognized by us as licensing revenue in the three months ended September 30,2006. No license revenue was recorded in 2005 or 2004.

**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 and the adoption of our technology at customer sites.

*IndirectSales.**  *Through our partnership organization, we seek tobuild a set of relationships with strategic partners and value added resellers,in order to establish, and then expand an indirect channel of sales for ourproducts.

*Marketing.**  *Our marketing efforts are directed towards selectvertical markets, with a current emphasis on the financial services industry.We have identified specific collaboration needs for enterprises, specific tothe vertical market. 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.

Wealso use marketing programs to build recognition of our corporate brand, fosterpartnerships, and promote our technology in regards to licensing opportunities.

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

We provide a wide variety of services forinstallation, design and adoption of our video communications products. Thismay include the analysis of workflows in order to identify patterns ofcollaboration between workgroups so that the best configuration of networkedresources can be designed and implemented for the enterprise. We generallyinstall our systems for new customers. In an increasing number of cases, ourcustomers’ information technology group or services partner install follow-onorders. In the future, we expect our customers or their services partners willincreasingly perform the installation of additional systems.

The installation that we offerto our customers as a separately-priced service relates to the physical set upand configuration of desktop and infrastructure components of our solution. Toaccomplish this activity, our staff frequently interface with the customer’sinternal information technology (I.T.) staff and external suppliers, in orderto provide for connectivity to the customer’s local and wide area networks, andfor the physical placement (arranging for rack space and appropriateenvironmental conditions) and connections between the various componentspurchased. The effective operation of software and hardware is checked by ourstaff during this installation process. Although the “work time” of thisactivity at a single location may be only one or two days, the coordinationnecessary for accommodating the equipment and establishing connectivityfrequently creates cycle times of between two and six weeks from productshipment to installation at the customer’s site.

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 

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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 $87,000 at December 31,2006 and $100,000 at December 31, 2005. We expect most of the orders as ofDecember 31, 2006 will be shipped in the first quarter of 2007. Backlog isnot 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 generationactivities. 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 $5.8million in 2006, $3.5 million in 2005 and $2.6 million in 2004. 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 toperform some material assembly. Our operations staff develops manufacturingstrategies and qualifies and audits manufacturing processes and suppliers. Wework with our contract manufacturers to reduce manufacturing costs and toresolve quality control issues, as we perform the final assembly and testing ofour products. We believe our manufacturing strategy enables us to utilize thecapabilities of our contract manufacturers, while allowing us to focus on rapidsystem development and deployment, software architecture and development ofvideo communication applications. We use third party, commercially availablecamera components, microphones, speakers and monitors for desktop and roomsystems, as well as third party compression and decompression components forour gateways.

**Intellectual Property and Proprietary Rights**

Our ability to compete, and tocontinue 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 enhancements and reliable system support and maintenance are alsoessential to maintaining our 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 additionalregistrations 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 we held 27 United States patents and 47 non-UnitedStates patents as of December 31, 2006. The patents that have been issuedexpire at varying dates between 2013 and 2018. In addition, numerous patentapplications are pending in the United States and several other jurisdictions.Specifically, these patent applications, some of which relate to and 

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claim priority from anapplication originally filed in 1993, include both method and apparatus claims.These patents and pending patent applications disclose and/or claim aspects ofour analog or digital desktop video conferencing technology, video andmultimedia storage technology for messaging and publishing, directory services,and public wide area networking access, switching and architecture. A portionof these technologies is currently utilized in our system. To date, CPI hasfocused on expanding our patent portfolio, expediting patent issuance andlicensing of our patents to reinforce the adoption of our technology.

CPI seeks to license its broad portfolio of patentscovering, among other areas, video and rich media collaboration technologies,networked real-time text and non-text communications and desktop workstationecho cancellation. The broad suite of patents enables much of the functionalityof our AvistarVOS application platform. Licenses to third parties may coverpart or all of our patent portfolio. Examples of the many patented innovationsin our portfolio include: the handling of decentralized video call endpoints,unshielded twisted pair video conferencing with data conferencing and desktopworkstation echo cancellation.

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 software,and have a limited non-exclusive right to use and/or reproduce, maintain, update,enhance and produce derivative works of the software source code under theterms 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.

**Competition**

The market for videocollaboration products and systems is highly competitive. As a result ofadvances in technology, increases in communications capability and reductionsin 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 ASA, Sony Corporation, Apple Inc., Radvision, Ltd., and Emblaze-VCON Ltd.

With increasing interest in thepower of video collaboration and the establishment of communities of users, weface increasing competition from alternative video communications solutionsthat employ new technologies or new combinations of technologies from companiessuch as Cisco Systems, Inc., Avaya, Inc., Nortel NetworksCorporation, Microsoft Corporation, IBM Corporation and WebEx Communications, Inc.,that enable web-based or network-based video communications with low-costdigital camera systems.

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

·       productfeatures, functionality and scalability;

·       productquality and performance;

·       productreliability and ease of use;

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·       use of openstandards;

·       quality ofservice and support;

·       companyreputation, size and financial stability;

·       price andoverall cost of ownership;

·       integrationwith 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-basedpoint-to-point video communications products;

·       desktopvideo communications products;

·       broadcastvideo products;

·       videoretrieval and viewing products;

·       desktopcontent creation products; and

·       web-baseddata 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 ascomprehensive a set of functionality as our system provides. We believe thesecompanies in many cases can also represent complementary opportunities toextend the reach of our system by potentially expanding the market for videonetworking.

Weexpect competition to increase significantly in the future from existingproviders of specialized video communications products, voice over IP solutionproviders and companies as they enter our existing or future markets, possiblyincluding major telephone companies or communications equipment providers.These companies may develop similar or substitute solutions, which may be lesscostly or provide better performance or functionality than our systems. Anumber of our existing and potential competitors have longer operatinghistories, significantly greater financial, marketing, service, support,technical and other resources, significantly greater name recognition and alarger installed base of customers than we do. In addition, many of our currentor potential competitors have well-established relationships with our currentand potential customers, and have extensive knowledge of our industry. It ispossible that new competitors or alliances among competitors may emerge andacquire significant market share. To be successful, we must continue to respondpromptly and effectively 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, 2006, we had 88 employees, including personnel dedicatedto research and development, customer service, 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 are 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.

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**Executive Officers**

Our officers and their ages as of December 31, 2006were as follows:

| Name                 | ** ** | ** ** | ** ** | ** **                                           | **Age** | ** ** | ** ** | **Position** |
|----------------------|------------|------------|------------|------------------------------------------------------|---------|------------|------------|--------------|
| Gerald  J. Burnett   |       | 64         |       | Chairman  of the Board and Chief Executive Officer   |
| William  L. Campbell |       | 58         |       | Vice Chairman, Chief Operating Officer and Secretary |
| Robert  J. Habig     |       | 52         |       | Chief Financial Officer                              |
| J.  Chris Lauwers    |       | 45         |       | Chief Technology and Product Officer                 |
| Anton  F. Rodde      |       | 64         |       | President, Collaboration Properties, Inc.       |
| Gary  Stager         |       | 54         |       | Vice President, Engineering                          |
| Robert  T. Garrigan  |       | 45         |       | Vice President, Sales                                |
| Stephen F. Arisco    |       | 48         |       | Vice  President, Operations and Customer Support     |

 

*Gerald J. Burnett* is one of our founders and has been Chairman of our Boardof Directors and our Chief Executive Officer since March 2000. He servedas Chief Executive Officer of Avistar Systems from December 1998 until March of2000. From 1993 to 1997, he was a director of Avistar Systems or a principal ofits predecessor limited partnership. He is a member of the Corporation (Boardof Trustees) of the Massachusetts Institute of Technology. Dr. Burnettholds a B.S. and an M.S. from the Massachusetts Institute of Technology inelectrical engineering and computer science, and a Ph.D. from PrincetonUniversity in computer science and communications.

*WilliamL. Campbell***is one of our founders and has been a member ofour Board of Directors and our Executive Vice President since March 2000.He has been our Corporate Secretary since June 2001 and served as ourinterim Chief Financial Officer from April 2001 to May 2001. He hasbeen Chief Executive Officer of CPI since December 1997. In July 2005he received the title of Chief Operating Officer. Mr. Campbell holds aB.S. in general engineering from the U.S. Military Academy and an M.S. inmanagement from the Sloan School of the Massachusetts Institute of Technology.

*RobertJ. Habig* has been our Chief Financial Officer since May 2001.He had previously served as Chief Financial Officer at think3 Corporation, aprivate computer-aided design software company from March 1999 to February 2001,as Chief Financial Officer at CrossWorlds Software, Inc., an enterprisesoftware company from July 1998 to February 1999, as Executive VicePresident at First Data Corporation, a financial transactions processing company,from May 1997 to June 1998, as a business unit Chief FinancialOfficer at AlliedSignal Corporation, an automotive, aerospace and chemicalmanufacturing company from 1994 to 1997, and held a number of positions withPepsiCo from 1979 to 1994. Mr. Habig holds a B.A. in economics andbusiness from Lafayette College and an M.B.A. from the Simon Graduate School ofBusiness at the University of Rochester.

*J.Chris Lauwers***hasbeen our Chief Technology and Product Officer since August 2005. He served as ChiefTechnology Officer from March 2001 to 2005. He was our Vice President ofEngineering from 1996 to 2001 and Director of Engineering from 1994 to 1996. 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. Dr. Lauwers holdsa B.S. in electrical engineering from the Katholieke Universiteit Leuven ofBelgium. Dr. Lauwers also holds an M.S. and a Ph.D. in electricalengineering and computer science from Stanford University.

*AntonF. 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 2002, as Group Vice President at Manugistics from 2002 to 2003,the company which 

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acquiredWestern Data Systems, as President and General Manager of several subsidiariesof Teknekron 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. Dr. Rodde holds a B.S. in physics from Benedictine University and anM.S. and Ph.D. in physics from the Illinois Institute of Technology.

*GaryStager***joined Avistar in December 2006 as VicePresident of Engineering. From 2004 to 2006, Mr. Stager was Senior VicePresident of Engineering and Operations for Exavio, Inc. in Santa Clara,California and Beijing, China, where he was responsible for the design,manufacture and support of Exavio’s networked storage products for digitalmedia production and HPC applications. From 2001 to 2003, he served as VP ofEngineering at Omneon Video Networks. Mr. Stager holds degrees inElectrical Engineering and Liberal Arts from the University of Florida.

*RobertGarrigan***joined Avistar in April 2005 as Vice President ofSales. Prior to joining Avistar, Mr. Garrigan was senior vice president ofsales at The NewsMarket, Incorporated, a broadcast news distribution servicedelivering video content via an Internet-based platform from September 2004to May 2005. From 2003 to 2004, Mr. Garrigan served as Senior VicePresident of Sales at Thompson Financial in both the US and Europe and, from1998 to 2001, Mr. Garrigan served as Executive Vice President of Sales andBusiness Development with IntraLinks in New York. Mr. Garrigan holds aB.A. in Economics from The State University of New York.

*Stephen F. Arisco***has been our Vice President of Operations andCustomer Service since February 2000. He previously served as the Directorof Operations and Customer Service of Avistar Systems from December 1997to January 2000. From 1987 through December 1997, he was Director ofCustomer Service and Operations at TRW Financial Systems, Inc., a systemsintegration company. Mr. Arisco holds a B.S. in Business from theUniversity of Phoenix, and an Executive MBA from Pepperdine University.

**Item 1a.**   *Risk Factors*

**Factors Affecting Future Operating Results**

**We have incurred substantiallosses in the past and may not be profitable in the future.**

We incurred net losses of $8.1million for 2006, $5.2 million for 2005 and $8.7 million for 2004. As of December 31, 2006, our accumulated deficit was $102.8million. Our revenue and income from settlement and patent licensing maynot increase, or even remain at its current level. In addition, our operatingexpenses may increase as we continue to develop our business and pursuelicensing opportunities. As a result, to become profitable, we will need toincrease our revenue by increasing sales to existing customers and byattracting additional customers and licensees. If our expenses increase morerapidly than our revenue, or if revenue and expense levels remain the same, wemay never become profitable. If we do become profitable, as we did during thethird quarter of 2006, we may not be able to sustain or increase profitabilityon a quarterly or annual basis. In addition, if we fail to reach profitabilityor to sustain or grow our profits within the time frame expected by investors,the market price of our common stock may be adversely impacted.

**Our market is in the earlystages of development, and our system may not be widely accepted.**

Our ability to achieveprofitability depends in part on the widespread adoption of networked videocommunications systems and the sale and adoption of our video 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 or achieveprofitability. The market for our system is relatively new and evolving. Wehave to devote substantial resources to educating prospective customers aboutthe uses and benefits of our system. Our efforts to educate potential customersmay not result in our system achieving broad market acceptance. In 

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addition,businesses that have invested or may invest substantial resources in othervideo products may be reluctant or slow to adopt our system. Consequently, theconversion from traditional methods of communication to the extensive use ofnetworked video may not occur as rapidly as we wish.

**Our lengthy sales cycle toacquire new customers or large follow-on orders may cause our operating resultsto vary significantly and make it more difficult 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 one of the factors that hascaused, and may continue to cause in the future, our operating results to varysignificantly from quarter-to-quarter and year-to-year. This makes it difficultfor us to forecast revenue, and could cause volatility in the market price ofour common stock. A lost or delayed order could result in lower revenue thanexpected in a particular quarter or year.

**General economic conditions have and may impact ourrevenues and harm our business in the future.**

The international economicslowdown and the downturn in the investment banking industry that began in 2000negatively affected our business, and a reoccurrence of a difficult economicenvironment may do so in the future. During this most recent economic downturn,the investment banking industry suffered a sharp decline, which caused many ofour existing and potential customers to cancel or delay orders for ourproducts. Although the U.S. economy has improved, our customers and potentialcustomers may continue to delay ordering our products, and we could fall shortof our revenue expectations for 2007 and beyond. Slower growth among ourcustomers, tightening of customers’ operating budgets, retrenchment in thecapital markets and other general economic factors all have had, and could inthe future have, a materially adverse effect on our revenue, capital resources,financial condition and results of operations.

**Future revenues and income fromsettlement and licensing activities are difficult to predict for severalreasons, including our lengthy and costly licensing cycle. Our failure topredict revenues and income accurately may cause us to miss analysts’ estimatesand result in our stock price declining.**

Because our licensing cycle is alengthy process, the accurate prediction of future revenues and income fromsettlement and patent licensing from new licensees is difficult. The process ofpersuading companies to adopt our technologies or convincing them that theirproducts infringe upon our intellectual property rights can be lengthy. Thereis also a tendency in the technology industry to close business deals at theend of a quarter, thereby increasing the likelihood that a possible materialdeal would not be concluded in a current quarter, but slip into a subsequentreporting period. This kind of delay may result in a given quarter’sperformance being below analyst or shareholder expectations. The proceeds ofour intellectual property licensing and enforcement efforts tend to be sporadicand difficult to predict. Recognition of such proceeds as revenue or incomefrom settlement and licensing activities depends on the terms of the licenseagreement involved, and the circumstances surrounding the agreement. As aresult, our licensing and enforcement efforts are expected to result insignificant volatility in our quarterly and annual financial condition andresults of operations, which may result in us missing investor expectations,which may cause our stock price to decline.

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**Since a majority of our productrevenue has come from follow-on orders, our financial performance could beharmed if we fail 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 utilization and resultant value. Our strategy is to pursueadditional and larger follow-on orders after these initial orders. Excludinglicensing revenue, product revenue generated from follow-on orders accountedfor approximately 95% of our revenue in 2006, 99% in 2005 and 78% in 2004. Ourfuture financial performance depends on successful initial installations of oursystem, and successful generation of follow-on orders as the Avistar networkexpands within a customer’s organization. If our system does not meet the needsand expectations of customers, we may not be able to generate follow-on orders.

**Because we depend on a fewcustomers for a majority of our product revenue, services revenue, and incomefrom settlement and patent licensing, the loss of one or more of them couldcause a significant decrease in our operating results.**

We have historically derived the majority of ourrevenue from a limited number of customers, particularly Deutsche Bank AG andtheir affiliates and UBS Warburg LLC and their affiliates. In 2006, thesecustomers and Sony Corporation accounted for 83% of our total revenue. DeutscheBank AG and their affiliates and UBS Warburg LLC and their affiliates accountedfor 84% of our revenue for 2005. Deutsche Bank AG and their affiliates and UBSWarburg LLC and their affiliates accounted for 71% of our revenue for 2004. Noother customers individually contributed greater than 10% of our total revenuefor 2006, 2005 or 2004. As of December 31, 2006, three customersrepresented 44%, 20% and 20% of gross accounts receivable. As of December 31,2005, three customers represented 48%, 32% and 17% of gross accountsreceivable. As of December 31, 2004, approximately 81% of our accountsreceivable were concentrated with one customer.

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. If we are unable to license our patent portfolio to additionalparties on terms equal to or better than our agreements with Polycom prior tothe completion of our amortization of the Polycom proceeds in 2009, our incomefrom settlement and licensing will decline, which could cause our losses toincrease. We currently depend on a limited number of customers with lengthybudgeting cycles and unpredictable buying patterns, and as a result, ourrevenue from quarter-to-quarter or year-to-year may be volatile. Adversechanges in our revenue or operating results as a result of these budgetingcycles or any other reduction in capital expenditures by our large customerscould substantially reduce the trading price of our common stock.

**Our expected future workingcapital needs may require that we seek additional debt or equity funding which,if not available on acceptable terms, could cause our business to suffer.**

As of December 31, 2006, our accumulated deficit was $102.8million. Our revenue and income from settlement and patent licensing maynot increase, or even remain at its current level. In addition, our operatingexpenses may increase as we continue to develop our business and pursuelicensing opportunities. As a result, we may need to arrange for theavailability of additional funding in order to meet our future businessrequirements. If we are unable to obtain additional funding when needed onacceptable terms, we may not be able to develop or enhance our products, takeadvantage of future opportunities, respond to competitive pressures orunanticipated requirements, or finance our efforts to protect and enforce ourintellectual property rights, which could seriously harm our business,financial condition, results of operations and ability to continue operations.

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**We may not be able to modify andimprove our products in a timely and cost effective manner to respond totechnological 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:

·       rapidtechnological change;

·       theemergence 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 forvideo at the desktop, with increasing availability of bandwidth and quality ofservice.

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 Microsoft Windows servers. However, our software may not operatecorrectly on other hardware and software platforms or with other programminglanguages, database environments and systems that our customers use. Also, wemust constantly modify and improve our system to keep pace with changes made toour customers’ platforms, data networking infrastructures, and their evolvingability to transport video and other applications. This may result inuncertainty relating to the timing and nature of our new release announcements,introductions or modifications, which in turn may cause confusion in themarket, with a potentially harmful effect on our business. If we fail topromptly modify or improve our system in response to evolving industry standardsor customers’ demands, our system could become less competitive, which wouldharm our financial condition and reputation.

**Difficulties or delays ininstalling our products could harm our revenue and margins.**

We recognize product andinstallation revenue upon the installation of our system in those cases wherewe are responsible for installation, which often entails working withsophisticated software and computing and communications systems. If weexperience difficulties with installation or do not meet deadlines due todelays caused by our customers or ourselves, we could be required to devotemore customer support, technical and other resources to a particularinstallation. If we encounter delays in installing our products for new orexisting customers or installation requires significant amounts of ourprofessional services support, our revenue recognition could be delayed, ourcosts could increase and our margins could suffer.

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

Currently, our competition comes from many other kindsof companies, including communication equipment, integrated solution, broadcastvideo and stand-alone point solution providers. Within the video-enablednetwork communications market, we compete primarily against Polycom, TandbergASA, Sony Corporation, Apple Inc., Radvision, Ltd. and Emblaze-VCON Ltd. With increasing interest in the power of videocollaboration and the establishment of communities of users, we believewe face increasing competition from alternative video communications solutionsthat employ new technologies or new combinations of technologies from companiessuch as Cisco Systems, Inc., Avaya, Inc., Microsoft Corporation,Nortel Networks Corporation and WebEx Communications, Inc., that enableweb-based or network-based video communications with low-cost digital camerasystems. The market in which we operate is highly competitive. In addition,because our industry is relatively new and one which is characterized by rapidtechnological change, evolving user needs, developing industry standards and 

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protocols and theintroduction of new products and services, it is difficult for us to predictwhether or when new competing technologies or new competitors will enter ourmarket.

We expect competition to increase in the future fromexisting competitors, partnerships of competitors, and from new market entrantswith products that may be less expensive than ours, or that may provide betterperformance or additional features not currently provided by our products. Manyof our current and potential competitors have substantially greater financial,technical, manufacturing, marketing, distribution and other resources, greatername recognition and market presence, longer operating histories, lower cost structuresand larger customer bases than we do. As a result, they may be able to adaptmore 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 successfully against current and future competitors andpartnerships of our competitors, or that competitive pressures faced by us willnot harm our business, financial condition and results of operations.

**Infringementof our proprietary rights could affect our competitive position, harm ourreputation 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-disclosure and other agreements with our consultants,suppliers, customers and employees. However, these laws and agreements provideonly limited protection of our proprietary rights. In addition, we may not havesigned agreements in every case, and the contractual provisions that are inplace and the protection they produce may not provide us with adequateprotection in all circumstances. Although CPI holds patents and has filedpatent applications covering some of the inventions embodied in our systems,our means of protecting our proprietary rights may not be adequate. It may bepossible for a third party to copy or otherwise obtain and use our technologywithout authorization and without our detection. In the event that webelieve a third party is infringing our intellectual property rights, aninfringement claim brought by us could, regardless of the outcome, result insubstantial cost to us, divert our management’s attention and resources, betime consuming to prosecute and result in unpredictable damage awards. A third party may also develop similar technologyindependently, without infringing upon our patents and copyrights. In addition,the laws of some countries in which we sell our system may not protect oursoftware and intellectual property rights to the same extent as the laws of theUnited States or other countries where we hold patents. As we move to more of asoftware based system, unauthorized copying, use or reverse engineering of oursystem could harm our business, financial condition or results of operations.

**Others may bring infringementclaims against us, which could be time-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. The prosecution and defense of these lawsuits where we are involvedmay require us and CPI to expend significant financial and managerialresources, and therefore may have a material negative impact on our financialposition and results of operations. The duration and ultimate outcome of theseproceedings are uncertain. We may be a party to additional litigation in thefuture, to protect our intellectual property or as a result of an allegedinfringement of the intellectual property of others. These claims and anyresulting lawsuit, could subject us to significant liability for damages andinvalidation of proprietary rights. These lawsuits, regardless of theirsuccess, would likely be time-consuming and expensive to resolve and woulddivert management’s time and 

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attention.Any potential intellectual property litigation also could force us to do one ormore 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 inability to protect theintellectual property created by us would cause our business to suffer.**

We rely on a combination of license, development andnondisclosure agreements, trademark, trade secret and copyright law, and contractualprovisions to protect our other, non-patentable intellectual property rights.If we fail to protect these intellectual property rights, our licensees,potential licensees and others may seek to use our technology without thepayment of license fees and royalties, which could weaken our competitiveposition, reduce our operating results and increase the likelihood of costlylitigation. The growth of our business depends in part on the applicability ofour intellectual property to the products of third parties, and our ability toenforce intellectual property rights against them. In addition, effective tradesecret protection may be unavailable or limited in certain foreign countries.Although we intend to protect our rights vigorously, if we fail to do so, ourbusiness will suffer.

**Our system could have defectsfor which we could be held liable for, and which could result in lost revenue,increased costs, and loss of our credibility or delay in the further acceptanceof 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 their merits, could be costly to defend andcould require us to pay damages and potentially 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 welicense with our system may also contain errors or defects for which we do notmaintain insurance. Typically, our license agreements transfer any warrantyfrom the third party to our 

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customersto the extent permitted. Product liability, warranty or other claims broughtagainst us with respect to such warranties could, regardless of their merits,harm our business, financial condition or results of operations.

**The loss of any of our outsidecontract manufacturers or third party equipment suppliers that produce keycomponents of our system could significantly disrupt our manufacturing and newproduct 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. In addition, during the first quarter of 2006,we began using an offshore contract resource in China for product developmentwork. Our reliance on these third parties involves a number 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 or human resources were notavailable, we would suffer an interruption in the manufacture and shipment ofour systems until 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;

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

·       the possible misappropriation of our source code through reverseengineering or other means by contract developers or other parties.

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 expenses,and 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.

**If we are unable to expand ourdirect sales force and/or add distribution channels, 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 

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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 impact our revenue growth.

**We may not be able to retain ourexisting key personnel, or hire and retain the additional personnel that weneed to sustain and grow our business.**

We depend on the continued services of our executiveofficers 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.

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 need to attract and retain highlyskilled technical and managerial personnel for whom there is intense competition.If we are unable to attract and retain qualified technical and managerialpersonnel due to our own cost constraints, limited availability of qualifiedpersonnel or other reasons, our results of operations could suffer and we maynever achieve profitability. The failure of new personnel to develop thenecessary skills in a timely manner could harm our business.

**Ourplans call for growth in our business, and our inability to achieve or managegrowth could harm our business.**

Failure to achieve oreffectively manage growth will harm our business, financial condition andoperating results. Furthermore, in order to remain competitive or to expand ourbusiness, 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 acquisitionsuccessfully, to finance the acquisition or to integrate the acquiredbusinesses, products or technologies into our existing business and operations.In addition, completing a potential acquisition and integrating an acquiredbusiness may strain our resources and require significant management time.

**Our international operationsexpose us to potential tariffs and other trade barriers, unexpected changes inforeign regulatory requirements and laws and economic and politicalinstability, as well as other risks that could adversely affect our results ofoperations.**

International revenue, which consists of sales to customers withoperations principally in Western Europe and Asia,  comprised 75% of total revenue for 2006, 63% for2005 and 52% for 2004. 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;

·       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

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·       limitations in communications infrastructures in some foreign countries.

Some of our products are subjectto various federal, state and international laws governing substances andmaterials in products, including those restricting the presence of certainsubstances in electronics products. We could incur substantial costs, includingfines and sanctions, or our products could be enjoined from entering certainjurisdictions, if we were to violate environmental laws or if our productsbecome non-compliant with environmental laws. We also face increasingcomplexity in our product design and procurement operations as we adjust to newand future requirements relating to the materials composition of our products,including the restrictions on lead and certain other substances that apply tospecified electronics products sold in the European Union as of July 1,2006 (Restriction of Hazardous Substances Directive). The ultimate costs underenvironmental laws and the timing of these costs are difficult to predict.Similar legislation has been or may be enacted in other regions, including inthe United States, the cumulative impact of which could be significant.

**International politicalinstability may increase our cost of doing business and disrupt our business.**

Increased international political instability, evidencedby the threat or occurrence of terrorist attacks, enhanced national securitymeasures and/or sustained military action may halt or hinder our ability to dobusiness, may increase our costs and may adversely affect our stock price. Thisincreased instability has had and may continue to have negative effects onfinancial markets, including significant price and volume fluctuations insecurities markets. If this international political instability continues orescalates, our business and results of operations could be harmed and themarket price of our common stock could decline.

**If our customers do not perceiveour system or services to be effective or of high quality, our brand and namerecognition 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 continuedlisting criteria for the NASDAQ Capital Market, which could materially andadversely affect the price and liquidity of our stock, our business and ourfinancial condition.**

For continued listing of our common stock on theNASDAQ Capital 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 Capital Market. There can be no assurance that we willcontinue to meet all requirements for continued listing on the NASDAQ CapitalMarket.

If we are unable to continue to list our common stockfor trading on the NASDAQ Capital 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 thereunder.Delisting of our common stock from the NASDAQ Capital Market could also have amaterially adverse effect on our business, including, among other things: ourability to raise additional financing to fund our operations; our ability toattract and retain customers; and our ability to attract and retain personnel,including management personnel. In addition, if we were 

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unable to list our commonstock for trading on NASDAQ, many institutional investors would no longer beable to retain their interests in and/or make further investments in our commonstock because of their internal rules and protocols.

**Our common stock has been andwill likely continue to be subject to substantial price and volume fluctuationsdue to a number of factors, many of which will be beyond our control, which mayprevent our stockholders from reselling 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;

·       the size and timing of agreements to license our patent portfolio;

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

·       announcements of competitive product introductions by our competitors;

·       sales, or the perception in the market of possible sales, of a largenumber of 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.In addition, 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 securities litigation, which is costly andtime-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.

**Provisions of our certificate ofincorporation, our bylaws and Delaware law may make it difficult for a thirdparty to acquire us, despite the possible benefits 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 10,000,000 sharesof preferred stock and to determine the terms of this preferred stock, withoutany further vote or action on the part of the stockholders.

These provisions may have theeffect of delaying, deferring or preventing a change in the control of Avistardespite possible benefits to our stockholders, may discourage bids at a premiumover the market 

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priceof our common stock, and may adversely affect the market price of our commonstock and the voting and other rights of our stockholders.

**Our principal stockholders can exercise a controllinginfluence over our business affairs and they may make business decisions withwhich you disagree that will affect the value of your investment.**

Our executive officers,directors and entities affiliated with them, in the aggregate, beneficiallyowned approximately 63% of our common stock as of December 31, 2006. 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 Avistar, which couldcause the market price of our common stock to decline.

**Changes in stock option accounting rules enactedhave and will continue to adversely impact our reported operating resultsprepared in accordance with generally accepted accounting principles, which mayin turn adversely impact our stock price and our ability to attract and retainemployees.**

In December 2004, theFinancial Accounting Standards Board (FASB) issued Statements of FinancialAccounting Standards (SFAS) No. 123R  (revised 2004), *Share-Based Payment*(SFAS No. 123R). SFAS No. 123R requires employee stock options andrights to purchase shares under stock participation plans to be accounted forunder the fair value method, and eliminates the ability to account for theseinstruments under the intrinsic value method prescribed by AccountingPrinciples Board (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 years beginning after June 15, 2005. SFAS No. 123R allowsfor either a modified prospective recognition of compensation expense orretrospective recognition back to the original issuance of SFAS No. 123.

We adopted SFAS No. 123R inthe first quarter of 2006 using the modified prospective method. We use theBlack-Scholes-Merton model to estimate the fair value of share-based paymentsto employees, which is then amortized on a ratable basis over the requisiteservice period and adjusted for estimated forfeiture rates for executives andnon-executives.

The pro forma impact ofthe adoption of SFAS No. 123 on our historical financial statements isincluded in the notes to the consolidated financial statements presentedelsewhere in this Annual Report on Form 10-K. We expect to continueto grant stock options to employees. The impact of SFAS No. 123R had amaterial impact on our results of operations.

**Item 1b.**   *Unresolved Staff Comments*

None.

**Item 2.**   *Properties*

Ourcorporate headquarters are located in Redwood Shores, California, where weoccupy approximately 17,000 square feet under a lease that expires in March 2007.We have leased new facilities in San Mateo, California for our corporateheadquarters totaling approximately 22,000 square feet under a lease thatbegins February 2007 and expires in March 2012. We believe that ourcurrent leased facilities, together with facilities that are available to us orare being negotiated, will be sufficient to meet our needs for the next twelvemonths. In addition, we lease a combined total of approximately 11,000 squarefeet of office space in New York, New York, and London, England. As of December 31,2006, approximately 2,000 square feet of our corporate headquarters was beingutilized by CPI, our wholly-owned subsidiary.

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**Item 3.**   *Legal Proceedings*

On May 11, 2005, CPI, our wholly-owned patentprosecution and licensing subsidiary, commenced a patent infringement lawsuitagainst Tandberg ASA and Tandberg, Inc., alleging that numerous Tandbergvideoconferencing products infringe three patents held by CPI. The suit wasfiled in the United States District Court for the Northern District ofCalifornia. The three patents involved were U.S. Patent Nos. 5,867,654;5,896,500; and 6,212,547. Both of the Tandberg entities answered the complainton July 15, 2005, at which time they asserted that they did not infringethe patents and that the patents were invalid and unenforceable.

On January 30, 2006, Tandberg Telecom AS, awholly-owned subsidiary of Tandberg ASA, filed a patent infringement lawsuitagainst us and CPI in the United States District Court for the Eastern Districtof Texas. The suit alleged that our videoconferencing products infringe one patentpurchased by Tandberg Telecom AS. The patent involved is U.S. Patent No. 6,621,515,which claims a method and system for routing video calls. We responded to thecomplaint on March 23, 2006, at which time we asserted that we did notinfringe the patent, that the patent was invalid, and that the claim waswithout merit.

On February 15, 2007,we entered into a patent license agreement with Tandberg ASA, Tandberg AS andTandberg, Inc. Under this agreement, CPI agreed to dismiss itsinfringement suit against Tandberg, Tandberg agreed to dismiss its infringementsuit against us and CPI, and the companies agreed to cross-license eachother’s patent portfolios. The agreement resulted in a payment to us fromTandberg in the amount of $12.0 million, of which $4.3 million was used by usto pay contingent legal fees we incurred in connection with the litigation.

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

None.

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**PART II**

**Item 5.*   Market forRegistrant’s Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities***

Ourcommon stock has traded on the NASDAQ National Market from August 17, 2000to October 29, 2002 and has traded on the NASDAQ Capital Market since October 30,2002 under 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, 2006** | ** ** | **Year Ended  December 31, 2005** | ** ** |
|-----------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **      | ** ** | **High**                                         | ** ** | **Low**                                          | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter   |       | $                                                | 1.79       |                                             | $          | 1.22 |   | $ | 2.53 |   | $ | 1.11 |   |
| Second Quarter  |       | $                                                | 1.76       |                                             | $          | 1.25 |   | $ | 3.10 |   | $ | 2.08 |   |
| Third Quarter   |       | $                                                | 1.81       |                                             | $          | 1.33 |   | $ | 2.50 |   | $ | 1.99 |   |
| Fourth  Quarter |       | $                                                | 2.52       |                                             | $          | 1.44 |   | $ | 2.10 |   | $ | 1.52 |   |

 

On December 31,2006, the last reported sale price of our common stock on the NASDAQ CapitalMarket was $1.81 per share. According tothe records of our transfer agent, as of December 31, 2006 there were 76holders of record of our common stock and we believe there are a substantiallygreater number of beneficial holders.

**Dividend Policy**

Wehave never paid cash dividends on our common stock, and we do not anticipatepaying cash dividends in the foreseeable future.

**Equity Compensation Plan Information**

Theinformation required by this Item is included under Item 12 of Part III ofthis Annual Report on Form 10-K.

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**StockPerformance Graph**

This performance graph shall not be deemed “filed” forpurposes of Section 18 of the Securities Exchange Act of 1934, as amendedor otherwise subject to the liabilities under that Section, and shall not bedeemed to be incorporated by reference into any filing of Avistar under theSecurities Act of 1933, as amended or the Exchange Act. Set forth below is aline graph comparing the percentage change in the cumulative return to theholders of our common stock with the cumulative return of The NASDAQ CompositeU.S. Index and a group of industry peers within the communications softwareinfrastructure and video communications industries for the period commencing August 17,2000 and ending on December 31, 2006. Returns for the indices are weightedbased on market capitalization at the beginning of each fiscal year. Data forThe NASDAQ Composite Index and the Peer Group assumes reinvestment ofdividends. We have never paid dividends on our common stock and have no presentplans to do so. Our common stock was transferred from The NASDAQ Global Marketto The NASDAQ Capital Market on October 30, 2002.

**TOTAL RETURN TO STOCKHOLDERS(Assumes $100 investment on 12/31/01)**

****

**Total Return Analysis**

| ** **                    | ** ** | **12/31/2001** | ** ** | **12/31/2002** | ** ** | **12/31/2003** | ** ** | **12/31/2004** | ** ** | **12/31/2005** | ** ** | **12/31/2006** | ** ** |   |
|-------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|--------|
| Avistar  Communications Corp. |       |           | $          | 100.00         |       |           |       | $              | 11.50      |           |       |           | $          | 76.00  |   |   |   | $ | 66.50 |   |   |   | $ | 77.01 |   |   |   | $ | 90.50 |   |   |
| Peer  Group                   |       |           | $          | 100.00         |       |           |       | $              | 67.62      |           |       |           | $          | 118.95 |   |   |   | $ | 132.54 |   |   |   | $ | 137.28 |   |   |   | $ | 205.76 |   |   |
| Nasdaq Composite              |       |           | $          | 100.00         |       |           |       | $              | 68.47      |           |       |           | $          | 102.72 |   |   |   | $ | 111.54 |   |   |   | $ | 113.07 |   |   |   | $ | 123.84 |   |   |

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Source: CTA IntegratedCommunications www.ctaintegrated.com (303) 665-4200. Data fromReutersBRIDGE Data Networks

(1)          The abovegraph sets forth the cumulative total return to our stockholders during the periodfrom August 17, 2000 to December 31, 2006. The graph assumes theinvestment on December 31, 2001 of $100 in our common stock, The NASDAQComposite Index, and an Industry Peer Group. Stockholder returns over theindicated period should not be considered indicative of future stockholderreturns.

(2)          TheIndustry Peer Group consists of Webex Communications, Inc., RealNetworksInc., Packeteer, Inc., and Radvision Ltd. Although the companies includedin the industry peer group were selected because of similar industrycharacteristics, they are not entirely representative of our business.

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**Item6.*   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, 2006, 2005 and 2004 and the selected balance sheet dataas of December 31, 2006 and 2005 are derived from, and are qualified byreference to, the audited financial statements included elsewhere in thisAnnual Report on Form 10-K. The selected statement of operationsdata for the year ended December 31, 2003 and 2002 and the selectedbalance sheet data as of December 31, 2004, 2003 and 2002 is derived fromour financial statements not included in the Annual Report on Form 10-K.The historical results presented below are not necessarily indicative of futureresults.

| ** **                                                                         | ** ** | **Year Ended December 31,**                                      | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                                                        | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                         | ** ** | **(In thousands, except per share data)  Restated(1)** | ** ** |
| **Statements  of Operations Data**                                                 | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                                           |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Product                                                                            |       | $                                                                               | 4,528      |   | $ | 3,403 |   | $ | 3,121 |   | $ | 2,817 |   | $ | 4,430 |   |
| Licensing                                                                          |       | 5,155                                                                           |       | — |   | — |   | — |   | — |   |
| Services,  maintenance and support                                                 |       | 3,542                                                                           |       | 3,508 |   | 3,200 |   | 3,775 |   | 4,369 |   |
| Total  revenue                                                                     |       | 13,225                                                                          |       | 6,911 |   | 6,321 |   | 6,592 |   | 8,799 |   |
| Costs  and expenses:                                                               |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Cost  of product*                                                                  |       | 3,185                                                                           |       | 1,892 |   | 1,435 |   | 1,425 |   | 2,170 |   |
| Cost  of services, maintenance and support*                                        |       | 1,820                                                                           |       | 2,220 |   | 1,937 |   | 2,119 |   | 2,348 |   |
| Income  from settlement and patent licensing                                       |       | (4,226                                                                          | )          | (4,226 | ) | (575 | ) | — |   | — |   |
| Research  and development*                                                         |       | 5,753                                                                           |       | 3,544 |   | 2,588 |   | 2,432 |   | 3,731 |   |
| Sales  and marketing*                                                              |       | 5,488                                                                           |       | 3,379 |   | 2,456 |   | 3,702 |   | 4,006 |   |
| General  and administrative*                                                       |       | 9,682                                                                           |       | 5,697 |   | 6,956 |   | 6,038 |   | 4,600 |   |
| Total  costs and expenses                                                          |       | 21,702                                                                          |       | 12,506 |   | 14,797 |   | 15,716 |   | 16,855 |   |
| Loss  from operations                                                              |       | (8,477                                                                          | )          | (5,595 | ) | (8,476 | ) | (9,124 | ) | (8,056 | ) |
| Other  income (expenses):                                                          |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Interest  income                                                                   |       | 299                                                                             |       | 537 |   | 118 |   | 44 |   | 269 |   |
| Other  income (expense), net                                                       |       | (2                                                                              | )          | (94 | ) | 15 |   | 481 |   | 227 |   |
| Total  other income (expense), net                                                 |       | 297                                                                             |       | 443 |   | 133 |   | 525 |   | 496 |   |
| Loss  before provision for (recovery from) income taxes                            |       | (8,180                                                                          | )          | (5,152 | ) | (8,343 | ) | (8,599 | ) | (7,560 | ) |
| Provision  for (recovery from) income taxes                                        |       | (31                                                                             | )          | 22 |   | 363 |   | 20 |   | 18 |   |
| Net  loss                                                                          |       | $                                                                               | (8,149     | ) | $ | (5,174 | ) | $ | (8,706 | ) | $ | (8,619 | ) | $ | (7,578 | ) |
| Net  loss per share—basic and diluted                                         |       | $                                                                               | (0.24      | ) | $ | (0.15 | ) | $ | (0.27 | ) | $ | (0.33 | ) | $ | (0.30 | ) |
| Weighted  average shares used in calculating basic and diluted  net loss per share |       | 33,928                                                                          |       | 33,600 |   | 32,610 |   | 26,368 |   | 25,260 |   |
| *       Including stock-based compensation of:       |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Cost of product,  services, maintenance and support revenue                        |       | $                                                                               | 155        |   | $ | — |   | $ | — |   | $ | 15 |   | $ | 41 |   |
| Research and development                                                           |       | 618                                                                             |       | — |   | — |   | 12 |   | 32 |   |
| Sales and marketing                                                                |       | 497                                                                             |       | — |   | — |   | 104 |   | 278 |   |
| General and administrative                                                         |       | 764                                                                             |       | 100 |   | 24 |   | 4 |   | 7 |   |

 

| ** **                          | ** ** | **As of December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                          | ** ** | **(In thousands)  Restated(1)**  | ** ** |
| **Balance Sheet Data**              |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash  and cash equivalents          |       | $                                     | 7,854      |   | $ | 8,216 |   | $ | 21,656 |   | $ | 4,438 |   | $ | 4,783 |   |
| Short-term  investments             |       | —                                |       | 2,995 |   | — |   | 1,000 |   | 2,402 |   |
| Working  capital (deficit)          |       | (2,575                                | )          | 6,306 |   | 16,367 |   | 4,848 |   | 7,250 |   |
| Total  assets                       |       | 14,699                                |       | 20,358 |   | 30,408 |   | 8,228 |   | 10,400 |   |
| Stockholders’ equity (deficit) |       | (9,949                                | )          | (4,158 | ) | 514 |   | 5,491 |   | 7,948 |   |
|                                     |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          See Note2 “Correction of an Error” of the Notes to Consolidated Financial Statements.

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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. Certain statements in this “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” are forward looking statements.These statements relate to future events or our future financial performanceand involve known and unknown risks, uncertainties and other factors that maycause our or our industry’s actual results, levels of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by the forwardlooking statements. These risks and other factors include those listed under “RiskFactors” elsewhere in this Annual Report on Form 10-K. In somecases, you can identify forward looking statements by terminology such as “may”,“will”, “should”, “expects”, “intends”, “plans”, “anticipates”, “believes”, “estimates”,“predicts”, “potential”, “continue” or the negative of these terms, or othercomparable terminology. These statements are only predictions. Actual events orresults may differ materially. In evaluating these statements, you shouldspecifically consider various factors, including the risks outlined under “RiskFactors.” These factors may cause our actual results to differ materially fromany 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 toconform our prior statements to actual results.

**Overview**

We develop, market and support an integrated suite ofvBusiness—video-enabled eBusiness—applications, all powered by the AvistarVOSapplication platform. From the desktop, we deliver high quality interactivevideo calling, content creation and publishing, broadcast origination anddistribution, video-on-demand, and integrated data sharing. The Avistar videoand data collaboration applications are all managed by the AvistarVOS softwareapplication. By integrating video tightly into the way they work, our customerscan use our system to help reduce costs and improve productivity andcommunications within the enterprise and between enterprises, to enhance relationshipswith customers, 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 also seek to license ourbroad portfolio of patents covering, among other areas, video and rich mediacollaboration technologies, networked real-time text and non-textcommunications and desktop workstation echo cancellation.

We operate on a 52-weekfiscal year 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 haverecognized the innovative value of our research and development efforts, andhave invested in securing protection for these innovations through domestic andforeign patent applications and issuance. As of December 31, 2006, we held74 U.S. and foreign patents, which we look to license to others in thecollaboration technology marketplace.

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**Change in AccountingTreatment**

In September 2005, wereceived a comment letter from the SEC relating to our 2004 Form 10-K,which included questions regarding our accounting for the November 2004settlement and patent cross-license agreement with Polycom, Inc.. The settlementand patent cross-license agreement resulted in a $27.5 million one-time paymentby Polycom, Inc. to us, and a payment by us to our own litigation counselof $6.4 million in contingent legal fees. Our Form 10-K for thefiscal year ended December 31, 2004 and Form 10-Q for thethree, six and nine months ended March 31, 2005, June 30, 2005 and September 30,2005, respectively, reported the one time payment by Polycom, Inc. asrevenue, recognized ratably over a five-year period, net of contingent legal fees.As a result of the SEC’s inquiry as to whether the Polycom, Inc.transaction should be characterized as revenue and after discussions with theSEC, we concluded that a reclassification of license revenues from revenue to acomponent of operating expenses and reflected as “Income from settlement andpatent licensing” was necessary for previously filed financial reports. Thereclassification of the proceeds and expenses from the Polycom, Inc.settlement and patent cross-license agreement had no effect on reported netloss, loss per share, stockholders’ equity (deficit) or net cash flows fromoperating, investing or financing activities, but did have the effect ofoverstating revenues and operating expenses for previously issued interim andannual consolidated financial statements, as of and for the quarters andyear-to-date periods ended December 31, 2004, March 31, 2005, June 30,2005 and September 30, 2005. In addition, the balance sheet as of December 31,2004 was amended to reflect the gross effect of the $27.5 million payment byPolycom, Inc. to us, and the payment of $6.4 million of contingent legalfees by us, which was previously reported on a net basis as deferred revenue.Significant concentrations, revenue recognition, segment reporting footnotesand the unaudited interim results have been modified to reclassify the Polycom, Inc.proceeds from revenue to “Income from settlement and patent licensing,” to beconsistent with the presentation of the net proceeds from the Polycom, Inc.settlement and patent cross-license agreement in the 2006 and 2005 Statementsof Operations. The presentation within operations is supported by adetermination that the Polycom, Inc. licensing transaction is central tothe activities that constitute our ongoing major or central operations, butthat the settlement may also contain a gain element related to the settlement,which is not considered revenue under the Financial Accounting Standards BoardConcepts Statement No. 6, Elements of Financial Statements. We did nothave sufficient historical evidence to support a reasonable determination ofvalue for the purpose of segregating the transaction into revenue related tothe patent licensing and an operating or non-operating gain upon settlement oflitigation, resulting in the determination that the entire transaction is moreappropriately classified as “Income from settlement and patent licensing”within operations, as opposed to revenue. See Note 2 “Correction of an error”of the Notes to Consolidated Financial Statements.

**License Agreementwith Sony Corporation**

In July 2006, weentered into a Patent License Agreement with Sony Corporation and Sony ComputerEntertainment, Inc.. Under the license agreement, CPI granted SonyCorporation and its subsidiaries a license to all of CPI’s patents with afiling date on or before January 1, 2006 for a specific field of userelating to video conferencing. The license covers Sony’s video conferencingapparatus as well as other products, including video-enabled personal computerproducts and certain Sony Computer Entertainment, Inc. PlayStationproducts. As consideration for the licenses granted under the agreement, SonyCorporation agreed to make an upfront license payment of $5.0 million andSony Computer Entertainment, Inc. has agreed to make future royaltypayments relating to the sale, in certain countries, of certain Sony ComputerEntertainment, Inc. products. The $5.0 million upfront payment wasrecognized by us as licensing revenue in the three month period ended September 30,2006 and future royalty payments, if any, will be recognized as they occur inaccordance with Statement of Position (“SOP”)  97-2*, Software RevenueRecognition*(“SOP 97-2”).

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**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;

·       Incomefrom settlement and patent licensing;

·       Stockbased compensation;

·       Valuationof accounts receivable; and

·       Valuation of inventories.

**Revenue Recognition**

We derive product revenue from the sale and licensingof our video-enabled networked communications system, consisting of a suite ofAvistar-designed software and hardware products, including third partycomponents. We also derive revenue from fees for installation, maintenance,support, training services and software development. In addition, we deriverevenue from the licensing of our intellectual property portfolio. In 2006, welicensed all of CPI’s patents with a filing date on or before January 1,2006 for a specific field of use relating to video conferencing to SonyCorporation and Sony Computer Entertainment, Inc. Product revenue as apercentage of total revenue was 34%, 49% and 49% for 2006, 2005 and 2004,respectively.

We recognize product and services revenue inaccordance 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”).We derive product revenue from the sale and licensing of a set of desktop(endpoint) products (hardware and software) and infrastructure products(hardware and software) that combine to form an Avistar video-enabledcollaboration solution. Services revenue includes revenue from installationservices, post-contract customer support, training, out of pocket expenses,freight and software development. The installation services that we offer tocustomers relate to the physical set-up and configuration of desktop andinfrastructure components of our solution. The fair value of all product,installation services, post-contract customer support and training offered tocustomers is determined based on the price charged when such products orservices are sold separately.

Arrangements thatinclude multiple product and service elements may include software and hardwareproducts, as well as installation services, post-contract customer support andtraining. Pursuant to SOP 97-2, we recognize revenue when all of thefollowing criteria are met: (i) persuasive evidence of an arrangementexists, (ii) delivery has occurred, (iii) the fee is fixed ordeterminable, and (iv) collectibility is probable. We apply these criteriaas discussed below:

·       *Persuasive evidence of an arrangement exists.* We require awritten contract, signed by both the customer and us, or a purchase order fromthose customers that have previously negotiated a standard end-user licensearrangement or volume purchase agreement with us prior to recognizing revenueon an arrangement.

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·       *Delivery has occurred.* We deliver software and hardware toour customers physically. Our standard delivery terms are FOB shipping point.

·       *The fee is fixed or determinable.* Our determination that anarrangement fee is fixed or determinable depends principally on the arrangement’spayment terms. Our standard terms generally require payment within 30 to 90days of the date of invoice. Where these terms apply, we regard the fee asfixed or determinable, and we recognize revenue upon delivery (assuming otherrevenue recognition criteria are met). If the payment terms do not meet thisstandard, but rather involve “extended payment terms,” we may not consider thefee to be fixed or determinable and would then recognize revenue when customerinstallments are due and payable.

·       *Collectibility is probable.* To recognize revenue, we mustjudge collectibility of the arrangement fees, which we do on acustomer-by-customer basis pursuant to our credit review policy. We typicallysell to customers with which we have had a history of successful collections.For new customers, we evaluate the customer’s financial position and ability topay. If we determine that collectibility is not probable based upon our creditreview process or the customer’s payment history, we recognize revenue whencash is collected.

If there are any undelivered elements, we deferrevenue for those elements, as long as Vendor Specific Objective Evidence (“VSOE”)exists for the undelivered elements. Additionally, when we provide installationservices, the product and installation revenue is recognized upon completion ofthe installation process and receipt of customer confirmation, subject to thesatisfaction of the revenue recognition criteria described above. We believethat the fee associated with the delivered product elements does not meet the collectibilitycriteria if the installation services have not been completed. Customerconfirmation is obtained and documented by means of a standard form indicatingthe installation services were provided and the hardware and softwarecomponents were installed. When the customer or a third party providesinstallation services, the product revenue is recognized upon shipment, subjectto satisfaction of the revenue recognition criteria described above.

Payment for product is due upon shipment, subject tospecific payment terms. Payment for installation and professional services isdue upon providing the services, subject to specific payment terms.Reimbursements received for out of pocket expenses and shipping costs incurredduring installation and support services have not been significant to date.These expenses are recognized as revenue in accordance with Emerging IssuesTask Force (“EITF”) Issue No. 01-14 (“EITF 01-14”), *Income Statement Characterization of ReimbursementsReceived for “Out of Pocket” Expenses Incurred.*

The price charged for maintenance and/or support isdefined in the product sale contract, and is based on a fixed price for bothhardware and software components as stipulated in the customer agreement.Customers have the option to renew the maintenance and/or support services insubsequent periods at the same or similar rate as paid in the initial yearsubject to contractual adjustments for inflation in some cases. Revenue frommaintenance and support is recognized pro-rata over the maintenance and/orsupport term, which is typically one year in length. Payments for services madein advance of the provision of services are recorded as deferred revenue andcustomer deposits in the accompanying balance sheets. Training services areoffered independently of the purchase of product. The value of these trainingservices is determined based on the price charged when such services are soldseparately. Training revenue is recognized upon performance of the service.

We recognize service revenue from software developmentcontracts in accordance with SOP 81-1, *Accounting for Performance of Construction-Type and CertainProduction-Type Contracts.*Revenue related to contracts for softwaredevelopment is recognized using the percentage of completion method, when allof the following conditions are met: a contract exists with the customer at afixed price, we have fulfilled all of our material contractual obligations tothe customer for each deliverable of the contract, verification of completionof the deliverable has been received, and collection of the receivable isprobable. Amounts 

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billed to customers inexcess of revenues recognized to date are deferred and recorded as deferredrevenue 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.

We also derive revenue from the licensing of ourintellectual property portfolio. We recognize revenue from the licensing of ourintellectual property portfolio according to SOP 97-2, based on theterms of the royalty, partnership and cross-licensing agreements involved. Inthe event that a license to our intellectual property is granted after thecommencement of litigation proceedings between us and the licensee, theproceeds of such transaction are recognized as licensing revenue by us only ifsufficient historical evidence exists for the determination of fair value ofthe licensed patents to support the segregation of the proceeds between a gainon litigation settlement and patent license revenues consistent with FinancialAccounting Standards Board (“FASB”) Concepts Statement No. 6, *Elements of Financial Statements*. As of December 31,2006, these criteria for recognizing license revenue following the commencementof litigation had not been met.

To date, a significant portion of our revenue hasresulted from sales to a limited number of customers. For 2006, we recordedrevenue of approximately $10.9 million, or 83% of total revenue from SonyCorporation and Sony Computer Entertainment, Inc, Deutsche Bank AG and theiraffiliates, and UBS Warburg LLC and their affiliates, each of whom accountedfor greater than 10% of our total revenue. For 2005, we recorded revenue ofapproximately $5.8 million, or 84% of total revenue, from Deutsche Bank AG andtheir affiliates, and UBS Warburg LLC and their affiliates, each of whom accountedfor greater than 10% of our total revenue. For 2004, we recorded revenue ofapproximately $4.5 million, or 71% of total revenue, from Deutsche Bank AG andtheir affiliates and UBS Warburg LLC and their affiliates, each of whomaccounted for greater than 10% of our total revenue for 2004. We anticipatethat our revenue, and therefore, our operating results for any given period,will continue to depend to a significant extent on a limited number ofcustomers. As a result, the loss of or a reduction in sales to any one of thesecustomers would have a significant adverse impact on our operations andfinancial performance.

Internationalrevenue, which consists of sales to customers with operations principally inWestern Europe and Asia,  comprised75% of total revenue for 2006, 63% for 2005 and 52% for 2004.

**Income fromSettlement and Patent Licensing**

We recognize the proceedsfrom settlement and patent licensing agreements based on the terms involved.When litigation has been filed prior to a settlement and patent licensingagreement, and insufficient historical evidence exists for the determination offair value of the patents licensed to support the segregation of the proceedsbetween a gain on litigation settlement and patent license revenues, we reportall proceeds in “income from settlement and patent licensing” within operatingcosts and expenses. The gain portion of the proceeds, when sufficienthistorical evidence exists to segregate the proceeds, would be reported inother income according to SFAS No. 5, *Accounting forContingencies*. To date, all proceeds from settlement and patentlicensing agreements entered into following the commencement of litigation havebeen reported as income from settlement and patent licensing. When a patentlicense agreement is entered into prior to the commencement of litigation, wereport the proceeds of such transaction as licensing revenue in the period inwhich such proceeds are received, subject to the revenue recognition criteriadescribed above.

**Stock Based Compensation**

We adopted SFAS No. 123R effective January 1,2006. SFAS No. 123R is a new and very complex accounting standard, theapplication of which requires significant judgment and the use of estimates, 

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particularly surroundingBlack-Scholes-Merton assumptions such as stock price volatility and expectedoption terms, as well as expected option forfeiture rates used to valueequity-based compensation. There is little experience or guidance with respectto developing these assumptions and models for nontransferable options. SFAS No. 123Rrequires the recognition of the fair value of stock compensation in net income(loss). We incurred $1.9 million, or $0.06 earnings per share in employeestock-based compensation expense in 2006 due to adoption of SFAS No. 123R,all of which was recorded to net loss in 2006. We received no tax benefit inthe year ended 2006 due a full valuation allowance against the tax benefits ofthe stock-based compensation. Refer to Notes 3 and 8 in the Notes to ourAudited Consolidated Financial Statements included elsewhere in this AnnualReport on Form 10-K for more information.

In November 2005, theFASB issued FASB Staff Position SFAS No. 123R-3, *Transition Election Related to Accounting for the Tax Effects ofShare-Based Payment Awards*, which provides a practical exceptionwhen a company transitions to the accounting requirements in SFAS No. 123R.SFAS No. 123R requires a company to calculate the pool of excess taxbenefits available to absorb tax deficiencies recognized subsequent to adoptingSFAS No. 123R, otherwise know as the “APIC Pool”, assuming the company hadbeen following the recognition provisions prescribed by SFAS No. 123. Wehave elected to use the shortcut method under FASB Staff Position SFAS No. 123R-3to calculate our APIC Pool.

**Valuation ofAccounts Receivable**

Estimates are used indetermining our allowance for doubtful accounts and are based on our historicalcollection experience, historical write-offs, current trends, and the creditquality of our customer base and the characteristics of our accounts receivableby aging category. If the allowance for doubtful accounts were to beunderstated, our operating income could be significantly reduced. The impact ofany such change or deviation may be increased by our reliance on a relativelysmall number of customers for a large portion of our total revenue. As of December 31,2006, three customers represented 44%, 20% and 20% of our gross accountsreceivable balance. As of December 31, 2005, three customers represented48%, 32% and 17% of our gross accounts receivable balance.

**Valuation ofInventories**

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 results for such period.

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**Results ofOperations**

Thefollowing table sets forth data expressed as a percentage of total revenue forthe periods indicated.

| ** **                                              | ** ** | **Percentage of Total Revenue** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                              | ** ** | **Year Ended December 31,**     | ** ** |
| ** **                                              | ** ** | **2006**                                       | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                              | ** ** | ** **                                     | ** ** | ** ** | ** ** | **Restated(1)** | ** ** |
| Revenue:                                                |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Product                                                 |       |                                           | 34         | % |   |   | 49 | % |   |   | 49 | % |   |
| Licensing                                               |       |                                           | 39         |   |   |   | — |   |   |   | — |   |   |
| Services, maintenance and  support                      |       |                                           | 27         |   |   |   | 51 |   |   |   | 51 |   |   |
| Total revenue                                           |       |                                           | 100        |   |   |   | 100 |   |   |   | 100 |   |   |
| Costs and expenses:                                     |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Cost of product                                         |       |                                           | 24         |   |   |   | 28 |   |   |   | 23 |   |   |
| Cost of services, maintenance  and support              |       |                                           | 14         |   |   |   | 32 |   |   |   | 30 |   |   |
| Income from settlement and  patent licensing            |       |                                           | (32        | ) |   |   | (61 | ) |   |   | (9 | ) |   |
| Research and development                                |       |                                           | 44         |   |   |   | 51 |   |   |   | 41 |   |   |
| Sales and marketing                                     |       |                                           | 41         |   |   |   | 49 |   |   |   | 39 |   |   |
| General and administrative                              |       |                                           | 73         |   |   |   | 82 |   |   |   | 110 |   |   |
| Total costs and expenses                                |       |                                           | 164        |   |   |   | 181 |   |   |   | 234 |   |   |
| Loss from operations                                    |       |                                           | (64        | ) |   |   | (81 | ) |   |   | (134 | ) |   |
| Other income (expense):                                 |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Interest income                                         |       |                                           | 2          |   |   |   | 8 |   |   |   | 2 |   |   |
| Other income (expense), net                             |       |                                           | —     |   |   |   | (2 | ) |   |   | — |   |   |
| Total other income, net                                 |       |                                           | 2          |   |   |   | 6 |   |   |   | 2 |   |   |
| Loss before provision for  (recovery from) income taxes |       |                                           | (62        | ) |   |   | (75 | ) |   |   | (132 | ) |   |
| Provision for (recovery from)  income taxes             |       |                                           | —     |   |   |   | — |   |   |   | 6 |   |   |
| Net loss                                                |       |                                           | (62        | )% |   |   | (75 | )% |   |   | (138 | )% |   |

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(1)          See Note2 “Correction of an Error” of the Notes to Consolidated Financial Statements.

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***COMPARISON OF 2006 AND 2005***

**Revenue**

Total revenue increased by91% in 2006 to $13.2 million from $6.9 million for 2005. The increase in totalrevenue in 2006 relative to 2005 was primarily due to the licensing revenue of$5.2 million from Sony Corporation, Sony Computer Entertainment, Inc. andothers, compared to no license revenue in 2005. The proceeds of ourintellectual property licensing efforts tend to be sporadic and difficult topredict, which is expected to continue to contribute to the volatility of ourfinancial condition and operating results. Product revenue increased by $1.1million, or 33%, to $4.5 million in 2006 from $3.4 million in 2005, dueprimarily to additional sales to our existing customer base. Services,maintenance and support revenue totaled $3.5 million in 2006 and 2005. In 2006,three customers accounted for 83% of our revenue as compared to 2005 when twocustomers accounted for 84% of our revenue. The level of sales to any customermay vary from quarter to quarter and year to year. We anticipate that ourrevenue will 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.

**Cost of Revenue**

Total cost of revenueincreased by 22% in 2006 to $5.0 million from $4.1 million for 2005. Theincrease in total cost of revenue in 2006 relative to 2005 was attributable toincreased personnel utilized to support our maintenance and services offeringsand additional product costs related to increased product sales. We expect costof revenue to vary in the future based on the future mix of product revenuesbetween hardware and software and the mix of services revenues.

**Income from Settlement and Patent Licensing**

Income from settlement andpatent licensing was $4.2 million in 2006 and 2005, reflecting a full year ofamortization of income associated with the Polycom, Inc. settlement and patent cross-license agreement.

**Operating Expenses**

*Research and development.**  *Research and development expenses increased by 62% in2006 to $5.8 million from $3.5 million in 2005. The increase in research anddevelopment expenses in 2006 relative to 2005 was due to the hiring of newemployees focused on research and development projects in 2006, the use ofexternal labor to augment our internal development capacities, and stock-basedcompensation of $618,000. There was no stock-based compensation recorded in2005. Research and development projects associated with customer fundeddevelopment are expensed to cost of sales in the period in which they areincurred. Research and development expenses in 2007 are expected to increasedue to additional hiring of software engineering personnel required to executeour 2007 research and development programs.

*Sales and marketing.**  *Sales and marketing expenses increased by 62% in 2006to $5.5 million from $3.4 million in 2005. The increase in sales and marketingexpenses in 2006 relative to 2005 was due to the hiring of additional sales andmarketing personnel and stock-based compensation of $497,000. There was nostock-based compensation recorded in 2005. Sales and marketing expenses in 2007are expected to increase due to additional hiring of personnel required toexecute our 2007 sales programs.

*General andadministrative.**  *Generaland administrative expenses increased by 70% in 2006 to $9.7 million from $5.7million in 2005. The increase in general and administrative expenses in 2006relative to 2005 was due primarily to an increase in legal fees associated withthe litigation with Tandberg, which concluded in a patent license agreement on February 15,2007, and stock-based compensation of $764,000 

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compared to$100,000 in 2005    General andadministrative expenses in 2007 are expected to decrease due to decreasedlitigation activity.

*Other income, net.**  *Other income, net decreased by 33% in 2006 to$297,000 from $443,000 in 2005. The decrease in other income, net in 2006relative to 2005 was due primarily to the effect of reduced interest paymentson lower levels of deposited cash, cash equivalents, and short and long terminvestments in 2006, offset by higher short-term interest rates.

*Provision for (recoveryfrom) income taxes.*   Provision for (recoveryfrom) income taxes decreased to a $31,000 recovery in 2006, from an expense of$22,000 in 2005 due to the recovery of $53,000 in 2006 of tax overpayments madein 2004, offset by foreign tax expenses of $22,000 in 2006.

***COMPARISON OF 2005 AND 2004***

**Revenue**

Total revenue increased by9% in 2005 to $6.9 million from $6.3 million for 2004. The increase in total revenuein 2005 relative to 2004 was due to increases in product and services,maintenance and support revenues. Product revenue increased by $282,000 to $3.4million in 2005 from $3.1 million in 2004, due primarily to additional sales toour existing customer base. Services, maintenance and support revenue increasedby $308,000 to $3.5 million in 2005 from $3.2 million in 2004, due primarily tonew services provided primarily to our existing customer base. In 2005, twocustomers accounted for 84% of our revenue.

**Cost of Revenue**

Total cost of revenueincreased by 22% in 2005 to $4.1 million from $3.4 million for 2004. Theincrease in total cost of revenue in 2005 relative to 2004 was attributable toincreased personnel utilized to support our maintenance and services offerings,and a shift among our existing customer base from the purchase of softwareofferings with no cost of revenue to more hardware-focused offerings with costof revenue.

**Income from Settlement and Patent Licensing**

Income from settlement andpatent licensing  increased by $3.7million to $4.2 million in 2005 from $575,000 in 2004, due to a full year ofamortization in 2005 of income associated with the Polycom, Inc. settlement and patent cross-license agreement.

**Operating Expenses**

*Research and development.**  *Research and development expenses increased by 37% in2005 to $3.5 million from $2.6 million in 2004. The increase in research anddevelopment expenses in 2005 relative to 2004 was due to the hiring of newemployees focused on research and development projects in 2005.

*Sales and marketing.**  *Sales and marketing expenses increased by 38% in 2005to $3.4 million from $2.5 million in 2004. The increase in sales and marketingexpenses in 2005 relative to 2004 was due to the hiring of additional sales andmarketing personnel.

*General andadministrative.**  *Generaland administrative expenses decreased by 18% in 2005 to $5.7 million from $7.0million in 2004. The decrease in general and administrative expenses in 2005relative to 2004 was due primarily to a decrease in legal fees associated withour litigation with Polycom, Inc., which was concluded through asettlement and patent cross-licensing agreement signed on November 12,2004.

*Other income, net.**  *Other income, net increased by 233% in 2005 to $443,000from $133,000 in 2004. The increase in other income, net in 2005 relative to2004 was due primarily to the effect of higher short-

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term interest ratesand higher levels of cash, cash equivalents and short and long-term investmentsin 2005 versus 2004, resulting in a 355% increase in interest income to$537,000 in 2005, from $118,000 in 2004.

*Provision for incometaxes.**  *Provisionfor income taxes decreased to $22,000 in 2005, from $363,000 in 2004 due to thelack of  US taxes being due as a resultof taxable losses in 2005. The provision for income taxes in 2004 of $363,000was due primarily to federal, state and foreign income taxes due as a result oftaxable income generated by the settlementand cross-license patent agreement with Polycom, Inc. signed on November 12,2004. The net $21.1 million license fee paid to us by Polycom, Inc. was deferred for financial reporting purposes,to be recognized as income from settlement and patent licensing ratably overthe five year period beginning November 12, 2004. For tax reportingpurposes, the $21.1 million license fee was accounted for as taxable income in2004, thus generating a federal and state tax liability, net of utilization ofour net operating losses and tax credits.

***Liquidity and Capital Resources***

We have funded ouroperations since inception primarily from product and services revenue, the netproceeds of $31.3 million from our August 2000 initial public offering ofcommon stock, lines of credit with related parties and financial institutions,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, the net proceeds of approximately $21.1 million from thesettlement and patent cross-license agreement signed with Polycom, Inc. onNovember 12, 2004 and approximately $5.0 million from the licenseagreement signed with Sony Corporation and Sony Computer Entertainment, Inc.in July 2006.

We had cash, cashequivalents and short and long term investments of $7.9 million as of December 31,2006 and cash, cash equivalents and short and long-term investments of $12.2million as of December 31, 2005. For 2006, we had a net decrease in cash,cash equivalents and short and long-term investments of $4.3 million resultingprimarily from a net loss from operations of $8.1 million, and a net decreasein deferred income from settlement and patent licensing and other, deferredservices revenue and deposits and deferred settlement and patent licensingcosts of $2.9 million partially offset by $3.0 million drawn on a line ofcredit, and $2.0 million in non-cash stock-based compensation, and a $1.3 millionincrease in net accounts payable, accrued liabilities and other.

We had cash and cashequivalents of $7.9 million as of December 31, 2006 and $8.2 million as ofDecember 31, 2005. For 2006, we had a net cash outflow of $362,000resulting primarily from net cash outflows from operations of $7.3 million, netcash inflows from investing activities of $3.7 million and net cash inflowsfrom financing activities of $3.3 million. The net cash outflows fromoperations were primarily due to a net loss of $8.1 million, a decrease indeferred income from settlement and patent licensing and other of $5.5 million,partially offset by non-cash expenses of $2.4 million associated with theexpensing of stock-based compensation and depreciation, a decrease in deferredsettlement and patenting licensing costs of $1.3 million, an increase indeferred services revenue and customer deposits of $1.3 million, and anincrease in account payable, accrued liabilities and other of $1.3 million. Thenet cash inflows from investing were due to $4.0 million in short and long-terminvestments that matured in 2006 offset by the purchase of $290,000 of propertyand equipment. The net cash inflows from financing activities were due to $3.0million drawn on our line of credit and $312,000 from the issuance of commonstock through our employee stock purchase plan and stock option plans.

We had cash and cashequivalents of $8.2 million as of December 31, 2005 and $21.7 million asof December 31, 2004. For 2005, we had a net cash outflow of $13.4 millionresulting primarily from net cash outflows from operations of $9.5 million andnet cash outflows from investing activities of $4.4 million. The net cashoutflows from operations were primarily due to a net loss of $5.2 million, adecrease in deferred income from settlement and patent licensing of $5.4million and an increase in accounts receivable of $641,000, partially offset bya decrease in deferred costs from settlement and patenting licensing of $1.3 

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millionand non cash expenses of $472,000. The net cash outflows from investing weredue to $4.0 million in purchases of short and long-term investments and thepurchase of $392,000 of property and equipment. The net cash inflows fromfinancing activities were due to $414,000 in proceeds from the issuance ofcommon stock.

We had cash and cashequivalents of $21.7 million as of December 31, 2004. For 2004, we had anet cash inflow of $17.2 million resulting primarily from net cash proceedsfrom the issuance of common stock of $3.7 million and net cash provided byoperations of $12.7 million. The net cash proceeds from the issuance ofcommon stock were primarily due to the private sale of 3,000,000 shares of ourcommon stock 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 incomefrom settlement and patent licensing of $26.8 million as a result of thesettlement and patent cross-license agreement signed with Polycom, Inc. onNovember 12, 2004, offset by a net loss of $8.7 million and an increase indeferred costs from settlement and patent licensing of $6.2 million.

Expenditures for property and equipment in 2006 wereapproximately $290,000. At December 31, 2006, we did not have any materialcommitments for future capital expenditures. We anticipate spending approximately$1.0 million in capital expenditures during the next 12 months.

Thefollowing table summarizes our known contractual obligations and commitments asof December 31, 2006 (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*    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating  Lease Obligations |       | $                                         | 7,317      |   |   | $ | 1,091 |   |   | $ | 2,379 |   | $ | 2,038 |   |   | $ | 1,809 |   |   |
| Purchase  Obligations        |       | 927                                       |       |   | 248 |   |   | 679 |   | — |   |   | — |   |   |
| Total                        |       | $                                         | 8,244      |   |   | $ | 1,339 |   |   | $ | 3,058 |   | $ | 2,038 |   |   | $ | 1,809 |   |   |

 

On March 26, 2004, wecompleted the private sale of a total of 3,000,000 shares of our common stockto Fuller & Thaler Avalanche Fund, L.P. and Fuller & ThalerBehavioral 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.

On November 12, 2004,we entered into settlement and patent cross-license agreement with Polycom, Inc.Under this agreement, CPI agreed to dismiss, with prejudice, its infringementsuit against Polycom, Inc. and both companies agreed to cross-license eachother’s patent portfolios. The original litigation was initiated in September 2002,in the Federal District Court for the Northern District of California andinvolved the following CPI patents: U.S. Patent Nos. 5,867,654; 5,896,500;6,212,547; and 6,343,314. The agreement resulted in a payment, net of legalfees, to us from Polycom, Inc. in the amount of $21.1 million.

In July 2006, we enteredinto a Patent License Agreement with Sony Corporation and Sony ComputerEntertainment, Inc.. Under the license agreement, CPI granted SonyCorporation and its subsidiaries a license to all of CPI’s patents with afiling date on or before January 1, 2006 for a specific field of userelating to video conferencing. As consideration for the licenses granted underthe agreement, Sony Corporation agreed to make an upfront license payment of$5.0 million and Sony Computer Entertainment, Inc. has agreed to makefuture royalty payments relating to the sale, in certain countries, of certainSCEI products.

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On December 23, 2006,we entered into a Revolving Credit and Promissory Note and a Security Agreementwith a financial institution to borrow up to $10.0 million under a revolvingline of credit. The agreement includes a first priority security interest inall of our assets. Gerald Burnett, our Chairman and Chief Executive Officer,provided a collateralized guarantee to the financial institution, assuring paymentof our obligations under the agreement and as a consequence, there are norestrictive covenants, allowing us greater access to the full amount of thefacility. The line of credit requires monthly interest-only payments based onLIBOR plus 0.75%, or 6.1% at December 31, 2006 or Prime Rate minus 2.0%,or 6.3% at December 31, 2006. On December 28, 2006, we borrowed $3.0million under the revolving line of credit. The Revolving Credit and PromissoryNote expires on December 23, 2007, and is subject to annual renewal.

On February 15, 2007,we entered into a patent license agreement with Tandberg ASA, Tandberg AS andTandberg, Inc. Under this agreement, CPI agreed to dismiss, withprejudice, its infringement suit against Tandberg and both companies agreed tocross-license each other’s patent portfolios. The original litigation wasinitiated in May 2005, in the Federal District Court for the NorthernDistrict of California and involved the following CPI patents: U.S. Patent Nos.5,867,654; 5,896,500 and 6,212,547. The agreement resulted in a payment to usfrom Tandberg in the amount of $12.0 million, $4.3 million of which was used byus to pay our contingent legal fees associated with the Tandberg litigation.

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 conditions andconditions in the financial services industry in particular, the level andtiming of product, services and licensing revenue, the costs and timing of our productdevelopment efforts and the success of these development efforts, the costs andtiming of our sales and marketing activities, the extent to which our existingand new products gain market acceptance, competing technological and marketdevelopments, the costs and proceeds involved in maintaining and enforcingpatent claims and other intellectual property rights, all of which may impactour ability to achieve and maintain profitability. From time to time, we may berequired to raise additional funds through public or private financing,strategic relationships or other arrangements. There can be no assurance thatsuch funding, if needed, will be available on terms attractive to us, or atall. Furthermore, any additional debt or equity financing arrangements may bedilutive to stockholders, and debt financing, if available, may involverestrictive covenants. Strategic arrangements, if necessary to raise additionalfunds, may require us to relinquish our rights to certain of our technologiesor products. Our failure to raise capital when needed could have a materialadverse effect on our business, operating results and financial condition.

**Recent Accounting Pronouncements**

In June 2006,the Emerging Issues Task Force issued EITF No. 06-3, *How Taxes Collected from Customers and Remitted to GovernmentalAuthorities Should Be Presented in the Income Statement (That Is, Gross versusNet Presentation)* (“EITF 06-3”), which clarifies diversity inpractice on the presentation of different types of taxes in the financialstatements. The Task Force concluded that, for taxes within the scope of theissue, a company may adopt a policy of presenting taxes either gross withinrevenue or net. That is, it may include charges to customers for taxes withinrevenues and the charge for the taxes from the taxing authority within cost ofsales, or, alternatively, it may net the charge to the customer and the chargefrom the taxing authority. If taxes subject to this Issue are significant, acompany is required to disclose its accounting policy for presenting taxes andthe amounts of such taxes that are recognized on a gross basis. The guidance inthis consensus is effective for the first interim reporting period beginningafter December 15, 2006. We are currently assessing the impact, if any,that the adoption of this EITF will have on our financial statements.

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In July 2006,the FASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109*(“FIN No. 48”), which became effective for us on January 1,2007. This interpretation clarifies the accounting for income tax benefits thatare uncertain in nature. Under FIN No. 48, a company will recognize a taxbenefit in the financial statements for an uncertain tax position only if management’sassessment is that its position is “more likely than not” (i.e., a greater than50 percent likelihood) to be upheld on audit based only on the technicalmerits of the tax position. This accounting interpretation also providesguidance on measurement methodology, derecognition thresholds, financialstatement classification and disclosures, interest and penalties recognition,and accounting for the cumulative-effect adjustment. The new interpretation isintended to provide better financial statement comparability among companies.

Requiredannual disclosures include a tabular reconciliation of unrecognized taxbenefits at the beginning and end of the period; the amount of unrecognized taxbenefits that, if recognized, would affect the effective tax rate; the amountsof interest and penalties recognized in the financial statements; any expectedsignificant impacts from unrecognized tax benefits on the financial statementsover the subsequent 12-month reporting period; and a description of thetax years remaining to be examined in major tax jurisdictions. FIN No. 48is effective for fiscal years beginning onor after December 15, 2006. We are currently assessing the impact, if any,that the adoption of FIN No. 48 will have on our financial statements.

In September 2006,the FASB issued FASB Statement No. 157, *Fair ValueMeasurements* (“FAS No.157”), which will become effective for us on January 1,2008. This standard defines fair value, establishes a framework for measuringfair value and expands disclosures about fair value measurements. The Statementdoes not require any new fair value measurements but would apply to assets andliabilities that are required to be recorded at fair value under otheraccounting standards. The impact, if any, to us from the adoption of FAS No.157in 2008 will depend on our assets and liabilities at that time that they arerequired to be measured at fair value.

In September 2006,the SEC issued Staff Accounting Bulletin (SAB) SAB No. 108. SAB No. 108provides guidance on how prior year misstatements should be taken intoconsideration when quantifying misstatements in current year financialstatements for purposes of determining whether the current year’s financialstatements are materially misstated. SAB No.108 permits registrants torecord the cumulative effect of initial adoption by recording the necessary “correcting”adjustments to the carrying values of assets and liabilities as of thebeginning of the 2006 year with the offsetting adjustment recorded to theopening balance of retained earnings. SAB No. 108 is effective forfiscal years ending on or after November 15, 2006. The application of SAB No. 108did not have any impact on our consolidated balance sheets, statements ofoperations, or statements of equity (deficit) for 2006, 2005 or 2004.

**Item 7a.**   *Quantitative and QualitativeDisclosures About Market Risk*

Wedevelop products primarily in the United States, and sell those productsprimarily in North America, Europe and Asia. International revenue, whichconsists of sales to customers with operations principally in Western Europeand Asia, comprised 75%, 63% and 52% of total revenue for the years ended 2006,2005 and 2004, respectively. As a result, our financial condition could beaffected by factors such as changes in foreign currency exchange rates or weakeconomic conditions in foreign markets. As all of our sales are currently madein United States dollars, a strengthening of the United States dollar couldmake our products less competitive in foreign markets. We do not use derivativefinancial instruments for speculative or trading purposes, nor do we engage inany foreign currency hedging transactions.

Ourinterest income is sensitive to changes in the general level of United Statesinterest rates, particularly since the majority of our cash equivalents areinvested in money market funds or securities.

49

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**Cash and Cash Equivalents andShort and Long-Term Investments**

Cash equivalents consistprimarily of securities and money market funds acquired with remaining maturityperiods of three months or less, and are stated at cost, plus accrued interestthat approximates market value. We would not expect our operating results orcash flow to be significantly impacted by the effect of sudden changes inmarket interest rates given the nature of our short-term investments.

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, 2006.

| ** **                                                 | ** **   | **Amounts**             | ** **   | **Weighted Average  Interest Rate** | ** **   |
|------------------------------------------------------------|--------------|-------------------------|--------------|-----------------------------------------------|--------------|
| ** **                                                 | ** **   | **(in thousands)** | ** **   | ** **                                    | ** **   |
| ***Description***                                          | *** *** |                    | *** *** | *** ***                                  |         |   | *** *** | *** *** |   |
| Cash and cash equivalents and  short-term investments:     |         |                    |         | *** ***                                  |         |   |   |   |   |
| Cash                                                       |         |                    | $            | 4,224                                         | *** *** |   |   | — |   |   |
| Commercial  Paper (average 22 remaining days to maturity)  |         |                    | 3,630        | *** ***                                  |         |   | 5.29 | % |   |
| Total cash and cash  equivalents at December 31, 2006 |         |                    | $            | 7,854                                         | *** *** |   |   |   |   |   |

 

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

Ourconsolidated financial statements and Reports of Independent Registered PublicAccounting Firms appear on pages F-1 through F-30 of thisReport.

**Item 9.**   *Changes in and Disagreements with Accountants on Accounting andFinancial Disclosure*

None

**Item9a.**   *Controls and Procedures*

(a)  Evaluation of disclosure controls andprocedures: Our management evaluated, with the participation of our ChiefExecutive Officer and Chief Financial Officer, the effectiveness of ourdisclosure controls and procedures as of the end of the period covered by thisAnnual Report on Form 10-K. Based on this evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934 (the ExchangeAct)) are effective to provide reasonable assurance that information requiredto be disclosed by us in reports that we file or submit under the Exchange Act (i) isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate to allow timely decisionsregarding required disclosure, and (ii) is recorded, processed, summarizedand reported within the time periods specified in Securities and ExchangeCommission rules and forms. In designing and evaluating thedisclosure controls and procedures, management recognizes that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives. In addition,the design of disclosure controls and procedures must reflect the fact thatthere are resource constraints and that management is required to apply itsjudgment in evaluating the benefits of possible controls and proceduresrelative to their costs.

(b) Changes in internal control over financialreporting: There was no change in our internal control over financial reportingthat occurred during the quarter ended December 31, 2006 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

**Item 9b.**   *Other Information*

None

50

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**PART III**

**Item10.****  ***Directors, Executive Officers of the Registrant and CorporateGovernance Matters*

The information required by thisitem is incorporated by reference to the sections captioned “Election ofDirectors” and “Section 16(a) Beneficial Ownership ReportingCompliance” contained in our Proxy Statement related to the 2007 Annual Meetingof Stockholders, to be filed with the Securities and Exchange Commission within120 days of December 31, 2006, pursuant to General Instruction G(3) ofForm 10-K (the “Proxy Statement”). Certain information required bythis item concerning executive officers is set forth in Part I of thisReport in “Business—Executive Officers,” and certain other information requiredby this item is incorporated by reference from the sections captioned “PrincipalStockholders” contained in our Proxy 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 andEthics Policy.”*

Weintend to satisfy the disclosure requirement under Item 5.05 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.

**Item11.****   *Executive Compensation***

Theinformation required by this item is incorporated by reference to the sectioncaptioned “Executive Compensation and Other Matters” contained in our ProxyStatement.

**Item12.****  ***Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters*

The information required by thisitem is incorporated by reference to the sections captioned “PrincipalStockholders”,  “Executive Compensationand Other Matters” and “Certain Transactions” contained in our Proxy Statement.

51

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**Equity CompensationPlan Information**

The following table provides information as of December 31,2006 with respect to the shares of our Common Stock that may be issued underour existing equity compensation plans.

| ** **                                                  | ** ** | **A**      | ** ** | **B**                                                                                                            | ** ** | **C**                                                                       | ** ** |
|-------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| **Plan Category**                                      | ** ** | ** ** | ** ** | **Number of securities  to be issued upon  exercise of outstanding  options** | ** ** | **Weighted-average  exercise price of  outstanding options** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  Column A)** | ** ** |
| Equity  compensation plans approved by security holders     |       |       | 8,888,722  | (1)                                                                                                              |       |                                                                        | $          | 2.87 |   |   |   | 3,567,433 | (2) |   |
| Equity  compensation plans not approved by security holders |       |       | —     |                                                                                                             |       |                                                                        | —     |   |   |   | — |   |   |
| Total                                                       |       |       | 8,888,722  |                                                                                                             |       |                                                                        | $          | 2.87 |   |   |   | 3,567,433 |   |   |
|                                                             |            |            |            |                                                                                                                  |            |                                                                             |            |  |  |  |  |  |  |  |  |  |

 

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(1)          This number reflects the number of shares to be issued upon exercise ofoutstanding options under our 2000 Director Option Plan (“Director Plan”), the1997 Stock Option Plan (the “1997 Plan”) and the 2000 Stock Option Plan (the “2000Option Plan”). This number excludes purchase rights accruing under the EmployeeStock Purchase Plan (“Purchase Plan”). The Purchase Plan authorizes thegranting of stock purchase rights to eligible employees during six monthoffering periods.. Shares are purchased through employee payroll deductions atpurchase prices equal to 85% of the lesser of the fair market value of ourCommon Stock at either the first day of each offering period or the date ofpurchase.

(2)          Includes1,858,643 shares available for issuance under the 2000 Option Plan, 230,750 shares available for issuanceunder the Director Plan and 1,478,040 shares available for issuance under thePurchase Plan. No securities are available for future issuance under the 1997Plan. The 2000 Option Plan provides for an annual increase in the number ofshares of Common Stock reserved for issuance thereunder on the first day of ourfiscal year in an amount equal to the lesser of (x) 1,200,000 shares, (y) 4%of the outstanding shares of Avistar as of the last day of the prior fiscalyear or (z) such lesser amount as determined by the Board. The DirectorPlan currently provides for an annual increase to the number of shares reservedthereunder on the first day of Avistar’s fiscal year equal to the lesser of (x) 175,000shares, (y) 1% of the outstanding shares of our Common Stock on such dateor (z) such amount as determined by the Board. The Purchase Plan providesfor an annual increase in the number of shares of Common Stock reservedthereunder on the first day of our fiscal year in an amount equal to the lesserof (x) 900,000 shares, (y) 3% of our outstanding shares on the lastday of the prior fiscal year or (z) such amount as determined by theBoard. Under the terms of the Plans, on January 1, 2006, 1,200,000 and175,000 shares were added to the 2000 Option Plan and the Director Plan,respectively. No shares were added to the Purchase Plan on January 1,2006.

**Item13.****  ***Certain Relationships and Related Transactions and DirectorIndependence*

Theinformation required by this item is incorporated by reference to the sectionscaptioned “Proposal One—Election of Directors,” “Compensation CommitteeInterlocks and Insider Participation” and “Certain Transactions” contained inour Proxy Statement.

**Item14.****  ***Principal Accountant Fees and Services*

The information required by thissection is incorporated by reference from the information in the sectionentitled “Ratification of Appointment of Independent Accountants” in our ProxyStatement.

52

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**PART IV**

**Item15.****   *Exhibits, Financial Statement Schedules***

(a)(1) *FinancialStatements*

The following financial statements are incorporated byreference in Item 8 of this Annual Report:

|                                                                                                                            | ** ** | **Page** | ** ** |   |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|--------|
| Reports of  Independent Registered Public Accounting Firms                                                                 |       |     | F-2        |   |   |
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                                         |       |     | F-4        |   |   |
| Consolidated  Statements of Operations for the years ended December 31, 2006, 2005 and  2004                          |       |     | F-5        |   |   |
| Consolidated  Statements of Stockholders’ Equity (Deficit) for the years ended  December 31, 2006, 2005 and 2004 |       |     | F-6        |   |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2006, 2005 and  2004                          |       |     | F-7        |   |   |
| Notes to the  Consolidated Financial Statements                                                                            |       |     | F-8        |   |   |
|                                                                                                                            |            |          |            |        |  |  |  |

 

(a)(2) *FinancialStatement Schedules*

**Schedule II—Valuationand Qualifying Accounts and Reserves (see page S-1)**

Schedules not listed above have been omitted because the informationrequired to be set forth therein is not applicable or is shown in the financialstatements or notes thereto.

(a)(3) *Exhibits*

| 3.2(1)    |   | Restated Certificate of  Incorporation                                                                                                                                                         |
|-----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.3(11)   |   | 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(12)  |   | 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(6)   |   | Settlement  Agreement and Release between the Registrant and R. Stephen Heinrichs dated  April 26, 2001*                                                                                  |
| 10.8(8)   |   | Office  Lease Agreement between CA-Twin Dolphin Plaza Limited Partnership and the  Registrant dated July 30, 2003                                                                         |
| 10.9(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 |
| 10.10(10) |   | Stock Purchase Agreement  among the Registrant, Fuller & Thaler Behavioral Finance Fund, Ltd.  and Fuller & Thaler Avalanche Fund, L.P. dated March 23, 2004            |

53

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| 10.11(11)       |   | Settlement Agreement  among the Registrant, Collaboration Properties, Inc. and  Polycom, Inc. dated November 12, 2004                                                               |
|-----------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.12(12)† |   | Patent Cross-License  Agreement Among the Company, Collaboration Properties, Inc. and  Polycom, Inc. dated November 12, 2004                                                        |
| 10.13(4)†  |   | Patent License Agreement  dated May 15, 2006 among the Registrant, Collaboration  Properties, Inc., Sony Corporation and Sony Computer  Entertainment, Inc.                         |
| 10.14           |   | Revolving Credit  Promissory Note dated December 26, 2006 issued by the Registrant to  JPMorgan Chase Bank, N.A.                                                                              |
| 10.15           |   | Collateral Agreement  between the Registrant and JPMorgan Chase Bank, N.A. dated December 23,  2006                                                                                           |
| 10.16           |   | Security Agreement  between the Registrant and JPMorgan Chase Bank, N.A. dated December 23,  2006                                                                                             |
| 10.17           |   | Guaranty issued by  Gerald J. Burnett and The Gerald J. Burnett and Marjorie J. Burnett Revocable  Trust in favor of JPMorgan Chase Bank, N.A. dated December 23, 2006                        |
| 10.18           |   | Form of Note Sale  Agreement among Gerald J. Burnett, The Gerald J. Burnett and Marjorie J.  Burnett Revocable Trust and JPMorgan Chase Bank, N.A.                                       |
| 10.19           |   | Lease Agreement among  the Registrant and Crossroads Associates and Clocktower Associates dated  December 1, 2006                                                                             |
| 21.1(7)         |   | Subsidiaries  of the Company                                                                                                                                                                       |
| 23.1            |   | Consent  of Independent Registered Public Accounting Firm: Burr, Pilger &  Mayer LLP                                                                                                      |
| 23.2            |   | Consent  of Independent Registered Public Accounting Firm: KPMG LLP                                                                                                                                |
| 24.1            |   | Power  of Attorney (see page 56)                                                                                                                                                              |
| 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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*                    Indicatesmanagement contract or compensatory plan or arrangement required to be filed anexhibit pursuant to Item 14(c) of Form 10-K.

†                     Portions of the exhibit have been omittedpursuant to a request for confidential treatment and the omitted portions havebeen 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)          Reserved.

(3)          Reserved.

(4)          Filed asan exhibit to the Registrant’s Quarterly Report on Form  10-Q forthe three months ended September 30, 2006 filed with the Securities andExchange Commission on November 14, 2006.

(5)          Reserved.

54

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(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)          Reserved.

(10) Filedas an exhibit to the Registrant’s Quarterly Report on Form 10-Q forthe quarter ended March 31, 2004 filed with the Securities and ExchangeCommission on May 11, 2004.

(11) Filedas an exhibit to the Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2004 filed with the Securities and ExchangeCommission on March 28, 2005.

(12) Filedas an exhibit to the Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2005 filed with the Securities and ExchangeCommission on April 28, 2006.

55

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, as amended, the Registrant has duly causedthis annual report to be signed on its behalf by the undersigned, thereuntoduly authorized.

|                           |     | AVISTAR COMMUNICATIONS  CORPORATION |
|---------------------------|----------|-------------------------------------|
|                      |     | By:                                 | /s/   GERALD J. BURNETT |
|                      |     |                                | Gerald J. Burnett |
|                      |     |                                | *Chief Executive* |
|                      |     |                                | *Officer and Chairman* |
| Date: March 22, 2007 | * * | * *                            | * * | * * |
|                           |          |                                     |  |  |  |

 

**POWER OF 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 lawfulattorneys-in-fact and agents, with full power of substitution andresubstitution, to sign any and all amendments (including post- effectiveamendments) to this Annual Report on Form 10-K and to file the same,with all exhibits thereto and other documents in connection therewith, with theSecurities and Exchange Commission, granting unto said attorneys-in-fact andagents, full power and authority to do and perform each and every act and thingrequisite and necessary to be done in connection therewith, as fully to allintents and purposes as he or she might or could do in person, hereby ratifyingand confirming all that said attorneys-in-fact and agents, 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 22, 2007  |
| Gerald J. Burnett                         |          | (Principal Executive Officer)              |       |                 |
| /s/   ROBERT J. HABIG      |          | Chief  Financial Officer (Principal        |       | March 22,  2007 |
| Robert J. Habig                           |          | Financial and Accounting Officer)          |       |                 |
| /s/   WILLIAM L. CAMPBELL  |          | Executive  Vice President, Chief Operating |       | March 22,  2007 |
| William L. Campbell                       |          | Officer and Director                       |       |                 |
| /s/   CRAIG F. HEIMARK     |          | Director                                   |       | March 22,  2007 |
| Craig F. Heimark                          |          |                                       |       |                 |
| /s/   R. STEPHEN HEINRICHS |          | Director                                   |       | March 22,  2007 |
| R. Stephen Heinrichs                      |          |                                       |       |                 |
| /s/   ROBERT P. LATTA      |          | Director                                   |       | March 22,  2007 |
| Robert P. Latta                           |          |                                       |       |                 |
| /s/   ROBERT M. METCALFE   |          | Director                                   |       | March 22,  2007 |
| Robert M. Metcalfe                        |          |                                       |       |                 |
| /s/   JAMES W. ZEIGON      |          | Director                                   |       | March 22,  2007 |
| James W. Zeigon                           |          |                                       |       |                 |

 

56

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**INDEXTO FINANCIAL STATEMENTS**

|                                                                                                                                | ** ** | **Page** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Reports of Independent Registered Public Accounting  Firms                                                                     |       | F-2      |
| Consolidated Balance Sheets as of December 31,  2006 and 2005                                                             |       | F-4      |
| Consolidated Statements of Operations for the years  ended December 31, 2006, 2005 and 2004                               |       | F-5      |
| Consolidated Statements of Stockholders’ Equity  (Deficit) for the years ended December 31, 2006, 2005 and 2004 |       | F-6      |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005 and 2004                               |       | F-7      |
| Notes to the  Consolidated Financial Statements                                                                                |       | F-8      |

 

F-1

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**Report ofIndependent Registered Public Accounting Firm**

To the Board of Directors andStockholders ofAvistar Communications Corporation

We have audited the accompanyingconsolidated balance sheets of Avistar Communications Corporation and itssubsidiaries as of December 31, 2006 and 2005, and the relatedconsolidated statements of operations, stockholders’ equity (deficit), and cashflows for each of the two years in the period ended December 31, 2006. Ouraudits also included the related financial statement schedule listed in Item15(a)(2). These consolidated financial statements and financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these consolidated financial statements and financialstatement schedule based on our audits.

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. The Company is not required to have, nor have we beenengaged to perform an audit of the Company’s internal control over financialreporting. Our audits included consideration of internal control over financialreporting as a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting.Accordingly, we express no such opinion. An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

In our opinion, the consolidatedfinancial statements referred to above present fairly, in all materialrespects, the financial position of Avistar Communications Corporation and itssubsidiaries as of December 31, 2006 and 2005, and the results of theiroperations and their cash flows for each of the two years in the period ended December 31, 2006, in conformitywith accounting principles generally accepted in the United States of America. Also,in our opinion, the related financial statement schedule, when considered inrelation to the consolidated financial statements taken as a whole, presentsfairly, in all material respects, the information set forth therein.

As discussed in Note 3 to the consolidated financialstatements, on January 1, 2006 the Company changed its method ofaccounting for stock-based compensation as a result of adopting Statement ofFinancial Accounting Standards No. 123(R), *Share BasedPayment,*applying the modified prospective method.
|                        | /s/ Burr,  Pilger & Mayer LLP |
|------------------------|----------------------------------------|
| Palo  Alto, California |
| March 19, 2007    |

 

F-2

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**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and StockholdersAvistar Communications Corporation:

We have audited the accompanying consolidatedstatements of operations, stockholders’ equity, and cash flows of Avistar CommunicationsCorporation and subsidiaries for the year ended December 31, 2004. Inconnection with our audit of the consolidated financial statements, we alsohave audited the financial statement schedule for the year ended December 31,2004. These consolidated financial statements and financial statement scheduleare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on these consolidated financial statements and financialstatement schedule based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards 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 audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the results ofoperations and cash flows of Avistar Communications Corporation andsubsidiaries for the year ended December 31, 2004, in conformity with U.S.generally accepted accounting principles. Also in our opinion, the relatedfinancial statement schedule for the year ended December 31, 2004, whenconsidered in relation to the consolidated financial statements taken as awhole, presents fairly, in all material respects, the information set forththerein.

Asdiscussed in Note 2 to the accompanying consolidated financial statements, theconsolidated statements of operations and cash flows of Avistar CommunicationsCorporation and subsidiaries for the year ended December 31, 2004 havebeen restated.

|                                       | /s/ KPMG LLP |
|--------------------------------------------|--------------|
| Mountain View, California                  |
| January 28, 2005, except as to        |
| Note 2, which is as of April 26, 2006 |

 

F-3

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**AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSas of December 31, 2006 and 2005(in thousands, except share and per share data)**

| ** **                                                                                                                                                                                   | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **Assets:**                                                                                                                                                                                  | ** ** |                        | ** ** | ** **                  |       |   | ** ** | ** ** |   |
| Current assets:                                                                                                                                                                              |       |                        |       |                        |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                    |       |                        | $          | 7,854                       |       |   |   | $ | 8,216 |   |   |
| Short-term investments                                                                                                                                                                       |       |                        | —     |                        |       |   | 2,995 |   |   |
| Accounts receivable, net of allowance for doubtful  accounts of $51 and $121 at December 31, 2006 and 2005, respectively                                                                |       |                        | 1,409      |                        |       |   | 1,428 |   |   |
| Inventories, including inventory shipped to  customers’ sites, not yet installed of $70 and $28 at December 31, 2006  and 2005, respectively                                       |       |                        | 712        |                        |       |   | 675 |   |   |
| Deferred settlement and patent licensing costs                                                                                                                                               |       |                        | 1,256      |                        |       |   | 1,256 |   |   |
| Prepaid expenses and other current assets                                                                                                                                                    |       |                        | 534        |                        |       |   | 463 |   |   |
| Total current assets                                                                                                                                                                         |       |                        | 11,765     |                        |       |   | 15,033 |   |   |
| Long-term investments                                                                                                                                                                        |       |                        | —     |                        |       |   | 958 |   |   |
| Property and equipment, net                                                                                                                                                                  |       |                        | 256        |                        |       |   | 311 |   |   |
| Long-term deferred settlement and patent licensing  costs                                                                                                                                    |       |                        | 2,391      |                        |       |   | 3,685 |   |   |
| Other assets                                                                                                                                                                                 |       |                        | 287        |                        |       |   | 371 |   |   |
| Total assets                                                                                                                                                                                 |       |                        | $          | 14,699                      |       |   |   | $ | 20,358 |   |   |
| **Liabilities  and Stockholders’ Equity (Deficit):**                                                                                                                                    | ** ** |                        | ** ** | ** **                  |       |   | ** ** | ** ** |   |
| Current  liabilities:                                                                                                                                                                        |       |                        |       |                        |       |   |   |   |   |
| Line of credit                                                                                                                                                                               |       |                        | $          | 3,000                       |       |   |   | — |   |   |
| Accounts payable                                                                                                                                                                             |       |                        | 1,578      |                        |       |   | $ | 1,004 |   |   |
| Deferred income from settlement and patent licensing                                                                                                                                         |       |                        | 5,520      |                        |       |   | 5,520 |   |   |
| Deferred services revenue and customer deposits                                                                                                                                              |       |                        | 1,979      |                        |       |   | 712 |   |   |
| Accrued liabilities and other                                                                                                                                                                |       |                        | 2,263      |                        |       |   | 1,491 |   |   |
| Total current liabilities                                                                                                                                                                    |       |                        | 14,340     |                        |       |   | 8,727 |   |   |
| Long-term  liabilities:                                                                                                                                                                      |       |                        |       |                        |       |   |   |   |   |
| Long-term deferred income from settlement and patent  licensing                                                                                                                              |       |                        | 10,308     |                        |       |   | 15,789 |   |   |
| Total liabilities                                                                                                                                                                            |       |                        | 24,648     |                        |       |   | 24,516 |   |   |
| Commitments and  contingencies (Notes 5 and 9)                                                                                                                                               |       |                        |       |                        |       |   |   |   |   |
| Stockholders’  equity (deficit):                                                                                                                                                        |       |                        |       |                        |       |   |   |   |   |
| Common stock, $0.001 par value; 250,000,000 shares  authorized at December 31, 2006 and 2005; 35,219,768 and 34,939,124  shares issued at December 31, 2006 and 2005, respectively |       |                        | 35         |                        |       |   | 35 |   |   |
| Less: treasury common stock, 1,181,625 shares at  December 31, 2006 and 2005, at cost                                                                                                   |       |                        | (53        | )                           |       |   | (53 | ) |   |
| Additional paid-in-capital                                                                                                                                                                   |       |                        | 92,865     |                        |       |   | 90,519 |   |   |
| Other comprehensive loss                                                                                                                                                                     |       |                        | —     |                        |       |   | (12 | ) |   |
| Accumulated deficit                                                                                                                                                                          |       |                        | (102,796   | )                           |       |   | (94,647 | ) |   |
| Total stockholders’ equity (deficit)                                                                                                                                                    |       |                        | (9,949     | )                           |       |   | (4,158 | ) |   |
| Total liabilities  and stockholders’ equity (deficit)                                                                                                                                   |       |                        | $          | 14,699                      |       |   |   | $ | 20,358 |   |   |

 

The accompanying notes are an integral part of these financial statements.

F-4

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**AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSfor the years ended December 31, 2006, 2005 and 2004(in thousands, except per share data)**
|                                                                                                                             | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                                  | ** ** | ** **                                 | ** ** | ** ** | ** ** | **Restated(1)** | ** ** |
| Revenue:                                                                                                                    |       |                                       |       |   |   |   |   |   |   |
| Product                                                                                                                     |       | $                                          | 4,528      |   | $ | 3,403 |   |   | $ | 3,121 |   |   |
| Licensing                                                                                                                   |       | 5,155                                      |       | — |   |   | — |   |   |
| Services, maintenance and support                                                                                           |       | 3,542                                      |       | 3,508 |   |   | 3,200 |   |   |
| Total revenue                                                                                                               |       | 13,225                                     |       | 6,911 |   |   | 6,321 |   |   |
| Costs and expenses:                                                                                                         |       |                                       |       |   |   |   |   |   |   |
| Cost of product revenues*                                                                                                   |       | 3,185                                      |       | 1,892 |   |   | 1,435 |   |   |
| Cost of services, maintenance and support revenues*                                                                         |       | 1,820                                      |       | 2,220 |   |   | 1,937 |   |   |
| Income from settlement and patent licensing                                                                                 |       | (4,226                                     | )          | (4,226 | ) |   | (575 | ) |   |
| Research and development*                                                                                                   |       | 5,753                                      |       | 3,544 |   |   | 2,588 |   |   |
| Sales and marketing*                                                                                                        |       | 5,488                                      |       | 3,379 |   |   | 2,456 |   |   |
| General and administrative*                                                                                                 |       | 9,682                                      |       | 5,697 |   |   | 6,956 |   |   |
| Total costs and expenses                                                                                                    |       | 21,702                                     |       | 12,506 |   |   | 14,797 |   |   |
| Loss from operations                                                                                                        |       | (8,477                                     | )          | (5,595 | ) |   | (8,476 | ) |   |
| Other income (expense):                                                                                                     |       |                                       |       |   |   |   |   |   |   |
| Interest income                                                                                                             |       | 299                                        |       | 537 |   |   | 118 |   |   |
| Other income (expense), net                                                                                                 |       | (2                                         | )          | (94 | ) |   | 15 |   |   |
| Total other income, net                                                                                                     |       | 297                                        |       | 443 |   |   | 133 |   |   |
| Loss before  provision for (recovery from) income taxes                                                                     |       | (8,180                                     | )          | (5,152 | ) |   | (8,343 | ) |   |
| Provision for  (recovery from) income taxes                                                                                 |       | (31                                        | )          | 22 |   |   | 363 |   |   |
| Net loss                                                                                                                    |       | $                                          | (8,149     | ) | $ | (5,174 | ) |   | $ | (8,706 | ) |   |
| Net loss per  share—basic and diluted                                                                                  |       | $                                          | (0.24      | ) | $ | (0.15 | ) |   | $ | (0.27 | ) |   |
| Weighted average shares  used in calculating basic and diluted net loss per share        |       | 33,928                                     |       | 33,600 |   |   | 32,610 |   |   |

----

| *  Including stock-based compensation of:              |   |   |   |   |   |   |   |   |   |
|-------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Cost of product, services, maintenance and support  revenue |   | $      | 155    |   | $      | — |   |   | $      | — |   |   |
| Research and development                                    |   | 618    |   | — |   |   | — |   |   |
| Sales and marketing                                         |   | 497    |   | — |   |   | — |   |   |
| General and  administrative                                 |   | 764    |   | 100    |   |   | 24     |   |   |
|                                                             |        |        |        |        |        |        |        |        |        |  |  |  |

 

(1)          See Note 2“Correction of an Error” of the Notes to Consolidated Financial Statements

The accompanying notes are an integral part of these financial statements.

F-5

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**AVISTAR COMMUNICATIONS CORPORATIONCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)for the years ended December 31, 2006, 2005 and 2004(in thousands, except share amounts)**

| ** **                                                                      | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **        | ** ** | **Additional**  | ** ** | **Other**              | ** ** | ** **  | ** ** | **Total**                 | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-------------|------------|-------------------|------------|-----------------|------------|------------------------|------------|-------------|------------|---------------------------|------------|
| ** **                                                                      | ** ** | **Common Stock** | ** ** | **Treasury Stock** | ** ** | **Paid-In** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                      | ** ** | **shares**            | ** ** | **amount**              | ** ** | **shares**  | ** ** | **amount**        | ** ** | **Capital**     | ** ** | **Income (Loss)** | ** ** | **Deficit** | ** ** | **Equity (Deficit)** | ** ** |
| 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 |   |   |
| Issuance of common  stock to employees pursuant to employee stock purchase plan |       | 182,594               |       |                    | —     |        |       | —            |       |            | —     |                   |       |        | 143        |                      |       |   | — |   |   |   | — |   |   |   | 143 |   |   |
| Issuance of common  stock to employees pursuant to exercise of options          |       | 214,196               |       |                    | —     |        |       | —            |       |            | —     |                   |       |        | 271        |                      |       |   | — |   |   |   | — |   |   |   | 271 |   |   |
| Non-employee  stock-based compensation                                          |       | —                |       |                    | —     |        |       | —            |       |            | —     |                   |       |        | 100        |                      |       |   | — |   |   |   | — |   |   |   | 100 |   |   |
| Unrealized loss on  short and long-term investments                             |       | —                |       |                    | —     |        |       | —            |       |            | —     |                   |       |        | —     |                      |       |   | (12 | ) |   |   | — |   |   |   | (12 | ) |   |
| Net loss                                                                        |       | —                |       |                    | —     |        |       | —            |       |            | —     |                   |       |        | —     |                      |       |   | — |   |   |   | (5,174 | ) |   |   | (5,174 | ) |   |
| Balance at  December 31, 2005                                              |       | 34,939,124            |       |                    | 35         |        |       | 1,181,625         |       |            | (53        | )                      |       |        | 90,519     |                      |       |   | (12 | ) |   |   | (94,647 | ) |   |   | (4,158 | ) |   |
| Issuance of common  stock to employees pursuant to employee stock purchase plan |       | 225,657               |       |                    | —     |        |       | —            |       |            | —     |                   |       |        | 266        |                      |       |   | — |   |   |   | — |   |   |   | 266 |   |   |
| Issuance of common  stock to employees pursuant to exercise of options          |       | 54,987                |       |                    | —     |        |       | —            |       |            | —     |                   |       |        | 46         |                      |       |   | — |   |   |   | — |   |   |   | 46 |   |   |
| Non-employee  stock-based compensation                                          |       | —                |       |                    | —     |        |       | —            |       |            | —     |                   |       |        | 93         |                      |       |   | — |   |   |   | — |   |   |   | 93 |   |   |
| Employee  stock-based compensation                                              |       | —                |       |                    | —     |        |       | —            |       |            | —     |                   |       |        | 1,941      |                      |       |   | — |   |   |   | — |   |   |   | 1,941 |   |   |
| Unrealized gain on  short and long-term investments                             |       | —                |       |                    | —     |        |       | —            |       |            | —     |                   |       |        | —     |                      |       |   | 12 |   |   |   | — |   |   |   | 12 |   |   |
| Net loss                                                                        |       | —                |       |                    | —     |        |       | —            |       |            | —     |                   |       |        | —     |                      |       |   | — |   |   |   | (8,149 | ) |   |   | (8,149 | ) |   |
| Balance at  December 31, 2006                                              |       | 35,219,768            |       |                    | $          | 35          |       |              | 1,181,625  |            |       | $                      | (53        | )           |       |                      | $          | 92,865 |   |   |   | $ | — |   |   |   | $ | (102,796 | ) |   |   | $ | (9,949 | ) |   |

 

The accompanying notes are an integral part of these financial statements.

F-6

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**AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSfor the years ended December 31, 2006, 2005 and 2004(in thousands)**
|                                                                                            | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                 | ** ** | ** **                                 | ** ** | ** ** | ** ** | **Restated(1)** | ** ** |
| Cash Flows from  Operating Activities:                                                     |       |                                       |       |   |   |   |   |   |   |
| Net loss                                                                                   |       | $                                          | (8,149     | ) | $ | (5,174 | ) |   | $ | (8,706 | ) |   |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                                       |       |   |   |   |   |   |   |
| Depreciation                                                                               |       | 345                                        |       | 273 |   |   | 339 |   |   |
| Employee stock-based compensation                                                          |       | 1,941                                      |       | — |   |   | — |   |   |
| Compensation on options issued to consultants                                              |       | 93                                         |       | 100 |   |   | 24 |   |   |
| Provision for doubtful accounts                                                            |       | (70                                        | )          | 99 |   |   | 77 |   |   |
| Changes in assets  and liabilities:                                                        |       |                                       |       |   |   |   |   |   |   |
| Accounts receivable                                                                        |       | 89                                         |       | (641 | ) |   | (268 | ) |   |
| Inventories                                                                                |       | (37                                        | )          | 62 |   |   | 200 |   |   |
| Prepaid expenses and other current assets                                                  |       | (71                                        | )          | (9 | ) |   | 61 |   |   |
| Deferred settlement and patent licensing costs                                             |       | 1,294                                      |       | 1,256 |   |   | (6,197 | ) |   |
| Other assets                                                                               |       | 84                                         |       | (85 | ) |   | 5 |   |   |
| Accounts payable                                                                           |       | 574                                        |       | (101 | ) |   | 164 |   |   |
| Deferred income from settlement and patent licensing  and other                            |       | (5,481                                     | )          | (5,445 | ) |   | 26,754 |   |   |
| Deferred services revenue and customer deposits                                            |       | 1,267                                      |       | (36 | ) |   | 77 |   |   |
| Accrued liabilities and other                                                              |       | 772                                        |       | 204 |   |   | 162 |   |   |
| Net cash (used in) provided by operating activities                                        |       | (7,349                                     | )          | (9,497 | ) |   | 12,692 |   |   |
| Cash Flows from  Investing Activities:                                                     |       |                                       |       |   |   |   |   |   |   |
| Purchase of short and long-term investments                                                |       | —                                     |       | (3,965 | ) |   | — |   |   |
| Maturities of short and long-term investments                                              |       | 3,965                                      |       | — |   |   | 1,000 |   |   |
| Purchase of property and equipment                                                         |       | (290                                       | )          | (392 | ) |   | (179 | ) |   |
| Net cash provided by (used in) investing activities                                        |       | 3,675                                      |       | (4,357 | ) |   | 821 |   |   |
| Cash Flows from  Financing Activities:                                                     |       |                                       |       |   |   |   |   |   |   |
| Proceeds from line of credit                                                               |       | 3,000                                      |       | — |   |   | — |   |   |
| Proceeds from issuance of common stock                                                     |       | 312                                        |       | 414 |   |   | 3,707 |   |   |
| Repurchases of common stock                                                                |       | —                                     |       | — |   |   | (2 | ) |   |
| Net cash provided by financing activities                                                  |       | 3,312                                      |       | 414 |   |   | 3,705 |   |   |
| Net (decrease) increase in cash and cash equivalents                                       |       | (362                                       | )          | (13,440 | ) |   | 17,218 |   |   |
| Cash and cash equivalents, beginning of year                                               |       | 8,216                                      |       | 21,656 |   |   | 4,438 |   |   |
| Cash and cash equivalents, end of year                                                     |       | $                                          | 7,854      |   | $ | 8,216 |   |   | $ | 21,656 |   |   |
| Supplemental Cash Flow  Information:                                                       |       |                                       |       |   |   |   |   |   |   |
| Cash paid for income taxes                                                                 |       | $                                          | —     |   | $ | 357 |   |   | $ | 60 |   |   |
| Cash paid for  interest                                                                    |       | $                                          | 2          |   | $ | 1 |   |   | $ | 6 |   |   |

----

(1)          See Note2 “Correction of an Error” of the Notes to Consolidated Financial Statements

The accompanying notes are an integral part of these financial statements.

F-7

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**AVISTAR COMMUNICATIONSCORPORATION AND SUBSIDIARIESNOTES TO FINANCIAL STATEMENTS**

**1.**                 Business, Organization, Reorganization, InitialPublic Offering, Basis of Presentation, and Risks and Uncertainties

**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 AvistarVOS softwareplatform, which facilitates distribution over local and wide area networksusing Internet or telephony services as appropriate. Avistar’s services includesoftware development, consulting, implementation, training, maintenance andsupport. In addition, Avistar seeks to prosecute, maintain, support and licensethe intellectual property developed by the Company through its wholly-ownedsubsidiary, Collaboration Properties, Inc., a Nevada corporation (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 and 2,171,400 sharesof common stock. Effective December 31, 1997, all operations previouslyconducted 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 byASC. Three of the stockholders of CPI and VCT owned approximately 95% of CPIand 100% 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 thebusiness were then contributed to a wholly owned subsidiary, Avistar SystemsCorporation (“Avistar Systems”), a Delaware corporation. At the same time, theowners of CPI and VCT transferred all of their stock in those entities toAvistar as a capital contribution. As a result, CPI and VCT are recorded attheir historical cost basis and became wholly owned subsidiaries of Avistar asof March 31, 2000. In April 2000, the operations of VCT were mergedwith 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 inASLP. In addition, all of the shares of Avistar’s common stock, held by ASLP,were distributed to the Company’s employees, former advisors and officers.These common shares represent an amount equal to those shares of Class Bunits in ASLP that were owned by the respective individuals before theacquisition.

F-8

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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 proceedshave been used to fund the Company’s working capital requirements.

**Basis of Presentation**

The accompanying financialstatements present the consolidated financial position, results of operations,and cash flows of Avistar and its two wholly-owned operating subsidiaries,Avistar Systems U.K. Limited (“ASUK”) and CPI after elimination of allintercompany accounts and transactions. The consolidated results are referredto, collectively, as those of Avistar or the Company in these notes. TheCompany has prepared the accompanying consolidated financial statements inconformity with accounting principles generally accepted in the United Statesof America.

The functional currency of ASUK is the United Statesdollar. Accordingly, all gains and losses resulting from transactionsdenominated in currencies other than the United States dollar are included inthe statements of operations and have not been material.

TheCompany’s fiscal year end is December 31.

**Reclassifications**

Certainprior year amounts have been reclassified to conform with the current year’spresentation, none of which had an impact on total assets, stockholders’ equity(deficit), net loss, or net loss per share.

**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$102.8 million as of December 31, 2006. The Company’s operating resultsmay fluctuate 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 

F-9

----

marketdevelopments, the costs involved in maintaining, enforcing and defending patentclaims and other intellectual property rights, the level and timing of revenue,and other factors.

**2.**                 Correction of an Error

In September 2005, the Company received a commentletter from the U. S. Securities and Exchange Commission (“SEC”) relating tothe Company’s 2004 Form 10-K, which included a question regardingthe Company’s accounting for the November 2004 settlement and patentcross-license agreement with Polycom, Inc. (“Polycom”). The settlement andpatent cross-license agreement resulted in a $27.5 million one-time payment byPolycom to Avistar and a payment by Avistar to its own litigation counsel of$6.4 million in contingent legal fees. The Company’s Form 10-K forthe fiscal year ended December 31, 2004 and Form 10-Q for thethree, six and nine months ended March 31, 2005, June 30, 2005 and September 30,2005, respectively, reported the one time payment by Polycom as revenue,recognized ratably over a five-year period, net of contingent legal fees. As aresult of the SEC’s inquiry as to whether the Polycom transaction should becharacterized as revenue, and after discussions with the SEC, the Companyconcluded that a reclassification of license revenues from revenue to acomponent of operating expenses and reflected as “Income from settlement and patentlicensing” was necessary for previously filed financial reports. Therestatement of the net proceeds and expenses from the Polycom settlement andpatent cross-license agreement had no effect on reported net loss, loss pershare, stockholders’ equity (deficit) or net cash flows from operating,investing or financing activities, but did have the effect of overstatingrevenues and operating expenses for previously issued interim and annualconsolidated financial statements, as of and for the quarters and year-to-dateperiods ended December 31, 2004, March 31, 2005, June 30, 2005and September 30, 2005. In addition, the balance sheet as of December 31,2004 was restated to reflect the gross effect of the $27.5 million payment byPolycom to Avistar, and the payment of $6.4 million of contingent legal fees byAvistar, which was previously reported on a net basis as deferred revenue.Notes 3, 12 and 14 regarding significant concentrations, revenuerecognition, segment reporting and the unaudited interim results have beenrestated to reclassify the Polycom proceeds from revenue to “Income fromsettlement and patent licensing,” to be consistent with the presentation of thenet proceeds from the Polycom settlement and patent cross-license agreement inthe 2006 and 2005 Statements of Operations. The presentation within operationsis supported by a determination that the Polycom licensing transaction iscentral to the activities that constitute the Company’s ongoing major orcentral operations, but that the settlement may also contain a gain elementrelated to the settlement, which is not considered revenue under the FinancialAccounting Standards Board (“FASB”) Concepts Statement No. 6, *Elements of Financial Statements.* TheCompany did not have sufficient historical evidence to support a reasonabledetermination of value for purposes of segregating the transaction into revenuerelated to the patent licensing and an operating or non-operating gain uponsettlement of litigation, resulting in the determination that the entiretransaction is more appropriately classified as “Income from settlement andpatent licensing” within operations, as opposed to revenue.

Thefollowing table presents the impact of the adjustment to the consolidatedstatement of operations and cash flows for the fiscal year ended December 31,2004 (in thousands):

| ** **                                  | ** ** | **Year Ended December 31, 2004** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                  | ** ** | **As  Previously  Reported**                         | ** ** | **Adjustment** | ** ** | **As  Restated** | ** ** |
| **Statement of Operations**                 |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Revenues:                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Licensing revenue                           |       |                                                 | $          | 575 |   |   |   | $ | (575 | ) |   |   | $ | — |   |   |
| Costs and expenses:                         |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Income from settlement and patent licensing |       |                                                 | $          | — |   |   |   | $ | (575 | ) |   |   | $ | (575 | ) |   |

 

F-10

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| ** **                                           | ** ** | **Year Ended December 31, 2004** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                           | ** ** | **As  Previously  Reported**                         | ** ** | **Adjustment** | ** ** | **As  Restated** | ** ** |
| **Statement of Cash Flows**                          |       |                                                 |       |   |   |   |   |   |   |   |   |
| Cash  flows from Operating Activities:               |       |                                                 |       |   |   |   |   |   |   |   |   |
| Deferred settlement and patent  licensing costs      |       |                                                 | $          | — |   |   |   | $ | (6,197 | ) |   | $ | (6,197 | ) |
| Deferred license revenue                             |       |                                                 | 20,557     |   |   |   | (20,557 | ) |   | — |   |
| Deferred income from settlement and patent licensing |       |                                                 | $          | — |   |   |   | $ | 26,754 |   |   | $ | 26,754 |   |

 

Theabove adjustments correct an error within the meaning of the AccountingPrinciples Board Opinion No. 20, *Accounting Changes.*

**3.**                 Summary of Significant Accounting Policies andBalance Sheet Details

**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, income and expenses during the period. Actualresults could differ from those estimates.

**Cash and Cash Equivalents and Short and Long-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. Auction rate securities with original or remaining maturities ofmore than three months are considered short-term investments even if they aresubject to repricing within three months. Investment securities with originalor remaining maturities of one year or more are considered long-term investments.The Company’s cash equivalents at December 31,2006 and 2005 consisted of money market funds and short-term commercial paperwith original maturities of three months or less.

The Company accounts for its short-term and long-terminvestments in accordance with Statement of Financial Accounting Standards(SFAS) No. 115, *Accounting for CertainInvestments in Debt and Equity Securities*. The Company’s short andlong-term investments in securities are classified as available-for-sale andare reported at fair value, with unrealized gains and losses, net of tax,recorded in other comprehensive income (loss). Realized gains or losses anddeclines in value judged to be other than temporary, if any, on available-for-sale securities are reported in other income, net. The Company reviews thesecurities for impairments considering current factors including the economicenvironment, market conditions and the operational performance and otherspecific factors relating to the business underlying the securities. The Companyrecords impairment charges equal to the amount that the carrying value of itsavailable-for-sale securities exceeds the estimated fair market value of thesecurities as of the evaluation date. The fair value for publicly heldsecurities is determined based on quoted market prices as of the evaluationdate. In computing realized gains and losses on available-for-sale securities,the Company determines cost based on amounts paid, including direct costs suchas commissions, to acquire the security using the specific identificationmethod. The Company had no short or long-term investment securities as of December 31,2006.

F-11

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Cash,cash equivalents, short and long-term investments consisted of the following atDecember 31, 2006 and 2005 (in thousands):

| ** **                                                              | ** **   | **December 31,** | ** **   |
|-------------------------------------------------------------------------|--------------|-----------------------|--------------|
| ** **                                                              | ** **   | **2006**              | ** **   | **2005** | ** ** |
| ***Description***                                                       | *** *** | *** ***          | *** *** | *** *** | *** *** |
| Cash and cash equivalents:                                              |         |                  |         |   |   |
| Cash                                                                    |         | $                     | 4,224        |   | $ | 549 |   |
| Commercial paper cash  equivalents                                      |         | 3,630                 |         | 7,667 |   |
| Total cash and cash  equivalents                                        |         | 7,854                 |         | 8,216 |   |
| Short-term investments:                                                 |         |                  |         |   |   |
| Short-term investments (average  60 remaining days to maturity in 2005) |         | —                |         | 2,995 |   |
| Total cash and cash  equivalents and short term-investments             |         | 7,854                 |         | 11,211 |   |
| Long-term-investments(average 390 remaining days to maturity in 2005)   |         | —                |         | 958 |   |
| Total cash, cash equivalents and short- term and long-term investments  |         | $                     | 7,854        |   | $ | 12,169 |   |

 

**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 for each fiscal year are as follows:

| ** **  | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------|------------|----------|------------|----------|------------|----------|------------|
| Customer A  |       |     | 38         | %        |       |     | *          | % |   |   | * | % |   |
| Customer B  |       |     | 25         | %        |       |     | 39         | % |   |   | 55 | % |   |
| Customer  C |       |     | 20         | %        |       |     | 45         | % |   |   | 16 | % |   |

----

*                    Lessthan 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, or restrict placement of these investments tofinancial institutions evaluated as highly credit worthy. As of December 31,2006, the Company had cash and cash equivalents on deposit with a majorfinancial institution that were in excess of FDIC insured limits. Historically,the Company has not experienced any loss of its cash and cash equivalents dueto such concentration of credit risk. Concentrations of credit risk withrespect to trade receivables relate to those trade receivables from both UnitedStates and foreign entities, primarily in the financial services industry. Asof December 31, 2006, three customers represented 44%, 20% and 20% of theCompany’s gross accounts receivable balance. As of December 31, 2005,three customers represented 48%, 32% and 17% of the Company’s gross accountsreceivable.

**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. Accounts are generally considered delinquent whenthirty days past due. Uncollectible accounts are written off directly to theallowance for 

F-12

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doubtfulaccounts. If the allowance for doubtful accounts was understated, operatingincome could be significantly reduced. The impact of any such change ordeviation may be increased by the Company’s reliance on a relatively smallnumber of customers for a large portion of its total  revenue.

**Fair Value ofFinancial Instruments**

Thecarrying amounts of the Company’s financial assets and liabilities, includingcash and cash equivalents, short -term investments, accounts receivable, lineof credit,  and accounts payable at December 31,2006 and 2005, 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.Inventories consisted of the following (in thousands):

| ** **                                             | ** ** | **December 31,_** | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|
| ** **                                             | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Raw materials and sub-assemblies                       |       | $                      | 59         |   | $ | 43 |   |
| Finished goods                                         |       | 583                    |       | 604 |   |
| Inventory shipped to customer sites, not yet installed |       | 70                     |       | 28 |   |
|                                                   |       | $                      | 712        |   | $ | 675 |   |

 

Inventory shipped tocustomer sites, not yet installed, represents product shipped to customer sitespending completion of the installation process by the Company. As of December 31,2006 and December 31, 2005, the Company had billed approximately $70,000and $28,000, respectively, to customers related to these shipments, but did notrecord the revenue, as the installations had not been completed and confirmedby the customer. Although customers are billed in accordance with purchasingagreements, 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 or five years) of the assets. Repairs and maintenance are expensedas incurred. Property and equipment consisted of the following (in thousands):

| ** **                        | ** ** | **December 31,** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Computer equipment                |       | $                     | 1,013      |   | $ | 876 |   |
| Computer software                 |       | 389                   |       | 364 |   |
| Furniture, fixtures and equipment |       | 304                   |       | 346 |   |
|                              |       | 1,706                 |       | 1,586 |   |
| Less: Accumulated depreciation    |       | (1,450                | )          | (1,275 | ) |
|                              |       | $                     | 256        |   | $ | 311 |   |

 

F-13

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**Accrued Liabilities and Other**

Accrued liabilities and other consisted of the following(in thousands):

| ** **                               | ** ** | **December 31,** | ** ** |
|------------------------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Accrued consulting and professional fees |       | $                     | 1,029      |   | $ | 570 |   |
| Accrued payroll and related benefits     |       | 705                   |       | 522 |   |
| Accrued commissions and bonuses          |       | 157                   |       | 116 |   |
| Other                                    |       | 372                   |       | 283 |   |
|                                     |       | $                     | 2,263      |   | $ | 1,491 |   |

 

**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 $0.7million, $0.4 million, and $0.1 million for 2006, 2005, and 2004, respectively,and are reflected in general and administrative expenses in the accompanyingstatements of operations.

**Revenue Recognition and Deferred Revenue**

The Company recognizes product and services revenue inaccordance with Statement of Position (“SOP”) 97-2, Software Revenue Recognition (“SOP 97-2”),as amended by SOP 98-9, Modificationof SOP 97-2, Software Revenue Recognition, With Respect to CertainTransactions**(“SOP 98-9”).The Company derives product revenue from the sale and licensing of a set ofdesktop (endpoint) products (hardware and software) and infrastructure products(hardware and software) that combine to form an Avistar video-enabledcollaboration solution. Services revenue includes revenue from installationservices, post-contract customer support, training and software development.The installation services that the Company offers to customers relate to thephysical set-up and configuration of desktop and infrastructure components ofthe Company’s solution. The fair value of all product, installation services,post-contract customer support and training offered to customers is determinedbased on the price charged when such products or services are sold separately.

Arrangements thatinclude multiple product and service elements may include software and hardwareproducts, as well as installation services, post-contract customer support andtraining. Pursuant to SOP 97-2, the Company recognizes revenue whenall of the following criteria are met: (i) persuasive evidence of anarrangement exists, (ii) delivery has occurred, (iii) the fee isfixed or determinable, and (iv) collectibility is probable. The Companyapplies these criteria as discussed below:

·       *Persuasive evidence of an arrangement exists*. The Companyrequires a written contract, signed by both the customer and the Company, or apurchase order from those customers that have previously negotiated a standardend-user license arrangement or volume purchase agreement, prior to recognizingrevenue on an arrangement.

·       *Delivery has occurred*. The Company delivers software andhardware to customers physically. The standard delivery terms are FOB shippingpoint.

·       *The fee is fixed or determinable*. The Company’sdetermination that an arrangement fee is fixed or determinable dependsprincipally on the arrangement’s payment terms. The Company’s standard termsgenerally require payment within 30 to 90 days of the date of invoice. Wherethese terms apply, the Company regards the fee as fixed or determinable, andrecognizes revenue upon delivery (assuming other revenue recognition criteriaare met). If the payment terms do not meet this standard, but rather, involve “extendedpayment terms,” the fee may not be considered to be fixed 

F-14

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or determinable and therevenue would then be recognized when customer installments are due andpayable.

·       *Collectibility is probable*. To recognize revenue, theCompany judges collectibility of the arrangement fees on a customer-by-customerbasis pursuant to a credit review policy. The Company typically sells tocustomers with which it has had a history of successful collections. 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.

If there are any undelivered elements, the Companydefers revenue for those elements, as long as Vendor Specific ObjectiveEvidence (“VSOE”) exists for the undelivered elements. Additionally, perparagraph 14 of SOP 97-2, when the Company provides installationservices, the product and installation revenue is recognized upon completion ofthe installation process and receipt of customer confirmation, subject to thesatisfaction of the revenue recognition criteria described above. The Companybelieves that the fee associated with the delivered product elements does notmeet the collectibility criteria if the installation services have not beencompleted. Customer confirmation is obtained and documented by means of astandard form indicating the installation services have been provided and thehardware and software components installed. When the customer or a third partyprovides installation services, the product revenue is recognized uponshipment, subject to satisfaction of the revenue recognition criteria describedabove.

Payment for product is due upon shipment, subject tospecific payment terms. Payment for installation and professional services isdue upon providing the services, subject to specific payment terms.Reimbursements received for out-of-pocket expenses and shipping costs incurredduring installation and support services, which have not been significant todate, are recognized as revenue in accordance with Emerging Issues Task Force (“EITF”)Issue No. 01-14 (“EITF 01-14”), Income Statement Characterization of Reimbursements Received for “Outof Pocket” Expenses Incurred.

The price charged for maintenance and/or support isdefined in the contract, and is based on a fixed price for both hardware andsoftware components as stipulated in the customer agreement. Customers have theoption to renew the maintenance and/or support arrangement in subsequentperiods at the same or similar rate as paid in the initial year subject tocontractual adjustments for inflation in some cases. Revenue from maintenanceand support services is deferred and recognized pro-rata over the maintenanceand/or support term, which is typically one year in length. Payments forservices made in advance of the provision of services are recorded as deferredrevenue and customer deposits in the accompanying balance sheets. Trainingservices are offered independently of the purchase of product. The value ofthese training services is determined based on the price charged when suchservices are sold separately. Training revenue is recognized upon performanceof the service.

The Company recognizes service revenue from softwaredevelopment contracts in accordance with SOP 81-1, Accounting for Performance ofConstruction-Type and Certain Production-Type Contracts. Revenue relatedto contracts for software development is recognized using the percentage ofcompletion method, when all of the following conditions are met: a contractexists with the customer at a fixed price, the Company has fulfilled all of itsmaterial contractual obligations to the customer for each deliverable of the contract,verification of completion of the deliverable has been received, and collectionof the receivable is probable. The amounts billed to customers in excess ofrevenues recognized to date are deferred and recorded as deferred revenue andcustomer deposits in the accompanying balance sheets. Assumptions used forrecording revenue and earnings are adjusted in the period of change to reflectrevisions in contract value and estimated costs to complete the contract. Anyanticipated losses on contracts in progress are charged to earnings whenidentified.

F-15

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The Company also derives revenue from the licensing ofits intellectual property portfolio. The Company recognizes revenue from thelicensing of its intellectual property portfolio according to SOP 97-2,based on the terms of the royalty, partnership and cross-licensing agreementsinvolved. In the event that a license to the Company’s intellectual property isgranted after the commencement of litigation proceedings between the Companyand the licensee, the proceeds of such transaction are recognized as licensingrevenue by us only if sufficient historical evidence exists for thedetermination of fair value of the licensed patents to support the segregationof the proceeds between a gain on litigation settlement and patent licenserevenues consistent with Financial Accounting Standards Board (“FASB”) ConceptsStatement No. 6, *Elements of FinancialStatements*. As of December 31, 2006, these criteria forrecognizing license revenue following the commencement of litigation had notbeen met.

On July 17, 2006,Avistar and CPI entered into a Patent License Agreement with Sony Corporation (“Sony”)and Sony Computer Entertainment, Inc. (“SCEI”). Under the licenseagreement, CPI granted Sony and its subsidiaries a license to all of CPI’spatents with a filing date on or before January 1, 2006 for a specificfield of use relating to video conferencing. The license covers Sony’s videoconferencing apparatus as well as other products, including video-enabledpersonal computer products and certain SCEI PlayStation products. The$5.0 million upfront payment was recognized by the Company as licensingrevenue in the three months ending September 30, 2006 and future royaltypayments, if any, will be recognized as they occur in accordance withSOP 97-2.

**Income from Settlement and Patent Licensing**

The Company recognizes the proceeds from settlementand patent licensing agreements based on the terms involved. When litigationhas been filed prior to a settlement and patent licensing agreement, andinsufficient historical evidence exists for the determination of fair value ofthe patents licensed to support the segregation of the proceeds between a gainon litigation settlement and patent license revenues, the Company reports allproceeds in “income from settlement and patent licensing” within operatingcosts and expenses. The gain portion of the proceeds, when sufficienthistorical evidence exists to segregate the proceeds, would be reported inother income according to SFAS No. 5, *Accountingfor Contingencies*. When a patent license agreement is entered intoprior to the commencement of litigation, the Company reports the proceeds ofsuch transaction as licensing revenue in the period in which such proceeds arereceived, subject to the revenue recognition criteria described above.

On November 12, 2004, theCompany entered into a settlement and a patent cross-license agreement  with Polycom, thus ending litigation againstPolycom for patent infringement. As part of the settlement and patent cross-licenseagreement with Polycom, Avistar granted Polycom a non-exclusive, fully paid-uplicense to its entire patent portfolio. The settlement and patent cross-licenseagreement includes a five year capture period from the date of the settlement,adding all new patents with a priority date extending up to five years from thedate of execution of the agreement. Polycom, as part of the settlementand patent cross-licensing agreement, made a one time payment to the Company of$27.5 million and Avistar paid $6.4 million in contingent legal fees to Avistar’slitigation counsel upon completion of the settlement and patent cross-licensingagreement. The contingent legal fees were payable only in the event of afavorable outcome from the litigation with Polycom. The Company expects to recognize the gross proceeds of $27.5 million fromthe settlement and patent cross-license agreement as income from settlement andpatent licensing within operations over the five-year capture period, due to alack of evidence necessary to apportion the proceeds between an impliedpunitive gain element in the settlement of the litigation, and software licenserevenues from the cross-licensing of Avistar’s patented technologies for prior and future use by Polycom. Additionally,the $6.4 million in contingent legal fees was deferred and is expected to beamortized to income from settlement and patent licensing over the five yearcapture period, resulting in a net of $21.1million being recognized as income within operations over the five year captureperiod.

F-16

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Thepresentation within operating expenses is supported by a determination that thetransaction is central to the activities that constitute Avistar’songoing major or central operations, but may contain a gain element related tothe settlement, which is not considered as revenue under the FinancialAccounting Standards Board (“FASB”) Concepts Statement No. 6, *Elements of Financial Statements.* The Company did not havesufficient historical evidence to support a reasonable determination of valuefor the purposes of segregating the transaction into revenue related to thepatent licensing and an operating or non-operating gain upon settlement oflitigation, resulting in the determination that the entire transaction is moreappropriately classified as “income from settlement and patent licensing”within operations, as opposed to revenue.  See Note 2 “Correction of an Error.”

**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 $1,000 as of December 31, 2006 and$1,000 as of December 31, 2005, and was included in accrued liabilities inthe accompanying balance sheets.

**Research andDevelopment**

Research and developmentcosts include engineering expenses, such as salaries and related benefits,depreciation, professional services and overhead expenses related to thegeneral development of Avistar’s products, and are expensed as incurred.Software development costs are capitalized beginning when a product’stechnological feasibility has been established and ending when a product isavailable for general release to customers. Avistar has not capitalized anysoftware development costs since the period between establishing technologicalfeasibility is relatively short, and these costs have not been significant.

**Stock-Based Compensation**

On December 16, 2004, the Financial AccountingStandards Board issued SFAS No. 123 (revised 2004), Share-BasedPayment (“SFAS No. 123R”), which establishes the accounting forstock-based awards granted for employee services. Effective January 1,2006, the Company adopted the fair value recognition provisions of SFAS No. 123R,using the modified prospective transition method and therefore has not restatedresults for prior periods. Under this transition method, stock-basedcompensation expense for fiscal 2006 includes compensation expense for allstock-based compensation awards granted prior to, but not yet vested as of January 1,2006, based on the grant date fair value estimated in accordance with theoriginal provision of SFAS No. 123, Accounting for Stock-BasedCompensation (“SFAS No. 123”). Stock-based compensation expense forall stock-based compensation awards granted after January 1, 2006 is basedon the grant-date fair value estimated in accordance with the provisions ofSFAS No. 123R. The Company recognizes these compensation costs on astraight-line basis over the requisite service period of the award. In March 2005,the SEC issued Staff Accounting Bulletin No. 107 (“SAB No.107”)regarding the SEC’s interpretation of SFAS No. 123R and the valuation ofshare-based payments for public companies. The Company has applied theprovisions of SAB 107 in its adoption of SFAS No. 123R. Avistarincurred $1.9 million in employee stock-based compensation in 2006 due toadoption of SFAS No. 123R and SAB No. 107, all of which was recordedto net loss in 2006. Had the Company continued to account for stock-basedcompensation under Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees (“APBNo. 25”), and related interpretations, no employee compensationexpense would have been recorded in 2006. The impact on both basic and dilutedloss per share for the year ended December 31, 2006  was $0.06 per share.

In November 2005, the FASB issued FASB StaffPosition SFAS No. 123R-3, Transition Election Related to Accountingfor the Tax Effects of Share-Based Payment Awards, which provides a practicalexception when a company transitions to the accounting requirements in SFAS No. 123R.SFAS No. 123R 

F-17

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requires a company tocalculate the pool of excess tax benefits available to absorb tax deficienciesrecognized subsequent to adopting SFAS No. 123R, otherwise know as the “APICPool”, assuming the company had been following the recognition provisionsprescribed by SFAS No. 123. Avistar has elected to use the shortcut methodunder FASB Staff Position SFAS No. 123R-3 to calculate our APICPool.

TheCompany previously applied APB No. 25 and provided the required pro formadisclosures of SFAS No. 123. Prior to the adoption of SFAS No. 123R,the Company provided the disclosures required under SFAS No. 123 asamended by SFAS No. 148, Accounting for Stock-Based Compensation—Transitionand Disclosures. The pro forma information for 2005 and 2004 was as follows andillustrates the effect on net loss if the fair-value-based methodhad been applied to all outstanding and unvested awards in each period (inthousands, except per share data): 

| ** **                                                                                                                   | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **(in thousands)**                    | ** ** |
| ** **                                                                                                                   | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Net loss, as reported                                                                                                        |       | $                                          | (5,174     | ) | $ | (8,706 | ) |
| Add stock-based employee compensation expense  included in reported net loss, net of tax                                |       | —                                     |       | — |   |
| Deduct total stock-based employee compensation expense determined  under fair-value-based method for all  awards, net of tax |       | (1,886                                     | )          | (2,206 | ) |
| Pro forma net loss                                                                                                           |       | $                                          | (7,060     | ) | $ | (10,912 | ) |
| Basic and diluted net loss per share                                                                                         |       |                                       |       |   |   |
| As reported                                                                                                                  |       | $                                          | (0.15      | ) | $ | (0.27 | ) |
| Pro forma                                                                                                                    |       | $                                          | (0.21      | ) | $ | (0.33 | ) |

 

Theweighted average fair value of options granted during 2005 and 2004 estimatedon the date of grant using the Black-Scholes-Merton option pricing model was$2.40 and $1.10, respectively. The Black-Scholes-Merton option-pricing modelwas developed for use in estimating the fair value of traded options that haveno vesting restrictions and are fully transferable. In addition, option-pricingmodels require the input of highly subjective assumptions, including a factorto represent expected stock price volatility. Because the Company’s employeestock options have characteristics significantly different from those of tradedoptions, and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in management’s opinion, the existing models donot necessarily provide a reliable single measure of the fair value of theCompany’s options. Although the fair value of employee stock options isdetermined in accordance with SFAS No. 123R and SAB 107 using anoption-pricing model, that value may not be indicative of the fair valueobserved in a willing buyer/willing seller market transaction. The effects ofapplying SFAS No. 123 for providing pro forma disclosure for 2005 and2004 are not likely to be representative of the effects on reported net incomeand net income per share for future years since options vest over severalyears, additional awards are made each year and stock-based compensation underSFAS No. 123R may be higher or lower than stock-based compensation underSFAS No. 123.

**Other Comprehensive Income**

SFAS No. 130 (“SFAS 130”),Reporting Comprehensive Income, establishes standards for the reporting and thedisplay of comprehensive income (loss) and its components. This standarddefines comprehensive income as the changes in equity of an enterprise, exceptthose resulting from stockholder transactions. Accordingly, comprehensiveincome includes certain changes in equity that are excluded from the net incomeor loss. The comprehensive loss was $8.1 million, $5.2 million and $8.7 millionfor the years ended 2006, 2005 and 2004, respectively.

F-18

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The components of comprehensive loss were as follows (inthousands):

| ** **                                                 | ** ** | **Year Ending December 31,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss                                                   |       | $                                           | (8,149     | ) | $ | (5,174 | ) | $ | (8,706 | ) |
| Other  comprehensive income (loss):                        |       |                                        |       |   |   |   |   |
| Change in net unrealized gains  and losses on  investments |       | 12                                          |       | (12 | ) | — |   |
| Total  comprehensive loss                                  |       | $                                           | (8,137     | ) | $ | (5,186 | ) | $ | (8,706 | ) |

 

**Recent Accounting Pronouncements**

In June 2006, the EmergingIssues Task Force issued EITF No.06-3, How Taxes Collected from Customersand Remitted to Governmental Authorities Should Be Presented in the IncomeStatement (That Is, Gross versus Net Presentation) (“EITF No.06-3”),which clarifies diversity in practice on the presentation of different types oftaxes in the financial statements. The Task Force concluded that, for taxeswithin the scope of the issue, a company may adopt a policy of presenting taxeseither gross within revenue or net. That is, it may include charges tocustomers for taxes within revenues and the charge for the taxes from thetaxing authority within cost of sales, or, alternatively, it may net the chargeto the customer and the charge from the taxing authority. If taxes subject tothis Issue are significant, a company is required to disclose its accountingpolicy for presenting taxes and the amounts of such taxes that are recognizedon a gross basis. The guidance in this consensus is effective for the firstinterim reporting period beginning after December 15, 2006. The Company iscurrently assessing the impact, if any, that the adoption EITF No.06-03will have on its financial statements.

In July 2006, the FASBissued FASB Interpretation No. 48, Accounting for Uncertainty in IncomeTaxes—An Interpretation of FASB Statement No. 109 (“FIN No. 48”),which became effective for the Company on January 1, 2007. Thisinterpretation clarifies the accounting for income tax benefits that areuncertain in nature. Under FIN No. 48, a company will recognize a taxbenefit in the financial statements for an uncertain tax position only ifmanagement’s assessment is that its position is “more likely than not” (i.e., agreater than 50 percent likelihood) to be upheld on audit based only onthe technical merits of the tax position. This accounting interpretation alsoprovides guidance on measurement methodology, derecognition thresholds,financial statement classification and disclosures, interest and penaltiesrecognition, and accounting for the cumulative-effect adjustment. The newinterpretation is intended to provide better financial statement comparabilityamong companies.

Required annual disclosuresinclude a tabular reconciliation of unrecognized tax benefits at the beginningand end of the period; the amount of unrecognized tax benefits that, if recognized,would affect the effective tax rate; the amounts of interest and penaltiesrecognized in the financial statements; any expected significant impacts fromunrecognized tax benefits on the financial statements over the subsequent 12-monthreporting period; and a description of the tax years remaining to be examinedin major tax jurisdictions. FIN No. 48 is effective for fiscal years beginning on or after December 15,2006. The Company is currently assessing the impact, if any, that the adoptionof FIN No. 48 will have on its financial statements.

In September 2006, the FASBissued FASB Statement No. 157, Fair Value Measurements (“FAS No. 157”),which will become effective for the Company on January 1, 2008. Thisstandard defines fair value, establishes a framework for measuring fair valueand expands disclosures about fair value measurements. The Statement does notrequire any new fair value measurements but would apply to assets andliabilities that are required to be recorded at fair value under otheraccounting standards. The impact, if any, to the Company from the adoption ofFAS 157 in 2008 will depend on the Company’s assets and liabilities at thattime that they are required to be measured at fair value.

F-19

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In September 2006,the SEC issued Staff Accounting Bulletin (“SAB”) SAB No. 108.SAB No. 108 provides guidance on how prior year misstatements shouldbe taken into consideration when quantifying misstatements in current yearfinancial statements for purposes of determining whether the current year’sfinancial statements are materially misstated. SAB No. 108 permitsregistrants to record the cumulative effect of initial adoption by recordingthe necessary “correcting” adjustments to the carrying values of assets andliabilities as of the beginning of the 2006 year with the offsetting adjustment recorded to the opening balance ofretained earnings. SAB No. 108 is effective for fiscal years endingon or after November 15, 2006. The application of SAB No. 108 did nothave any impact on the Company’s consolidated balance sheets, statements ofoperations or statements of stockholders’ equity (deficit) for 2006, 2005 or2004.

**4.**                 Line of Credit

On December 23, 2006,the Company entered into a Revolving Credit and Promissory Note and a SecurityAgreement with a financial institution to borrow up to $10.0 million under arevolving line of credit. The agreement includes a first priority securityinterest in all of our assets. Gerald Burnett, our Chairman and Chief ExecutiveOfficer, provided a collateralized guarantee to the financial institution,assuring payment of our obligations under the agreement and as a consequence,there are no restrictive covenants, allowing us greater access to the fullamount of the facility. The line of credit requires monthly interest-onlypayments based on LIBOR plus 0.75%, or 6.1% at December 31, 2006 or PrimeRate minus 2.0%, or 6.3% at December 31, 2006. On December 28, 2006,the Company borrowed $3.0 million under the revolving line of credit. TheRevolving Credit and Promissory Note matures on December 23, 2007, and issubject to annual renewal with the consent of the Company and the lender.

**5.**                 Commitments and Contingencies

At December 31, 2006, the Company had openpurchase orders and other contractual obligations of approximately $927,000,primarily related to inventory purchases. These purchase order commitments andcontractual obligations will be reflected in the Company’s financial statementsonce goods or services have been received, or payments related to theobligations become due.

The Company leases its facilities under operating leasesthat expire through March 2017. As of December 31, 2006, the futureminimum lease commitments under all leases were as follows (in thousands):

| **Year Ending December 31,** | ** ** | ** ** | ** ** | **Amount** | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| 2007                                        |       |       | $          | 1,091      |       |   |
| 2008                                        |       |       | 1,250      |       |       |
| 2009                                        |       |       | 1,129      |       |       |
| 2010                                        |       |       | 1,009      |       |       |
| 2011 and thereafter                         |       |       | 2,838      |       |       |
| Total  minimum lease payments               |       |       | $          | 7,317      |       |   |

 

Rentexpense under all operating leases for 2006, 2005 and 2004 was approximately$0.8 million, $0.7 million and $0.6 million, respectively.

F-20

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**SoftwareIndemnifications**

Avistar enters intostandard indemnification agreements in the ordinary course of business.Pursuant to these agreements, Avistar indemnifies, holds harmless, and agreesto reimburse the indemnified party for losses suffered or incurred by theindemnified party, generally Avistar’s business partners or customers, inconnection with any patent, copyright or other intellectual propertyinfringement claim by any third party with respect to its products. The term ofthese indemnification agreements is generally perpetual. The maximum potentialamount of future payments Avistar could be required to make under theseindemnification agreements is unlimited. Avistar has never incurred costs todefend lawsuits or settle claims related to these indemnification agreements.Accordingly, Avistar has no liabilities recorded for these agreements as of December 31,2006.

**6.**                 RelatedParty Transactions

Certaindirectors with controlling interests in the Company are also the majorityowners of one entity that conducted business with the Company, Vicor Inc. (“Vicor”).Descriptions of certain transactions between the Company and this relatedentity 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, 2006 and 2005, UBS Warburg LLC held lessthan 5% of the Company’s stock. Revenue from UBS Warburg LLC and its affiliatesrepresented 20%, 45% and 16% of total revenue for 2006, 2005 and 2004,respectively. Management believes the transactions with UBS Warburg LLC and itsaffiliates are at terms comparable to those provided to unrelated thirdparties. As of December 31, 2006 and 2005, the Company had accountsreceivable outstanding from UBS Warburg LLC and its affiliates of approximately$298,000 and $749,000, respectively.

Revenuefrom Vicor represented less than 10% of total revenue for 2006, 2005 and 2004.Management believes the transactions with Vicor are at terms comparable tothose provided to unrelated third parties. As of December 31, 2006 and2005, the Company did not have any accounts receivable outstanding from Vicor.

**Fees to Related Parties**

Robert P. Latta, a memberof the law firm Wilson Sonsini Goodrich & Rosati, a ProfessionalCorporation (“WSGR”), has served as a director of the Company since February 2001.Mr. Latta and WSGR have represented the Company and its predecessors ascorporate counsel since 1997. During 2006, 2005 and 2004, payments of $118,000,$119,000 and $114,000, respectively, were made to WSGR for legal servicesprovided to the Company. The Company had outstanding payables of $20,000 toWSGR as of December 31, 2006.

**7. Stockholders’Equity**

**Private Placement of Common Stock**

On March 26, 2004, the Company completed theprivate sale of a total of 3,000,000 shares of common stock to Fuller &Thaler Avalanche Fund, L.P. and Fuller & Thaler Behavioral FinanceFund, Ltd. at a price per share of $1.20. The net proceeds of this privatefinancing after deducting expenses of the financing were approximately $3.6million.

F-21

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**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, the Company repurchased 2,000 shares at an aggregate cost of $2,000. Noshares of common stock were repurchased by the Company during 2006 or 2005.

**Preferred Stock**

In April 2000,the stockholders 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, 2006, the Company had 10,000,000 shares of convertiblepreferred stock authorized, at $0.001 per share par value. No shares ofconvertible preferred stock were issued or outstanding as of December 31,2006.

**8.**                 Stock Option 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 have had acontractual life of ten years.

Optionsgranted under the plan vested over a four-year period, with 25% vesting afterone year and the remaining balance vesting 6.25% per quarter. At December 31,2006, options to purchase a total of 798,400 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 an increase of 1,004,936 shares. In January 2002, theBoard approved an increase of 1,007,858 shares. In January 2003, the Boardapproved an increase of 1,011,957 shares. In January 2004, 2005 and 2006the Board approved an increase of 1,200,000 shares. As of December 31,2006, a total of 9,624,751 shares had been reserved for issuance under the 2000Plan. The contractual term of the options granted under this plan may notexceed 10 years and in the case of the grantees who own more than 10% of theCompany’s outstanding stock at the time of grant, the contractual term of theoption may not exceed five years. Options granted under the 2000 Plan vest andbecome exercisable as set forth in each option agreement; generally one quartervest after one year and one-twelfth vest quarterly thereafter. In the event ofa merger or sale of substantially all assets, these options must be assumed bythe successor and if not assumed, will fully vest. The 2000 Plan will terminatein 2010. As a result of past and future increases, a maximum of 15,000,000shares of common stock could be issued under the 2000 Plan. The Company grantedoptions to purchase approximately 1.4 million, 2.0 million and 1.3 millionshares under the plan in 2006, 2005 and 2004, respectively. At December 31,2006 options to purchase a total of 7,393,322 shares were outstanding under the2000 Plan and 1,858,643 options were available for future grant.

F-22

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**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 2004,2005 and 2006, the Board approved annual increases of 175,000 shares. As of December 31,2006, the Company has authorized a total of 989,000 shares for issuance underthis plan. As a result of past and future annual increases, a maximum of1,689,000 shares of common stock could be issued over the 10-year life ofthe plan. The Company granted options to purchase 145,000, 170,000 and 170,000shares under this plan in 2006, 2005 and 2004 respectively. At December 31,2006 options to purchase a total of 697,000 shares were outstanding under theDirector Plan and 230,750 options were available for future grant.

In April 2005, the board of directors authorizedfurther amendments to the Director Plan, subject to stockholder approval, to: (i) providethat annual grants under the plan shall take place on January 1 of eachyear starting in 2006, (ii) provide that, after the first year, optionsgranted under the plan vest at a rate of 1/48 per month rather than 1/4 peryear, (iii) provide that options granted under the plan shall continue tovest and be exercisable for so long as the option holder remains a director orconsultant to the Company, subject to the term of the option; (iv) extendthe time period for optionees to exercise options following the date on whichthey are no longer a director or consultant to the Company, and (v) toprovide the board of directors with the authority to make amendments to theDirector Plan applicable to all options granted under the Director Plan,including options granted prior to the effective date of the amendment. Theproposed amendments were approved by stockholders in June 2005 but did notaffect options already granted under the Director Plan prior to the effectivedate of the amendments.

A summary of the 1997 Plan, the 2000 Plan, and theDirector Plan activity and related information for the years ended December 31,2006, 2005 and 2004 is as follows:

| ** **                       | ** ** | ** **                                        | ** ** | **Options Outstanding** | ** ** |
|----------------------------------|------------|---------------------------------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **Shares  Available for  Option Grant** | ** ** | **Shares**                   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| 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 |   |   |
| Authorized                       |       |                                              | 1,375,000  |                         |       | — |   |   | — |   |   |
| Granted                          |       |                                              | (2,180,500 | )                            |       | 2,180,500 |   |   | 2.71 |   |   |
| Exercised                        |       |                                              | —     |                         |       | (214,196 | ) |   | 1.27 |   |   |
| Expired                          |       |                                              | 150,000    |                         |       | (150,000 | ) |   | 9.35 |   |   |
| Canceled/repurchased             |       |                                              | 460,720    |                         |       | (484,720 | ) |   | 1.69 |   |   |
| Balance,  December 31, 2005 |       |                                              | 1,678,455  |                         |       | 7,979,647 |   |   | $ | 3.06 |   |   |
| Authorized                       |       |                                              | 1,375,000  |                         |       | — |   |   | — |   |   |
| Granted                          |       |                                              | (1,511,000 | )                            |       | 1,511,000 |   |   | 1.39 |   |   |
| Exercised                        |       |                                              | —     |                         |       | (54,987 | ) |   | 0.87 |   |   |
| Expired                          |       |                                              | 150,000    |                         |       | (150,000 | ) |   | 1.52 |   |   |
| Canceled                         |       |                                              | 396,938    |                         |       | (396,938 | ) |   | 1.72 |   |   |
| Balance, December 31,  2006 |       |                                              | 2,089,393  |                         |       | 8,888,722 |   |   | $ | 2.87 |   |   |

 

F-23

----

Thepretax intrinsic value of outstanding options is the difference between theclosing price of Avistar shares as quoted on the NASDAQ Capital Market for December 31,2006 and the exercise price, multiplied by the number of in-the-money options. Theaggregate intrinsic value of the options outstanding at December 31, 2006for all options outstanding was $3.3 million and $2.3 million for only vestedoptions outstanding. Vested and exercisable options outstanding atDecember 31, 2006 had a weighted average remaining contractual life of 5.4years. The intrinsic value of options changes based on the fair market value ofAvistar stock. The Company had 8,195,134 options vested and exercisable andexpected to be vested and exercisable at December 31, 2006 with a weightedaverage exercise price of $2.96, a weighted average remaining contractual termof 6.1 years, and an aggregate intrinsic value of $3.1 million. Totalintrinsic value of options exercised for the year ended December 31, 2006was $47,000.

| **Options Outstanding**            | ** ** | **Options Exercisable**                                 | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  Outstanding at  December 31, 2006** | ** ** | **Weighted-Average  Remaining  Contractual Life** | ** ** | **Weighted-Average  Exercise Price** | ** ** | **Number  Exercisable at  December 31, 2006** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
| $0.25  - 0.90                           |       |                                                         | 1,410,734  |   |   |   | 6.08 |   |   |   | $ | 0.83 |   |   |   | 1,187,135 |   |   |   | $ | 0.83 |   |   |
| $0.95  - 1.27                           |       |                                                         | 2,558,338  |   |   |   | 7.02 |   |   |   | 1.18 |   |   |   | 1,429,212 |   |   |   | 1.15 |   |   |
| $1.30  - 1.95                           |       |                                                         | 1,164,200  |   |   |   | 6.80 |   |   |   | 1.53 |   |   |   | 609,387 |   |   |   | 1.48 |   |   |
| $2.09  - 2.91                           |       |                                                         | 2,763,500  |   |   |   | 7.46 |   |   |   | 2.61 |   |   |   | 1,550,649 |   |   |   | 2.52 |   |   |
| $3.95  - 5.31                           |       |                                                         | 76,300     |   |   |   | 3.90 |   |   |   | 4.81 |   |   |   | 76,300 |   |   |   | 4.81 |   |   |
| $8.50                                   |       |                                                         | 437,700    |   |   |   | 3.71 |   |   |   | 8.50 |   |   |   | 437,700 |   |   |   | 8.50 |   |   |
| $17.25                                  |       |                                                         | 477,950    |   |   |   | 3.25 |   |   |   | 17.25 |   |   |   | 477,950 |   |   |   | 17.25 |   |   |
|                                    |       |                                                         | 8,888,722  |   |   |   | 6.59 |   |   |   | $ | 2.87 |   |   |   | 5,768,333 |   |   |   | $ | 3.43 |   |   |

 

As of December 31, 2006, the Company had anunrecognized stock-based compensation balance related to stock options ofapproximately $4.8 million before estimated forfeitures. SFAS No. 123R requiresforfeitures to be estimated at the time of grant and revised if necessary insubsequent periods if actual forfeitures differ from those estimates. Based onthe Company’s historical experience of option pre-vesting cancellations, theCompany has assumed an annualized forfeiture rate of 7% for its executiveoptions and 29% for non-executive options. Accordingly, as of December 31,2006, the Company estimated that the stock-based compensation for the awardsnot expected to vest was approximately $1.2 million and therefore, theunrecognized deferred stock-based compensation balance related to stock optionswas adjusted to approximately $3.6 million after estimated forfeitures.This amount will be recognized over an estimated weighted average period of 2.0years. The Company granted 1,486,000 stock options to employees, with anestimated total grant-date fair value of $1.9 million during 2006, or $1.29 pershare. During 2006, 1.4 million options vested with a total fair value of $2.5million.

**2000 Employee Stock Purchase Plan**

In April 2000, the Company adopted the 2000Employee Stock Purchase Plan (“Employee Stock Purchase Plan”). Initially, atotal of 1,500,000 shares of common stock were approved by the Board forissuance under the plan, together with an annual increase in the number ofshares of common stock reserved thereunder as provided in the plan beginning onthe first day of the Company’s fiscal year, commencing January 1, 2001. InJanuary 2001, the Board approved an increase of 753,702 shares. As of December 31,2006, the Company has authorized a total of 2,253,702 shares for issuance underthis plan. As a result of past and future annual increases, a maximum of10,500,000 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 total of 225,657, 182,594 and118,139 shares were sold under this plan during 2006, 2005 and 2004,respectively.

F-24

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On July 19, 2006, theCompensation Committee of the Board of Directors of the Company approvedamendments to the 2000 Employee Stock Purchase Plan to (i) change theoffering periods under the plan from approximately 24 months to approximatelysix months, commencing on the first trading day on or after February 1 andAugust 1 of each year, and (ii) eliminate the section of the planthat provided for automatic withdrawal and re-enrollment in the event that thefair market value of the common stock on any exercise date was lower than thefair market value of the common stock on the enrollment date of the sameoffering period.

**ValuationAssumptions**

TheCompany estimated the fair value of stock options granted during 2006, using aBlack-Scholes-Merton valuation model, consistent with the provisions of SFAS No. 123R,and SEC Staff Accounting Bulletin (“SAB”) No. 107. The Company’s priorperiod pro forma disclosures of stock-based compensation for 2005 and 2004 weredetermined under a fair value method as prescribed by SFAS No. 123. Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes-Merton option valuation model and the straight-line attributionapproach with the following weighted-average assumptions:

| ** **                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|
| ** **                      | ** ** | **  2006  **           | ** ** | **  2005  ** | ** ** | **  2004  ** | ** ** |
| **Employee Stock Option Plan**  | ** ** |                                       | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Expected dividend               |       |                                       | 0          | % |   |   | 0 | % |   |   | 0 | % |   |
| Average risk-free interest rate |       |                                       | 4.9        | % |   |   | 4.38 | % |   |   | 3.5 | % |   |
| Expected volatility             |       |                                       | 143        | % |   |   | 152 | % |   |   | 230 | % |   |
| Expected  term (years)          |       |                                       | 6.1        |   |   |   | 4 |   |   |   | 4 |   |   |

 

| ** **                       | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **  2006  **           | ** ** | **  2005  ** | ** ** | **  2004  ** | ** ** |
| **Employee Stock Purchase Plan** | ** ** |                                       | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Expected dividend                |       |                                       | 0          | % |   |   | 0 | % |   |   | 0 | % |   |
| Average risk-free interest rate  |       |                                       | 4.0        | % |   |   | 3.3 | % |   |   | 3.3 | % |   |
| Expected volatility              |       |                                       | 89         | % |   |   | 96 | % |   |   | 479 | % |   |
| Expected  term (months)          |       |                                       | 6          |   |   |   | 6 |   |   |   | 6 |   |   |

 

The dividend yield of zero is based on the fact thatthe Company has never paid cash dividends and has no present intention to paycash dividends. The risk-free interest rates are taken from the Daily FederalYield Curve Rates as of the grant dates as published by the Federal Reserve,and represent the yields on actively traded Treasury securities for terms equalto the expected term of the options. Expected volatility is based on thehistorical volatility of the Company’s common stock over a period consistentwith the expected term of the stock option. The expected term calculation isbased on an average prescribed by SAB No. 107, based on the vestingperiods, which is generally over four years, and the term of the option, whichis generally 10 years, divided by 2.

For the year ended December 31,2006, stock-based compensation expense associated with employee stock optionsand ESPP shares amounted to $1.8 million and $0.1 million,respectively.

F-25

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**Common StockReserved for Future Issuance**

As of December 31, 2006, the Company had reservedthe following shares of common stock for issuance in connection with:

| Stock options under stock option plans |   | 11,412,151 |   |
|----------------------------------------|--------|------------|--------|
| Employee stock purchase plan           |   | 2,253,702  |   |
| Total                                  |   | 13,665,853 |   |

 

**9.**                 LegalProceedings

On May 11, 2005, CPI, Avistar’s wholly-ownedpatent prosecution and licensing subsidiary, commenced a patent infringement lawsuitagainst Tandberg ASA and Tandberg, Inc., alleging that numerous Tandbergvideoconferencing products infringe three patents held by CPI. The suit wasfiled in the United States District Court for the Northern District ofCalifornia. Both of the Tandberg entities answered the complaint on July 15,2005, at which time they asserted that they did not infringe the patents andthat the patents were invalid and unenforceable.

On January 30, 2006, Tandberg Telecom AS, awholly-owned subsidiary of Tandberg ASA, filed a patent infringement lawsuitagainst Avistar in the United States District Court for the Eastern District ofTexas. The suit alleges that Avistar videoconferencing products infringe onepatent purchased by Tandberg Telecom AS.

The prosecution of thislawsuit and the defense of the Tandberg Telecom AS claim required Avistar andCPI to expend significant financial and managerial resources. See Note 13Subsequent Events for information on the settlement of these lawsuits among theCompany, CPI and Tandberg.

**10.**          Income Taxes

The Company accounts for income taxes in accordancewith SFAS No. 109, *Accounting for IncomeTaxes* (“SFAS 109”). SFAS 109 provides for an asset and liabilityapproach to account for income taxes under which deferred tax assets andliabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities, and their respective tax basis. Deferred tax assets andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to berecovered or settled. Deferred tax assets are reduced by a valuation allowancewhen, in the opinion of management, it is more likely than not that some or allof the deferred tax assets will not be realized. The effect on deferred taxassets and liabilities of a change in tax rates is recognized in income in theperiod of enactment.

The (recovery from) provision for income taxes relatesto Federal, State and Foreign tax. The Company provided for income taxes forits subsidiary in the United Kingdom (ASUK) of approximately $22,000, $22,000and $60,000 in 2006, 2005 and 2004, respectively. Federal and Stateoverpayments of 2004 income taxes were refunded in 2006.

F-26

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The (recovery from) provision for income taxes consistedof the following (in thousands):

| ** **           | ** ** | **Year Ended December 31,** | ** ** |
|----------------------|------------|--------------------------------------------|------------|
| ** **           | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current:             |       |                                       |       |   |   |   |   |
| Federal              |       | $                                          | (33        | ) | $ | — |   | $ | 237 |   |
| State                |       | (20                                        | )          | — |   | 66 |   |
| Foreign              |       | 22                                         |       | 22 |   | 60 |   |
|                 |       | (31                                        | )          | 22 |   | 363 |   |
| Deferred benefits:   |       |                                       |       |   |   |   |   |
| Federal              |       | (2,789                                     | )          | (2,262 | ) | (2,691 | ) |
| State                |       | (311                                       | )          | (460 | ) | (335 | ) |
|                 |       | (3,100                                     | )          | (2,722 | ) | (3,026 | ) |
| Valuation  allowance |       | 3,100                                      |       | 2,722 |   | 3,026 |   |
|                 |       | $                                          | (31        | ) | $ | 22 |   | $ | 363 |   |

 

For financial reporting purposes, loss before provisionfor income taxes included the following components (in thousands):

| ** **                              | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Domestic                                |       | $                                          | (9,611     | ) | $ | (4,839 | ) | $ | (8,668 | ) |
| Foreign                                 |       | 1,431                                      |       | (313 | ) | 325 |   |
| Loss before provision for  income taxes |       | $                                          | (8,180     | ) | $ | (5,152 | ) | $ | (8,343 | ) |

 

The Company’s effective income tax provision differedfrom the federal statutory rate of 34% due to the following (in thousands):

| ** **                                                                                       | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected  tax benefit at federal statutory rate                                                  |       | $                                          | (2,771     | ) | $ | (1,652 | ) | $ | (2,837 | ) |
| Foreign  and state taxes, net                                                                    |       | 2                                          |       | 22 |   | 126 |   |
| Recovery  of federal tax payments                                                                |       | (33                                        | )          |   |   |   |   |
| Permanent  non-deductible                                                                        |       | 463                                        |       | 17 |   | — |   |
| Utilization  of net operating losses                                                             |       | —                                     |       | — |   | (3,786 | ) |
| Current  year operating losses and temporary  differences for which no tax benefit is recognized |       | 2,308                                      |       | 1,635 |   | 6,860 |   |
| Provision for income taxes                                                                       |       | $                                          | (31        | ) | $ | 22 |   | $ | 363 |   |

 

Permanent 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, 2006 and 2005 (in thousands):

| ** **                                     | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred income tax assets:                    |       |     |       |     |       |
| Federal  net operating loss carry-forwards     |       | $        | 15,178     |     | $          | 11,514 |   |
| State  net operating loss carry-forwards       |       | 956      |       | 694      |       |
| Tax  credit carry-forwards                     |       | 2,992    |       | 2,312    |       |
| Deferred  settlement and patent licensing, net |       | 4,728    |       | 6,507    |       |
| Reserves                                       |       | 522      |       | 294      |       |
| Property  and Equipment                        |       | 240      |       | 195      |       |
|                                           |       | 24,616   |       | 21,516   |       |
| Valuation  allowance                           |       | (24,616  | )          | (21,516  | )          |
| Net deferred income tax asset                  |       | $        | —     |     | $          | — |   |

 

F-27

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Net operating losscarry-forwards at December 31, 2006 were approximately $45 million and $19million, for Federal and state income tax purposes, respectively. The Federalnet operating loss carry-forwards expire on various dates through the year 2026.

As of December 31, 2006,unused research and development tax credits of approximately $1.5 million and$1.4 million are available to reduce future Federal and California incometaxes, respectively. Federal credit carry-forwards expire beginning in year2014. California credits will carry forward indefinitely.

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

**11.**          Net Loss 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 periodspresented.

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 outstanding stock options and sharessubject to repurchase from the calculation of diluted net loss per share for2006, 2005, and 2004, because all such securities are antidilutive (owing tothe fact that the Company is in a loss position). Accordingly, diluted net lossper share is equal to basic net loss per share for all years presented.

The total number of potential common shares excludedfrom the calculations of diluted net loss per share was 846,929, 1,668,006 and1,873,782 for 2006, 2005, and 2004, respectively.

The following table presents the calculation of basicand diluted net loss per share (in thousands, except per share data):

| ** **                                                                     | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net  loss                                                                      |       | $                                          | (8,149     | ) | $ | (5,174 | ) | $ | (8,706 | ) |
| Weighted  average shares of common stock used in  computing net loss per share |       | 33,928                                     |       | 33,600 |   | 32,610 |   |
| Net loss per share basic and  diluted                                          |       | $                                          | (0.24      | ) | $ | (0.15 | ) | $ | (0.27 | ) |

 

**12.**          Segment Reporting

Disclosure of segments ispresented in accordance with SFAS No. 131 (“SFAS 131”), *Disclosures About Segments of an Enterprise and Related Information*.SFAS 131 establishes standards for disclosures regarding operating segments,products and services, geographic areas and major customers. The Company is organized and operates as twooperating segments: (1) the design, development, manufacturing, sale andmarketing of networked video communications products (Avistar) and (2) theprosecution, maintenance, support and licensing of the intellectual property,some of which is used in the Company’s products (CPI). Service revenue relates mainly to the maintenance, support, training,software development and installation of products, and is included in Avistarfor purposes of reporting and decision-making. Avistar also engages incorporate functions, and provides financing and services to its subsidiaries.The Company’s chief operating decision-maker, its Chief Executive Officer,monitors the 

F-28

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Company’soperations based upon the information reflected in the following table (inthousands). The table includes a reconciliation of the revenue and expenseclassification used by the Company’s CEO with the classification of revenue,other income and expenses as set forth in the Company’s audited financialstatements included elsewhere herein. The reconciliation for the revenuecategory reflects the fact that the CEO views activity recorded in the account “incomefrom settlement and licensing activity” as revenue within the CPI subsidiary.

| ** **                                           | ** ** | **CPI** | ** ** | **Avistar** | ** ** | **Reconciliation** | ** ** | **Total** | ** ** |
|------------------------------------------------------|------------|---------|------------|-------------|------------|--------------------|------------|-----------|------------|
| **Year  Ended December 31, 2006**               |       |    |       |        |       |               |       |      |       |   |   |
| Revenue                                              |       | $       | 9,381      |        | $          | 8,070              |       |      | (4,226     | ) |   | $ | 13,225 |   |
| Depreciation  expense                                |       | —  |       | (345        | )          |               | —     |      |       | (345 | ) |
| Stock-based  compensation                            |       | 440     |       | 1,594       |       |               | —     |      |       | 2,034 |   |
| Total  costs and expenses                            |       | (5,701  | )          | (20,227     | )          |               | 4,226      |      |       | (21,702 | ) |
| Interest  income                                     |       | —  |       | 299         |       |               | —     |      |       | 299 |   |
| Interest  expense                                    |       | —  |       | 1           |       |               | —     |      |       | 1 |   |
| Net  income (loss)                                   |       | 3,680   |       | (11,829     | )          |               | —     |      |       | (8,149 | ) |
| Assets                                               |       | 3,752   |       | 10,947      |       |               | —     |      |       | 14,699 |   |
| **Year  Ended December 31, 2005**               |       |    |       |        |       |               |       |      |       |   |   |
| Revenue                                              |       | $       | 4,226      |        | $          | 6,911              |       |      | (4,226     | ) |   | $ | 6,911 |   |
| Depreciation  expense                                |       | —  |       | (273        | )          |               | —     |      |       | (273 | ) |
| Total  costs and expenses                            |       | (2,535  | )          | (14,197     | )          |               | 4,226      |      |       | (12,506 | ) |
| Interest  income                                     |       | —  |       | 537         |       |               | —     |      |       | 537 |   |
| Interest  expense                                    |       | —  |       | 1           |       |               | —     |      |       | 1 |   |
| Net  loss                                            |       | 1,691   |       | (6,865      | )          |               | —     |      |       | (5,174 | ) |
| Assets                                               |       | 5,081   |       | 15,277      |       |               | —     |      |       | 20,358 |   |
| **Year  Ended December 31, 2004 (as restated)** |       |    |       |        |       |               |       |      |       |   |   |
| Revenue                                              |       | $       | 575        |        | $          | 6,321              |       |      | $          | (575 | ) |   | $ | 6,321 |   |
| Depreciation  expense                                |       | —  |       | (339        | )          |               | —     |      |       | (339 | ) |
| Total  costs and expenses                            |       | (3,898  | )          | (11,474     | )          |               | 575        |      |       | (14,797 | ) |
| Interest  income                                     |       | —  |       | 118         |       |               | —     |      |       | 118 |   |
| Interest  expense                                    |       | —  |       | 6           |       |               | —     |      |       | 6 |   |
| Net  loss                                            |       | (3,322  | )          | (5,384      | )          |               | —     |      |       | (8,706 | ) |
| Assets                                               |       | 6,330   |       | 24,078      |       |               | —     |      |       | 30,408 |   |
|                                                      |            |         |            |             |            |                    |            |           |            |  |  |  |  |  |  |

 

International revenue, whichconsists of sales to customers with operations principally in Western Europeand Asia,  comprised 75%, 63% and 52%of total revenue for 2006, 2005, and 2004, respectively. Revenue is allocatedto individual countries by customer based on where the product is shipped to,location of services performed or the location of equipment that is under anannual maintenance agreement. For 2006, 2005, and 2004, respectively,international revenues to customers in the United Kingdom accounted for 12%,23%, and 31% respectively, of total revenue. The Company had no significantlong-lived assets in any country other than the United States for any periodpresented.

**13.**          Subsequent Events

On February 15, 2007,the Company entered into a patent license agreement with Tandberg ASA, TandbergAS and Tandberg, Inc. Under this agreement, CPI agreed to dismiss itsinfringement suit against Tandberg, Tandberg agreed to dismiss its infringementsuit against CPI and the Company and the companies agreed to cross-license eachother’s patent portfolios. The original litigation was initiated in May 2005,in the Federal District Court for the Northern District of California andinvolved the following CPI patents: U.S. Patent Nos. 5,867,654; 5,896,500 and6,212,547. The agreement resulted in a payment to the Company from Tandberg inthe amount of $12.0 million, approximately $4.3 million of which was used bythe Company to pay its own contingent legal fees incurred in connection withthe litigation.

F-29

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**14.**          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 preparethis information 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. In July 2006, theCompany entered into a Patent License Agreement with Sony and SCEI. Under thelicense agreement, CPI granted Sony and its subsidiaries a license to all ofCPI’s patents with a filing date on or before January 1, 2006 for aspecific field of use relating to video conferencing. As consideration for thelicenses granted under the agreement, Sony agreed to make an upfront licensepayment of $5.0 million. The $5.0 million upfront payment wasrecognized by Avistar as licensing revenue in the three months ended September 30,2006. As described in the Summary of Significant Accounting Policies, Incomefrom Settlement and Patent Licensing, we expect to recognize the paymentreceived from Polycom and the associated deferred contingent legal costs paidin settlement and patent licensing in equal installments over a five-yearperiod starting November 12, 2004. The payment from Polycom and itsrecognition in settlement and patent licensing may affect the comparability ofthe Companies financial statements for periods before and after the recognitionperiods.

| ** **                                         | ** ** | **Quarter Ended**                                            | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **December 31,  2006**                                       | ** ** | **September 30,  2006** | ** ** | **June 30,  2006** | ** ** | **March 31,  2006** | ** ** |
| ** **                                         | ** ** | **(In thousands except per share data)** | ** ** |
| Total revenue                                      |       |                                                              | $          | 2,337 |   |   |   | $ | 7,276 |   |   | $ | 1,754 |   |   | $ | 1,858 |   |   |
| Cost of product  revenue                           |       |                                                              | 834        |   |   |   | 998 |   |   | 721 |   |   | 632 |   |   |
| Cost of services,  maintenance and support revenue |       |                                                              | 454        |   |   |   | 374 |   |   | 385 |   |   | 607 |   |   |
| Net (loss) income                                  |       |                                                              | $          | (3,191 | ) |   |   | $ | 1,818 |   |   | $ | (3,720 | ) |   | $ | (3,056 | ) |   |
| Net (loss) income per share—Basic/Diluted     |       |                                                              | $          | (0.09 | ) |   |   | $ | 0.05 |   |   | $ | (0.11 | ) |   | $ | (0.09 | ) |   |
| Weighted average shares—Basic                 |       |                                                              | 34,031     |   |   |   | 33,965 |   |   | 33,880 |   |   | 33,834 |   |   |
| Weighted  average shares—Diluted              |       |                                                              | 34,031     |   |   |   | 34,860 |   |   | 33,880 |   |   | 33,834 |   |   |

 

| ** **                                         | ** ** | **Quarter Ended**                                            | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **December 31,  2005**                                       | ** ** | **September 30,  2005** | ** ** | **June 30,  2005** | ** ** | **March 31,  2005** | ** ** |
| ** **                                         | ** ** | **(In thousands except per share data)** | ** ** |
| Total revenue (As Previously Reported)             |       |                                                              | $          | 1,809 |   |   |   | $ | 2,891 |   |   | $ | 2,403 |   |   | $ | 2,979 |   |   |
| Total revenue (Adjustment)                         |       |                                                              | —     |   |   |   | (1,057 | ) |   | (1,056 | ) |   | (1,057 | ) |   |
| Total revenue (As Restated)                        |       |                                                              | 1,809      |   |   |   | 1,834 |   |   | 1,347 |   |   | 1,922 |   |   |
| Cost of product  revenue                           |       |                                                              | 593        |   |   |   | 531 |   |   | 318 |   |   | 450 |   |   |
| Cost of services,  maintenance and support revenue |       |                                                              | 632        |   |   |   | 616 |   |   | 525 |   |   | 447 |   |   |
| Net loss                                           |       |                                                              | $          | (2,102 | ) |   |   | $ | (1,425 | ) |   | $ | (1,260 | ) |   | $ | (387 | ) |   |
| Net loss per share—Basic/Diluted              |       |                                                              | $          | (0.06 | ) |   |   | $ | (0.04 | ) |   | $ | (0.04 | ) |   | $ | (0.01 | ) |   |
| Weighted  average shares—Basic/Diluted        |       |                                                              | 33,738     |   |   |   | 33,687 |   |   | 33,547 |   |   | 33,420 |   |   |

 

F-30

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**Item 15(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, 2006              |       |                                         | $          | 121                                        | ** ** |           |       | $                                          | (61        | ) |   |   | $ | (9 | ) |   |   | $ | 51 | ** ** |   |
| December 31, 2005              |       |                                         | $          | 22                                         | ** ** |           |       | $                                          | 120        |   |   |   | $ | (21 | ) |   |   | $ | 121 | ** ** |   |
| December 31, 2004              |       |                                         | $          | 44                                         | ** ** |           |       | $                                          | 77         |   |   |   | $ | (99 | ) |   |   | $ | 22 | ** ** |   |

 

S-1

----

**INDEXTO EXHIBITS**

| **Exhibits** | ** ** | ** ** | ** ** | ** **                                                                                                                                                                                    |
|--------------|------------|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         | 3.2        | (1)        |       | Restated Certificate of Incorporation                                                                                                                                                         |   |
|         | 3.3        | (11)       |       | 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       | (12)       |       | 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       | (6)        |       | Settlement Agreement and Release between the Registrant and R. Stephen  Heinrichs dated April 26, 2001*                                                                                  |   |
|         | 10.8       | (8)        |       | Office Lease Agreement between CA-Twin Dolphin Plaza Limited  Partnership and the Registrant dated July 30, 2003                                                                         |   |
|         | 10.9       | (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 |   |
|         | 10.10      | (10)       |       | Stock Purchase  Agreement among the Registrant, Fuller & Thaler Behavioral Finance  Fund, Ltd. and Fuller & Thaler Avalanche Fund, L.P. dated  March 23, 2004          |   |
|         | 10.11      | (11)       |       | Settlement  Agreement among the Registrant, Collaboration Properties, Inc. and  Polycom, Inc. dated November 12, 2004                                                          |   |
|         | 10.12      | (12)† |       | Patent  Cross-License Agreement Among the Company, Collaboration  Properties, Inc. and Polycom, Inc. dated November 12, 2004                                                   |   |
|         | 10.13      | (4)†  |       | Patent License  Agreement dated May 15, 2006 among the Registrant, Collaboration  Properties, Inc., Sony Corporation and Sony Computer  Entertainment, Inc.                    |   |
|         | 10.14      |       |       | Revolving Credit  Promissory Note dated December 26, 2006 issued by the Registrant to  JPMorgan Chase Bank, N.A.                                                                         |   |
|         | 10.15      |       |       | Collateral  Agreement between the Registrant and JPMorgan Chase Bank, N.A. dated  December 23, 2006                                                                                      |   |
|         | 10.16      |       |       | Security  Agreement between the Registrant and JPMorgan Chase Bank, N.A. dated  December 23, 2006                                                                                        |   |
|         | 10.17      |       |       | Guaranty issued  by Gerald J. Burnett and The Gerald J. Burnett and Marjorie J. Burnett  Revocable Trust in favor of JPMorgan Chase Bank, N.A. dated December 23,  2006                  |   |
|         | 10.18      |       |       | Form of Note  Sale Agreement among Gerald J. Burnett, The Gerald J. Burnett and Marjorie J.  Burnett Revocable Trust and JPMorgan Chase Bank, N.A.                                       |   |
|         | 10.19      |       |       | Lease Agreement  among the Registrant and Crossroads Associates and Clocktower Associates  dated December 1, 2006                                                                        |   |
|         | 21.1       | (7)        |       | Subsidiaries of the Company                                                                                                                                                                   |   |

----

 

|   | 23.1 |   |   | Consent of Independent Registered Public Accounting Firm: Burr,  Pilger & Mayer LLP                                                                                                  |   |
|--------|------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   | 23.2 |   |   | Consent of Independent Registered Public Accounting Firm: KPMG LLP                                                                                                                            |   |
|   | 24.1 |   |   | Power of Attorney (see page 51)                                                                                                                                                          |   |
|   | 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 |   |

----

*                    Indicatesmanagement contract or compensatory plan or arrangement required to be filed anexhibit pursuant to Item 14(c) of Form 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)          Reserved.

(3)          Reserved.

(4)          Filed asan exhibit to the Registrant’s Registration Statement on Form S-8filed with the Securities and Exchange Commission on November 14, 2006.

(5)          Reserved.

(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)          Reserved.

(10) Filedas an exhibit to the Registrant’s Quarterly Report on Form 10-Q forthe quarter ended March 31, 2004 filed with the Securities and ExchangeCommission on May 11, 2004.

(11) Filedas an exhibit to the Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2004 filed with the Securities and ExchangeCommission on March 28, 2005.

(12) Filedas an exhibit to the Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2005 filed with the Securities and ExchangeCommission on April 28, 2006.

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