**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

** **

**FORM 10-Q**

** **

**(Mark One)**

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

** **

**For the quarterly period ended September 30, 2007**

** **

**OR**

** **

**o**           TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OFTHE SECURITIES EXCHANGE ACT OF 1934

** **

**For the transition periodfrom               to               **

** **

**Commission File Number 0-22871**

** **

**OMTOOL, LTD.**

(Exact Name ofRegistrant as Specified in Its Charter)

 

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

 

**(978) 327-5700**

(Registrant’sTelephone Number Including Area Code)

 

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of 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 x   No o

 

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

 

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

 

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

 

Yes o   No x

 

There were 4,554,712 shares of the Company’s commonstock, par value $0.01, outstanding on November 9, 2007.

 

 

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**OMTOOL, LTD. AND SUBSIDIARIES**

 

FORM 10-Q

For the Quarter Ended September 30, 2007

CONTENTS

 

**Item Number**

 
| PART I: FINANCIAL INFORMATION |                                                                                                                       |
|-------------------------------|----------------------------------------------------------------------------------------------------------------------------|
|                          |                                                                                                                       |   |
| Item 1.                       | Consolidated Financial Statements                                                                                          |   |
|                          | Consolidated Balance Sheets as of September  30, 2007 (Unaudited) and December 31, 2006                                    |   |
|                          | Consolidated Statements of Operations for  the three months and nine months ended September 30, 2007 and 2006  (Unaudited) |   |
|                          | Consolidated Statements of Cash Flows for  the nine months ended September 30, 2007 and 2006 (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 1A.                      | Risk Factors                                                                                                               |   |
|                          |                                                                                                                       |   |
| 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**

**ConsolidatedBalance Sheets**

 
| ** **                                                                                                                                                                                                                                      | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                      | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                      | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                                                                                 |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                                       |       | $                            | 2,107,371  |                        | $          | 5,469,366 |   |
| Accounts receivable, net of reserves of  $55,000 at September 30, 2007 and $14,000 at December 31, 2006,  respectively                                                                                                                     |       | 2,174,670                    |       | 2,100,266                   |       |
| Unbilled accounts receivable                                                                                                                                                                                                                    |       | 459,646                      |       | 677,624                     |       |
| Inventory                                                                                                                                                                                                                                       |       | 49,958                       |       | 111,389                     |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                       |       | 453,864                      |       | 491,483                     |       |
| Total current assets                                                                                                                                                                                                                            |       | 5,245,509                    |       | 8,850,128                   |       |
| Property and equipment, net                                                                                                                                                                                                                     |       | 1,348,981                    |       | 1,525,028                   |       |
| Goodwill                                                                                                                                                                                                                                        |       | 1,883,096                    |       | 1,776,051                   |       |
| Intangible assets, net                                                                                                                                                                                                                          |       | 1,403,743                    |       | 1,785,000                   |       |
| Unbilled accounts receivable, long-term                                                                                                                                                                                                         |       | 278,556                      |       | 424,469                     |       |
| Other assets                                                                                                                                                                                                                                    |       | 296,339                      |       | 66,730                      |       |
| Total assets                                                                                                                                                                                                                                    |       | $                            | 10,456,224 |                        | $          | 14,427,406 |   |
|                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                                                            |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                |       | $                            | 1,084,020  |                        | $          | 2,069,727 |   |
| Accrued liabilities                                                                                                                                                                                                                             |       | 1,719,655                    |       | 1,521,644                   |       |
| Deferred revenue, current                                                                                                                                                                                                                       |       | 4,101,649                    |       | 4,026,773                   |       |
| Capital lease obligations, current                                                                                                                                                                                                              |       | 92,879                       |       | 442,438                     |       |
| Amount due to seller                                                                                                                                                                                                                            |       | —                       |       | 562,090                     |       |
| Note payable, current                                                                                                                                                                                                                           |       | 561,234                      |       | 467,695                     |       |
| Total current liabilities                                                                                                                                                                                                                       |       | 7,559,437                    |       | 9,090,367                   |       |
| Long term liabilities:                                                                                                                                                                                                                          |       |                         |       |                        |       |
| Deferred rent                                                                                                                                                                                                                                   |       | 467,440                      |       | 498,348                     |       |
| Deferred revenue, long-term                                                                                                                                                                                                                     |       | 668,282                      |       | 436,086                     |       |
| Capital lease obligations, long-term                                                                                                                                                                                                            |       | 284,299                      |       | —                      |       |
| Note payable, long-term                                                                                                                                                                                                                         |       | 841,851                      |       | 1,216,007                   |       |
| Total liabilities                                                                                                                                                                                                                               |       | 9,821,309                    |       | 11,240,808                  |       |
|                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| 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 —  4,743,209 shares at September 30, 2007 and December 31, 2006;  Outstanding — 4,554,712 shares at September 30, 2007 and 4,432,101 shares at  December 31, 2006, respectively |       | 47,432                       |       | 47,432                      |       |
| Additional paid-in capital                                                                                                                                                                                                                      |       | 36,681,534                   |       | 36,668,927                  |       |
| Accumulated deficit                                                                                                                                                                                                                             |       | (34,469,448                  | )          | (31,608,373                 | )          |
| Treasury stock, at cost, 188,497 shares at  September 30, 2007 and 311,108 shares at December 31, 2006                                                                                                                                |       | (1,538,259                   | )          | (1,858,435                  | )          |
| Accumulated other comprehensive loss                                                                                                                                                                                                            |       | (86,344                      | )          | (62,953                     | )          |
| Total stockholders’ equity                                                                                                                                                                                                                 |       | 634,915                      |       | 3,186,598                   |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                 |       | $                            | 10,456,224 |                        | $          | 14,427,406 |   |

 

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

 

3

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**OMTOOL, LTD. AND SUBSIDIARIES**

**ConsolidatedStatements of Operations**

(Unaudited)

 
| ** **                                               | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                               | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenue:                                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Software license                                         |       | $                                                    | 1,212,104  |                                                | $          | 1,031,839 |   | $ | 3,540,879 |   | $ | 2,989,554 |   |
| Hardware and media                                       |       | 514,626                                              |       | 605,273                                             |       | 1,570,317 |   | 1,569,340 |   |
| Service and other                                        |       | 2,381,855                                            |       | 2,003,999                                           |       | 7,105,605 |   | 5,487,277 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Total revenue                                            |       | 4,108,585                                            |       | 3,641,111                                           |       | 12,216,801 |   | 10,046,171 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Cost of revenue:                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Software license                                         |       | 103,427                                              |       | 60,024                                              |       | 311,972 |   | 143,465 |   |
| Hardware and media                                       |       | 314,006                                              |       | 372,619                                             |       | 1,008,144 |   | 987,301 |   |
| Service and other                                        |       | 888,001                                              |       | 856,000                                             |       | 2,900,280 |   | 2,450,783 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Total cost of revenue                                    |       | 1,305,434                                            |       | 1,288,643                                           |       | 4,220,396 |   | 3,581,549 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Gross profit                                             |       | 2,803,151                                            |       | 2,352,468                                           |       | 7,996,405 |   | 6,464,622 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Operating expenses:                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Sales and marketing                                      |       | 1,555,984                                            |       | 1,992,144                                           |       | 5,622,928 |   | 6,203,344 |   |
| Research and development                                 |       | 624,390                                              |       | 664,335                                             |       | 2,234,152 |   | 2,095,889 |   |
| General and administrative                               |       | 686,590                                              |       | 809,438                                             |       | 2,538,534 |   | 2,527,866 |   |
| Restructuring costs                                      |       | —                                               |       | —                                              |       | 343,450 |   | — |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Total operating expenses                                 |       | 2,866,964                                            |       | 3,465,917                                           |       | 10,739,064 |   | 10,827,099 |   |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Loss from operations                                     |       | (63,813                                              | )          | (1,113,449                                          | )          | (2,742,659 | ) | (4,362,477 | ) |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Interest and other income                                |       | 21,504                                               |       | 39,440                                              |       | 69,536 |   | 128,071 |   |
| Interest expense                                         |       | (40,261                                              | )          | (8,908                                              | )          | (135,796 | ) | (14,010 | ) |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss                                                 |       | $                                                    | (82,570    | )                                                   | $          | (1,082,917 | ) | $ | (2,808,919 | ) | $ | (4,248,416 | ) |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss per share:                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and diluted                                        |       | $                                                    | (0.02      | )                                                   | $          | (0.27 | ) | $ | (0.62 | ) | $ | (1.06 | ) |
|                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted average shares used in per share  calculations: |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and diluted                                        |       | 4,557,292                                            |       | 4,013,722                                           |       | 4,526,510 |   | 4,021,447 |   |

 

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

 

4

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**OMTOOL,LTD. AND SUBSIDIARIES**

**ConsolidatedStatements of Cash Flows**

(Unaudited)

 
| ** **                                                                   | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Cash Flows from Operating Activities:                                        |       |                                                |       |   |   |
| Net loss                                                                     |       | $                                                   | (2,808,919 | ) | $ | (4,248,416 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                                |       |   |   |
| Depreciation and amortization                                                |       | 600,913                                             |       | 158,162 |   |
| Accounts receivable reserves                                                 |       | 41,099                                              |       | (16,602 | ) |
| Stock-based compensation                                                     |       | 265,484                                             |       | 247,023 |   |
| Changes in assets and liabilities:                                           |       |                                                |       |   |   |
| Accounts receivable                                                          |       | (104,274                                            | )          | (368,818 | ) |
| Unbilled accounts receivable                                                 |       | 363,891                                             |       | — |   |
| Prepaid expenses and other current assets                                    |       | 40,557                                              |       | (197,642 | ) |
| Inventory                                                                    |       | 61,431                                              |       | (14,856 | ) |
| Other assets                                                                 |       | (229,609                                            | )          | (41,568 | ) |
| Accounts payable                                                             |       | (993,118                                            | )          | 274,904 |   |
| Accrued liabilities                                                          |       | 185,413                                             |       | 194,587 |   |
| Deferred revenue                                                             |       | 293,017                                             |       | 596,587 |   |
| Deferred rent                                                                |       | (30,908                                             | )          | 404,874 |   |
|                                                                         |       |                                                |       |   |   |
| Net cash used in operating activities                                        |       | (2,315,023                                          | )          | (3,011,765 | ) |
|                                                                         |       |                                                |       |   |   |
| Cash Flows from Investing Activities:                                        |       |                                                |       |   |   |
| Additional purchase consideration for prior  period acquisition              |       | (107,045                                            | )          | — |   |
| Purchases of property and equipment                                          |       | (42,463                                             | )          | (971,230 | ) |
|                                                                         |       |                                                |       |   |   |
| Net cash used in investing activities                                        |       | (149,508                                            | )          | (971,230 | ) |
|                                                                         |       |                                                |       |   |   |
| Cash Flows from Financing Activities:                                        |       |                                                |       |   |   |
| Net proceeds from issuance of common stock                                   |       | 17,974                                              |       | 20,507 |   |
| Net proceeds from issuance of restricted  common stock                       |       | 1,452                                               |       | 622 |   |
| Forfeiture of restricted common stock                                        |       | (305                                                | )          | — |   |
| Purchase of treasury stock                                                   |       | —                                              |       | (153,332 | ) |
| Payment for amount due to seller                                             |       | (562,090                                            | )          | — |   |
| Principal payments for note payable                                          |       | (280,617                                            | )          | — |   |
| Principal payments for capital lease  obligations                            |       | (65,260                                             | )          | (27,342 | ) |
|                                                                         |       |                                                |       |   |   |
| Net cash used in financing activities                                        |       | (888,846                                            | )          | (159,545 | ) |
|                                                                         |       |                                                |       |   |   |
| Exchange rate effect on cash and cash  equivalents                           |       | (8,618                                              | )          | 37,739 |   |
|                                                                         |       |                                                |       |   |   |
| Net decrease in cash and cash equivalents                                    |       | (3,361,995                                          | )          | (4,104,801 | ) |
|                                                                         |       |                                                |       |   |   |
| Cash and cash equivalents, beginning of  period                              |       | 5,469,366                                           |       | 10,471,272 |   |
|                                                                         |       |                                                |       |   |   |
| Cash and cash equivalents, end of period                                     |       | $                                                   | 2,107,371  |   | $ | 6,366,471 |   |
| Supplemental Disclosure of Cash Flow  Information:                           |       |                                                |       |   |   |
| Cash paid during the period for interest                                     |       | $                                                   | 125,565    |   | $ | 14,010 |   |
| Property and equipment purchased under  capital lease                        |       | $                                                   | —     |   | $ | 493,736 |   |

 

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

 

5

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**OMTOOL, LTD. AND SUBSIDIARIES**

**Notes toConsolidated Financial Statements**

(Unaudited)

 

**(1) Basis of Presentation**

 

Omtool, Ltd. (“Omtool” or the “Company”)provides document and information handling solutions that control documentlifecycles and simplify the integration of paper and electronic documents inenterprise information systems. As a result of the Company’s acquisition ofBlueChip Technologies, Ltd. (“BlueChip”) in December 2006, the Companynow also provides electronic forms automation, document imaging and object archivingsolutions for the healthcare vertical market.

 

The accompanyingunaudited consolidated financial statements have been prepared by Omtoolpursuant to the rules and regulations of the Securities and Exchange Commission(“SEC”) regarding interim financial reporting. Accordingly, they do notinclude all of the information and footnotes required by generally acceptedaccounting principles for complete financial statements and should be read inconjunction with the consolidated financial statements and notes thereto forthe year ended December 31, 2006 as filed with the SEC as part of the Company’sAnnual Report on Form 10-K on March 26, 2007. The accompanying unauditedconsolidated financial statements reflect all adjustments (consisting of normalrecurring adjustments) that are, in the opinion of management, necessary for afair presentation of results for the interim periods presented. The results ofoperations for the three and nine month periods ended September 30, 2007 arenot necessarily indicative of the results to be expected for the full fiscalyear.

 

**(2)** **Net Loss Per Share**

 

TheCompany reports net loss per share in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 128,**“*Earnings per Share*.” Dilutedweighted average shares outstanding for the three and nine month periods ended September30, 2007 and 2006 exclude 432,660 and 405,000, respectively of potential commonshares from stock options and 51,000 shares for a common stock warrant becauseto include them would have been anti-dilutive for the periods presented giventhat the Company reported a net loss during these periods.

 

**(3) Income Taxes**

 

SFAS No. 109,**“*Accounting for Income Taxes*,”requires a valuation allowance to be recorded against deferred tax assets whenit is more likely than not that some or all of the deferred tax assets will notbe realized. As a result of cumulative losses in recent years and continuedeconomic uncertainty, the Company has provided a full valuation allowanceagainst its net deferred tax assets and will do so until it returns to anappropriate level of sustained taxable income. The ultimate realization ofthese deferred tax assets depends upon the Company’s ability to generatesufficient future taxable income. If the Company is successful in generatingsufficient future taxable income, the Company will reduce the valuationallowance through a reduction in income tax expense in the future.

 

As of January 1, 2007,the Company adopted the provisions of Financial Accounting Standards Board (“FASB”)Interpretation No. 48, *“Accounting forUncertainty in Income Taxes, an Interpretation of FASB Statement No. 109”*(“FIN 48”). The adoption of FIN 48, did not have a material impact onthe Company’s financial position or results of operations for the three and ninemonths ended September 30, 2007.

 

During the three and ninemonth periods ended September 30, 2007 and September 30, 2006, the Company didnot record an income tax benefit associated with any pre-tax loss due to theuncertainty regarding future taxable income.

 

**(4) Comprehensive Loss**

 

The components of theCompany’s comprehensive loss are as follows:

 
| ** **                               | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                               | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net loss                                 |       | $                                                    | (82,570    | )                                                   | $          | (1,082,917 | ) | $ | (2,808,919 | ) | $ | (4,248,416 | ) |
| Foreign currency translation adjustments |       | (11,168                                              | )          | (1,573                                              | )          | (23,391 | ) | 8,868 |   |
| Comprehensive loss                       |       | $                                                    | (93,738    | )                                                   | $          | (1,084,490 | ) | $ | (2,832,310 | ) | $ | (4,239,548 | ) |

 

6

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**(5) Acquisition**

 

On December 29, 2006, theCompany acquired all of the outstanding shares of BlueChip for $562,090 incash, $1,683,702 in a promissory note issued to BlueChip’s principalshareholder (“Seller”), 375,331 shares of the Company’s common stock(valued at $1,478,804), the issuance of vested options to purchase the Company’scommon stock in substitution for outstanding BlueChip stock options (valued at$368,090), and direct acquisition costs of $563,838, which consisted primarilyof financial advisory, legal and accounting services. The Company acquiredBlueChip in order to strengthen and expand its presence in the healthcarevertical market.

 

On December 31, 2006, the $562,090 owed to the Sellerwas classified in the accompanying consolidated balance sheet as “Amount due toseller.” This amount was paid in January 2007.

 

The promissory note that the Company issued to theSeller is payable in thirty-six equal monthly installments of approximately$47,000. The Company made the first principal and interest payment in April2007 and has made total payments of $379,038, consisting of principal andinterest, during the nine month period ended September 30, 2007.

 

Goodwill in the accompanying consolidated balancesheets as of September 30, 2007 and December 31, 2006, represents the excess ofthe purchase price over the net tangible and identifiable intangible assets forthe acquisition of BlueChip.

 

The changes in the carrying amount of goodwill were asfollows:

 
| ** **                                      | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Beginning of the period                         |       | $                            | 1,776,051  |                        | $          | — |   |
| Acquisition of BlueChip                         |       | —                       |       | 1,776,051                   |       |
| Additional purchase consideration for  BlueChip |       | 107,045                      |       | —                      |       |
| End of the period                               |       | $                            | 1,883,096  |                        | $          | 1,776,051 |   |

 

Additional purchaseconsideration for BlueChip for the nine month period ending September 30, 2007represents direct acquisition costs consisting of legal and accountingservices.

 

Gross carrying amounts and accumulated amortizationfor each intangible asset class were as follows:

 
| ** **                           | ** ** | **September 30, 2007** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **Gross Carrying  Amount**  | ** ** | **Accumulated  Amortization** | ** ** | **Net  Balances** | ** ** |
| Purchased technology                 |       | $                                | 774,000    |   | $ | 140,742 |   | $ | 633,258 |   |
| Customer contracts and relationships |       | 850,000                          |       | 210,902 |   | 639,098 |   |
| Trade names                          |       | 110,000                          |       | 16,863 |   | 93,137 |   |
| Non-compete agreements               |       | 51,000                           |       | 12,750 |   | 38,250 |   |
|                                 |       | $                                | 1,785,000  |   | $ | 381,257 |   | $ | 1,403,743 |   |

 
| ** **                           | ** ** | **December 31, 2006** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Balances** | ** ** |
| Purchased technology                 |       | $                               | 774,000    |   | $ | — |   | $ | 774,000 |   |
| Customer contracts and relationships |       | 850,000                         |       | — |   | 850,000 |   |
| Trade names                          |       | 110,000                         |       | — |   | 110,000 |   |
| Non-compete agreements               |       | 51,000                          |       | — |   | 51,000 |   |
|                                 |       | $                               | 1,785,000  |   | $ | — |   | $ | 1,785,000 |   |

 

The amortization periodfor identifiable intangible assets ranges from three to ten years.

 

7

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The estimated futureamortization expense of identifiable intangible assets for the three monthsended December 31, 2007 and each of the next five years, thereafter is asfollows:

 
| **Year ending December 31,** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2007                                        |       | $          | 127,087    |   |
| 2008                                        |       | 376,249    |       |
| 2009                                        |       | 307,265    |       |
| 2010                                        |       | 237,778    |       |
| 2011                                        |       | 196,694    |       |
| 2012                                        |       | 61,176     |       |
| Thereafter                                  |       | 97,494     |       |
| Total                                       |       | $          | 1,403,743  |   |

 

**(6) Stock-based Compensation**

 

The Company’s 1996 Stock Option Plan and 1997 Stock Plan, as amended,provide for the issuance of common stock pursuant to the grant to employees of “incentivestock options” within the meaning of the Internal Revenue Code and the grant ofnonqualified stock options, stock awards or opportunities to make directpurchases of stock in the Company to employees, consultants, directors, and officersof the Company. The 1997 Stock Planexpired on April 14, 2007. The Company’s 2007 Equity Compensation IncentivePlan (the “2007 Plan”) was approved by the board of directors on April16, 2007 and by the Company’s shareholders at the annual meeting ofshareholders on May 22, 2007. The 2007 Plan provides for the issuance of sharesof common stock to employees, consultants, directors and officers of theCompany much like the 1997 Stock Plan. The aggregate number of shares that canbe issued pursuant to the 2007 Plan is 500,000. As of September 30, 2007, 16,500shares had been issued under the 2007 Plan. Shares issued pursuant tothese plans are issued from treasury to the extent they are available.Stock-based compensation is accounted for in accordance with SFAS No. 123(R), “*Share-Based Payment*”**(“SFAS 123R”).

 

The Company incurredstock-based compensation expense for restricted common stock, stock options,and the employee stock purchase plan as follows:

 
| ** **                                                                      | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Stock-based compensation expense included  in cost of service and other revenue |       | $                                                    | 2,178      |                                                | $          | 4,267 |   | $ | 6,905 |   | $ | 11,310 |   |
| Stock-based compensation expense included  in operating expenses                |       | 92,776                                               |       | 75,902                                              |       | 258,579 |   | 235,713 |   |
| Total stock-based compensation expense                                          |       | $                                                    | 94,954     |                                                | $          | 80,169 |   | $ | 265,484 |   | $ | 247,023 |   |

 

***Stock Options***

 

Underthe terms of the Company’s 1996 Stock Option Plan, 1997 Stock Plan and 2007Plan, options vest and become exercisable as determined by the Board ofDirectors and expire 10 years after the date of grant. In 1997, theCompany’s Board of Directors voted that no further options would be grantedunder the Company’s 1996 Stock Option Plan. As the 1997 Stock Plan has expired,no further options will be granted under the 1997 Stock Plan. In accordancewith the 2007 Plan, stock options granted under this plan that are canceled orexpired are added back to the potential options available for future issuance. Stock option compensation expense calculatedunder the fair value approach is recognized ratably over the four year vestingperiod. The fair value for granted options was estimated at the time of grantusing the Black-Scholes option-pricing model. Based upon historical informationand management’s estimate of future voluntary turnover rates, theCompany has calculated this expense based on an annualized estimated forfeiture rate of 2%. The Company trues-upestimated forfeitures to actual forfeitures at the end of each reportingperiod. The Company did not grant any stock options during the nine monthsended September 30, 2007 and 2006. During the nine months ended September 30,2007, 5,196 shares of common stock were issued upon the exercise of outstandingoptions.

 

***Employee Stock Purchase Plan***

 

The1997 Employee Stock Purchase Plan (“ESPP”) provided for the issuance ofa maximum of 57,142 shares of common stock pursuant to the exercise ofnontransferable options granted to participating employees. The exercise pricefor the option for each six-month purchase period is 85% of the lesser of themarket price of the common stock on the first or last 

 

8

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businessday of the six-month purchase period. Employee stock purchase plan compensationexpense calculated under the fair value approach is recognized ratably over thesix-month purchase period. The weighted average fair value of the sharessubject to purchase under the employee stock purchase plan was $1.32 for the ninemonths ended September 30, 2007, based upon the following assumptions:

 
| ** **              | ** ** | **Nine months  Ended  September  30, 2007** | ** ** |
|-------------------------|------------|-------------------------------------------------------|------------|
| Risk-free interest rate |       | 5.1                                                   | %          |
| Volatility              |       | 57.0                                                  | %          |
| Expected dividend yield |       | 0.0                                                   |       |
| Expected life           |       | 0.5 Years                                             |       |

 

We relied on historical stock price information todetermine the expected volatility assumptions. The expected life is equal tothe six-month purchase period.

 

In July 2007, the Company terminated the ESPP.

 

***Restricted Common Stock***

 

TheCompany previously sold shares of restricted common stock (“restricted stock”)under the Company’s 1997 Stock Plan, to certain directors and employees of theCompany at a price per share of $0.01. The Company has continued to issueshares of restricted stock in a similar manner under the 2007 Plan. The sharesof restricted stock vest as determined by the board of directors, typicallyover a three- or four-year service period. In the event that a restrictedstockholder ceases to provide services to the Company prior to the vesting ofany of the then unvested shares held by that stockholder, the restrictedstockholder is required to sell any unvested shares of restricted stock back tothe Company at the original purchase price of $0.01 per share. Restrictedstock-based compensation expense calculated under the fair value approach is basedupon the current stock price and is recognized ratably over the three- or four-yearvesting period. Based upon historical information and management’s estimate offuture voluntary turnover rates, the Company has calculated this expense basedon an annualized estimated forfeiture rate of 10%. The Company trues-upestimated forfeitures to actual forfeitures at the end of each reporting period.During the nine months ended September 30, 2007, the Company sold a total of 145,175shares of restricted stock, to its Board of Directors and certain employees ofthe Company at a price per share of $0.01, of which 128,675 shares were issued underthe Company’s 1997 Stock Plan, as amended, and 16,500 shares were issued underthe 2007 Plan. During the nine months ended September 30, 2006, the Companysold 62,196 shares of restricted stock, under the Company’s 1997 Stock Plan, asamended, to its Board of Directors and certain employees of the Company at aprice per share of $0.01

 

Thefollowing is a summary of the Company’s nonvested restricted stock awards:

 
| ** **                        | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------|------------|----------------------------|------------|---------------------------------------------------------|------------|
| Nonvested, December 31, 2006 |       | 185,926                    |       | $                                                       | 6.58       |   |
| Granted                           |       | 145,175                    |       | 3.02                                                    |       |
| Vested                            |       | (29,825                    | )          | 7.32                                                    |       |
| Forfeited                         |       | (30,480                    | )          | 7.47                                                    |       |
| Nonvested, September 30, 2007     |       | 270,796                    |       | $                                                       | 4.49       |   |

 

9

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**(7) Accrued Liabilities**

 

Accrued liabilitiesconsist of the following:

 
| ** **                        | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Accrued health insurance expense  |       | $                            | 291,881    |                        | $          | 258,083 |   |
| Accrued state sales tax           |       | 309,810                      |       | 343,212                     |       |
| Accrued salary and salary-related |       | 716,026                      |       | 538,224                     |       |
| Accrued professional fees         |       | 146,598                      |       | 154,306                     |       |
| Other accrued expenses            |       | 255,340                      |       | 227,819                     |       |
|                              |       | $                            | 1,719,655  |                        | $          | 1,521,644 |   |

 

**(8)** **Capital Lease Obligations**

 

OnMay 1, 2006, the Company entered into a capital lease agreement in the amountof $491,000 to finance the purchase of furniture and equipment for the Company’sheadquarters located in Andover, Massachusetts. The lease has a five-year termwhich expires on May 31, 2011 and is payable in 60 equal monthly installments.The interest rate on the capital lease is 6.2%. Total interest payments overthe life of the lease are estimated to be $99,000. The lease contained aprovision whereby the Company is required to repay the outstanding principalbalance should the Company’s cash balance ever be less than $5,000,000. InJanuary 2007, the Company’s cash balance fell below $5,000,000. Accordingly, theentire principal balance of the capital lease in the amount of $442,438 wasclassified as a current liability in the Company’s consolidated balance sheetas of December 31, 2006.

 

OnAugust 6, 2007, the Company entered into an amendment to the aforementionedcapital lease that changed the Company’s required minimum cash balance from$5,000,000 to $2,100,000. In addition, on August 30, 2007, the Company enteredinto a pledge and security agreement with the capital financing provider that requiresa minimum balance of cash and cash equivalents of no less than $250,000 (“pledgedcollateral”) and in the event the Company’s cash balance falls below$250,000 the Company will immediately provide the amount necessary to coversuch shortfall to the capital financing provider. In the event of default inmaintaining the required amount of pledged collateral or the making of anylease payments, the pledged collateral will first be used as payment for costsand expenses incurred to enforce the security and pledge agreement and second forpayment in full of the outstanding principal loan balance. As of September 30,2007, the pledged collateral of $250,000 has been classified as “other assets”in the accompanying balance sheet.

 

Asof September 30, 2007, $92,879 has been classified as current capital leaseobligations and $284,299 has been classified as long-term capital leaseobligations.

 

**(9) NotePayable**

 

OnDecember 29, 2006, the Company issued a promissory note in the amount of$1,683,702 to the BlueChip Seller in partial consideration of all theoutstanding shares of BlueChip (See Note 5). The note is payable in thirty-sixequal monthly principal installments of approximately $47,000 plus interest,commencing on March 30, 2007. The promissory note bears interest on the unpaidprincipal amount at a rate per annum equal to (a) the Prime Rate as set forthin the Wall Street Journal Money Rates column on the last business day of eachmonth, which rate shall be deemed to be in effect for the entirety of suchmonth; plus (b) one percent. During the nine month period ended September 30,2007, the Company made total payments of $379,038, consisting of principalpayments totaling $280,617 and accumulated interest of $98,421, based upon anaverage interest rate of 9.25%.

 

**(10) RestructuringCosts**

 

SinceMarch 2007, the Company has reduced its headcount by thirty-one positionsconsisting of twelve positions that were eliminated in a March 2007 restructuringof certain operations, four positions that were eliminated in a restructuringthat the Company initiated in May 2007, and an additional fifteen positionsthat were eliminated due to non-replaced employee attrition.

 

Asa result of these cost reduction initiatives, the Company recorded a pre-taxcharge during the nine month period ended September 30, 2007 of $343,450, whichincluded $308,278 of severance-related costs and $35,172 of costs relating tothe closing of BlueChip’s former headquarters. The total cash impact of therestructuring was $343,450; and all of these amounts were paid in full duringthe nine month period ended September 30, 2007.

 

10

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**(11) Segment and Geographic Information**

 

To date, the Company hasviewed its operations and manages its business as principally one segment:software, hardware and media 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,**“*DisclosuresAbout Segments of an Enterprise and Related Information*.”

 

Totalrevenue from international sources was approximately $704,000 and $2,444,000for the three months and nine months ended September 30, 2007 and $585,000 and$1,535,000 for the three and nine months ended September 30, 2006,respectively.

 

The following tablerepresents amounts relating to geographic locations: 

 
| ** **       | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **       | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Total revenue(1) | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| United States    |       | $                                                    | 3,405,061  |                                                | $          | 3,056,310 |   | $ | 9,772,864 |   | $ | 8,511,444 |   |
| United Kingdom   |       | 218,657                                              |       | 146,129                                             |       | 936,205 |   | 482,435 |   |
| Canada           |       | 247,225                                              |       | 133,605                                             |       | 637,483 |   | 486,588 |   |
| South Africa     |       | 45,385                                               |       | 210,339                                             |       | 392,313 |   | 291,876 |   |
| Rest of World    |       | 192,257                                              |       | 94,728                                              |       | 477,936 |   | 273,828 |   |
|             |       | $                                                    | 4,108,585  |                                                | $          | 3,641,111 |   | $ | 12,216,801 |   | $ | 10,046,171 |   |

 

| ** **           | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------|------------|------------------------------|------------|-----------------------------|------------|
| Long-lived assets(2) |       |                         |       |                        |       |
| United States        |       | $                            | 5,189,733  |                        | $          | 5,549,313 |   |
| United Kingdom       |       | 20,982                       |       | 27,965                      |       |
|                 |       | $                            | 5,210,715  |                        | $          | 5,577,278 |   |

 

----

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

 

(2)             Long-livedassets include net property and equipment, goodwill, net intangible assets,long-term unbilled accounts receivable and other assets.

 

11

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**Item 2.**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS**

**OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Management’s Discussionand Analysis of Financial Condition and Results of Operations for the three andnine months ended September 30, 2007 should be read in conjunction with theaccompanying consolidated financial statements for the periods specified andthe associated notes. Further reference should be made to our Annual Report onForm 10-K for the year ended December 31, 2006, as filed with the SEC on March26, 2007.

 

**Overview**

 

We are a provider ofdocument and information-handling solutions that control document lifecyclesand simplify the integration of paper and electronic documents in enterpriseinformation systems. Our enterprise document-handling platform streamlines thecapture, conversion, and communication of any combination of paper andelectronic information, enabling fast, secure, and simultaneous distribution tomultiple destinations in multiple formats.

 

*Business*

 

InMarch 2007, we announced a restructuring of certain of our operations that hasresulted in a reduction in headcount of thirty-one positions and a reduction inother operating expenses. We are currently experiencing the benefit of thesecost cutting measures as our operating expenses decreased by approximately $1.2million in the third quarter of 2007 compared to the first quarter of 2007 andour net loss decreased from $1.9 million in the first quarter of 2007, to$779,000 in the second quarter and to $83,000 in the third quarter. Our threegoals in undertaking these cost reduction measures and restructuring ouroperations were: one, to achieve financial results that will enable us to be ator near cash flow break even by the end of fiscal year 2007; two, to enable oursales force to focus on selling our products to customers in the legal andhealthcare vertical markets directly and also in partnership with indirectsales channels, while allowing our partners to focus on selling our products tocustomers in the financial services and other vertical markets; and three, tosupport our integration of the BlueChip business.

 

Our gains in softwarelicense revenue from sales of our flagship product, AccuRoute®, have surpassedthe declines in revenue from our legacy fax business and, as a result, ourtotal revenue is growing as compared to last year. While our growing revenue indicatesthe success of our strategic plan, we still have challenges to address as weseek to expand our business, including expanding our sales in the legal,healthcare and financial services vertical markets; promoting our products andtechnologies through reseller and marketing relationships with leadingmulti-function device providers; and improving our results outside of theAmericas. Additionally, we have incurred quarterly losses since the quarterended September 30, 2005******and maycontinue to incur similar losses.

 

OnAugust 2, 2007, our common stock was delisted from The Nasdaq Capital Market (“Nasdaq”)for our failure to comply with Nasdaq’s continued listing requirements. Our commonstock is now quoted on the Over the Counter Bulletin Board, a regulatedquotation service that displays real-time quotes, last-sale prices and volumeinformation in over-the-counter equity securities, and the Pink Sheets, anelectronic quotation service for securities traded over-the-counter. Thetrading of our stock on the Over the Counter Bulletin Board and the Pink Sheetsmakes ourstock significantly less liquid, and may affect its value and couldsignificantly impair our ability to raise capital in the future should wechoose to do so.

 

In light of our current and historical operating results and thecontinuing challenges we face, and in order to maximize shareholder value, weare in an ongoing process of examining our operations as well as our strategicand financial alternatives. The strategic and financial options we may considercould include a variety of different business arrangements including, but notlimited to: combinations with or a sale to another entity; equity or debtfinancings; strategic partnerships and joint ventures; the sale or spin off ofcertain assets; the acquisition of complementary businesses, technologies orproduct lines; investments in new businesses; reorganization, recapitalization,or distribution alternatives; deregistering as a public company; or otheralternatives. We have engaged the investment banking firm of America’s GrowthCapital to assist us with the exploration of strategic and financialalternatives. Changes, if any, implemented as a result of the strategic andfinancial alternatives review could affect the basic nature of our Company. Forexample, deregistering as a public company common stock under the Exchange Actcould have an adverse effect on the market price of our common stock and wouldlikely mean that there would be less information about us available toshareholders and potential investors than what is currently contained in theperiodic reports we file pursuant to the Exchange Act.

 

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*Products*

 

AccuRoute, our flagship product, provides faster, moreefficient document workflows, while reducing cost, complexity, and the risk oflosing documents. We also include full enterprise fax capabilities integratedwithin our AccuRoute product. These solutions are used worldwide by businessesin document-intensive industries and sectors (such as legal, financialservices, government, and healthcare) that demand secure handling, integration,and tracking of documents in full compliance with a range of regulatory requirements.

 

Companies can deploy our software products onheterogeneous, multi-platform networks, digital scanning devices, andmulti-function peripherals and integrate them with both desktop and enterprisesoftware applications. To address customer needs, our products are modular andscaleable. As a result, customers can add additional communication capacitythrough the addition of system components and connectors to keep pace withgrowing demands. In addition, due to this scalable, modular design, customerscan add additional Omtool product servers to a configuration to providefailover redundancy, helping to ensure continuous operation.

 

Our GenifaxTM product is a multi-tieredclient/server solution for automating and integrating fax communication throughoutan enterprise. As a component of an enterprise software system, our Genifaxproduct is deployed on heterogeneous, multi-platform networks and integrateswith desktop and enterprise software applications.

 

Our GenidocsTM product is a client/servermessaging application that enables users to deliver documents through theInternet with comprehensive security and tracking to external parties. Genidocsoffers the security features and functionality of traditional, paper-basedcommunications with the speed, efficiency, and cost advantages of electroniccommunications.

 

Fax Sr., our legacy network fax product, is aclient/server software solution for automating and integrating faxcommunication throughout an enterprise. As an integrated component of an enterprisesoftware system, our Fax Sr. product is deployed on heterogeneous, multi-platformnetworks and integrates with desktop and enterprise software applications.

 

We continue to maintain Genidocs and Fax Sr. and earnrecurring maintenance revenue from our installed base, although we have notsold these products in recent periods. At this time, however, we do not haveplans to extend these technologies with new features or new releases.

 

We resell certain hardware products (such asintelligent fax boards) and media products (such as admission labels andpatient wristbands), which we purchase from third-party vendors as aconvenience to our customers, who alternatively can opt to obtain hardware andmedia directly from third-party vendors. We sell support contracts for thesoftware products that we license to our customers and offer certainconsulting, training, installation and implementation services for ourproducts.

 

***Products stemming from ouracquisition of BlueChip***

** **

Our December 2006 acquisition of BlueChip brought intoour product family document workflow solutions for the healthcare verticalmarket, as well as forms processing and document archiving technologies forother vertical markets. BlueChip also brings deep domain expertise andlongstanding customer relationships in the healthcare vertical market that willhelp to accelerate our penetration in that market. We are incorporatingBlueChip’s forms automation and document archiving functionalities into ourAccuRoute product line.

 

This acquisition has enabled us to extend ourAccuRoute product line to include the BlueChip solutions for document imagingand workflow systems for hospital admissions and billing functions, as well asBlueChip’s document archive product. The end result will be a robust suite ofproducts that are well-suited to handle the workflows of healthcare documents.Omtool’s Healthcare Suite of products includes:

 

•                  **ADT eFormsTM**-****a productionsystem****that provides hospitals with on-demandADT (admissions, discharge, and transfer) electronic forms for registration andpatient identification.

 

•                  **eForms StationTM** - an electronic forms library****that gives immediate access to a hospital’s custom libraryof electronic and printable forms.

 

13

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•                  **Image-InTM Point of Service**-****an imagecapture system that scans****images ofcommon non-clinical documents such as insurance cards, driver’s licenses,referral forms, and Health Insurance Portability and Accountability Actnotices, and displays them on a desktop paneled window.

 

•                  **Image-In Business**- a document and form capture system thatconverts paper-based business documents to electronic records.

 

•                  **Image-In Clinical** - a medical records scan facility thatenables users to capture fully the entire patient file after discharge.

 

•                  **Image-In Queue**- a document viewer****thatenables administrators to manage, view, and disseminate electronic documents tothe proper departments and/or patient files.

 

•                  **AccuRoute** - a document-handling platform that supportsdistributed document capture for scanning, routing, and archiving medicalinformation throughout the patient service cycle and provides document distributioninto the document workflow products found in Omtool’s Healthcare Suite.

 

•                  **ObjectArchiveTM**- an electronic archive that provides thefoundation to securely store information designed, developed, and capturedthrough any of the Omtool Healthcare Suite products.

 

*VerticalMarket Focus*

 

Threeyears ago, we introduced AccuRoute 2.0, our innovative document handlingplatform for enterprise document routing and managing the distributed capture,processing, distribution, and archiving of both paper and electronic documents.AccuRoute’s features are horizontal in nature and apply to many different markets,including the legal, healthcare, and financial services vertical markets. Werecently issued an extension to AccuRoute that provides greater functionalityin support of the e-filing requirements that are critical to many of our legalcustomers. Earlier this year, we announced expanded support for additionallitigation and document support systems as we continue to focus on improvingthe quality of and customer satisfaction with our products. Additionally, wecontinue to work on integrating our Healthcare Suite of products into ourAccuRoute product.

 

Ourposition in document handling in the legal vertical market will continue to bean area of primary focus for us, but in order to grow our business, we areexpanding on this focus. Based on our success in the legal vertical market, theindustry accolades about AccuRoute that we continue to receive from thirdparties (including industry experts), and the fact that AccuRoute salespresently represent approximately 78****percent of oursoftware license revenue, we see a large market opportunity for AccuRoute inother vertical market segments.

 

Whilewe have invested considerable resources to penetrate further the financialservices vertical market and have created and are pursuing opportunities withinthat vertical market, we have found that sales opportunities for our AccuRouteproduct in the financial services vertical market, though significant, arelonger term opportunities. Therefore, while we will continue to pursue theseopportunities, primarily working with our large strategic and channel partners,we believe the best opportunities for replicating our continued success in thelegal vertical market is in the healthcare vertical market. Similar to ourviews on the legal vertical market, and based on the high level of focus byhealthcare providers on electronic medical records, we see a significantopportunity to present AccuRoute as the solution of choice to the challenge ofcapturing the paper documents that are endemic in healthcare systems.

 

Weanticipate that the structure and buying patterns in the healthcare verticalmarket will present us with more near-term opportunities than the financialservices vertical market. Based on this view, in December 2006, weacquired BlueChip, a privately held provider of electronic forms automation,document imaging, and object archiving solutions for the healthcare verticalmarket. BlueChip provides complementary value to us through verticalmarket-specific document workflow solutions for healthcare providers, as wellas forms processing and document archiving technologies for other markets.Moreover, BlueChip brings deep domain expertise and longstanding customerrelationships in the healthcare vertical market that will help to accelerateour penetration in that market. We are incorporating BlueChip forms automationand document archiving functionalities into our AccuRoute product line.

 

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*Operating Results*

 

Our revenue consistsprimarily of software license revenue, hardware and media revenue, and serviceand other revenue, all as further described below. The following table is apresentation of our total revenue for the periods indicated:

 
| ** **                                    | ** ** | **Total Revenue** | ** ** | **Net Loss**    | ** ** | **Software License  Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|----------------------|------------|------------------------------------|------------|
| Three months ended September 30, 2007         |       | $4,108,585             |       | $(82,570)            |       | $1,212,104                         |       |
| Three months ended September 30, 2006         |       | $3,641,111             |       | $(1,082,917)         |       | $1,031,839                         |       |
| Change over same period of prior fiscal year  |       | $467,474  or 12.8%     |       | $1,000,347  or 92.4% |       | $180,265  or 17.5%                 |       |
| ** **                                    | ** ** | ** **             | ** ** | ** **           | ** ** | ** **                         | ** ** |
| Nine months ended September 30, 2007          |       | $12,216,801            |       | $(2,808,919)         |       | $3,540,879                         |       |
| Nine months ended September 30, 2006          |       | $10,046,171            |       | $(4,248,416)         |       | $2,989,554                         |       |
| Change over same period of prior fiscal  year |       | $2,170,630  or 21.6%   |       | $1,439,497  or 33.9% |       | $551,325  or 18.4%                 |       |

 

During the first nine months of 2007 as compared tothe first nine months of 2006, our revenue increased by approximately $2.2million and our net loss decreased by approximately $1.4 million fromapproximately $4.2 million to approximately $2.8 million. Our gross profit forthe nine months ended September 30, 2007 increased by approximately $1.5million as compared to the same period in the prior fiscal year due primarilyto an increase in revenue from our customers in the healthcare and legal verticalmarkets. Despite the costs associated with the additional employees that weadded from the BlueChip business, our operating expenses decreased byapproximately $88,000 in the first nine months of fiscal 2007 as compared tothe same period in 2006, due a reduction in expenses resulting from therestructuring plan adopted during the first quarter of fiscal year 2007. We areexperiencing the benefit of our cost cutting measures as our net loss decreasedfrom $1,948,000 in the first quarter of 2007, to $779,000 in the second quarterand to $83,000 in the third quarter. Excluding the restructuring charge, ouroperating expenses decreased by $431,000 during the nine month period endedSeptember 30, 2007 as compared to the same period in 2006.

 

The increase in totalrevenue of approximately $2.2 million during the nine months ended September 30,2007 as compared to the same period of 2006 was primarily due to the revenueassociated with the new healthcare customers we gained as a result of ouracquisition of BlueChip in December 2006. The revenue from these customersaccounted for approximately $1.9 million of our total revenue during the first ninemonths of fiscal year 2007. The contractual practices that we inherited fromBlueChip result in a delay in revenue recognition for contracts involving thesale of implementation services, because the contracts are written in such away that, when combined with BlueChip’s selling practices, they lackvendor-specific objective evidence (“VSOE”) for all elements in thecustomers’ orders. Therefore, we do not recognize software license revenue forproducts sold pursuant to these contracts until the products are actuallyinstalled, implemented and operating at the customer site. During the thirdquarter of fiscal year 2007, we fulfilled some customer contracts that weentered into during the first half of fiscal year 2007 and therefore were ableto recognize the associated revenue. As of September 30, 2007, our orderbacklog, which consists of invoiced and uninvoiced orders received but forwhich we could not recognize revenue, was approximately $297,000. We aremodifying those contractual practices so that we can book the associated revenuein a more timely fashion in future quarters.

 

We experienced a 66%increase in AccuRoute software license revenue due to increased AccuRoute salesin the legal and healthcare vertical markets and a 41% decrease in our legacyfax product line for the nine months ended September 30, 2007 as compared tothe same period in the prior fiscal year. We continue to experience generalmarket acceptance of our AccuRoute product in the legal vertical market whilethe demand for and our marketing of our legacy fax product has continued todecrease. We experienced an increase in service and other revenue for the ninemonths ended September 30, 2007 as compared to the same period in the priorfiscal year due to an increase in support revenue from our AccuRoute product,which was due in part to the addition of new customers that we gained as aresult of our acquisition of BlueChip.

 

Any decrease in demandfor our products would likely result in decreased revenue, which would, inturn, have a significant negative impact on our financial results because asignificant portion of our operating costs such as personnel, rent, anddepreciation costs are fixed in advance of a particular quarter. As a result, thecosts we incur for sales and 

 

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marketing, research and development, and general andadministrative could continue to increase as a percentage of our revenue,thereby negatively affecting our operating results.

 

In the coming months aswe continue to explore our strategic alternatives, our primary focus will be topenetrate further vertical and geographic markets through sales and marketinginvestments, primarily in the healthcare and legal vertical markets. At thesame time, we will continue developing our strategic relationships in thosemarkets, the financial services vertical market, and other vertical markets. Wewill continue these efforts through direct sales and our strategic and channelpartners, all with the goal of increasing AccuRoute sales opportunities inother vertical markets.

 

Sales from our Europeanoperations, which were in a steady decline for several years, have increased by30% during the first nine months of 2007 as compared to the first nine monthsof 2006. We remain optimistic that we will continue to see improvements outsidethe Americas, but for now, we will rely primarily on our U.S. salesorganization for our shorter-term growth. While total revenue from our legacyfax business continues to decline, the maintenance component of that businesshas remained stable during the first nine months of fiscal year 2007. Thisrecent stabilization and the continued growth of our AccuRoute business givesus confidence that our planned investments are warranted, as we believe theywill produce significant improvements in our financial results over time whencombined with our cost savings plan described herein.

 

The following is a presentation of our domestic and internationalrevenue:

 
| ** **                                    | ** ** | **Total Revenue** | ** ** | **United States Revenue**    | ** ** | **Non-United States Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|
| Three months ended  September 30, 2007        |       | $4,108,585             |       | $3,405,061  or 82.9% of Total  Revenue |       | $703,524  or 17.1% of Total  Revenue    |       |
|                                          |       |                   |       |                                   |       |                                    |       |
| Three months ended  September 30, 2006        |       | $3,641,111             |       | $3,056,310  or 83.9% of Total  Revenue |       | $584,801  or 16.1% of Total  Revenue    |       |
|                                          |       |                   |       |                                   |       |                                    |       |
| Change from same period  of prior fiscal year |       | $467,474  or 12.8%     |       | $348,751                               |       | $118,723                                |       |
| ** **                                    | ** ** | ** **             | ** ** | ** **                             | ** ** | ** **                              | ** ** |
| Nine months ended  September 30, 2007         |       | $12,216,801            |       | $9,772,864  or 80.0% of Total  Revenue |       | $2,443,937  or 20.0% of Total  Revenue  |       |
|                                          |       |                   |       |                                   |       |                                    |       |
| Nine months ended  September 30, 2006         |       | $10,046,171            |       | $8,511,444  or 84.7% of Total  Revenue |       | $1,534,727  or 15.3% of Total  Revenue  |       |
|                                          |       |                   |       |                                   |       |                                    |       |
| Change from same period  of prior fiscal year |       | $2,170,630  or 21.6%   |       | $1,261,420                             |       | $909,210                                |       |

 

We have historicallyderived a majority of our total revenue from sales within the United States. Revenuefrom outside of the United States increased by approximately $119,000 and $909,000,respectively, during the three and nine months ended September 30, 2007 ascompared to the same periods in 2006. The increase for the three month periodended September 30, 2007 is due to our overall revenue growth, while theincrease for the nine month period ended September 30, 2007 is due primarily tonew business from a customer located in the United Kingdom that purchased onelarge software license, a service agreement and other services. We willcontinue to leverage our AccuRoute base in Europe, as well as our indirectchannel relationships in Europe, to focus sales resources on the legal andfinancial services vertical markets in that region. However, we expect that inthe short-term U.S. sales are likely to constitute a greater percentage ofrevenue than sales outside the U.S. and there can be no assurance that we willbe able to increase international sales of our products. The failure to growour international sales may have a material adverse effect on our business,financial condition, and results of operations.

 

Our United Kingdomsubsidiary, Omtool Europe Limited, transacts business primarily in its localcurrency. We then translate results generated by that entity into U.S. dollarsand consolidate them with our domestic results for reporting purposes. As wesell our products to customers in a variety of countries, significant currencyexchange rate fluctuations could have a material impact on our results ofoperations. We manage our foreign currency exchange exposure by monitoring our 

 

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net monetary position using natural hedges of ourassets and liabilities denominated in local currencies. There can be noassurance that this policy will eliminate all foreign currency exchangeexposure. Foreign currency exposure has not been material to our financialposition or results of operations to date. If the volume of our businessdenominated in foreign currencies increases, we may be required to usederivatives to hedge foreign currency exposure.

 

We will continue toleverage our existing distribution channels, where appropriate, to broaden ourreach to our target vertical markets and further penetrate our installedcustomer base. We are pursuing sales opportunities through oursolution/reseller channels, as well as focusing sales efforts on specificmarket segments, in order to facilitate acceptance of our products. However, asshown in the following table, in recent periods, more of our sales resourceshave been focused on selling directly to customers and we have consequentlyderived a significant portion of our revenue from direct sales:

 
| ** **                                    | ** ** | **Total Software  License,  Hardware and  Media  Revenue** | ** ** | **Software License,  Hardware and Media  Revenue from  Indirect Distribution  Channel Sales** | ** ** | **Software License,  Hardware and Media  Revenue From  Indirect Distribution  Channel Sales as a  Percentage of Total  Software License,  Hardware and  Media Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $1,726,730                                                           |       | $481,709                                                                                                                    |       | 27.9%                                                                                                                                                                                                                                    |       |
| Three months ended September 30, 2006         |       | $1,637,112                                                           |       | $561,204                                                                                                                    |       | 34.3%                                                                                                                                                                                                                                    |       |
| Change from same period of prior fiscal  year |       | $89,618  or 5.5%                                                     |       | $(79,495)  or (14.2)%                                                                                                       |       | (6.4) percentage  points (“ppt”)                                                                                                                                                                                               |       |
|                                          |       |                                                                 |       |                                                                                                                        |       |                                                                                                                                                                                                                                     |       |
| Nine months ended September 30, 2007          |       | $5,111,196                                                           |       | $1,447,841                                                                                                                  |       | 28.3%                                                                                                                                                                                                                                    |       |
| Nine months ended September 30, 2006          |       | $4,558,894                                                           |       | $1,851,799                                                                                                                  |       | 40.6%                                                                                                                                                                                                                                    |       |
| Change from same period of prior fiscal  year |       | $552,302                                                             |       | $(403,958)                                                                                                                  |       | (12.3) ppt                                                                                                                                                                                                                               |       |
|                                          |       | or 12.1%                                                             |       | or (21.8)%                                                                                                                  |       |                                                                                                                                                                                                                                     |       |

 

**Critical Accounting Policies and Estimates**

 

We have identified thepolicies and estimates below as critical to our business operations and theunderstanding of our results of operations. The impact and any associated risksrelated to these policies on our reported and expected financial results andbusiness operations are discussed in appropriate sections throughout Management’sDiscussion and Analysis of Financial Condition and Results of Operations. Ourpreparation of this Form 10-Q required us to make estimates andassumptions that affect the reported amount of assets and liabilities, thedisclosure of contingent assets and liabilities as of the date of the financialstatements included herein and the reported amounts of revenue and expensesduring the period covered by this report. There can be no assurance that actualresults will not differ materially from those estimates.

 

*RevenueRecognition and Accounts Receivable Reserves.*Wederive our revenue primarily from two sources: (i) product revenue, whichincludes software license, hardware, and media revenue, and (ii) serviceand support revenue, which includes software maintenance and support,installation, implementation, training, and consulting revenue. We license oursoftware products on a perpetual basis. We generate revenue from licensing therights to use our software products and sales of hardware directly to end-usersand indirectly through resellers. Our resellers order products from us based onpurchase orders received from end-users and do not order stock. We generallysell our products to resellers and directly to end-users without anyspecifically stated rights of return. Occasionally, however, in our solediscretion, we will accept a product return if the end-user finds that theproduct does not fit its needs. We sell hardware and media products, which areprovided by a third-party, at cost plus an additional mark-up, directly toend-users and, in the case of hardware, indirectly through resellers as well. Thehardware products that we resell are not functional without our software. Tosupport our software products, we sell software maintenance and support,installation, implementation, training, and consulting services directly toend-users and indirectly through resellers.

 

We apply the provisions of Statement of Position (“SOP”)97-2,**“*Software Revenue Recognition*,”as amended by SOP 98-9, Modification of SOP 97-2,**“*Software Revenue Recognition with Respect to CertainTransactions*” (“SOP 98-9”), to all transactionsinvolving the sale of multiple elements including software, hardware andservice revenue. We apply the provisions of  SFAS No. 48,**“*Revenue Recognition When Right of Return Exists*,”with respect to providing for potential future product returns. As describedbelow, we must make and use significant judgments and estimates in connectionwith the revenue recognized in any accounting period. Material differences mayhave resulted in the amount and timing of our revenue if we had made differentjudgments or utilized different estimates.

 

17

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We recognize revenue from the sale of softwareproducts, hardware and media to both end-users and resellers when persuasiveevidence of an arrangement exists, the products have been delivered, the fee isfixed or determinable, collection of the resulting receivable is probable, andthere are no uncertainties regarding customer acceptance. We maintain a reservefor potential product returns. We sell monthly, annual, and multiple-yearmaintenance contracts and the associated revenue is recognized over the term ofthe related maintenance period, beginning on the date of delivery. We recognizeother service revenue as we perform the associated services. If an arrangementincludes an acceptance provision and acceptance is uncertain, then we willdefer all revenue until the customer accepts the products purchased. Acceptancein these instances generally occurs upon the earlier of receipt of a writtencustomer acceptance or expiration of the acceptance period. If an arrangementincludes an acceptance provision tied to determination that our product meetspublished specifications and there are no uncertainties with regard to thecustomer’s acceptance, then we will recognize revenue at the time of sale,provided that all of the other previously mentioned revenue recognitioncriteria have been met and the acceptance period is of short duration.

 

Our transactions frequently involve the sale ofsoftware, hardware, and related services under multiple element arrangements.Revenue under multiple element arrangements is allocated to each element, tothe extent VSOE of fair value exists, under the residual method, in accordancewith SOP 98-9. Under this method, revenue is allocated first to all undeliveredelements, such as services, based on the fair value of those elements, which iscalculated to be the price charged when these elements are sold separately andunaccompanied by other elements. Our services generally are not essential tothe functionality of the software, as these services do not alter thecapabilities of the software and do not carry a significant degree of risk toperform. The amount allocated to the delivered elements, such as softwarelicense and hardware revenue, is the difference between the total arrangementvalue and the amount allocated to the undelivered elements. If the deliveredelements include both software and hardware, the amount allocated to hardwarerevenue is based on the price charged to us by the third party vendor plus anadditional mark up, with the remainder allocated to software revenue. To theextent that a discount is offered in the arrangement, the entire discount isallocated to the delivered element or elements. If the delivered elementsinclude hardware and software, the discount is allocated to the hardware andsoftware based on their respective list prices.

 

For our suite of products for the healthcare verticalmarket that we acquired in the BlueChip acquisition, we have established VSOEof fair value for our support services and installation services but not forthe software license or implementation services provided to our customers. Wheneverthe software license, implementation services, installation services andsupport services are sold together, we first allocate revenue to the support servicesand installation services based upon the respective fair value. The remainingrevenue is then allocated to the software license and implementation services. Recognitionof revenue from software licenses sold with implementation services isrecognized once the software license has been delivered and the implementationservices have been completed. We are currently working towards establishingVSOE for the implementation services provided to these customers.

 

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

 

At the time of a transaction, we assess whether thefee associated with the transaction is fixed or determinable and whether or notcollection is probable. If a significant portion of a fee is due beyond ournormal payment terms, which are thirty to sixty days from invoice date, weaccount for the fee as not being fixed or determinable. In these cases, werecognize revenue as the fees become due. We assess collectability based on anumber of factors, including past transaction history with the customer and thecreditworthiness of the customer. We review Dunn & Bradstreet creditreports for all of our resellers and adjust our credit limits with thoseresellers accordingly. If a particular reseller does not have a favorablereport or if we do not have enough credit information to determine whether thereseller is creditworthy then we would typically sell to that reseller on cashon delivery terms. We do not request collateral from our customers. If wedetermine that collection of a fee is not reasonably assured, the fee isdeferred and revenue is recognized at the time collection becomes probable,which is generally upon receipt of payment.

 

We maintain reserves for potential product returns andmake adjustments to these reserves as needed based on historical product returnrates. We also consider the impact of new product introductions, changes incustomer demand, and acceptance of our products on the adequacy of thesereserves. Our calculation of the estimated return reserve is based upon(1) an account-specific review of potential returns, where a returnprobability is known; and (2) an estimate based upon past historicalreturns as a percentage of revenue. We must make and use significant judgmentsand estimates in connection with establishing the product returns reserve inany accounting period. Material differences may have resulted in the amount andtiming of revenue for this or any prior period if we made different judgmentsor utilized different estimates.

 

18

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As with the product return reserve, we must makeestimates of our ability to collect on our accounts receivable. We record tradeaccounts receivable at the invoiced amount and these accounts do not bearinterest. We specifically analyze accounts receivable, historical bad debts,customer creditworthiness, current economic trends, and changes in customerpayment patterns when evaluating the adequacy of our allowance for doubtfulaccounts. We review our allowance for doubtful accounts on a monthly basis. Ourcalculation of the estimated accounts receivable reserve is also based upon(1) an account-specific review of potential uncollectible accounts, wherea bad debt probability is known; and (2) an estimate based upon pasthistorical bad debts as a percentage of accounts receivable. We do not have anyoff-balance-sheet credit exposure to our customers.

 

Our combined accounts receivable and product returnsreserve was $55,000 and $14,000 at September 30, 2007 andDecember 31, 2006, respectively. Both components of calculating theestimated reserve — specific identification and historic experience —are material judgments that we make. We base these judgments on historictrends, taking into consideration current business and economic conditions,which could change materially, thus changing the required reserve levelmaterially. The potential change to the size of our required reserve could bepositive in the event the reserve estimate proves unnecessary, or negative, ifthe reserve proves inadequate.

 

Our deferred revenue is comprised mainly of revenuethat is deferred for software maintenance and support contracts as well assales of our products targeted to the healthcare vertical market that involveboth the sale of software and implementation services for which theimplementation services have not yet been performed and accepted by thecustomer. The other components of deferred revenue are amounts from salestransactions that were deferred because they did not meet all of the provisionsof our revenue recognition policy.

 

*SoftwareDevelopment Costs.*We consider software developmentcosts for capitalization when technological feasibility is established inaccordance with SFAS No. 86,**“*Accountingfor the Costs of Computer Software To Be Sold, Leased or Otherwise Marketed*.” We sell software in a market that issubject to rapid technological change, new product introductions, and changingcustomer needs. Accordingly, we have determined that we cannot ascertaintechnological feasibility until the development state of the product is nearlycomplete. The time period during which cost could be capitalized from the pointof reaching technological feasibility until the time of general product releaseis very short and, consequently, the amounts that might be capitalized are notmaterial to our consolidated financial position or results of operations. Therefore,we charge all software development costs to operations in the period incurred.

 

*Goodwill and Intangible Assets.*Weaccount for goodwill in accordance with SFAS No. 142 “*Goodwill andOther Intangible Assets*” (“SFAS 142”). Goodwill representsthe excess of purchase price in a business combination over the fair value ofnet tangible and intangible assets acquired. In accordance with SFAS 142,goodwill amounts are not amortized, but rather are tested for impairment atleast annually. Intangible assets that are not considered to have an indefiniteuseful life are amortized over their useful lives, which range from three toten years.

 

*Weaccount for intangible assets in accordance with SFAS No. 144 “*Accountingfor the Impairment or Disposal of Long-Lived Assets.”  Intangible assets includecustomer contracts and relationships, purchased technology, trade names, andnon-compete agreements. The carrying amount of the intangible assets isreviewed whenever events or changes in circumstances indicate that the carryingvalue of an asset may not be recoverable. Recoverability of these intangibleassets is measured by comparison of the carrying amount of the asset to thefuture undiscounted cash flows the asset is expected to generate. If theintangible asset is considered to be impaired, the amount of any impairment ismeasured as the difference between the carrying value and the fair value of theimpaired asset.

* *

We account for business combinations in accordancewith SFAS No. 141, “*Business Combinations*”**(“SFAS 141”), whichrequires the use of the purchase method of accounting for business combinations.In accordance with SFAS 141, we determine the recognition of intangibleassets based on the following criteria: (i) the intangible asset arisesfrom contractual or other rights; or (ii) the intangible asset isseparable or divisible from the acquired entity and capable of being sold,transferred, licensed, returned, or exchanged. In accordance withSFAS 141, we allocate the purchase price of our business combinations tothe tangible assets, liabilities, and intangible assets acquired, includingin-process research and development, based on their estimated fair values. Theexcess purchase price over those fair values is recorded as goodwill.

 

*Stock Based Compensation.*EffectiveJanuary 1, 2006, we adopted the provisions of SFAS 123R, using the modifiedprospective method. SFAS 123R requires us to measure the cost of employeeservices in exchange for an award of an equity instrument based on thegrant-date fair value of the award and to recognize expense over the requisiteservice period. Under the modified prospective method, financial statements forperiods prior to the date of adoption are not adjusted for the change inaccounting, thus, prior period financial statements have not been restated.However, compensation expense is recognized for (a) all share-based paymentsgranted after the effective date and (b) all awards granted to employees priorto

 

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the effective date that remain unvested on theeffective date. Based upon historical information and management’s estimate offuture voluntary turnover rates, we have calculated our stock-basedcompensation expense using an annualized estimated forfeiture rate of 10% forrestricted stock and 2% for stock options. Estimated forfeitures are trued-upto actual forfeitures at the end of each reporting period.

 

On November 10, 2005, FASB issued FASB Staff PositionFAS 123R-3 “*Transition Election Related to Accounting for TaxEffects of Share-Based Payment Awards.*”  The Company elected to adopt the alternativetransition method provided by the FASB Staff Position for calculating the taxeffects (if any) of stock-based compensation expense pursuant to SFAS 123R. Thealternative transition method includes simplified methods to establish thebeginning balance of the additional paid-in-capital pool related to the taxeffects of employee stock-based compensation, and to determine the subsequentimpact to the additional paid-in-capital pool and the consolidated statementsof operations and cash flows of the tax effects of employee stock-basedcompensation awards that are outstanding upon adoption of SFAS 123R.

 

*Taxes.*We are required to estimate our income and state salestaxes. This process involves estimating our actual current tax obligations,while also assessing differences resulting from the different treatment ofitems for tax and accounting purposes that result in deferred income tax assetsand liabilities and accrued state sales tax liabilities. We include deferredincome tax assets and liabilities and accrued state sales tax liabilities inour consolidated balance sheet.

 

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

 

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

 

We estimate accrued state sales taxes for each reportingperiod based on tax rates in effect for the reporting periods in each of thestates where we have a potential nexus and for the time period during which wehave that nexus. The assumptions and estimates used to determine this liabilityare subject to change as they are difficult to measure or value. In the eventthat actual results differ from these estimates, our state sales tax expensecould be materially impacted.

 

**New Accounting Pronouncements**

 

In September 2006, theFASB issued Statement No. 157 “*Fair Value Measurements*”**(“SFAS 157”), which establishes a framework formeasuring fair value in generally accepted accounting principles and expandsdisclosures about fair value financial instruments. SFAS 157 becomes effectivefor fiscal years beginning after November 15, 2007. We will adopt thisstatement prospectively once it is effective and applicable to us. We do notexpect SFAS 157 to have a material impact on our financial position or resultsof operations.

 

In February 2007, the FASB issued SFAS No.159 “*The Fair Value Option for Financial Assets andFinancial Liabilities*”**(“SFAS 159”),which permits entities to choose to measure many financial instruments andcertain other items at fair value. SFAS 159 becomes effective for fiscal yearsbeginning after November 15, 2007. We will adopt this statement prospectively once it is effective andapplicable to us. We do not expect theadoption of SFAS 159 to have a material impact on our financial position orresults of operations.

 

20

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**Results of Operations**

 

The following table sets forth certain financial datafor the periods indicated as a percentage of total revenue:

 
| ** **                 | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                 | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenue:                   |       |                                                 |       |                                                |       |   |   |   |   |
| Software license           |       | 29.5                                                 | %          | 28.4                                                | %          | 29.0 | % | 29.8 | % |
| Hardware and media         |       | 12.5                                                 |       | 16.6                                                |       | 12.9 |   | 15.6 |   |
| Service and other          |       | 58.0                                                 |       | 55.0                                                |       | 58.1 |   | 54.6 |   |
| Total revenue              |       | 100.0                                                |       | 100.0                                               |       | 100.0 |   | 100.0 |   |
| Cost of revenue:           |       |                                                 |       |                                                |       |   |   |   |   |
| Software license           |       | 2.5                                                  |       | 1.6                                                 |       | 2.5 |   | 1.4 |   |
| Hardware and media         |       | 7.7                                                  |       | 10.2                                                |       | 8.3 |   | 9.8 |   |
| Service and other          |       | 21.6                                                 |       | 23.5                                                |       | 23.7 |   | 24.4 |   |
| Total cost of revenue      |       | 31.8                                                 |       | 35.3                                                |       | 34.5 |   | 35.6 |   |
| Gross profit               |       | 68.2                                                 |       | 64.7                                                |       | 65.5 |   | 64.4 |   |
| Operating expenses:        |       |                                                 |       |                                                |       |   |   |   |   |
| Sales and marketing        |       | 37.9                                                 |       | 54.7                                                |       | 46.0 |   | 61.7 |   |
| Research and development   |       | 15.2                                                 |       | 18.3                                                |       | 18.3 |   | 20.9 |   |
| General and administrative |       | 16.7                                                 |       | 22.2                                                |       | 20.8 |   | 25.2 |   |
| Restructuring costs        |       | 0.0                                                  |       | 0.0                                                 |       | 2.8 |   | 0.0 |   |
| Total operating expenses   |       | 69.8                                                 |       | 95.2                                                |       | 87.9 |   | 107.8 |   |
| Loss from operations       |       | (1.6                                                 | )          | (30.5                                               | )          | (22.4 | ) | (43.4 | ) |
| Interest and other income  |       | 0.5                                                  |       | 1.0                                                 |       | 0.5 |   | 1.2 |   |
| Interest expense           |       | (0.9                                                 | )          | (0.2                                                | )          | (1.1 | ) | (0.1 | ) |
|                       |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss                   |       | (2.0                                                 | )%         | (29.7                                               | )%         | (23.0 | )% | (42.3 | )% |
|                       |       |                                                 |       |                                                |       |   |   |   |   |
| Gross profit:              |       |                                                 |       |                                                |       |   |   |   |   |
| Software license           |       | 91.5                                                 | %          | 94.2                                                | %          | 91.2 | % | 95.2 | % |
| Hardware and media         |       | 39.0                                                 |       | 38.4                                                |       | 35.8 |   | 37.1 |   |
| Service and other          |       | 62.7                                                 |       | 57.3                                                |       | 59.2 |   | 55.3 |   |

 

**Revenue**

 

*Software License. *During the three and nine month periods ended September 30, 2007, weexperienced an increase in our software license revenue as compared to the sameperiods in the prior fiscal year. This increase was due to greater revenue fromsales of our AccuRoute product, due in part to the addition of former BlueChipcustomers, which was offset in part by a decrease in revenue from sales of ourlegacy fax products. We continue to experience general market acceptance of ourAccuRoute product in the legal vertical market while the demand for and ourmarketing of our legacy fax product has continued to decrease.

 

During the three months and nine months ended September30, 2007, our software license revenue by product category, as compared to thesame period in the prior fiscal year was as follows:

 
| ** **                                    | ** ** | **Total  Revenue**   | ** ** | **Software  License  Revenue** | ** ** | **AccuRoute  License  Revenue** | ** ** | **Legacy Fax  License  Revenue** | ** ** | **Freight and  Allowances  for Returns** | ** ** |
|-----------------------------------------------|------------|----------------------|------------|--------------------------------|------------|---------------------------------|------------|---------------------------------------|------------|----------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $4,108,585           |       | $1,212,104                     |       | $896,444                        |       | $299,711                              |       | $15,949                                            |       |
| Three months ended September 30, 2006         |       | $3,641,111           |       | $1,031,839                     |       | $541,872                        |       | $491,521                              |       | $(1,554)                                           |       |
| Change from same period of prior fiscal  year |       | $467,474  or 12.8%   |       | $180,265  or 17.5%             |       | $354,572  or 65.4%              |       | $(191,810)  or (39.0)%                |       | $17,503  or 1,126.3%                               |       |
|                                          |       |                 |       |                           |       |                            |       |                                  |       |                                               |       |
| Nine months ended September 30, 2007          |       | $12,216,801          |       | $3,540,879                     |       | $2,760,956                      |       | $769,626                              |       | $10,297                                            |       |
| Nine months ended September 30, 2006          |       | $10,046,171          |       | $2,989,554                     |       | $1,664,235                      |       | $1,313,763                            |       | $11,556                                            |       |
| Change from same period of prior fiscal  year |       | $2,170,630  or 21.6% |       | $551,325  or 18.4%             |       | $1,096,721  or 65.9%            |       | $(544,137)  or (41.4)%                |       | $(1,259)  or (10.9)%                               |       |

 

 

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During the three months endedSeptember 30, 2007, our software license revenue increased as a percentage oftotal revenue compared to the same period in 2006 due to a 65% increase insales of our AccuRoute product. During the nine months ended September 30, 2007,our software license revenue represented a slightly decreased percentage of ourtotal revenue as compared to the same period in 2006, due primarily to anincrease in service and other revenue as discussed in greater detail below.

 

| ** **                                    | ** ** | **Software License Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | 29.5%                                                                                             |       |
| Three months ended September 30, 2006         |       | 28.3%                                                                                             |       |
| Change from same period of prior fiscal  year |       | 1.2ppt                                                                                            |       |
| ** **                                    | ** ** | ** **                                                                                        | ** ** |
| Nine months ended September 30, 2007          |       | 29.0%                                                                                             |       |
| Nine months ended September 30, 2006          |       | 29.8%                                                                                             |       |
| Change from same period of prior fiscal  year |       | (0.8)ppt                                                                                          |       |

 

The results for the three months and nine months endedSeptember 30, 2007 and September 30, 2006 demonstrate that our software licenserevenue continues to shift toward our AccuRoute product, as displayed in thetable below, which summarizes revenue from our major product lines as apercentage of our total software license revenue:

 
| ** **                                    | ** ** | **AccuRoute License Revenue as  a Percentage of Software  License Revenue** | ** ** | **Legacy Fax License  Revenue as a Percentage of  Software License Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | 74.0%                                                                                                          |       | 24.7%                                                                                                                |       |
| Three months ended September 30, 2006         |       | 52.5%                                                                                                          |       | 47.6%                                                                                                                |       |
| Change from same period of prior fiscal  year |       | 21.5ppt                                                                                                   |       | (22.9)ppt                                                                                                            |       |
| ** **                                    | ** ** | ** **                                                                                                     | ** ** | ** **                                                                                                           | ** ** |
| Nine months ended September 30, 2007          |       | 78.0%                                                                                                          |       | 21.7%                                                                                                                |       |
| Nine months ended September 30, 2006          |       | 55.7%                                                                                                          |       | 43.9%                                                                                                                |       |
| Change from same period of prior fiscal  year |       | 22.3ppt                                                                                                        |       | (22.2)ppt                                                                                                            |       |

 

Thisshift toward AccuRoute revenue is due to the continued market acceptance ofAccuRoute in the legal vertical market, the decline in our legacy fax business andthe increase in revenue from our newly acquired healthcare customers, whichfalls under our AccuRoute product line.

 

*Hardware and Media.* Hardware and media revenue decreased during the three month period ended September30, 2007 as compared to the same period in 2006. Included in hardware and mediarevenue for the three and nine month periods ended September 30, 2007 is $124,000and $438,000, respectively, of media revenue that we added during these periodsas a result of our acquisition of BlueChip. The decrease in hardware and mediarevenue for the third quarter of fiscal year 2007 was due primarily to adecrease in sales of our legacy fax products which are the main driver for ourhardware sales. This decrease was offset in part by the media component of ourrevenue, which we added as a result of the acquisition of BlueChip. Hardware andmedia revenue for the first nine months of 2007 is consistent with the firstnine months of 2006. 

 
| ** **                                    | ** ** | **Hardware and Media  Revenue** | ** ** | **Hardware and Media  Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $514,626                                  |       | 12.5%                                                                                                |       |
| Three months ended September 30, 2006         |       | $605,273                                  |       | 16.6%                                                                                                |       |
| Change from same period of prior fiscal  year |       | $(90,647)  or (15.0)%                     |       | (4.1) ppt                                                                                            |       |
|                                          |       |                                      |       |                                                                                                 |       |
| Nine months ended September 30, 2007          |       | $1,570,317                                |       | 12.9%                                                                                                |       |
| Nine months ended September 30, 2006          |       | $1,569,340                                |       | 15.6%                                                                                                |       |
| Change from same period of prior fiscal  year |       | $977  or 0.0%                             |       | (2.7) ppt                                                                                            |       |

 

*Service and Other. *Service and other revenue, which consists primarily of the sale of supportcontracts to complement software products sold to customers and, to a lesserextent, consulting, training, and installation services, increased in the threeand nine month periods ended September 30, 2007 as compared to the same periodsin the prior fiscal year.  This increase was due to the addition ofservice and other revenue that resulted from our December 2006 acquisition of

 

22

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BlueChip, as well as anincrease of 36% and 47% for the three and nine month periods ended September30, 2007, respectively, in support revenue from our AccuRoute product.

 
| ** **                                    | ** ** | **Service and Other Revenue** | ** ** | **Service and Other Revenue as  a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $2,381,855                                   |       | 58.0%                                                                                                   |       |
| Three months ended September 30, 2006         |       | $2,003,999                                   |       | 55.0%                                                                                                   |       |
| Change from same period of prior fiscal  year |       | $377,856  or 18.9%                           |       | 3.0 ppt                                                                                                 |       |
| ** **                                    | ** ** | ** **                                   | ** ** | ** **                                                                                              | ** ** |
| Nine months ended September 30, 2007          |       | $7,105,605                                   |       | 58.2%                                                                                                   |       |
| Nine months ended September 30, 2006          |       | $5,487,277                                   |       | 54.6%                                                                                                   |       |
| Change from same period of prior fiscal  year |       | $1,618,328  or 29.5%                         |       | 3.6 ppt                                                                                                 |       |

 

We are focused onimproving the renewal rate of software maintenance contracts with our existingcustomer base in the United States, Europe, and other non-U.S. locations, andwe continue to focus our attention on generating additional service and otherrevenue in future quarters.

 

**Cost of Revenue**

 

*SoftwareLicense. * Cost of software license revenue consistsprimarily of the costs we incur in sublicensing third-party software products,purchasing product media, and contracting for product duplication, as well as theamortization of purchased technology.  Cost of software license revenuefor the three and nine month periods ended September 30, 2007 increased ascompared to the corresponding periods in the previous fiscal year.  Thisincrease is due primarily to the amortization of purchased technologyassociated with our acquisition of BlueChip, which is being amortized over itsestimated future life of five years. To a lesser extent, our cost of softwarelicense revenue increased during the nine month period September 30, 2007 dueto a higher royalty fees. We have recently revised some of our royaltycontracts so that our fees are fixed and not dependent upon the number of unitssold. As a result, our cost of software license revenue will tend to be moreconsistent quarter-over-quarter, but our gross margins may fluctuate dependingupon our volume of revenue. We may license additional third-party softwarecomponents in the future and, if that were to happen, we would expect that ourcost of software license revenue as a percentage of software license revenuewould increase slightly.

 

As a result of the increase in the cost of software license revenuethat we incurred during the first nine months of 2007, we incurred a decreasein our software license gross margin percentage as set forth in the followingtable:

 
| ** **                                    | ** ** | **Cost of Software License Revenue** | ** ** | **Software License Gross Margin** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $103,427                                                 |       | 91.5%                                            |       |
| Three months ended September 30, 2006         |       | $60,024                                                  |       | 94.2%                                            |       |
| Change from same period of prior fiscal  year |       | $43,403  or 72.3%                                        |       | (2.7) ppt                                        |       |
| ** **                                    | ** ** | ** **                                               | ** ** | ** **                                       | ** ** |
| Nine months ended September 30, 2007          |       | $311,972                                                 |       | 91.2%                                            |       |
| Nine months ended September 30, 2006          |       | $143,465                                                 |       | 95.2%                                            |       |
| Change from same period of prior fiscal  year |       | $168,507  or 117.5%                                      |       | (4.0) ppt                                        |       |

 

*Hardware and Media. *Cost of hardware and media revenue consists primarily of the costs we incur inpurchasing third-party hardware and media products.  Our cost of hardwareand media revenue decreased during the third quarter of 2007 as compared to thethird quarter of 2006 due to a reduction in hardware sales resulting from ourdeclining legacy fax business, offset in part by the costs associated with themedia sales that we are now making as a result of our acquisition of BlueChip. Duringthe nine month period ended September 30, 2007, cost of hardware and media revenueincreased as compared to the nine month period ended September 30, 2006 due tocosts associated with our media sales. Our hardware and media gross marginpercentage remained relatively consistent for the third quarter of fiscal year2007 as compared to the third quarter of fiscal 2006. We experienced a decreasein our hardware and media gross margin during the nine month period ended September30, 2007 as compared to the same period in the prior fiscal year, primarily dueto an unfavorable change in the mix of particular hardware products that wesold, offset in part by an increase in the gross margin related to media sales,which had a higher gross margin than our hardware. We do not expect significantchanges in unit prices for media and hardware for the remainder of 2007.

 

23

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| ** **                                    | ** ** | **Cost of Hardware and Media Revenue** | ** ** | **Hardware and Media Gross  Margin** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $314,006                                                        |       | 39.0%                                                         |       |
| Three months ended September 30, 2006         |       | $372,619                                                        |       | 38.4%                                                         |       |
| Change from same period of prior fiscal  year |       | $(58,613)  or (15.7)%                                           |       | 0.6 ppt                                                       |       |
| ** **                                    | ** ** | ** **                                                      | ** ** | ** **                                                    | ** ** |
| Nine months ended September 30, 2007          |       | $1,008,144                                                      |       | 35.8%                                                         |       |
| Nine months ended September 30, 2006          |       | $987,301                                                        |       | 37.1%                                                         |       |
| Change from same period of prior fiscal  year |       | $20,843  or 2.1%                                                |       | (1.3) ppt                                                     |       |

 

*Service and Other. *Cost of service and other revenue consists primarily of the costs we incur inproviding telephone support, installation and other customer service-relatedexpenses. We experienced an increase in cost of service and other revenue inabsolute dollars and gross margin during the three and nine month periods endedSeptember 30, 2007 as compared to the same periods in fiscal year 2006. The increase in absolute dollars is primarily due to the December 2006 additionof former BlueChip employees to our service department, offset in part by areduction in expenses, including wages and recruiting, as a result of our 2007restructuring plan. The increase in gross margin is due to the increase insupport revenue from BlueChip customers. 

 
| ** **                                    | ** ** | **Cost of Service and Other  Revenue** | ** ** | **Gross Margin for Service  and Other Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $888,001                                                   |       | 62.7%                                                                    |       |
| Three months ended September 30, 2006         |       | $856,000                                                   |       | 57.3%                                                                    |       |
| Change from same period of prior fiscal  year |       | $32,001  or 3.7%                                           |       | 5.4 ppt                                                                  |       |
| ** **                                    | ** ** | ** **                                                 | ** ** | ** **                                                               | ** ** |
| Nine months ended September 30, 2007          |       | $2,900,280                                                 |       | 59.2%                                                                    |       |
| Nine months ended September 30, 2006          |       | $2,450,783                                                 |       | 55.3%                                                                    |       |
| Change from same period of prior fiscal  year |       | $449,497  or 18.3%                                         |       | 3.9 ppt                                                                  |       |

 

**Operating Expenses**

 

*Salesand Marketing. * Sales and marketing expenses consistprimarily of employee salaries, benefits, commissions, and associated overheadcosts, as well as the cost of marketing programs such as direct mailings,public relations, trade shows, seminars, and related communication costs. Sales and marketing expenses decreased in absolute dollars and as a percentageof total revenue during the three and nine month periods ended September 30,2007 as compared to the same periods in 2006, due to a reduction in headcountas a result of our recently completed restructuring plan, which resulted indecreased wages and other costs associated with supporting those employees. Inaddition, our marketing program expenditures decreased in accordance with ourcost reduction plan. These decreases were offset in part by the addition offormer BlueChip employees to our sales and marketing departments. We expect oursales and marketing expenses to remain consistent in absolute dollars for theremainder of 2007.

 
| ** **                                    | ** ** | **Sales and Marketing Expenses** | ** ** | **Sales and Marketing Expenses as  a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $1,555,984                                      |       | 37.9%                                                                                                      |       |
| Three months ended September 30, 2006         |       | $1,992,144                                      |       | 54.7%                                                                                                      |       |
| Change from same period of prior fiscal  year |       | $(436,160)  or (21.9)%                          |       | (16.8) ppt                                                                                                 |       |
|                                          |       |                                            |       |                                                                                                       |       |
| Nine months ended September 30, 2007          |       | $5,622,928                                      |       | 46.0%                                                                                                      |       |
| Nine months ended September 30, 2006          |       | $6,203,344                                      |       | 61.7%                                                                                                      |       |
| Change from same period of prior fiscal year  |       | $(580,416)  or (9.4)%                           |       | (15.7) ppt                                                                                                 |       |

 

*Research and Development.* Research and development expenses include expenses associated with thedevelopment of new products, enhancements of existing products, and qualityassurance activities.  These expenses consist primarily of employeesalaries, benefits, associated overhead costs, consulting expenses, and thecost of software development tools. For 

 

24

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the third quarter of fiscal year 2007 as compared tothe third quarter of fiscal year 2006, our research and development expensesdecreased due to a reduction in headcount as a result of our 2007 restructuringplan. During the nine month period ended September 30, 2007, our research anddevelopment expenses increased in absolute dollars as compared to the sameperiod in the prior fiscal year due to an increase in expenses resulting fromnew research and development personnel hired through our acquisition ofBlueChip, offset in part by a reduction in headcount as a result of our 2007restructuring plan. Research and development expenses as a percentage of totalrevenue decreased in both the three and nine month periods ended September 30,2007 as compared to the same periods in 2006, due to an increase in revenue asdiscussed in greater detail above. We expect our research and developmentexpenses for the fourth quarter of 2007 to remain consistent with the thirdquarter of 2007.

 
| ** **                                    | ** ** | **Research and Development  Expenses** | ** ** | **Research and Development  Expenses as a Percentage of  Total Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $624,390                                         |       | 15.2%                                                                                                       |       |
| Three months ended September 30, 2006         |       | $664,335                                         |       | 18.2%                                                                                                       |       |
| Change from same period of prior fiscal  year |       | $(39,945)  or (6.0)%                             |       | (3.0) ppt                                                                                                   |       |
| ** **                                    | ** ** | ** **                                       | ** ** | ** **                                                                                                  | ** ** |
| Nine months ended September 30, 2007          |       | $2,234,152                                       |       | 18.3%                                                                                                       |       |
| Nine months ended September 30, 2006          |       | $2,095,889                                       |       | 20.9%                                                                                                       |       |
| Change from same period of prior fiscal  year |       | $138,263  or 6.6%                                |       | (2.6) ppt                                                                                                   |       |

 

*General and Administrative. *General and administrative expenses consist primarily of employee salaries,benefits for administrative, executive and finance personnel, and associatedcorporate, general, and administrative expenses.  During the third quarterof 2007 as compared to the third quarter of 2006, our general andadministrative expenses decreased in absolute dollars due to a reduction in headcountat our European operations resulting from our March 2007 restructuring plan andto a lesser extent, reductions in Board of Directors fees because of a reducednumber of meetings, professional fees associated with our compliance effortswith Section 404 of the Sarbanes-Oxley Act of 2002 and sales tax expense. Duringthe nine months ended September 30, 2007, our general and administrativeexpenses increased slightly compared to the corresponding period in 2006, dueto an increase in consulting expenses and in legal and accounting fees relatedprimarily to work associated with public company reporting requirements and areview of our existing commercial and licensing agreements. This increase wasoffset in part by a reallocation of resources within the department resultingin decreased wage expenses as well as a reduction in headcount at our Europeanoperations. General and administrative expenses as a percentage of totalrevenue decreased in both periods due to our overall revenue growth. We expectour general and administrative expenses to remain at current levels during theremainder of fiscal year 2007. 

 
| ** **                                    | ** ** | **General and Administrative  Expenses** | ** ** | **General and Administrative Expenses  as a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $686,590                                           |       | 16.7%                                                                                                             |       |
| Three months ended September 30, 2006         |       | $809,439                                           |       | 22.2%                                                                                                             |       |
| Change from same period of prior fiscal  year |       | $(122,849)  or (15.2)%                             |       | (5.5) ppt                                                                                                         |       |
|                                          |       |                                               |       |                                                                                                              |       |
| Nine months ended September 30, 2007          |       | $2,538,534                                         |       | 20.8%                                                                                                             |       |
| Nine months ended September 30, 2006          |       | $2,527,866                                         |       | 25.2%                                                                                                             |       |
| Change from same period of prior fiscal  year |       | $10,668  or 0.4%                                   |       | (4.4) ppt                                                                                                         |       |

 

*Restructuring Costs*. In March 2007, we announced a restructuringof certain of our operations. Since that time, we have reduced our headcount bythirty-one positions consisting of twelve positions that were eliminated in theMarch 2007 restructuring, four positions that were eliminated in arestructuring that we initiated in May 2007, and an additional fifteenpositions that were eliminated due to employee attrition. We believe thisreduction in headcount, combined with other operating expense reductions, hasresulted in an annual savings of approximately $4.0 million from first quarter2007 expense levels. Our three goals in undertaking these cost reductionmeasures and restructuring our operations were: one, to achieve financialresults that will enable us to be at or near cash flow break even by the end offiscal year 2007; two, to enable our sales force to focus on selling ourproducts to customers in the legal and healthcare vertical markets directly andalso in partnership with indirect sales channels, while allowing our partnersto focus on selling our products to customers in the financial services andother vertical markets; and three, to support our integration of the BlueChipbusiness.

 

25

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Asa result of these cost reduction activities, we recorded a pre-tax charge of$343,450 for the nine months ended September 30, 2007, which charge included$308,278 of severance-related costs and $35,172 of costs relating to theclosing of BlueChip’s former headquarters. The total cash impact of therestructuring was $343,450; and all of these amounts have been paid in full duringthe nine months ended September 30, 2007.

 
| ** **                                    | ** ** | **Restructuring Costs** | ** ** | **Restructuring Costs  as a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $0                           |       | 0.0%                                                                                    |       |
| Three months ended September 30, 2006         |       | $0                           |       | 0.0%                                                                                    |       |
| Change from same period of prior fiscal  year |       | $0 or 0.0%                   |       | 0.0 ppt                                                                                 |       |
| ** **                                    | ** ** | ** **                   | ** ** | ** **                                                                              | ** ** |
| Nine months ended September 30, 2007          |       | $343,450                     |       | 2.8%                                                                                    |       |
| Nine months ended September 30, 2006          |       | $0                           |       | 0.0%                                                                                    |       |
| Change from same period of prior fiscal  year |       | $343,450  or 100.0%          |       | 2.8 ppt                                                                                 |       |

 

*Interestand Other Income and Interest Expense. * Interest andother income consists primarily of interest income earned on cash and cashequivalent balances. The decrease in interest and other income during the threeand nine month periods ended September 30, 2007 compared to the same periods in2006 is a result of a lower average investment balance. Interest expenserepresents the interest associated with the capital lease that we entered intoin May 2006 to finance the purchase of furniture and equipment for our newheadquarters, as well as interest expense associated with the promissory noteissued to the BlueChip Seller in December 2006.

 

We expect interest and other income and interestexpense to remain relatively stable for the remainder of fiscal year 2007. 

 
| ** **                                    | ** ** | **Interest and  Other Income** | ** ** | **Interest  Expense**   | ** ** | **Interest and Other  Income  as a Percentage  of Total Revenue** | ** ** | **Interest Expense  as a Percentage  of Total Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------------------------|------------|-------------------------|------------|-------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| Three months ended September 30, 2007         |       | $21,504                                  |       | $(40,261)               |       | 0.5%                                                                                            |       | (0.9)%                                                                           |       |
| Three months ended September 30, 2006         |       | $39,440                                  |       | $(8,908)                |       | 1.1%                                                                                            |       | (0.2)%                                                                           |       |
| Change from same period of prior fiscal  year |       | $(17,936)  or (45.5)%                    |       | $(31,353)  or (352.0)%  |       | (0.6) ppt                                                                                       |       | (0.7) ppt                                                                        |       |
|                                          |       |                                     |       |                    |       |                                                                                            |       |                                                                             |       |
| Nine months ended September 30, 2007          |       | $69,536                                  |       | $(135,796)              |       | 0.6%                                                                                            |       | (1.1)%                                                                           |       |
| Nine months ended September 30, 2006          |       | $128,071                                 |       | $(14,010)               |       | 1.3%                                                                                            |       | (0.1)%                                                                           |       |
| Change from same period of prior fiscal  year |       | $(58,535)  or (45.7)%                    |       | $(121,786) or  (869.3)% |       | (0.7) ppt                                                                                       |       | (1.0) ppt                                                                        |       |

 

**Inflation**

 

During the fiscal years ended December 31, 2004, 2005and 2006 and the nine months ended September 30, 2007, neither inflation norchanging prices have had a material impact on our net sales, revenue or incomefrom continuing operations.

 

**Liquidity and Capital Resources**

 

Since 1996, we have financed our operations primarilythrough cash flow from operations and private and public sales of securities. Asof September 30, 2007, we had cash and cash equivalents of $2.1 million and anet working deficit of $2.3 million.  We believe that our existing cashand cash equivalents will be sufficient to meet our working capital, capitalexpenditures, and other liquidity requirements for at least the next twelvemonths. 

 
| ** **                                    | ** ** | **Cash Used In**    | ** ** |
|-----------------------------------------------|------------|-------------------------------|------------|
| ** **                                    | ** ** | **Operating Activities** | ** ** | **Investing Activities** | ** ** | **Financing Activities** | ** ** |
| Nine months ended September 30, 2007          |       | $(2,315,023)                  |       | $(149,508) |   | $(888,846) |   |
| Nine months ended September 30, 2006          |       | $(3,011,765)                  |       | $(971,230) |   | $(159,545) |   |
| Change from same period of prior fiscal  year |       | $696,742  or 23.1%            |       | $821,722  or 84.6% |   | $(729,301)  or (457.1)% |   |

 

26

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Our operating activities used cash of $2.3 million and$3.0 million for the nine months ended September 30, 2007 and 2006,respectively.  We believe that the resources we are allocating to improvethe success of our AccuRoute product in the legal vertical market and itsexpansion into the healthcare and financial services vertical markets willcontinue to put pressure on our earnings during the next few quarters, but thatour existing cash is sufficient for at least the next twelve months.

 

Net cash used during the nine months ended September30, 2007 consisted primarily of a net loss from operations and a decrease inaccounts payable, offset in part by a decrease in unbilled accounts receivable,an increase in deferred revenue, as well as by the non-cash effects ofdepreciation and amortization and stock-based compensation, predominately forvesting of shares of restricted stock.

 

The decrease in accountspayable is primarily due to the payment of financial advisory, legal, andaccounting expenses associated with our acquisition of BlueChip as well as thetiming of other vendor payments. The increase in deferred revenue is primarilydue to deferred implementation services for BlueChip customers that wererecorded as deferred revenue for purposes of purchase accounting. The decreasein unbilled accounts receivable is due to the fulfillment of contracts that hadnot been completed by BlueChip prior to the acquisition. The increase indepreciation and amortization expense is due to the amortization related to thenet identifiable intangible assets recorded in connection with our December2006 acquisition of BlueChip.

 

Net cash used during the ninemonths ended September 30, 2006 consisted primarily of net loss from operationsand an increase in accounts receivable and prepaids and other current assets,offset in part by an increase in deferred revenue deferred rent and accountspayable, as well as the non-cash effects of stock-based compensation anddepreciation.

 

Investing activities used cash of $150,000 and $971,000during the nine months ended September 30, 2007 and 2006, respectively. The primary use of cash for investing activities during the first nine monthsof 2007 was for additional legal and accounting fees related to our December2006 acquisition of BlueChip. The sole use of cash for investing activities duringthe first nine months of 2006 was for the purchases of furniture and equipmentand the construction costs associated with the moving of our headquarters.

 

Financing activities used cash of $889,000 and $160,000during the nine months ended September 30, 2007 and September 30, 2006,respectively. The primary use of cash during the nine months ended September 30,2007 consisted of the $562,000 cash payment and $281,000 for principal paymentsmade to the Seller of BlueChip as part of the purchase consideration forBlueChip. Cash used during the nine months ended September 30, 2006 consistedprimarily of the purchase of stock from an unaffiliated stockholder.

 

Based on our performance for the nine months ended September30, 2007 and current expectations for the remainder of 2007, we believe thatour current cash and cash equivalents balance, as well as the cash expected tobe generated from operations for the remainder of the year, will satisfy ourworking capital needs, capital expenditures, and other liquidity requirementsthrough at least the next twelve months. We expect that principal uses of cashwill be for operations, repayment of capital lease obligations, and notespayable. However, it is possible that we will seek additional financing and therecan be no assurance that any necessary additional financing will be availableto us on commercially reasonable terms, or at all. The issuance of additionalequity or equity-related securities would be dilutive to our stockholders. Ifwe cannot raise funds on acceptable terms, or at all, we may not be able todevelop or enhance our products or respond appropriately to competitivepressures, which would seriously limit our ability to increase our revenue andgrow our business.

 

Thefollowing table represents the approximate amounts of payments due underspecified contractual obligations as of September 30, 2007:

 
| **Contractual Obligations** | ** ** | **Total** | ** ** | **Less than  one year** | ** ** | **One to  Three years** | ** ** | **Three to  five years** | ** ** | **More than  Five years** | ** ** |
|----------------------------------|------------|-----------|------------|-----------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|
|                             |       |      |       |                              |       |                              |       |                               |       |                                |       |
| Operating lease obligations(1,2) |       | $         | 3,473,638  |                              | $          | 346,790                           |       | $                                  | 311,536    |                                | $          | 300,241 |   | $ | 2,515,071 |   |
| Capital lease obligations(3)     |       | 432,335   |       | 117,910                           |       | 117,910                           |       | 117,910                            |       | 78,605                              |       |
| Note payable(4)                  |       | 1,570,725 |       | 720,484                           |       | 850,241                           |       | —                             |       | —                              |       |
| Total contractual obligations    |       | $         | 5,476,698  |                              | $          | 1,185,184                         |       | $                                  | 1,279,687  |                                | $          | 418,151 |   | $ | 2,593,676 |   |

 

----

(1)             Operatinglease requirements consist mainly of lease payments for our offices in Andover,Massachusetts and London, England, United Kingdom. As of September 30, 2007, wedid not have material commitments for capital expenditures, or other long-termliabilities for which payments are required.

 

27

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(2)             Excludessublease rental income of $344,000 through February 2011.

 

(3)             Capitallease obligations are payable in 60 monthly principal installments ofapproximately $10,000 plus interest.

 

(4)             Thenote, which was issued to the BlueChip Seller as part of the consideration forBlueChip, is payable in 36 monthly principal installments of $47,000 plusinterest.

 

**Off-Balance Sheet Arrangements**

 

Wedo not have any relationships with unconsolidated entities or financialpartnerships, such as entities often referred to as structured finance orspecial purpose entities, that would have been established for the purpose offacilitating off-balance sheet arrangements (as that term is defined in Item303(a)(4)(ii) of Regulation S-K) or other contractually narrow or limitedpurposes.  As such, we are not exposed to any financing, liquidity, marketor credit risk that could arise if we had engaged in those types ofrelationships.

 

**Item 3. Quantitative and Qualitative Disclosures AboutMarket Risk**

 

*Derivative Financial Instruments,Other Financial Instruments, and Derivative Commodity Instruments.*Asof September 30, 2007, the Company did not participate in any derivativefinancial instruments or other financial and commodity instruments for whichfair value disclosure would be required under SFAS No. 133, “*Accounting for Derivative Instruments and Hedging Activities.*”All of the Company’s investments consist of money market funds and commercialpaper that are carried on the Company’s books at amortized cost, which approximatesfair market value. Accordingly, the Company has no quantitative informationconcerning the market risk of participating in such investments.

 

*Primary Market Risk Exposures.*TheCompany’s primary market risk exposures are in the areas of interest rate riskand foreign currency exchange rate risk. The Company’s current 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 to currency exchange rate fluctuations hasbeen and is expected to continue to be modest due to the fact that theoperations of its United Kingdom subsidiary are almost exclusively conducted inthe United Kingdom subsidiary’s local currency. The Company translates theoperating results of its United Kingdom subsidiary into U.S. dollars andconsolidates them for reporting purposes. The impact of currency exchange ratemovements on intercompany transactions was immaterial for the quarter ended September30, 2007. The Company manages its foreign currency exchange risk by monitoringits net monetary position using natural hedges of its assets and liabilitiesdenominated in local currencies. There can be no assurance that this approachwill eliminate all foreign currency exchange rate exposure. Currently, theCompany does not engage in foreign currency hedging activities.

 

**Item 4. Controls and Procedures**

 

(a)   Evaluation of disclosure controlsand procedures.

 

As of September 30, 2007 (the “Evaluation Date”),the Company, under the supervision and with the participation of the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, evaluated the effectiveness of the design and operation of the Company’sdisclosure controls and procedures pursuant to Rule 13a-15(b) promulgatedunder the Securities Exchange Act of 1934, as amended (the “Exchange Act”).Based upon that evaluation, the Company’s Chief Executive Officer and ChiefFinancial Officer concluded that, as of the Evaluation Date, the Company’sdisclosure controls and procedures were effective in ensuring that informationrelating to the Company (including its consolidated subsidiaries) required tobe disclosed by the Company in the reports that it files or submits under theExchange Act is recorded, processed, summarized, and reported within the timeperiods specified in the Securities and Exchange Commission’s rules andforms, including ensuring that this 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.

 

(b)   Changes in internal control overfinancial reporting

 

There were no changes inthe Company’s internal control over financial reporting during the Company’sfiscal quarter ended September 30, 2007 or in other factors that havematerially affected, or are reasonably likely to materially affect, the Company’sinternal control over financial reporting.

 

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**PART II:  OTHER INFORMATION**

 

**Item 1A. Risk Factors**

 

**From time to time we update, revise and supplement the risk factorsdescribed under the title “Risk Factors” in our Annual Report on Form 10-K forthe fiscal year ended December 31, 2006.  We updated those risk factors inconnection with the filing of our Quarterly Reports on Form 10-Q for thequarters ended March 31, 2007 and June 30, 2007. There are no material changesto the risk factors described in the “Risk Factors” section in our AnnualReport on Form 10-K for the fiscal year ended December 31, 2006, asupdated by the risk factors described in our Quarterly Reports on Form 10-Q forthe quarters ended March 31, 2007 and June 30, 2007, other than the inclusionherein of one additional Risk Factors below entitled, “****If we fail tomaintain adequate internal control over financial reporting, if we are unableto complete our assessment of the effectiveness of our internal controls overfinancial reporting in a timely manner, or if our independent registered publicaccounting firm cannot attest to our assessment of our internal control overfinancial reporting, we may be subject to regulatory sanctions and a loss ofpublic confidence, the trading price of our common stock could be negativelyimpacted and our strategic and financial alternatives could be affected.****”  This Risk Factor replaces a Risk Factorincluded in our Annual Report on Form 10-K entitled: “***Theeffectiveness of our disclosure controls and procedures and internal controlover financial reporting may be limited*.”

 

**We operate in a rapidly changing environment that involves a number ofrisks, some of which are beyond our control.  This discussion highlightssome of the risks that may affect future operating results.  These are therisks and uncertainties we believe are most important for you toconsider.  Additional risks and uncertainties not presently known to us,which we currently deem immaterial or which are similar to those faced by othercompanies in our industry or business in general, may also impair our businessoperations.  If any of the following risks or uncertainties actuallyoccurs, our business, financial condition, and operating results would likely suffer.**

 

****If we fail to maintain adequate internal controlover financial reporting, if we are unable to complete our assessment of theeffectiveness of our internal controls over financial reporting in a timelymanner, or if our independent registered public accounting firm cannot attestto our assessment of our internal control over financial reporting, we may besubject to regulatory sanctions and a loss of public confidence, the tradingprice of our common stock could be negatively impacted and our strategic andfinancial alternatives could be affected********.****Effectiveinternal controls are necessary for us to provide reliable financial reportsand effectively detect and prevent fraud. Pursuant to Section 404 of theSarbanes-Oxley Act of 2002, under currently published SEC rules, beginning withour fiscal year ending December 31, 2007, we will be required to performan assessment of the effectiveness of our internal control over financialreporting and publicly disclose the assessment in our Annual Report on Form 10-Kfor the year ending December 31, 2007. Attestation by our auditor onour internal control over financial reporting will be required for theyear ended December 31, 2008.  Because our limited financial andmanagerial resources are focused on the pursuit of strategic and financialalternatives and company operations, we may likely be unable to completeour evaluation, enhancement and assessment of internal control over financialreporting, comply with all of our reporting obligations and successfully completethe procedures and certification requirements of Section 404 by thetime that we are required to file our 2007 Annual Report.  In such event,we may not then be current in our SEC filings.  If we identify materialweaknesses in our internal control over financial reporting, fail to achieveand maintain the adequacy of our internal control structure, or fail toaddress any deficiencies that may be identified by our auditors, we may not beable to conclude, on an ongoing basis, that we have effective internal controlover financial reporting in accordance with the Sarbanes-Oxley Act of 2002. Thereremains risk that the processes and procedures on which we currently rely willfail to be sufficiently effective. In addition, because of the inherentlimitations in all control systems, no evaluation of controls can provideabsolute assurance that all control issues have been detected.Moreover, any failure to satisfy the requirements of Section 404 on atimely basis could result in the loss of investor confidence in the reliabilityof our financial statements, which in turn could harm our business andnegatively impact the trading price of our common stock.

 

**In light of internal control and other public company requirements, aswell as public company costs, we may consider taking action to deregister ourcommon stock under the Securities Exchange Act of 1934.**We may consider this alternative inorder to enhance our operating resources by reducing publiccompany costs, such as the costs of maintaining internal controls andprocedures and complying with the provisions of Section 404.  Ifwe deregister our common stock, there may be an adverse effect on themarket price of our common stock and there will likely be lessinformation about us available to 

 

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shareholdersthan is currently contained in the periodic reports that wefile pursuant to the Exchange Act.  The deregistration ofour common stock would result in our common stock no longer being eligiblefor trading on the Over the Counter Bulletin Board, although weexpect our common stock would continue to be traded over the counteron the Pink Sheets quotation service.

 

**Item 5. Other Information**

 

There have been no changes to the procedures by whichsecurity holders may recommend nominees to the Company’s Board of Directorsduring the time period covered by this Quarterly Report on Form 10-Q.

 

**Item 6. Exhibits**

 

Exhibits

 
| 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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OMTOOL, LTD.

 

**Signatures**

** **

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                   |   |   | OMTOOL, LTD. |
|-------------------|--------|--------|--------------|
|              |   |   |         |   |
|              |   |   | By:          | /s/ Daniel A. Coccoluto |
| November 14, 2007 |   |   |         | Daniel A. Coccoluto |
|              |   |   |         | Chief Financial  Officer, Secretary and Treasurer |
|              |   |   |         | (Duly authorized  officer and principal financial  officer) |

 

**Exhibit Index**

 
| 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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