** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, DC 20549**

**FORM 10-Q**

**(MarkOne)**
| **x**                                                                                                                                                                          | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                     | ** **                                                                                     |
| **For the  quarterly period ended September 30, 2006**                                                                                                                         |
| ** **                                                                                                                                                                     | ** **                                                                                     |
| **OR**                                                                                                                                                                         |
| ** **                                                                                                                                                                     | ** **                                                                                     |
| **o**                                                                                                                                                                          | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                     | ** **                                                                                     |
| **For the  transition period from              to             ** |

 

**Commission File Number 0-22871**

**OMTOOL, LTD.**(Exact Name of Registrant as Specified in Its Charter)

| **Delaware**                              |   | **02-0447481**          |
|-------------------------------------------|--------|-------------------------|
| (State or Other  Jurisdiction of          |   | (I.R.S. Employer        |
| Incorporation or  Organization)           |   | Identification  Number) |
|                                      |   |                    |
| **6  Riverside Drive, Andover, MA**       |   | **01810**               |
| (Address of  Principal Executive Offices) |   | (Zip Code)              |

 

**(978) 327-5700**

(Registrant’s Telephone Number Including Area Code)

 

Indicate by checkmark whether the Registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

Yes  x   No  o

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of accelerated filer and large accelerated filer in Rule 12b-2 ofthe Exchange Act.

| Large Accelerated Filer  o |   | Accelerated  Filer  o |   | Non-accelerated  Filer  x |
|--------------------------------------|--------|---------------------------------|--------|-------------------------------------|

 

Indicate by checkmark whether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes  o   No  x

There were 4,010,770shares of the Company’s common stock, par value $0.01, outstanding on November14, 2006.

 

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**OMTOOL, LTD. AND SUBSIDIARIES**

FORM 10-QFor the Quarter Ended September 30, 2006CONTENTS
| **Item Number** | ** **                                                                                                                      | ** ** |
|-----------------|---------------------------------------------------------------------------------------------------------------------------------|------------|
|            |                                                                                                                            |       |
| PART I:         | FINANCIAL INFORMATION                                                                                                           | 3          |
|            |                                                                                                                            |       |
| Item 1.         | Consolidated  Financial Statements                                                                                              | 3          |
|            | Consolidated Balance  Sheets as of September 30, 2006 (Unaudited) and December 31, 2005                                         | 3          |
|            | Consolidated  Statements of Operations for the three months and nine months ended September 30,  2006 and 2005 (Unaudited) | 4          |
|            | Consolidated  Statements of Cash Flows for the nine months ended September 30, 2006 and  2005 (Unaudited)                       | 5          |
|            | Notes to Consolidated  Financial Statements                                                                                     | 6          |
|            |                                                                                                                            |       |
| Item 2.         | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                     | 12         |
|            |                                                                                                                            |       |
| Item 3.         | Quantitative  and Qualitative Disclosures About Market Risk                                                                     | 28         |
|            |                                                                                                                            |       |
| Item 4.         | Controls and Procedures                                                                                                         | 28         |
|            |                                                                                                                            |       |
| PART II:        | OTHER INFORMATION                                                                                                               | 29         |
|            |                                                                                                                            |       |
| Item  1A.       | Risk  Factors                                                                                                                   | 29         |
|            |                                                                                                                            |       |
| Item 2.         | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                    | 29         |
|            |                                                                                                                            |       |
| Item 5.         | Other Information                                                                                                               | 29         |
|            |                                                                                                                            |       |
| Item  6.        | Exhibits                                                                                                                        | 29         |
|            |                                                                                                                            |
| Signatures      | 30                                                                                                                              |
|            |                                                                                                                            |
| Exhibit  Index  | 31                                                                                                                              |
|            |                                                                                                                            |
| Exhibits        |                                                                                                                            |

 

2

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**PART I:  FINANCIAL INFORMATION**

**Item 1.  Consolidated Financial Statements**

**OMTOOL, LTD. AND SUBSIDIARIES**

**ConsolidatedBalance Sheets**
| ** **                                                                                                                                                                                                                                                                  | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                  | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                  | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                                                                                                             |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                  |       | $                            | 6,366,471  |                        | $          | 10,471,272 |   |
| Accounts receivable,  net of reserves of $16,000 at September 30, 2006 and $33,000 at December 31,  2005                                                                                                                                                               |       | 2,019,538                    |       | 1,618,799                   |       |
| Inventory                                                                                                                                                                                                                                                                   |       | 73,236                       |       | 58,380                      |       |
| Prepaid expenses and  other current assets                                                                                                                                                                                                                                  |       | 536,885                      |       | 333,419                     |       |
| Total current assets                                                                                                                                                                                                                                                        |       | 8,996,130                    |       | 12,481,870                  |       |
| Property and equipment,  net                                                                                                                                                                                                                                                |       | 1,481,043                    |       | 175,566                     |       |
| Other assets                                                                                                                                                                                                                                                                |       | 53,130                       |       | 11,562                      |       |
| Total assets                                                                                                                                                                                                                                                                |       | $                            | 10,530,303 |                        | $          | 12,668,998 |   |
|                                                                                                                                                                                                                                                                        |       |                         |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                                                              | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                        |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                            |       | $                            | 1,186,574  |                        | $          | 905,288 |   |
| Accrued liabilities                                                                                                                                                                                                                                                         |       | 1,398,369                    |       | 1,170,508                   |       |
| Accrued state sales tax                                                                                                                                                                                                                                                     |       | 317,705                      |       | 343,279                     |       |
| Deferred revenue,  current                                                                                                                                                                                                                                                  |       | 3,977,929                    |       | 3,408,002                   |       |
| Capital lease  obligations, current                                                                                                                                                                                                                                         |       | 86,206                       |       | —                      |       |
| Total current  liabilities                                                                                                                                                                                                                                                  |       | 6,966,783                    |       | 5,827,077                   |       |
| Long term liabilities:                                                                                                                                                                                                                                                      |       |                         |       |                        |       |
| Deferred revenue,  long-term                                                                                                                                                                                                                                                |       | 474,497                      |       | 410,232                     |       |
| Deferred rent                                                                                                                                                                                                                                                               |       | 404,874                      |       | —                      |       |
| Capital lease  obligations, long-term                                                                                                                                                                                                                                       |       | 377,188                      |       | —                      |       |
| Total liabilities                                                                                                                                                                                                                                                           |       | 8,223,342                    |       | 6,237,309                   |       |
|                                                                                                                                                                                                                                                                        |       |                         |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                                                                                                  |       |                         |       |                        |       |
| Preferred Stock, $0.01  par value —  Authorized — 2,000,000 shares; Issued and outstanding — none                                                                                                                                                            |       | —                       |       | —                      |       |
| Common Stock, $0.01 par  value —  Authorized — 35,000,000 shares; Issued — 4,367,878 shares at September 30,  2006 and December 31, 2005; Outstanding — 4,010,770,shares at September 30,  2006 and 3,977,022 shares at December 31, 2005, respectively |       | 43,679                       |       | 43,679                      |       |
| Deferred compensation                                                                                                                                                                                                                                                       |       | —                       |       | (775,865                    | )          |
| Additional paid-in  capital                                                                                                                                                                                                                                                 |       | 34,735,719                   |       | 35,556,639                  |       |
| Accumulated deficit                                                                                                                                                                                                                                                         |       | (30,576,178                  | )          | (26,327,762                 | )          |
| Treasury stock, at  cost, 357,108 shares at September 30, 2006 and 390,856 shares at December 31,  2005                                                                                                                                                                     |       | (1,845,743                   | )          | (2,005,618                  | )          |
| Accumulated other  comprehensive loss                                                                                                                                                                                                                                       |       | (50,516                      | )          | (59,384                     | )          |
| Total stockholders’  equity                                                                                                                                                                                                                                            |       | 2,306,961                    |       | 6,431,689                   |       |
|                                                                                                                                                                                                                                                                        |       |                         |       |                        |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                             |       | $                            | 10,530,303 |                        | $          | 12,668,998 |   |

 

The accompanying notes are an integral part of theseunaudited consolidated financial statements.

3

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**OMTOOL, LTD. AND SUBSIDIARIES**

**Consolidated Statements of Operations**

**(Unaudited)**
| ** **                                               | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:                                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Software license                                         |       | $                                                    | 1,031,839  |                                                | $          | 877,357 |   | $ | 2,989,554 |   | $ | 3,333,046 |   |
| Hardware                                                 |       | 605,273                                              |       | 582,976                                             |       | 1,569,340 |   | 2,142,283 |   |
| Service and  other                                       |       | 2,003,999                                            |       | 1,705,437                                           |       | 5,487,277 |   | 5,122,224 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Total revenue                                            |       | 3,641,111                                            |       | 3,165,770                                           |       | 10,046,171 |   | 10,597,553 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Cost of revenue:                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Software license                                         |       | 60,024                                               |       | 41,983                                              |       | 143,465 |   | 113,185 |   |
| Hardware                                                 |       | 372,619                                              |       | 333,761                                             |       | 987,301 |   | 1,361,141 |   |
| Service and  other                                       |       | 856,000                                              |       | 682,896                                             |       | 2,450,783 |   | 2,082,023 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Total cost of  revenue                                   |       | 1,288,643                                            |       | 1,058,640                                           |       | 3,581,549 |   | 3,556,349 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Gross profit                                             |       | 2,352,468                                            |       | 2,107,130                                           |       | 6,464,622 |   | 7,041,204 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Operating  expenses:                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Sales and  marketing                                     |       | 1,992,144                                            |       | 1,352,295                                           |       | 6,203,344 |   | 3,672,547 |   |
| Research and  development                                |       | 664,335                                              |       | 579,422                                             |       | 2,095,889 |   | 1,617,112 |   |
| General and  administrative                              |       | 809,438                                              |       | 570,421                                             |       | 2,527,866 |   | 2,071,729 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Total operating  expenses                                |       | 3,465,917                                            |       | 2,502,138                                           |       | 10,827,099 |   | 7,361,388 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Loss from  operations                                    |       | (1,113,449                                           | )          | (395,008                                            | )          | (4,362,477 | ) | (320,184 | ) |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Interest and  other income, net                          |       | 30,532                                               |       | 51,578                                              |       | 114,061 |   | 137,335 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Loss before  income tax provision                        |       | (1,082,917                                           | )          | (343,430                                            | )          | (4,248,416 | ) | (182,849 | ) |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Income tax  provision                                    |       | —                                               |       | —                                              |       |   |   | 6,777 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss                                                 |       | $                                                    | (1,082,917 | )                                                   | $          | (343,430 | ) | $ | (4,248,416 | ) | $ | (189,626 | ) |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss per  share:                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                    |       | $                                                    | (0.27      | )                                                   | $          | (0.09 | ) | $ | (1.06 | ) | $ | (0.05 | ) |
| Diluted                                                  |       | $                                                    | (0.27      | )                                                   | $          | (0.09 | ) | $ | (1.06 | ) | $ | (0.05 | ) |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted average  shares used in per share calculations: |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                    |       | 4,013,722                                            |       | 3,926,451                                           |       | 4,021,447 |   | 3,947,529 |   |
| Diluted                                                  |       | 4,013,722                                            |       | 3,926,451                                           |       | 4,021,447 |   | 3,947,529 |   |

 

The accompanying notes are an integral part of theseunaudited consolidated financial statements*.*

4

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**OMTOOL, LTD. AND SUBSIDIARIES**

**Consolidated Statements of Cash Flows**

**(Unaudited)**
| ** **                                                                        | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Cash Flows from  Operating Activities:                                            |       |                                                |       |   |   |
| Net loss                                                                          |       | $                                                   | (4,248,416 | ) | $ | (189,626 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities— |       |                                                |       |   |   |
| Depreciation                                                                      |       | 158,162                                             |       | 120,610 |   |
| Accounts  receivable reserves                                                     |       | (16,602                                             | )          | (41,650 | ) |
| Stock-based  compensation                                                         |       | 247,023                                             |       | 80,802 |   |
| Changes in  assets and liabilities:                                               |       |                                                |       |   |   |
| Accounts  receivable                                                              |       | (368,818                                            | )          | 134,036 |   |
| Prepaid expenses  and other current assets                                        |       | (197,642                                            | )          | (123,814 | ) |
| Inventory                                                                         |       | (14,856                                             | )          | 102,316 |   |
| Other assets                                                                      |       | (41,568                                             | )          | — |   |
| Accounts payable                                                                  |       | 274,904                                             |       | (89,246 | ) |
| Accrued  liabilities                                                              |       | 220,160                                             |       | (5,561 | ) |
| Accrued state  sales tax                                                          |       | (25,573                                             | )          | (245,899 | ) |
| Deferred revenue                                                                  |       | 596,587                                             |       | 97,179 |   |
| Deferred rent                                                                     |       | 404,874                                             |       | — |   |
|                                                                              |       |                                                |       |   |   |
| Net cash used in  operating activities                                            |       | (3,011,765                                          | )          | (160,853 | ) |
|                                                                              |       |                                                |       |   |   |
| Cash Flows from  Investing Activities:                                            |       |                                                |       |   |   |
| Purchases of  property and equipment                                              |       | (971,230                                            | )          | (82,854 | ) |
|                                                                              |       |                                                |       |   |   |
| Net cash used in  investing activities                                            |       | (971,230                                            | )          | (82,854 | ) |
|                                                                              |       |                                                |       |   |   |
| Cash Flows from  Financing Activities:                                            |       |                                                |       |   |   |
| Net proceeds  from issuance of common stock                                       |       | 20,507                                              |       | 36,619 |   |
| Net proceeds  from issuance of restricted common stock                            |       | 622                                                 |       | — |   |
| Purchase of treasury  stock                                                       |       | (153,332                                            | )          | — |   |
| Repayment of  capital lease obligations                                           |       | (27,342                                             | )          | — |   |
|                                                                              |       |                                                |       |   |   |
| Net cash (used  in) provided by financing activities                              |       | (159,545                                            | )          | 36,619 |   |
|                                                                              |       |                                                |       |   |   |
| Exchange rate  effect on cash and cash equivalents                                |       | 37,739                                              |       | (62,177 | ) |
|                                                                              |       |                                                |       |   |   |
| Net decrease in  cash and cash equivalents                                        |       | (4,104,801                                          | )          | (269,265 | ) |
|                                                                              |       |                                                |       |   |   |
| Cash and cash  equivalents, beginning of period                                   |       | 10,471,272                                          |       | 10,655,121 |   |
|                                                                              |       |                                                |       |   |   |
| Cash and cash  equivalents, end of period                                         |       | $                                                   | 6,366,471  |   | $ | 10,385,856 |   |
|                                                                              |       |                                                |       |   |   |
| Supplemental  Disclosure of Noncash Investing and Financing Activities:           |       |                                                |       |   |   |
| Property and equipment  purchased under capital lease                             |       | $                                                   | 490,736    |   | $ | — |   |

 

The accompanying notes are an integral part of theseunaudited consolidated financial statements*.*

5

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**OMTOOL, LTD. AND SUBSIDIARIES**

**Notes to Consolidated FinancialStatements**

(Unaudited)

**(1)****                                 Basis of Presentation**

Omtool, Ltd. (“Omtool” orthe “Company”) provides document routing solutions and services that enableorganizations to manage the capture, processing and distribution of “mixed-mode”documents (i.e., documents that contain both paper and electronic components)to electronic information systems such as enterprise content management,document management, records management, e-mail and document-archiving systems,leveraging application interfaces with which users are already familiar.  The accompanying unaudited consolidatedfinancial statements have been prepared by Omtool pursuant to the rules andregulations of the Securities and Exchange Commission (“SEC”) regarding interimfinancial reporting.  Accordingly, they do not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements and should be read in conjunction with theconsolidated financial statements and notes thereto for the year ended December31, 2005 as filed with the SEC as part of the Company’s Annual Report on Form10-K on March 28, 2006.  The accompanyingunaudited consolidated financial statements reflect all adjustments (consistingof normal recurring adjustments) that are, in the opinion of management,necessary for a fair presentation of results for the interim periodspresented.  The results of operations for the three and nine month periodsended September 30, 2006 are not necessarily indicative of the results to beexpected for the full fiscal year.

Certain amounts in theDecember 31, 2005 financial statements have been reclassified to conform to thecurrent period presentation.

**(2)****                                 Net Loss per CommonShare**

The Company reports earnings per share in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 128,**“*Earnings per Share*.”  Thedilutive effect of potential common shares consisting of outstanding stockoptions and a stock warrant is determined using the treasury stock method, inaccordance with SFAS No. 128.  Diluted weighted average sharesoutstanding for the three and nine month periods ended September 30, 2006 andSeptember 30, 2005, exclude 405,000 and 421,000 shares of potential common sharesfrom stock options and a stock warrant, respectively, because to include themwould have been anti-dilutive for the periods presented as the Company reporteda net loss during the periods.

**(3)****                                 Income Taxes**

SFASNo. 109,**“*Accounting for Income Taxes*,”**requires a valuation allowance tobe recorded against deferred tax assets when it is more likely than not thatsome or all of the deferred tax assets will not be realized.  As a resultof cumulative losses in recent years and continued economic uncertainty, theCompany has provided a full valuation allowance against its net deferred taxassets and will do so until it returns to an appropriate level of sustainedtaxable income.  The ultimate realization of these deferred tax assetsdepends upon the Company’s ability to generate sufficient future taxableincome.  If the Company is successful ingenerating sufficient future taxable income, the Company will reduce thevaluation allowance through a reduction in income tax expense in the future.

Duringthe nine months ended September 30, 2006, the Company did not record a taxprovision due to the net loss incurred during the period.  During the nine months ended September 30,2005, the Company recorded a tax provision of approximately $7,000 for expectedtax liability in the United States.

6

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**(4)****                                 Comprehensive Loss**

The components of the Company’s comprehensive loss areas follows:
| ** **                                | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net loss                                  |       | $                                                    | (1,082,917 | )                                                   | $          | (343,430 | ) | $ | (4,248,416 | ) | $ | (189,626 | ) |
| Foreign currency  translation adjustments |       | (1,573                                               | )          | (15,020                                             | )          | 8,868 |   | (39,233 | ) |
| Comprehensive loss                        |       | $                                                    | (1,084,490 | )                                                   | $          | (358,450 | ) | $ | (4,239,548 | ) | $ | (228,859 | ) |

 

**(5)****                                 Stock BasedCompensation**

The Company’s 1996 StockOption Plan and 1997 Stock Plan, as amended, provide for the issuance of commonstock pursuant to the grant to employees of “incentive stock options” withinthe meaning of the Internal Revenue Code and the grant of nonqualified stockoptions, stock awards or opportunities to make direct purchases of stock in theCompany to employees, consultants, directors and officers of the Company.  The aggregate number of shares of commonstock that may be issued pursuant to the 1997 Stock Plan is 1,228,570.  Shares issued pursuant to these plans areissued from treasury to the extent they are available.

Prior to January1, 2006, the Company accounted for its stock-based compensation for employeesunder Accounting Principles Board (“APB”) Opinion No. 25, “*Accounting for Stock Issued to Employees*” and related interpretations andfollowed the disclosure-only alternative under SFAS No. 123, “*Accounting for Stock-Based Compensation*,”as amended by SFAS No. 148, “*Accountingfor Stock-Based Compensation — Transition and Disclosure*,” for options granted using theBlack-Scholes option pricing model.

Effective January1, 2006, the Company adopted the provisions of SFAS No. 123(R), “*Share-Based Payment*”**(“SFAS No.123R”), using the modified prospective method. SFAS No. 123R requires the Company to measure the cost of employeeservices in exchange for an award of an equity instrument based on thegrant-date fair value of the award and to recognize expense over the requisiteservice period.  Under the modified prospectivemethod, financial statements for periods prior to the date of adoption are notadjusted for the change in accounting, thus, prior period financial statementshave not been restated.  However,compensation expense is recognized for (a) all share-based payments grantedafter the effective date and (b) all awards granted to employees prior to theeffective date that remain unvested on the effective date.

As a result of adoptingSFAS No. 123R as of January 1, 2006, the Company incurred stock-basedcompensation expense during the three and nine months ended September 30, 2006of approximately $8,000 and $23,000, respectively, for stock options and sharespurchased under our employee stock purchase plan, of which $2,000 and $5,000,respectively, is recorded in cost of service and other revenue and $6,000 and$18,000, respectively, is recorded in operating expenses.

7

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The net impact ofadopting the new accounting guidance was as follows:
|                                        | ** ** | **Three months ended  September 30, 2006** | ** ** | **Nine months ended  September 30, 2006**     | ** ** |
|----------------------------------------|------------|----------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                             | ** ** | **Under Adoption of  SFAS No. 123R**       | ** ** | **If SFAS 123R   had not  been adopted** | ** ** | **Under Adoption  of SFAS  No. 123R** | ** ** | **If SFAS 123R  had not  been adopted** | ** ** |
| Loss from  operations                  |       | $                                                              | (1,113,449 | )                                                                 | $          | (1,105,388 | ) | $ | (4,362,477 | ) | $ | (4,339,156 | ) |
| Net Loss                               |       | $                                                              | (1,082,917 | )                                                                 | $          | (1,074,856 | ) | $ | (4,248,416 | ) | $ | (4,225,095 | ) |
| Cash Used in  Operating Activities     |       | $                                                              | (402,324   | )                                                                 | $          | (394,263 | ) | $ | (3,011,765 | ) | $ | (2,988,444 | ) |
| Cash Provided by  Financing Activities |       | $                                                              | (1,314,486 | )                                                                 | $          | (1,314,486 | ) | $ | (971,230 | ) | $ | (971,230 | ) |
| Basic Loss per  Share                  |       | $                                                              | (0.27      | )                                                                 | $          | (0.27 | ) | $ | (1.06 | ) | $ | (1.05 | ) |
| Diluted Loss per Share                 |       | $                                                              | (0.27      | )                                                                 | $          | (0.27 | ) | $ | (1.06 | ) | $ | (1.05 | ) |

 

The following tableillustrates the effect on net income and net income per share that would havebeen reported if the fair value method had been used to account for stock-basedcompensation in 2005.  The estimated fairvalue of each option is calculated using the Black-Scholes option-pricingmodel.
|                                                                                                             | ** ** | **Three months  Ended  September 30,** | ** ** | **Nine months  Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2005**                                         | ** ** | **2005**                                        | ** ** |
| Net loss, as  reported                                                                                      |       | $                                                | (343,430   | )                                               | $          | (189,626 | ) |
| Add: Stock  compensation included in net loss                                                               |       | 33,054                                           |       | 80,710                                          |       |
| Deduct: Total  stock-based employee compensation expense determined under fair value method  for all awards |       | (37,808                                          | )          | (126,074                                        | )          |
| Pro forma net  loss                                                                                         |       | $                                                | (348,184   | )                                               | $          | (234,990 | ) |
|                                                                                                        |       |                                             |       |                                            |       |
| Net loss per  share:                                                                                        |       |                                             |       |                                            |       |
| Basic and  diluted, as reported                                                                             |       | $                                                | (0.09      | )                                               | $          | (0.05 | ) |
| Basic and diluted, pro  forma                                                                               |       | $                                                | (0.09      | )                                               | $          | (0.06 | ) |

 

***Stock Options***

Underthe terms of the Company’s 1996 Stock Option Plan and 1997 Stock Plan, optionsvest and become exercisable as determined by the Board of Directors and expire10 years after the date of grant. In 1997, the Company’s Board of Directors voted that no further optionswould be granted or issued under the Company’s 1996 Stock Option Plan.  In accordance with the 1997 Stock Plan, stockoptions that are canceled or expired are added back to the potential optionsavailable for future issuance.  Stock option compensation expense calculatedunder the fair value approach is recognized ratably over the four year vestingperiod.  The fair value for grantedoptions was estimated at the time of grant using the Black-Scholesoption-pricing model.  Based uponhistorical information and management’s estimate of future voluntary turnoverrates, the Company has calculated this expense based on an annualized estimated forfeiture rate of10%.  The Company trues-up estimatedforfeitures to actual at the end of each reporting period.  The Company did not grant any stock optionsduring the nine months ended September 30, 2006 and September 30, 2005.  The total fair value of stock options vestedduring the nine month period ended September 30, 2006 was $8,000.

Total compensation expense related to unvested stockoptions was $16,000 as of September 30, 2006, which amount the Company expectsto recognize over a weighted average period of 1.1 years.

8

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Stock option activity for the nine months endedSeptember 30, 2006 was as follows:
|                                      | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life in Years** | ** ** | **Aggregate   Intrinsic  Value** | ** ** |
|--------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|------------------------------------------------------------------------|------------|---------------------------------------|------------|
| Outstanding,  December 31, 2005 |       | 363,714                    |       | $                                          | 5.73       |                                                                   |       |                                  |       |   |
| Granted                              |       | —                     |       | —                                     |       |                                                                   |       |                                  |       |
| Exercised                            |       | (2,572                     | )          | 0.83                                       |       |                                                                   |       |                                  |       |
| Canceled and  expired                |       | (7,068                     | )          | 5.36                                       |       |                                                                   |       |                                  |       |
| Outstanding,  September 30, 2006     |       | 354,074                    |       | $                                          | 5.77       |                                                                   | 4.4        |                                  | $          | 1,700,737 |   |
| Exercisable, September  30, 2006     |       | 333,264                    |       | $                                          | 6.01       |                                                                   | 4.2        |                                  | $          | 1,616,339 |   |

 

***Employee Stock Purchase Plan***

TheCompany’s 1997 Employee Stock Purchase Plan (the “1997 Purchase Plan”) providesfor the issuance of a maximum of 57,142 shares of common stock pursuant to theexercise of nontransferable options granted to participating employees.  The exercise price for the option for eachsix-month purchase period is 85% of the lesser of the market price of thecommon stock on the first or last business day of the six-month purchaseperiod.  Employee stock purchase plan compensation expense calculated under thefair value approach is recognized ratably over the six-month purchaseperiod.  The weighted average fair valueof the shares purchased under the employee stock purchase plan was $2.29 forthe nine month period ended September 30, 2006, based upon the followingassumptions:

|                          | ** ** | **Nine months Ended  September 30, 2006** | ** ** |
|--------------------------|------------|---------------------------------------------------------------|------------|
| Risk-free  interest rate |       | 4.82                                                          | %          |
| Volatility               |       | 95.0                                                          | %          |
| Expected  dividend yield |       | 0.0                                                           |       |
| Expected life            |       | 0.5 Years                                                     |       |

 

Historical information regarding the Company’scommon stock was the primary basis for the expected volatilityassumptions.  The expected life is equalto the six-month purchase period.  As ofSeptember 30, 2006, there was $2,000 of unrecognized expense related toestimated purchases.

***Restricted Stock***

The Company sells sharesof restricted common stock (“restricted stock”) under the Company’s 1997 StockPlan, as amended, to its Board of Directors and certain employees of theCompany at a price per share of $0.01. The shares of restricted stock vest ratably over a four year serviceperiod.  In the event that a restrictedstockholder ceases to provide services to the Company prior to the vesting ofany of the then unvested shares held by that stockholder, the restrictedstockholder is required to sell any unvested shares of restricted stock back tothe Company at the original purchase price of $0.01 per share.

Prior to the adoption of SFAS No. 123R, the Company recorded deferredcompensation based on the intrinsic value of the shares of restricted stock atthe time of sale.  The Company thenrecognized deferred compensation as compensation expense ratably over theexpected four year vesting period.  Dueto the adoption of SFAS No. 123R, the balance of deferred compensation ofapproximately $776,000 as of December 31, 2005, relating entirely to restrictedstock grants, has been reclassified to additional paid-in-capital in theaccompanying unaudited consolidated balance sheet as of September 30,2006.  With respect to restricted stock,the Company recognized approximately $72,000 and $224,000 of stock-basedcompensation expense during the three and nine month periods ended September30, 2006, respectively, and $33,000 and $80,000 during the three and nine monthperiods ended September 30, 2005, respectively.

Restricted stockcompensation expense calculated under the fair value approach is based upon thecurrent stock price at the time of grant and is recognized ratably over thefour year vesting period.  Based uponhistorical information and management’s estimate of future voluntary turnoverrates, the Company has calculated this expense based on an annualized estimatedforfeiture rate of 6%.  The Companytrues-up estimated forfeitures to actual at the end of each reportingperiod.  During the nine months endedSeptember 30, 2006 and September 30, 2005, the Company sold 62,196 and 68,016shares of

9

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restrictedstock, respectively.  The aggregate fairvalue of restricted stock vested during the nine month period ended September30, 2006 was $130,000.

Total compensationexpense related to unvested shares of restricted stock was $922,000 as ofSeptember 30, 2006, which amount the Company expects to recognize over aweighted average period of 3.0 years.

Restricted stock activity for the nine months endedSeptember 30, 2006 was as follows:
|                                   | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------|------------|----------------------------|------------|---------------------------------------------------------|------------|
| Unvested,  December 31, 2005 |       | 114,260                    |       | $                                                       | 7.90       |   |
| Granted                           |       | 62,196                     |       | 6.84                                                    |       |
| Vested                            |       | (16,685                    | )          | 7.78                                                    |       |
| Forfeited                         |       | (7,969                     | )          | 7.38                                                    |       |
| Unvested, September 30,  2006     |       | 151,802                    |       | $                                                       | 7.51       |   |

 

**(6)****                                 Accrued Liabilities**

Accrued liabilities consist of the following:
|                                    | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Accrued health  insurance expense  |       | $                            | 258,083    |                        | $          | 169,811 |   |
| Accrued salary  and salary-related |       | 652,651                      |       | 639,297                     |       |
| Accrued  professional fees         |       | 218,162                      |       | 128,801                     |       |
| Other accrued  expenses            |       | 269,473                      |       | 232,599                     |       |
|                               |       | $                            | 1,398,369  |                        | $          | 1,170,508 |   |

 

**(7)**                                 **Capital Lease Obligations**

TheCompany entered into a capital lease agreement in the amount of $491,000 on May1, 2006 to finance the purchase of furniture and equipment for the Company’snew headquarters located in Andover, Massachusetts.  The lease has a five year term which expireson May 31, 2011 and is payable in 60 equal monthly installments.  The interest rate on the capital lease is6.2%.  Total interest payments over thelife of the lease are estimated to be $99,000. The lease contains a provision whereby the Company would be required torepay the outstanding principal balance should the Company’s cash balance everbe less than $5,000,000.

**(8)****                                 DeferredRent**

InJanuary 2006, the Company entered into a new lease agreement forapproximately 44,000 square feet of office space.  The Company moved to the new headquarterslocated in Andover, Massachusetts in April 2006. The lease has a ten-year termwith an option to renew the lease for an additional five-year term at thethen-applicable fair market rent.  Underthe terms of the lease, the Company receives free rent for the first six monthsand the landlord will provide a tenant improvement allowance of up to$308,000.  The balance of deferred rentin the accompanying balance sheet as of September 30, 2006 represents theaccumulated amount due for the free rent period plus the tenant improvementallowance of $247,000 received as of September 30, 2006.

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**(9)****                                ****Segment and GeographicInformation**

To date, the Company has viewed its operations andmanages its business as principally one segment, software and hardware salesand associated services. As a result, the financial information disclosedherein represents all of the material financial information related to theCompany’s principal operating segment in accordance with SFAS No. 131,**“*Disclosures About Segments of an Enterprise andRelated Information*.”

Total revenue from international sources was $585,000and $1.5 million for the three months and nine months ended September 30, 2006,respectively, and $725,000 and $2.0 million for the three months and ninemonths ended September 30, 2005, respectively. The following table represents amounts relating to geographic locations:
| ** **         | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **         | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Total revenue  (1) |       |                                                 |       |                                                |       |   |   |   |   |
| United States      |       | $                                                    | 3,056,310  |                                                | $          | 2,440,509 |   | $ | 8,511,444 |   | $ | 8,610,429 |   |
| United Kingdom     |       | 146,129                                              |       | 158,925                                             |       | 482,435 |   | 654,457 |   |
| Canada             |       | 133,605                                              |       | 240,904                                             |       | 486,588 |   | 514,630 |   |
| South Africa       |       | 210,339                                              |       | 63,115                                              |       | 291,876 |   | 239,376 |   |
| Rest of World      |       | 94,728                                               |       | 262,320                                             |       | 273,828 |   | 578,661 |   |
|               |       | $                                                    | 3,641,111  |                                                | $          | 3,165,770 |   | $ | 10,046,171 |   | $ | 10,597,553 |   |

 
| ** **             | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Long-lived  assets (2) |       |                         |       |                        |       |
| United States          |       | $                            | 1,513,607  |                        | $          | 168,360 |   |
| United Kingdom         |       | 20,566                       |       | 18,768                      |       |
|                   |       | $                            | 1,534,173  |                        | $          | 187,128 |   |

----

(1)             Revenueis attributed to geographic regions based on location of customer.

(2)             Long-lived assetsinclude property and equipment and other assets.

**(10)         SubsequentEvent**

TheCompany, Blue Chip Technologies Ltd. (“Blue Chip”), BC Acquisition, Inc.,a wholly-owned acquisition subsidiary of the Company (“Merger Sub”), OmtoolHealthcare, LLC, a wholly-owned subsidiary of the Company (the “LLC”), andWilliam J. Rynkowski, Jr. (the “Principal Shareholder”) entered into anAgreement and Plan of Merger (the “Merger Agreement”), dated November 13,2006, pursuant to which Merger Sub will, subject to the terms and conditions inthe Merger Agreement, merge with and into Blue Chip (the “Merger”). As a resultof the Merger, Blue Chip will become a wholly-owned subsidiary of the Company.Promptly following the Merger, the Company will cause Blue Chip to merge withand into the LLC.

Theestimated aggregate consideration for the Company’s acquisition, by merger, ofBlue Chip is up to $4.1 million, subject to adjustment, consisting of acombination of cash, promissory notes and common stock of the Company. TheCompany will hold back a portion of the purchase price as a source of paymentfor any indemnification claims that may arise under the Merger Agreement. TheMerger, which is subject to customary and other closing conditions, includingthe entry by the Company and the Principal Shareholder into a piggy-backregistration rights agreement and an employment agreement, is expected to closein December 2006.

BlueChip, based in Danvers, Massachusetts, is a provider of electronic formsautomation, document imaging and object archiving solutions to the healthcarevertical market.

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**Item 2.**

**MANAGEMENT’S DISCUSSIONAND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

Management’s Discussionand Analysis of Financial Condition and Results of Operations for the three andnine months ended September 30, 2006 should be read in conjunction with theaccompanying consolidated financial statements for the periods specified andthe associated notes.  Further reference should be made to our AnnualReport on Form 10-K for the year ended December 31, 2005, as filed with the SECon March 28, 2006.

**Overview**

In the first quarter of 2004, we introduced a newand innovative document routing platform for the distributed capture, processand distribution of both paper and electronic documents.  That platform, AccuRoute® 2.0, was initially targeted at thelegal vertical market.  AlthoughAccuRoute’s features are horizontal in nature and apply to many differentmarkets - not just the legal vertical market - we made a strategic decision tofocus primarily on the legal vertical market for two reasons.  First, we believed the characteristics of thelegal vertical market were such that a company of our size could identify,segment and, using our small direct sales force, sell to the majority of thelargest law firms.  Second, based on ourenterprise fax experience in that vertical market, we understood that large lawfirms had intense document routing requirements due to their paper-intensivebusiness processes.  These wererequirements that we believed closely matched those of much larger enterprisesand could provide the foundation for future market expansion.  Today, we view this strategy as having beenvery successful.  Despite the relativelysmall size of the legal vertical market, to date we have well in excess of 150law firms and almost 40% of the top 100 law firms as AccuRoute customers.  AccuRoute has received product accolades fromleading industry vendors and product analysts, which we believe underscores theproduct capabilities for other key vertical markets.

At this time, we expect that our leading position inthe document capture and routing segment of the legal vertical market willcontinue to be an area of primary focus for us, but will not continue toprovide the substantial growth opportunities we are seeking to achieve.  Based on our success in the legal verticalmarket, the industry accolades about AccuRoute that we continue to receive fromthird parties and the fact that AccuRoute sales presently represent more than50% of our software license revenue, we see a large market opportunity forAccuRoute in several other vertical market segments, particularly financialservices and healthcare.

In April 2005, we outlined a strategic initiative tosignificantly increase our investments in sales and marketing in order tocapitalize on that larger market opportunity. Our sales and marketing expenses increased gradually during the latterhalf of 2005, we did not fill the key senior management positions in sales andmarketing until October and November of 2005 and have since continued to fillkey positions on our sales teams.  Due tothe challenge of staffing our sales and marketing organization and inpenetrating new vertical markets, we have not yet achieved the market successthat we anticipate in those expanded vertical markets.  Despite the strategic completion of thehiring of our management team only at the end of 2005, we believe there aremany indications that our increased investments are starting to bearfruit.  If these key business indicatorscontinue on their current trajectories, we expect that our investments willincreasingly have a positive impact on our financial results going forward.

Further, we believe that:

1.               the continued growth in AccuRoute softwarelicense revenue (now representing more than 50% of total software license revenue);

2.               our recently announced relationships withpartners such as HP and Xerox (as announced during the third quarter) which area direct result of our significant investment in indirect sales; and

3.               the continued increase in revenue quarterover quarter in 2006 (up 16% on the strength of AccuRoute from the second tothe third quarter), notwithstanding the continued steady decline in new salesof our legacy fax software and hardware over that same period;

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all indicate that we are poised to take the next step to advance ourbusiness and grow our top-line revenue.

In addition to the growth attributed to our directsales efforts, another specific area of steady growth has resulted from oursignificant investment in indirect sales (also referred to as channelsales).  We have seen growth in indirectsales bookings over the last four quarters****andcontinue to believe that, with continued focus and investment, indirect saleswill ultimately become our primary distribution method to drive widespreadmarket coverage of our products.

Clearly, we have many remaining challenges as weseek to expand our business into new vertical markets, offset declines in ourlegacy fax business (including the hardware revenues associated with suchsales) with increased software license revenue from AccuRoute sales and improveour results outside of the Americas. Beyond the legal vertical market, we are starting to see an increasingnumber of opportunities in other vertical markets, but progress has been slowerand more expensive than we initially expected. As indicated by our operating results for the third quarter of 2006, wecontinue to invest in direct and indirect sales efforts, as well as marketingefforts, ahead of anticipated revenues attributable to these expenses.

Sales from our European operations, which were in asteady decline for several years, have been relatively flat for the past fourquarters and have not yet achieved the upward trajectory of our U.S.operations.  We remain optimistic that wewill see improvements outside the Americas, but for now, we will lookprimarily to our U.S. sales for our immediate future growth.  Despite these challenges, the recentstabilization of our legacy maintenance business and the continued growth ofour AccuRoute business give us confidence that our continued investments arewarranted, as we believe they will produce significant improvements in ourfinancial results over time.

**Products and Services Overview**

We provide documentrouting solutions and services that enable organizations to manage the capture,processing and distribution of “mixed-mode” documents (i.e., documents thatcontain both paper and electronic components) to electronic information systemssuch as enterprise content management, document management, records management,e-mail and document-archiving systems, leveraging application interfaces withwhich users are already familiar.  Ourenterprise-class products are used by organizations that manage paper-baseddocuments as part of their standard business processes or that have stringentcompliance requirements for secure document handling, storage, integration andtracking of a variety of documents to or from corporate information systems.

We help companies achievethose levels of control by leveraging existing information technology (“IT”)infrastructures and integrating with industry-leading electronic informationsystems.  We add secure documentmanagement and routing functions, along with high-volume fax functionality, toa company’s existing communication infrastructure.  Since paper remains integral to many businessprocesses, we also provide technology that incorporates electronic delivery,distributed document capture, security and billing functionality intoindustry-leading multi-function and scanning devices.

AccuRoute, our flagshipproduct, is a software platform for the distributed capture of paper documentsand, along with existing electronic documents, provides a mechanism for theirsimplified, simultaneous and secure distribution.  Our AccuRoute product allows companies tocontrol the integration and distribution of mixed-mode documents intoever-changing corporate information systems and processes.  Similar in concept to a network router, ourAccuRoute product is the document routing hub, transforming both paper andelectronic-based documents into electronic files, dynamically converting thedocument formats to the required output format, and routing them both withinand outside an organization.

Working with majormulti-function devices (“MFDs”) and electronic information systems (enterprisecontent management, document management, records management and archivalsystems, as well as fax and e-mail systems), our AccuRoute product provides adevice-independent, personalized solution that enables users to distributedocuments from a multi-function device panel or right from their desktopcomputers using a familiar and comfortable interface.  In addition, our AccuRoute product supportsthe movement of electronic documents and information, enabling companies toincrease employee productivity by quickly capturing hardcopy documents,distributing them in electronic form and, through its security features,complying with privacy regulations related to health, financial and otherconfidential information.

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We plan to continue thedevelopment of our AccuRoute product line; encapsulate the functionality of allour products into a single, configurable platform; expand our integration withcomplementary technologies (such as document and records management tools); andextend our document capture capabilities to continue to include compatibilitywith virtually all MFDs and scanners.  Inaddition, we continue to focus on tailoring our products to the specific needsof new markets we are entering.

GenidocsTM,our secure document-delivery application product, integrates with existinge-mail systems and provides multiple options for content and attachmentencryption, authentication, audit trail, delivery confirmation and digitalsignatures.  GenifaxTM, our enterprise faxproduct, offers a scalable, server-based feature set and shares a commonMicrosoft® Windows® server-basedarchitecture with our Genidocs product line.

Companies can deploy oursoftware products on heterogeneous, multi-platform networks, digital scanningdevices and MFDs and can integrate them with both desktop and enterprisesoftware applications such as content management, e-mail and groupwaresystems.  To address customer needs, ourproducts are modular and scaleable.  As aresult, customers can add additional communication capacity through theaddition of system components and connectors to keep pace with growingdemands.  In addition, due to thisscalable, modular design, customers can add additional Omtool product serversto a configuration to provide failover redundancy, helping to ensure continuousoperation.  We license our products on acombination server/seat basis and as external hardware devices become moretechnologically advanced, we will extend a portion of our license fees to adevice-based model.

We resell certainhardware products (such as intelligent fax boards) from third-party vendorstypically in connection with sales of our Genifax product.  In most instances, hardware sales are aresult of either new sales or sales to existing customers who are upgradingtheir IT infrastructure.  Occasionally,where our customers also want fax capabilities, we sell hardware products withour AccuRoute product.  We undertakethese hardware sales as a convenience to our customers, who alternatively canopt to obtain hardware directly from a third-party vendor.  The fax boards and fax modems that we resellare not functional without our product software and we are not generally in thebusiness of selling fax boards and modems. We purchase these hardware products as needed to ship to our customersand we typically maintain a minimal inventory of these hardware products.

Service and other revenuehas historically consisted primarily of the sale of support contracts tocomplement software products we license to our customers.  We generate a smaller portion of our serviceand other revenue from consulting, training and installation services.

The following table is apresentation of our total revenue:
| ** **                                    | ** ** | **Total Revenue** | ** **        | **Net Loss** | ** ** | **Software License  Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------|-------------------|-------------------|------------|------------------------------------|------------|
| Three months  ended September 30, 2006        |       | $                      | 3,641,111         |              | $          | (1,082,917                         | )          | $ | 1,031,839 |   |
| Three months  ended September 30, 2005        |       | $                      | 3,165,770         |              | $          | (343,430                           | )          | $ | 877,357 |   |
| Change over same  period of prior fiscal year |       | $                      | 475,341  or 15.0  | %                 | $          | (739,487  or (215.3                | )  )%      | $ | 154,482  or 17.6 | % |
|                                          |       |                   |              |              |       |                               |       |
| Nine months  ended September 30, 2006         |       | $                      | 10,046,171        |              | $          | (4,248,416                         | )          | $ | 2,989,554 |   |
| Nine months  ended September 30, 2005         |       | $                      | 10,597,553        |              | $          | (189,626                           | )          | $ | 3,333,046 |   |
| Change over same  period of prior fiscal year |       | $                      | (551,382  or (5.2 | )  )%             | $          | (4,058,790  or (2,140.4            | )  )%      | $ | (343,492  or (10.3 | )  )% |

Duringthe first nine months of 2006, we experienced a decrease in our revenue dueprimarily to a decrease in sales for our legacy fax product that impacted bothour software license and hardware revenue. This decrease was, however, partially offset by an increase in ourAccuRoute software license revenue during the same period.  Our service and other revenue increased duringthe nine month period ended September 30, 2006 as compared to the same periodin 2005 as a result of a 76% increase in AccuRoute related support servicesrevenue.

Any decrease in demandfor our products would likely result in decreased revenue, which would, inturn, have a significant negative impact on our financial results because asignificant portion of our operating costs such as personnel, rent

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anddepreciation are fixed in advance of a particular quarter.  As a result, our costs for sales andmarketing, research and development and general and administrative couldcontinue to increase as a percentage of revenue, thereby negatively affectingour operating results.

Our future revenue andoperating results may fluctuate from quarter to quarter based on the number andsize of sales transactions we enter into with customers, the adequacy ofprovisions for losses, general economic conditions and other factors.  In addition, revenue from one or more largeorders may constitute a significant portion of our total revenue in aparticular quarter, further exacerbating fluctuations in quarterly results.

We have historicallyderived a majority of our total revenue from sales within the UnitedStates.  Revenue from our Europeanoperations decreased during the nine months ended September 30, 2006, ascompared to the same period in 2005, due to a decrease in license and hardwarerevenue from our European customers.  Wewill continue to leverage our AccuRoute base in Europe, as well as our indirectchannel relationships in Europe, to focus sales resources on the legal andfinancial services vertical markets. There can be, however, no assurance that we will be able to increaseinternational sales of our products and the failure to do so may have amaterial adverse effect on business, financial condition and results ofoperations.

Thefollowing is a presentation of our domestic and international revenue:
| ** **                                    | ** ** | **Total Revenue** | ** **        | **United States Revenue** | ** ** | **Non-United States  Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------|-------------------|-------------------------------------|------------|-------------------------------------|------------|
| Three months ended  September 30, 2006        |       | $                      | 3,641,111         |                                | $          | 3,056,310  or 83.9                  | %          | $ | 584,801  or 16.1 | % |
| Three months ended  September 30, 2005        |       | $                      | 3,165,770         |                                | $          | 2,440,509  or 77.1                  | %          | $ | 725,261  or 22.9 | % |
| Change from same period  of prior fiscal year |       | $                      | 475,341  or 15.0  | %                                   | $          | 615,801  or 25.2                    | %          | $ | (140,460  or (19.4 | )  )% |
|                                          |       |                   |              |                                |       |                                |       |
| Nine months ended  September 30, 2006         |       | $                      | 10,046,171        |                                | $          | 8,511,444  or 84.7                  | %          | $ | 1,534,727  or 15.3 | % |
| Nine months ended  September 30, 2005         |       | $                      | 10,597,553        |                                | $          | 8,610,429  or 81.2                  | %          | $ | 1,987,124  or 18.8 | % |
| Change from same period  of prior fiscal year |       | $                      | (551,382  or (5.2 | )  )%                               | $          | (98,985  or (1.1                    | )  )%      | $ | (452,397  or (22.8 | )  )% |

 

OurUnited Kingdom subsidiary, Omtool Europe Limited, transacts business primarilyin its local currency.  We then translateresults generated by that entity into United States dollars and consolidatethem with our domestic results for reporting purposes.  As we make sales to customers in a variety ofcountries, significant currency exchange rate fluctuations could have amaterial impact on our results of operations. We manage our foreign currency exchange exposure by monitoring our netmonetary position using natural hedges of our assets and liabilitiesdenominated in local currencies.  Therecan be no assurance that this policy will eliminate all foreign currencyexchange exposure.  Foreign currencyexposure has not been material to our financial position or results ofoperations to date.  If the volume of ourbusiness denominated in foreign currencies increases, we may be required to usederivatives to hedge foreign currency exposure.

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Wewill continue to leverage our existing distribution channels, where appropriate,to broaden our reach to our target vertical markets and further penetrate ourinstalled base.  We are pursuing salesopportunities via our solution/reseller channels, as well as focusing salesefforts on specific market segments, in order to facilitate acceptance of ourproducts.  However, we currently havemore of our sales resources focused on the direct model and have consequentlyderived a significant portion of our revenue from direct sales.
| ** **                                    | ** ** | **Total Software  License and  Hardware  Revenue** | ** **          | **Software License and  Hardware Revenue from  Indirect Distribution  Channel Sales** | ** ** | **Software License  and Hardware  Revenue From  Indirect Distribution  Channel Sales as a  Percentage of Total  Software License  and Hardware Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------------------|---------------------|---------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Three months  ended September 30, 2006        |       | $                                                            | 1,637,112           |                                                                                                                | $          | 561,204                                                                                                                                                                                                              |       | 34.3 | % |
| Three months  ended September 30, 2005        |       | $                                                            | 1,460,333           |                                                                                                                | $          | 589,205                                                                                                                                                                                                              |       | 40.3 | % |
| Change from same  period of prior fiscal year |       | $                                                            | 176,779  or 12.1    | %                                                                                                                   | $          | (28,001  or (4.8                                                                                                                                                                                                     | )  )%      | (6.0 | )% |
| Nine months  ended September 30, 2006         |       | $                                                            | 4,558,894           |                                                                                                                | $          | 1,851,799                                                                                                                                                                                                            |       | 40.6 | % |
| Nine months  ended September 30, 2005         |       | $                                                            | 5,475,329           |                                                                                                                | $          | 2,029,058                                                                                                                                                                                                            |       | 37.1 | % |
| Change from same  period of prior fiscal year |       | $                                                            | (916,435  or (16.7) | )  %                                                                                                                | $          | (177,259  or (8.7                                                                                                                                                                                                    | )  )%      | 3.5 | % |

 

*HeadquartersLease Arrangements*

InJanuary 2006, we entered into a new lease agreement for approximately44,000 square feet of office space.  Wemoved our headquarters to this facility in Andover, Massachusetts at the end ofApril 2006.  The lease has aten-year term and we have an option to renew the lease for an additionalfive-year term at the then-applicable fair market rent.  Under the terms of the lease, we receive freerent for the first six months and the landlord will provide us with a tenantimprovement allowance of up to $308,000, of which we have received $247,000 asof September 30, 2006.  Additionally, wehave a one-time right to terminate the lease, upon twelve months’ writtennotice, after the sixth year of the lease term. If we decide to terminate the lease, we must pay a penalty of ninemonths’ rent and the unamortized portion of the tenant improvementallowance.  We believe the new facilitywill be suitable and sufficient for our needs for the foreseeable future.

**Critical Accounting Policies and Estimates**

We have identified thepolicies and estimates below as critical to our business operations and theunderstanding of our results of operations. The impact and any associated risks related to these policies on ourreported and expected financial results and business operations are discussedin appropriate sections throughout Management’s Discussion and Analysis ofFinancial Condition and Results of Operations. Our preparation of this Form 10-Q required us to makeestimates and assumptions that affect the reported amount of assets andliabilities, the disclosure of contingent assets and liabilities as of the dateof the financial statements included herein and the reported amounts of revenueand expenses during the period covered by this report.  There can be no assurance that actual resultswill not differ materially from those estimates.

*Revenue Recognition andAccounts Receivable Reserves.**  *We derive our revenue primarilyfrom two sources: (i) product revenue, which includes software license andhardware revenue; and (ii) service and support revenue, which includessoftware maintenance and support, installation, training and consulting revenue.  We license our software products on aperpetual basis.  We generate revenuefrom licensing the rights to use our software products and sales of hardwaredirectly to end-users and indirectly through resellers.  Our resellers order products from us based onpurchase orders received from end-users and do not order stock.  We generally sell our products to resellersand directly to end-users without any specifically stated rights of return.  Occasionally, however, in our solediscretion, we will accept a product return if the end-user finds that theproduct does not fit its needs.  We alsosell hardware products, which are provided by a third-party, at cost plus anadditional mark-up, to end-users and indirectly through resellers.  The hardware products that we resell are notfunctional without our software.  Tosupport our software products, we sell software maintenance, support,installation, training and consulting services to end-users and indirectlythrough resellers.

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We apply the provisionsof Statement of Position (“SOP”) 97-2,**“*Software Revenue Recognition*,” as amended by SOP 98-9,Modification of SOP 97-2,**“*SoftwareRevenue Recognition with Respect to Certain Transactions*,” toall transactions involving the sale of multiple elements including software,hardware and service revenue.  We applythe provisions of SFAS No. 48,**“*RevenueRecognition When Right of Return Exists*,” with respect toproviding for potential future product returns. As described below, we must make and use significant judgments andestimates in connection with the revenue recognized in any accountingperiod.  Material differences may haveresulted in the amount and timing of our revenue if we had made differentjudgments or utilized different estimates.

We recognize revenue fromthe sale of software products and hardware to both end-users and resellers whenpersuasive evidence of an arrangement exists, the products have been delivered,the fee is fixed or determinable, collection of the resulting receivable isprobable and there are no uncertainties regarding customer acceptance.  We maintain a reserve for potential productreturns.  We recognize softwaremaintenance and support revenue over the term of the related maintenanceperiod, which is typically a one-year period, beginning on the date ofdelivery.  On those occasions when wesell multiple-year maintenance contracts, we recognize the associated revenueover the multiple-year term of the maintenance contract.  We recognize other service revenue as weperform the services.  If an arrangementincludes an acceptance provision and acceptance is uncertain, then we willdefer all revenue until the customer accepts the products purchased.  Acceptance in these instances generallyoccurs upon the earlier of receipt of a written customer acceptance orexpiration of the acceptance period.  Ifan arrangement includes an acceptance provision tied to determination that ourproduct meets published specifications and there are no uncertainties withregard to the customer’s acceptance, then we will recognize revenue at the timeof sale, provided that all other revenue recognition criteria previouslymentioned have been met and the acceptance period is of short duration.

Our transactionsfrequently involve the sale of software, hardware and related services undermultiple element arrangements.  Revenueunder multiple element arrangements is allocated to each element under theresidual method, in accordance with SOP 98-9.  Under this method, revenue is allocated firstto all undelivered elements, such as services, based on the fair value of thoseelements, which is calculated to be the price charged when these elements aresold separately and unaccompanied by other elements.  Our services generally are not essential tothe functionality of the software, as these services do not alter thecapabilities of the software and do not carry a significant degree of risk toperform.  The amount allocated to thedelivered elements, such as software license and hardware revenue, is thedifference between the total arrangement value and the amount allocated to theundelivered elements.  If the deliveredelements include both software and hardware, the amount allocated to hardwarerevenue is based on the price charged to us by the third party vendor plus anadditional mark up, with the remainder allocated to software revenue.  To the extent that a discount is offered inthe arrangement, the entire discount is allocated to the delivered element orelements.  If the delivered elementsinclude hardware and software, the discount is allocated to the hardware andsoftware based on their respective list prices.

For all sales, we use abinding purchase order, a signed contract or a credit card authorization asevidence of an arrangement.  Salesthrough our resellers are evidenced by a master agreement governing therelationship, together with binding purchase orders issued on atransaction-by-transaction basis.

At the time of atransaction, we assess whether the fee associated with the transaction is fixedor determinable and whether or not collection is probable.  If a significant portion of a fee is duebeyond our normal payment terms, which are thirty to sixty days from invoicedate, we account for the fee as not being fixed or determinable.  In these cases, we recognize revenue as thefees become due.  We assess collectionbased on a number of factors, including past transaction history with thecustomer and the credit-worthiness of the customer.  We review Dunn & Bradstreet creditreports for our resellers and adjust our credit limits with those resellersaccordingly.  If a particular resellerdoes not have a favorable report or if we do not have enough credit informationto determine if the reseller is creditworthy then we predominantly sell tothose resellers on cash on delivery terms. We do not request collateral from our customers.  If we determine that collection of a fee isnot reasonably assured, the fee is deferred and revenue is recognized at thetime collection becomes reasonably assured, which is generally upon receipt ofpayment.

We maintain reserves forpotential product returns and make adjustments to these reserves as neededbased on historical product return rates. We also consider the impact of new product introductions, changes incustomer demand and acceptance of our products on the adequacy of thesereserves.  Our calculation of theestimated return reserve is based upon (1) an account specific review ofpotential returns where a return probability is known and (2) an estimatebased upon past

17

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historicalreturns as a percentage of revenue.  Wemust make and use significant judgments and estimates in connection withestablishing the product returns reserve in any accounting period.  Material differences may have resulted in theamount and timing of revenue for this or any prior period if we made differentjudgments or utilized different estimates.

As with the productreturn reserve, we must make estimates of our ability to collect on ouraccounts receivable.  We record tradeaccounts receivable at the invoiced amount and these accounts do not bearinterest.  We specifically analyzeaccounts receivable, historical bad debts, customer credit-worthiness, currenteconomic trends and changes in customer payment patterns when evaluating theadequacy of our allowance for doubtful accounts.  We review our allowance for doubtful accountson a monthly basis.  Our calculation ofthe estimated accounts receivable reserve is also based upon (1) , anaccount specific review of potential uncollectible accounts, where a bad debtprobability is known, and (2) an estimate based upon past historical baddebts as a percentage of accounts receivable. We do not have any off-balance-sheet credit exposure to our customers.

Our combined accountsreceivable and product returns reserve was $16,000 and $33,000 at September 30,2006 and December 31, 2005, respectively.  Both components of calculating the estimatedreserve — specific identification and historic experience — are materialjudgments that we make.  We base thesejudgments on historic trends, taking into consideration current business andeconomic conditions, which could change materially, thus changing the requiredreserve level materially.  The potentialchange to the size of our required reserve could be positive, in the event thereserve estimate proves unnecessary, or negative, if the reserve provesinadequate.

Our deferred revenue iscomprised mainly of revenue that is deferred for software maintenance andsupport contracts.  The other componentsof deferred revenue are amounts from sales transactions that were deferredbecause they did not meet all of the provisions of our revenue recognitionpolicy.

*Software DevelopmentCosts.**  *We consider software development costs forcapitalization when technological feasibility is established in accordance withSFAS No. 86,**“*Accountingfor the Costs of Computer Software To Be Sold, Leased or Otherwise Marketed*.”  We sell software in a market that is subjectto rapid technological change, new product introductions and changing customerneeds.  Accordingly, we have determinedthat we cannot ascertain technological feasibility until the development stateof the product is nearly complete.  Thetime period during which cost could be capitalized from the point of reachingtechnological feasibility until the time of general product release is veryshort and, consequently, the amounts that might be capitalized are not materialto our consolidated financial position or results of operations.  Therefore, we charge all software developmentcosts to operations in the period incurred.

*Taxes*.   Weare required to estimate our income and state sales taxes.  This process involves estimating our actualcurrent tax obligations, while also assessing differences resulting from thedifferent treatment of items for tax and accounting purposes that result indeferred income tax assets and liabilities and accrued state sales taxliabilities.  We include deferred incometax assets and liabilities and accrued state sales tax liabilities in ourbalance sheet.

We assess our deferredtax assets for each reporting period to determine whether it is more likelythan not that we will recover from future taxable income.  In making this assessment, we includeassumptions regarding ongoing tax planning strategies.  We establish a valuation allowance for assetswhen their recovery is not certain.  Weinclude changes to the valuation allowance as an expense or benefit within thetax provision in our statement of operations.

We provide a fullvaluation allowance against all of our net deferred tax assets and willcontinue to do so until we return to an appropriate level of sustained taxableincome.  The ultimate realization ofthese deferred tax assets depends upon our ability to generate sufficientfuture taxable income.  If we aresuccessful in generating sufficient future taxable income, we will reduce thevaluation allowance through a reduction in income tax expense in the future.

We estimate accrued statesales taxes for each reporting period based on tax rates in effect for thereporting periods in each of the states where we have a potential nexus and forthe time period during which we have that nexus.  The assumptions and estimates used todetermine this liability are subject to change as they are difficult to measureor value.  In the event that actualresults differ from these estimates, our state sales taxes expense could bematerially impacted.

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**New Accounting Pronouncements**

In June 2006, the FASB issued FASB InterpretationNo. 48, “*Accounting for Uncertaininty in Income Taxes, anInterpretation of FASB Statement No. 109*”**(“FIN48”)*,* which clarifies the accounting foruncertainty in income taxes recognized in a company’s financial statements inaccordance with SFAS No. 109.  FIN 48prescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return.  FIN 48 becomeseffective for fiscal years beginning after December 15, 2006.  We do not currently expect to elect earlyadoption of this statement.  We do notexpect FIN 48 to have a material impact on our financial position and resultsof operations.

In September 2006, the FASB issued Statement No. 157“*Fair Value Measurements”*(“SFAS No. 157”),which establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair value financialinstruments.  SFAS No. 157 becomeseffective for fiscal years beginning after November 15, 2007.  We will adopt this statement prospectivelyonce it is effective and applicable to us. We do not expect SFAS No. 157 to have a material impact on our financialposition and results of operations.

In September 2006, the Securities and ExchangeCommissued issued Staff Accounting Bulletin No. 108 (“SAB No. 108”), whichprovides guidance on the consideration of the effects of prior yearmisstatements in quantifying current year misstatements for the purpose of amateriality assessment.  SAB No. 108 ifeffective for fiscal years ending after November 15, 2006.  We do not expect SAB No. 108 to have amaterial impact on our financial potion or results of operations.

**Results of Operations**

Thefollowing table sets forth certain financial data as a percentage of totalrevenue:
| ** **                      | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:                        |       |                                                 |       |                                                |       |   |   |   |   |
| Software license                |       | 28.4                                                 | %          | 27.7                                                | %          | 29.8 | % | 31.5 | % |
| Hardware                        |       | 16.6                                                 |       | 18.4                                                |       | 15.6 |   | 20.2 |   |
| Service and  other              |       | 55.0                                                 |       | 53.9                                                |       | 54.6 |   | 48.3 |   |
| Total revenue                   |       | 100.0                                                |       | 100.0                                               |       | 100.0 |   | 100.0 |   |
| Cost of revenue:                |       |                                                 |       |                                                |       |   |   |   |   |
| Software license                |       | 1.6                                                  |       | 1.3                                                 |       | 1.4 |   | 1.1 |   |
| Hardware                        |       | 10.2                                                 |       | 10.5                                                |       | 9.8 |   | 12.8 |   |
| Service and  other              |       | 23.5                                                 |       | 21.6                                                |       | 24.4 |   | 19.7 |   |
| Total cost of  revenue          |       | 35.3                                                 |       | 33.4                                                |       | 35.6 |   | 33.6 |   |
| Gross profit                    |       | 64.7                                                 |       | 66.6                                                |       | 64.4 |   | 66.4 |   |
| Operating  expenses:            |       |                                                 |       |                                                |       |   |   |   |   |
| Sales and  marketing            |       | 54.7                                                 |       | 42.7                                                |       | 61.7 |   | 34.6 |   |
| Research and  development       |       | 18.3                                                 |       | 18.3                                                |       | 20.9 |   | 15.3 |   |
| General and  administrative     |       | 22.2                                                 |       | 18.0                                                |       | 25.2 |   | 19.5 |   |
| Total operating  expenses       |       | 95.2                                                 |       | 79.0                                                |       | 107.8 |   | 69.4 |   |
| Loss from  operations           |       | (30.5                                                | )          | (12.4                                               | )          | (43.4 | ) | (3.0 | ) |
| Interest and  other income, net |       | 0.8                                                  |       | 1.6                                                 |       | 1.1 |   | 1.3 |   |
| Income tax  provision           |       | 0.0                                                  |       | 0.0                                                 |       | 0.0 |   | 0.1 |   |
|                            |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss                        |       | (29.7                                                | )%         | (10.8                                               | )%         | (42.3 | )% | (1.8 | )% |
|                            |       |                                                 |       |                                                |       |   |   |   |   |
| Gross profit:                   |       |                                                 |       |                                                |       |   |   |   |   |
| Software license                |       | 94.2                                                 | %          | 95.2                                                | %          | 95.2 | % | 96.6 | % |
| Hardware                        |       | 38.4                                                 |       | 42.7                                                |       | 37.1 |   | 36.5 |   |
| Service and other               |       | 57.3                                                 |       | 60.0                                                |       | 55.3 |   | 59.4 |   |

 

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**Revenue**

*SoftwareLicense*.  Our softwarelicense revenue increased by approximately 18% to $1.0 million in the threemonths ended September 30, 2006, compared to $877,000 in the same period in2005, due to an increase in revenue from our AccuRoute product.  Our software license revenue decreased byapproximately 10% to $3.0 million in the nine months ended September 30, 2006,compared to $3.3 million in the same period in 2005, due to a decline insoftware license revenue for our legacy fax product offset in part by a 7%increase in our AccuRoute license revenue.  We did not have any material sales of ourother software products during the nine month period ended September 30, 2006,which reflects our continued focus on the development and sale of our AccuRouteproduct.

Duringthe three and nine month periods ended September 30, 2006, our revenue byproduct category (excluding freight and allowances for returns), as compared tothe same period in the prior fiscal year was as follows:
| ** **                                    | ** ** | **Total  Revenue** | ** **        | **Software License  Revenue** | ** ** | **AccuRoute  License  Revenue** | ** ** | **Legacy Fax   License  Revenue** | ** **       | **Other  Software  License  Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------|-------------------|------------------------------------|------------|---------------------------------|------------|---------------------------------------------|------------------|---------------------------------------|------------|
| Three months ended  September 30, 2006   |       | $                  | 3,641,111         |                               | $          | 1,031,839                       |       | $                                           | 541,872          |                                  | $          | 491,521 |   | $ | 0 |   |
| Three months ended  September 30, 2005   |       | $                  | 3,165,770         |                               | $          | 877,357                         |       | $                                           | 381,851          |                                  | $          | 489,438 |   | $ | 0 |   |
| Change from same period  of prior fiscal year |       | $                  | 475,341  or 15.0  | %                                  | $          | 154,482  or 17.6                | %          | $                                           | 160,021  or 41.9 | %                                     | $          | 2,083  or 0.4 | % | $ | 0  or 0 | % |
|                                          |       |               |              |                               |       |                            |       |                                        |             |                                  |       |
| Nine months ended  September 30, 2006    |       | $                  | 10,046,171        |                               | $          | 2,989,554                       |       | $                                           | 1,664,235        |                                  | $          | 1,313,763 |   | $ | 0 |   |
| Nine months ended  September 30, 2005    |       | $                  | 10,597,553        |                               | $          | 3,333,046                       |       | $                                           | 1,550,070        |                                  | $          | 1,709,166 |   | $ | 4,845 |   |
| Change from same period  of prior fiscal year |       | $                  | (551,382  or (5.2 | )  )%                              | $          | (343,492  or (10.3              | )  )%      | $                                           | 114,165  or 7.4  | %                                     | $          | (395,403  or (23.1 | )  )% | $ | (4,845  or (100.0 | )  )% |

 

The following tablepresents software license revenue as a percentage of total revenue for thethree and nine month periods ended September 30, 2006, as compared to the sameperiods in 2005:
| ** **                                    | ** ** | **Software License Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|
| Three months ended  September 30, 2006        |       | 28.3                                                                                              | %          |
| Three months ended  September 30, 2005        |       | 27.7                                                                                              | %          |
| Change from same period  of prior fiscal year |       | 0.6                                                                                               | %          |
|                                          |       |                                                                                              |       |
| Nine months ended  September 30, 2006         |       | 29.8                                                                                              | %          |
| Nine months ended September  30, 2005         |       | 31.5                                                                                              | %          |
| Change from same period of prior fiscal year  |       | (1.7                                                                                              | )%         |

 

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The results for the threeand nine month periods ended September 30, 2006 and 2005 demonstrate that ourlicense revenue continues to shift toward our AccuRoute product, as displayedin the table below, which summarizes revenue from each of our major productlines (excluding freight and allowances for returns) as a percentage of ourtotal software license revenue:
| ** **                                    | ** ** | **AccuRoute License Revenue as  a Percentage of Software  License Revenue** | ** ** | **Legacy Fax License  Revenue as  Percentage of  Software License Revenue** | ** ** | **Other Software License  Revenue as a Percentage of  Software License Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| Three months  ended September 30, 2006   |       | 52.5                                                                                                           | %          | 47.6                                                                                                                | %          | 0.0                                                                                                                      | %          |
| Three months  ended September 30, 2005   |       | 43.5                                                                                                           | %          | 55.8                                                                                                                | %          | 0.0                                                                                                                      | %          |
| Change from same  period of prior fiscal year |       | 9.0                                                                                                            | %          | (8.2                                                                                                                | )%         | 0.0                                                                                                                      | %          |
|                                          |       |                                                                                                           |       |                                                                                                                |       |                                                                                                                     |       |
| Nine months  ended September 30, 2006    |       | 55.7                                                                                                           | %          | 43.9                                                                                                                | %          | 0.0                                                                                                                      | %          |
| Nine months  ended September 30, 2005    |       | 46.5                                                                                                           | %          | 51.3                                                                                                                | %          | 0.1                                                                                                                      | %          |
| Change from same period  of prior fiscal year |       | 9.2                                                                                                            | %          | (7.4                                                                                                                | )%         | (0.1                                                                                                                     | )%         |

 

Included insoftware license revenue for the nine months ended September 30, 2005 is a netreduction of $24,000 in the sales returns and allowance reserve relatingprimarily to specific accounts where we have determined that the risk of areturn is no longer present.

Although we cannotaccurately predict the exact mix of products that we will sell in the future,we expect that software license revenue will continue to constitute a largerpercentage of our total revenue in the future if demand for our AccuRouteproduct, which generally does not require the purchase of additional hardware,continues to grow and if our AccuRoute product gains additional marketacceptance.

*Hardware.*  Hardware revenue increased during the threemonth period ended September 30, 2006 as compared to the three month periodended September 30, 2005, as a result of the differences in configuration inour legacy fax sales, which sales are the main driver for our hardware revenue.  However, given the overall increase in oursoftware license revenue and decrease in sales of our legacy fax product,hardware revenue for the nine months ended September 30, 2006 represented alower percentage of total revenue than in the same period of the prior year.
| ** **                                    | ** ** | **Hardware Revenue** | ** **         | **Hardware Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------|--------------------|--------------------------------------------------------------------------------------|------------|
| Three months  ended September 30, 2006        |       | $                         | 605,273            |                                                                                 | 16.6       | % |
| Three months  ended September 30, 2005        |       | $                         | 582,976            |                                                                                 | 18.4       | % |
| Change from same  period of prior fiscal year |       | $                         | 22,297  or 3.8     | %                                                                                    | (1.8       | )% |
|                                          |       |                      |               |                                                                                 |       |
| Nine months  ended September 30, 2006         |       | $                         | 1,569,340          |                                                                                 | 15.6       | % |
| Nine months  ended September 30, 2005         |       | $                         | 2,142,283          |                                                                                 | 20.2       | % |
| Change from same period  of prior fiscal year |       | $                         | (572,943  or (26.7 | )  )%                                                                                | (4.6       | )% |

 

We expect market demandfor AccuRoute, which generally does not require our customers to purchaseadditional hardware, to increase and, if it does, we anticipate hardwarerevenue will continue to decline and constitute a smaller percentage of ourtotal revenue.

*Serviceand Other.*  Service andother revenue, which consists primarily of the sale of support contracts tocomplement software products sold to customers and, to a lesser extent,consulting, training and installation services, increased in the three and ninemonth periods ended September 30, 2006 as compared to the same periods in theprior fiscal

21

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year. This increase is due primarily to an increase in sales of AccuRoute-relatedsupport services, which increased by 83% and 76% for the three and nine monthperiods ended September 30, 2006, respectively, as compared to the same periodsin 2005.  During the nine months endedSeptember 30, 2006 this increase was offset in part by a decrease in supportrevenue related to our legacy fax product line.   
| ** **                                    | ** ** | **Service and Other Revenue** | ** **       | **Service and Other Revenue as  a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------|------------------|---------------------------------------------------------------------------------------------------------|------------|
| Three months  ended September 30, 2006        |       | $                                            | 2,003,999        |                                                                                                    | 55.0       | % |
| Three months  ended September 30, 2005        |       | $                                            | 1,705,437        |                                                                                                    | 53.9       | % |
| Change from same  period of prior fiscal year |       | $                                            | 298,562  or 17.5 | %                                                                                                       | 1.1        | % |
|                                          |       |                                         |             |                                                                                                    |       |
| Nine months  ended September 30, 2006         |       | $                                            | 5,487,277        |                                                                                                    | 54.6       | % |
| Nine months  ended September 30, 2005         |       | $                                            | 5,122,224        |                                                                                                    | 48.3       | % |
| Change from same  period of prior fiscal year |       | $                                            | 365,053  or 7.1  | %                                                                                                       | 6.3        | % |

 

We arefocused on improving the renewal rate of software maintenance contracts withour existing customer base in both our United States and European operationsand continue to focus our attention on generating additional service and otherrevenue in future quarters.

**Cost of Revenue**

*SoftwareLicense.*  Cost ofsoftware license revenue consists primarily of the costs we incur insublicensing third-party software products, product media and productduplication.  Software license grossmargin percentage decreased and the cost of software license revenue increasedfor the three and nine month periods ended September 30, 2006 as compared tothe corresponding periods in 2005.  Thisincrease in absolute dollars and decrease in gross margin percentage is dueprimarily to increased royalty payments associated with additional third-partysoftware that we incorporated into our products during the third quarter of2005.  We may license additionalthird-party software components in the future and, therefore, we expect thatour software license cost as a percentage of software license revenue mayincrease slightly in the future.
| ** **                                    | ** ** | **Cost of Software License Revenue** | ** **      | **Software License Gross Margin** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------|-----------------|--------------------------------------------------|------------|
| Three months  ended September 30, 2006        |       | $                                                        | 60,024          |                                             | 94.2       | % |
| Three months  ended September 30, 2005        |       | $                                                        | 41,983          |                                             | 95.2       | % |
| Change from same  period of prior fiscal year |       | $                                                        | 18,041  or 43.0 | %                                                | (1.0       | )% |
|                                          |       |                                                     |            |                                             |       |
| Nine months  ended September 30, 2006         |       | $                                                        | 143,465         |                                             | 95.2       | % |
| Nine months  ended September 30, 2005         |       | $                                                        | 113,185         |                                             | 96.6       | % |
| Change from same period  of prior fiscal year |       | $                                                        | 30,280  or 26.8 | %                                                | (1.4       | )% |

 

*Hardware.*  Cost of hardware revenue consists primarilyof the cost we incur in purchasing third-party hardware products.  During the three month period ended September30, 2006, we experienced an increase in our cost of hardware revenue and adecrease in our hardware gross margin percentage compared to the three monthperiod ended September 30, 2005.  Theincrease in absolute dollars for the cost of hardware revenue is primarily dueto an increase in hardware unit sales. The gross margin percentage for hardware sales decreased due to a changein the mix of particular hardware products sold.

During the ninemonth period ended September 30, 2006, we experienced a decrease in our cost ofhardware revenue and a slight increase in our hardware gross margin percentagecompared to the nine month period ended September 30, 2005.  The decrease in absolute dollars of the costof hardware revenue is due to a decrease in hardware unit sales.  The increase in the gross margin percentagefor hardware sales is primarily due to a change in the mix of particular hardwareproducts sold.

We do not expectsignificant changes in unit prices for the remainder of 2006 and into early2007.

22

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| ** **                                    | ** ** | **Cost of Hardware Revenue** | ** **         | **Hardware Gross Margin** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|--------------------|-------------------------------------|------------|
| Three months  ended September 30, 2006        |       | $                                           | 372,619            |                                | 38.4       | % |
| Three months  ended September 30, 2005        |       | $                                           | 333,761            |                                | 42.7       | % |
| Change from same  period of prior fiscal year |       | $                                           | 38,858  or 11.6    | %                                   | (4.3       | )% |
|                                          |       |                                        |               |                                |       |
| Nine months  ended September 30, 2006         |       | $                                           | 987,301            |                                | 37.1       | % |
| Nine months  ended September 30, 2005         |       | $                                           | 1,361,141          |                                | 36.5       | % |
| Change from same period  of prior fiscal year |       | $                                           | (373,840  or (27.5 | )  )%                               | 0.6        | % |

 

*Serviceand Other.*  Cost ofservice and other revenue consists primarily of the costs we incur in providingtelephone support as well as other miscellaneous customer service-relatedexpenses.  The cost of service and otherrevenue increased in absolute dollars and the gross margin percentage forservice and other revenue decreased during the three and nine month periodsended September 30, 2006 as compared to the same periods in 2005.  For the three months ended September 30,2006, cost of service and other revenue increased in absolute dollars dueprimarily to an increase in wages expense as a result of hiring new employeesin the service department during the period as well as an increase in travel costs.   Also contributing to the increase inexpenses, though to a lesser degree, was an increase in overhead expensesincluding additional costs associated with our new headquarters and an increasein recruiting fees associated with new employees hired during the third quarterof 2006, which costs together resulted in a decline in our service and otherrevenue gross margin percentage.

The increase inabsolute dollars and decrease in gross margin we experienced during the ninemonths ended September 30, 2006 is due primarily to an increase in overheadexpenses, including an increase in healthcare costs and additional costsassociated with our new headquarters, as well as an increase in recruiting feesassociated with new employees hired in the service department during theperiod.   To a lesser extent, cost ofservice and other revenue increased in the nine months ended September 30, 2006in absolute terms as a result of an increased wages expense as a result of thenew employees hired.

We do not expectany significant variances in our service and other revenue gross margin for theremainder of fiscal year 2006 and into early 2007.
| ** **                                    | ** ** | **Cost of Service and Other  Revenue** | ** **       | **Gross Margin for Service  and Other Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------|------------------|--------------------------------------------------------------------------|------------|
| Three months  ended September 30, 2006        |       | $                                                          | 856,000          |                                                                     | 57.3       | % |
| Three months  ended September 30, 2005        |       | $                                                          | 682,896          |                                                                     | 60.0       | % |
| Change from same  period of prior fiscal year |       | $                                                          | 173,104  or 25.3 | %                                                                        | (2.7       | )% |
|                                          |       |                                                       |             |                                                                     |       |
| Nine months  ended September 30, 2006         |       | $                                                          | 2,450,783        |                                                                     | 55.3       | % |
| Nine months  ended September 30, 2005         |       | $                                                          | 2,082,023        |                                                                     | 59.4       | % |
| Change from same period  of prior fiscal year |       | $                                                          | 368,760  or 17.7 | %                                                                        | (4.1       | )% |

 

**Operating Expenses**

*Salesand Marketing.*  Sales and marketing expenses consist primarily ofemployee salaries, benefits, commissions, and associated overhead costs, andthe cost of marketing programs such as direct mailings, public relations, tradeshows, seminars and related communication costs.  Sales and marketing expenses increased in thethree and nine month periods ended September 30, 2006 as compared to the same periodsof 2005 due to an increased number of employees in our sales and marketingdepartments and the associated costs of supporting those employees.  To a lesser extent, sales and marketingexpenses increased during the nine month period ended September 30, 2006 due toan increase in recruiting expenses as a result of new employees hired duringthe period as well as higher overhead expenses due primarily to an increase inhealthcare costs and additional costs associated with our new headquarters.

23

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Additionally,we increased our marketing program expenditures, including trade shows, leadgeneration programs market research and public relations during the thirdquarter and first nine months of 2006 as compared to the same periods of 2005.  These increased expenditures reflect ourinitiative to further penetrate the legal vertical market with our AccuRouteproduct, as well as our initiative to target new vertical markets, includingthe financial services and healthcare vertical markets.  Building on the success of the currentversion of our AccuRoute product within the legal vertical market since itsintroduction in 2004, we intend to continue broadening our current sales andmarketing strategy, which we began in the second quarter of 2005, to encompassthe financial services and healthcare vertical markets.  During the remainder of 2006 our investmentin sales and marketing and business development will remain at the currentlevel and we expect that these investments will increasingly have a positiveimpact on our financial results going forward.
| ** **                                    | ** ** | **Sales and Marketing Expenses** | ** **         | **Sales and Marketing Expenses as  a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|--------------------|------------------------------------------------------------------------------------------------------------|------------|
| Three months  ended September 30, 2006        |       | $                                               | 1,992,144          |                                                                                                       | 54.7       | % |
| Three months  ended September 30, 2005        |       | $                                               | 1,352,295          |                                                                                                       | 42.7       | % |
| Change from same  period of prior fiscal year |       | $                                               | 639,849  or 47.3   | %                                                                                                          | 12.0       | % |
|                                          |       |                                            |               |                                                                                                       |       |
| Nine months  ended September 30, 2006         |       | $                                               | 6,203,344          |                                                                                                       | 61.7       | % |
| Nine months  ended September 30, 2005         |       | $                                               | 3,672,547          |                                                                                                       | 34.7       | % |
| Change from same period  of prior fiscal year |       | $                                               | 2,530,797  or 68.9 | %                                                                                                          | 27.0       | % |

 

*Research and Development.* Research anddevelopment expenses include expenses associated with the development of newproducts, enhancements of existing products and quality assurance activities.These expenses consist primarily of employee salaries, benefits, associatedoverhead costs, consulting expenses and the cost of software developmenttools.   While research and developmentexpenses increased in absolute dollars during the three months ended September30, 2006 compared to the same period in 2005, due an increase in the resourcesallocated to the department resulting in increased wages expense as well as anincrease in consulting costs related to product development, research anddevelopment expenses as a percentage of total revenue remained virtuallyconsistent as compared to the third quarter of 2005 due to the increase in ourtotal revenue.

Researchand development expenses increased during the nine month period ended September30, 2006 as compared to the same period in the prior fiscal year due to anincrease in consulting costs related to product development, as well as anincrease in the resources allocated to the department resulting in increasedwages expense.  To a lesser extent,research and development expenses increased during the nine months endedSeptember 30, 2006 due to an increase in overhead costs as a result of higherhealthcare costs.

24

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Weexpect research and development expenses to remain consistent in absolutedollars for the remainder of 2006, as we believe we currently have a sufficientamount of engineers and third party consultants to support our expansion of ourAccuRoute product into other vertical markets.
| ** **                                    | ** ** | **Research and Development  Expenses** | ** **       | **Research and Development  Expenses as a Percentage of  Total Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------------|-------------------------------------------------------------------------------------------------------------|------------|
| Three months  ended September 30, 2006        |       | $                                                | 664,335          |                                                                                                        | 18.2       | % |
| Three months  ended September 30, 2005        |       | $                                                | 579,422          |                                                                                                        | 18.3       | % |
| Change from same  period of prior fiscal year |       | $                                                | 84,913  or 14.7  | %                                                                                                           | (0.1       | )% |
|                                          |       |                                             |             |                                                                                                        |       |
| Nine months  ended September 30, 2006         |       | $                                                | 2,095,889        |                                                                                                        | 20.9       | % |
| Nine months  ended September 30, 2005         |       | $                                                | 1,617,112        |                                                                                                        | 15.3       | % |
| Change from same period  of prior fiscal year |       | $                                                | 478,777  or 29.6 | %                                                                                                           | 5.6        | % |

 

*Generaland Administrative.* General and administrative expenses consist primarily of employeesalaries and benefits for administrative, executive and finance personnel, aswell as associated corporate general and administrative expenses. In the threeand nine month periods ended September 30, 2006, our general and administrativeexpenses increased as compared to the same periods in the prior fiscalyear.  The increase in general andadministrative expenses during the three and nine month periods ended September30, 2006, both in dollar amount and as a percentage of total revenue, is due toan increase in resources allocated to the department,  resulting in increased wages and stock-basedcompensation expense.  During the thirdquarter of 2006 as compared to the same period in 2005, we experienced anincrease in state sales tax expense, as a result of a reduction in the state salestax accrual in the third quarter of 2005as a result of our settlement of sales tax obligations with certain states atan amount less than what we had estimated. This increase in state sales tax expense also contributed to theincrease in our general and administrative expenses for the nine moth periodended September 30, 2006.  In addition,during the three months ended September 30, 2006, we experienced an increase inprofessional fees related to our compliance efforts with Section 404 of theSarbanes Oxley Act of 2002****as well ashigher legal expenses as a result of increased patent work.

During the nine monthsended September 30, 2006, our general and administrative expenses increased duein part to an increase in wages expenses as a result of hiring a ManagingDirector for our United Kingdom subsidiary, as well as an increase in overheadexpenses as a result of higher healthcare costs and expenses incurred inconnection with the relocation to our new headquarters.  In addition, we experienced an increase inaccounting and legal expenses during the first nine months of 2006 as a resultof increased sales tax compliance and patent work, which was offset by adecrease in professional fees related to the compliance with Section 404 of theSarbanes-Oxley Act of 2002.
| ** **                                    | ** ** | **General and Administrative  Expenses** | ** **       | **General and Administrative Expenses  as a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------|------------------|-------------------------------------------------------------------------------------------------------------------|------------|
| Three months  ended September 30, 2006        |       | $                                                  | 809,439          |                                                                                                              | 22.2       | % |
| Three months  ended September 30, 2005        |       | $                                                  | 570,421          |                                                                                                              | 18.0       | % |
| Change from same  period of prior fiscal year |       | $                                                  | 239,018  or 41.9 | %                                                                                                                 | 4.2        | % |
|                                          |       |                                               |             |                                                                                                              |       |
| Nine months  ended September 30, 2006         |       | $                                                  | 2,527,867        |                                                                                                              | 25.2       | % |
| Nine months  ended September 30, 2005         |       | $                                                  | 2,071,729        |                                                                                                              | 19.5       | % |
| Change from same period  of prior fiscal year |       | $                                                  | 456,138  or 22.0 | %                                                                                                                 | 5.7        | % |

 

*Interest and Other Income, net.*  Interest and other income, net consistsprincipally of interest income earned on cash and cash equivalent balances,offset by interest expense associated with a capital lease that we entered intoin May 2006 to finance the purchase of furniture and equipment for our newheadquarters.  Interest and other income,net decreased as a result of a lower average cash balance during the three andnine month periods ended September 30, 2006 as compared to the same periods of2005 and also as a result of finance charges related to the capital leasediscussed above.  We expect that interestand other income, net will be relatively stable quarter over quarter for thefourth quarter of fiscal year 2006.

25

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| ** **                                      | ** ** | **Interest and Other Income** | ** **        | **Interest and Other Income as a  Percentage of Total Revenue** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|-------------------|---------------------------------------------------------------------------------------------------------|------------|
| Three months  ended September 30, 2006          |       | $                                            | 30,532            |                                                                                                    | 0.8        | % |
| Three months  ended September 30, 2005          |       | $                                            | 51,578            |                                                                                                    | 1.6        | % |
| Increase from  same period of prior fiscal year |       | $                                            | (21,046  or (40.8 | )  )%                                                                                                   | (0.8       | )% |
|                                            |       |                                         |              |                                                                                                    |       |
| Nine months  ended September 30, 2006           |       | $                                            | 114,061           |                                                                                                    | 1.1        | % |
| Nine months  ended September 30, 2005           |       | $                                            | 137,335           |                                                                                                    | 1.3        | % |
| Increase from same  period of prior fiscal year |       | $                                            | (23,274  or (16.9 | )  )%                                                                                                   | (0.2       | )% |

 

*Provision for Income Taxes.*  Wedid not record a tax provision during the three or nine month periods endedSeptember 30, 2006 due to the net loss incurred during the period.  We did not record a tax provision for thethree month period ended September 30, 2005, but did record a net tax provisionof $7,000 for expected tax liability in the United States during the nine monthperiod ended September 30, 2005.

**Subsequent Event: Entry into a Definitive Agreement toAcquire Blue Chip Technologies Ltd.**

Aspreviously disclosed on the Company’s Current Report on Form 8-K filedwith the Securities and Exchange Commission on November 14, 2006 (the “8-K”),the Company, Blue Chip Technologies Ltd. (“Blue Chip”), BC Acquisition,Inc., a wholly-owned acquisition subsidiary of the Company (“Merger Sub”),Omtool Healthcare, LLC, a wholly-owned subsidiary of the Company (the “LLC”),and William J. Rynkowski, Jr. (the “Principal Shareholder”) entered into anAgreement and Plan of Merger (the “Merger Agreement”), dated November 13,2006, pursuant to which Merger Sub will, subject to the terms and conditions inthe Merger Agreement, merge with and into Blue Chip (the “Merger”). As a resultof the Merger, Blue Chip will become a wholly-owned subsidiary of the Company.Promptly following the Merger, the Company will cause Blue Chip to merge withand into the LLC.

Theestimated aggregate consideration for the Company’s acquisition, by merger, ofBlue Chip is up to $4.1 million, subject to adjustment, consisting of acombination of cash, promissory notes and common stock of the Company. The Companywill hold back a portion of the purchase price as a source of payment for anyindemnification claims that may arise under the Merger Agreement. The Merger,which is subject to customary and other closing conditions, including the entryby the Company and the Principal Shareholder into a piggy-back registrationrights agreement and an employment agreement, the forms of which are attachedto the Merger Agreement as Exhibit E and Exhibit F, respectively, isexpected to close in December 2006.

A copyof the Merger Agreement and certain exhibits thereto was attached to the 8-K asExhibit 2.1 and is incorporated herein by reference. The foregoing description of the Merger Agreementand certain exhibits thereto is qualified in its entirety by reference to thefull text of the Merger Agreement and such exhibits.

BlueChip, based in Danvers, Massachusetts, is a provider of electronic formsautomation, document imaging and object archiving solutions to the healthcarevertical market.

**Inflation**

During the fiscalyears ended December 31, 2005, 2004 and 2003 and the first three fiscalquarters of 2006, neither inflation nor changing prices have had a materialimpact on our net sales, revenue or income from continuing operations.

**Liquidity and Capital Resources**

Since 1996, we have financed our operations primarilythrough cash flow from operations, private sales of preferred stock and commonstock and our initial public offering of common stock completed inAugust 1997.  As of September 30,2006, we had cash and cash equivalents of $6.4 million and working capital of$2.0 million.  We believe that ourexisting cash and cash equivalents will be sufficient to meet our workingcapital, capital expenditures and other liquidity requirements for at least thenext twelve months.
| ** **                                    | ** ** | **Cash Provided (Used)** | ** **              |
|-----------------------------------------------|------------|------------------------------------|-------------------------|
| ** **                                    | ** ** | **Operating  Activities**          | ** **              | **Investing Activities** | ** ** | **Financing Activities** | ** ** |
| Nine months ended  September 30, 2006         |       | $                                  | (3,011,765              | ) | $ | (971,230 | ) | $ | (159,545 | ) |
| Nine months ended  September 30, 2005         |       | $                                  | (160,853                | ) | $ | (82,854 | ) | $ | 36,619 |   |
| Change from same period  of prior fiscal year |       | $                                  | (2,850,912  or (1,772.4 | )  )% | $ | (888,376  or (1,072.2 | )  )% | $ | (196,164  or (535.7 | )  )% |

 

Ouroperating activities used cash of $3.0 million and $161,000 during the ninemonths ended September 30, 2006 and September 30, 2005, respectively.  We believethat the additional resources being allocated to improve the success of ourAccuRoute product in the legal vertical market and its expansion into thefinancial services and healthcare vertical markets will continue to putpressure on our earnings and operating cash flow during the remainder of 2006,but that our existing cash is sufficient for at least the next twelve months.

Netcash used during the nine months ended September 30, 2006 consisted primarilyof a net loss from operations and an increase in accounts receivable andprepaids and other current assets, offset in part by a increase in deferredrevenue, deferred rent and accounts payable as well as the non-cash effects ofstock-based compensation and depreciation.

Theincrease in accounts receivable is due to the fact that much of our sales orderprocessing occurred at the end of the quarter. The increase in prepaid expenses and other current assets is due topayments for insurance and third party royalty agreements for softwarelicenses.  The increase in accountspayable is due to the timing of vendor payments.  The increase in deferred rent is a result ofcash received from a tenant improvement allowance related to our newheadquarters and the six month free rental period associated with the lease forour headquarters office space.  Theincrease in deferred revenue is due to a higher volume of support contracts andan increase in orders for which we hold contracts but had to defer revenuerecognition because the associated sales did not yet meet all of the criteriafor revenue recognition.

26

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Netcash used during the nine months ended September 30, 2005 consistedprimarily of a net loss from operations, a decrease in accrued state sales taxand an increase in prepaid expenses and other current assets, offset in part bythe non-cash effects of depreciation and stock based compensation and adecrease in accounts receivable and inventory.

Investingactivities used cash of $971,000 and $83,000 during the nine months endedSeptember 30, 2006 and 2005, respectively.  The primary use of cash forinvesting activities during the first nine months of 2006 was the purchase offurniture and equipment for our new headquarters.  We do not expect to make any significantinvestments in computer-related software and hardware products during thefourth quarter of 2006 since we have already improved our IT infrastructure andfacilities during the first half of fiscal year 2006 as part of our relocationof our office. The sole use of cash for investing activities during the firstnine months of 2005 consisted of hardware and software purchases.

Financingactivities used cash of $160,000 for the nine months ended September 30, 2006primarily for the purchase of stock from an unaffiliated stockholder.  Financing activities provided $37,000 of cashfor the nine months ended September 30, 2005 due to the net proceeds from theissuance of common stock from our employee stock purchase program.

Based on our performance for the first nine months of 2006and current expectations for the remainder of the fiscal year, we believe thatour current cash and cash equivalents balance, as well as the cash expected tobe generated from operations for the remainder of the year, will be sufficientto satisfy our working capital needs, capital expenditures and other liquidityrequirements associated with our operations through at least the next twelvemonths.  We expect that principal uses of cash will be for operations,working capital, payment of sales taxes and purchases of property andequipment.  There can be no assurance that any necessary additionalfinancing will be available to us on commercially reasonable terms, or atall.  The issuance of additional equityor equity-related securities would be dilutive to our stockholders.  If we cannot raise funds on acceptable terms,or at all, we may not be able to develop or enhance our products or respondappropriately to competitive pressures, which would seriously limit our abilityto increase our revenue and grow our business.

The following table represents the approximate amountsof payments due under specified contractual obligations as of September 30,2006:
| **Contractual Obligations** | ** ** | **Total** | ** ** | **Less than  one year** | ** ** | **One to  Three years** | ** ** | **Three to  five years** | ** ** | **More than  Five years** | ** ** |
|----------------------------------|------------|-----------|------------|-----------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|
|                             |       |      |       |                              |       |                              |       |                               |       |                                |       |
| Capital lease  obligations       |       | $         | 550,245    |                              | $          | 117,910                           |       | $                                  | 235,819    |                                | $          | 196,516 |   | $ | — |   |
| Operating lease  obligations     |       | $         | 4,123,409  |                              | $          | 365,381                           |       | $                                  | 766,802    |                                | $          | 820,027 |   | $ | 2,171,199 |   |
| Total contractual  obligations   |       | $         | 4,673,654  |                              | $          | 483,291                           |       | $                                  | 1,002,621  |                                | $          | 1,016,543 |   | $ | 2,171,199 |   |

 

Capital lease obligations consist of a capital leasewith a five-year term related to the purchase of furniture and equipment forour new Andover, Massachusetts headquarters. Operating lease obligations consist of lease payments for our offices inAndover, Massachusetts and London, England, United Kingdom. As of September 30,2006, we did not have any material commitments for capital expenditures orother long-term liabilities for which payments are required.

**Off-Balance Sheet Arrangements**

We do not have any relationships with unconsolidatedentities or financial partnerships, such as entities often referred to asstructured finance or special purpose entities, that would have beenestablished for the purpose of facilitating off-balance sheet arrangements (asthat term is defined in Item 303(a)(4)(ii) of Regulation S-K) or othercontractually narrow or limited purposes.  As such, we are not exposed toany financing, liquidity, market or credit risk that could arise if we had engagedin those types of relationships.

27

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**Item 3.  Quantitativeand Qualitative Disclosures About Market Risk**

*Derivative Financial Instruments,Other Financial Instruments, and Derivative Commodity Instruments.*** ** As of September 30, 2006, theCompany did not participate in any derivative financial instruments or otherfinancial and commodity instruments for which fair value disclosure would berequired under SFAS No. 133,**“*Accountingfor Derivative Instruments and Hedging Activities*.” All ofthe Company’s investments consist of money market funds and commercial paperthat are carried on the Company’s books at amortized cost, which approximatesfair market value.  Accordingly, theCompany has no quantitative information concerning the market risk ofparticipating in such investments.

*Primary Market Risk Exposure*s.* * The Company’s primary market riskexposures are in the areas of interest rate risk and foreign currency exchangerate risk. The Company’s investment portfolio of cash equivalents is subject tointerest rate fluctuations, but the Company believes this risk is immaterialdue to the short-term nature of these investments.  The Company’s exposure to currency exchangerate fluctuations has been and is expected to continue to be modest due to thefact that the operations of its United Kingdom subsidiary are almostexclusively conducted in its local currency. The Company translates the operating results of its United Kingdomsubsidiary into U.S. dollars and consolidates them for reporting purposes.  The Company translates the operating resultsof its impact of currency exchange rate movements on intercompany transactionswas immaterial for the quarter ended September 30, 2006.  The Company manages its foreign currency exchangerisk by monitoring its net monetary position using natural hedges of its assetsand liabilities denominated in local currencies.  There can be noassurance that this approach will eliminate all foreign currency exchange rateexposure. Currently, the Company does not engage in foreign currency hedgingactivities.

**Item 4. Controls and Procedures**

(a)                                  Evaluationof disclosure controls and procedures.

As of September 30, 2006 (the “Evaluation Date”), theCompany, under the supervision and with the participation of the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, evaluated the effectiveness of the Company’s disclosure controls andprocedures pursuant to Rule 13a-15(b) promulgated under the Securities ExchangeAct of 1934, as amended (the “Exchange Act”).  Based upon that evaluation,the Company’s Chief Executive Officer and Chief Financial Officer concludedthat, as of the Evaluation Date, the Company’s disclosure controls andprocedures were effective in ensuring that information relating to the Company(including its consolidated subsidiaries) required to be disclosed by theCompany in the reports that it files or submits under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms, including ensuringthat such information is accumulated and communicated to the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, as appropriate to allow timely decisions regarding requireddisclosure.

(b)                                 Changesin internal control over financial reporting

Therewas no change in the Company’s internal control over financial reporting duringthe Company’s fiscal quarter ended September 30, 2006 or in other factors thathas materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

28

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**PART II:  OTHER INFORMATION**

**Item 1A.  Risk Factors**

Thereare no material changes from risk factors as previously disclosed in **Item 1A, “Risk Factors,”of our 2005 Form 10-K.**

**Item 2.  UnregisteredSales of Equity Securities and Use of Proceeds**

**ISSUER PURCHASES OF EQUITY SECURITIES**
| **Period**                                       | ** ** | **(a) Total Number  of Shares  Purchased** | ** ** | **(b) Average Price  Paid per Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **(d) Maximum Number  of Shares  that May Yet Be  Purchased Under the  Plans or Programs** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                             |       |                                                      |       |                                                      |       |                                                                                                                                      |       |                                                                                                                                         |       |
| June 1, 2006 — June 30,  2006               |       | 25,000                                                    |       | $                                                         | 5.51       |                                                                                                                                      | —     |                                                                                                                                         | —     |   |
| July 1, 2006 — July 31,  2006               |       | —                                                    |       | —                                                    |       | —                                                                                                                                    |       | —                                                                                                                                       |       |
| September 1, 2006 — September 30, 2006 |       | —                                                    |       | —                                                    |       | —                                                                                                                                    |       | —                                                                                                                                       |       |
|                                                  |            |                                                           |            |                                                           |            |                                                                                                                                           |            |                                                                                                                                              |            |  |

 

----

(1)  On June 1,2006, the Company, in an open-market transaction, repurchased 25,000 shares ofits Common Stock from a non-affiliated stockholder.  The Company effected this share repurchase ata purchase price of $5.51 per share.

**Item5.  Other Information**

Therehave been no changes to the procedures by which security holders may recommendnominees to the Company’s Board of Directors during the time period covered bythis Quarterly Report on Form 10-Q.

**Item6.  Exhibits**
| 2.1    | Agreement and Plan of Merger, dated  November 13, 2006, by and among Omtool, Ltd., Blue Chip Technologies  Ltd., BC Acquisition, Inc., Omtool Healthcare, LLC and William J. Rynkowski,  Jr. previously filed as an exhibit to Omtool’s Current Report on  Form 8-K dated November 13, 2006 and incorporated herein by  reference. |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                   |
| 10.1   | Sublease Agreement, dated July 28, 2006 and  effective July 1, 2006, by and between Omtool, Ltd. and eSped.com, Inc.,  previously filed as an exhibit to Omtool’s Current Report on Form 8-K dated  July 28, 2006 and incorporated herein by reference.                                                                                           |
|   |                                                                                                                                                                                                                                                                                                                                                   |
| 31.1   | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                   |
| 31.2   | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                   |
| 32.1   | Certification of Chief Executive Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                   |
| 32.2   | Certification of Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                   |

 

29

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**Signatures**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                    | OMTOOL, LTD. |
|--------------------|--------------|
|               |         |
|               |         |
| November 14,  2006 | By:          | /s/ Daniel A. Coccoluto |   |
|               |         | Daniel A. Coccoluto |
|               |         | Chief Financial  Officer, Secretary and Treasurer |
|               |         | (Duly authorized  officer and principal financial officer) |

 

30

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**Exhibit Index**
| 2.1    | Agreement and Plan of Merger, dated  November 13, 2006, by and among Omtool, Ltd., Blue Chip Technologies  Ltd., BC Acquisition, Inc., Omtool Healthcare, LLC and William J. Rynkowski,  Jr. previously filed as an exhibit to Omtool’s Current Report on  Form 8-K dated November 13, 2006 and incorporated herein by  reference. |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                   |
| 10.1   | Sublease Agreement, dated July 28, 2006 and  effective July 1, 2006, by and between Omtool, Ltd. and eSped.com, Inc.,  previously filed as an exhibit to Omtool’s Current Report on Form 8-K dated  July 28, 2006 and incorporated herein by reference.                                                                                           |
|   |                                                                                                                                                                                                                                                                                                                                                   |
| 31.1   | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                   |
| 31.2   | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                   |
| 32.1   | Certification of Chief Executive Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                   |
| 32.2   | Certification of Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                   |

 

31

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