**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

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

 

**Forthe quarterly period ended September 30, 2005**

 

**OR**

 

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

 

**Forthe transition period from            to           **

 

**CommissionFile Number 0-22871**

 

**OMTOOL, LTD.**

(Exact Name of Registrant asSpecified in Its Charter)

 
| **Delaware**                                                     | ** ** | **02-0447481**                            |
|------------------------------------------------------------------|------------|-------------------------------------------|
| (State or  Other Jurisdiction of  Incorporation or Organization) |       | (I.R.S.  Employer  Identification Number) |
|                                                             |       |                                      |
| **8A Industrial Way, Salem, NH**                                 | ** ** | **03079**                                 |
| (Address of  Principal Executive Offices)                        |       | (Zip Code)                                |
|                                                             |       |                                      |
| **(603) 898-8900**                                               |
| (Registrant’s  Telephone Number Including Area Code)        |

 

Indicate by check mark whether the Registrant has: (1) filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

 

Yes  ý  No  o

 

Indicate by check mark whether the Registrant is an accelerated filer(as defined in Rule 12b-2 of the Securities Exchange Act of 1934).

 

Yes  o  No  ý

 

Indicate by check mark whetherthe registrant is a shell company (as defined in Rule 12b-2 of the Securities ExchangeAct of 1934).

 

Yes  o  No  ý

 

There were 3,962,706 shares of the Company’s common stock, par value$0.01, outstanding on November 11, 2005.

 

 

----

 

**OMTOOL,LTD. AND SUBSIDIARIES**

 

FORM 10-Q

For the Quarter Ended September 30,2005

CONTENTS

 
| **Item  Number**                   | ** ** | ** **                                                                                                                     | ** ** |
|------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------|------------|
|                               |       |                                                                                                                           |       |
| PART I: FINANCIAL INFORMATION |       |
|                               |       |                                                                                                                           |       |
| Item 1.                            |       | Consolidated Financial Statements                                                                                              |       |
|                               |       | Consolidated Balance Sheets as of September 30, 2005 (Unaudited)  and December 31, 2004                              |       |
|                               |       | Consolidated Statements of Operations for the three months and nine  months ended September 30, 2005 and 2004 (Unaudited) |       |
|                               |       | Consolidated Statements of Cash Flows for the nine months ended  September 30, 2005 and 2004 (Unaudited)                  |       |
|                               |       | Notes to Consolidated Financial Statements                                                                                     |       |
|                               |       |                                                                                                                           |       |
| Item 2.                            |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                    |       |
|                               |       |                                                                                                                           |       |
| Item 3.                            |       | Quantitative and Qualitative Disclosures  About Market Risk                                                                    |       |
|                               |       |                                                                                                                           |       |
| Item 4.                            |       | Controls and Procedures                                                                                                        |       |
|                               |       |                                                                                                                           |       |
| PART II: OTHER INFORMATION    |       |
|                               |       |                                                                                                                           |       |
| Item 5.                            |       | Other Information                                                                                                              |       |
|                               |       |                                                                                                                           |       |
| Item 6.                            |       | Exhibits                                                                                                                       |       |
|                               |       |                                                                                                                           |       |
| Signatures                         |       |
|                               |       |                                                                                                                           |       |
| Exhibit Index                 |       |
|                               |       |                                                                                                                           |       |
| Exhibits                           |       |

 

2

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**PART I:  FINANCIAL INFORMATION**

Item 1.  Consolidated Financial Statements

 

**OMTOOL,LTD. AND SUBSIDIARIES**

**Consolidated Balance Sheets**

 
| ** **                                                                                                                                                                                                                                                                                     | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                     | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Current assets:                                                                                                                                                                                                                                                                                |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                                      |       | $                            | 10,385,856 |                        | 10,655,121 |   |
| Accounts receivable, less reserves of  $39,000 at September 30, 2005 and $82,000 at December 31, 2004                                                                                                                                                                                |       | 1,690,602                    |       | 1,802,784                   |       |
| Inventories                                                                                                                                                                                                                                                                                    |       | 35,676                       |       | 137,992                     |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                                      |       | 378,632                      |       | 278,972                     |       |
| Total current assets                                                                                                                                                                                                                                                                           |       | 12,490,766                   |       | 12,874,869                  |       |
| Property and equipment, net                                                                                                                                                                                                                                                                    |       | 175,053                      |       | 213,512                     |       |
| Other assets                                                                                                                                                                                                                                                                                   |       | 11,562                       |       | 11,562                      |       |
| Total assets                                                                                                                                                                                                                                                                                   |       | 12,677,381                   |       | 13,099,943                  |       |
|                                                                                                                                                                                                                                                                                           |       |                         |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                  | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                                           |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                               |       | 754,925                      |       | 849,572                     |       |
| Accrued liabilities                                                                                                                                                                                                                                                                            |       | 1,220,474                    |       | 1,258,672                   |       |
| Accrued state sales tax                                                                                                                                                                                                                                                                        |       | 453,917                      |       | 699,816                     |       |
| Deferred revenue, short term                                                                                                                                                                                                                                                                   |       | 3,345,158                    |       | 3,205,072                   |       |
| Total current liabilities                                                                                                                                                                                                                                                                      |       | 5,774,474                    |       | 6,013,132                   |       |
| Long term liabilities:                                                                                                                                                                                                                                                                         |       |                         |       |                        |       |
| Deferred revenue, long-term                                                                                                                                                                                                                                                                    |       | 383,138                      |       | 455,604                     |       |
| Total liabilities                                                                                                                                                                                                                                                                              |       | 6,157,612                    |       | 6,468,736                   |       |
|                                                                                                                                                                                                                                                                                           |       |                         |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Preferred Stock, $0.01 par value —  Authorized — 2,000,000 shares; Issued and outstanding — none                                                                                                                                                                                |       | —                       |       | —                      |       |
| Common Stock, $0.01 par value — Authorized  — 35,000,000 shares; Issued — 4,367,878 shares at September 30, 2005 and  December 31, 2004; Outstanding — 3,930,206 shares at September 30,  2005 and 3,851,472 shares at December 31, 2004, respectively |       | 43,679                       |       | 43,679                      |       |
| Deferred compensation                                                                                                                                                                                                                                                                          |       | (448,735                     | )          | —                      |       |
| Additional paid-in capital                                                                                                                                                                                                                                                                     |       | 35,421,889                   |       | 35,259,706                  |       |
| Accumulated deficit                                                                                                                                                                                                                                                                            |       | (26,207,637                  | )          | (26,018,011                 | )          |
| Treasury stock, at cost (437,672 shares at  September 30, 2005 and 516,406 shares at December 31, 2004)                                                                                                                                                                              |       | (2,245,783                   | )          | (2,649,756                  | )          |
| Accumulated other comprehensive loss                                                                                                                                                                                                                                                           |       | (43,644                      | )          | (4,411                      | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                                                |       | 6,519,769                    |       | 6,631,207                   |       |
|                                                                                                                                                                                                                                                                                           |       |                         |       |                        |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                                                |       | $                            | 12,677,381 |                        | $          | 13,099,943 |   |
|                                                                                                                                                                                                                                                                                                |            |                              |            |                             |            |  |  |

 

The accompanying notes are an integral part of these unaudited consolidatedfinancial statements.

 

3

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**OMTOOL,LTD. AND SUBSIDIARIES**

**Consolidated Statements of Operations**

(Unaudited)

 
| ** **                                      | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                      | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                        |       |                                       |       |                                      |       |   |   |   |   |
| Software  license                               |       | $                                          | 877,357    |                                      | $          | 1,011,298 |   | $ | 3,333,046 |   | $ | 3,314,682 |   |
| Hardware                                        |       | 582,976                                    |       | 696,715                                   |       | 2,142,283 |   | 2,312,461 |   |
| Service and  other                              |       | 1,705,437                                  |       | 1,739,991                                 |       | 5,122,224 |   | 5,216,520 |   |
| Total  revenue                                  |       | 3,165,770                                  |       | 3,448,004                                 |       | 10,597,553 |   | 10,843,663 |   |
| Cost of  revenue:                               |       |                                       |       |                                      |       |   |   |   |   |
| Software  license                               |       | 41,983                                     |       | 32,659                                    |       | 113,185 |   | 150,833 |   |
| Hardware                                        |       | 333,761                                    |       | 404,545                                   |       | 1,361,141 |   | 1,393,065 |   |
| Service and  other                              |       | 682,896                                    |       | 676,073                                   |       | 2,082,023 |   | 2,067,721 |   |
| Total cost  of revenue                          |       | 1,058,640                                  |       | 1,113,277                                 |       | 3,556,349 |   | 3,611,619 |   |
| Gross profit                                    |       | 2,107,130                                  |       | 2,334,727                                 |       | 7,041,204 |   | 7,232,044 |   |
| Operating  expenses:                            |       |                                       |       |                                      |       |   |   |   |   |
| Sales and  marketing                            |       | 1,352,295                                  |       | 1,013,316                                 |       | 3,672,547 |   | 3,045,097 |   |
| Research and  development                       |       | 579,422                                    |       | 478,108                                   |       | 1,617,112 |   | 1,431,273 |   |
| General and  administrative                     |       | 570,421                                    |       | 527,364                                   |       | 2,071,729 |   | 1,799,052 |   |
| Total  operating expenses                       |       | 2,502,138                                  |       | 2,018,788                                 |       | 7,361,388 |   | 6,275,422 |   |
| Income  (loss) from operations                  |       | (395,008                                   | )          | 315,939                                   |       | (320,184 | ) | 956,622 |   |
| Interest and  other income, net                 |       | 51,578                                     |       | 30,476                                    |       | 137,335 |   | 104,931 |   |
| Tax  (benefit) provision                        |       | —                                     |       | (47,794                                   | )          | 6,777 |   | 9,909 |   |
|                                            |       |                                       |       |                                      |       |   |   |   |   |
| Net income  (loss)                              |       | $                                          | (343,430   | )                                         | $          | 394,209 |   | $ | (189,626 | ) | $ | 1,051,644 |   |
|                                            |       |                                       |       |                                      |       |   |   |   |   |
| Net income  (loss) per share:                   |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                           |       | $                                          | (0.09      | )                                         | $          | 0.10 |   | $ | (0.05 | ) | $ | 0.28 |   |
| Diluted                                         |       | $                                          | (0.09      | )                                         | $          | 0.10 |   | $ | (0.05 | ) | $ | 0.27 |   |
|                                            |       |                                       |       |                                      |       |   |   |   |   |
| Weighted  average of common shares outstanding: |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                           |       | 3,926,451                                  |       | 3,936,706                                 |       | 3,947,529 |   | 3,738,216 |   |
| Diluted                                         |       | 3,926,451                                  |       | 4,126,239                                 |       | 3,947,529 |   | 3,924,607 |   |

 

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

 

4

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**OMTOOL,LTD. AND SUBSIDIARIES**

**Consolidated Statements of Cash Flows**

(Unaudited)

 
| ** **                                                                                        | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                        | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| Cash Flows  from Operating Activities:                                                            |       |                                      |       |   |   |
| Net income  (loss)                                                                                |       | $                                         | (189,626   | ) | $ | 1,051,644 |   |
| Adjustments  to reconcile net income to net cash (used in) provided by operating activities– |       |                                      |       |   |   |
| Depreciation                                                                                      |       | 120,610                                   |       | 188,477 |   |
| Accounts  receivable reserves                                                                     |       | (41,650                                   | )          | (245,033 | ) |
| Amortization  of deferred compensation                                                            |       | 80,802                                    |       | — |   |
| Changes in  assets and liabilities–                                                          |       |                                      |       |   |   |
| Accounts  receivable                                                                              |       | 134,036                                   |       | 522,434 |   |
| Prepaid  expenses and other current assets                                                        |       | (123,814                                  | )          | (192,352 | ) |
| Inventory                                                                                         |       | 102,316                                   |       | (272 | ) |
| Accounts  payable                                                                                 |       | (89,246                                   | )          | (98,125 | ) |
| Accrued  liabilities                                                                              |       | (5,561                                    | )          | 44,170 |   |
| Accrued  state sales tax                                                                          |       | (245,899                                  | )          | (182,420 | ) |
| Accrued  restructuring                                                                            |       | —                                    |       | (443,830 | ) |
| Other assets                                                                                      |       | —                                    |       | 2,399 |   |
| Deferred  revenue                                                                                 |       | 97,179                                    |       | (384,430 | ) |
|                                                                                              |       |                                      |       |   |   |
| Net cash  provided by (used in) operating activities                                              |       | (160,853                                  | )     | 262,662 |   |
|                                                                                              |       |                                      |       |   |   |
| Cash Flows  from Investing Activities:                                                            |       |                                      |       |   |   |
| Purchases of  property and equipment                                                              |       | (82,854                                   | )          | (35,758 | ) |
|                                                                                              |       |                                      |       |   |   |
| Net cash  used in investing activities                                                            |       | (82,854                                   | )          | (35,758 | ) |
|                                                                                              |       |                                      |       |   |   |
| Cash Flows  from Financing Activities:                                                            |       |                                      |       |   |   |
| Net proceeds  from issuance of common stock                                                       |       | 36,619                                    |       | 3,570,856 |   |
| Purchase of  treasury stock                                                                       |       | —                                    |       | (2,012,500 | ) |
|                                                                                              |       |                                      |       |   |   |
| Net cash  provided by financing activities                                                        |       | 36,619                                    |       | 1,558,356 |   |
|                                                                                              |       |                                      |       |   |   |
| Exchange  rate effect on cash                                                                     |       | (62,177                                   | )          | 4,912 |   |
|                                                                                              |       |                                      |       |   |   |
| Net  (decrease) increase in cash and cash equivalents                                             |       | (269,265                                  | )     | 1,790,172 |   |
|                                                                                              |       |                                      |       |   |   |
| Cash and  cash equivalents, beginning of period                                                   |       | 10,655,121                                |       | 8,242,067 |   |
|                                                                                              |       |                                      |       |   |   |
| Cash and  cash equivalents, end of period                                                         |       | $                                         | 10,385,856 |   | $ | 10,032,239 |   |

 

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

 

5

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**OMTOOL,LTD. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements**

(Unaudited)

 

**(1) Basis of Presentation**

 

Omtool, Ltd. (“Omtool”or the “Company”) provides enterprise document messaging applications thatstreamline workflows, reduce costs and ensure secure, confidential e-documentexchange.  The accompanying unauditedconsolidated financial statements have been prepared by Omtool pursuant to the rules andregulations of the Securities and Exchange Commission (“SEC”) regarding interimfinancial reporting.  Accordingly, they do not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements and should be read in conjunction with theconsolidated financial statements and notes thereto for the year ended December 31,2004 as filed with the SEC as part of the Company’s Annual Report on Form 10-Kon March 29, 2005. The accompanying consolidated financial statementsreflect all adjustments (consisting of normal recurring adjustments) that are,in the opinion of management, necessary for a fair presentation of results forthe interim periods presented.  The results of operations for the threeand nine month periods ended September 30, 2005 are not necessarilyindicative of the results to be expected for the full fiscal year.

 

**(2) Net Income per Common Share**

 

The Companyreports earnings per share in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 128,*Earningsper Share*.  The dilutive effect of potential common shares in2004, consisting of outstanding stock options and a stock warrant, isdetermined using the treasury stock method, in accordance with SFAS No. 128. Diluted weighted average shares outstanding for the three months and ninemonths ended September 30, 2005 exclude 421,000 potential common sharesfrom stock options and a stock warrant because to include them would have beenanti-dilutive for the periods presented as the Company reported a net lossduring the periods.  For the three monthsand nine months ended September 30, 2004, the dilutive calculationexcluded 126,278 and 175,738 shares of common stock, respectively, potentiallyissuable upon the exercise of outstanding stock options that have ananti-dilutive effect since their exercise price exceeds the market value of theCompany’s common stock.  A reconciliation of basic and diluted commonshares outstanding is as follows:

 
| ** **                                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted  average number of common shares outstanding          |       | 3,926,451                                  |       | 3,936,706                                 |       | 3,947,529 |   | 3,738,216 |   |
| Potential  common shares pursuant to stock options and warrant |       | —                                     |       | 189,533                                   |       | — |   | 186,391 |   |
| Diluted  weighted average shares                               |       | 3,926,451                                  |       | 4,126,239                                 |       | 3,947,529 |   | 3,924,607 |   |
| Basic net income  per common share                             |       | $                                          | (0.09      | )                                    | $          | 0.10 |   | $ | (0.05 | )  | $ | 0.28 |   |
| Diluted net  income per common and potential common share      |       | $                                          | (0.09      | )                                    | $          | 0.10 |   | $ | (0.05 | )  | $ | 0.27 |   |

 

**(3)  Income Taxes**

 

SFAS No. 109,*Accounting for Income Taxes,* requires theCompany to record a valuation allowance against deferred tax assets when it ismore likely than not that some or all of the deferred tax assets will not berealized.  As a result of cumulative losses in recent years and continuedeconomic uncertainty, the Company has provided a full valuation allowanceagainst all of its net deferred tax assets and will continue to do so until itreturns to an appropriate level of sustained taxable income.  The ultimaterealization of these deferred tax assets depends upon the Company’s ability togenerate sufficient future taxable income. If the Company is successful ingenerating sufficient future taxable income, the Company will reduce thevaluation allowance through a reduction in income tax expense in the future.

 

During thenine months ended September 30, 2005, the Company recorded a net taxprovision of $6,777 for expected tax liability in the United States.  There was no tax provision required for theCompany’s United Kingdom subsidiary, Omtool Europe Limited (“OEL”) for the ninemonths ended September 30, 2005.

 

During thenine months ended September 30, 2004, the Company recorded a net taxprovision of $9,909 for expected tax liability in the United States and forexpected tax liability related to OEL. The provision for the first nine months of 2004 was net of a $28,800adjustment related to a fiscal year 2003 transfer pricing adjustment.

 

6

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

 

The componentsof the Company’s comprehensive income (loss) are as follows:

 
| ** **                                | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income  (loss)                        |       | $                                          | (343,430   | )                                         | $          | 394,209 |   | $ | (189,626 | ) | $ | 1,051,644 |   |
| Foreign  currency translation adjustments |       | (15,020                                    | )          | 11,259                                    |       | (39,233 | ) | 976 |   |
| Comprehensive  income (loss)              |       | $                                          | (358,450   | )                                         | $          | 405,468 |   | $ | (228,859 | ) | $ | 1,052,620 |   |

 

**(5) Stock Based Compensation**

 

The Companyaccounts for stock-based compensation for employees under the recognition andmeasurement principles of Accounting Principles Board Opinion No. 25,*Accounting for Stock Issued to Employees,*and related interpretations.  The following table illustrates the effecton net income and net income per share if the Company had applied the fairvalue recognition provisions of Statement of Financial Accounting StandardsBoard (“SFAS”) No. 123,*Accounting forStock-Based Compensation,* as amended by SFAS No. 148,*Accounting for Stock-Based Compensation — Transitionand Disclosure* to stock-based employee compensation.  In December 2004, the FASB issued SFAS No. 123(R)*Share-Based Payment. *SFAS No. 123(R) amends SFAS No. 123.  The Company will be required to adopt SFAS123(R) in the first fiscal quarter of 2006 and does not expect it to have amaterial impact on its future results of operations.

 
| ** **                                                                                                  | ** ** | **Three months Ended  September 30,** | ** ** | **Nine months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                        |       |                                       |       |                                      |       |   |   |   |   |
| Net income  (loss), as reported                                                                             |       | $                                          | (343,430   | )                                    | $          | 394,209 |   | $ | (189,626 | ) | $ | 1,051,644 |   |
| Add: Stock  compensation included in net income                                                             |       | 33,054                                     |       | —                                    |       | 80,710 |   | — |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  method for all awards |       | (37,808                                    | )          | (46,452                                   | )          | (126,074 | ) | (169,422 | ) |
| Pro forma  net income (loss)                                                                                |       | $                                          | (348,184   | )                                         | $          | 347,757 |   | $ | (234,990 | )  | $ | 882,222 |   |
|                                                                                                        |       |                                       |       |                                      |       |   |   |   |   |
| Net income  per share:                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Basic, as  reported                                                                                         |       | $                                          | (0.09      | )                                    | $          | 0.10 |   | $ | (0.05 | )  | $ | 0.28 |   |
| Diluted, as  reported                                                                                       |       | $                                          | (0.09      | )                                    | $          | 0.10 |   | $ | (0.05 | )  | $ | 0.27 |   |
| Basic, pro  forma                                                                                           |       | $                                          | (0.09      | )                                    | $          | 0.09 |   | $ | (0.06 | )  | $ | 0.24 |   |
| Diluted, pro  forma                                                                                         |       | $                                          | (0.09      | )                                    | $          | 0.08 |   | $ | (0.06 | )  | $ | 0.22 |   |

 

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

 

Accruedliabilities consist of the following:

 
| ** **                         | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Accrued  health insurance expense  |       | $                            | 147,317    |                        | $          | 178,464 |   |
| Accrued  salary and salary-related |       | 658,289                      |       | 688,622                     |       |
| Accrued  professional fees         |       | 94,328                       |       | 141,322                     |       |
| Other  accrued expenses            |       | 320,540                      |       | 250,264                     |       |
|                               |       | $                            | 1,220,474  |                        | $          | 1,258,672 |   |

 

**(7)  Equity Transactions**

 

In January 2005 and July 2005, theCompany sold a total of 58,684 and 9,333 shares, respectively, of restrictedcommon stock under its 1997 Stock Plan, as amended, to the members of its Boardof Directors and certain employees of the Company at a price per share of$0.01. The shares of restricted common stock vest ratably over the four-yearservice period, so long as the restricted stockholder continues to provideservices to the Company. During 2005, the Company recorded deferredcompensation of approximately $529,000 for the intrinsic value of the shares ofrestricted common stock. The Company will recognize deferred compensation ascompensation expense over the expected four year vesting period. In the eventthat a restricted stockholder ceases to provide services to the Company priorto the vesting of any of the then unvested shares held by that stockholder, therestricted stockholder is required to sell all such unvested shares ofrestricted common stock back to the Company at the original purchase price of$0.01 per share.

 

7

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On March 30, 2004, the Company raised$3.6 million through the private placement to institutional and otheraccredited investors of 600,000 shares of its common stock at a price of $6.00per share.  The fees associated with issuing the shares in connection withthe private placement were approximately $147,000 and were recorded as areduction of additional paid-in capital.  Furthermore, Omtool issued51,000 shares of common stock and a warrant to purchase an additional 51,000shares of common stock, exercisable over a five-and-a-half-year period at aprice of $6.00 per share, to its financial advisor or the advisor’s designeesas payment for advisory services related to the private placement.

 

On March 30,2004, Omtool’s Board of Directors approved a two-for-one stock split of theCompany’s common stock in the form of a dividend, effective April 27,2004, payable to each stockholder of record as of April 7, 2004.  Allreferences in the consolidated financial statements referring to shares, shareprices, per share amounts and stock plans have been adjusted retroactively forthis two-for-one stock split.

 

On March 31, 2004, the Companyrepurchased 350,000 shares of its outstanding common stock from ASAInternational Ltd., an existing shareholder, in a private transaction at aprice of $5.75 per share. The 350,000 shares that were repurchased have beenrecorded and are held as treasury stock.

 

**(8) Segment and Geographic Information**

 

To date, theCompany has viewed its operations and manages its business as principally onesegment, software and hardware sales and associated services. As a result, thefinancial information disclosed herein represents all of the material financialinformation related to the Company’s principal operating segment in accordancewith SFAS No. 131,*Disclosures About Segmentsof an Enterprise and Related Information*.

 

Total revenuesfrom international sources were $603,000 and $1.9 million for the three monthsand nine months ended September 30, 2005 and $403,000 and $2.4 million forthe three months and nine months ended September 30, 2004,respectively.  The Company’s revenues from international sources wereprimarily generated from customers located in Europe. The following tablerepresents amounts relating to geographic locations:

 
| ** **             | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **             | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Total  revenues (1)    | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| United  States         |       | $                                          | 2,562,288  |                                      | $          | 3,044,993 |   | $ | 8,732,208 |   | $ | 8,406,656 |   |
| United  Kingdom        |       | 158,924                                    |       | 131,190                                   |       | 654,457 |   | 952,161 |   |
| Rest of  World         |       | 444,558                                    |       | 271,821                                   |       | 1,210,888 |   | 1,484,846 |   |
|                   |       | $                                          | 3,165,770  |                                      | $          | 3,448,004 |   | $ | 10,597,553 |   | $ | 10,843,663 |   |
|                   |       |                                       |       |                                      |       |   |   |   |   |
| ** **             | ** ** | **September 30,  2005**               | ** ** | **December 31,  2004**               | ** ** | ** ** | ** ** | ** ** | ** ** |
|                   | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Long-lived  assets (2) | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| United  States         |       | $                                          | 176,679    |                                      | $          | 215,879 |   | ** ** | ** ** | ** ** | ** ** |
| United  Kingdom        |       | 9,936                                      |       | 9,195                                     |       | ** ** | ** ** | ** ** | ** ** |
|                   |       | $                                          | 186,615    |                                      | $          | 225,074 |   | ** ** | ** ** | ** ** | ** ** |

 

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(1) Revenues are attributed to geographic regions based onlocation of customer.

(2) Long-lived assets include property and equipment and otherassets.

 

8

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Item 2.

 

**MANAGEMENT’SDISCUSSION AND ANALYSIS**

**OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Management’sDiscussion and Analysis of Financial Condition and Results of Operations shouldbe read in conjunction with the accompanying consolidated financial statementsfor the periods specified and the associated notes.  Further reference should be made to ourAnnual Report on Form 10-K for the year ended December 31, 2004 asfiled with the SEC on March 29, 2005.

 

**Overview**

 

We provide enterprise document messagingapplications that streamline workflows, reduce costs and ensure secure,confidential e-document exchange.  Weaccomplish this by providing products that integrate with industry-leadinge-mail messaging, enterprise resource and document management systems to addsecure delivery and high volume fax functionality to a company’s existingcommunication infrastructure.  Becausepaper remains an integral part of many business processes, we also providetechnology that incorporates electronic delivery, security and billingfunctionality into industry-leading multi-function and scanning devices.

 

AccuRoute®,our document routing and distribution software, integrates with many digitalscanning and multi-functional devices to allow paper documents to be digitized,distributed and archived.  In addition,our AccuRoute software provides for the movement of electronic documents andinformation, enabling companies to capture and distribute hard copy documentsin electronic form and comply with privacy regulations related to health,financial or other confidential information.

 

GenifaxTM, ourenterprise fax software, offers a scalable, server-based feature set and sharesa common Windows® server-based architecture with our GenidocsTM productline.  Genidocs, our secure documentdelivery application, integrates with existing e-mail systems and providesmultiple options for content and attachment encryption, authentication, audittrail, delivery confirmation and digital signatures.  Our AccuRoute software further unifies thecode bases and architecture of our Genidocs and Genifax product lines.  Further, with its routing capabilities, ourAccuRoute software provides a customer specific product that easily managesdocuments, both paper and electronic, with little or no user training required.

 

Our software products can be deployed onheterogeneous, multi-platform networks and digital scanning andmulti-functional devices and can be integrated with both desktop and enterprisesoftware applications such as e-mail and groupware systems.  To addresscustomer needs, our products are modular and scaleable; communication capacitycan be implemented and added over time through the addition of systemcomponents and connectors as needed to keep pace with an enterprise’s growingdemand.  Additional Omtool servers can beadded to a configuration to provide failover through redundancy, helping toensure continuous operation.  We licenseour products on a combination server/seat basis or on a server only or seatonly basis.

 

We intend tomaintain a leadership position in our traditional market  – secureelectronic document exchange – while continuing to consolidate thefunctionality of all our products into a single, configurable platform, toexpand the level of integration with complementary technologies such asdocument and records management tools and to extend our document capturecapability to include virtually all multi-functional devices and scanners.  In doing so, we will be pursuing a leadershipposition in the broader document delivery/exchange and management market, whichwe believe will grow in response to increasingly regulated communications andstringent privacy requirements.  We willcontinue to focus on those vertical markets where regulations or businesspractices require confidentiality, timely electronic delivery and archiving ofcritical documents in electronic and paper format.

 

We resell,from third-party vendors, certain hardware products, including intelligent faxboards and fax modems, to our customers. Typically, our hardware sales are a result of either new fax sales orexisting fax customers upgrading their information technologyinfrastructure.  On occasion, where ourcustomers also want fax capabilities, we sell hardware products with ourAccuRoute product.  We undertake thesehardware sales as a convenience to our customers, who alternatively can opt toobtain hardware from a third-party vendor. The fax boards and fax modems that we resell are not functional withoutour software and we are not generally in the business of selling fax boards andmodems.  We purchase these hardwareproducts as needed to ship to our customers and we maintain a minimal inventoryof these hardware products.  We believethat we have a good business relationship with our suppliers of these productsand that supply of these products is stable.

 

Service andother revenue has historically consisted primarily of the sale of supportcontracts to complement software products licensed to customers.  We generate a smaller portion of our serviceand other revenue from consulting, training and

 

9

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installationservices.  We are focused on, and areconsidering reallocating certain resources to increasing our service and otherrevenue.

 

Building on the current version of ourAccuRoute product within the legal vertical market since its introduction in2004 and consistent with the strategy we outlined earlier this year, we arebroadening our sales and marketing strategy to encompass first the financevertical market and, thereafter, the healthcare vertical market.  We do not anticipate that these increasedexpenditures will produce a sufficient increase in sales over the balance of2005 to offset the associated expenses over the same period.  These expenses will therefore continue toexert pressure on earnings for the remainder of 2005.  Based on our historical performance for thefourth quarter, we believe that the profits realized from our revenue from thelegal vertical market and from our legacy fax business will allow us to absorbsome of the incremental expenses resulting in only a modest loss or a potentialbreakeven finish for 2005.  We believethat our existing cash and cash equivalents will be sufficient to meet ourworking capital and capital expenditure needs for at least the nexttwelve months.

 
| ** **                                    | ** ** | **Total Revenue**   | ** ** | **Net Income (Loss)**   | ** ** | **Software License  Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------|------------|-------------------------|------------|-------------------------------|------------|
| Three months ended September 30, 2005    |       | $3,165,770          |       | $(343,430)              |       | $877,357                      |       |
| Three months ended September 30, 2004    |       | $3,448,004          |       | $394,209                |       | $1,011,298                    |       |
| Change over same period of prior fiscal  year |       | $(282,234)  or (8)% |       | $(737,639)  or (187)%   |       | $(133,941)  or (13)%          | ** ** |
|                                          |       |                |       |                    |       |                          |       |
| Nine months ended September 30, 2005     |       | $10,597,553         |       | $(189,626)              |       | $3,333,046                    |       |
| Nine months ended September 30, 2004     |       | $10,843,663         |       | $1,051,644              |       | $3,314,682                    |       |
| Change over same period of prior fiscal  year |       | $(246,110)  or (2)% |       | $(1,241,270)  or (118)% |       | $18,364  or 0.6%              | ** ** |

 

During the third quarter of 2005, weexperienced a decline in software license revenue for our AccuRoute and Genifaxproducts.  Revenue from these productswas negatively impacted in the third quarter by seasonal weakness affectingAccuRoute revenue, a decline in our legacy fax business and an increase ofapproximately $240,000 in orders for which we hold contracts but had to defer recognitionof revenue because the associated sales did not yet meet all of the criteriafor revenue recognition. This amount is included in our deferred revenuebalance.  We expect to be able torecognize the revenue for these orders during the fourth quarter of 2005.  The increase in this component of deferredrevenue was due to the fact that a significant amount of orders for the thirdquarter were received during the last few weeks of the quarter, which impactedour ability to recognize the revenue from these transactions.  Historically, sales of our products duringthe third quarter have been slower as compared to other quarters.  We have found that we experience someseasonal fluctuations in our revenue due to the tendency of many of ourcustomers to make information technology purchases either early or late intheir fiscal years when they either have a replenished annual budget orleftover money in the budget.  Inaddition, we experience some seasonality, particularly in the third quarter dueto the higher frequency of scheduled vacations of key personnel at ourcustomers during the summer months, particularly in Europe.

 

Commencing at the end of the third quarter,we increased the resources allocated to our United Kingdom subsidiary, aneffort that we expect will result in increased European revenue in futurequarters.  Although we believe that, overthe last several quarters, there has been some improvement in the demand forenterprise software solutions and increased market acceptance of our products,we cannot predict whether or when that market will soften or if marketacceptance of our products will occur. If the market or the market acceptance of our products changes, wecannot predict whether, and to what extent, the demand for our products will increaseor decrease.  Any decrease in demand forour products would likely result in decreased revenue, which would, in turn,have a significant negative impact on our financial results because asignificant portion of our operating costs such as personnel, rent anddepreciation are fixed in advance of a particular quarter.  As a result, our costs for sales andmarketing, research and development and general and administrative couldcontinue to increase as a percentage of revenue, thereby negatively affectingour operating results.

 

Our future revenue and operating results mayfluctuate from quarter to quarter based on the number and size of salestransactions we enter into with customers, the adequacy of provisions forlosses, general economic conditions and other factors.  In addition, revenue from one or more largeorders may constitute a significant portion of our total revenue in aparticular quarter, further exacerbating fluctuations in quarterly results.

 

We have historically derived a majority ofour total revenue from sales within the United States.  Revenue from our European operationsdecreased in the first nine months of 2005 as compared to the first nine monthsof 2004, due to a decrease in Europe of 

 

10

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sales of our legacy faxsoftware.  We will continue to leverageour AccuRoute base in Europe, as well as its indirect channel relationships, tofocus sales resources on the legal vertical market.  In addition, we have recently added newresources to our European operations, including a new managing director ofEurope, Middle East and Africa, which we expect will help to improve ourresults in the region.  There can be,however, no assurance that we will be able to increase international sales ofour products and the failure to do so may have a material adverse effect onbusiness, financial condition and results of operations.

 

The following is a presentation of our domestic and internationalrevenue:

 
| ** **                                    | ** ** | **Total Revenue** | ** ** | **U.S. Revenue**        | ** ** | **Non-U.S. Revenue**    | ** ** |
|-----------------------------------------------|------------|-------------------|------------|-------------------------|------------|-------------------------|------------|
| Nine months  ended September 30, 2005    |       | $10,597,553       |       | $9,564,574              |       | $1,032,979              |       |
|                                          |       |              |       | or 90% of Total Revenue |       | or 10% of Total Revenue |       |
| Nine months  ended September 30, 2004    |       | $10,843,663       |       | $9,268,669              |       | $1,574,994              |       |
|                                          |       |              |       | or 85% of Total Revenue |       | or 15% of Total Revenue |       |
| Change from  same period of prior fiscal year |       | $(246,110)        |       | $295,905                |       | $(542,015)              |       |
|                                          |       | or (2)%           |       | or 3%                   |       | or (34)%                |       |

 

Our United Kingdom subsidiary, Omtool EuropeLimited, transacts business primarily in its local currency.  We then translate results generated by thatentity into U.S. dollars and consolidate them with our domestic results forreporting purposes.  As we make sales tocustomers in a variety of countries, significant currency exchange ratefluctuations could have a material impact on our results of operations.  We manage our foreign currency exchangeexposure by monitoring our net monetary position using natural hedges of ourassets and liabilities denominated in local currencies.  There can be no assurance that this policywill eliminate all foreign currency exchange exposure.  Foreign currency exposure has not beenmaterial to our financial position or results of operations to date.  If the volume of our business denominated inforeign currencies increases, we may be required to use derivatives to hedgeforeign currency exposure.

 

We will continue to leverage our existingdistribution channels, where appropriate, to broaden our reach to our targetvertical markets and further penetrate 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, we currentlyhave more of our sales resources focused on the direct model.  As a result, we derive a significant portionof 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  Indirect Distribution Channel Sales as a  Percentage of Total Software License  and Hardware Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
| Nine months ended September 30, 2005     |       | $5,475,329                                         |       | $2,029,058                                                                            |       | 19%                                                                                                                                     |       |
| Nine months ended September 30, 2004     |       | $5,627,143                                         |       | $2,066,194                                                                            |       | 19%                                                                                                                                     |       |
| Change from same period of prior fiscal  year |       | $(151,814)                                         |       | $(37,136)                                                                             |       | 0%                                                                                                                                      |       |
|                                          | or (3)%    |                                               | or (2)%    |                                                                                  |       |                                                                                                                                    |

 

**Critical Accounting Policies and Estimates**

 

We haveidentified the policies and estimates below as critical to our businessoperations and the understanding of our results of operations.  The impact and any associated risks relatedto these policies on our reported and expected financial results and businessoperations are discussed in appropriate sections throughout Management’sDiscussion and Analysis of Financial Condition and Results of Operations.  Our preparation of this Form 10-Qrequired us to make estimates and assumptions that affect the reported amountof assets and liabilities, the disclosure of contingent assets and liabilitiesas of the date of the financial statements included herein, and the reportedamounts of revenue and expenses during the period covered by this report.  There can be no assurance that actual resultswill not differ materially from those estimates.

 

*Revenue Recognition and Accounts ReceivableReserves. *Wederive our revenue primarily from two sources (i) product revenue, whichincludes software license and hardware revenue, and (ii) services andsupport revenue, which includes software maintenance and support, installation,training and consulting revenue.  Welicense our software products on a perpetual basis.  We generate revenue from licensing the rightsto use our software products and sales of hardware directly to end-users andindirectly through resellers.  Ourresellers order products from us based on purchase orders received fromend-users and do not order stock.  Wegenerally sell our products to resellers and directly to end-users without anyspecifically stated rights of return. Occasionally, however, we, in our sole discretion, will accept a productreturn if the end-user finds that the product does not fit its needs.  We also

 

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sell hardware products, whichare provided by a third-party, at cost plus an additional mark-up, to end-usersand indirectly through resellers.  Thehardware products that we resell are not functional without our software.  To support our software products, we sellsoftware maintenance and support, installation, training and consultingservices to end-users and indirectly through resellers.

 

We apply theprovisions of Statement of Position (“SOP”) 97-2,*Software Revenue Recognition*, as amended by SOP 98-9,Modification of SOP 97-2,*Software RevenueRecognition, With Respect to Certain Transactions*, to alltransactions involving the sale of multiple elements including software,hardware and service revenue.  We applythe provisions of Statement of Financial Accounting Standards (“SFAS”) No. 48,*Revenue Recognition When Right of Return Exists*,with respect to providing for potential future product returns.  As described below, we must make and usesignificant judgments and estimates in connection with the revenue recognizedin any accounting period.  Materialdifferences may have resulted in the amount and timing of our revenue if we hadmade different judgments or utilized different estimates.

 

We recognizerevenue from the sale of software products and hardware to both end-users andresellers when persuasive evidence of an arrangement exists, the products havebeen delivered, the fee is fixed or determinable, collection of the resultingreceivable is reasonably assured and there are no uncertainties regardingcustomer acceptance. We maintain a reserve for potential product returns. Werecognize software maintenance and support revenue over the term of the relatedmaintenance period, which is typically a one-year period.  On those occasions when we sell multiple-yearmaintenance contracts, we recognize the associated revenue over themultiple-year term of the maintenance contract. We recognize other services revenue as we perform the services.  If an arrangement includes an acceptanceprovision and acceptance is uncertain, then we will defer all revenue until thecustomer accepts the products purchased. Acceptance in these instances generally occurs upon the earlier ofreceipt of a written customer acceptance or expiration of the acceptanceperiod.  If an arrangement includes anacceptance provision tied to determination that our product meets publishedspecifications and there are no uncertainties with regard to the customer’sacceptance, then we will recognize revenue at the time of sale, provided thatall other revenue recognition criteria previously mentioned have been met andthe acceptance period is of short duration.

 

Ourtransactions frequently involve the sale of software, hardware and relatedservices under multiple element arrangements. Revenue under multiple element arrangements is allocated to each elementunder the residual method, in accordance with SOP 98-9, Modification of SOP 97-2,*Software Revenue Recognition, With Respect toCertain Transactions*.  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 generallyare not essential to the functionality of the software, as these services donot alter the capabilities of the software and do not carry a significantdegree 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 both software and hardware, the amountallocated to hardware revenue is based on the price charged to us by the thirdparty vendor plus an additional mark up, with the remainder allocated tosoftware revenue.  To the extent that adiscount is offered in the arrangement, the entire discount is allocated to thedelivered element or elements.  If thedelivered elements include hardware and software, the discount is allocated tothe hardware and software based on their respective list prices.

 

For all sales,we use a binding purchase order, a signed contract or a credit cardauthorization as evidence of an arrangement. Sales through our resellers are evidenced by a master agreementgoverning the relationship, together with binding purchase orders, on atransaction-by-transaction basis.

 

At the time ofa transaction, we assess whether the fee associated with the transaction isfixed or determinable and whether or not collection is reasonably assured.  If a significant portion of a fee is duebeyond our normal payment terms, which are thirty to sixty days from invoicedate, we account for the fee as not being fixed or determinable.  In these cases, we recognize revenue as thefees become due.  We assess collectionbased on a number of factors, including past transaction history with thecustomer and the credit-worthiness of the customer.  We review Dunn & Bradstreet creditreports for all of our resellers and adjust our credit limits with thoseresellers accordingly.  If a particularreseller does not have a favorable report or if we do not have enough creditinformation to determine if the reseller is credit-worthy then we predominantlysell to those resellers on cash on delivery terms.  We do not request collateral from ourcustomers.  If we determine thatcollection of a fee is not reasonably assured, the fee is deferred and revenueis recognized at the time collection becomes reasonably assured, which isgenerally upon receipt of payment.

 

We maintainreserves for potential product returns and make adjustments to these reservesas needed based on historical product return rates.  We also consider the impact of new productintroductions, changes in customer demand and acceptance of our products on theadequacy of these reserves.  Ourcalculation of the estimated return reserve is based upon (1) an accountspecific review of potential returns, where a return probability is known, and (2) ageneral estimate based upon past historical returns as a percentage ofrevenue.  We must make and usesignificant judgments and estimates in connection with establishing the productreturns reserve in any accounting period. 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.

 

12

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As with theproduct return reserve, we must make estimates of our ability to collect on ouraccounts receivable.  We record tradeaccounts receivable at the invoiced amount; these accounts do not bear interest.  We specifically analyze accounts receivableand historical bad debts, customer credit-worthiness, current economic trendsand changes in customer payment patterns when evaluating the adequacy of theallowance for doubtful accounts.  Wereview the allowance for doubtful accounts on a monthly basis.  Our calculation of the estimated accountsreceivable reserve is also based upon (1) an account specific review ofpotential uncollectible accounts, where a bad debt probability is known, and (2) ageneral estimate based upon past historical bad debts as a percentage ofaccounts receivable.  We do not have anyoff-balance-sheet credit exposure to our customers.

 

Our combinedaccounts receivable and product returns reserve was $39,000 and $82,000 at September 30,2005 and December 31, 2004, respectively.  Both components of calculating the estimatedreserve – specific identification and historic experience – are materialjudgments made by us.  We base thesejudgments on historic trends, taking into consideration current business andeconomic conditions, which could change materially, thus changing the requiredreserve level materially.  The potentialchange to the size of our required reserve could be positive, in the event thereserve estimate proves unnecessary, or negative, if the reserve provesinadequate.

 

Our deferredrevenue is comprised mainly of revenue that is deferred for softwaremaintenance and support contracts.  Theother components of deferred revenue are amounts from sales transactions thatwere deferred because they did not meet all of the provisions of our revenuerecognition policy.

 

*Software Development Costs. *Software developmentcosts are considered for capitalization when technological feasibility isestablished in accordance with SFAS No. 86,*Accounting for the Costs of Computer Software To Be Sold, Leased orOtherwise Marketed*.  We sellsoftware in a market that is subject to rapid technological change, new productintroductions and changing customer needs. Accordingly, we have determined that we cannot ascertain technologicalfeasibility until the development state of the product is nearly complete.  The time period during which cost could becapitalized from the point of reaching technological feasibility until the timeof general product release is very short and, consequently, the amounts thatmight be capitalized are not material to our consolidated financial position orresults of operations.  Therefore, wecharge all software development costs to operations in the period incurred.

 

*Taxes. *We are required to estimate our income andstate sales taxes.  This process involvesestimating our actual current tax obligations, while also assessing differencesresulting from the different treatment of items for tax and accounting purposesthat result in deferred income tax assets and liabilities and accrued statesales tax liabilities.  We includedeferred income tax assets and liabilities and accrued state sales taxliabilities in our balance sheet.

 

We assess ourdeferred tax assets for each reporting period to determine whether it is morelikely than not that they will be recovered from future taxable income.  In making this assessment, we includeassumptions regarding ongoing tax planning strategies.  We establish a valuation allowance for assetswhen their recovery is not certain. Changes to the valuation allowance are included as an expense or benefitwithin the tax provision in our statement of operations.

 

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

 

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

 

**New Accounting Pronouncements**

 

In May 2005, the FASB issued FASBStatement No. 154, “Accounting Changes and Error Corrections, areplacement of APB Opinion No. 20 and FASB Statement No. 3” (SFAS No. 154).  Previously, APB No. 20, “AccountingChanges” and SFAS No. 3, “Reporting Accounting Changes in InterimFinancial Statements” required the inclusion of the cumulative effect ofchanges in accounting principle in net income of the period of the change.  SFAS No. 154 requires companies torecognize a change in accounting principle, including a change required by anew accounting pronouncement when the pronouncement does not include specifictransition provisions, retrospectively to prior periods’ financial statements.We will assess the impact of a retrospective application of a change inaccounting principle in accordance with SFAS No. 154 when such a changearises after the effective date of January 1, 2006.

 

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In December 2004, the FASB issued SFAS No. 123(R),*Share-Based Payment*. SFAS No. 123(R)amends SFAS No. 123 to require that companies record as expense the effectof equity-based compensation, including stock options over the applicablevesting period. We currently disclose the effect on income that stock optionswould have were they recorded as expense. SFAS No. 123(R) also requiresmore extensive disclosures concerning stock options than required under currentstandards. The new rule applies to option grants made after a company’sadoption of the standard, as well as options that are not vested at the date ofadoption. SFAS No. 123(R) becomes effective in our case not later than thebeginning of the fiscal year that begins after December 15, 2005. We donot currently expect to elect early adoption of this standard and have notdetermined whether we will apply this new standard prospectively in the firstquarter of 2006, retroactively from the beginning of 2006, or on a restatedbasis for all prior periods on a comparable basis. We do not expect that theadoption of SFAS No. 123(R) will have a material impact on our futureresults of operations.

 

In November 2004,the FASB issued SFAS No. 151,*InventoryCosts, an Amendment of ARB No. 43, Chapter 4.* SFAS No. 151modifies the accounting for abnormal inventory costs and the manner in whichcompanies allocate fixed overhead expenses to inventory. SFAS No. 151 iseffective for inventory costs incurred during annual periods beginning after June 15,2005. We do not expect SFAS No. 151 to have a material impact on ourfinancial position and results of operations.

 

**Results of Operations**

 

The following table sets forth certain financial data for the periodsindicated as a percentage of total revenues:

 
| ** **                      | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                        |       |                                       |       |                                      |       |   |   |   |   |
| Software  license               |       | 27.7                                       | %          | 29.3                                      | %          | 31.5 | % | 30.6 | % |
| Hardware                        |       | 18.4                                       |       | 20.2                                      |       | 20.2 |   | 21.3 |   |
| Service and  other              |       | 53.9                                       |       | 50.5                                      |       | 48.3 |   | 48.1 |   |
| Total  revenue                  |       | 100.0                                      |       | 100.0                                     |       | 100.0 |   | 100.0 |   |
| Cost of  revenue:               |       |                                       |       |                                      |       |   |   |   |   |
| Software  license               |       | 1.3                                        |       | 1.0                                       |       | 1.1 |   | 1.4 |   |
| Hardware                        |       | 10.5                                       |       | 11.7                                      |       | 12.8 |   | 12.8 |   |
| Service and  other              |       | 21.6                                       |       | 19.6                                      |       | 19.7 |   | 19.1 |   |
| Total cost  of revenue          |       | 33.4                                       |       | 32.3                                      |       | 33.6 |   | 33.3 |   |
| Gross profit                    |       | 66.6                                       |       | 67.7                                      |       | 66.4 |   | 66.7 |   |
| Operating  expenses:            |       |                                       |       |                                      |       |   |   |   |   |
| Sales and  marketing            |       | 42.7                                       |       | 29.4                                      |       | 34.6 |   | 28.1 |   |
| Research and  development       |       | 18.3                                       |       | 13.9                                      |       | 15.3 |   | 13.2 |   |
| General and  administrative     |       | 18.0                                       |       | 15.3                                      |       | 19.5 |   | 16.6 |   |
| Total  operating expenses       |       | 79.0                                       |       | 58.6                                      |       | 69.4 |   | 57.9 |   |
| Income  (loss) from operations  |       | (12.4                                      | )          | 9.1                                       |       | (3.0 | ) | 8.8 |   |
| Interest and  other income, net |       | 1.6                                        |       | 0.9                                       |       | 1.3 |   | 1.0 |   |
| Tax  provision (benefit)        |       | —                                     |       | (1.4                                      | )          | 0.1 |   | 0.1 |   |
|                            |       |                                       |       |                                      |       |   |   |   |   |
| Net income  (loss)              |       | (10.8                                      | )%         | 11.4                                      | %          | (1.8 | )% | 9.7 | % |
|                            |       |                                       |       |                                      |       |   |   |   |   |
| Gross  profit:                  |       |                                       |       |                                      |       |   |   |   |   |
| Software  license               |       | 95.2                                       | %          | 96.8                                      | %          | 96.6 | % | 95.4 | % |
| Hardware                        |       | 42.7                                       |       | 41.9                                      |       | 36.5 |   | 39.8 |   |
| Service and  other              |       | 60.0                                       |       | 61.1                                      |       | 59.4 |   | 60.4 |   |

 

**Three Months Ended September 30, 2005and 2004**

 

*Revenue*

 

*SoftwareLicense. *Duringthe three months ended September 30, 2005, our total revenue was $3.2million, a decrease of $0.2 million from $3.4 million for the three monthsended September 30, 2004.  Oursoftware license revenues decreased by approximately 13% to $877,000 in thethree months ended September 30, 2005 compared to $1.0 million in the sameperiod in 2004 as a result of a

 

14

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decline in software licenserevenue for both our AccuRoute and Genifax products over the same periods.  Revenue from these products was negativelyimpacted in the third quarter by seasonal weakness affecting AccuRoute revenue,a decline in our legacy fax business and an increase of approximately $240,000in orders for which we hold contracts but had to defer recognition of revenuebecause the associated sales did not yet meet all of the criteria for revenuerecognition. This amount is included in our deferred revenue balance.  We expect to recognize most of this deferredrevenue during the fourth quarter of this year. We did not have any sales of our other software products such asGenidocs and Swiftwriter during either of the three month periods ended September 30,2005 or 2004, which reflects our growing focus on the development and sale ofour AccuRoute product.

 

The following table summarizes our revenue,and particularly our software license revenue, by product category (excludingfreight and allowances for returns) for the recently completed fiscal quarter,as compared to the same period in the prior fiscal year.

 
| ** **                                    | ** ** | **Total  Revenue** | ** ** | **Software License  Revenue** | ** ** | **AccuRoute  License  Revenue** | ** ** | **Legacy Fax  Product License  Revenue** | ** ** | **Other Software  Product License  Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|-------------------------------|------------|---------------------------------|------------|------------------------------------------|------------|----------------------------------------------|------------|
| Three months ended September 30, 2005    |       | $3,165,770         |       | $877,357                      |       | $381,851                        |       | $489,438                                 |       | $0                                           |       |
| Three months ended September 30, 2004    |       | $3,448,004         |       | $1,011,298                    |       | $453,626                        |       | $542,094                                 |       | $0                                           |       |
| Change from same period of prior fiscal  year |       | $(282,234)         |       | $(133,941)                    |       | $(71,775)                       |       | $(52,656)                                |       | $0                                           |       |
|                                          | or (8.2)%  |               | or (13.2)% |                          | or (15.8)% |                            | or (9.7)%  |                                     | or 0%      |                                         |

 

During the three months ended September 30,2005, our software license revenue represented a decreased percentage of ourtotal revenue, based primarily on a decrease in software license sales for thethree months ended September 30, 2005 when compared to the same period in2004.

 
| ** **                                    | ** ** | **Software License Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------|------------|
| Three months ended September 30, 2005    |       | 27.7%                                                          |       |
| Three months ended September 30, 2004    |       | 29.3%                                                          |       |
| Change from same period of prior fiscal  year |       | (1.6)%                                                         |       |

 

During the three months ended September 30,2005 and 2004, our license revenue from each of our major product lines andother components of revenue (including freight and allowances for returns)represented the following percentages of our total software license revenue:

 
| ** **                                                 | ** ** | **AccuRoute License Revenue as  a Percentage of Software  License Revenue** | ** ** | **Fax Product License  Revenue as  Percentage of  Software License Revenue** | ** ** | **Other Component License  Revenue as a Percentage of  Software License Revenue** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|
| Three months ended September 30, 2005                 |       | 44%                                                                         |       | 56%                                                                               |       | 0%                                                                                |       |
| Three months ended September 30, 2004                 |       | 46%                                                                         |       | 54%                                                                               |       | 0%                                                                                |       |
| Increase (decrease) from same period of  prior fiscal year |       | (2)%                                                                        |       | 2%                                                                                |       | 0%                                                                                |       |

 

Included in software license revenue for thethree months ended September 30, 2005 and 2004 is a reduction of $4,000and $19,000, respectively, in the sales returns and allowance reserve relatingprimarily to a general estimate based upon past historical returns for 2005 andto specific accounts from 2004 where we determined that the risk of a returnwas no longer present in 2004.

 

*Hardware.*  Hardwarerevenue decreased during the three month period ended September 30, 2005as compared to the three month period ended September 30, 2004 due to adecrease in legacy fax product sales, which sales are the main driver for ourhardware revenues.

 

15

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| ** **                                                 | ** ** | **Hardware Revenue** | ** ** | **Hardware Revenue as a  Percentage of Total Revenue** | ** ** |
|------------------------------------------------------------|------------|----------------------|------------|--------------------------------------------------------|------------|
| Three months ended September 30, 2005                 |       | $582,976             |       | 18%                                                    |       |
| Three months ended September 30, 2004                 |       | $696,715             |       | 20%                                                    |       |
| Increase (decrease) from same period of  prior fiscal year |       | $(113,739)           |       | (2)%                                                   |       |
|                                                       | or (16.3)% |                 |       |                                                   |

 

Included in hardware revenue for the threemonths ended September 30, 2005 and 2004 is a reduction of $1,000 and $6,000,respectively, in the sales returns and allowance reserve relating primarily toa general estimate based upon past historical returns for 2005 and to specificaccounts from 2004 where we determined that the risk of a return is no longerpresent in 2004.  We expect market demandfor AccuRoute, which generally does not require our customers to purchaseadditional hardware, to increase and, if it does, we anticipate hardwarerevenue will constitute a smaller percentage of our total revenue.

 

*Service and Other. *Service and otherrevenue, which consists primarily of the sale of support contracts tocomplement software products sold to customers and, to a lesser extent,consulting, training and installation services, decreased slightly in the threemonths ended September 30, 2005, as compared to the same period in theprior fiscal year.  This decrease was dueprimarily to reduced maintenance revenue from our subsidiary in the UnitedKingdom.  This decrease was partiallyoffset by increased overall service revenue from installation, consulting andtraining services for the same periods.

 
| ** **                                                 | ** ** | **Service and Other Revenue** | ** ** | **Service and Other Revenue as  a Percentage of Total Revenue** | ** ** |
|------------------------------------------------------------|------------|-------------------------------|------------|-----------------------------------------------------------------|------------|
| Three months ended September 30, 2005                 |       | $1,705,437                    |       | 53.9%                                                           |       |
| Three months ended September 30, 2004                 |       | $1,739,991                    |       | 50.5%                                                           |       |
| Increase (decrease) from same period of  prior fiscal year |       | $(34,554)  or (2.0)%          |       | 3.4%                                                            |       |

 

The increase in service and other revenue asa percentage of our total revenue is due primarily to the decreases in softwarelicense and hardware revenue for the quarter. We are focused on improving the renewal rate of software maintenancecontracts with our existing customer base in both our North American andEuropean operations and we have increased our attention on generating additionalservice and other revenue in future quarters.

 

***Cost of Revenue***

 

*SoftwareLicense. *Costof software license revenue consists primarily of the costs of sublicensingthird-party software products, product media and product duplication.  Cost of software license revenue for thethree months ended September 30, 2005 increased by 29% as compared to thecorresponding period in the previous fiscal year.  The increase is due primarily to increasedroyalty payments associated with additional third-party software weincorporated into our products during the third quarter of 2005.  We believe that these newly licensedthird-party software components will improve the capabilities and functionalityof our products.  Given that we mightlicense additional third-party software components in the future, we expectthat our software license cost as a percentage of software license revenue mayincrease slightly.

 

As a result of the increase in the cost ofsoftware license revenue that we incurred during the third quarter of 2005, weincurred a decrease in our software license gross margin percentage as setforth in the following table:

 
| ** **                                                 | ** ** | **Software License Gross Margin** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------|------------|
| Three months  ended September 30, 2005                |       | 95.2%                             |       |
| Three months  ended September 30, 2004                |       | 96.8%                             |       |
| Increase (decrease)  from same period of prior fiscal year |       | (1.6)%                            |       |

 

*Hardware. *Cost of hardwarerevenue consists primarily of the costs of third-party hardware products.  Cost of hardware revenue represented 57% and58% of hardware revenue for each respective period.  During the three months ended September 30,

 

16

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2005, we incurred decreaseddollar costs related to hardware revenue due primarily to the decrease in ourhardware unit sales.  Further, our grossmargin percentage for hardware sales increased during this period due to achange in the mix of particular hardware products sold.  We do not expect significant changes in unitprices for the remainder of 2005 or into 2006.

 
| ** **                                                 | ** ** | **Hardware Gross Margin** | ** ** |
|------------------------------------------------------------|------------|---------------------------|------------|
| Three months  ended September 30, 2005                |       | 42.7%                     |       |
| Three months  ended September 30, 2004                |       | 41.9%                     |       |
| Increase  (decrease) from same period of prior fiscal year |       | 0.8%                      |       |

 

*Service andOther. *Cost ofservice and other revenue consists primarily of the costs incurred in providingtelephone support as well as other miscellaneous customer service-relatedexpenses.  The gross margin percentagefor service and other revenue decreased to 60% for the three months ended September 30,2005, compared to 61% in the same period in 2004.  The decrease in gross margin percentage isdue to an increase in the wages related expenses and associated overhead costsof employees in the support department. We do not expect any significant variances in our service and othergross margin percentages for the remainder of fiscal year 2005.

 
| ** **                                                 | ** ** | **Cost of Service and Other  Revenue** | ** ** | **Gross Margin for Service  and Other Revenue** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------|------------|-------------------------------------------------|------------|
| Three months ended September 30, 2005                 |       | $682,896                               |       | 60.0%                                           |       |
| Three months ended September 30, 2004                 |       | $676,073                               |       | 61.1%                                           |       |
| Increase (decrease) from same period of  prior fiscal year |       | $6,823                                 |       | (1.1)%                                          |       |
|                                                       | or 1.0%    |                                   |       |                                            |

 

***Operating Expenses***

 

*Sales andMarketing. *Salesand marketing expenses consist primarily of employee salaries, benefits,commissions, and associated overhead costs, and the cost of marketing programssuch as advertisements, direct mailings, public relations, trade shows,seminars and related communication costs. Sales and marketing expenses increased in the third quarter of 2005 ascompared to the same period in 2004 due to an increased number of employees inour sales and marketing departments and the associated costs of supportingthose employees.

 

Additionally, we increased our generaladvertising and consulting expenditures during the third quarter of 2005 ascompared to the same period in the prior fiscal year.  These expense increases reflect ourinitiative to further penetrate the legal vertical market with our AccuRouteproduct, as well as our initiative to target new vertical markets.  Building on the success of the currentversion of our AccuRoute product within the legal vertical market since itsintroduction in 2004, we intend to continue broadening our current sales andmarketing strategy, which we began in the second quarter of 2005, to encompassfirst the finance vertical market and, thereafter, the healthcare verticalmarket.  We anticipate that theadditional expenditures necessary to enter these markets will be approximately$250,000 for the balance of 2005.  Muchof these additional expenses will be sales and marketing related.  Consequently, we expect that our sales andmarketing expenses will increase in absolute dollars as we continue to hireadditional sales and marketing staff during the balance of this year.

 
| ** **                                                 | ** ** | **Sales and Marketing Expenses** | ** ** | **Sales and Marketing Expenses as  a Percentage of Total Revenue** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------------------------------------------|------------|
| Three months ended September 30, 2005                 |       | $1,352,295                       |       | 42.7%                                                              |       |
| Three months ended September 30, 2004                 |       | $1,013,316                       |       | 29.4%                                                              |       |
| Increase (decrease) from same period of  prior fiscal year |       | $338,979                         |       | 13.3%                                                              |       |
|                                                       | or 33.5%   |                             |       |                                                               |

 

*Research andDevelopment.* Research and development expenses include expenses associated with thedevelopment of new products, enhancements of existing products and qualityassurance activities.  These expensesconsist primarily of employee salaries, benefits, associated overhead costs,consulting expenses and the cost of software development tools.  In the most recently completed

 

17

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fiscal quarter, our researchand development expenses increased as compared to the same period in the priorfiscal year due primarily to an increase in the number of employees in ourresearch and development department and the associated costs of supportingthose employees.

 
| ** **                                      | ** ** | **Research and Development  Expenses** | ** ** | **Research and Development  Expenses as a Percentage of  Total Revenue** | ** ** |
|-------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Three months ended September 30, 2005      |       | $579,422                               |       | 18.3%                                                                    |       |
| Three months ended September 30, 2004      |       | $478,108                               |       | 13.9%                                                                    |       |
| Increase from same period of prior fiscal  year |       | $101,314                               |       | 4.4%                                                                     |       |
|                                            |       | or 21.2%                               |       |                                                                     |       |

 

Additionally, the increase in research anddevelopment expenses in dollars and as a percentage of total revenue is aresult of an increase in consulting expenses in the research and developmentdepartment during 2005 as compared with the comparable period in 2004.  We expect our research and developmentexpenses to increase in absolute dollars as we hire additional engineers andengage in more third party consulting arrangements to support our expansion ofour AccuRoute product into other vertical markets.

 

*General and Administrative. *General andadministrative expenses consist primarily of employee salaries, benefits foradministrative, executive and finance personnel and associated corporategeneral and administrative expenses.  Inthe most recently completed fiscal quarter, our general and administrativeexpenses increased as compared to the same period in the prior fiscal year.

 
| ** **                                    | ** ** | **General and Administrative  Expenses** | ** ** | **General and Administrative Expenses  as a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| Three months ended September 30, 2005    |       | $570,421                                 |       | 18.0%                                                                     |       |
| Three months ended September 30, 2004    |       | $527,364                                 |       | 15.3%                                                                     |       |
| Change from same period of prior fiscal  year |       | $43,057                                  |       | 2.7%                                                                      |       |
|                                          | or 8.2%    |                                     |       |                                                                      |

 

The increase in general and administrativeexpenses, both in dollar amount and as a percentage of total revenue, is due toincreases in wages paid to our employees and fees paid to our board ofdirectors during the quarter partially offset by decreases in travelexpenses.  We expect that we willcontinue to experience slight increases to general and administrative expensesin the form of professional fees and consulting expenditures during theremainder of 2005 and into 2006 as we continue to comply with Section 404of the Sarbanes-Oxley Act of 2002.  Thedeadline for compliance with Section 404 has been moved back to the firstfiscal year ending on or after July 15, 2007 for companies with publicfloat of less than $75 million.

 

*Interest and OtherIncome. *Interestand other income consists principally of interest income earned on cash andcash equivalent balances.

 
| ** **                                      | ** ** | **Interest and Other Income** | ** ** | **Interest and Other Income as a  Percentage of Total Revenue** | ** ** |
|-------------------------------------------------|------------|-------------------------------|------------|-----------------------------------------------------------------|------------|
| Three months ended September 30, 2005      |       | $51,578                       |       | 1.6%                                                            |       |
| Three months ended September 30, 2004      |       | $30,476                       |       | 0.9%                                                            |       |
| Increase from same period of prior fiscal  year |       | $21,102                       |       | 0.7%                                                            |       |
|                                            | or 69.2%   |                          |       |                                                            |

 

The increase in interest income is primarilya result of a higher interest rates earned on our investment accounts duringthe three months ended September 30, 2005 as compared to the three monthsended September 30, 2004.

 

*Provision for IncomeTaxes. *Duringthe three months ended September 30, 2005, we did not record a net taxprovision for expected tax liability in the United States.  During the three months ended September 30,2004, we recorded a net tax benefit of $47,794 as a result of a decrease in ourestimated taxes payable resulting from a revised international transfer pricingagreement with our United Kingdom subsidiary.

 

18

----

 

**Nine Months Ended September 30, 2005 and2004**

 

## ***Revenue***

##  

*SoftwareLicense. *Duringthe nine months ended September 30, 2005, our total revenue decreased to$10.6 million as compared to $10.8 million for the nine months ended September 30,2004.  However, our software licenserevenue has increased by approximately $18,000 to $3.3 million.  Further, revenue from our AccuRoute productincreased to $1.5 million during the nine months ended September 30, 2005as compared to $1.2 million during the nine months ended September 30,2004. This increase is reflective of the continued market acceptance of ourAccuRoute product.  Software revenue fromour legacy fax product line has decreased to $1.7 million during the ninemonths ended September 30, 2005 from $1.9 million during the same periodin 2004 as we continue to focus our resources on the expansion of the AccuRouteproduct line and we experience diminished sales from the maturing legacy faxmarket.  Various other components ofsoftware license revenue, including sales returns and allowance adjustments andsales of our other software products such as Genidocs and Swiftwriter, haveincreased to $74,000 during the nine months ended September 30, 2005 ascompared to $22,000 during the same period in 2004.

 

During the nine months ended September 30,2005, as compared to the same period during 2004, the mix of productsaccounting for our revenue has continued shifting towards AccuRoute, asdisplayed in the tables below.  Thefollowing table summarizes our revenue, and particularly our software licenserevenue, by product category (excluding freight and allowances for returns) forthe nine months ended September 30, 2005, as compared to the same periodin the prior fiscal year.

 
| ** **                                                 | ** ** | **Total  Revenue**    | ** ** | **Software License  Revenue** | ** ** | **AccuRoute  Revenue** | ** ** | **Legacy Fax  Product Revenue** | ** ** | **Other Software Product  Revenue** | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|-------------------------------|------------|------------------------|------------|---------------------------------|------------|-------------------------------------|------------|
| Nine months ended September 30, 2005                  |       | $10,597,553           |       | $3,333,046                    |       | $1,550,070             |       | $1,709,166                      |       | $4,845                              |       |
| Nine months ended September 30, 2004                  |       | $10,843,663           |       | $3,314,682                    |       | $1,219,402             |       | $1,915,924                      |       | $21,974                             |       |
| Increase (decrease) from same period of  prior fiscal year |       | $(246,110)  or (2.3)% |       | $18,364  or 0.6%              |       | $330,668  or 27.1%     |       | $(206,758)  or (10.8)%          |       | $(17,129)  or (77.9)%               |       |

 

During the nine months ended September 30,2005, our software license revenue represented an increased percentage of ourtotal revenue, based primarily on the fact that hardware and services revenuesdeclined during the nine months ended September 30, 2005 when compared tothe same period in 2004.

 
| ** **                                                 | ** ** | **Software License Revenue as a  Percentage of Total Revenue** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| Nine months ended September 30, 2005                  |       | 31.5%                                                          |       |
| Nine months ended September 30, 2004                  |       | 30.6%                                                          |       |
| Increase (decrease) from same period of  prior fiscal year |       | 0.9%                                                           |       |

 

During this period, our AccuRoute productline continued to represent an increasing percentage of our total softwarerevenue. Overall, our various product lines and other components of revenue(including freight and allowances for returns) represented the followingpercentages of our total software license revenue:

 
| ** **                                                 | ** ** | **AccuRoute Revenue  as a Percentage of  Software License  Revenue** | ** ** | **Fax Product Revenue as  Percentage of Software  License Revenue** | ** ** | **Other Component Revenue as a  Percentage of Software License Revenue** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Nine months ended September 30, 2005                  |       | 46.5%                                                                |       | 51.3%                                                               |       | 2.2%                                                                     |       |
| Nine months ended September 30, 2004                  |       | 36.8%                                                                |       | 57.8%                                                               |       | 5.4%                                                                     |       |
| Increase (decrease) from same period of  prior fiscal year |       | 9.7%                                                                 |       | (6.5)%                                                              |       | (3.2)%                                                                   |       |

 

19

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Included in software license revenue for thenine months ended September 30, 2005 and 2004 is a reduction of $24,000and $159,000, respectively, in the sales returns and allowance reserve relatingprimarily to a general estimate based upon past historical returns for 2005 andto specific accounts from 2004 where we determined that the risk of a return isno longer present.  Although we cannotaccurately predict the exact mix of products that we will sell in the future,we expect that software license revenue will constitute a larger percentage ofour total revenue in the future if demand for AccuRoute, which generally doesnot require the purchase of additional hardware, continues to gain additionalmarket acceptance.

 

*Hardware. *Hardware revenuedecreased during the nine month period ended September 30, 2005 as comparedto the nine month period ended September 30, 2004 due to a decrease inlegacy fax product sales, which sales are the main driver for our hardwarerevenues, and an overall decrease in demand from existing customers who haveupgraded information systems hardware in their worldwide locations.

 
| ** **                                                 | ** ** | **Hardware Revenue**  | ** ** | **Hardware Revenue as a  Percentage of Total  Revenue** | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|---------------------------------------------------------|------------|
| Nine months ended September 30, 2005                  |       | $2,142,283            |       | 20%                                                     |       |
| Nine months ended September 30, 2004                  |       | $2,312,461            |       | 21%                                                     |       |
| Increase (decrease) from same period of  prior fiscal year |       | $(170,178)  or (7.4)% |       | (1)%                                                    |       |

 

Included in hardware revenue for the ninemonths ended September 30, 2005 and 2004 is a reduction of $8,000 and$50,000, respectively, in the sales returns and allowance reserve relatingprimarily to a general estimate based upon past historical returns for 2005 andto specific accounts from 2004 where we determined that the risk of a return isno longer present.  We expect marketdemand for AccuRoute, which generally does not require our customers topurchase additional hardware, to increase and, if it does, we anticipatehardware revenue will constitute a smaller percentage of our total revenue.

 

*Service and Other. *Service and otherrevenue decreased slightly in the nine months ended September 30, 2005, ascompared to the same period in the prior fiscal year.  This decrease was due primarily to reducedsupport maintenance revenue from our subsidiary in the United Kingdom.  This decrease was partially offset byincreased overall service revenue from installation and consulting services forthe same periods.

 
| ** **                                                 | ** ** | **Service and Other  Revenue** | ** ** | **Service and Other Revenue as  a Percentage of Total Revenue** | ** ** |
|------------------------------------------------------------|------------|--------------------------------|------------|-----------------------------------------------------------------|------------|
| Nine months ended September 30, 2005                  |       | $5,122,224                     |       | 48.3%                                                           |       |
| Nine months ended September 30, 2004                  |       | $5,216,520                     |       | 48.1%                                                           |       |
| Increase (decrease) from same period of  prior fiscal year |       | $(94,296)  or (1.8)%           |       | 0.2%                                                            |       |

 

The increase in service and other revenue asa percentage of total revenue is due primarily to the decrease in hardwarerevenues.  We are focused on improving the renewal rate of softwaremaintenance contracts with our existing customer base in both our NorthAmerican and European operations and we have increased our attention ongenerating additional service and other revenue in future quarters.

 

***Cost of Revenue***

 

*SoftwareLicense. *Costof software license revenue for the nine months ended September 30, 2005decreased by 25% as compared to the corresponding period in 2004.  The decrease is due primarily to decreasedroyalty payments associated with sales of royalty-bearing products.  This decrease is also reflected in the grossmargin, which improved from 95% to 97%. We have recently added third-party software into our products and weexpect that our software license cost as a percentage of software license revenueswill increase slightly in the future.  Webelieve that these newly licensed third-party software components will improvethe capabilities and functionality of our products.

 

20

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| ** **                                                 | ** ** | **Software License  Gross Margin** | ** ** |
|------------------------------------------------------------|------------|------------------------------------|------------|
| Nine months ended September 30, 2005                  |       | 96.6%                              |       |
| Nine months ended September 30, 2004                  |       | 95.4%                              |       |
| Increase (decrease) from same period of  prior fiscal year |       | 1.2%                               |       |

 

*Hardware. *Cost of hardwarerevenue represented 64% and 60% of hardware revenue for each respectiveperiod.  During the nine months ended September 30,2005, we incurred decreased dollar costs related to hardware revenue dueprimarily to the decrease in our hardware unit sales.  Further, our gross margin percentage forhardware sales decreased during this period due to a change in the mix ofparticular hardware products sold.  We donot expect significant changes in unit prices for the remainder of 2005 andinto 2006.

 
| ** **                                                 | ** ** | **Hardware Gross  Margin** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|
| Nine months ended September 30, 2005                  |       | 36.5%                      |       |
| Nine months ended September 30, 2004                  |       | 39.8%                      |       |
| Increase (decrease) from same period of  prior fiscal year |       | (3.3)%                     |       |

 

*Service andOther. *Thegross margin percentage for service and other revenue decreased due to anincrease in the wages related expenses and associated overhead costs ofemployees in the support department.  Wedo not expect any significant variances in our service and other gross marginpercentage for the remainder of fiscal year 2005 and into 2006.

 
| ** **                                                 | ** ** | **Cost of Service and  Other Revenue** | ** ** | **Gross Margin for Service  and Other Revenue** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------|------------|-------------------------------------------------|------------|
| Nine months ended September 30, 2005                  |       | $2,082,083                             |       | 59.4%                                           |       |
| Nine months ended September 30, 2004                  |       | $2,067,721                             |       | 60.4%                                           |       |
| Increase (decrease) from same period of  prior fiscal year |       | $14,362  or 0.7%                       |       | (1.1)%                                          |       |

 

***Operating Expenses***

 

*Sales andMarketing. *Salesand marketing expenses increased on a dollar basis in the third quarter of 2005as compared to the same period in 2004 due to an increased number of employeesin our sales and marketing departments and the associated costs of supportingthose employees.* *Additionally, we have increasedour general advertising and consulting expenditures during the nine monthsended September 30, 2005 as compared to the same period in the priorfiscal year.  These expense increasesreflect our initiative to further penetrate the legal vertical market with ourAccuRoute product, as well as our initiative to target new verticalmarkets.  Building on the success of thecurrent version of our AccuRoute product within the legal vertical market sinceits introduction in 2004, we intend to continue broadening our current salesand marketing strategy, which we began in the second quarter of 2005, toencompass first the finance vertical market and, thereafter, the healthcarevertical market.  We anticipate that theadditional expenditures necessary to enter these markets will be approximately$250,000 for the balance of 2005.  Muchof these additional expenses will be sales and marketing related.  We have experienced some delays in investingthe full budgeted amount for these initiatives due primarily to some delays inthe hiring of our executive sales and marketing team, all of whom have now beenhired.  We expect our spending in salesand marketing to continue to increase in future quarters as we move forwardwith our initiative of investing now for future growth.

 

21

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| ** **                                                 | ** ** | **Sales and  Marketing Expenses** | ** ** | **Sales and Marketing Expenses as  a Percentage of Total Revenue** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------------------------------------------------|------------|
| Nine months ended September 30, 2005                  |       | $3,672,547                        |       | 34.6%                                                              |       |
| Nine months ended September 30, 2004                  |       | $3,045,097                        |       | 28.1%                                                              |       |
| Increase (decrease) from same period of  prior fiscal year |       | $627,450  or 20.6%                |       | 6.5%                                                               |       |

 

*Research andDevelopment.*  Weincurred an increase in our research and development expenses, both in dollarsand as a percentage of total revenue, for the nine months ended September 30,2005 as compared to the corresponding period in 2004 due to an increased numberof employees in our research and development department during 2005 and theassociated costs of supporting that new personnel.  Our consulting expenses also increased duringthe nine months ended September 30, 2005 as we utilized outside vendors toassist in technical improvements to our products. We expect our research anddevelopment expenses will increase in absolute dollars as we hire additionalengineers and engage in more third party consulting arrangements to support ourexpansion of our AccuRoute product into other vertical markets.

 
| ** **                                                 | ** ** | **Research and  Development Expenses** | ** ** | **Research and Development Expenses  as a Percentage of Total Revenue** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Nine months ended September 30, 2005                  |       | $1,617,112                             |       | 15.3%                                                                   |       |
| Nine months ended September 30, 2004                  |       | $1,431,273                             |       | 13.2%                                                                   |       |
| Increase (decrease) from same period of  prior fiscal year |       | $185,839  or 13.0%                     |       | 2.1%                                                                    |       |

 

*General andAdministrative. *Theincrease in dollar amount and as a percentage of total revenue for the ninemonths ended September 30, 2005 as compared to the corresponding period in2004 is due to increases in management consulting expenses related to ourinitial compliance efforts with Section 404 of the Sarbanes-Oxley Act of2002, fees paid to our board of directors and wage related expenses.  We expect that we will continue to experienceslight increases to general and administrative expenses in the form ofprofessional fees and consulting expenditures during the remainder of 2005 andinto 2006 as we continue to comply with Section 404 of the Sarbanes-OxleyAct of 2002.  

 
| ** **                                                 | ** ** | **General and  Administrative Expenses** | ** ** | **General and Administrative Expenses  as a Percentage of Total Revenue** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| Nine months ended September 30, 2005                  |       | $2,071,729                               |       | 19.5%                                                                     |       |
| Nine months ended September 30, 2004                  |       | $1,799,052                               |       | 16.6%                                                                     |       |
| Increase (decrease) from same period of  prior fiscal year |       | $272,677  or 15.2%                       |       | 2.9%                                                                      |       |

 

*Interest and OtherIncome. *Interestand other income consists principally of interest income earned on cash andcash equivalent balances.  The increasefor the nine months ended September 30, 2005 as compared to thecorresponding period in 2005 is a result of increased interest rates.  Included in interest and other income for thenine months ended September 30, 2004 is other income of $5,000 related tothe fair value of a warrant to purchase 8,580 shares of common stock of VersoTechnologies (“Verso”).  We mark the fairvalue of this warrant to market in each financial reporting period.  Therefore, for the duration of time that wehold the Verso warrant, which expires in November 2005, we may have torecord future changes in the fair value of that security in our income andother expenses.  We expect that interestand other income will be relatively stable quarter over quarter for theremainder of 2005 and into 2006.

 

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| ** **                                                | ** ** | **Interest and Other Income** | ** ** | **Interest and Other Income as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------|------------|-----------------------------------------------------------------|------------|
| Nine months ended September 30, 2005                 |       | $137,335                      |       | 1.3%                                                            |       |
| Nine months ended September 30, 2004                 |       | $104,931                      |       | 1.0%                                                            |       |
| Increase (decrease)from same period of  prior fiscal year |       | $32,404  or 30.9%             |       | 0.3%                                                            |       |

 

*Provision for IncomeTaxes. *Duringthe nine months ended September 30, 2005, the Company recorded a net taxprovision of $6,777 for expected tax liabilities in the United States and  abroad for our United Kingdom subsidiary. Theprovision for the first nine months of 2004 for expected tax liability in theUnited States and for expected tax liability to our United Kingdom subsidiarywas $9,909 and was net of a $28,800 adjustment related to a fiscal year 2003transfer pricing adjustment.

 

**Inflation**

 

During the fiscal years ended December 31,2004, 2003 and 2002 and the nine months ended September 30, 2005, neitherinflation nor changing prices have had a material impact on our net sales,revenue or income from continuing operations.

 

**Liquidity and Capital Resources**

 

Since 1996, wehave financed our operations primarily through cash flow from operations,private sales of preferred stock and common stock and our initial publicoffering of common stock completed in August 1997.  As of September 30, 2005, we had cashand cash equivalents of $10.4 million and working capital of $6.7 million.  We believe that our existing cash and cashequivalents will be sufficient to meet our working capital, capitalexpenditures and other liquidity requirements for at least the next twelvemonths.

 
| ** **                                                 | ** ** | **Cash Provided (Used)**  | ** ** |
|------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                 | ** ** | **Operating  Activities** | ** ** | **Investing Activities** | ** ** | **Financing Activities** | ** ** |
| Nine months ended September 30, 2005                  |       | $(160,853)                |       | $(82,854) |   | $36,619 |   |
| Nine months ended September 30, 2004                  |       | $262,662                  |       | $(35,758) |   | $1,558,356 |   |
| Increase (decrease) from same period of  prior fiscal year |       | $(423,515)  or (161)%     |       | $(47,096  or (132)% |   | $(1,521,737)  or (98)% |   |

 

Our operating activities used cash of$160,853 for the nine months ended September 30, 2005 and provided cash of$262,662 for the nine months ended September 30, 2004, respectively.  We believe that the additional resourcesbeing allocated to improve the success of our AccuRoute product in the legalvertical market and its expansion first into the finance vertical market and,thereafter, the healthcare vertical market, will put pressure on our earningsduring the remainder of 2005, but that our existing cash is sufficient for atleast the next twelve months.

 

Net cash used during the nine months ended September 30,2005 consisted primarily of a net loss from operations, a decrease to theaccounts receivable reserve and decreases in accounts payable and accrued statesales tax, combined with an increase in prepaid expenses and other currentassets, and offset by the non-cash effects of depreciation and amortization, adecrease to accounts receivable, decrease to inventory and an increase indeferred revenues. The decrease to the accounts receivable reserve relatesprimarily to a general estimate based upon historical returns, whichdemonstrated a reduced need for this reserve. The decrease in accounts payableis due to the timing of vendor payments, which have been made on a more timelybasis. The decrease to accrued state sales tax is a result of continuedsettlement with states in which we may have nexus thereby subjecting us tosales tax within a state. The increase in prepaid expenses and other currentassets is due both to cash paid for annual enterprise licenses related to salesand marketing software that is part of our strategic initiative to invest inadditional resources and renewal of our directors and officers insurancepolicy. The decrease to accounts receivable is primarily due to continued andsuccessful efforts to expedite timely payments from our customers. The decreaseto inventory is related to a reduction in onsite inventory and continuedemphasis on shipments directly from our third party vendor. The increase indeferred revenue is due primarily to the fact that we entered into severalrevenue transactions that occurred at the end of the quarter and did not, as ofthe end of the quarter, meet all of our criteria for revenue recognition. Weanticipate that these transactions will meet our recognition standards duringthe fourth quarter of 2005. Net cash provided during the nine months ended September 30,2004 consisted primarily of a net profit from operations, depreciation and

 

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amortization and a decrease in accounts receivable, partially offset byan increase to prepaid expenses and other current assets, a decrease to theaccounts receivable reserve and decreases to accrued restructuring, deferredrevenue and accrued state sales tax.

 

Investing activities used cash of $82,854 and$35,758 during the nine months ended September 30, 2005 and 2004, respectively.  The sole use of cash for investing activitiesfor each period was for purchases of property and equipment related to computerrelated software and hardware products. We expect that we will increase our investments in computer relatedsoftware and hardware products in 2005 and into 2006 in order to improve ourinformation technology infrastructure so we can support newly hired employees.

 

Financing activities provided cash of $36,619and $1,558,356 for the nine months ended September 30, 2005 and 2004,respectively. Cash provided for the nine months ended September 30, 2005was due primarily to the net proceeds from the issuance of common stock fromour employee stock purchase program and employee exercises of stockoptions.  Cash provided for the ninemonths ended September 30, 2004 was due to the net proceeds from theissuance of common stock.  On March 30,2004, we completed the sale of 600,000 shares of common stock, at a price of$6.00 per share, in a private placement to institutional and other accreditedinvestors.  The proceeds of that privateplacement, which totaled $3.6 million, are being used for additional workingcapital and other general corporate purposes. The cash we received on the consummation of this private placement wasoffset by our usage of $2.0 million in cash during the nine months ended September 30,2004, when we repurchased 350,000 shares of our outstanding common stock fromASA International Ltd., an existing shareholder, in a private transaction at aprice of $5.75 per share.  We repurchasedthose shares from ASA International Ltd. with generally available corporatefunds and we will hold those shares in treasury.

 

Based on ourperformance for the first nine months of 2005 and current expectations for theremainder of the year, we believe that our current cash and cash equivalentsbalance, as well as the cash expected to be generated from operations for theremainder of the year, will satisfy our working capital needs, capitalexpenditures and other liquidity requirements associated with our operationsthrough at least the next twelve months. We expect that principal uses of cash will be for operations, workingcapital, payment of sales taxes and purchases of property and equipment.  We do not currently have a plan to obtainadditional financing if these expectations are not met.  There can be no assurance that any necessaryadditional financing will be available to us on commercially reasonable terms,or at all.

 

The following table represents theapproximate amounts of payments due under specified contractual obligations asof September 30, 2005:

 
| **Contractual Obligations**  | ** ** | **Total** | ** ** | **Less than  one year** | ** ** | **One to  Three years** | ** ** | **Three to  five years** | ** ** | **More than  Five years** | ** ** |
|------------------------------|------------|-----------|------------|-------------------------|------------|-------------------------|------------|--------------------------|------------|---------------------------|------------|
|                         |       |      |       |                    |       |                    |       |                     |       |                      |       |
| Operating  lease obligations |       | $83,000   |       | $83,000                 |       | —                  |       | —                   |       | —                    |       |

 

Operatinglease requirements consist mainly of lease payments for our offices in Salem,NH and London, England, United Kingdom. As of September 30, 2005, we did not have any long-term debtobligations, material commitments for capital expenditures, capital leaseobligations, or other long-term liabilities for which payments arerequired.  Our lease for our Salem, NHlocation expires on December 31, 2005. We believe that this facility is adequate for our presentoperations.  However, there can be noassurance that we will be able to renew this lease on sufficiently favorableterms and we may therefore have to relocate our headquarters location.

 

**Off-Balance Sheet Arrangements**

 

We do not haveany relationships with unconsolidated entities or financial partnerships, suchas entities often referred to as structured finance or special purposeentities, that would have been established for the purpose of facilitatingoff-balance sheet arrangements (as that term is defined in Item 303(a)(4)(ii) ofRegulation S-K) or other contractually narrow or limited purposes.  As such, we are not exposed to any financing,liquidity, market or credit risk that could arise if we had engaged in thosetypes of relationships.

 

**Certain Factors Affecting Future Operating Results**

 

We operate ina rapidly changing environment that involves a number of risks, some of whichare beyond our control.  The discussionbelow highlights some of the risks that may affect future operating results.

 

Informationprovided by us from time to time, including statements in this Form 10-Qthat are not historical facts, consists of so-called “forward-lookingstatements” that involve risks and uncertainties, made pursuant to the safe harborprovisions of the Private

 

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Securities Litigation ReformAct of 1995.  In particular, statementscontained in Management’s Discussion and Analysis of Financial Condition andResults of Operations that are not historical facts (including, but not limitedto, statements concerning: our plans and objectives; expectations for sales andmarketing, research and development and general and administrative expenses;developments relating to our product and service offerings, markets andacquisitions; anticipated trends in our business; our strategic alliances;changes in the regulatory environment; our expected liquidity and capitalresources and our critical accounting policies) may constitute forward-lookingstatements.  These forward-lookingstatements are neither promises nor guarantees, but are subject to risk anduncertainties that could cause actual results to differ materially from theexpectations set forth in the forward-looking statements.  Factors that may cause these kinds ofdifferences include, but are not limited to, the factors discussed below andthe other risks discussed from time to time in our other filings with theSecurities and Exchange Commission.

 

***Our future operatingresults are uncertain and difficult to predict****. *Weincorporated and shipped our initial facsimile software products in 1991.  Although we recorded an operating profit inthe year ended December 31, 2004, we had operating losses and decreasingrevenue in the years ending December 31, 2003 and 2002.  We introduced the initial version of ourAccuRoute product in the second quarter of 2002 and the current version in thefirst quarter of 2004.  Ultimately,AccuRoute represented 40% of software revenue in 2004.  There can be no assurance that we will beable to increase our level of revenue or maintain our profitability in thefuture, as our operating history makes the accurate prediction of futureoperating results difficult or impossible. Increases in operating expenses are expected and, together with pricingpressures and any decline in the growth rate of the overall U.S. economy or ourindustry in particular, may result in a decrease in operating income andoperating margin percentage.  Our abilityto improve our operating results will depend upon, among other things, ourability to increase sales of our AccuRoute, Genifax and Genidocs softwareproducts to new customers, as well as our ability to increase productpenetration into existing customers.  Werecently expanded our strategic focus to include document routing anddistribution software.  To date, we havelimited financial and operating data and a limited operating history relevantto this solution.  Accordingly, it isdifficult to evaluate the prospects for the level of acceptance of thissolution.  In addition, we plan tocontinue investing significantly in the expansion of our AccuRoute product intonew vertical markets, specifically first the finance vertical market and thenthe healthcare vertical market, in advance of significant related revenue fromthose markets.  We cannot predict thetiming or level of revenue resulting from these investments.  Future operating results will depend on manyother factors, including, without limitation, the degree and rate of growth ofthe markets in which we compete; the level of acceptance of the Windows NT®,Windows 2000® and Windows XP® operating systems; the level of product and pricecompetition; our ability to establish strategic relationships and develop andmarket new and enhanced products; our ability to control costs; our ability toexpand our direct sales force and indirect distribution channels bothdomestically and internationally; and our ability to attract and retain keypersonnel.  As a result, it is possiblethat in the future, our operating results will be below the expectations ofpublic market analysts and investors.  Inthat event, the price of our common stock would likely be materially adverselyaffected.

 

***All of our productsare concentrated in the electronic document exchange market****. *Todate, much of our revenue has been attributable to licenses of ourfacsimile-based enterprise solutions and related products and services.  We expect these products and related servicesto continue to account for significant amounts of our future revenue.  However, recently the amount of revenueattributable to licenses of these products has declined and there can be noassurances that this decline will not continue. Furthermore, we introduced our secure business-to-business electronicdocument exchange products, Genidocs and Genifax, to the market in the fourthquarter of 2000.  Further, we introducedthe initial version of our proprietary document and routing software,AccuRoute, in the second quarter of 2002 and the current version of thatproduct in the first quarter of 2004.  Wehave only recently begun to recognize a significant amount of revenue from ourAccuRoute product.  We expect that thisproduct may account for an increasing portion of future revenue.  However, there can be no assurances that ourAccuRoute product will be financially successful or result in any significantrevenue in the future.  Factors adverselyaffecting the pricing of or demand for this product, such as competition ortechnological change, could have a material adverse effect on our business,financial condition and results of operations. All of our products are concentrated in the electronic document exchangemarket and, therefore, any factors affecting demand for these sorts ofsolutions could cause our operating results to decline.  Investors must evaluate our prospects inlight of the risks and difficulties frequently encountered by companiesdependent upon operating revenue from a new product line in an emerging andrapidly evolving market.

 

***The markets for ourproducts are subject to rapid technological change and we may not be able tokeep pace with evolving industry standards or end-user requirements****. *Themarkets for our products are relatively new and are characterized by rapidtechnological change, evolving industry standards, changes in end-user requirementsand frequent new product introductions and enhancements.  Our future success will depend upon ourability to enhance our current products and to develop and introduce newproducts that keep pace with technological developments and respond to evolvingend-user requirements.  There can be noassurance that we will be successful in developing and marketing new productsor product enhancements on a timely basis, or that new products or productenhancements developed by us, such as our AccuRoute, Genidocs and Genifaxproducts, will achieve market acceptance. The introduction of products embodying new technologies and theemergence of new industry standards could render our existing products obsoleteand unmarketable.  From time to time, weand our competitors may announce new products, capabilities or technologiesthat have the potential to replace or shorten the life cycle of our existingproduct offerings.  There can be noassurance

 

 

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that announcements of newproduct offerings by us or our competitors will not cause customers to defer orforego the licensing of our existing or planned products and have a materialadverse effect on our business, financial condition and results of operations.

 

***The market forsecure business-to-business document exchange solutions is new and evolvingrapidly and there can be no assurance that our products will be successful inthis market****. *The market for Genidocs, oursecure business-to-business electronic document exchange solution is relativelynew and evolving rapidly.  Our successwill depend upon the extent and timing of adoption and use by current andpotential customers of secure business-to-business electronic document exchangesolutions.  Our success will also dependupon acceptance of our technology as the standard for providing thesesolutions.  The adoption and use of oursecure business-to-business electronic document exchange solution will involvechanges in the manner in which businesses have traditionally exchangedinformation.  Our ability to influenceusage of our secure business-to-business electronic document exchange solutionby customers is limited.  We intend tospend resources educating potential customers about the value of securebusiness-to-business electronic document exchange solutions.  It is difficult to assess or to predict withany assurance the present and future size of the potential market for oursecure business-to-business electronic document exchange solution, or thegrowth rate, if any, for this market. Moreover, we cannot predict whether our secure business-to-businesselectronic document exchange solution will achieve any market acceptance and wenote that we did not make any sales of Genidocs in the third fiscal quarter ofeach of 2004 and 2005.  If any of ourfuture products or future product enhancements are not favorably received byour customers, we may be less or not profitable and we may therefore sufferdamage to our reputation or brand name.

 

***Were we to suffer anunexpectedly large decline in our legacy fax business, our results ofoperations would be significantly impaired and we might incur an operating loss****. *Wecurrently derive a significant though declining portion of our revenue fromlicenses of our Genifax product and related services and resale of relatedhardware.  However, sales of Genifax, ourmulti-tiered client/server software for automating and integrating faxcommunications throughout an enterprise, were lower in 2004 than they were in2003, a trend that continued in the first nine months of 2005.  Though we expect our sales of our legacy faxproducts to continue to decline in 2005, an unexpectedly large decline in themarket acceptance of our Genifax product would have a negative impact on ourfuture success.  As a result, anyunexpectedly large decline in demand for or failure to maintain expected marketacceptance of the Genifax product line as a result of competition,technological change or otherwise, would have a material adverse effect on ourbusiness, financial condition and results of operations.  Our future financial performance will dependin part on new and enhanced versions of the Genifax product.  There can be no assurance that we willcontinue to be successful in marketing the Genifax product or any new orenhanced versions of the Genifax product at expected levels.  There can be no assurance that we will besuccessful in developing products for new or enhanced operating systems such asWindows 2000 or Windows XP, or that these systems will not obviate the need forour products.  If any new or enhancedoperating system gains widespread use and we fail to develop and provide ourproducts for this operating system on a timely basis, our business, financialcondition and results of operations could be materially adversely affected.

 

***Wedepend on the revenue generated by sales of our AccuRoute product and would benegatively impacted if market interest – whether in the legal vertical marketthat we have already targeted or the finance and healthcare vertical marketsthat we are currently targeting – were to decline or fail to grow as expected****. *Wecurrently derive a significant portion of our revenue from licenses of ourAccuRoute product and related services. Sales of AccuRoute were higher in 2004 than they were in 2003, a trendthat continued during the first nine months of 2005.  Continued market acceptance of our AccuRouteproduct is critical to our future success. As a result, any decline in demand for or failure to maintain broadmarket acceptance of our AccuRoute product line as a result of competition,technological change or otherwise would have a material adverse effect on ourbusiness, financial condition and results of operations.  Our future financial performance will dependin large part on new and enhanced versions of our AccuRoute product.  There can be no assurance that we willcontinue to be successful in marketing our AccuRoute product in the legalvertical market or that our marketing efforts in the finance and healthcarevertical markets will be successful. Further, there can be no assurance that any new or enhanced versions ofour AccuRoute product will be successful.

 

***We have historicallydepended on our sales of fax products to generate revenue and could face adecline in overall revenue if the declines we face in this market are largerthan expected***. Our enterprise client/server facsimile software products are intended tohelp organizations efficiently manage their facsimile communications, utilizinga client/server computing environment. There can be no assurance that organizations will move away from the useof stand-alone fax machines or continue to adopt client/server environments, orthat those of our customers who have begun the migration to a client/serverenvironment will broadly implement this model of computing.  Our future financial performance will dependin large part on our ability to capture an expected portion of the market forclient/server applications.  The size ofthis market will depend in part on the growth in the number of organizationsimplementing client/server computing environments.  There can be no assurance that these marketswill continue to grow or that we will be able to capture sales to or respondeffectively to the evolving requirements of these markets.  If the market for client/server applicationproducts and services does not grow in the future, grows more slowly than weanticipate, or if we fail to respond effectively to evolving requirements ofthis market, our business, financial condition and results of operations couldbe materially adversely affected.

 

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***Our common stock islisted on the Nasdaq SmallCap Market and any failure to maintain that listingcould significantly impair our stock price and our ability to raise futurecapital. ***InAugust 2002, the Nasdaq National Market (“Nasdaq”) informed us that ourcommon stock had traded for 30 consecutive trading days below Nasdaq’s minimumbid price and that we had until November 4, 2002, to demonstratecompliance with Nasdaq’s listing requirements by maintaining a bid price forour common stock of at least $1.00 for a minimum of ten consecutive tradingdays.  We did not regain compliance andon October 29, 2002, we applied to transfer from the Nasdaq NationalMarket to the Nasdaq SmallCap Market.  OnNovember 26, 2002, we transferred to the Nasdaq SmallCap Market and wewere afforded the remainder of this market’s 180 calendar day grace period, oruntil February 3, 2003, to regain compliance with the minimum bid priceper share requirement.  On January 14,2003, our Board of Directors and stockholders, at a special meeting, approvedan amendment to our certificate of incorporation to effect a one-for-sevenreverse stock split.  On February 5,2003, Nasdaq notified us that we had regained compliance with the NasdaqSmallCap Market’s listing standards.  Inaddition, we cannot predict our ability to maintain our listing in the futureon the Nasdaq SmallCap Market.  Thedelisting of our common stock from the Nasdaq SmallCap Market, if that were tooccur, could materially impair stockholders’ ability to buy and sell shares ofour common stock and could have an adverse effect on the market price of, andthe efficiency of the trading market for, our common stock.  Furthermore, the delisting of our common stockcould significantly impair our ability to raise capital should we desire to doso in the future.

 

***The markets in whichwe sell our products are characterized by intense and growing competition andour future success is dependent on our ability to distinguish our products fromthose of our competitors and reach our target customers****. *Inthe distributed document capture and delivery market in which our AccuRoutesoftware competes, we are likely to see competitive products being offered byhardware vendors such as Xerox, Canon, Ricoh, Lexmark and others.  In some cases these products are the resultof partnerships with U.S.-based software companies.  We also expect competition in this marketfrom a number of independent software vendors whose business focus wasinitially the high volume production scanning segment such as Kofax andCaptiva, or forms management and process routing companies such asCardiff.  e-Copy, a former Omtoolbusiness partner, has formed a relationship with Canon and has embedded theirdocument capture and routing capabilities into the front panel of the CanonImageRunner Multifunction Printer (“MFP”) device.  Other potential software competitors includeScanSoft, as well as document management vendors like Hummingbird andInterwoven/iManage who are seeking to develop, either through partnerships orinternal resources, scan-to-archive capabilities using standard e-mail as thetransport and a generic document profile as a means of entering the contentinto their repository.  We believe thatour ability to compete successfully in the distributed document capture anddelivery market depends upon a number of factors both within and beyond ourcontrol including product performance; reliability and features; ease of use;product scalability; quality of support services; price/performance; timelinessof enhancements and new product releases by us and our competitors.  We expect this market to mature and becomeincreasingly competitive with success resulting from the formation of criticalpartnerships and alliances with both selected hardware and software partners.

 

The market forclient/server computer-based facsimile solutions is also competitive and ismore established and mature than the markets in which the AccuRoute andGenidocs products compete.  We believethat our ability to compete successfully in the fax market depends upon anumber of factors both within and beyond our control including productperformance; reliability and features; ease of use; product scalability;quality of support services; price/performance; timeliness of enhancements andnew product releases by us and our competitors. Given these factors, we believe that in order to be successful, we mustcontinue our focus on delivering a core, modular and scalable product on one ofthe most prolific system platforms, Windows 2000/2003®, with features thatappeal to the broadest segment of the electronic document exchange market,which includes fax and all of the other document control and managementfeatures that we offer.

 

We competedirectly with a number of vendors of facsimile products, including providers offacsimile software products for client/server networks such asCaptaris/RightFax, Dicom/TopCall and Biscom. We also compete with providers offering a range of alternative facsimilesolutions including outsourcing network facsimile solutions, such as EasylinkServices and Xpedite; operating systems containing facsimile and documente-mail features; low-end fax modem products; providers of desktop fax software;single-platform facsimile software products; and customized proprietarysoftware solutions.  In addition,providers of operating systems or business software applications may bundlecompetitive facsimile solutions as part of their broader product offerings.

 

In theintensely competitive and rapidly changing business-to-business secure documentexchange market, we compete directly with Authentica, Sigaba, Tumbleweed, andZixit and a number of other providers. There are also other categories of technology solutions that overlap andcompete in certain ways with aspects of our products.  These include:

 

•              Document management solutions fromvendors such as EMC/Documentum, Hummingbird and Interwoven/iManage whoseelectronic collaboration solutions compete with certain aspects of oursolutions;

 

•              Electronicforms and electronic signature solutions from vendors such as Adobe, PureEdge,Silanis that offer the creation of electronic documents with electronicsignatures; and

 

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•              Security infrastructure solutionsfrom vendors such as Verisign and Entrust whose solutions can be used to buildapplications that enable secure document communications.

 

We expect the level of competition in the business-to-business securedocument exchange market to increase over time.

 

Many of ourcompetitors and potential competitors have longer operating histories andgreater financial, technical, sales, marketing and other resources, as well asgreater name recognition and market acceptance of their products andtechnologies than we do.  In addition,there are relatively low barriers to entry in the markets in which we operateand intend to operate, and new competition may arise either from expansion byestablished companies or from new emerging companies or from resellers of ourproducts.  There can be no assurance thatour current or potential competitors will not develop products comparable orsuperior — in terms of price and performance features – to those developed byus.  Further, our competitors may adaptmore quickly than we do to new or emerging technologies and changes in marketopportunities or customer requirements, establish alliances with industryleaders or take advantage of acquisition opportunities more readily than we canor do.  In addition, no assurance can begiven that we will not be required to make substantial additional investmentsin connection with our research, development, engineering, marketing, sales andcustomer service efforts in order to meet any competitive threat, or that thoserequired investments will not have a material adverse effect on our operatingmargins.  Changes in governing laws andregulations may also affect our ability to remain competitive.  Increased competition may result in reductionin market share, pressure for price reductions and related reductions in grossmargins, any of which could materially adversely affect our ability to achieveour financial and business goals.  Therecan be no assurance that, in the future, we will be able to successfullycompete against current and future competitors.

 

***Our business issubject to seasonality and fluctuations on a quarterly and annual basis due tothe long sales cycle for our products and numerous other factors and, therefore,our results may vary from quarter-to-quarter and year-to-year****. *Ourquarterly revenue and results of operations have fluctuated significantly inthe past and will likely continue to fluctuate significantly in thefuture.  Causes of these fluctuationshave included and may include, among others: the demand for our products andservices; the size and timing of orders; the number, timing and significance ofnew product announcements by us and our competitors; our ability to develop,introduce, market and ship new and enhanced versions of our current and plannedproducts on a timely basis; the level of product and price competition; changesin operating expenses; changes in average selling prices and mix of ourproducts; changes in our sales incentive strategy; the mix of direct andindirect sales; and general economic factors, including factors affecting theoverall U.S. economy and the demand for enterprise information technologysolutions.  In addition, the sale of ourproducts often involves delays because customers tend to implement the productsthey purchase from us on a large scale, requiring them first to establishcertain minimum hardware capabilities. Moreover, we have historically experienced some seasonal fluctuations inthe sales of our products, due to the fact that many companies make informationtechnology purchases either early or late in their fiscal years (when theyeither have a replenished annual budget or leftover money in the budget) andmore frequently scheduled vacations of key personnel at customers during thesummer months (particularly in Europe). Our products therefore often have a lengthy sales cycle while potentialcustomers evaluate and receive approvals for the purchase of our products.  During these sales cycles, we may expendsubstantial funds and management efforts, yet receive no revenue.  It is difficult to accurately predict thesales cycle of any large order.  If oneor more large orders fail to close as forecasted in a fiscal quarter, ourrevenue and operating results for that quarter could be materially adverselyaffected.  Any one or more of these orother factors could have a material adverse effect on our business, financialcondition and results of operations.  Thepotential occurrence of any one or more of these factors makes the predictionof revenue and results of operations on a quarterly basis difficult andperformance forecasts derived from these predictions unreliable.

 

In addition,we may invest in research and development and marketing expenses in order topromote further our products within current or new vertical markets, includingour current plan to incur additional sales and marketing expenses as we firsttarget the finance vertical market and then, shortly thereafter, the healthcaremarket with our AccuRoute software product. Because we must make these investments in advance of related marketacceptance of and revenue from our AccuRoute product in those vertical markets,any failure of our products to achieve planned levels of acceptance would havea material adverse effect on our business, financial condition and results ofoperations on a quarter-to-quarter basis and overall.

 

In general, itis difficult for us to forecast revenue because the market for securebusiness-to-business electronic document exchange, enterprise client/serverfacsimile solutions software and routing and distribution software is evolvingrapidly and our sales cycle – from the customer’s initial evaluation throughpurchase of licenses and the related support services – varies substantiallyfrom customer to customer.  License feerevenue in any quarter depends on orders received and shipped in that quarter,with a significant percentage of orders in any quarter arriving in the lastweeks of the quarter.  License feerevenue from quarter-to-quarter is difficult to forecast, as no significantorder backlog exists at the end of any quarter because our products typicallyare shipped upon receipt of customers’ orders.

 

A substantial portion of our operatingexpense is related to personnel, facilities, equipment and marketingprograms.  The level of spending forthese expenses cannot be adjusted quickly and is therefore fixed in the shortterm.  Our expense levels for personnel,facilities, equipment and marketing programs are based, in significant part, onour expectations of future revenue on a

 

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quarterly basis.  If actual revenue levels on a quarterly basisare below our expectations, our results of operations are likely to be adverselyaffected by a similar amount because a relatively small amount of our expensevaries with our revenue in the short term.

 

Due to all of the foregoing factors, it islikely that in some future periods our results of operations will be below theexpectations of securities analysts and investors.  In such event, the price of our common stockwould likely be materially adversely affected.

 

***In addition todirect sales, we utilize indirect sales and distribution channels and strategicalliances with compatible partners in order to broaden sales of ourproducts.  Any failure on our part toform and leverage relationships with these indirect sales and distributionchannel partners could have a material adverse affect on our business andresults of operations****. *We market ourproducts and services directly through telesales and indirectly throughmarketing channels such as value added resellers (“VARs”), systems integrators,distributors and strategic business partners. Although we have historically focused our efforts on marketing throughour sales force, we continue to utilize resources to develop and expandindirect marketing channels.  There canbe no assurance that we will be able to attract and retain a sufficient numberof qualified VARs, systems integrators, distributors and strategic businesspartners, or that those third parties will successfully market ourproducts.  In addition, there can be noassurance that our resellers and strategic business partners will not develop,acquire or market computer-based electronic document exchange, document routingand distribution and facsimile products that are competitive with ourproducts.  The failure to retain ourVARs, systems integrators, distributors and strategic partners could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

The distributor agreements governing ourrelationships with third party distribution chain partners generally providethat either party may terminate the agreement without cause upon 30 days writtennotice to the other party.  We alsoresell our products on a purchase order basis through other VARs, systemsintegrators and distributors.  Generally,in those situations, either party may terminate the relationship at any time,and therefore there can be no assurance that any VAR, systems integrator ordistributor will continue to represent and sell our products.  Furthermore, our strategic alliancesgenerally may be terminated by either party, at any time; there can thereforebe no assurances that these strategic alliances will continue.  The inability to retain certain VARs, systemsintegrators, distributors or strategic business partners, or thedevelopment or marketing by VARs, systems integrators, distributors orstrategic business partners of competitive offerings, could have a materialadverse effect on our business, financial condition and results of operations.

 

Sellingthrough indirect channels may limit our contacts with our customers, therebyhindering our ability to accurately forecast sales, evaluate customersatisfaction and recognize emerging customer requirements.  Our strategy of marketing our productsdirectly to end-users and indirectly through VARs, systems integrators anddistributors may result in distribution channel conflicts.  Our direct sales efforts may compete withthose of our indirect channels and, to the extent different resellers targetthe same customers, resellers may also come into conflict with each other.  As we strive to expand our indirectdistribution channels, there can be no assurance that emerging channelconflicts will not materially adversely affect our relationships with existingVARs, systems integrators or distributors or adversely affect our ability toattract new VARs, systems integrators and distributors.

 

***The success of ourbusiness is dependent on our ability to expand our sales internationally, whichwill subject us to regulatory, exchange rate and other risks that might hinderour ability to meet our targets for international sales and might impair ourresults of operation****. *An element of ourstrategy is to increase our international sales.  We expect to face competition from securebusiness-to-business electronic document exchange solutions and local facsimileproduct providers in their native countries. To successfully maintain international sales, we need to recruit andretain additional international resellers and distributors.  There can be no assurance that we will beable to maintain international sales of our products or that our internationaldistribution channels will be able to adequately market, service and supportour products.  International operationsgenerally are subject to certain risks, including dependence on independentresellers, fluctuations in foreign currency exchange rates, compliance withforeign regulatory and market requirements, variability of foreign economicconditions and changing restrictions imposed by United States export laws.  Additional risks inherent in ourinternational business activities generally include unexpected changes inregulatory requirements, tariffs and other trade barriers, costs of localizingproducts for foreign countries, lack of acceptance of localized products inforeign countries, longer accounts receivable payment cycles, difficulties inmanaging international operations, difficulties in enforcing intellectualproperty rights and the burdens of complying with a wide variety of foreignlaws.

 

We currentlyhave a sales office in the United Kingdom. Our non-United States presence subjects us to certain additional risksincluding difficulties in staffing and managing these foreign operations andpotentially adverse tax consequences including restrictions on the repatriationof earnings.  There can be no assurancethat these factors will not have a material adverse effect on our futureinternational sales and, consequently, our business, financial condition andresults of operations.  To date, amajority of our sales have been made in United States dollars and we have notengaged in any hedging transactions through the purchase of derivativesecurities or otherwise.  Our UnitedKingdom subsidiary transacts business primarily in its local currency.  We translate our United Kingdom subsidiary’soperating results into U.S. dollars and consolidate them with our domesticresults for reporting purposes.  As

 

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we make sales to customers in avariety of countries, significant currency exchange rate fluctuations couldhave a material impact on our results of operations.

 

***Given the nature ofour business, we may not be able to obtain sufficient or attractive financing,should that become necessary****. *Weexpect that our current cash, cash equivalents and investments will meet ournormal working capital and capital expenditure needs for at least the nexttwelve months.  We may, however, need toraise additional funding at that time or earlier if we decide to undertake morerapid expansion, including acquisitions of complementary products ortechnologies, or if we increase our marketing and/or research and developmentefforts in order to respond to competitive pressures.  We cannot be certain that we will be able toobtain additional financing on favorable terms, if at all.  We may obtain additional financing by issuingshares of our common stock, which could dilute our existing stockholders.  If we cannot raise needed funds on acceptableterms, or at all, we may not be able to develop or enhance our products orrespond appropriately to competitive pressures, which would seriously harm ourbusiness.

 

***We may notsuccessfully complete acquisitions or integrate acquisitions we do make, whichcould impair our ability to compete and could harm our operating results. ***We may augmentour internal growth with acquisitions of businesses, products and technologiesthat could complement or expand our business. Certain of these businesses may be only marginally profitable or evenunprofitable.  In order to achieveanticipated benefits from these acquisitions, we will have to successfullyintegrate the acquired businesses with our existing operations.  We cannot assure you that we will besuccessful in this regard.  We havelimited experience in integrating acquired companies into our operations, inexpanding the scope of operations of required businesses, in managinggeographically dispersed operations and in operating internationally.  In the past, we have incurred one-time costsand expenses in connection with acquisitions and it is likely that we couldincur similar one-time costs and expenses in connection with futureacquisitions.  In addition, we might berequired to amortize significant intangible assets in connection with futureacquisitions, which could adversely affect our operating results.  Further, attractive acquisitions aredifficult to identify and complete for a number of reasons, includingcompetition among prospective buyers and the possible need to obtain regulatoryapproval.  There can be no assurance thatwe will be able to complete future acquisitions.  In order to finance potential futureacquisitions, we may need to raise additional funds either through public orprivate financings, including bank borrowings. Any financing, if available at all, may be on terms that are notfavorable to us.  Finally, we may also issueshares of our common stock to acquire attractive businesses, which may diluteour existing stockholders.

 

***Ourfuture success depends on our ability to manage the growth and expansion of ourbusiness. ***Wemay expand our operations as we anticipate that expansion may be required inorder to address potential market opportunities.  We may also increase the size of our salesand marketing and research and development expenditures as necessary.  There can be no assurance that we will beable to complete this expansion successfully or that the expansion wouldgenerate sufficient revenue to cover our expenses.  We will need to continue to attract andretain highly qualified technical, sales and managerial personnel.  There can be no assurance that we will be ableto retain or continue to hire this kind of personnel in the future or to retainthis kind of personnel in a sufficiently timely manner.  Our inability to effectively expandoperations and manage growth, if any, could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

***The effectiveness ofour disclosure controls and procedures and internal control over financialreporting may be limited. ***Pursuantto the requirements of the Sarbanes-Oxley Act of 2002, we must maintain andenhance our internal control over financial reporting.  Presently, we are not an “accelerated filer”as that term is defined in the Securities Act. As a result, we are not required to deliver a report regarding ourdetermination of the effectiveness of our internal control over financialreporting until we file our annual report on Form 10-K for the fiscal yearending December 31, 2007.  Further,under Section 404 of Sarbanes-Oxley, in connection with our annual reporton Form 10-K for the fiscal year ending December 31, 2007, ourindependent registered public accounting firm will be required to deliver anattestation report regarding management’s assessment of the effectiveness ofour internal control over financial reporting. As a result, during the fiscal years ending December 31, 2005, 2006and 2007, we will expend considerable time, attention and resources todetermining the strength and effectiveness of our internal control overfinancial reporting and, where appropriate, making improvements.

 

Our disclosurecontrols and procedures and internal control over financial reporting may notprevent all errors and intentional misrepresentations.  Any system of internal controls can onlyprovide reasonable assurance that all control objectives have been and willcontinue to be met.  Some of thepotential risks involved could include, without limitation, managementjudgments, simple errors or mistakes, willful misconduct regarding controls ormisinterpretation.  Though we believethat our disclosure controls and procedures and internal control over financialreporting are effective, there can be no guarantee that existing controls andprocedures will prevent or detect all material issues, errors or intentionalmisrepresentations.  Further, our existingcontrols may not be effective in future situations.  Any failure of our disclosure controls andprocedures or internal control over financial reporting could have a materialimpact on our financial condition and results of operation.  Our assessment of our internal control overfinancial reporting may identify weaknesses in our internal control overfinancial reporting that we need to remedy or may raise other issues of concernfor our investors.  Should we determinethat a material weakness exists in our internal control over financialreporting, the price of our common stock might decline.

 

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***Our reliance on asole hardware supplier could adversely impact our business****. *Wecurrently purchase hardware products for sale to our customers from a singlethird-party supplier.  We do not have along-term, fixed-price or minimum volume contract with this supplier.  Instead, we order hardware equipment throughpurchase orders from time to time.  We donot carry significant inventories of these hardware products and do not have aguaranteed supply arrangement with this supplier.  Recently, our sole supplier of hardwareproducts was sold to a third-party.  Wedo not believe that this change of ownership will impact our ability topurchase hardware products from this supplier or the terms under which we makethose purchases.  Were this supplier toraise its prices or refocus its business, we might be negatively impacted as wewould have to develop a new supply relationship for these products.  Although we believe that we could securethese hardware products from alternative suppliers, in the event of adisruption of supply from this sole supplier, we might not be able to develop analternative source in a timely manner or at favorable prices.  Even if we were able to purchase thesehardware components from alternative sources, we would have little control overthe costs of these products.  Were weforced to pay significantly higher prices for these hardware products, it mightlimit the mark-up over the price paid by us that we can reasonably charge ourcustomers.  Were we unable to providethis hardware to our customers, forcing our customers to buy this hardwaredirectly from third parties, or were we forced to decrease the size of ourmark-up, our hardware and total revenue would be negatively impacted.

 

***We may faceadditional expenses and disruption due to the upcoming expiration of the leaseon our headquarters space, especially if we elect to relocate. ***We lease officespace, used as our headquarters and primary business location, at 8A IndustrialWay in Salem, New Hampshire.  Our currentlease terminates on December 31, 2005. As a result, we have engaged a real estate agent to assist us inconsidering our options. At this time, we have not determined whether we willbe able to renew our lease at our present location on sufficiently favorableterms or whether we will instead lease a new facility and relocate.  The process of evaluating options andnegotiating a new or renewed lease will require time and attention from membersof our management.  Further, if we electto relocate our operations to a new location, we will incur related expensesand will encounter disruption of operations related to the move, all of which couldhave a material adverse effect on our financial condition and results ofoperation.

 

***Weare dependent on our key personnel and any inability to retain or hire keypersonnel could impact our business and results of operations****. *Ourfuture performance depends, in significant part, upon the continued service ofour key technical, sales and senior management personnel, most of whom are notbound by employment agreements or noncompetition agreements.  The loss of the services of one or more ofour executive officers or other key employees could have a material adverseeffect on our business, financial condition and results of operations.  Our future success also depends on ourcontinuing ability to attract and retain highly qualified technical, sales andmanagerial personnel, particularly in light of our expanded AccuRoute sales andmarketing strategy.  Competition forhighly qualified personnel is intense and we have historically experienceddifficulty in recruiting qualified technical personnel.  There can be no assurance that we will beable to retain or continue to hire key technical, sales and managerialpersonnel in the future.

 

**Item 3. Quantitative and QualitativeDisclosures About Market Risk**

 

*Derivative FinancialInstruments, Other Financial Instruments, and Derivative Commodity Instruments.*****As of September 30, 2005, the Companydid not participate in any derivative financial instruments or other financialand commodity instruments for which fair value disclosure would be requiredunder SFAS No. 107,*Disclosures aboutFair Value of Financial Instruments*. All of the Company’s investments consist of money market funds andcommercial paper that are carried on the Company’s books at amortized cost,which approximates fair market value. Accordingly, the Company has no quantitative information concerning themarket risk of participating in such investments.

 

*Primary Market RiskExposure*s. * *The Company’s primary market riskexposures are in the areas of interest rate risk and foreign currency exchangerate risk.  The Company’s investmentportfolio of cash equivalents is subject to interest rate fluctuations, but theCompany believes this risk is immaterial due to the short-term nature of theseinvestments.  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 Kingdom subsidiary’s operatingresults are translated into U.S. dollars and consolidated for reportingpurposes.  The impact of currencyexchange rate movements on intercompany transactions was immaterial for thequarter ended September 30, 2005. 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, the Company does not engage inforeign currency hedging activities.

 

**Item 4. Controls and Procedures**

 

As of the end of the fiscal quarter (the “EvaluationDate”), the Company, under the supervision and with the participation of theCompany’s management, including the Company’s Chief Executive Officer and ChiefFinancial Officer, evaluated the

 

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effectiveness of the Company’sdisclosure controls and procedures pursuant to Rule 13a-15(b) and 15d-15(b) promulgatedunder the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Based upon that evaluation, the Company’sChief Executive Officer and Chief Financial Officer concluded that, as of theEvaluation Date, the Company’s disclosure controls and procedures are effectivein ensuring that information relating to the Company (including itsconsolidated subsidiaries) required to be disclosed by the Company in thereports that it files or submits under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms, including ensuring that such information is accumulated and communicatedto the Company’s management, including the Company’s Chief Executive Officerand Chief Financial Officer, as appropriate to allow timely decisions regardingrequired disclosure.

 

There was no change in the Company’s internalcontrol over financial reporting during the Company’s last fiscal quarter thathas materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

**PART II:  OTHER INFORMATION**

 

**Item 5.  Other Information**

 

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         |       | Form of Indemnification Agreement  between Omtool and each of Robert L. Voelk, Daniel A. Coccoluto, Richard D.  Cramer, Arnold E. Ditri, William J. Drummey, Andrew E. Lietz, James P.  O’Halloran and Martin A. Schultz, previously filed as an exhibit to Omtool’s  Current Report on Form 8-K dated July 22, 2005 and incorporated  herein by reference. |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 31.1         |       | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                                                                                                                                                                     |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 31.2         |       | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                                                                                                                                                                     |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 32.1         |       | Certification of Chief Executive Officer  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                       |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 32.2         |       | Certification of Chief Financial Officer  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                       |

 

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Signatures

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|                   | OMTOOL, LTD. |
|------------------------|--------------|
|                   |         |   |
|                   |         |   |
| November 14, 2005 | By:          | /s/ Daniel A. Coccoluto |   |
|                   |         | Daniel A. Coccoluto |
|                   |         | Chief Financial Officer, Secretary and  Treasurer |
|                   |         | (Duly authorized officer and principal  financial officer) |

 

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**OMTOOL,LTD. AND SUBSIDIARIES**

 

**EXHIBIT INDEX**

 

** **
| **Exhibit** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                      |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.1        |       | Form of Indemnification Agreement  between Omtool and each of Robert L. Voelk, Daniel A. Coccoluto, Richard D.  Cramer, Arnold E. Ditri, William J. Drummey, Andrew E. Lietz, James P.  O’Halloran and Martin A. Schultz, previously filed as an exhibit to Omtool’s  Current Report on Form 8-K dated July 22, 2005 and incorporated  herein by reference. |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 31.1        |       | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                                                                                                                                                                     |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 31.2        |       | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                                                                                                                                                                     |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 32.1        |       | Certification of Chief Executive Officer  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                       |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 32.2        |       | Certification of Chief Financial Officer  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                       |

 

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