** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

** **

**FORM 10-Q**

**(Mark One)**

** **

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGEACT OF 1934

** **

**For the quarterly periodended March 31, 2006**

** **

**OR**

** **

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGEACT OF 1934

** **

**For the transition periodfrom               to            **

** **

**Commission File Number 0-22871**

** **

**OMTOOL, LTD.**

(Exact Name of Registrantas Specified in Its Charter)

| **Delaware**                                                     | ** ** | **02-0447481**                           |
|------------------------------------------------------------------|------------|------------------------------------------|
| (State or Other  Jurisdiction of  Incorporation or Organization) |       | (I.R.S. Employer  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 check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

Yes   x    No   o

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

Large acceleratedfiler  o Acceleratedfiler  o           Non-acceleratedfiler  x

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

Yes   o    No   x

Therewere 4,040,075 shares of the Company’s common stock, par value $0.01,outstanding on May 9, 2006.

 

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**OMTOOL, LTD. ANDSUBSIDIARIES**

FORM 10-QFor the Quarter Ended March 31, 2006CONTENTS
| Item Number                         | ** ** | ** **                                                                                                                               | ** ** | ** ** |
|-------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|                                |       |                                                                                                                                     |       |       |
| PART I:  FINANCIAL INFORMATION |       | 3                                                                                                                                        |
|                                |       |                                                                                                                                     |       |       |
| Item 1.                             |       | Consolidated Financial Statements                                                                                                        |       | 3          |
|                                |       | Consolidated  Balance Sheets as of March 31, 2006 (Unaudited) and December 31,  2005        |       | 3          |
|                                |       | Consolidated Statements of Operations for the three  months ended March 31, 2006 and 2005 (Unaudited)                               |       | 4          |
|                                |       | Consolidated Statements of Cash Flows for the three  months ended March 31, 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                |       | 11         |
|                                |       |                                                                                                                                     |       |       |
| Item 3.                             |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                              |       | 21         |
|                                |       |                                                                                                                                     |       |       |
| Item  4.                            |       | Controls  and Procedures                                                                                                                 |       | 21         |
|                                |       |                                                                                                                                     |       |       |
| PART II: OTHER INFORMATION     |       | 22                                                                                                                                       |
|                                |       |                                                                                                                                     |       |       |
| Item  1A.                           |       | Risk  Factors                                                                                                                            |       | 22         |
|                                |       |                                                                                                                                     |       |       |
| Item 2.                             |       | Unregistered Sales of Equity Securities and Use of  Proceeds                                                                             |       | 22         |
|                                |       |                                                                                                                                     |       |       |
| Item 5.                             |       | Other  Information                                                                                                                       |       | 22         |
|                                |       |                                                                                                                                     |       |       |
| Item 6.                             |       | Exhibits                                                                                                                                 |       | 22         |
|                                |       |                                                                                                                                     |       |       |
| Signatures                          |       | 23                                                                                                                                       |
|                                |       |                                                                                                                                     |       |       |
| Exhibit Index                  |       | 24                                                                                                                                       |
|                                |       |                                                                                                                                     |       |       |
| Exhibits                            |       |                                                                                                                                     |
|                                     |            |                                                                                                                                          |            |            |  |  |  |

 

2

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**PART I: FINANCIAL INFORMATIONItem 1. Consolidated Financial Statements**

**OMTOOL,LTD. AND SUBSIDIARIESConsolidated Balance Sheets**
|                                                                                                                                                                                                                                                        | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                             | ** ** | **(Unaudited)**          | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                             | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                                                                                        |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                                             |       | $                        | 9,136,988  |                        | $          | 10,471,272 |   |
| Accounts  receivable, net of reserves of $11,000 at March 31, 2006 and $33,000 at  December 31, 2005, respectively                                                                                                                           |       | 1,645,914                |       | 1,618,799                   |       |
| Inventories                                                                                                                                                                                                                                            |       | 27,093                   |       | 58,380                      |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                                             |       | 329,265                  |       | 333,419                     |       |
| Total current  assets                                                                                                                                                                                                                                  |       | 11,139,260               |       | 12,481,870                  |       |
| Property and  equipment, net                                                                                                                                                                                                                           |       | 517,863                  |       | 175,566                     |       |
| Other assets                                                                                                                                                                                                                                           |       | 21,562                   |       | 11,562                      |       |
| Total assets                                                                                                                                                                                                                                           |       | $                        | 11,678,685 |                        | $          | 12,668,998 |   |
|                                                                                                                                                                                                                                                   |       |                     |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                                         | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                                                                   |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                       |       | $                        | 1,202,830  |                        | $          | 905,288 |   |
| Accrued  liabilities                                                                                                                                                                                                                                   |       | 1,153,773                |       | 1,222,972                   |       |
| Accrued state  sales tax                                                                                                                                                                                                                               |       | 292,593                  |       | 290,815                     |       |
| Deferred revenue,  current                                                                                                                                                                                                                             |       | 3,448,798                |       | 3,408,002                   |       |
| Total current  liabilities                                                                                                                                                                                                                             |       | 6,097,994                |       | 5,827,077                   |       |
| Long term liabilities:                                                                                                                                                                                                                                 |       |                     |       |                        |       |
| Deferred revenue,  long-term                                                                                                                                                                                                                           |       | 437,657                  |       | 410,232                     |       |
| Total liabilities                                                                                                                                                                                                                                      |       | 6,535,651                |       | 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 March 31, 2006 and  December 31, 2005; Outstanding — 4,037,576 shares at March 31,  2006 and 3,977,022 shares at December 31, 2005, respectively |       | 43,679                   |       | 43,679                      |       |
| Deferred  compensation                                                                                                                                                                                                                                 |       | —                   |       | (775,865                    | )          |
| Additional  paid-in capital                                                                                                                                                                                                                            |       | 34,546,128               |       | 35,556,639                  |       |
| Accumulated  deficit                                                                                                                                                                                                                                   |       | (27,695,764              | )          | (26,327,762                 | )          |
| Treasury stock,  at cost, 330,302 shares at March 31, 2006 and 390,856 shares at  December 31, 2005                                                                                                                                          |       | (1,698,810               | )          | (2,005,618                  | )          |
| Accumulated other  comprehensive loss                                                                                                                                                                                                                  |       | (52,199                  | )          | (59,384                     | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                       |       | 5,143,034                |       | 6,431,689                   |       |
|                                                                                                                                                                                                                                                   |       |                     |       |                        |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                                       |       | $                        | 11,678,685 |                        | $          | 12,668,998 |   |

 

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

3

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**OMTOOL,LTD. AND SUBSIDIARIESConsolidated Statements of Operations(Unaudited)**
|                                                          | ** ** | **Three months ended  March 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Revenue:                                                 |       |                                             |       |   |   |
| Software license                                         |       | $                                                | 1,031,819  |   | $ | 1,317,629 |   |
| Hardware                                                 |       | 557,400                                          |       | 837,344 |   |
| Service and other                                        |       | 1,747,285                                        |       | 1,706,511 |   |
|                                                     |       |                                             |       |   |   |
| Total revenue                                            |       | 3,336,504                                        |       | 3,861,484 |   |
|                                                     |       |                                             |       |   |   |
| Cost of revenue:                                         |       |                                             |       |   |   |
| Software license                                         |       | 31,441                                           |       | 20,767 |   |
| Hardware                                                 |       | 345,078                                          |       | 543,677 |   |
| Service and other                                        |       | 713,099                                          |       | 717,375 |   |
|                                                     |       |                                             |       |   |   |
| Total cost of  revenue                                   |       | 1,089,618                                        |       | 1,281,819 |   |
|                                                     |       |                                             |       |   |   |
| Gross profit                                             |       | 2,246,886                                        |       | 2,579,665 |   |
|                                                     |       |                                             |       |   |   |
| Operating expenses:                                      |       |                                             |       |   |   |
| Sales and  marketing                                     |       | 2,052,207                                        |       | 1,179,316 |   |
| Research and  development                                |       | 707,252                                          |       | 516,990 |   |
| General and administrative                               |       | 899,942                                          |       | 775,171 |   |
|                                                     |       |                                             |       |   |   |
| Total operating  expenses                                |       | 3,659,401                                        |       | 2,471,477 |   |
|                                                     |       |                                             |       |   |   |
| Income (loss)  from operations                           |       | (1,412,515                                       | )          | 108,188 |   |
|                                                     |       |                                             |       |   |   |
| Interest and  other income, net                          |       | 44,513                                           |       | 40,629 |   |
|                                                     |       |                                             |       |   |   |
| Income (loss)  before tax provision                      |       | (1,368,002                                       | )          | 148,817 |   |
|                                                     |       |                                             |       |   |   |
| Income tax  provision                                    |       | —                                           |       | 6,777 |   |
|                                                     |       |                                             |       |   |   |
| Net income (loss)                                        |       | $                                                | (1,368,002 | ) | $ | 142,040 |   |
|                                                     |       |                                             |       |   |   |
| Net income (loss) per  share:                            |       |                                             |       |   |   |
| Basic                                                    |       | $                                                | (0.34      | ) | $ | 0.04 |   |
| Diluted                                                  |       | $                                                | (0.34      | ) | $ | 0.04 |   |
|                                                     |       |                                             |       |   |   |
| Weighted average shares  used in per share calculations: |       |                                             |       |   |   |
| Basic                                                    |       | 4,020,573                                        |       | 3,853,933 |   |
| Diluted                                                  |       | 4,020,573                                        |       | 4,055,264 |   |

 

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

4

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**OMTOOL, LTD. AND SUBSIDIARIESConsolidated Statements of Cash Flows(Unaudited)**
|                                                                                       | ** ** | **Three months ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Cash Flows from  Operating Activities:                                                |       |                                             |       |   |   |
| Net income (loss)                                                                     |       | $                                                | (1,368,002 | ) | $ | 142,040 |   |
| Adjustments to reconcile  net income (loss) to net cash used in operating activities: |       |                                             |       |   |   |
| Depreciation                                                                          |       | 32,391                                           |       | 46,581 |   |
| Accounts  receivable reserves                                                         |       | (2,863                                           | )          | (23,408 | ) |
| Stock-based  compensation                                                             |       | 77,265                                           |       | 19,415 |   |
| Changes in assets and  liabilities:                                                   |       |                                             |       |   |   |
| Accounts  receivable                                                                  |       | (22,174                                          | )          | (576,946 | ) |
| Prepaid expenses  and other current assets                                            |       | 4,945                                            |       | (103,653 | ) |
| Inventory                                                                             |       | 31,287                                           |       | (17,666 | ) |
| Other assets                                                                          |       | (10,000                                          | )          | - |   |
| Accounts payable                                                                      |       | 296,675                                          |       | 141,120 |   |
| Accrued  liabilities                                                                  |       | (70,245                                          | )          | 4,229 |   |
| Accrued state  sales tax                                                              |       | 1,778                                            |       | (25,439 | ) |
| Deferred revenue                                                                      |       | 63,119                                           |       | 230,518 |   |
|                                                                                  |       |                                             |       |   |   |
| Net cash used in  operating activities                                                |       | (965,824                                         | )          | (163,209 | ) |
|                                                                                  |       |                                             |       |   |   |
| Cash Flows from  Investing Activities:                                                |       |                                             |       |   |   |
| Purchases of  property and equipment                                                  |       | (374,461                                         | )          | (27,525 | ) |
|                                                                                  |       |                                             |       |   |   |
| Net cash used in  investing activities                                                |       | (374,461                                         | )          | (27,525 | ) |
|                                                                                  |       |                                             |       |   |   |
| Cash Flows from  Financing Activities:                                                |       |                                             |       |   |   |
| Net proceeds from  issuance of common stock                                           |       | 9,792                                            |       | 18,739 |   |
| Net proceeds from  issuance of restricted common stock                                |       | 622                                              |       | — |   |
| Purchase of  treasury stock                                                           |       | (15,517                                          | )          | — |   |
|                                                                                  |       |                                             |       |   |   |
| Net cash (used  in) provided by financing activities                                  |       | (5,103                                           | )          | 18,739 |   |
|                                                                                  |       |                                             |       |   |   |
| Exchange rate  effect on cash and cash equivalents                                    |       | 11,104                                           |       | (14,393 | ) |
|                                                                                  |       |                                             |       |   |   |
| Net decrease in  cash and cash equivalents                                            |       | (1,334,284                                       | )          | (186,388 | ) |
|                                                                                  |       |                                             |       |   |   |
| Cash and cash  equivalents, beginning of period                                       |       | 10,471,272                                       |       | 10,655,121 |   |
|                                                                                  |       |                                             |       |   |   |
| Cash and cash  equivalents, end of period                                             |       | $                                                | 9,136,988  |   | $ | 10,468,733 |   |

 

The accompanyingnotes are an integral part of these unaudited consolidated financial statements*.*

5

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**OMTOOL,LTD. AND SUBSIDIARIESNotes to Consolidated Financial Statements(Unaudited)**

**(1)  Basis ofPresentation**

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. Theaccompanying unaudited consolidated financial statements have been prepared byOmtool pursuant to the rules and regulations of the Securities andExchange Commission (“SEC”) regarding interim financial reporting. Accordingly,they do not include all of the information and footnotes required by generallyaccepted accounting principles for complete financial statements and should beread in conjunction with the consolidated financial statements and notesthereto for the year ended December 31, 2005 as filed with the SEC as partof the Company’s Annual Report on Form 10-K on March 28, 2006. Theaccompanying unaudited consolidated financial statements reflect all adjustments(consisting of normal recurring adjustments) that are, in the opinion ofmanagement, necessary for a fair presentation of results for the interimperiods presented. The results of operations for the three month period ended March 31,2006 are not necessarily indicative of the results to be expected for the fullfiscal year.

**(2)  NetIncome (Loss) Per Share**

TheCompany reports earnings per share in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 128,**“*Earningsper Share*.”  Dilutedweighted average shares outstanding for the fiscal quarter ended March 31,2006 exclude 414,142 potential common shares from stock options and a stockwarrant because to include them would have been anti-dilutive for the periodpresented as the Company reported a net loss during the period. The dilutiveeffect of potential common shares for the fiscal quarter ended March 31,2005, consisting of outstanding stock options and a stock warrant, isdetermined using the treasury stock method, in accordance with SFAS No. 128.For the fiscal quarter ended March 31, 2005 the dilutive calculationexcludes the potential common shares related to 112,560 outstanding stockoptions that have an anti-dilutive effect since their exercise price exceedsthe market value of the Company’s common stock. A reconciliation of basic anddiluted common shares outstanding is as follows:
|                                                                        | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Weighted average  number of common shares outstanding                  |       | 4,020,573                                        |       | 3,853,933 |   |
| Potential common  shares pursuant to stock options and warrant         |       | —                                           |       | 201,331 |   |
| Diluted weighted  average shares                                       |       | 4,020,573                                        |       | 4,055,264 |   |
| Basic net income  (loss) per common share                              |       | $                                                | (0.34      | ) | $ | 0.04 |   |
| Diluted net income  (loss) per common share and potential common share |       | $                                                | (0.34      | ) | $ | 0.04 |   |

 

**(3)  IncomeTaxes**

SFAS No. 109,**“*Accountingfor Income Taxes*,”** requires a valuation allowance to be recordedagainst deferred tax assets when it is more likely than not that some or all ofthe deferred tax assets will not be realized. As a result of cumulative lossesin recent years and continued economic uncertainty, the Company has provided afull valuation allowance against its net deferred tax assets and will do sountil it returns to an appropriate level of sustained taxable income. Theultimate realization of these deferred tax assets depends upon the Company’sability to generate sufficient future taxable income. If the Company issuccessful in generating sufficient future taxable income, the Company willreduce the valuation allowance through a reduction in income tax expense in thefuture.

During the three monthsended March 31, 2006, the Company did not record a tax provision due thenet loss incurred during the period. During the three months ended March 31,2005, the Company recorded a tax provision of approximately $7,000 for expectedtax liability in the United States.

6

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

Thecomponents of the Company’s comprehensive income (loss) are as follows:
|                                           | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Net income (loss)                         |       | $                                                | (1,368,002 | ) | $ | 142,040 |   |
| Foreign currency  translation adjustments |       | 7,185                                            |       | (10,136 | ) |
| Comprehensive income  (loss)              |       | $                                                | (1,360,817 | ) | $ | 131,904 |   |

 

**(5)  Stock-basedCompensation**

Effective January 1, 2006, the Company adoptedthe provisions of SFAS No. 123(R),”*Share-Based Payment*”**(“SFAS No. 123R”), using the modified prospectivemethod.  SFAS No. 123R requires theCompany to measure the cost of employee services in exchange for an award of anequity instrument based on the grant-date fair value of the award and torecognize expense over the requisite service period. Under the modifiedprospective method, financial statements for periods prior to the date ofadoption are not adjusted for the change in accounting, thus, prior periodfinancial statements have not been restated. However, compensation expense isrecognized for (a) all share-based payments granted after the effectivedate and (b) all awards granted to employees prior to the effective datethat remain unvested on the effective date.

The Company’s 1996 Stock Option Plan and 1997 StockPlan, as amended, provide for the issuance of common stock pursuant to thegrant to employees of “incentive stock options” within the meaning of theInternal Revenue Code and the grant of nonqualified stock options, stock awardsor opportunities to make direct purchases of stock in the Company to employees,consultants, directors and officers of the Company. The aggregate number ofshares of common stock that may be issued pursuant to the 1997 Stock Plan is1,228,570. Shares issued pursuant to these plans are issued from treasury tothe extent they are available.

Prior to the adoption of SFAS No. 123R, theCompany recorded deferred compensation based on the intrinsic value of theshares of restricted stock at the time of sale. The Company then recognizeddeferred compensation as compensation expense ratably over the expected fouryear vesting period. Due to the adoption of SFAS No. 123R, the balance ofdeferred compensation of approximately $776,000, relating entirely torestricted stock grants, as of December 31, 2005, has been reclassified toadditional paid-in-capital in the accompanying unaudited consolidated balancesheet as of March 31, 2006.  Withrespect to restricted stock, the Company recognized approximately $69,000 and$19,000 of stock-based compensation expense during the three month period endedMarch 31, 2006 and March 31, 2005, respectively.

Prior to January 1, 2006, the Company accountedfor its other stock-based compensation for employees under AccountingPrinciples Board (“APB”) Opinion No. 25, “*Accountingfor Stock Issued to Employees*”and related interpretations and followed the disclosure-only alternative underSFAS No. 123, “*Accounting forStock-Based Compensation*,” as amended by SFAS No. 148, “*Accounting for Stock-Based Compensation —Transition and Disclosure*,”for options granted using the Black-Scholes option pricing model.

As a result of adopting SFAS No. 123R as of January 1,2006, the Company incurred stock-based compensation expense during the threemonths ended March 31, 2006 of approximately $8,000 for stock options andthe employee stock purchase plan, of which $2,000 is recorded in cost ofservice and other revenue and $6,000 is recorded in operating expenses.

Thenet impact of adopting the new accounting guidance for the three months ended March 31,2006 was as follows:
|                                | ** ** | **Under Adoption of  SFAS No. 123R** | ** ** | **If SFAS 123R had not  been adopted** | ** ** |
|--------------------------------|------------|----------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| Income (Loss)  from operations |       | $                                                        | (1,412,515 | )                                                               | $          | (1,404,608 | ) |
| Net Loss                       |       | $                                                        | (1,368,002 | )                                                               | $          | (1,360,095 | ) |
| Basic Loss per  Share          |       | $                                                        | (0.34      | )                                                               | $          | (0.34 | ) |
| Diluted Loss per Share         |       | $                                                        | (0.34      | )                                                               | $          | (0.34 | ) |

 

7

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Thefollowing table illustrates the effect on net income and net income per sharethat would have been reported if the fair value method had been used to accountfor stock-based compensation in 2005. The estimated fair value of each optionis calculated using the Black-Scholes option-pricing model.
|                                                                                                             | ** ** | **Three Months  Ended  March 31, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Net income, as  reported                                                                                    |       | $                                                      | 142,040    |   |
| Add: Stock  compensation included in net income                                                             |       | 19,415                                                 |       |
| Deduct: Total  stock-based employee compensation expense determined under fair value method  for all awards |       | (45,704                                                | )          |
| Pro forma net  income                                                                                       |       | $                                                      | 115,751    |   |
|                                                                                                        |       |                                                   |       |
| Net income per share:                                                                                       |       |                                                   |       |
| Basic, as  reported                                                                                         |       | $                                                      | 0.04       |   |
| Diluted, as  reported                                                                                       |       | $                                                      | 0.04       |   |
| Basic, pro forma                                                                                            |       | $                                                      | 0.03       |   |
| Diluted, pro  forma                                                                                         |       | $                                                      | 0.03       |   |

 

**Stock Options**

Under the terms of the Company’s 1996 Stock OptionPlan and 1997 Stock Plan, options vest and become exercisable as determined bythe Board of Directors and expire 10 years after the date of grant. In1997, the Company’s Board of Directors voted that no further options would begranted or issued under the Company’s 1996 Stock Option Plan. In accordancewith the 1997 Stock Plan, stock options that are canceled or expired are addedback to the potential options available for future issuance. Stock option compensation expense calculatedunder the fair value approach is recognized ratably over the four year vestingperiod. The fair value for granted options was estimated at the time of grantusing the Black-Scholes option-pricing model. Based upon historical informationand management’s estimate of future voluntary turnover rates, theCompany has calculated this expense based on an annualized estimated forfeiture rate of 10%. The Company trues-upestimated forfeitures to actual at the end of each reporting period. TheCompany did not grant any stock options during the three months ended March 31,2006 or March 31, 2005. The total fair value of stock options vestedduring the period ended March 31, 2006 was $3,900.

Total compensation expense related to unvested stockoptions was $25,000 as of March 31, 2006, which amount the Company expectsto recognize over a weighted average period of 0.9 years.

Stockoption activity for the three months ended March 31, 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                    |       | $                                          | 5.733      |                                                                   |       |                                |       |   |
| Granted                              |       | —                     |       | —                                     |       |                                                                   |       |                                |       |
| Exercised                            |       | —                     |       | —                                     |       |                                                                   |       |                                |       |
| Canceled and expired                 |       | (572                       | )          | 6.31                                       |       |                                                                   |       |                                |       |
| Outstanding,  March 31, 2006    |       | 363,142                    |       | $                                          | 5.73       |                                                                   | 4.9        |                                | $          | 1,225,481 |   |
| Exercisable,  March 31, 2006    |       | 336,260                    |       | $                                          | 6.04       |                                                                   | 4.7        |                                | $          | 1,190,994 |   |

 

**Employee StockPurchase Plan**

The 1997 Employee Stock Purchase Plan (the “1997Purchase Plan”) provides for the issuance of a maximum of 57,142 shares ofcommon stock pursuant to the exercise of nontransferable options granted toparticipating employees. The exercise price for the option for each six-monthpurchase period is 85% of the lesser of the market price of the common stock onthe first or last business day of the six-month purchase period. Employee stock purchase plan compensationexpense calculated under the fair value approach is recognized ratably over thesix-month purchase period. The weighted average fair value of the sharessubject to purchase under the employee stock purchase plan was $2.77 for thethree months ended March 31, 2006, based upon the following assumptions:

8

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|                          | ** ** | **Three Months  Ended  March 31, 2006** | ** ** |
|--------------------------|------------|--------------------------------------------------------|------------|
| Risk-free  interest rate |       | 4.4                                                    | %          |
| Volatility               |       | 95.0                                                   | %          |
| Expected dividend  yield |       | 0.0                                                    |       |
| Expected life            |       | 0.5 Years                                              |       |

 

Historical Companyinformation was the primary basis for the expected volatility assumptions. Theexpected life is equal to the six-month purchase period. The remaining expenseto be recognized related to estimated purchases was $2,600 as of March 31,2006, which amount the Company expects to recognize in the second quarter offiscal year 2006.

**Restricted Stock**

As discussed further below, the Company has soldshares of restricted common stock (“restricted stock”) under the Company’s 1997Stock Plan, 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 vestratably over a four year service period. 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. Restricted stockcompensation expense calculated under the fair value approach is based upon thecurrent stock price and is recognized ratably over the four year vesting period.Based upon historical information and management’s estimate of future voluntaryturnover rates, the Company has calculated this expense based on an annualizedestimated forfeiture rate of 6%. The Company trues-up estimated forfeitures toactual at the end of each reporting period. During the three months ended March 31,2006 and March 31, 2005, the Company sold 62,196 and 58,684 shares ofrestricted stock, respectively, under the Company’s 1997 Stock Plan, asamended, to its Board of Directors and certain employees of the Company at aprice per share of $0.01. The total fair value of restricted stock vestedduring the period ended March 31, 2006 was $111,000.

Total compensation expense related to unvested sharesof restricted stock was $1,112,000 as of March 31, 2006, which amount theCompany expects to recognize over a weighted average period of 3.5 years.

Restrictedstock activity for the three months ended March 31, 2006 was as follows:

|                                   | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------|------------|----------------------------|------------|---------------------------------------------------------|------------|
| Unvested,  December 31, 2005 |       | 114,260                    |       | $                                                       | 7.93       |   |
| Granted                           |       | 62,196                     |       | 6.84                                                    |       |
| Vested                            |       | (14,357                    | )          | 7.70                                                    |       |
| Forfeited                         |       | (1,406                     | )          | 7.70                                                    |       |
| Unvested, March 31,  2006    |       | 160,693                    |       | 7.51                                                    |       |
|                                   |            |                            |            |                                                         |            |  |

 

**(6)  AccruedLiabilities**

Accruedliabilities consist of the following:
|                                    | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Accrued health  insurance expense  |       | $                        | 189,848    |                        | $          | 169,811 |   |
| Accrued salary  and salary-related |       | 629,057                  |       | 639,297                     |       |
| Accrued  professional fees         |       | 108,637                  |       | 128,801                     |       |
| Other accrued  expenses            |       | 226,231                  |       | 285,063                     |       |
|                               |       | $                        | 1,153,773  |                        | $          | 1,222,972 |   |

 

**(7)  Segmentand Geographic Information**

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 $438,000and $455,000 for the three months ended March 31, 2006 and 2005,respectively.

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Thefollowing table represents amounts relating to geographic locations:
|                   | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------|------------|--------------------------------------------------|------------|
| ** **        | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Total revenue (1) |       |                                             |       |   |   |
| United States     |       | $                                                | 2,898,667  |   | $ | 3,406,408 |   |
| United Kingdom    |       | 171,614                                          |       | 181,922 |   |
| Canada            |       | 175,268                                          |       | 97,876 |   |
| South Africa      |       | 30,653                                           |       | 36,662 |   |
| Rest of World     |       | 60,302                                           |       | 138,616 |   |
|              |       | $                                                | 3,336,504  |   | $ | 3,861,484 |   |

 
|                       | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------|------------|--------------------------|------------|-----------------------------|------------|
| Long-lived assets (2) |       |                     |       |                        |       |
| United States         |       | $                        | 519,166    |                        | $          | 168,360 |   |
| United Kingdom        |       | 20,259                   |       | 18,768                      |       |
|                  |       | $                        | 539,425    |                        | $          | 187,128 |   |

----

(1)          Revenues are attributedto geographic regions based on location of customer.

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

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** **

**Item 2.**

**MANAGEMENT’SDISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

Management’s Discussionand Analysis of Financial Condition and Results of Operations for the threemonths ended March 31, 2006 should be read in conjunction with the accompanyingconsolidated financial statements for the periods specified and the associatednotes. Further reference should be made to our Annual Report on Form 10-Kfor the year ended December 31, 2005, as filed with the SEC on March 28,2006.

**Overview**

We provide document routing solutions and servicesthat enable organizations to manage the capture, processing and distribution of“mixed-mode” documents (i.e., documents that contain both paper and electroniccomponents) to electronic information systems such as enterprise contentmanagement, document management, records management, e-mail anddocument-archiving systems, leveraging application interfaces with which usersare already familiar. Our enterprise-class products are used by organizationsthat manage paper-based documents as part of their standard business processesand or have stringent compliance requirements for secure document handling,storage, integration and tracking of a variety of documents to or fromcorporate information systems.

We help companies achieve those levels of control byleveraging existing information technology (“IT”) infrastructures andintegrating with industry-leading electronic information systems. We add securedocument management and routing functions, along with high-volume faxfunctionality, to a company’s existing communication infrastructure. Sincepaper remains integral to many business processes, we also provide technologythat incorporates electronic delivery, security and billing functionality intoindustry-leading multi-function and scanning devices.

AccuRoute®, our flagship product, is a softwareplatform for simplified, simultaneous and secure document distribution. OurAccuRoute product allows companies to control the integration and distributionof mixed-mode documents into ever-changing corporate information systems andprocesses. Similar in concept to a network router, our AccuRoute product is thedocument routing hub, transforming both paper and electronic-based documentsinto electronic files and routing that information both within and outside anorganization.

Working with virtually all multi-function devices (“MFDs”)and electronic information systems (enterprise content management, documentmanagement, records management and archival systems, as well as fax and e-mailsystems), our AccuRoute product provides a device-independent, personalizedsolution that enables users to distribute documents from a multi-functiondevice panel or right from their desktop computers using a familiar andcomfortable interface. In addition, our AccuRoute product supports the movementof electronic documents and information, enabling companies to increaseemployee productivity by quickly capturing hardcopy documents, distributingthem in electronic form and, through its security features, complying withprivacy regulations related to health, financial and other confidentialinformation.

GenidocsTM, our secure document-delivery applicationproduct, integrates with existing e-mail systems and provides multiple optionsfor content and attachment encryption, authentication, audit trail, deliveryconfirmation and digital signatures. GenifaxTM, our enterprise fax product,offers a scalable, server-based feature set and shares a common Microsoft® Windows® server-based architecture with our Genidocsproduct line.

Our AccuRoute product further unifies the code basesand architecture of our Genidocs and Genifax products. With its routingcapabilities, our AccuRoute product provides a customer-specific softwaresolution that easily manages both paper and electronic documents, with littleor no user training required.

Companies can deploy our software products onheterogeneous, multi-platform networks and digital scanning and MFDs and canintegrate them with both desktop and enterprise software applications such ascontent management, e-mail and groupware systems. To address customer needs,our products are modular and scaleable. As a result, customers can addadditional communication capacity through the addition of system components andconnectors to keep pace with growing demands. 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 a combination server/seat basis and asexternal hardware devices become more technologically advanced, we will extenda portion of our license fees to a device-based model.

We will continue to focus on those vertical marketswhere regulations or business practices require confidentiality, timelyelectronic delivery and archiving of critical documents in electronic and paperformat. We also expect to maintain an established position in our  historic market — secure electronicdocument exchange primarily via fax. In addition, we plan to continue theevolution 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. In this manner, we will pursue aleadership position in the broader document delivery/routing and managementmarket that we believe will grow in response to increasingly regulatedcommunications and stringent privacy requirements.

We resell certain hardware products (such asintelligent fax boards) from third-party vendors typically in connection withsales of our Genifax product. In most instances, hardware sales are a result ofeither new sales or sales to existing customers who are upgrading their ITinfrastructure. Occasionally, where our customers also want fax capabilities,we sell hardware products with our AccuRoute product. We undertake thesehardware sales as a convenience to our customers, who alternatively can opt toobtain 

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hardware directly from a third-party vendor. The faxboards and fax modems that we resell are not functional without our productsoftware and we are not generally in the business of selling fax boards andmodems. 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 revenue has historically consistedprimarily of the sale of support contracts to complement software products welicense to our customers. We generate a smaller portion of our service andother revenue from consulting, training and installation services.

We continue to expand our presence and penetration ofthe legal vertical market through the development of reference accounts and byproving AccuRoute’s viability as evidenced by adoption of our AccuRoute productby approximately 120 law firms. In parallel, we are building a firm base uponwhich to launch our AccuRoute product in the financial services and healthcarevertical markets. During the second half of 2005, we dramatically increased oursales and marketing spending, as called for in our strategic plan. While the resultsof these investments that began in late 2005 were not evident in our financialresults for the first quarter of 2006, we believe that we will start to seegradual improvement in our financial results throughout the remainder of 2006as we continue to implement a substantial and long-term growth path for theCompany. One expected driver for growth during the remainder of 2006 isanticipated further market acceptance of our AccuRoute product. Going forward,our primary focus is to penetrate further targeted vertical and geographicmarkets, reaping the benefits of our sales and marketing investments. Duringthe remainder of 2006, in both the United States and Europe, we will continueto focus our AccuRoute sales in the legal vertical market, while also expandingour focus to encompass the financial services and healthcare vertical marketsthrough direct sales efforts. In parallel, we will also expand our focus ondistribution and reseller partners. During 2006, we will continue — infact accelerate — our investment in sales and marketing and businessdevelopment and we expect to start seeing the impact of these investments ingrowing our business during the remainder of 2006. Achieving quarterlyprofitability with these investments will require an overall increase inrevenue. We expect revenue to increase gradually during the remainder of 2006. Webelieve that our existing cash and cash equivalents will be sufficient to meetour working capital and capital expenditure needs for at least the nexttwelve months.

Commencing at the end of the third quarter of 2005, weincreased the resources allocated to our United Kingdom subsidiary, an effortthat we expect will result in increased European revenue in future quarters. Althoughwe believe that, over the last several quarters, there has been someimprovement in the demand for enterprise software solutions and increasedmarket acceptance of our products in Europe, we cannot predict whether or whenthat market will soften or if market acceptance of our products will occur. Ifthe European market or the market acceptance of our products changes, we cannotpredict whether and to what extent, the demand for our products will increaseor decrease.

Thefollowing table is a presentation of our total revenue for the periodsindicated:
|                                               | ** ** | **Total Revenue** | ** **            | **Net Income (Loss)** | ** ** | **Software License  Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------|-----------------------|---------------------------------|------------|------------------------------------|------------|
| Three months  ended March 31, 2006       |       | $                      | 3,336,504             |                            | $          | (1,368,002                         | )          | $ | 1,031,819 |   |
| Three months  ended March 31, 2005       |       | $                      | 3,861,484             |                            | $          | 142,040                            |       | $ | 1,317,629 |   |
| Change over same period  of prior fiscal year |       | $                      | (524,980)  or (13.6)% |                            | $          | (1,510,042)  or (1,063.1)%         |       | $ | (285,810)  or (21.7)% |   |

 

During the first three months of 2006, we experienceda decrease in our software license revenue as a result of a decrease in salesfor both our legacy fax and AccuRoute products. The decline in our hardwarerevenue was due to a decrease in legacy fax product sales, which are the maindriver for our hardware revenue. We experienced an increase in service andother revenue due primarily to an increase in AccuRoute related support, whichmore than doubled compared to the first quarter of 2005. This increase inservice and other revenue was offset in part by a decline in our fax relatedmaintenance support revenue. Any decrease in demand for our products wouldlikely result in decreased revenue, which would, in turn, have a significantnegative impact on our financial results because a significant portion of ouroperating costs such as personnel, rent and depreciation are fixed in advance ofa particular quarter. As a result, our costs for sales and marketing, researchand development and general and administrative could continue to increase as apercentage of revenue, thereby negatively affecting our operating results.

Our future revenue and operating results may fluctuatefrom quarter to quarter based on the number and size of sales transactions weenter into with customers, the adequacy of provisions for losses, generaleconomic conditions and other factors. In addition, revenue from one or morelarge orders may constitute a significant portion of our total revenue in aparticular quarter, further exacerbating fluctuations in quarterly results.

We have historically derived a majority of our totalrevenue from sales within the United States. Revenue from our Europeanoperations decreased during the three months ended March 31, 2006, ascompared to the same period in 2005, due to a decrease in Europe of sales ofour legacy fax software. We will continue to leverage our AccuRoute base inEurope, as well as our indirect channel relationships in Europe, to focus salesresources on the legal and financial services vertical markets. In addition, wehave recently added new resources to our European operations, including a newmanaging director of Europe, Middle East and Africa, which we expect will helpto improve our results in the region. There can be, however, no assurance thatwe will be able to increase international sales of our products and the failureto do so may have a material adverse effect on business, financial conditionand results of operations.

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Thefollowing is a presentation of our domestic and international revenue:
|                            | ** ** | **Total Revenue** | ** ** | **United States Revenue** | ** ** | **Non-United States Revenue** | ** ** |
|----------------------------|------------|------------------------|------------|-------------------------------------|------------|-----------------------------------------|------------|
| Three months ended         |       | $3,336,504             |       | $2,898,667                          |       | $437,837                                |       |
| March 31, 2006        |       |                   |       | or  86.9% of  Total Revenue         |       | or  13.1% of  Total Revenue             |       |
|                       |       |                   |       |                                |       |                                    |       |
| Three months  ended        |       | $3,861,484             |       | 3,406,408                           |       | $455,076                                |       |
| March 31, 2005        |       |                   |       | or  88.2% of  Total Revenue         |       | or  11.8% of  Total Revenue             |       |
|                       |       |                   |       |                                |       |                                    |       |
| Change from same period of |       | $(524,980)             |       | $(507,741)                          |       | $(17,239)                               |       |
| prior fiscal year          |       | or (13.6)%             |       | or (14.9)%                          |       | or (3.8)%                               |       |

 

Our United Kingdom subsidiary, Omtool Europe Limited,transacts business primarily in its local currency. We then translate resultsgenerated by that entity into United States dollars and consolidate them withour domestic results for reporting purposes. As we make sales to customers in avariety of countries, significant currency exchange rate fluctuations couldhave a material impact on our results of operations. We manage our foreigncurrency exchange exposure by monitoring our net monetary position usingnatural hedges of our assets and liabilities denominated in local currencies. Therecan be no assurance that this policy will eliminate all foreign currencyexchange exposure. Foreign currency exposure has not been material to ourfinancial position or results of operations to date. If the volume of ourbusiness denominated in foreign currencies increases, we may be required to usederivatives to hedge foreign currency exposure.

Wewill continue to leverage our existing distribution channels, whereappropriate, to broaden our reach to our target vertical markets and furtherpenetrate our installed base. We are pursuing sales opportunities via oursolution/reseller channels, as well as focusing sales efforts on specificmarket segments, in order to facilitate acceptance of our products. However, wecurrently have more of our sales resources focused on the direct model. As aresult, we derive 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  March 31, 2006  |       | $1,589,219                                                   |       | $571,281                                                                                                            |       | 35.9%                                                                                                                                                                                                                |       |
| Three months  ended March 31, 2005  |       | $2,154,973                                                   |       | $629,714                                                                                                            |       | 29.2%                                                                                                                                                                                                                |       |
| Change from same period of  prior             |       | $(565,754)                                                   |       | $(58,433)                                                                                                           |       | 6.7%                                                                                                                                                                                                                 |       |
| fiscal year                                   |       | or (26.3)%                                                   |       | or (9.3)%                                                                                                           |       |                                                                                                                                                                                                                 |       |

 

*Recent events*

In January 2006, weentered into a new lease agreement for approximately 44,000 square feet ofoffice space and moved our headquarters to this facility in Andover,Massachusetts at the end of April 2006. The lease has a ten-year term andwe have an option to renew the lease for an additional five-year term at thethen-applicable fair market rent. Under the terms of the lease, the landlordwill provide us with a tenant improvement allowance of up to $308,000. Additionally,we have 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 thelease, we must pay a penalty of six months’ rent and the unamortized portion ofthe tenant improvement allowance. We believe the new facility will be suitableand sufficient for our needs for the foreseeable future.

**Critical AccountingPolicies and Estimates**

We have identified the policies and estimates below ascritical to our business operations and the understanding of our results ofoperations. The impact and any associated risks related to these policies onour reported and expected financial results and business operations arediscussed in appropriate sections throughout Management’s Discussion andAnalysis of Financial Condition and Results of Operations. Our preparation ofthis Form 10-Q required us to make estimates and assumptions thataffect the reported amount of assets and liabilities, the disclosure ofcontingent assets and liabilities as of the date of the financial statementsincluded herein and the reported amounts of revenue and expenses during theperiod covered by this report. There can be no assurance that actual resultswill not differ materially from those estimates.

*Revenue Recognition and Accounts Receivable Reserves.**  *We derive our revenue primarily from twosources: (i) product revenue, which includes software license and hardwarerevenue, and (ii) service and support revenue, which includes softwaremaintenance and support, installation, training and consulting revenue. Welicense our software products on a perpetual basis. We generate revenue fromlicensing the rights to use our software products and sales of hardwaredirectly to end-users and indirectly through resellers. Our resellers orderproducts from us based on purchase orders received from end-users and do notorder stock. We generally sell our products to resellers and directly toend-users without any specifically stated rights of return. Occasionally,however, in our sole discretion, we will accept a product return if theend-user finds that the product does not fit its needs. We also 

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sell hardware products, which are provided by athird-party, at cost plus an additional mark-up, to end-users and indirectlythrough resellers. The hardware products that we resell are not functionalwithout our software. To support our software products, we sell softwaremaintenance, support, installation, training and consulting services toend-users and indirectly through resellers.

We apply the provisions of Statement of Position (“SOP”)97-2,**“*SoftwareRevenue 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 apply the provisions of Statement of FinancialAccounting Standards (“SFAS”) No. 48,**“*RevenueRecognition When Right of Return Exists*,” with respect toproviding for potential future product returns. As described below, we mustmake and use significant judgments and estimates in connection with the revenuerecognized in any accounting period. Material differences may have resulted inthe amount and timing of our revenue if we had made different judgments orutilized different estimates.

We recognize revenue from the sale of softwareproducts and hardware to both end-users and resellers when persuasive evidenceof an arrangement exists, the products have been delivered, the fee is fixed ordeterminable, collection of the resulting receivable is reasonably assured andthere are no uncertainties regarding customer acceptance. We maintain a reservefor potential product returns. We recognize software maintenance and supportrevenue over the term of the related maintenance period, which is typically aone-year period. On those occasions when we sell multiple-year maintenancecontracts, we recognize the associated revenue over the multiple-year term ofthe maintenance contract. We recognize other service revenue as we perform theservices. If an arrangement includes an acceptance provision and acceptance isuncertain, then we will defer all revenue until the customer accepts theproducts purchased. Acceptance in these instances generally occurs upon theearlier of receipt of a written customer acceptance or expiration of theacceptance period. If an arrangement includes an acceptance provision tied todetermination that our product meets published specifications and there are nouncertainties with regard to the customer’s acceptance, then we will recognizerevenue at the time of sale, provided that all other revenue recognitioncriteria previously mentioned have been met and the acceptance period is ofshort duration.

Our transactions frequently involve the sale ofsoftware, hardware and related services under multiple element arrangements. Revenueunder multiple element arrangements is allocated to each element under theresidual method, in accordance with SOP 98-9, Modification of SOP 97-2,**“*Software Revenue Recognition with Respect to CertainTransactions*.”  Underthis method, revenue is allocated first to all undelivered elements, such asservices, based on the fair value of those elements, which is calculated to bethe price charged when these elements are sold separately and unaccompanied byother elements. Our services generally are not essential to the functionalityof the software, as these services do not alter the capabilities of thesoftware and do not carry a significant degree of risk to perform. The amountallocated to the delivered elements, such as software license and hardwarerevenue, is the difference between the total arrangement value and the amountallocated to the undelivered elements. If the delivered elements include bothsoftware and hardware, the amount allocated to hardware revenue is based on theprice charged to us by the third party vendor plus an additional mark up, withthe remainder allocated to software revenue. To the extent that a discount isoffered in the arrangement, the entire discount is allocated to the deliveredelement or elements. If the delivered elements include hardware and software,the discount is allocated to the hardware and software based on theirrespective list prices.

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

At the time of a transaction, we assess whether thefee associated with the transaction is fixed or determinable and whether or notcollection is reasonably assured. If a significant portion of a fee is duebeyond our normal payment terms, which are thirty to sixty days from invoice date,we account for the fee as not being fixed or determinable. In these cases, werecognize revenue as the fees become due. We assess collection based on anumber of factors, including past transaction history with the customer and thecredit-worthiness of the customer. We review Dunn & Bradstreet creditreports for our resellers and adjust our credit limits with those resellersaccordingly. If a particular reseller does not have a favorable report or if wedo not have enough credit information to determine if the reseller iscredit-worthy then we predominantly sell to those resellers on cash on deliveryterms. We do not request collateral from our customers. If we determine thatcollection of a fee is not reasonably assured, the fee is deferred and revenue isrecognized at the time collection becomes reasonably assured, which isgenerally upon receipt of payment.

We maintain reserves for potential product returns andmake adjustments to these reserves as needed based on historical product returnrates. 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 the estimated return reserve is based upon (1) anaccount specific review of potential returns, where a return probability isknown and (2) an estimate based upon past historical returns as apercentage of revenue. We must make and use significant judgments and estimatesin connection with establishing the product returns reserve in any accountingperiod. Material differences may have resulted in the amount and timing ofrevenue for this or any prior period if we made different judgments or utilizeddifferent estimates.

As with the product return reserve, we must makeestimates of our ability to collect on our accounts receivable. We record tradeaccounts receivable at the invoiced amount and these accounts do not bearinterest. We specifically analyze accounts receivable, historical bad debts,customer credit-worthiness, current economic trends and changes in customerpayment patterns when evaluating the adequacy of our allowance for doubtfulaccounts. We review our allowance for doubtful accounts on a monthly basis. Ourcalculation of the 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 anyoff-balance-sheet credit exposure to our customers.

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Our combined accounts receivable and product returnsreserve was $11,000 and $33,000 at March 31, 2006 and December 31, 2005,respectively. Both components of calculating the estimated reserve —specific identification and historic experience — are material judgmentsthat we make. We base these judgments on historic trends, taking intoconsideration current business and economic conditions, which could changematerially, thus changing the required reserve level materially. The potential changeto the size of our required reserve could be positive, in the event the reserveestimate proves unnecessary, or negative, if the reserve proves inadequate.

Our deferred revenue is comprised mainly of revenuethat is deferred for software maintenance and support contracts. The othercomponents of deferred revenue are amounts from sales transactions that weredeferred because they did not meet all of the provisions of our revenuerecognition policy.

*Software Development Costs.**  *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 determined that we cannot ascertain technologicalfeasibility until the development state of 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, wecharge all software development costs to operations in the period incurred.

Taxes.   We are required toestimate our income and state sales taxes. This process involves estimating ouractual current tax obligations, while also assessing differences resulting fromthe different treatment of items for tax and accounting purposes that result indeferred income tax assets and liabilities and accrued state sales taxliabilities. We include deferred income tax assets and liabilities and accruedstate sales tax liabilities in our balance sheet.

We assess our deferred tax assets for each reportingperiod to determine whether it is more likely than not that we will recoverfrom future taxable income. In making this assessment, we include assumptionsregarding ongoing tax planning strategies. We establish a valuation allowancefor assets when their recovery is not certain. We include changes to thevaluation allowance as an expense or benefit within the tax provision in ourstatement of operations.

We provide a full valuation allowance against all ofour net deferred tax assets and will continue to do so until we return to anappropriate level of sustained taxable income. The ultimate realization ofthese deferred tax assets depends upon our ability to generate sufficientfuture taxable income. If we are successful in generating sufficient futuretaxable income, we will reduce the valuation allowance through a reduction inincome tax expense in the future.

We estimate accrued state sales taxes for eachreporting period based on tax rates in effect for the reporting periods in eachof the states where we have a potential nexus and for the time period duringwhich we have that nexus. The assumptions and estimates used to determine thisliability are subject to change as they are difficult to measure or value. Inthe event that actual results differ from these estimates, our state salestaxes expense could be materially impacted.

 

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**Results ofOperations**

Thefollowing table sets forth certain financial data for the periods indicated asa percentage of total revenues:

|                                 | ** ** | **Three months ended  March 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Revenue:                        |       |                                             |       |   |   |
| Software license                |       | 30.9                                             | %          | 34.1 | % |
| Hardware                        |       | 16.7                                             |       | 21.7 |   |
| Service and other               |       | 52.4                                             |       | 44.2 |   |
| Total revenue                   |       | 100.0                                            |       | 100.0 |   |
| Cost of revenue:                |       |                                             |       |   |   |
| Software license                |       | 0.9                                              |       | 0.5 |   |
| Hardware                        |       | 10.3                                             |       | 14.1 |   |
| Service and other               |       | 21.4                                             |       | 18.7 |   |
| Total cost of  revenue          |       | 32.6                                             |       | 33.3 |   |
| Gross profit                    |       | 67.4                                             |       | 66.7 |   |
| Operating expenses:             |       |                                             |       |   |   |
| Sales and  marketing            |       | 61.5                                             |       | 30.5 |   |
| Research and  development       |       | 21.2                                             |       | 13.4 |   |
| General and  administrative     |       | 27.0                                             |       | 20.1 |   |
| Total operating  expenses       |       | 109.7                                            |       | 64.0 |   |
| Income (loss)  from operations  |       | (42.3                                            | )          | 2.7 |   |
| Interest and other  income, net |       | 1.3                                              |       | 1.1 |   |
| Income tax  provision           |       | 0.0                                              |       | 0.2 |   |
|                            |       |                                             |       |   |   |
| Net income (loss)               |       | (41.0                                            | )%         | 3.6 | % |
|                            |       |                                             |       |   |   |
| Gross profit:                   |       |                                             |       |   |   |
| Software license                |       | 97.0                                             | %          | 98.4 | % |
| Hardware                        |       | 38.1                                             |       | 35.1 |   |
| Service and other               |       | 59.2                                             |       | 58.0 |   |

 

**Three Months Ended March 31,2006 and 2005**

*Revenue*

*Software License.*   During the three months ended March 31, 2006, our total revenuewas $3.3 million, a decrease of $0.5 million from $3.9 million for the threemonths ended March 31, 2005. Our software license revenue decreased byapproximately 22% to $1.0 in the three months ended March 31, 2006,compared to $1.3 million in the same period in 2005, as a result of a declinein software license revenue for both our legacy fax and AccuRoute products. Wedid not have any sales of our other software products during the three monthperiod ended March 31, 2006, which reflects our continued focus on thedevelopment and sale of our AccuRoute product.

Duringthe three months ended March 31, 2006, our revenue by product category(excluding freight and allowances for returns) for the three months ended March 31,2006, as compared to the 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  March 31, 2006 |       | $3,336,504         |       | $1,031,819                         |       | $521,889                        |       | $498,980                              |       | $0                                        |
| Three months ended March 31, 2005  |       | $3,861,484         |       | $1,317,629                         |       | $604,455                        |       | $690,588                              |       | $4,845                                    |
| Change from same period                 |       | $(524,980)         |       | $(285,810)                         |       | $(82,566)                       |       | $(191,608)                            |       | $(4,845)                                  |
| of prior fiscal year                    |       | or (13.6)%         |       | or (21.7)%                         |       | or (13.7)%                      |       | or (27.7)%                            |       | or (100.0)%                               |

 

Duringthe three months ended March 31, 2006, our software license revenuerepresented a decreased percentage of our total revenue, based primarily on adecrease in software license sales for the three months ended March 31,2006 when compared to the same period in 2005.

16

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|                                              | ** ** | **Software License Revenue as a  Percentage of Total Revenue** |
|----------------------------------------------|------------|----------------------------------------------------------------|
| Three months ended  March 31, 2006      |       | 30.9%                                                          |
| Three months ended  March 31, 2005      |       | 34.1%                                                          |
| Change from same period of prior fiscal year |       | (3.2)%                                                         |

 

Theresults for the three months ended March 31, 2006 and 2005 demonstratethat our license revenue has shifted towards our AccuRoute product, asdisplayed in the table below, which summarizes revenue from each of our majorproduct lines and other components of revenue (excluding freight and allowancesfor returns) as a percentage of our total 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  March 31, 2006      |       | 50.6%                                                                       |       | 48.4%                                                                            |       | 0.0%                                                                             |
| Three months ended  March 31, 2005      |       | 45.9%                                                                       |       | 52.4%                                                                            |       | 0.4%                                                                             |
| Change from same period of prior fiscal year                          |       | 4.7%                                                                        |       | (4.0)%                                                                           |       | (0.4)%                                                                           |

 

Included in software license revenue for the threemonths ended March 31, 2006 and 2005 is a reduction of $2,000 and $18,000respectively, in the sales returns and allowance reserve relating primarily toa general estimate based upon historical returns and in 2005, for specificaccounts from where we determined that the risk of a return was no longerpresent. Although we cannot accurately predict the exact mix of products thatwe will sell in the future, we expect that software license revenue willconstitute a larger percentage of our total revenue in the future if demand forour AccuRoute product, which generally does not require the purchase ofadditional hardware, continues to grow and if our AccuRoute product gainsadditional market acceptance.

*Hardware.*   Hardwarerevenue decreased during the three month period ended March 31, 2006 ascompared to the three month period ended March 31, 2005 due to a decreasein our legacy fax product, which sales are the main driver for our hardwarerevenues.

|                                              | ** ** | **Hardware  Revenue**  | ** ** | **Hardware Revenue as a  Percentage of  Total Revenue** |
|----------------------------------------------|------------|------------------------|------------|----------------------------------------------------------------------------------|
| Three months ended March 31, 2006       |       | $557,400               |       | 16.7%                                                                            |
| Three months ended March 31, 2005       |       | $837,344               |       | 21.7%                                                                            |
| Change from same period of prior fiscal year |       | $(279,944)  or (33.4)% |       | (5.0)%                                                                           |

 

Included in hardware revenue for the three monthsended March 31, 2006 and 2005 is a reduction of $1,000 and $6,000,respectively, in the sales returns and allowance reserve relating primarily toa general estimate based upon historical returns and in 2005, for specificaccounts where we determined that the risk of a return is no longer present. Weexpect market demand for AccuRoute, which generally does not require ourcustomers to purchase additional hardware, to increase and, if it does, weanticipate hardware revenue will constitute a smaller percentage of our totalrevenue.

*Serviceand Other.  *Service and other revenue, which consistsprimarily of the sale of support contracts to complement software products soldto customers and, to a lesser extent, consulting, training and installationservices, increased in the three months ended March 31, 2006, as comparedto the same period in the prior fiscal year. This increase was due primarily toan increase in AccuRoute related support, which more than doubled from thefirst quarter of 2005, as a result of increased sales during 2005 of ourAccuRoute product. This increase was offset in part by a decrease in supportrelated to our legacy fax product line.
|                                              | ** ** | **Service and Other Revenue** | ** ** | **Service and Other Revenue as  a Percentage of Total Revenue** |
|----------------------------------------------|------------|-------------------------------|------------|-----------------------------------------------------------------|
| Three months ended  March 31, 2006      |       | $1,747,285                    |       | 52.4%                                                           |
| Three months ended  March 31, 2005      |       | $1,706,511                    |       | 44.2%                                                           |
| Change from same period of prior fiscal year |       | $40,774  or 2.4%              |       | 8.2%                                                            |

 

We are focused onimproving the renewal rate of software maintenance contracts with our existingcustomer base in both our United States and European operations and continue tofocus our attention on generating additional service and other revenue infuture quarters.

**Cost of Revenue**

*SoftwareLicense.  *Cost of software license revenue consistsprimarily of the costs we incur in sublicensing third-party software products,product media and product duplication. Cost of software license revenue for thethree months ended March 31, 2006 increased by 51% as compared to thecorresponding period in the previous fiscal year. The increase is due primarilyto increased royalty payments associated with additional third-party softwarewe incorporated into our products during the third quarter of 2005 . We believethat these newly licensed third-party software components will improve thecapabilities and functionality of our products. 

17

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We may license additional third-party softwarecomponents in the future therefore, we expect that our software license cost asa percentage of software license revenue may increase slightly.

As a result of the increase in the cost of softwarelicense revenue that we incurred during the first quarter of 2006, we incurreda decrease in our software license gross margin percentage as set forth in thefollowing table:
|                                               | ** ** | **Cost of Software  License Revenue** | ** ** | **Software License Gross Margin** |
|-----------------------------------------------|------------|---------------------------------------|------------|-----------------------------------|
| Three months ended  March 31, 2006       |       | $31,441                               |       | 97.0%                             |
| Three months ended  March 31, 2005       |       | $20,767                               |       | 98.4%                             |
| Change from same period of  prior fiscal year |       | $10,674  or 51.4%                     |       | (1.4)%                            |

 

*Hardware.  *Cost of hardware revenueconsists primarily of the costs we incur in purchasing third-party hardwareproducts. Cost of hardware revenue represented 62% and 65% of hardware revenuefor the three months ended March 31, 2006 and March 31, 2005,respectively. During the first quarter of 2006, we incurred decreased dollarcosts related to hardware revenue due primarily to the decrease in our hardwareunit sales. However, our gross margin percentage for hardware sales increasedduring this period due to a favorable change in the mix of particular hardwareproducts sold. We do not expect significant changes in unit prices for theremainder of 2006.
|                                               | ** ** | **Cost of Hardware Revenue** | ** ** | **Hardware Gross Margin** |
|-----------------------------------------------|------------|------------------------------|------------|---------------------------|
| Three months ended  March 31, 2006       |       | $345,078                     |       | 38.1%                     |
| Three months ended  March 31, 2005       |       | $543,677                     |       | 35.1%                     |
| Change from same period of  prior fiscal year |       | $(198,599)                   |       | 3.0%                      |
|                                               |       | or (36.5)%                   |       |                      |

 

*Service and Other.  *Cost of serviceand other revenue consists primarily of the costs we incur in providingtelephone support as well as other miscellaneous customer service-relatedexpenses. Total cost of service and other revenue remained consistent with thesame period in prior year. Our gross margin percentage for service and otherrevenue increased to 59% for the three months ended March 31, 2006,compared to 58% in the same period in 2005. The slight increase in gross marginis primarily due to an increase in service and other revenue. We do not expectany significant variances in our service and other gross margin percentages forthe remainder of fiscal year 2006.
|                                               | ** ** | **Cost of Service  and Other Revenue** | ** ** | **Gross Margin for Service  and Other Revenue** |
|-----------------------------------------------|------------|----------------------------------------|------------|-------------------------------------------------|
| Three months ended  March 31, 2006       |       | $713,099                               |       | 59.2%                                           |
| Three months ended  March 31, 2005       |       | $717,375                               |       | 58.0%                                           |
| Change from same period of  prior fiscal year |       | $(4,276)                               |       | 1.2%                                            |
|                                               |       | or (0.6)%                              |       |                                            |

 

**Operating Expenses**

*Salesand Marketing.  *Sales and marketing expenses consistprimarily of employee salaries, benefits, commissions, and associated overheadcosts, and the cost of marketing programs such as  direct mailings, public relations, tradeshows, seminars and related communication costs. Sales and marketing expensesincreased in the first quarter of 2006 as compared to the same period in 2005due to an increased number of employees in our sales and marketing departmentsand the associated costs of supporting those employees.

Additionally,we increased our marketing program expenditures, including tradeshows, publicrelations and lead generation programs during the first quarter of 2006 ascompared to the same period in the prior fiscal year. These expense increasesreflect our initiative to further penetrate the legal vertical market with ourAccuRoute product, as well as our initiative to target new vertical markets. Buildingon the success of the current version of our AccuRoute product within the legalvertical market since its introduction in 2004, we intend to continuebroadening our current sales and marketing strategy, which we began in thesecond quarter of 2005, to encompass the financial services and healthcarevertical markets. During fiscal year 2006, we will continue — in fact accelerate— our investment in sales and marketing and business development and we expectto start seeing the impact of these investments in growing our business duringthe remainder of 2006.
|                                               | ** ** | **Sales and  Marketing Expenses** | ** ** | **Sales and Marketing Expenses as  a Percentage of Total Revenue** |
|-----------------------------------------------|------------|-----------------------------------|------------|--------------------------------------------------------------------|
| Three months ended  March 31, 2006       |       | $2,052,207                        |       | 61.5%                                                              |
| Three months ended March 31, 2005        |       | $1,179,316                        |       | 30.5%                                                              |
| Change from same period of prior  fiscal year |       | $872,891  or 74.0%                |       | 31.0%                                                              |

 

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* *

*Researchand Development.*Research and development expenses includeexpenses associated with the development of new products, enhancements ofexisting products and quality assurance activities. These expenses consistprimarily of employee salaries, benefits, associated overhead costs, consultingexpenses and the cost of software development tools. For the quarter ended March 31,2006, our research and development expenses increased as compared to the sameperiod in the prior fiscal year due primarily to an increase in consultingexpenses as compared with the same period in 2005, as we continue our thirdparty consulting arrangements in an effort to make our development process moreefficient. We expect our research and development expenses to increase inabsolute dollars as we hire additional engineers and engage in more third partyconsulting arrangements to support our expansion of our AccuRoute product intoother vertical markets.
|                                               | ** ** | **Research and  Development  Expenses** | ** ** | **Research and Development  Expenses as a Percentage of  Total Revenue** |
|-----------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------------------------------------|
| Three months ended  March 31, 2006       |       | $707,252                                |       | 21.2%                                                                    |
| Three months ended March 31, 2005        |       | $516,990                                |       | 13.4%                                                                    |
| Change from same period of  prior fiscal year |       | $190,262  or 36.8%                      |       | 7.8%                                                                     |

 

*General and Administrative.*General andadministrative expenses consist primarily of employee salaries, benefits foradministrative, executive and finance personnel and associated corporategeneral and administrative expenses. In the most recently completed fiscalquarter, our general and administrative expenses increased as compared to thesame period in the prior fiscal year. The increase in general andadministrative expenses, both in dollar amount and as a percentage of totalrevenue, is due to an increase in resources allocated to the departmentresulting in increased wages expense, including stock-based compensation. Inaddition, general and administrative expenses increased in the first quarter of2006 compared to the first quarter of 2005, due to an increase in accountingand legal expenses as a result of increased expenses related to sales taxcompliance and to a lesser extent, an increase in travel expenses. We did notincur any significant professional fees related to the compliance with Section 404of the Sarbanes-Oxley Act of 2002 during the first quarter of 2006. Thedeadline for compliance with Section 404 had been moved back to the firstfiscal year ending on or after July 15, 2007 for companies like us with apublic float of less than $75 million. In March 2006, the Securities andExchange Commission (“SEC”) Advisory Committee on Smaller Public Companiespublished proposed recommendations that would exempt smaller companies fromcompliance with Section 404 of the Sarbanes-Oxley Act. The report iscurrently being reviewed and no conclusion has been reached as of the date ofthis report.
|                                               | ** ** | **General and  Administrative  Expenses** | ** ** | **General and Administrative Expenses  as a Percentage of Total Revenue** |
|-----------------------------------------------|------------|-------------------------------------------|------------|---------------------------------------------------------------------------|
| Three months ended  March 31, 2006       |       | $899,942                                  |       | 27.0%                                                                     |
| Three months ended March 31, 2005        |       | $775,171                                  |       | 20.1%                                                                     |
| Change from same period of  prior fiscal year |       | $124,771  or 16.1%                        |       | 6.9%                                                                      |

 

*Interest and Other Income.*Interest andother income consists principally of interest income earned on cash and cashequivalent balances. The increase in interest income is a result of a higherinterest rates earned on our investment accounts during the three months ended March 31,2006 as compared to the three months ended March 31, 2005. We expect thatinterest and other income will be relatively stable quarter over quarter forfiscal year 2006.
|                                                 | ** ** | **Interest and  Other Income** | ** ** | **Interest and Other Income as a  Percentage of Total Revenue** |
|-------------------------------------------------|------------|--------------------------------|------------|-----------------------------------------------------------------|
| Three months ended  March 31, 2006         |       | $44,513                        |       | 1.3%                                                            |
| Three months ended March 31, 2005          |       | $40,629                        |       | 1.1%                                                            |
| Increase from same period of  prior fiscal year |       | $3,884  or 9.6%                |       | 0.2%                                                            |

 

*Income Tax Provision.*   During the threemonths ended March 31, 2006, we did not record a tax provision due to thenet loss incurred during the period. During the three months ended March 31,2005, we recorded a tax provision of $6,777 for expected tax liability in theUnited States.

**Inflation**

During the fiscal yearsended December 31, 2003, 2004, and 2005 and the three months ended March 31,2006, neither inflation nor changing prices have had a material impact on ournet sales, revenue or income from continuing operations.

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**Liquidityand Capital Resources**

Since1996, we have financed our operations primarily through cash flow fromoperations, private sales of preferred stock and common stock and our initialpublic offering of common stock completed in August 1997. As of March 31,2006, we had cash and cash equivalents of $9.1 million and working capital of$5.0 million. We believe that our existing cash and cash equivalents will besufficient to meet our working capital, capital expenditures and otherliquidity requirements for at least the next twelve months.
|                                                                                  | ** ** | **Cash Provided (Used)**  |
|----------------------------------------------------------------------------------|------------|---------------------------|
| ** **                                                                       | ** ** | **Operating  Activities** | ** ** | **Investing Activities** | ** ** | **Financing Activities** |
| Three months ended  March 31, 2006                                          |       | $(965,824)                |   | $(374,461) |   | $(5,103) |
| Three months ended  March 31, 2005                                          |       | $(163,209)                |   | $(27,525) |   | $18,739 |
| Change from same period of prior fiscal year       |       | $(802,615)  or (491.8)%   |   | $(346,936)  or (1,260.4)% |   | $(23,842)  or (127.2)% |

 

Our operating activities used cash of $966,000 for thethree months ended March 31, 2006 and used cash of $163,000 for the threemonths ended March 31, 2005. We believe that the additional resources weare allocating to improve the success of our AccuRoute product in the legalvertical market and its expansion into the financial services and healthcarevertical markets will continue to put pressure on our earnings during theremainder of 2006, but that our existing cash is sufficient for at least thenext twelve months.

Net cash used during the three months ended March 31,2006 consisted primarily of a net loss from operations and a decrease inaccrued liabilities, offset in part by an increase in accounts payable, anincrease in deferred revenue and a decrease in inventory as well as by thenon-cash effects of stock-based compensation and depreciation.

The decrease in accrued liabilities is primarily dueto the payment of state franchise taxes. The increase in accounts payable isdue to the timing of vendor payments. The decrease in inventory is related to areduction in onsite hardware inventory, as we primarily make shipments directlyfrom our third party vendor and did not stock inventory during the quarter. Theincrease in deferred revenue is primarily related to the increase in softwaremaintenance contracts sold during the three months ended March 31, 2006that complement our AccuRoute product.

Net cash used during the first quarter of March 31,2005 consisted primarily of net income from operations and the non-cash effectsof depreciation and an increase in accounts payable and deferred revenue,offset by increases to accounts receivable and prepaid expenses and othercurrent assets.

Investing activities used cash of $374,000 and $28,000during the three months ended March 31, 2006 and 2005, respectively. Theprimary use of cash for investing activities during the first quarter of 2006was for the purchases of furniture, equipment and construction costs associatedwith our new headquarters. In January 2006, we entered into a new leaseagreement for office space located at Six Riverside Drive, Andover,Massachusetts consisting of approximately 44,000 square feet. We moved ourexecutive offices and headquarters to this new space at the end of April 2006.We expect that we will increase our investments in property and equipmentduring the remainder of 2006 as we improve our information technologyinfrastructure as part of this relocation as well as purchase additionalfurniture for our new office space. The sole use of cash for investingactivities during the first quarter of 2005, consisted of purchases of propertyand equipment comprised predominantly of computer related software and hardwareproducts.

Financing activities used cash of $5,000 during thethree months ended March 31, 2006 and provided $19,000 of cash during thesame period in 2005. Cash used during the three months ended March 31,2006 consisted primarily of the purchase of treasury stock related to sales ofrestricted stock under our 1997 Stock Plan, offset in part by the net proceedsfrom the issuance of common stock pursuant to our employee stock purchaseprogram. Cash realized during the three months ended March 31, 2005consisted of the net proceeds from the issuance of common stock pursuant to ouremployee stock purchase program.

Based on our performance for the three months ended March 31,2006 and current expectations for the remainder of 2006, we believe that ourcurrent cash and cash equivalents balance, as well as the cash expected to begenerated from operations for the remainder of the year, will satisfy ourworking capital needs, capital expenditures and other liquidity requirementsassociated with our operations through at least the next twelve months. Weexpect that principal uses of cash will be for operations, working capital,payment of sales taxes and purchases of property and equipment and payment ofcertain leasehold improvements resulting from our move to Andover,Massachusetts. There can be no assurance that any necessary additional financingwill be available to us on commercially reasonable terms, or at all.

The following table represents the approximate amountsof payments due under specified contractual obligations as of March 31,2006:
| Contractual Obligations | ** ** | **Total** | ** ** | **Less than  one year** | ** ** | **One to  Three years** | ** ** | **Three to  five years** | ** ** | **More than  Five years** | ** ** |
|------------------------------|------------|-----------|------------|-----------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|
| Operating lease  obligations |       | $         | 4,223,000  |                              | $          | 307,000                           |       | $                                  | 758,000    |                                | 802,000    |   | 2,356,000 |   |
|                              |            |           |            |                                   |            |                                   |            |                                    |            |                                     |            |  |  |  |

 

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Operating leaserequirements consist mainly of lease payments for our offices in Andover,Massachusetts and London, England, United Kingdom. As of March 31, 2006,we did not have any long-term debt obligations, material commitments forcapital expenditures, capital lease obligations, or other long-term liabilitiesfor which payments are required.

**Off-Balance SheetArrangements**

We do not have anyrelationships with unconsolidated entities or financial partnerships, such asentities often referred to as structured finance or special purpose entities,that would have been established for the purpose of facilitating off-balancesheet arrangements (as that term is defined in Item 303(a)(4)(ii) ofRegulation S-K) or other contractually narrow or limited purposes. As such, weare not exposed to any financing, liquidity, market or credit risk that couldarise if we had engaged in those types of relationships.

**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

*DerivativeFinancial Instruments, Other Financial Instruments, and Derivative CommodityInstruments.*As of March 31, 2006, the Company did notparticipate in any derivative financial instruments or other financial andcommodity instruments for which fair value disclosure would be required underSFAS No. 107,**“*Disclosuresabout Fair Value of Financial Instruments*.”  All of the Company’s investments consist ofmoney market funds and commercial paper that are carried on the Company’s booksat amortized cost, which approximates fair market value. Accordingly, theCompany has no quantitative information concerning the market risk ofparticipating in such investments.

*PrimaryMarket 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 tocurrency exchange rate fluctuations has been and is expected to continue to bemodest due to the fact that the operations of its United Kingdom subsidiary arealmost exclusively conducted in its local currency. The United Kingdomsubsidiary’s operating results are translated into U.S. dollars andconsolidated for reporting purposes. The impact of currency exchange ratemovements on intercompany transactions was immaterial for the quarter ended March 31,2006. The Company manages its foreign currency exchange risk by monitoring itsnet monetary position using natural hedges of its assets and liabilitiesdenominated in local currencies. There can be no assurance that this approachwill eliminate all foreign currency exchange rate exposure. Currently, theCompany does not engage in foreign currency hedging activities.

**Item 4. Controlsand Procedures**

(a)           Evaluationof disclosure controls and procedures.

As of March 31, 2006(the “Evaluation Date”), the Company, under the supervision and with theparticipation of the Company’s management, including the Company’s ChiefExecutive Officer and Chief Financial Officer, evaluated the effectiveness ofthe design and operation of the Company’s disclosure controls and procedurespursuant to Rule 13a-15(b) promulgated under the SecuritiesExchange Act 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, includingensuring that this 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 required disclosure.

(b)          Changesin internal control over financial reporting

There were no changes inthe Company’s internal control over financial reporting during the Company’sfiscal quarter ended March 31, 2006 or in other factors that havematerially affected, or are reasonably likely to materially affect, the Company’sinternal control over financial reporting.

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**PART II: OTHER INFORMATION**

**Item 1A.  Risk Factors**

There are no materialchanges from risk factors as previously disclosed in **Item 1A, “Risk Factors,” of our2005 Form 10-K.**

**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds**

**ISSUERPURCHASES OF EQUITY SECURITIES**

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| 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** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| January 1,  2006 — January 31, 2006   |       | 1,347                                                     | (1)        | $                                                         | 7.19       |                                                                                                                                      | —     |                                                                                                                                         | —     |   |
| February 1,  2006 — February 28, 2006 |       | —                                                    |       | —                                                    |       | —                                                                                                                                    |       | —                                                                                                                                       |       |
| March 1, 2006 —  March 31, 2006       |       | —                                                    |       | —                                                    |       | —                                                                                                                                    |       | —                                                                                                                                       |       |
|                                                      |            |                                                           |            |                                                           |            |                                                                                                                                           |            |                                                                                                                                              |            |  |

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(1) On January 31, 2006, certain shares of restricted Common Stock of theCompany held by Robert Voelk and Daniel Coccoluto vested. The vesting of therestricted stock imposed tax withholding obligations on the Company and,accordingly, the Company purchased 1,030 and 317 shares of the vested CommonStock from Messrs. Voelk and Coccoluto, respectively, in order to fulfillthe withholding obligations. The Company purchased the shares to fulfill thetax withholding obligations in accordance with a Stock Purchase and RestrictionAgreement between the Company and each individual. All shares were purchased at$7.19 per share, which was the market price on January 31, 2006, the dateon which vesting occurred and the tax withholding obligations arose.

**Item 5.   OtherInformation**

There have been no changesto the procedures by which security holders may recommend nominees to theCompany’s Board of Directors during the time period covered by this QuarterlyReport on Form 10-Q.

**Item 6.   Exhibits**

Exhibits
| 10.1   |   | Lease Agreement, dated January 6, 2006, between  SFI I, LLC and Omtool, Ltd., previously filed as an exhibit to Omtool’s  Current Report on Form 8-K dated January 6, 2006 and  incorporated herein by reference.                                      |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                       |
| 10.2   |   | Agreement for Construction Projects, dated  January 24, 2006, between Omtool, Ltd. and Prism Builders, Inc.,  previously filed as an exhibit to Omtool’s Current Report on Form 8-K  dated January 24, 2006 and incorporated herein by reference. |
|   |   |                                                                                                                                                                                                                                                                       |
| *10.3  |   | Form of Stock Purchase and Restriction  Agreement—Officer                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                       |
| *10.4  |   | Form of Stock Purchase and Restriction Agreement—Director                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                       |
| 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.                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                       |
| (*)    |   | Indicates a management contract or any compensatory  plan, contract or arrangement.                                                                                                                                                                                        |

 

22

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**OMTOOL, LTD.**

Signatures

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                   |   | OMTOOL, LTD. |
|-------------------|--------|--------------|
|              |   |         |   |   |
| May 11, 2006 |   | By:          |   | /s/ Daniel A. Coccoluto |
|              |   |         |   | Daniel A. Coccoluto |
|              |   |         |   | Chief Financial Officer, Secretary and Treasurer |
|              |   |         |   | (Duly authorized officer and principal financial  officer) |

 

23

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**Exhibit Index**
| 10.1   |   | Lease Agreement, dated January 6, 2006, between  SFI I, LLC and Omtool, Ltd., previously filed as an exhibit to Omtool’s  Current Report on Form 8-K dated January 6, 2006 and  incorporated herein by reference.                                      |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                       |
| 10.2   |   | Agreement for Construction Projects, dated  January 24, 2006, between Omtool, Ltd. and Prism Builders, Inc.,  previously filed as an exhibit to Omtool’s Current Report on Form 8-K  dated January 24, 2006 and incorporated herein by reference. |
|   |   |                                                                                                                                                                                                                                                                       |
| *10.3  |   | Form of Stock Purchase and Restriction  Agreement—Officer                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                       |
| *10.4  |   | Form of Stock Purchase and Restriction  Agreement—Director                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                       |
| 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.                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                       |
| (*)    |   | Indicates a management contract or any compensatory  plan, contract or arrangement.                                                                                                                                                                                        |

 

24

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