**U.
      S. SECURITIES AND EXCHANGE COMMISSION**


WASHINGTON,
      D.C. 20549







**FORM
      10 - Q**


(Mark
      One)


**x
      QUARTERLY REPORT
      PURSUANT TO SECTION 13 OR 15(d) OF**


**THE
      SECURITIES EXCHANGE ACT OF 1934**





**For
      the Quarterly Period Ended September 30, 2006**





**OR**





**o
      TRANSITION REPORT
      PURSUANT TO SECTION 13 OR 15(d) OF**


**THE
      SECURITIES EXCHANGE ACT OF 1934**





**Commission
      File Number 0-21743**





**NEOMEDIA
      TECHNOLOGIES, INC.**


(Exact
      Name of Issuer as Specified In Its Charter)




**Delaware**
              **36-3680347**(State
                  or Other Jurisdiction of
              (I.R.S.
                  EmployerIncorporation
                  or Organization)
              Identification
                  No.)
 
 **2201
                  Second Street, Suite 600, Fort Myers, Florida**
              **33901**(Address
                  of Principal Executive Offices)
              (Zip
                  Code)





**239-337-3434** Issuer's
      Telephone Number (Including Area Code)





Check
      whether the issuer (1) filed all reports required to be filed by Section 13
      or
      15(d) of the Exchange Act during the past 12 months (or for such shorter period
      that the registrant was required to file such reports), and (2) has been subject
      to such filing requirements for the past 90 days. Yes x Noo




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      one): Large Accelerated Filer o
      Accelerated Filer x Non-accelerated Filer o





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). Yes oNo
x





As
      of
      October 23, 2006, there were 663,369,101 outstanding shares of the issuer's
      Common Stock, and 22,000 outstanding shares of the issuer’s Series C convertible
      preferred stock.









**TABLE
      OF CONTENTS**





PART
                I —
                FINANCIAL INFORMATION
            1ITEM
                1. FINANCIAL STATEMENTS
            1CONDENSED
                CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 2006 (UNAUDITED)
                AND
                DECEMBER 31, 2005
            1CONDENSED
                CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS FOR
                THE THREE
                MONTHS ENDED SEPTEMBER 30, 2006 AND 2005 (UNAUDITED)
            2CONDENSED
                CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS FOR
                THE NINE
                MONTHS ENDED SEPTEMBER 30, 2006 AND 2005 (UNAUDITED)
            4CONDENSED
                CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER
                30, 2006 AND 2005 (UNAUDITED)
            6UNAUDITED
                NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
            8ITEM
                2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
                RESULTS
                OF OPERATIONS
            54ITEM
                3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
                RISK.
            73ITEM
                4. CONTROLS AND PROCEDURES
            73PART
                II —
                OTHER INFORMATION
            74ITEM
                1. LEGAL PROCEEDINGS
            74ITEM
                1A. RISK FACTORS
            76ITEM
                2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
                PROCEEDS
            86ITEM
                3. DEFAULT UPON SENIOR SECURITIES
            86ITEM
                4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
            86ITEM
                5. OTHER INFORMATION
            86SIGNATURES
            88










**PART
      I -- FINANCIAL INFORMATION**


**ITEM
      1. FINANCIAL STATEMENTS**


**NeoMedia
      Technologies, Inc. and Subsidiaries**


**Condensed
      Consolidated Balance Sheet** **s**


**(In
      Thousands, Except Share Data)**




(Restated)**September
                  30,****2006**
            
            **December
                    31,**
                  **2005**(unaudited)
            
            *******ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            3,133
            
            $
            1,704Trade
                accounts receivable, net of allowance for doubtful accounts of $96
                and
                $203, respectively
            
            
            6,097
            
            
            130Inventories,
                net of allowance for obsolete & slow-moving inventory of
                $0
            
            
            53
            
            
            2Investment
                in marketable securities
            
            
            255
            
            
            104Prepaid
                expenses and other current assets
            
            
            753
            
            
            121Assets
                held for sale
            
            
            3,451
            
            
            4,058Total
                current assets
            
            
            13,742
            
            
            6,119Leasehold
                improvements & property and equipment, net
            
            
            564
            
            
            110Goodwill
            
            
            50,082
            
            
            —Other
                Intangible assets, net
            
            
            21,405
            
            
            3,274Cash
                surrender value of life insurance policy
            
            
            797
            
            
            769Loan
                to Mobot
            
            
            —
            
            
            1,500Other
                long-term assets
            
            
            1,232
            
            
            639**Total
                assets**
            
            $
            87,822
            
            $
            12,411**LIABILITIES
                AND SHAREHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            5,550
            
            $
            1,502Amounts
                payable under settlement agreements
            
            
            97
            
            
            97Liabilities
                of discontinued business unit
            
            
            676
            
            
            676Liabilities
                held for sale
            
            
            750
            
            
            669Taxes
                payable
            
            
            1,178
            
            
            85Accrued
                expenses
            
            
            4,771
            
            
            1,833Deferred
                revenues and other
            
            
            1,925
            
            
            307Notes
                payable
            
            
            2,340
            
            
            3,015Derivative
                financial instruments
            
            
            26,677
            
            
            —Total
                current liabilities
            
            
            43,964
            
            
            8,184Long
                term debentures payable
            
            
            73
            
            
            —Preferred
                stock, $0.01 par value, 25,000,000 shares authorized, 22,000
                issuedand
                outstanding, liquidation value of $22,000, and accreted dividends
                of
                $1,220.
            
            
            2,931
            
            
            —Shareholders’
                equity:Common
                stock, $0.01 par value, 5,000,000,000 shares authorized, 656,853,390
                and475,387,910
                shares issued and 655,211,964 and 467,601,717 outstanding,
                respectively
            
            
            6,552
            
            
            4,676Additional
                paid-in capital
            
            
            155,359
            
            
            106,287Deferred
                equity financing costs
            
            
            —
            
            
            (13,256
            )Accumulated
                deficit
            
            
            (119,618
            )
            
            (92,524
            )Accumulated
                other comprehensive loss
            
            
            (660
            )
            
            (177
            )Treasury
                stock, at cost, 201,230 shares of common stock
            
            
            (779
            )
            
            (779
            )Total
                shareholders’ equity
            
            
            40,854
            
            
            4,227**Total
                liabilities and shareholders’ equity**
            
            $
            87,822
            
            $
            12,411




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





*
      -
      Derived from NeoMedia's audited financial statements for the year ended December
      31, 2005 and restated
      for reclassification of assets and liabilities held for sale related to the
      Micro Paint business unit.




1


**NeoMedia
      Technologies, Inc. and Subsidiaries**


**Condensed
      Consolidated Statements of Operations** ****


**and
      Comprehensive Income (Loss) (Unaudited)**


**(In
      Thousands, Except Share and per Share Data)**


**Three
                    Months Ended September 30****2006**
                
                **2005**(Restated
                    *)Net
                    sales
                
                $
                6,249
                
                $
                193Cost
                    of sales
                
                
                4,112
                
                
                116Gross
                    profit
                
                
                2,137
                
                
                77Sales
                    and marketing expenses
                
                
                2,795
                
                
                589General
                    and administrative expenses
                
                
                2,659
                
                
                765Research
                    and development costs
                
                
                1,013
                
                
                123Stock
                    based compensation expense
                
                
                2,320
                
                
                93Loss
                    from operations
                
                
                (6,650
                )
                
                (1,493
                )Gain
                    on extinguishment of debt
                
                
                —
                
                
                1Interest
                    income (expense), net
                
                
                (112
                )
                
                (77
                )Write-off
                    of deferred equity financing costs
                
                
                (13,256
                )
                
                —Change
                    in fair value from revaluation of warrants and embedded conversion
                    features
                
                
                (9,271
                )
                
                —**NET
                    LOSS FROM CONTINUING OPERATIONS**
                
                
                **(29,289**
                **)**
                
                **(1,569**
                **)****DISCONTINUED
                    OPERATIONS (Note 4)**Net
                    loss from Micro Paint business to be sold
                
                
                (1,620
                )
                
                (381
                )**NET
                    LOSS**
                
                
                (30,909
                )
                
                (1,950
                )Accretion
                    of dividends on convertible preferred stock
                
                
                (604
                )
                
                —**NET
                    LOSS ATTRIBUTABLE TO COMMON SHAREHOLDERS**
                
                
                **(31,513**
                **)**
                
                **(1,950**
                **)**Comprehensive
                    Loss:Net
                    loss
                
                
                (30,909
                )
                
                (1,950
                )Other
                    comprehensive loss:Unrealized
                    loss on marketable securities
                
                
                (312
                )
                
                (4
                )Foreign
                    currency translation adjustment
                
                
                108
                
                
                15**COMPREHENSIVE
                    LOSS**
                
                **$**
                **(31,113**
                **)**
                **$**
                **(1,939**
                **)****Loss
                    per share from continuing operations--basic and
                    diluted**
                
                **$**
                **(0.05**
                **)**
                **$**
                **(0.00**
                **)****Loss
                    per share from discontinued operations--basic and
                    diluted**
                
                **$**
                **(0.00**
                **)**
                **$**
                **(0.00**
                **)****Net
                    loss per share--basic and diluted**
                
                **$**
                **(0.05**
                **)**
                **$**
                **(0.00**
                **)****Loss
                    per share attributable to common shareholders -- basic and diluted**
                
                **$**
                **(0.05**
                **)**
                **$**
                **(0.00**
                **)****Weighted
                    average number of common shares--basic and
                    diluted**
                
                
                **644,720,857**
                
                
                **456,695,836**


*
      -
      Restated for reclassification of operations related to the Micro Paint business
      unit (Note 4).




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




2


**NeoMedia
      Technologies, Inc. and Subsidiaries**


**Condensed
      Consolidated Statements of Operations** ****


**and
      Comprehensive Income (Loss) (Unaudited)**


**(In
      Thousands, Except Share and per Share Data)**


**Nine
                  Months Ended September 30****2006**
              
              **2005**(Restated
                  *)Net
                  sales
              
              $
              14,129
              
              $
              762Cost
                  of sales
              
              
              8,887
              
              
              440Gross
                  profit
              
              
              5,242
              
              
              322Sales
                  and marketing expenses
              
              
              6,719
              
              
              1,332General
                  and administrative expenses
              
              
              6,752
              
              
              2,143Research
                  and development costs
              
              
              2,309
              
              
              365Stock
                  based compensation expense
              
              
              4,948
              
              
              593Loss
                  from operations
              
              
              (15,486
              )
              
              (4,111
              )Gain
                  (loss) on extinguishment of debt
              
              
              (1,858
              )
              
              172Interest
                  income (expense), net
              
              
              (191
              )
              
              (223
              )Write-off
                  of deferred equity financing costs
              
              
              (13,256
              )
              
              —Change
                    in fair value from revaluation of warrants and embedded conversion
                    features
              
              
              6,523
              
              
              —**NET
                  LOSS FROM CONTINUING OPERATIONS**
              
              
              (24,268
              )
              
              (4,162
              )**DISCONTINUED
                  OPERATIONS (Note 4)**Net
                  loss from Micro Paint business to be sold
              
              
              (2,826
              )
              
              (1,307
              )**NET
                  LOSS**
              
              
              (27,094
              )
              
              (5,469
              )Accretion
                  of dividends on convertible preferred stock
              
              
              (1,220
              )
              
              **—****NET
                  LOSS ATTRIBUTABLE TO COMMON SHAREHOLDERS**
              
              
              (28,314
              )
              
              (5,469
              )Comprehensive
                  Loss:Net
                  loss
              
              
              (27,094
              )
              
              (5,469
              )Other
                  comprehensive loss:Unrealized
                  loss on marketable securities
              
              
              (49
              )
              
              (133
              )Foreign
                  currency translation adjustment
              
              
              (434
              )
              
              24**COMPREHENSIVE
                  LOSS**
              
              **$**
              (27,577
              )
              **$**
              (5,578
              )**Loss
                  per share from continuing operations--basic and
                  diluted**
              
              **$**
              (0.04
              )
              **$**
              (0.01
              )**Loss
                  per share from discontinued operations--basic and
                  diluted**
              
              **$**
              (0.00
              )
              **$**
              (0.00
              )**Net
                  loss per share--basic and diluted**
              
              **$**
              (0.04
              )
              **$**
              (0.01
              )**Loss
                  per share attributable to common shareholders -- basic and diluted**
              
              **$**
              (0.05
              )
              **$**
              (0.01
              )**Weighted
                  average number of common shares--basic and
                  diluted**
              
              
              **602,132,555**
              
              
              **451,487,240**




*
      -
      Restated for reclassification of operations related to the Micro Paint business
      unit (Note 4).




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


3





**NeoMedia
      Technologies, Inc. and Subsidiaries**


**Condensed
      Consolidated Statements of Cash Flows (Unaudited)**


**(In
      Thousands)**





**Nine
                Months Ended****September
                30,****2006**
            
            **2005**CASH
                FLOWS FROM OPERATING ACTIVITIES:
            
            
            
            (Restated*)Net
                loss from continuing operations
            
            
            ($24,268
            )
            
            ($4,162
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            2,209
            
            
            359Loss
                on early extinguishment of debt
            
            
            1,858
            
            
            —Change
                  in fair value from revaluation of warrants and embedded conversion
                  features
            
            
            (6,523
            )
            
            —Write-off
                of deferred equity financing costs
            
            
            13,256
            
            
            —Stock-based
                compensation expense
            
            
            4,948
            
            
            593Interest
                expense allocated to debt
            
            
            22
            
            
            —Increase
                in value of life insurance policies
            
            
            (28
            )
            
            (13
            )Changes
                in operating assets and liabilitiesTrade
                accounts receivable, net
            
            
            (918
            )
            
            (28
            )Inventory
            
            
            55
            
            
            —Other
                current assets
            
            
            (252
            )
            
            (671
            )Accounts
                payable, amounts due under settlement agreements,
                liabilitiesin
                excess of assets of discontinued business unit and accrued
                expenses
            
            
            553
            
            
            (283
            )Deferred
                revenue other current liabilities
            
            
            707
            
            
            (118
            )Net
                cash used in operating activities
            
            
            (8,381
            )
            
            (4,323
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Cash
                paid to acquire Mobot, Inc., Sponge Ltd., Gavitec AG, and 12Snap
                AG, net
                of cash acquired
            
            
            (11,891
            )
            
            —Acquisition
                of property and equipment
            
            
            (339
            )
            
            (54
            )Capitalization
                of software development and purchased intangible assets
            
            
            (160
            )
            
            (1,639
            )Investment
                in iPoint-media
            
            
            —
            
            
            (500
            )Advances
                to discontinued Micro Paint Repair subsidiary
            
            
            (1,633
            )
            
            (1,924
            )Acquisition
                related costs
            
            
            (164
            )
            
            —Amounts
                issued under notes receivable
            
            
            (500
            )
            
            —Net
                cash used in investing activities
            
            
            (14,687
            )
            
            (4,117
            )CASH
                FLOWS FROM FINANCING ACTIVITIES:Borrowing
                under notes payable and convertible debt instrument
            
            
            5,000
            
            
            9,932Repayments
                on notes payable and convertible debt instrument
            
            
            (2,530
            )
            
            (5,811
            )Net
                proceeds from issuance of common stock, net of issuance costs of
                $24 in
                2006 and $105 in 2005
            
            
            210
            
            
            6,262Net
                proceeds from issuance of Series C convertible preferred stock, net
                of
                issuance costs of $2,725 in 2006
            
            
            14,066
            
            
            —Net
                proceeds from exercise of stock options and warrants
            
            
            8,419
            
            
            909Cash
                commitment fee for $100 million Standby Equity Distribution
                Agreement
            
            
            —
            
            
            (1,000
            )Net
                cash provided by financing activities
            
            
            25,165
            
            
            10,292EFFECT
                OF EXCHANGE RATE CHANGES ON CASH FOR CONTINUING OPERATIONS
            
            
            (668
            )
            
            —**NET
                INCREASE IN CASH AND CASH EQUIVALENTS FROM CONTINUING
                OPERATIONS**
            
            
            1,429
            
            
            1,852CASH
                AND CASH EQUIVALENTS, BEGINNING OF PERIOD
            
            
            1,704
            
            
            2,606**CASH
                AND CASH EQUIVALENTS, END OF PERIOD**
            
            **$**
            **3,133**
            
            **$**
            **4,458**SUPPLEMENTAL
                CASH FLOW INFORMATION:Interest
                paid during the period
            
            
            48
            
            
            47Non-cash
                investing and financing activities:Unrealized
                gain (loss) on marketable securities
            
            
            (361
            )
            
            —Prepaid
                acquisition costs applied to purchase price
            
            
            168
            
            
            —Fair
                value of shares and notes receivable from Pickups Plus, Inc.acquired
                in exchange for Series C Convertible Preferred Stock
            
            
            594
            
            
            —Carrying
                value of promissory note and accrued interest paidin
                exchange for Series C Convertible Preferred Stock
            
            
            (3,208
            )
            
            —Fair
                value of shares issued to acquire Mobot, Inc., Sponge Ltd.,Gavitec
                AG, 12Snap AG, and BSD Software, Inc.
            
            
            46,964
            
            
            —Change
                in net assets resulting from acquisitions of Mobot, Inc., Sponge
                Ltd.,Gavitec
                AG, 12Snap AG, and BSD Software, Inc.
            
            
            62,240
            
            
            —Accretion
                of dividends on Series C Convertible Preferred Stock
            
            
            1,824
            
            
            —Fair
                value of outstanding warrants reclassified to
                liabilities
            
            
            13,884
            
            
            —Portion
                of change in fair value of outstanding warrants converted to liabilities
                recorded to paid-in capital
            
            
            3,790
            
            
            —Fair
                value of Series C Convertible Preferred Stock (host instrument
                only)
            
            
            4,908
            
            
            —Deferred
                stock-based financing costs associated with Series C Convertible
                Preferred
                Stock
            
            
            3,198
            
            
            —Difference
                between net proceeds and recorded fair value of Series C Convertible
                Preferred Stock
            
            
            4,041
            
            
            —Advance
                receivable from Mobot, Inc. forgiven upon acquisition
            
            
            1,500
            
            
            —Gain
                (loss) on extinguishment of debt paid in common stock
            
            
            —
            
            
            349Fair
                value of stock issued for services and deferred to future
                periods
            
            
            —
            
            
            239Direct
                costs associated with Standby Equity Distribution Agreement and Equity
                Line of Credit
            
            
            —
            
            
            1,204Fair
                value of warrants issued as fees related to the $100 million Standby
                Equity Distribution Agreement
            
            
            —
            
            
            12,256





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




*2005
      cash flows have been restated to remove the cash
      flows from the NeoMedia Micro Paint Repair business unit, which has been
      reclassified to discontinued operations and assets and liabilities held for
      sale.


4


**NEOMEDIA
      TECHNOLOGIES, INC. AND SUBSIDIARIES**


**UNAUDITED
      NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**





**1.** **BASIS
      OF PRESENTATION AND NATURE OF BUSINESS OPERATIONS**





**Basis
      of Presentation**





The
      condensed consolidated financial statements include the financial statements
      of
      NeoMedia Technologies, Inc. and its wholly-owned subsidiaries (“NeoMedia” or the
“Company”). The accompanying unaudited condensed consolidated financial
      statements have been prepared in accordance with the instructions to Form 10-Q
      and do not include all of the information and footnotes required by accounting
      principles generally accepted in the United States of America for complete
      consolidated financial statements. These condensed consolidated financial
      statements and related notes should be read in conjunction with the Company’s
      Form 10-KSB for the fiscal year ended December 31, 2005. In the opinion of
      management, these condensed consolidated financial statements reflect all
      adjustments which are of a normal recurring nature and which are necessary
      to
      present fairly the consolidated financial position of NeoMedia as of September
      30, 2006, the results of operations for the three and nine month periods ended
      September 30, 2006 and 2005, and cash flows for the nine month periods ended
      September 30, 2006 and 2005. The results of operations for the three and nine
      month periods ended September 30, 2006 are not necessarily indicative of the
      results which may be expected for the entire fiscal year. All significant
      intercompany accounts and transactions have been eliminated in preparation
      of
      the condensed consolidated financial statements.





**Going
      Concern**





The
      accompanying condensed consolidated financial statements have been prepared
      in
      conformity with accounting principles generally accepted in the United States
      of
      America, which contemplate continuation of the Company as a going concern.
      Net
      loss for the nine months ended September 30, 2006 was $27,094,000, which
      includes a gain from the change in fair value from revaluation of warrants
      and
      embedded conversion features of $6,523,000 and a charge for the write-off of
      the
      deferred equity financing costs of $13,256,000. NeoMedia also reported net
      losses of $9,147,000 and $7,230,000 for the years ended December 31, 2005 and
      2004, respectively, and has an accumulated deficit of $119,618,000 and a working
      capital deficit of $30,222,000 as of September 30, 2006.





In
      addition, NeoMedia has material liquidity events that could adversely affect
      its
      ability to continue as a going concern, primarily:





· In
      the
      event that NeoMedia’s stock price at the time the consideration shares issued in
      connection with the acquisitions of Mobot, Sponge, Gavitec, and 12Snap become
      saleable is less than the contractual price (between $0.3839 and $0.3956),
      NeoMedia is obligated to compensate the sellers in cash for the difference
      between the price at the time the shares become saleable and the relevant
      contractual price. Assuming a stock price at the time the shares become saleable
      of $0.10, which was the last sale price on October 23, 2006, NeoMedia would
      have
      a cash liability of $32.7 million relating to the guarantees.





· During
      the nine months ended September 30, 2006, NeoMedia made cash payments totaling
      $2.1 million to silent partners of 12Snap, as partial payment under silent
      partner agreements entered into by 12Snap prior to the acquisition of 12Snap
      by
      NeoMedia. The agreements call for additional cash payments of approximately
      $2.5
      million on or before December 31, 2006.





If
      the
      Company’s financial resources are insufficient, the Company may require
      additional financing in order to execute its operating plan and continue as
      a
      going concern. The Company cannot predict whether this additional financing
      will
      be in the form of equity, debt, or another form. The Company may not be able
      to
      obtain the necessary additional capital on a timely basis, on acceptable terms,
      or at all. In any of these events, the Company may be unable to implement its
      current plans for expansion, repay its debt obligations as they become due
      or
      respond to competitive pressures, any of which circumstances would have a
      material adverse effect on its business, prospects, financial condition and
      results of operations. The financial statements do not include any adjustments
      relating to the recoverability and reclassification of recorded asset amounts
      or
      amounts and reclassification of liabilities that might be necessary, should
      the
      Company be unable to continue as a going concern.





5


During
      August 2006, NeoMedia announced its intent to sell its Micro Paint Repair
      business unit. NeoMedia expects to receive cash proceeds from the sale of the
      division, which will be used to fund the operations and growth of the NeoMedia
      Mobile and NeoMedia Telecom Services businesses.





Should
      these financing sources fail to materialize, management would seek alternate
      funding sources such as the sale of common and/or preferred stock, the issuance
      of debt, or the sale of its marketable assets. Management’s plan is to secure
      adequate funding to bridge the profitability from the NeoMedia Mobile and
      NeoMedia Telecom Services businesses.





**Nature
      of Business Operations**





Historically,
      NeoMedia has been structured and evaluated by its Board of Directors and
      management as three distinct business units: NeoMedia Internet Switching
      Software (NISS), NeoMedia Micro Paint Repair (NMPR), and NeoMedia Consulting
      and
      Integration Services (NCIS).





NCIS
      is
      the original business line upon which the Company was founded. This unit resells
      client-server equipment and related software, and general and specialized
      consulting services. Because of decreased demand for systems integration
      products, and increased consolidation and competition in the industry in
      general, during 2005 resources allocated to the NCIS business unit were
      increasingly used in sales and business development efforts associated with
      the
      NISS business unit. During
      February 2006, NeoMedia’s Board of Directors elected to formally wind down the
      NCIS business unit. As a result, during February 2006, NeoMedia closed its
      Lisle, Illinois facility out of which the NCIS business unit was based. NeoMedia
      does, however, plan to continue servicing existing contracts and
      customers .





During
      the first quarter of 2006, following the completion of the acquisitions of
      12Snap AG (“12Snap”), Sponge Ltd. (“Sponge”), Gavitec AG (“Gavitec”), Mobot,
      Inc. (“Mobot”), and BSD Software, Inc. (“BSD”), as well as the winding down of
      the NCIS business unit, NeoMedia restructured into the following three business
      units:





-
      NeoMedia Mobile (NMM) - encompassing NeoMedia’s physical-world-to-internet and
      mobile marketing technologies branded under Qode®, 12Snap, Sponge, Gavitec and
      Mobot. During the second quarter of 2006, NeoMedia rebranded its PaperClick
      suite of products under the brand name Qode®.





-
      NeoMedia Telecom Services (NTS) - encompassing the billing, clearinghouse and
      information management services of Triton Global Business Services, the
      operating subsidiary of BSD Software, which was acquired in March
      2006





-
      NeoMedia Micro Paint Repair (NMPR) - encompassing the micro paint and auto
      aftermarket accessories manufactured and distributed by NeoMedia





On
      August
      30, 2006, NeoMedia signed a non-binding letter of intent to sell its Micro
      Paint
      Repair business unit to Jose
      Sada, a technology partner of NeoMedia Micro Paint Repair, backed
      by Global
      Emerging Markets Group of New York City .
      The
      letter of intent calls for completion
      of the transaction on or before **** November
      24, 2006.





6





**Reclassifications**





Certain
      amounts in the 2005 condensed consolidated financial statements have been
      reclassified to conform to the 2006 presentation, most notably, “License
      revenue” and “Resales of software and technology equipment and service fees”,
      which were formerly reported as separate line items on NeoMedia’s consolidated
      statement of operations, are now condensed into the category entitled,
“Technology license, service & products.” This is primarily due to the
      winding down of the former NCIS business unit and consolidation of revenues
      relating to the NCIS unit into the NMM unit, as well as the addition of new
      revenue streams from Mobot, Sponge, Gavitec, 12Snap, and BSD that fall into
      the
      same general category.





In
      addition, due to the pending sale of the Micro Paint Repair business unit,
      results of operations from this unit have been reclassified to restate into
      the
      caption “Net loss from Micro Paint business to be sold” for all periods shown,
      and assets and liabilities relating to this unit are combined into the captions
      “Assets held for sale” and “Liabilities held for sale,” respectively.
      Additionally, the statement of cash flows for the nine months ended September
      30, 2005 has been restated to exclude the cash flows of the discontinued Micro
      Paint Repair business unit.





**2.** **SUMMARY
      OF SIGNIFICANT ACCOUNTING POLICIES**





A s
      a
      result of the addition of the operations of Mobot, Sponge, Gavitec, 12Snap
      and
      BSD, and the issuance of the Series C convertible preferred stock and a
      convertible debenture during the nine months ended September 30, 2006, NeoMedia
      is presenting certain significant accounting policies that were not applicable
      as of the filing of its last annual report for the year ended December 31,
      2005.





**Stock-based
      Compensation**





Beginning
      January 1, 2006, NeoMedia began to account for stock-based compensation in
      accordance with SFAS No. 123(R), *Share-Based
      Payment* .
      Under
      the fair value recognition provisions of this statement, share-based
      compensation cost is measured at the grant date based on the value of the award
      and is recognized as expense over the vesting period. Determining the fair
      value
      of share-based awards at the grant date requires judgment, including estimating
      expected dividends. In addition, judgment is also required in estimating the
      amount of share-based awards that are expected to be forfeited. If actual
      results differ significantly from these estimates, stock-based compensation
      expense and our results of operations could be materially impacted. Stock-based
      compensation expense is calculated using the Black-Scholes-Merton option pricing
      model on the date of grant. This option valuation model requires input of highly
      subjective assumptions. Because NeoMedia’s employee stock options have
      characteristics significantly different from those of traded options, and
      because changes in the subjective input assumptions can materially affect the
      fair value estimate, in management's opinion, the existing model does not
      necessarily provide a reliable single measure of fair value of its employee
      stock options.





**Fair
      Value of Derivatives**





The
      Company generally does not use derivative financial instruments to hedge
      exposures to cash-flow risks or market-risks that may affect the fair values
      of
      its financial instruments. However, certain other financial instruments, such
      as
      warrants and embedded conversion features that are indexed to the Company’s
      common stock, are classified as liabilities when either (a) the holder possesses
      rights to net-cash settlement or (b) physical or net-share settlement is not
      within the control of the Company. In such instances, net-cash settlement is
      assumed for financial accounting and reporting, even when the terms of the
      underlying contracts do not provide for net-cash settlement. Such financial
      instruments are initially recorded at fair value and subsequently adjusted
      to
      fair value through a change to earnings at the close of each reporting period.





The
      caption “Derivative Financial Instruments” consists of (i) the fair values
      associated with derivative features embedded in the Series C convertible
      preferred stock, (ii) the fair values of the detachable warrants that were
      issued in connection with the preferred stock and the convertible debenture
      financing arrangements, and (iii) the fair value of detachable warrants that
      were outstanding prior to the issuance of the preferred stock and the
      convertible debenture financing arrangements. **





7





**Sales
      Taxes Payable**





Sales
      taxes payable represents amounts collected on behalf of specific regulatory
      agencies that require remittance on a specified date. These amounts are
      collected at the time of sales and are detailed on invoices provided to
      customers. At September 30, 2006 sales taxes payable were $1,178,000, of which
      $851,000 were delinquent sales taxes assumed by NeoMedia in connection with
      its
      acquisitions, certain of which are subject to payment plans. In compliance
      with
      the Emerging Issues Task Force consensus on issue number 06-03, NeoMedia
      accounts for sales taxes on a net basis.





**Revenue
      Recognition**





NeoMedia
      derives  revenues from the following  sources:  (1) license
      revenues relating to patents and internally-developed software, (2) hardware,
      software, and service revenues related to mobile marketing campaign design
      and
      implementation, and (3) sale of its proprietary Micro Paint Repair
      solution.





(1)   Technology
      license fees, including Intellectual Property licenses, represent revenue from
      the licensing of NeoMedia’s proprietary  software  tools and 
applications products.  NeoMedia licenses its  development  tools
      and  application  products pursuant to non-exclusive and 
non-transferable  license agreements.  The basis for license fee
      revenue recognition is substantially governed by American  Institute 
of  Certified  Public  Accountants  ("AICPA") 
Statement of Position 97-2 "Software Revenue  Recognition" ("SOP 97-2"), as
      amended, and Statement of Position 98-9, Modification of SOP 97-2, “Software
      Revenue Recognition, With Respect to Certain Transactions”.  License
      revenue is recognized if persuasive evidence of an agreement 
exists,  delivery has occurred, pricing is fixed and determinable, and
      collectibility is probable.  The Company defers revenue related to license
      fees for which amounts have been collected but for which revenue has not been
      recognized in accordance with the above, and recognizes the revenue over the
      appropriate period.








(2) 
      Technology service & product revenue, which includes sales of software and
      technology equipment, service fee and telecom revenue attributed primarily
      fees
      for processing Canadian and U.S. terminated call records for telecommunication
      companies.  These revenue generating items are recognized  based on
      guidance  provided in  SEC Staff  Accounting  Bulletin 
(“SAB”) No. 104,  "Revenue  Recognition  in Financial
      Statements,"  as amended (SAB 104).  Software
      and technology equipment resale revenue is recognized when
      persuasive evidence of an arrangement exists, the price to the customer is
      fixed
      and determinable, delivery of the service has occurred and collectibility is
      reasonably assured. 
Service revenues including maintenance fees for providing
      system updates for software products, user documentation and technical
      support are recognized over the life of the contract. 
Software  license revenue  from  long-term  contracts 
has  been  recognized  on a  percentage  of
      completion  basis,  along with the  associated  services
      being  provided.  Telecom revenues are recognized at the time that
      calls are accepted by the clearing house for billing to customers.  The
      Company’s recently acquired subsidiaries BSD, Mobot and Gavitec follow this
      policy. The Company defers revenue related to technology service & product
      revenue for which amounts have been invoiced and or collected but for which
      the
      requisite service has not been provided. Revenue is then recognized over the
      matching service period.





(3)  
      Technology service also includes mobile marketing services to its customers
      which mobile marketing projects are recognized after the completion of the
      project and accepted by the customer.  All response and messaging based
      revenues are recognized at the time such responses are received and processed
      and the Company recognizes its premium messaging revenues on a gross basis
      based
      on guidance provided in Emerging Issues Task Force Issues No. 99-19 (EITF
      99-19), “Reporting Revenue Gross as Principal or Net as an Agent,” and No. 01-09
      (EITF 01-09) “Accounting for Consideration Given by a Vendor to a
      Customer.”  However, pursuant to EITF 01-09, the Company offsets any
      consideration given to its customers against revenue. Consulting and management
      revenues and revenues for periodic services are recognized as services are
      performed.  NeoMedia uses  stand-alone  pricing to determine an
      element's  vendor  specific  objective  evidence 
(“VSOE”) in order to allocate an arrangement  fee amongst various pieces of
      a  multi-element  contract.  The Company’s recently acquired
      subsidiaries 12Snap and Sponge follow this policy. The Company defers revenue
      related to mobile marketing service fees for which amounts have been invoiced
      and/or collected but for which revenue has not been recognized. Revenue is
      then
      recognized over the matching service period.





8


(4)  
      Revenue for licensing and exclusivity on NeoMedia’s Micro Paint Repair systems
      is recognized equally over the term of the contract, which is currently one
      year.  A portion of the initial fee paid by the customer is allocated to
      licensing, training costs and initial products sold with the system. Revenue
      is
      recognized upon completion of training and shipment of the products, provided
      there is VSOE in a multiple element arrangement.  Ongoing product and
      service revenue is recognized as products are shipped and services
      performed.  The Company defers revenue related to micro paint repair
      licensing for which amounts have been invoiced and/or collected and revenue
      is
      then recognized over the estimated contract period, which is currently one
      year.





In
      December 2003, the SEC issued SAB 104, “Revenue Recognition.” SAB 104
      supersedes SAB 101, “Revenue Recognition in Financial Statements.”
SAB 104’s primary purpose is to rescind accounting guidance contained in
      SAB 101 related to multiple element revenue arrangements, superseded as a
      result of the issuance of EITF 00-21, “Accounting for Revenue Arrangements
      with Multiple Deliverables.” Additionally, SAB 104 rescinds the SEC’s
      Revenue Recognition in Financial Statements Frequently Asked Questions and
      Answers (the “FAQ”) issued with SAB 101 that had been codified in SEC Topic
      13, Revenue Recognition. Selected portions of the FAQ have been incorporated
      into SAB 104. While the wording of SAB 104 has changed to reflect the
      issuance of EITF 00-21, the revenue recognition principles of SAB 101
      remain largely unchanged by the issuance of SAB 104, which was effective
      upon issuance. The adoption of SAB 104 did not impact NeoMedia’s
      consolidated financial statements.




**3.
      ACQUISITIONS**





During
      the nine months ended September 30, 2006, NeoMedia completed acquisitions of
      Mobot, Sponge, Gavitec, 12Snap, and BSD.





**Acquisition
      of Mobot**





On
      February 9, 2006, NeoMedia and Mobot signed a definitive merger agreement,
      subject to closing conditions, under which NeoMedia acquired all of the
      outstanding shares of Mobot in exchange for $3,500,000 cash and 16,931,493
      shares of NeoMedia common stock (2,604,845 of which are being held in escrow
      for
      a period of one year from the closing date for the purpose of securing the
      indemnification obligations outlined in the purchase agreement). On February
      17,
      2006, NeoMedia and Mobot completed the closing requirements and the acquisition
      became effective. In addition to cash and stock, at closing NeoMedia forgave
      notes payable totaling $1,500,000 due from Mobot. This amount is considered
      other additional consideration in the purchase price allocation. Pursuant to
      the
      terms of the merger agreement, the number of shares of NeoMedia common stock
      that were issued as stock consideration was calculated using a share price
      of
      $0.3839, which was the volume-weighted average closing price of NeoMedia common
      stock for the ten days up to and including February 8, 2006. The merger
      agreement between NeoMedia and Mobot also contained a provision that, in the
      event that NeoMedia’s stock price at the time the consideration shares become
      saleable is less than $0.3839, NeoMedia would be obligated to compensate Mobot
      shareholders in cash for the difference between the price at the time the shares
      become saleable and $0.3839. Assuming a stock price at the time the shares
      become saleable of $0.10, which was the last sale price on October 23, 2006,
      NeoMedia would have had a cash liability of $4.8 million resulting from this
      clause.





9


Mobot
      is
      a pioneer in visual search and recognition technology designed to make marketing
      effective and innovative using mobile devices. Launched in 2004 to help
      companies cultivate rewarding relationships with mobile phone users, Mobot
      gives
      marketers, content providers and carriers the tools to make it easy for any
      consumer with a camera phone to interact with their offerings. Mobot’s customers
      include, amongst others, ELLEgirl magazine, for which Mobot “turned on”
advertisements throughout the magazine that linked to content and customer
      loyalty promotions on the mobile Internet; The Light Agency, who distributes
      Mobot’s visual search and recognition technology to the U.K. grocery sector
      through its award-winning mobile phone-based loyalty program with the
      Sainsburys-owned convenience store chain Jackson’s; and Warner Music Group’s
      U.S. sales and retail marketing company WEA Corp., running a snap-and-enter
      contest in music stores for music fans to win tailored offers, samples and
      discounts.





NeoMedia
      completed the acquisitions of Mobot, Sponge, Gavitec, and 12Snap in an effort
      to
      gain entry into the rapidly evolving global mobile marketing industry.





The
      actual purchase price was based on cash paid, the fair value of NeoMedia stock
      around the date of the Mobot acquisition, and direct costs associated with
      the
      combination. The purchase price was allocated as follows:


(Dollars
                inThousands)Value
                of 16,931,493 shares issued at $0.395 per share(1)
            
            $
            6,688Cash
                paid
            
            
            3,500Direct
                costs of acquisition
            
            
            8Advances
                to Mobot forgiven at acquisition
            
            
            1,500Total
                Fair Value of Purchase Price
            
            
            11,696Assets
                Purchased:Cash
                and cash equivalents
            
            $
            328Accounts
                receivable
            
            
            68Other
                current assets
            
            
            49Property,
                plant & equipment
            
            
            30Intangible
                assets
            
            
            13Customer
                contracts and relationships
            
            
            440Capitalized
                software platform
            
            
            4,200Copyrighted
                materials
            
            
            90Goodwill
            
            
            6,778Total
                Assets Purchased
            
            
            11,996Less
                Liabilities Assumed:Accounts
                payable
            
            $
            51Accrued
                liabilities
            
            
            132Deferred
                revenue
            
            
            117Total
                Liabilities Assumed
            
            
            300




(1)
      -
      Shares were valued using the average stock price for two days before and two
      days after the measurement date, as defined in SFAS 141 and EITF
      99-12




10





The
      combination was accounted for as a purchase business combination as defined
      by
      Statement of Financial Accounting Standards No. 141, Business Combinations.
      The
      allocation of the purchase price to the assets acquired and liabilities assumed
      was based on an independent valuation report obtained by the Company. The
      allocation is subject to change resulting from the purchase price guarantee
      contingency described above.





The
      values assigned to intangible assets, aside from goodwill, are subject to
      amortization. The intangible assets were assigned the following lives for
      amortization purposes:




Estimated
                useful
                life
                  (in years)Intangible
                assetCustomer
                contracts and relationships
            
            
            5Copyrighted
                materials
            
            
            5Capitalized
                software platform
            
            
            7




Goodwill
      was not assigned a life and will be tested for impairment as defined by
      Statement of Financial Accounting Standards No. 144, Accounting for the
      Impairment or Disposal of Long-Lived Assets.




The
      accompanying consolidated statement of operations presented herein for the
      nine
      months ended September 30, 2006, contains the results of operations for Mobot
      for the period from February 18, 2006, through September 30, 2006. The
      accompanying consolidated statement of operations presented herein for the
      three
      months ended September 30, 2006, contains the results of operations for Mobot
      for the entire nine month period. Pro-forma results of operations for the three
      and nine months ended September 30, 2006 and 2005 are presented at the end
      of
      this Note 3.




**Acquisition
      of Sponge**





On
      February 20, 2006, NeoMedia and Sponge signed a definitive share purchase
      agreement, subject to closing conditions, under which NeoMedia acquired all
      of
      the outstanding shares of Sponge in exchange for $6,141,000 cash and 33,097,135
      shares of NeoMedia common stock (3,400,490 of which are being held in escrow
      for
      a period of one year from the closing date for the
      purpose of securing the indemnification obligations outlined in the purchase
      agreement ).
      The
      agreement also calls for Sponge to earn an additional £2,500,000 (approximately
      $4.4 million) in the form of NeoMedia common stock if, during the two-year
      period beginning at closing, the Sponge business earns in excess of £1,300,000
      (approximately $2.3 million) in net profits. On February 23, 2006, NeoMedia
      and
      Sponge completed the closing requirements and the acquisition became effective.
      Pursuant to the terms of the merger agreement, the number of shares of NeoMedia
      common stock to be issued as consideration was calculated using a share price
      of
      $0.384, which was the volume-weighted average closing price of NeoMedia common
      stock for the ten days up to and including February 8, 2006. In the event that
      NeoMedia’s stock price (at the time the consideration shares are saleable) is
      less than $0.384, NeoMedia is obligated to compensate Sponge shareholders in
      cash for the difference between the price at the time the shares become saleable
      and $0.384. Assuming a stock price at the time the shares become saleable of
      $0.10, which was the last sale price on October 23, 2006, NeoMedia would have
      a
      cash liability of $9.4 million resulting from this clause.





Founded
      in 2001, Sponge has grown to become a U.K. market leader in providing mobile
      applications to agencies and media groups, and gain recognition as one of
      Europe’s top independent developers of mobile applications and content. Today,
      Sponge counts more than 40 agencies, including WPP, Aegis and BBH, as clients,
      and supplies services for over 100 world-class brands, including Coca
      Cola ® ,
      Heineken ® and
      Diageo. Sponge also supplies a range of mobile services to media groups,
      including News International, Trinity Mirror, Endemol and IPC. For
      Walker’s (Frito-Lay) potato chips, Sponge enabled a promotion that offered
      consumers of Walker’s -- the U.K.’s largest snack brand -- to win an iPod every
      5 minutes for 4 weeks, by texting a unique code found on-pack into the Sponge
      platform. More than 5% of the total U.K. population participated in the
      campaign, which has been expanded to Belgium and the Netherlands on the basis
      of
      its success in the U.K. A total of 23% of the U.K. population interacted with
      Sponge applications in 2005.





11


NeoMedia
      completed the acquisitions of Mobot, Sponge, Gavitec, and 12Snap in an effort
      to
      gain entry into the rapidly evolving global mobile marketing industry.





The
      actual purchase price was based on cash paid, the fair value of NeoMedia stock
      around the date of the Sponge acquisition, and direct costs associated with
      the
      combination. The purchase price has been allocated as follows:




(Dollars
                inThousands)Value
                of 33,097,135 shares issued at $0.395 per share(1)
            
            $
            13,073Cash
                paid
            
            
            6,141Direct
                costs of acquisition
            
            
            194Total
                Fair Value of Purchase Price
            
            
            19,408Assets
                Purchased:Cash
                and cash equivalents
            
            $
            177Accounts
                receivable
            
            
            617Other
                current assets
            
            
            35Property,
                plant & equipment
            
            
            53Customer
                contracts and relationships
            
            
            400Capitalized
                software platform
            
            
            1,300Brand
                name
            
            
            800Copyrighted
                materials
            
            
            50Goodwill
            
            
            16,692Total
                Assets Purchased
            
            
            20,124Less
                Liabilities Assumed:Accounts
                payable
            
            $
            190Accrued
                liabilities
            
            
            322Other
                current liabilities
            
            
            204Total
                Liabilities Assumed
            
            
            716




(1)
      -
      Shares were valued using the average stock price for two days before and two
      days after the measurement date, as defined in SFAS 141 and EITF
      99-12





The
      combination is being accounted for as a purchase business combination as defined
      by Statement of Financial Accounting Standards No. 141, Business Combinations.
      The allocation of the purchase price to the assets acquired and liabilities
      assumed is based on an independent valuation report obtained by the Company.
      The
      allocation is subject to change resulting from the purchase price guarantee
      contingency described above.




12


The
      values assigned to intangible assets, aside from goodwill, are subject to
      amortization. The intangible assets were assigned the following lives for
      amortization purposes:




Estimated
                usefulIntangible
                asset
            
            life
                (in years)Customer
                contracts and relationships
            
            
            5Copyrighted
                materials
            
            
            5Capitalized
                software platform
            
            
            7Brand
                name
            
            
            10




Goodwill
      was not assigned a life and will be tested for impairment as defined by
      Statement of Financial Accounting Standards No. 144, Accounting for the
      Impairment or Disposal of Long-Lived Assets.





The
      purchase agreement calls for the management of Sponge to earn an additional
      £2,500,000 (approximately $4.4 million) in the form of NeoMedia common stock
      if,
      during the two-year period beginning on February 23, 2006, the Sponge business
      earns in excess of £1,300,000 (approximately $2.3 million) in net profits, plus
£1 of NeoMedia common stock for each £1 that earnings exceed £1,300,000 during
      the two-year period. No shares are to be issued pro rata if the earnings target
      is not met.





At
      the
      end of the two-year measurement period (February 22, 2008), if the earnings
      target is met, the financial impact on NeoMedia of the issuance of additional
      shares would be a proportionate increase of approximately $4.4 million in the
      long-term assets acquired from Sponge, with a corresponding increase in
      depreciation expense from the point of issuance forward. If the earnings target
      is not met, no additional shares would be issued and there would be no financial
      impact to NeoMedia. Pursuant to SFAS 141, NeoMedia has not allocated a value
      to
      the contingent consideration in the initial purchase price. Accordingly the
      final purchase price will not be determined until the conclusion of this
      contingency.





The
      accompanying consolidated statement of operations presented herein for the
      nine
      months ended September 30, 2006, contains the results of operations for Sponge
      for the period from February 24, 2006, through September 30, 2006. The
      accompanying consolidated statement of operations presented herein for the
      three
      months ended September 30, 2006, contains the results of operations for Sponge
      for the entire three month period. Pro-forma results of operations for the
      three
      and nine months ended September 30, 2006 and 2005 are presented at the end
      of
      this Note 3.




**Acquisition
      of Gavitec**





On
      February 17, 2006, NeoMedia and Gavitec signed a definitive sale and purchase
      agreement, subject to closing conditions, under which NeoMedia acquired all
      of
      the outstanding shares of Gavitec in exchange for $1,800,000 cash and 13,660,511
      shares of NeoMedia common stock (1,366,051 of which are being held in escrow
      until December 31, 2006 for the
      purpose of securing the indemnification obligations outlined in the purchase
      agreement ).
      Pursuant to the terms of the merger agreement, the number of shares of NeoMedia
      common stock to be issued as consideration was calculated using a share price
      of
      $0.389, which
      was
      the volume-weighted average closing price of NeoMedia common stock for the
      ten
      days up to and including February 16, 2006. On
      February 23, 2006, NeoMedia and Gavitec completed the closing requirements
      and
      the acquisition became effective. In the event that NeoMedia’s stock price (at
      the time the consideration shares are saleable) is less than $0.389, NeoMedia
      is
      obligated to compensate Gavitec shareholders in cash for the difference between
      the price at the time the shares become saleable and $0.389. Assuming
      a stock price at the time the shares become saleable of $0.10, which was the
      last sale price on October 23, 2006, NeoMedia would have a cash liability of
      $3.9 million resulting from this clause .





13


Gavitec
      was founded in 1997 as a specialized provider and manufacturer of products
      and
      solutions for mobile marketing and mobile information technology. As a
      technology leader in code-reading systems and software for mobile applications,
      Gavitec offers its clients standardized or individual solutions in the areas
      of
      mobile marketing, mobile ticketing, mobile couponing, and mobile payment
      systems. Gavitec has
      run
      an in-market pilot program in Switzerland for its mobile macro-payment system
      with the leading Swiss retail bank PostFinance, Unisys, seven selected retailers
      including Migros, CoOp and McDonald’s and approximately a thousand consumers.
      Participants receive a personal Data Matrix code via text message to their
      mobile phone. Then to complete a purchase, participants hold their cell phone
      over Gavitec’s EXIO code reader and enter their PIN code to debit their
      PostFinance account. Gavitec has also run trials with “Coast Mobile” in
      conjunction with the British Broadcasting Corporation (BBC) and News
      International’s The Times newspaper, along with a number of other interactive
      mobile campaigns.





NeoMedia
      completed the acquisitions of Mobot, Sponge, Gavitec, and 12Snap in an effort
      to
      gain entry into the rapidly evolving global mobile marketing industry.




The
      actual purchase price was based on cash paid, the fair value of NeoMedia stock
      around the date of the Gavitec acquisition, and direct costs associated with
      the
      combination. The purchase price has been allocated as follows:





(Dollars
                inThousands)Value
                of 13,660,511 shares issued at $0.386 per share(1)
            
            $
            5,273Cash
                paid
            
            
            1,800Direct
                costs of acquisition
            
            
            114Total
                Fair Value of Purchase Price
            
            
            7,187Assets
                Purchased:Cash
                and cash equivalents
            
            $
            74Accounts
                receivable
            
            
            173Inventory
            
            
            106Other
                current assets
            
            
            53Property,
                plant & equipment
            
            
            15Intangible
                assets
            
            
            3Capitalized
                software platform
            
            
            4,600Copyrighted
                materials
            
            
            50Goodwill
            
            
            2,611Total
                Assets Purchased
            
            
            7,685Less
                Liabilities Assumed:Accounts
                payable
            
            $
            113Accrued
                liabilities
            
            
            24Deferred
                revenue
            
            
            117Other
                current liabilities
            
            
            244Total
                Liabilities Assumed
            
            
            498




(1)
      -
      Shares were valued using the average stock price for two days before and two
      days after the measurement date, as defined in SFAS 141 and EITF
      99-12




The
      combination is being accounted for as a purchase business combination as defined
      by Statement of Financial Accounting Standards No. 141, Business Combinations.
      The allocation of the purchase price to the assets acquired and liabilities
      assumed is based on an independent report obtained by the Company. The
      allocation is subject to change resulting from the purchase price guarantee
      contingency described above.





14


The
      values assigned to intangible assets, aside from goodwill, are subject to
      amortization. The intangible assets were assigned the following lives for
      amortization purposes:




Estimated
                usefulIntangible
                asset
            
            life
                (in years)Copyrighted
                materials
            
            
            5Capitalized
                software platform
            
            
            7Brand
                name
            
            
            10




Goodwill
      was not assigned a life and will be tested for impairment as defined by
      Statement of Financial Accounting Standards No. 144, Accounting for the
      Impairment or Disposal of Long-Lived Assets.




The
      accompanying consolidated statement of operations presented herein for the
      nine
      months ended September 30, 2006, contains the results of operations for Gavitec
      for the period from February 24, 2006, through September 30, 2006. The
      accompanying consolidated statement of operations presented herein for the
      three
      months ended September 30, 2006, contains the results of operations for Gavitec
      for the entire three month period. Pro-forma results of operations for the
      three
      and nine months ended September 30, 2006 and 2005 are presented at the end
      of
      this Note 3.




**Acquisition
      of 12Snap**





On
      February 10, 2006, NeoMedia and 12Snap signed a definitive sale and purchase
      agreement, subject to closing conditions, under which NeoMedia acquired all
      of
      the outstanding shares of 12Snap in exchange for $2,500,000 cash and 49,294,581
      shares of NeoMedia common stock. On February 28, 2006, NeoMedia and 12Snap
      completed the closing requirements and the acquisition became effective.
      Pursuant to the terms of the merger agreement, the number of shares of NeoMedia
      common stock to be issued as consideration was calculated using a share price
      of
      $0.3956, which
      was
      the volume-weighted average closing price of NeoMedia common stock for the
      ten
      days up to and including February 9, 2006 .
      In the
      event that NeoMedia’s stock price (at the time the consideration shares are
      saleable) is less than $0.3956, NeoMedia is obligated to compensate 12Snap
      shareholders in cash for the difference between the price at the time the shares
      become saleable and $0.3956. Assuming
      a stock price at the time the shares become saleable of $0.10, which was the
      last sale price on October 23, 2006, NeoMedia would have a cash liability of
      $14.6 million resulting from this clause .





12snap
      AG
      is headquartered in Munich with branches in Düsseldorf, New York, London, Milan,
      Stockholm and Vienna. As an expert in innovative marketing and entertainment
      for
      mobile phones, 12snap combines know-how in mobile applications, mobile loyalty
      and mobile marketing. In the mobile marketing space, 12snap creates and
      implements national and pan-European mobile marketing campaigns for
      international brands; its mobile loyalty business unit offers customer loyalty
      programs for companies and brands, and its mobile applications business unit
      is
      the center for development and software. 12snap sells and licenses a wide
      spectrum of mobile solutions to satisfy the demands of the current growing
      market and the new uses of the third mobile phone generation from dynamic video
      services and multiplayer games to personalized messaging applications. 12snap
      has 75 employees, and services to companies including McDonald's,
      MTV ® ,
      Coca-Cola, Ferrero, Wella, adidas, Unilever and Gillette ® .





NeoMedia
      completed the acquisitions of Mobot, Sponge, Gavitec, and 12Snap in an effort
      to
      gain entry into the rapidly evolving global mobile marketing industry.


15


The
      actual purchase price was based on cash paid, the fair value of NeoMedia stock
      around the date of the 12 Snap acquisition, and direct costs associated with
      the
      combination. The purchase price has initially allocated as follows:





(Dollars
                inThousands)Value
                of 49,294,581 shares issued at $0.394 per share(1)
            
            $
            19,422Cash
                paid
            
            
            2,500Direct
                costs of acquisition
            
            
            114Total
                Fair Value of Purchase Price
            
            
            22,036Assets
                Purchased:Cash
                and cash equivalents
            
            $
            465Investment
                in marketable securities
            
            
            951Accounts
                receivable
            
            
            2,683Other
                current assets
            
            
            554Property,
                plant & equipment
            
            
            224Intangible
                assets
            
            
            93Customer
                contracts and relationships
            
            
            400Capitalized
                software platform
            
            
            4,400Brand
                name
            
            
            1,600Copyrighted
                materials
            
            
            50Goodwill
            
            
            19,391Total
                Assets Purchased
            
            
            30,811Less
                Liabilities Assumed:Accounts
                payable
            
            $
            977Accrued
                liabilities
            
            
            1,990Deferred
                revenue
            
            
            1,434Other
                current liabilities
            
            
            225Notes
                payable
            
            
            4,149Total
                Liabilities Assumed
            
            
            8,775




(1)
      -
      Shares were valued using the average stock price for two days before and two
      days after the measurement date, as defined in SFAS 141 and EITF
      99-12





The
      combination is being accounted for as a purchase business combination as defined
      by Statement of Financial Accounting Standards No. 141, Business Combinations.
      The allocation of the purchase price to the assets acquired and liabilities
      assumed is based on an independent valuation report obtained by the Company.
      The
      allocation is subject to change resulting from the purchase price guarantee
      contingency described above.





The
      values assigned to intangible assets, aside from goodwill, are subject to
      amortization. The intangible assets were assigned the following lives for
      amortization purposes:




Estimated
                usefulIntangible
                asset
            
            life
                (in years)Customer
                contracts and relationships
            
            
            5Copyrighted
                materials
            
            
            5Capitalized
                software platform
            
            
            7Brand
                name
            
            
            10




16




Goodwill
      was not assigned a life and will be tested for impairment as defined by
      Statement of Financial Accounting Standards No. 144, Accounting for the
      Impairment or Disposal of Long-Lived Assets.





The
      accompanying consolidated statement of operations presented herein for the
      nine
      months ended September 30, 2006, contains the results of operations for 12Snap
      for the period from March 1, 2006, through September 30, 2006. The accompanying
      consolidated statement of operations presented herein for the three months
      ended
      September 30, 2006, contains the results of operations for 12Snap for the entire
      three month period. Pro-forma results of operations for the three and nine
      months ended September 30, 2006 and 2005 are presented at the end of this Note
      3.




**Acquisition
      of BSD**





On
      March
      21, 2006, NeoMedia completed its acquisition of BSD Software, Inc. of Calgary,
      Alberta, Canada for 7,123,698 shares of NeoMedia common stock. Pursuant to
      the
      terms of the merger agreement, the number of shares of NeoMedia common stock
      to
      be issued as consideration was calculated using a share price of $0.3467, which
      was
      the volume-weighted average closing price of NeoMedia common stock for the
      five
      days preceding March 21, 2006 .
      BSD
      owns 90% of the outstanding shares of Triton Global Business Services, Inc.,
      a
      provider of live and automated operator calling services and e-business support,
      including billing, clearinghouse and information management services, to
      companies in the telecommunications industry.





NeoMedia
      completed the acquisitions of BSD for the purpose of increasing its revenue
      and
      profit through establishment of a Telecom Services business unit, as well as
      gaining access to the Canadian telecom industry in order to penetrate that
      market with the products of the NeoMedia Mobile division.





The
      actual purchase price was based on cash paid, the fair value of NeoMedia stock
      around the date of the BSD acquisition, and direct costs associated with the
      combination. The purchase price has been allocated as follows:




(Dollars
                inThousands)Value
                of 7,123,698 shares issued at $0.352 per share(1)
            
            $
            2,508Direct
                costs of acquisition
            
            
            7Total
                Fair Value of Purchase Price
            
            
            2,515Assets
                Purchased:Cash
                and cash equivalents
            
            $
            55Accounts
                receivable
            
            
            1,733Other
                current assets
            
            
            13Property,
                plant & equipment
            
            
            61Customer
                contracts and relationships
            
            
            1,300Copyrighted
                materials
            
            
            130Goodwill
            
            
            4,402Total
                Assets Purchased
            
            
            7,694Less
                Liabilities Assumed:Accounts
                payable
            
            $
            2,424Accrued
                liabilities
            
            
            1,224Notes
                payable
            
            
            1,531Total
                Liabilities Assumed
            
            
            5,179




(1)
      -
      Shares were valued using the average stock price for two days before and two
      days after the measurement date, as defined in SFAS 141 and EITF
      99-12





17




The
      combination is being accounted for as a purchase business combination as defined
      by Statement of Financial Accounting Standards No. 141, Business Combinations.
      The allocation of the purchase price to the assets acquired and liabilities
      assumed is based on an independent valuation report obtained by the Company.





The
      values assigned to intangible assets, aside from goodwill, are subject to
      amortization. The intangible assets were assigned the following lives for
      amortization purposes:




Estimated
                usefulIntangible
                asset
            
            life
                (in years)Customer
                contracts and relationships
            
            
            5Copyrighted
                materials
            
            
            5




Goodwill
      was not assigned a life and will be tested for impairment as defined by
      Statement of Financial Accounting Standards No. 144, Accounting for the
      Impairment or Disposal of Long-Lived Assets.





The
      accompanying consolidated statement of operations presented herein for the
      nine
      months ended September 30, 2006, contains the results of operations for BSD
      for
      the period from March 22, 2006, through September 30, 2006. The accompanying
      consolidated statement of operations presented herein for the three months
      ended
      September 30, 2006, contains the results of operations for BSD for the entire
      three month period. Pro-forma results of operations for the three and nine
      months ended September 30, 2006 and 2005 are presented at the end
      of
      this Note 3 .




18





**Pro
      Forma Financial Information**





Pro-forma
      results of operations as if NeoMedia was combined with Mobot, Sponge, Gavitec,
      12Snap and BSD as of January 1, 2006 are as follows:





**Three
                Months Ended September 30, 2006****Pro****Forma****Adjust-**
            
            **Pro-forma****NeoMedia**
            
            **Mobot**
            
            **Sponge**
            
            **Gavitec**
            
            **12Snap**
            
            **BSD**
            
            **ments**
            
            **Combined**Total
                net sales
            
            $
            6,249
            
            $
            125
            
            $
            265
            
            $
            246
            
            $
            2,226
            
            $
            3,205
            
            
            ($6,067
            )(A)
            $
            6,249Net
                income (loss)
            
            
            ($30,909
            )
            
            ($388
            )
            
            ($420
            )
            
            ($359
            )
            
            ($166
            )
            $
            228
            
            $
            1,105
            (A)
            
            ($30,909
            )Net
                income (loss) per share-basic
                and diluted
            
            
            ($0.05
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            —
            
            
            ($0.05
            )Weighted
                average commonshares
                outstanding
            
            
            644,720,857
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            —
            
            
            644,720,857




**Nine
                Months Ended September 30, 2006****Pro****Forma****Adjust-**
            
            **Pro-forma****NeoMedia**
            
            **Mobot**
            
            **Sponge**
            
            **Gavitec**
            
            **12Snap**
            
            **BSD**
            
            **ments**
            
            **Combined**Total
                net sales
            
            $
            14,129
            
            $
            344
            
            $
            1,488
            
            $
            953
            
            $
            8,457
            
            $
            8,479
            
            
            ($13,876
            )(B)
            $
            19,974Net
                income (loss)
            
            
            ($27,094
            )
            
            ($1,007
            )
            
            ($458
            )
            
            ($428
            )
            
            ($51
            )
            $
            474
            
            $
            1,305
            (B)
            
            ($27,259
            )Net
                income (loss) per share-basic
                and diluted
            
            
            ($0.04
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            —
            (B)(C)
            
            ($0.04
            )Weighted
                average commonshares
                outstanding
            
            
            602,132,555
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            58,652,190
            (C)
            
            660,784,745





(A)
      -
      Adjustment to back out the operations of each subsidiary, which were included
      in
      NeoMedia’s consolidated operations for the entire three month period ended
      September 30, 2006





(B)
      -
      Adjustments are to reflect operations of each acquisition from the closing
      date
      through September 30, 2006 and amortization of intangible assets for the period
      January 1, 2006 through the respective closing dates. Results of operations
      for
      each acquisition from its respective closing date through September 30, 2006
      are
      included in NeoMedia's operations for the nine months ended September 30, 2006.
      Closing dates for each acquisition were: Mobot (February 17, 2006); Sponge
      and
      Gavitec (February 23, 2006); 12Snap (February 28, 2006); and BSD (March 21,
      2006).





(C)
      -
      Adjustment for shares that would have been issued in connection with
      acquisitions if they had occurred on January 1, 2006. Using the stock price
      around January 1, 2006, the pro forma number of shares that would have been
      issued was:




**Mobot**
            
            **Sponge**
            
            **Gavitec**
            
            **12Snap**
            
            **BSD**
            
            **Total**Total
                stock consideration
            
            $
            6,500,000
            
            $
            11,400,000
            
            $
            5,400,000
            
            $
            19,500,000
            
            $
            2,279,263
            
            $
            45,079,263NeoMedia
                stock price aroundJanuary
                1, 2006 (measurement date)
            
            $
            0.290
            
            $
            0.290
            
            $
            0.290
            
            $
            0.290
            
            $
            0.290Pro
                forma number of shares of NeoMediato
                be issued as purchase price consideration
            
            
            22,413,793
            
            
            39,310,345
            
            
            18,620,690
            
            
            67,241,379
            
            
            7,859,527
            
            
            155,445,734




19




The
      adjustment between the reported and the pro forma number of weighted average
      shares outstanding is caused by (i) the weighting of the pro forma shares for
      the entire nine month period ended September 30, 2006, whereas in the reported
      number the shares were only outstanding from the closing date through September
      30, 2006, and (ii) the number of pro forma shares being higher than the actual
      shares issued due to a lower stock price on the pro forma date of issuance.





Pro-forma
      results of operations as if NeoMedia was combined with Mobot, Sponge, Gavitec,
      12Snap and BSD as of January 1, 2005 are as follows:




**Three
                Months Ended September 30, 2005****Pro****Forma****(B)**
            
            **Adjust-**
            
            **Pro-forma****NeoMedia**
            
            **Mobot**
            
            **Sponge**
            
            **Gavitec**
            
            **12Snap**
            
            **BSD**
            
            **ments**
            
            **Combined**Total
                net sales
            
            $
            193
            
            $
            56
            
            $
            609
            
            $
            198
            
            $
            2,114
            
            $
            2,273
            
            
            —
            
            $
            5,443Net
                income (loss)
            
            
            ($1,950
            )
            
            ($818
            )
            $
            53
            
            
            ($492
            )
            
            ($140
            )
            
            ($134
            )
            
            ($723
            )(A)
            
            ($4,204
            )Net
                income (loss) per share-basic
                and diluted
            
            
            ($0.00
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            ($0.01
            )(A)(B)
            
            ($0.01
            )Weighted
                average commonshares
                outstanding
            
            
            456,695,836
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            172,717,482
            (B)
            
            629,413,318




**Nine
                Months Ended September 30, 2005****Pro****Forma****(B)**
            
            **Adjust-**
            
            **Pro-forma****NeoMedia**
            
            **Mobot**
            
            **Sponge**
            
            **Gavitec**
            
            **12Snap**
            
            **BSD**
            
            **ments**
            
            **Combined**Total
                net sales
            
            $
            762
            
            $
            144
            
            $
            1,544
            
            $
            590
            
            $
            5,600
            
            $
            6,387
            
            
            —
            
            $
            15,027Net
                income (loss)
            
            
            ($5,469
            )
            
            ($918
            )
            $
            172
            
            
            ($747
            )
            
            ($816
            )
            $
            127
            
            
            ($2,170
            )(A)
            
            ($9,821
            )Net
                income (loss) per share-basic
                and diluted
            
            
            ($0.01
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            ($0.01
            )(A)(B)
            
            ($0.02
            )Weighted
                average commonshares
                outstanding
            
            
            451,487,240
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            172,717,482
            (B)
            
            624,204,722





(A)
      -
      Adjustment for amortization of intangible assets for the periods presented.





(B)
      -
      Adjustment for shares that would have been issued in connection with
      acquisitions if they had occurred on January 1, 2006. Using the stock price
      around January 1, 2006, the pro forma number of shares that would have been
      issued was:





**Mobot**
            
            **Sponge**
            
            **Gavitec**
            
            **12Snap**
            
            **BSD**
            
            **Total**Total
                stock consideration
            
            $
            6,500,000
            
            $
            11,400,000
            
            $
            5,400,000
            
            $
            19,500,000
            
            $
            2,279,263
            
            $
            45,079,263NeoMedia
                stock price aroundJanuary
                1, 2005 (measurement date)
            
            $
            0.261
            
            $
            0.261
            
            $
            0.261
            
            $
            0.261
            
            $
            0.261Pro
                forma number of shares of NeoMediato
                be issued as purchase price consideration
            
            
            24,904,215
            
            
            43,678,161
            
            
            20,689,655
            
            
            74,712,644
            
            
            8,732,808
            
            
            172,717,483




20





**Tax
      Implications of Acquisitions**





For
      income tax purposes, amounts assigned to particular assets acquired and
      liabilities assumed in the business combinations are different than amounts
      used
      for financial reporting. The differences in assigned values for financial
      reporting and tax purposes result in temporary differences. In applying SFAS
      109, “Accounting for Income Taxes”, the Company is required to recognize the tax
      effect of these temporary differences and, accordingly, a deferred tax liability
      has been recognized. The Company determined that its pre-existing and
      acquired deferred tax assets, and those acquired, including those subject to
      limitations, were more likely than not to be realized to the extent of the
      deferred tax liability. The reduction in the valuation allowance resulting
      in an
      asset was used to offset the deferred tax liability arising from the
      business combinations, pursuant to SFAS 109.





In
      addition, the acquisitions of Sponge, Gavitec, 12Snap, and BSD involve a change
      of control of foreign entities, and as a result any net operating loss
      carryforward in existence prior to the acquisition may have limited or no use
      for NeoMedia.




21





**Intangible
      Assets**





As
      of
      September 30, 2006, NeoMedia had intangible assets with a cost as
      follows:





**12
                Snap**
            
            **Sponge**
            
            **Gavitec**
            
            **Mobot**
            
            **BSD**
            
            **Other**
            
            **Total**Customer
                Contracts
            
            $
            400
            
            $
            400
            
            $
            —
            
            $
            440
            
            $
            1,300
            
            $
            —
            
            $
            2,540Proprietary
                Software
            
            
            4,516
            
            
            1,300
            
            
            4,603
            
            
            4,210
            
            
            —
            
            
            937
            
            
            15,566Brand
                Name
            
            
            1,600
            
            
            800
            
            
            —
            
            
            5
            
            
            —
            
            
            —
            
            
            2,405Copyrighted
                Materials
            
            
            50
            
            
            50
            
            
            50
            
            
            90
            
            
            130
            
            
            —
            
            
            370Patents
            
            
            —
            
            
            —
            
            
            —
            
            
            10
            
            
            —
            
            
            4,888
            
            
            4,898Goodwill
            
            
            19,391
            
            
            16,799
            
            
            2,712
            
            
            6,778
            
            
            4,402
            
            
            —
            
            
            50,082Total
            
            $
            25,957
            
            $
            19,349
            
            $
            7,365
            
            $
            11,533
            
            $
            5,832
            
            $
            5,825
            
            $
            75,861





Accumulated
      amortization on NeoMedia's intangible assets as of September 30, 2006,
      was:





**12
                Snap**
            
            **Sponge**
            
            **Gavitec**
            
            **Mobot**
            
            **BSD**
            
            **Other**
            
            **Total**Customer
                Contracts
            
            $
            47
            
            $
            48
            
            $
            —
            
            $
            54
            
            $
            152
            
            $
            —
            
            $
            301Proprietary
                Software
            
            
            367
            
            
            112
            
            
            393
            
            
            370
            
            
            —
            
            
            667
            
            
            1,909Brand
                Name
            
            
            93
            
            
            48
            
            
            —
            
            
            2
            
            
            —
            
            
            —
            
            
            143Copyrighted
                Materials
            
            
            6
            
            
            6
            
            
            6
            
            
            11
            
            
            15
            
            
            —
            
            
            44Patents
            
            
            —
            
            
            —
            
            
            —
            
            
            2
            
            
            —
            
            
            1,974
            
            
            1,976Goodwill
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Total
            
            $
            513
            
            $
            214
            
            $
            399
            
            $
            439
            
            $
            167
            
            $
            2,641
            
            $
            4,373





The
      carrying value of NeoMedia's intangible assets as of September 30, 2006
      was:





**12
                Snap**
            
            **Sponge**
            
            **Gavitec**
            
            **Mobot**
            
            **BSD**
            
            **Other**
            
            **Total**Customer
                Contracts
            
            $
            353
            
            $
            352
            
            $
            —
            
            $
            386
            
            $
            1,148
            
            $
            —
            
            $
            2,239Proprietary
                Software
            
            
            4,149
            
            
            1,188
            
            
            4,210
            
            
            3,839
            
            
            —
            
            
            269
            
            
            13,655Brand
                Name
            
            
            1,507
            
            
            752
            
            
            —
            
            
            3
            
            
            —
            
            
            —
            
            
            2,262Copyrighted
                Materials
            
            
            44
            
            
            44
            
            
            44
            
            
            79
            
            
            115
            
            
            —
            
            
            326Patents
            
            
            —
            
            
            —
            
            
            —
            
            
            8
            
            
            —
            
            
            2,914
            
            
            2,922Goodwill
            
            
            19,391
            
            
            16,799
            
            
            2,712
            
            
            6,778
            
            
            4,402
            
            
            —
            
            
            50,082Total
            
            $
            25,444
            
            $
            19,135
            
            $
            6,966
            
            $
            11,093
            
            $
            5,665
            
            $
            3,183
            
            $
            71,486





Estimated
      future amortization expense on NeoMedia's intangible assets is expected to
      be:





**Customer
                Contracts**
            
            **Proprietary
                Software**
            
            **Brand
                Name**
            
            **Copyrighted
                Materials**
            
            **Patents**
            
            **Goodwill**
            
            **Total**2006
            
            $
            127
            
            $
            556
            
            $
            60
            
            $
            19
            
            $
            76
            
            $
            —
            
            $
            8382007
            
            
            508
            
            
            2,224
            
            
            241
            
            
            74
            
            
            304
            
            
            —
            
            
            3,3512008
            
            
            508
            
            
            2,224
            
            
            182
            
            
            74
            
            
            304
            
            
            —
            
            
            3,2922009
            
            
            508
            
            
            2,224
            
            
            182
            
            
            74
            
            
            304
            
            
            —
            
            
            3,2922010
            
            
            356
            
            
            2,224
            
            
            182
            
            
            74
            
            
            304
            
            
            —
            
            
            3,140Thereafter
            
            
            232
            
            
            4,204
            
            
            1,414
            
            
            11
            
            
            1,630
            
            
            —
            
            
            7,491Total
            
            $
            2,239
            
            $
            13,656
            
            $
            2,261
            
            $
            326
            
            $
            2,922
            
            $
            —
            
            $
            21,404





It
      is
      important to note that actual amortization expense could differ materially
      from
      the table due to subjective factors such as changes in assumptions of useful
      lives or impairment charges.




22





The
      weighted average remaining life for the intangible assets was approximately
      6.8
      years as of September 30, 2006.




**Letter
      of Intent to Acquire Hip Cricket**





On
      August
      24, 2006, NeoMedia terminated a non-binding letter of intent to acquire
      HipCricket, Inc. (“HipCricket”), due to an inability of the parties to come to
      terms on a definitive purchase price. On February 16, 2006, NeoMedia and Hip
      Cricket signed the letter of intent, under which NeoMedia intended to acquire
      all of the outstanding shares of Hip Cricket in exchange for $500,000 cash
      and
      $4,000,000 of NeoMedia common stock, subject to due diligence and signing of
      a
      mutually agreeable definitive purchase agreement by both parties.




In
      addition to signing the letter of intent, NeoMedia loaned HipCricket the
      principal amount of $500,000 in the form of a) a promissory note, dated February
      16, 2006, in the amount of $250,000 and (b) that certain promissory note, dated
      March 20, 2006, in the amount of $250,000. The notes accrue interest at a rate
      of 8% per annum. The notes were to be applied toward the cash portion of the
      purchase price upon signing of a definitive purchase agreement for the
      acquisition of all of the outstanding shares of HipCricket by NeoMedia, as
      contemplated in the letter of intent. Due to the termination of the letter
      of
      intent, and pursuant to the terms of the notes, the face amount of the notes,
      plus any and all interest accrued thereon, will become payable and due on
      November 22, 2006. In the event the Notes are not repaid by November 22, 2006,
      the notes will convert into shares of HipCricket common stock using a valuation
      of $4.5 million for HipCricket.





**4.
      DISCONTINUED OPERATIONS AND ASSETS AND LIABILITIES HELD FOR SALE - MICRO PAINT
      REPAIR BUSINESS UNIT**





On
      August
      30, 2006, NeoMedia signed a non-binding letter of intent to sell its Micro
      Paint
      Repair business unit to Jose
      Sada, a technology partner of NeoMedia Micro Paint Repair, backed
      by Global
      Emerging Markets Group of New York City .
      The
      letter of intent calls for completion
      of the transaction on or before **** November
      24, 2006.





The
      letter of intent contained the following material terms:





-
            the
                letter of intent is subject to completion of due diligence review
                by the
                buyers,


-
            the
                letter of intent is subject to negotiation of material terms of the
                transaction,


-
            the
                letter of intent is subject to negotiation of a sales price of the
                business unit,


-
            the
                letter of intent is subject to ability of the buyers to obtain funding,


-
            the
                letter of intent can be terminated by either party without cause
                with
                written notice,


-
            NeoMedia
                cannot shop the business unit to other buyers while the letter of
                intent
                is in effect, with the exception of specifically named alternate
                potential
                buyers.





SFAS
      144
      governs the accounting over this transaction. NeoMedia has analyzed the
      pertinent facts of the proposed transaction with respect to the criteria
      outlined in SFAS 144, and has determined that all of the criteria have been
      met.
      Accordingly NeoMedia is reporting the operating results of the MPR business
      unit
      as Discontinued Operations, and the assets and liabilities as Held for Sale.
      The
      amounts reported as discontinued operations and assets and liabilities held
      for
      sale have been appropriately reclassified and reported in the financial
      statements presented in this filing.





The
      operating results of the MPR business unit classified as discontinued operations
      are indicated in the following table.




23





**Three
                Months Ended**
            
            **Nine
                Months Ended****September
                30,**
            
            **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                sales
            
            $
            368
            
            $
            244
            
            $
            1,145
            
            $
            960Cost
                of sales
            
            
            605
            
            
            220
            
            
            1,592
            
            
            795Gross
                profit
            
            
            (237
            )
            
            24
            
            
            (447
            )
            
            165Sales
                and marketing expenses
            
            
            207
            
            
            216
            
            
            801
            
            
            1,019General
                and administrative expenses
            
            
            777
            
            
            68
            
            
            706
            
            
            230Research
                and development costs
            
            
            236
            
            
            121
            
            
            386
            
            
            223Stock-based
                compensation expense
            
            
            163
            
            
            —
            
            
            485
            
            
            —Loss
                from discontinued operations
            
            $
            (1,620
            )
            $
            (381
            )
            $
            (2,826
            )
            $
            (1,307
            )




The
      assets and liabilities of the MPR business unit classified as held for sale
      are
      as follows.





September
                30,
            
            December
                31,2006
            
            2005**ASSETS**
            
            UnauditedCurrent
                assets:Cash
                and cash equivalents
            
            $
            200
            
            $
            587Trade
                accounts receivable, net
            
            
            462
            
            
            211Inventories,
                net of allowance for obsolete & slow-moving inventory of
                $0
            
            
            148
            
            
            421Prepaid
                expenses and other current assets
            
            
            36
            
            
            30Total
                current assets
            
            
            846
            
            
            1,249Leasehold
                improvements & property and equipment, net
            
            
            135
            
            
            126Goodwill
            
            
            1,099
            
            
            1,099Other
                intangible assets, net
            
            
            1,371
            
            
            1,556Other
                long-term assets
            
            
            —
            
            
            28**Total
                assets held for sale**
            
            $
            3,451
            
            $
            4,058**LIABILITIES
                AND SHAREHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            16
            
            $
            72Taxes
                payable
            
            
            9
            
            
            —Accrued
                expenses
            
            
            74
            
            
            6Deferred
                revenues and other
            
            
            651
            
            
            591**Total
                liabilities held for sale**
            
            $
            750
            
            $
            669




Inventory
        included in the assets held for sale are as follows.
  September
                  30, 2006
              
              December
                  31, 2005Raw
                  materials
              
              $
              38
              
              $
              33Work-in-process
              
              
              —
              
              
              —Finished
                  goods
              
              
              11
              
              
              388Total
              
              $
              49
              
              $
              421


There
      is
      no tax expense or benefit related to this transaction due to NeoMedia’s net
      operating loss carry forward tax position.




24




**5.
      FINANCING**





**Series
      C Convertible Preferred Stock**





The
      Company entered into a Securities Purchase Agreement, dated February 17, 2006
      (the “Agreement”) with Cornell Capital Partners LP, an accredited investor (the
“Purchasers”). Pursuant to the Agreement, the Purchasers agreed to purchase 8%
      cumulative Series C convertible preferred stock to be fully converted three
      (3)
      years from the date of issuance in the aggregate amount of $22,000,000. Net
      consideration from this arrangement amounted to $17,854,000, comprised of cash
      of $14,066,000, marketable securities with a calculated fair value of $579,000
      and a purchase value of $2,000,000, and the extinguishment of $3,209,000 of
      preexisting indebtedness. In addition, the Purchaser withheld $2,725,000
      commitment and structuring fees from the gross proceeds. The Agreement also
      provided for the issuance to the Purchasers, at no additional cost to the
      purchasers, warrants to purchase shares of the Company's common stock. The
      Agreement also called for the purchasers to acquire an additional $5,000,000
      of
      Series C convertible preferred stock on the date a registration statement filed
      by the Company was declared effective by the U.S. Securities and Exchange
      Commission. In connection with the Agreement, the Company also entered into
      a
      registration rights agreement with the Purchasers that requires the Company
      to
      (i) file a registration statement with the SEC registering the resale of the
      shares of common stock issuable upon conversion of the preferred stock and
      the
      exercise of the warrants, (ii) achieve effectiveness by December 1,
      2006 and (iii) maintain effectiveness of the registration statement.
      Failure to meet these requirements will require the Company to incur liquidating
      damages amounting to 1% of the outstanding amount of Series C preferred stock
      per month, but in no event shall consideration paid as liquidating damages
      exceed $1,200,000.





On
      February 17, 2006, the Company issued the Purchasers $22,000,000 in aggregate
      amount of such 8% cumulative Series C convertible preferred stock. At any time
      from the closing date until February 17, 2009, the Purchasers have the right
      to
      convert the preferred stock, in whole or in part, into common stock of the
      Company at the then effective conversion price, which varies relative to the
      Company’s trading stock price, as follows: $0.50 per share, or 97% of the lowest
      closing bid price (as reported by Bloomberg) of the common stock for the 30
      trading days immediately preceding the conversion date. The conversions are
      limited such that the holder cannot exceed 4.99% ownership, unless the holders
      waive their right to such limitation. The limitation will terminate under any
      event of default.





The Series C
      convertible preferred stock, at the option of the holder, affords the Purchasers
      anti-dilution protection should, at any time while the Series C preferred stock
      instruments are outstanding, the Company offer, sell or grant any option to
      purchase or offer, sell or grant any right to re-price its securities, or
      otherwise dispose of or issue any common stock or common stock equivalents,
      entitle any person to acquire shares of common stock at an effective price
      per
      share less than the then effective conversion price (excluding employee stock
      options), as calculated by the formula described above; then, in such instance,
      the conversion price for the convertible preferred stock shares shall be reduced
      to the lower price. In case of any such adjustment in the effective conversion
      price for the convertible preferred shares, this could significantly dilute
      existing investors.




Under
      the
      Agreement, the Purchasers also received “A” warrants, “B” warrants and “C”
warrants to purchase an aggregate of up to 75,000,000 shares of common stock.
      The warrants were exercisable in three separate traunches at a price of $0.50,
      $0.40 and $0.35 respectively per share, subject to adjustment, included under
      anti-dilution protection similar to that described above .
      As an
      inducement to enter into subsequent financing arrangements related to Cornell
      Debentures, the warrants were repriced on August 24, 2006 to $0.10, $0.15,
      and
      $0.10 respectively subject to all the original terms and conditions of the
      agreement. The warrants have a five-year contractual life. NeoMedia can force
      exercise of the warrants if the closing bid price of NeoMedia stock is more than
      $0.10 greater than the exercise price of any of the warrants for 15 consecutive
      trading days.




25





At
      February 17, 2006, a summary of the allocation of the components of the
      transaction is as follows:





**Instrument:**Convertible
                preferred stock(1)
            
            $
            1,711,000Common
                stock warrants(2)
            
            
            16,172,000Embedded
                conversion feature
            
            
            1,935,000Debt
                extinguishment loss(3)
            
            
            (1,964,000
            )Total
                gross proceeds
            
            $
            17,854,000





(1)
            The
                discount to the face value of the 8% cumulative Series C convertible
                preferred stock that resulted from the allocation along with deferred
                costs is being accreted through periodic charges to additional paid-in
                capital using the effective interest method. Accretion of the deferred
                costs amounted to $604,000 and $0 during the three months ended September
                30, 2006 and 2005, respectively, and $1,220,000 and $0 during the
                nine
                months ended September 30, 2006 and 2005,
                respectively.





(2)
            The
                Company issued additional warrants to purchase aggregate 75,000,000
                shares
                of common stock in connection with the 8% cumulative Series C convertible
                preferred stock. The Company also issued 2,000,000 warrants (valued
                at
                $447,000) as financing fees.





(3)
            The
                financing arrangement settled face value $3,209,000 of preexisting
                indebtedness. The debt extinguishment loss was calculated as the
                amount
                that the fair value of securities issued (using a relative fair value
                basis) exceeded the Company’s carrying
                value.





The
      carrying value of the 8% cumulative Series C convertible preferred stock
      amounted to $2,931,000, net of unaccreted deferred cost of $24,349,000, at
      September 30, 2006. Face value of Series C convertible preferred stock at
      September 30, 2006 is $22,000,000. Derivative financial instruments arising
      from
      the issuance of Series C convertible preferred stock are initially recorded
      and
      continuously carried at fair values. Upon conversion of any derivative financial
      instrument, the change in fair value from the previous reporting date to the
      date of conversion is recorded to income (loss), and then the carrying value
      is
      recorded to paid-in capital, provided all other criteria for equity
      classification are met. The following tabular presentation reflects the
      components of derivative financial instruments on the Company’s balance sheet at
      September 30, 2006:




**(Assets)
                Liabilities:**
            
            **September
                30, 2006**Common
                stock warrants
            
            $
            4,625,000Embedded
                conversion features
            
            
            1,515,000Other
                warrants(1)
            
            
            2,126,000$
            8,266,000





(1)
            The
                fair values of certain other derivative financial instruments (warrants)
                that existed at the time of the issuance of Series C convertible
                preferred
                stock were reclassified from stockholders’ equity to liabilities when, in
                connection with the issuance of Series C convertible preferred stock,
                the
                Company no longer controlled its ability to share-settle these
                instruments. These derivative financial instruments had fair values
                of
                $13,883,000 and $2,072,000 on February 17, 2006 and September 30,
                2006,
                respectively. The decrease in fair value of these other derivative
                financial instruments resulted from a decrease in NeoMedia’s share price
                between February 17, 2006 and September 30, 2006. The change in fair
                value
                is reported as “Change in fair value from revaluation of warrants and
                embedded conversion features” in the accompanying condensed consolidated
                statement of operations. These warrants will be reclassified to
                stockholders’ equity when the Company reacquires the ability to
                share-settle the instruments.





The
      following tabular presentation reflects the number of common shares into which
      the aforementioned derivative financial instruments are indexed at September
      30,
      2006:




**Shares
                of common stock**Common
                stock warrants
            
            
            75,000,000Embedded
                conversion feature(1)
            
            
            216,494,845Other
                warrants
            
            
            33,325,000324,819,845





(1)
            The
                terms of the embedded conversion features (ECF) in the Series C
                convertible preferred stock provide for variable conversion rates
                that are
                indexed to the Company’s trading common stock price. As a result, the
                number of indexed shares is subject to continuous fluctuation. For
                presentation purposes, the number of shares of common stock into
                which the
                ECF was convertible as of September 30, 2006 was calculated as the
                face
                value of $22,000,000 plus assumed dividends of $1,220,000 if declared,
                divided by 97% of the lowest closing bid price for the 30 trading
                days
                preceding September 30, 2006 which was $0.111 per share.





26




Derivative
      income associated with adjustments recorded to reflect the aforementioned
      derivatives at fair value amounted to $19,934,000 and $0 for the nine months
      ended September 30, 2006 and 2005, respectively, and $4,161,000 and $0 for
      the
      three months ended September 30, 2006 and 2005, respectively. These amounts
      are
      reported as “Change in fair value from revaluation of warrants and embedded
      conversion features” in the accompanying condensed consolidated statement of
      operations.




Fair
      value considerations for derivative financial instruments :





Freestanding
      derivative instruments, consisting of warrants that arose from the financing
      and
      those reclassified as described above are valued using the Black-Scholes-Merton
      valuation methodology because that model embodies all of the relevant
      assumptions that address the features underlying these instruments. Significant
      assumptions included in this model as of September 30, 2006 are as
      follows:





Holder
            Cornell
                Capital Partners
            OtherInstrument
            Warrants
            WarrantsExercise
                price
            $0.10
                - $0.15
            $0.01
                - $3.45Term
                (years)
            5.0
            1.0
                - 5.0Volatility
            59.32%
            47.55%-59.32%Risk-free
                rate
            3.65%
            3.65%





Embedded
      derivative financial instruments, arising from the Series C convertible
      preferred stock, consist of multiple individual features that were embedded
      in
      the instrument. The Company evaluated all significant features of the hybrid
      instruments and, where required under current accounting standards, bifurcated
      features for separate report classification. These features were aggregated
      into
      one compound derivative financial instrument for financial reporting purposes.
      The compound embedded derivative instruments are valued using the Flexible
      Monte
      Carlo methodology because that model embodies certain relevant assumptions
      (including, but not limited to, interest rate risk, credit risk, and
      conversion/redemption privileges) that are necessary to value these complex
      derivatives.





Assumptions
      included exercise estimates/behaviors and the following other significant
      estimates:





**Instrument**
            **Features**Conversion
                prices
            $0.95
                - $1.29Remaining
                terms (years)
            1
                -
                5Equivalent
                volatility
            47.55%
                - 48.69%Equivalent
                interest-risk adjusted rate
            8.17%
                - 8.58%Equivalent
                credit-risk adjusted yield rate
            14.50%





Equivalent
      amounts reflect the net results of multiple modeling simulations that the Monte
      Carlo Simulation methodology applies to underlying assumptions. The assumptions
      included in the Monte Carlo Simulation calculation are highly subjective and
      subject to interpretation.




The
      8%
      cumulative Series C convertible preferred stock contains consequences in case
      of
      default. Events of default which could subject the Company to penalties,
      damages, and liabilities as specified in the Agreement include:




·
            Any
                case or action of bankruptcy or insolvency commenced by the Company
                or any
                subsidiary, against the Company or adjudicated by a court against
                the
                Company for the benefit of
                creditors;




·
            Any
                default in its obligations under a mortgage or debt in excess of
                $100,000;




27




·
            Any
                cessation in the eligibility of the Company’s stock to be quoted on a
                trading market;




·
            Failure
                to timely file the registration statement covering the shares related
                to
                the conversion option, or failure to make the registration statement
                effective timely.




·
            Any
                lapse in the effectiveness of the registration statement covering
                the
                shares related to the conversion option, the warrants as described
                and
                transacted in the securities purchase agreement and accompanying
                documents;




·
            Any
                failure to deliver certificates within the specified time;
                and




·
            Any
                failure, by the Company, to pay in full the amount of cash due pursuant
                to
                a buy-in or failure to pay any amounts owed on account on account
                of an
                event of default within 10 days of the date
                due.




Other
      provisions included in the Agreement include the following:




·
            The
                8% cumulative Series C convertible preferred stock is convertible
                into
                common stock, at the option of the Purchaser, at any time after the
                effective date.




·
            Conversions
                can be made in increments and from time to
                time.




·
            The
                8% cumulative Series C convertible preferred stock has voting rights
                on an
                “as converted” basis, meaning the Purchaser is entitled to vote the number
                of shares of common stock into which the 8% cumulative Series C
                convertible preferred stock was convertible as of the record date
                for a
                meeting of shareholders




·
            As
                promptly as practicable after any conversion date, the Company shall
                cause
                its transfer agent to deliver a certificate representing the converted
                shares, free of any legends and trading restrictions for the number
                of
                shares converted;




·
            The
                Company will reserve and keep available authorized and unissued registered
                shares available to be issued upon
                conversion;




·
            Purchaser
                will not be responsible for any transfer taxes relative to issuance
                of
                shares;




·
            If
                the Company offers, sells or grants stock at an effective per share
                price
                less than the then Conversion Price, then the Conversion Price shall
                be
                reduced to equal the effective conversion, exchange or purchase price
                for
                such common stock or common stock
                equivalents;




NeoMedia
      filed the registration statement covering the shares related to the conversion
      option beyond the date stipulated in the investor registration rights agreement.
      As such, NeoMedia has accrued $161,000 of liquidated damages relating to the
      Series C convertible stock.





28





**Secured
      Convertible Debenture**





The
      Company entered into a Securities Purchase Agreement, dated August 24, 2006,
      (the “Agreement”) with Cornell Capital Partners LP, an accredited investor (the
“Purchasers”). Pursuant to the Agreement, the Purchasers agreed to purchase 10%
      secured convertible debentures maturing two years from the date of issuance
      in
      the aggregate amount of $5,000,000. The Agreement also provided for the issuance
      to the Purchasers, at no additional cost to the purchasers, warrants to purchase
      shares of the Company's common stock. In connection with the Agreement, the
      Company also entered into a registration rights agreement with the Purchasers
      that requires the Company to (i) file a registration statement with the SEC
      registering the resale of the shares of common stock issuable upon conversion
      of
      the convertible debenture and the exercise of the warrants, (ii) achieve
      effectiveness prior to November 24, 2006 and (iii) maintain
      effectiveness of the registration statement. Failure to meet these requirements
      will require the Company to incur liquidating damages amounting to 2% of the
      principal per month, but in no event shall consideration paid as liquidating
      damages exceed $1,000,000. The debentures are secured by substantially all
      of
      the Company’s assets.





On
      August
      24, 2006, the Company issued the Purchasers $5,000,000 in aggregate principal
      amount of such convertible debentures. At any time from the closing date until
      August 24, 2008, the Purchasers have the right to convert the convertible
      debenture into common stock of the Company at the then effective conversion
      price, which varies relative to the Company’s trading stock price, as follows:
      $0.15 per share, or 90% of the lowest closing bid price (as reported by
      Bloomberg) of the common stock for the 30 trading days immediately preceding
      the
      conversion date. The conversion is limited such that the holder cannot exceed
      4.99% ownership, unless the holders waive their right to such limitation. The
      limitation will terminate under any event of default.





The
      convertible debenture, at the option of the holder, affords the Purchasers
      anti-dilution protection should, at any time while the convertible debenture
      is
      outstanding, the Company offer, sell or grant any option to purchase or offer,
      sell or grant any right to re-price its securities, or otherwise dispose of
      or
      issue any common stock or common stock equivalents, entitle any person to
      acquire shares of common stock at an effective price per share less than the
      then effective conversion price (excluding employee stock options), as
      calculated by the formula described above; then, in such instance, the
      conversion price for the convertible debenture shall be reduced to the lower
      price. In case of any such adjustment in the effective conversion price for
      the
      convertible debenture, this could significantly dilute existing investors.




Under
      the
      Agreement, the Purchasers also received “A” warrants, “B” warrants, “C” warrants
      and “D” warrants to purchase 25,000,000, 50,000,000, 50,000,000, and
      50,000,000 shares of common stock respectively. The warrants are
      exercisable in four separate traunches at a price of $0.15, $0.25, $0.20 and
      $0.05 respectively per share, subject to adjustment, included under
      anti-dilution protection similar to that described above .
      The
      warrants have a five-year contractual life. NeoMedia can force exercise of
      the
      warrants if the closing bid price of NeoMedia stock is more than $0.10 greater
      than the exercise price of any of the warrants for 15 consecutive trading days.




At
      August
      24, 2006, a summary of the allocation of the components of the transaction
      is as
      follows:





**Instrument:**Convertible
                debenture(1)
            
            $
            —Common
                stock warrants(2)
            
            
            18,507,000Embedded
                conversion feature
            
            
            970,000Derivative
                loss
            
            
            (14,477,000
            )Total
                gross proceeds
            
            $
            5,000,000





(1)
            There
                were insufficient proceeds to allocate amounts to the host debentures.
                Accordingly, for purposes of application of the effective interest
                method,
                the company applied the 1% convention which provides for recognition
                of 1%
                of the future value as amortization. Amortization of debt discount
                amounted to $73,000 at September 30, 2006. Unamortized debt discount
                at
                September 30, 2006 was $4,927,000.


(2)
            The
                Company issued warrants to purchase aggregate 175,000,000 shares
                of common
                stock in connection with the convertible debenture, as described
                above.




29




The
      carrying value of the convertible debenture amounted to $73,000 net of
      unamortized debt discount $4,927,000 at September 30, 2006. The face value
      of
      convertible debenture at September 30, 2006 is $5,000,000. The discount recorded
      at inception of the debenture was equal to the $5,000,000 face value
      and $1,000,000 of contractual interest at the stated rate of 10% over the
      term of the debenture was included in the computation of the effective
      interest rate. Derivative financial instruments arising from the issuance of
      convertible debenture are initially recorded and continuously carried at fair
      values. Upon conversion of any derivative financial instrument, the change
      in
      fair value from the previous reporting date to the date of conversion is
      recorded to income (loss), and then the carrying value is recorded to paid-in
      capital, provided all other criteria for equity classification are met. The
      following tabular presentation reflects the components of derivative financial
      instruments related to convertible debentures on the Company’s balance sheet at
      September 30, 2006:




**(Assets)
                Liabilities:**
            
            **September
                30, 2006**Common
                stock warrants
            
            $
            17,567,000Embedded
                conversion features
            
            
            864,000$
            18,431,000




The
      following tabular presentation reflects the number of common shares into which
      the aforementioned derivative financial instruments are indexed at September
      30,
      2006:




**Shares
                of common stock**Common
                stock warrants
            
            
            175,000,000Embedded
                conversion feature(1)
            
            
            50,505,051225,505,051





(1)
            The
                terms of the embedded conversion features (ECF) in the convertible
                debenture provide for variable conversion rates that are indexed
                to the
                Company’s trading common stock price. As a result, the number of indexed
                shares is subject to continuous fluctuation. For presentation purposes,
                the number of shares of common stock into which the ECF was convertible
                as
                of September 30, 2006 was calculated as the face value of $5,000,000
                plus
                assumed interest of $51,000 due at maturity, divided by 90% of the
                lowest closing bid price for the 30 trading days preceding September
                30,
                2006.





Derivative
      loss for the three and nine months ended September 30, 2006 and 2005
      associated with adjustments recorded to reflect the aforementioned derivatives
      at fair value amounted to $13,431,000 and $0, respectively, and is reported
      as
“Change in fair value from revaluation of warrants and embeddded conversion
      features” in the accompanying condensed consolidated statement of
      operations.




Fair
      value considerations for derivative financial instruments :





Freestanding
      derivative instruments, consisting of warrants that arose from the financing
      are
      valued using the Black-Scholes-Merton valuation methodology because that model
      embodies all of the relevant assumptions that address the features underlying
      these instruments. Significant assumptions included in this model as of
      September 30, 2006 are as follows:





Holder
            Cornell
                Capital PartnersInstrument
            WarrantsExercise
                price
            $0.05
                - $0.25Term
                (years)
            5.0Volatility
            67.62%Risk-free
                rate
            4.78%




Embedded
      derivative financial instruments, arising from the convertible debenture,
      consist of multiple individual features that were embedded in the instrument.
      The Company evaluated all significant features of the hybrid instruments and,
      where required under current accounting standards, bifurcated features for
      separate report classification. These features were aggregated into one compound
      derivative financial instrument for financial reporting purposes. The compound
      embedded derivative instruments are valued using the Flexible Monte Carlo
      methodology because that model embodies certain relevant assumptions (including,
      but not limited to, interest rate risk, credit risk, and conversion/redemption
      privileges) that are necessary to value these complex derivatives.




30





Assumptions
      included exercise estimates/behaviors and the following other significant
      estimates:





**Instrument:**
            **Features**Conversion
                prices
            $0.099Remaining
                terms (years)
            2Equivalent
                volatility
            56.03%
                - 58.00%Equivalent
                interest-risk adjusted rate
            %Equivalent
                credit-risk adjusted yield rate
            15.25%





Equivalent
      amounts reflect the net results of multiple modeling simulations that the Monte
      Carlo Simulation methodology applies to underlying assumptions. The assumptions
      included in the Monte Carlo Simulation calculation are highly subjective and
      subject to interpretation.





The
      convertible debenture contains consequences in case of default. Events of
      default which could subject the Company to penalties, liabilities, and
      foreclosure upon the assets of the Company as specified in the Agreement
      include:




·
            Any
                case or action of bankruptcy or insolvency commenced by the Company
                or any
                subsidiary, against the Company or adjudicated by a court against
                the
                Company for the benefit of
                creditors;




·
            Any
                default in its obligations under a mortgage or debt in excess of
                $100,000;




·
            Any
                cessation in the eligibility of the Company’s stock to be quoted on a
                trading market;




·
            Any
                lapse in the effectiveness of the registration statement covering
                the
                shares related to the conversion option, the warrants as described
                and
                transacted in the securities purchase agreement and accompanying
                documents;




·
            Any
                failure to deliver certificates within the specified time;
                and




·
            Any
                failure, by the Company, to pay in full the amount of cash due pursuant
                to
                a buy-in or failure to pay any amounts owed on account on account
                of an
                event of default within 3 days of the date
                due.




Other
      provisions included in the Agreement include the following:




·
            The
                convertible debenture is convertible into common stock, at the option
                of
                the Purchaser, at any time after the effective
                date.




·
            As
                promptly as practicable after any conversion date, the Company shall
                cause
                its transfer agent to deliver a certificate representing the converted
                shares, free of any legends and trading restrictions for the number
                of
                shares converted;




·
            The
                Company will reserve and keep available authorized and unissued registered
                shares available to be issued upon
                conversion;




31




·
            Purchaser
                will not be responsible for any transfer taxes relative to issuance
                of
                shares;




·
            If
                the Company offers, sells or grants stock at an effective per share
                price
                less than the then Conversion Price, then the Conversion Price shall
                be
                reduced to equal the effective conversion, exchange or purchase price
                for
                such common stock or common stock equivalents;




·
            Pursuant
                to the terms of the convertible debenture agreement between NeoMedia
                and
                Cornell signed in connection with the convertible debenture sale,
                without
                Cornell’s consent NeoMedia cannot




­-
            (i) issue
                or sell any shares of Common Stock or preferred stock without
                consideration or for consideration per share less than the closing
                bid
                price immediately prior to its issuance,




­-
            (ii) issue
                or sell any preferred stock, warrant, option, right, contract, call,
                or
                other security or instrument granting the holder thereof the right
                to
                acquire common stock for consideration per share less than the closing
                bid
                price immediately prior to its issuance,




­-
            (iii)
                enter into any security instrument granting the holder a security
                interest
                in any of its assets of,or




­-
            (iv)file any registration statements on Form S-8.




·
            In
                addition, pursuant to a security agreement between NeoMedia and Cornell
                signed in connection with the convertible debenture, Cornell has
                a
                security interest in all of NeoMedia’s assets.




32





**Standby
      Equity Distribution Agreements with Cornell**





On
      October 27, 2003, NeoMedia and Cornell entered into a $20 million Standby Equity
      Distribution Agreement (the “2003 SEDA”). The agreement provided for a maximum
“draw” of $280,000 per week, not to exceed $840,000 in any 30-day period, and
      Cornell was obligated to purchase up to $20 million of the Company’s common
      stock over a two-year period. The SEDA became effective during January 2004,
      and
      expired after a two-year term in January 2006. During the nine months ended
      September 30, 2006 and 2005, NeoMedia sold 751,880 and 19,337,119 shares of
      its
      common stock to Cornell pursuant to the 2003 SEDA. The following table
      summarizes funding received from Cornell during the nine months ended September
      30, 2006 and 2005:





**2006****Nine****Months****First**
            
            **Second**
            
            **Third**
            
            **Ended****Quarter**
            
            **Quarter**
            
            **Quarter**
            
            **September
                30**Number
                of shares sold to Cornell
            
            
            751,880
            
            
            —
            
            
            —
            
            
            751,880Gross
                Proceeds from sale of shares
            
            $
            234,000
            
            $
            —
            
            $
            —
            
            $
            234,000Less:
                discounts and fees*
            
            
            (24,000
            )
            
            —
            
            
            —
            
            
            (24,000
            )Net
                Proceeds from sale of shares
            
            $
            210,000
            
            $
            —
            
            $
            —
            
            $
            210,000




**2005****Nine****Months****First**
            
            **Second**
            
            **Third**
            
            **Ended****Quarter**
            
            **Quarter**
            
            **Quarter**
            
            **September
                30**Number
                of shares sold to Cornell
            
            
            6,998,931
            
            
            7,258,094
            
            
            5,080,094
            
            
            19,337,119Gross
                Proceeds from sale of shares
            
            $
            1,709,000
            
            $
            3,219,000
            
            $
            2,130,000
            
            $
            7,058,000Less:
                discounts and fees*
            
            
            (204,000
            )
            
            (489,000
            )
            
            (170,000
            )
            
            (863,000
            )Net
                Proceeds from sale of shares
            
            $
            1,505,000
            
            $
            2,730,000
            
            $
            1,960,000
            
            $
            6,195,000





*
      Pursuant
      to the terms of the 2003 SEDA, stock was valued at 98% of the lowest closing
      bid
      price during the week it was sold.





On
      March
      30, 2005, NeoMedia and Cornell entered into a Standby Equity Distribution
      Agreement (the “2005 SEDA”) under which Cornell agreed to purchase up to $100
      million of NeoMedia common stock over a two-year period, with the timing and
      amount of the purchase at NeoMedia’s discretion. The maximum amount of each
      purchase would be $2,000,000 with a minimum of five business days between
      advances. The shares would be valued at 98% of the lowest closing bid price
      during the five-day period following the delivery of a notice of purchase by
      NeoMedia, and NeoMedia would pay 5% of the gross proceeds of each purchase
      to
      Cornell. Based on NeoMedia’s current market capitalization and other outstanding
      securities, NeoMedia does not believe that the 2005 SEDA is currently a viable
      source of financing.





As
      a
      commitment fee for Cornell to enter into the 2005 SEDA, NeoMedia issued 50
      million warrants to Cornell with an exercise price of $0.20 per share for a
      term
      of three (3) years, and also paid a cash commitment fee of $1 million. During
      the nine months ended September 30, 2006, Cornell exercised 40 million of the
      warrants, generating cash proceeds of $8 million to NeoMedia. During August
      2006, in connection with the Convertible Debenture, NeoMedia repriced the
      remaining 2 million warrants to an exercise price of $0.10 per share. NeoMedia
      also issued 4 million warrants with an exercise price of $0.227 to a consultant
      as a fee in connection with the 2005 SEDA, which have not been exercised. NeoMedia
      recorded the $13,256,000 fair value of the warrants to “Deferred equity
      financing costs” at inception. This amount was written off during the three
      months ended September 30, 2006 because t he
      Company believes that it can no longer consider the SEDA a viable financing
      source due to the requirements of the preferred stock financing and the
      debenture financing.




33




**Promissory
      Note Payable to Cornell**





On
      March
      30, 2005, NeoMedia borrowed from Cornell the principal amount of $10,000,000
      before discounts and fees in the form of a secured promissory note. Cornell
      withheld structuring and escrow fees of $68,000 related to the note. The note
      was originally scheduled to be repaid at a rate of $1,120,000 per month
      commencing May 1, 2005, which was subsequently changed to $840,000 per month,
      continuing until principal and interest were paid in full. The note accrued
      interest at a rate of 8% per annum on any unpaid principal. In connection with
      the note, NeoMedia and Cornell entered into a Security Agreement under which
      the
      note was secured by all of NeoMedia's assets other than its patents and patent
      applications. NeoMedia also escrowed 25,000,000 shares of its restricted common
      stock as security for the note. During the period from March 30, 2005 through
      January 9, 2006, NeoMedia made payments against the principal totaling
      $7,210,000. On February 17, 2006, NeoMedia retired the balance of the principal
      in the amount of $2,790,000, plus accrued interest of $419,000, from the
      proceeds of the Series C convertible preferred financing arrangement with
      Cornell. In connection with the payment and issuance of the Series C convertible
      preferred stock, NeoMedia recognized a loss on extinguishment of debt of
      $1,964,000 during the nine months ended September 30, 2006.




**6.** **INVESTMENT
      IN MARKETABLE SECURITIES**





On
      February 25, 2005, NeoMedia invested $250,000 in exchange for 8,333,333 shares
      of Pickups Plus, Inc (“PUPS”) restricted common stock. On February 17, 2006, as
      a component of net proceeds from the issuance of 8% Series C convertible
      preferred stock, NeoMedia received marketable securities with a fair value
      of
      $579,000, of which, $200,000 represented 20,000,000 shares of PUPS common stock
      and $379,000 in notes designated as held to maturity. NeoMedia acquired an
      additional 20,000,000 shares of PUPS common stock for a purchase price equal
      to
      $389,000. PUPS is
      a
      retail operator and franchiser of retail automotive parts and accessories stores
      catering to the light truck market, and also provides new vehicle preparation,
      environmental protection packages, detailing and reconditioning products and
      services. In accordance with Statements
      of Financial Accounting Standards No. 115, “Accounting for Certain Investments
      in Debt and Equity Securities,” the investment in PUPS is being recorded as
      available-for-sale securities and reported at fair value. Accordingly,
      unrealized gains and losses on the equity securities are reflected in the
      condensed consolidated statement of operations and comprehensive income (loss).





The
      investments in marketable securities are summarized as follows:





**Unrealized**
            
            **Unrealized**
            
            **Fair
                Value**
            
            **Fair****Cost**
            
            **Holding
                Gain**
            
            **Holding
                Losses**
            
            **Adjustments**
            
            **Value**Available-for-sale
            
            $
            639,000
            
            $
            -
            
            
            ($384,000
            )
            $
            -
            
            $
            255,000Held
                to maturity
            
            $
            379,000
            
            $
            -
            
            $
            -
            
            $
            108,000
            
            $
            487,000





Held
      to
      maturity securities consist of four notes receivable from PUPS with a face
      value
      of $1,611,000 and a fair value of $487,000. The fair value of $487,000 is
      recorded in other long-term assets on the consolidated balance sheet as of
      September 30, 2006, and is based upon a risk adjusted anticipated rate of
      return. The notes are delinquent and accrue interest at rates between 12 -
      24%.
      NeoMedia has not recorded any interest since the Company is using the cost
      recovery method.





34





**7.** **FINANCIAL
      INSTRUMENTS**




The
      carrying amount of the Company's cash equivalents, accounts receivable, prepaid
      expenses, other current assets, cash surrender value of life insurance policy,
      accounts payable and accrued expenses, accrued salaries and benefits, and
      payable to merchants approximates their estimated fair values due to the
      short-term maturities of those financial instruments.





Rates
      currently available to the Company for debt with similar terms and remaining
      maturities are used to estimate fair value of existing debt.




It
      is not
      practicable to estimate the fair value of the Company’s 17% investment in the
      common stock of i-Point Media Ltd. and its investments of 250,000 shares of
      preferred stock of Intactis Software, Inc ., because
      of the lack of quoted market prices and the inability to estimate fair value
      without incurring excessive costs. During the year ended December 31, 2005
      NeoMedia took an impairment of the carrying values of its investments in
      iPoint-media and Intactis of $530,000 and $250,000, respectively. No impairment
      charge was taken during the nine months ended September 30, 2006. The net
      carrying value of these investments were $470,000 as of September 30, 2006.




For
      all
      available-for-sale investment securities, the carrying values represents fair
      value of the securities and unrealized gain (losses) that are other than
      temporary are recognized as other comprehensive income (loss). NeoMedia does
      not
      hold these securities for speculative or trading purposes. Also see Note
      6.





**8.** **COMPUTATION
      OF NET INCOME (LOSS) PER SHARE**





Basic
      net
      loss per share is computed by dividing net loss by the weighted average number
      of shares of common stock outstanding during the period. During the three and
      nine month periods ended September 30, 2006 and 2005, the Company reported
      net
      loss per share, and as such basic and diluted loss per share were equivalent.
      The Company has excluded all outstanding stock options and warrants from the
      calculation of diluted net loss per share because these securities are
      anti-dilutive for all years presented. The shares excluded from the calculation
      of diluted net loss per share are detailed in the table below:





**September
                30, 2006**
            
            **September
                30, 2005**Outstanding
                Stock Options
            
            
            117,317,058
            
            
            77,629,221Outstanding
                Warrants
            
            
            276,325,000
            
            
            72,775,000




35





**9.
      STOCK BASED COMPENSATION**





**Option-based
      Compensation Expense**





At
      September 30, 2006, NeoMedia has four employee stock option plans (the 1996
      Stock Option Plan, the 1998 Stock Option Plan, the 2003 Stock Option Plan,
      and
      the 2005 Stock Option Plan) and one employee stock compensation plan (the 2003
      Stock Incentive Plan) (collectively, the “Plans”). Prior to January 1, 2006,
      NeoMedia accounted for those plans under the recognition and measurement
      provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees,
      and
      related Interpretations, as permitted by FASB Statement No. 123, Accounting
      for
      Stock-Based Compensation (“Statement 123(R)”). No stock-based employee
      compensation cost was recognized in the statement of operations for the fiscal
      years or interim periods ended prior to December 31, 2005, as all options
      granted under those plans had an exercise price equal to the market value of
      the
      underlying common stock on the date of grant. Effective January 1, 2006,
      NeoMedia adopted the fair value recognition provisions of Statement 123(R),
      using the modified-prospective-transition method. Under that transition method,
      compensation cost recognized in 2006 includes: (a) compensation cost for all
      share-based payments granted prior to, but not yet vested as of January 1,
      2006,
      based on the grant date fair value estimated in accordance with the original
      provisions of Statement 123, and (b) compensation cost for all share-based
      payments granted subsequent to January 1, 2006, based on the grant-date fair
      value estimated in accordance with the provisions of Statement 123(R). Results
      for prior periods have not been restated.





As
      a
      result of adopting Statement 123(R) on January 1, 2006, NeoMedia’s net loss for
      the three and nine months ended September 30, 2006 is $2,483,000 and $5,433,000
      higher (including $163,000 and $485,000 relating to discontinued operations)
      respectively, than if it had continued to account for share-based compensation
      under Opinion 25. Basic and diluted loss per share, as well as loss per share
      attributable to common shareholders, are each higher by less than $0.01 per
      share for the three months ended September 30, 2006 than they would have been
      if
      NeoMedia had not adopted Statement 123(R). Basic and diluted loss per share,
      as
      well as loss per share attributable to common shareholders, are each higher
      by
      $0.01 per share for the nine months ended September 30, 2006 than they would
      have been if NeoMedia had not adopted Statement 123(R). Estimated income tax
      benefits recognized during the three and nine months ended September 30, 2006
      were offset by a valuation allowance since realization was not reasonably
      assured.





Prior
      to
      the adoption of Statement 123(R), it was NeoMedia’s policy to present all tax
      benefits of deductions resulting from the exercise of stock options as operating
      cash flows in its statement of cash flows, however, due to NeoMedia’s tax loss
      carryforward, any such benefits were always fully offset by a valuation
      allowance. Statement 123(R) requires the cash flows resulting from the tax
      benefits resulting from tax deductions in excess of the compensation cost
      recognized for those options (excess tax benefits) to be classified as financing
      cash flows. NeoMedia will use this presentation if and when it has exhausted
      its
      tax loss carryforward.




36





The
      following table illustrates the effect on net loss and loss per share if
      NeoMedia had applied the fair value recognition provisions of Statement
      123(R) to
      options granted under NeoMedia’s stock option plans in 2005. For purposes of
      this pro forma disclosure, the value of the options is estimated using a
      Black-Scholes option-pricing formula and amortized to expense over the options’
vesting periods.





**Three
                Months**
            
            **Nine
                Months****Ended
                September 30,**
            
            **Ended
                September 30,****2005**
            
            **2005**Net
                Loss, as reported
            
            
            ($1,950
            )
            
            ($5,469
            )Add:
                Stock-based employee compensationexpense
                included in reported net income,net
                of related tax effects
            
            
            —
            
            
            —Deduct:
                Total stock-based employeecompensation
                expense determined underfair
                value method for all awards, net ofrelated
                tax effects
            
            
            (1,080
            )
            
            (2,760
            )Pro-forma
                net loss
            
            
            ($3,030
            )
            
            ($8,229
            )Net
                Loss per share:Basic
                and diluted - as reported
            
            
            ($0.00
            )
            
            ($0.01
            )Basic
                and diluted - pro-forma
            
            
            ($0.01
            )
            
            ($0.02
            )





Note
      that
      the above pro forma disclosures are provided for the three and nine months
      ended
      September 30, 2005 because employee stock options were not accounted for using
      the fair-value method during those periods.





The
      Plans
      permit the grant of share options and shares to NeoMedia’s employees, board of
      directors, and outside consultants. NeoMedia believes that such awards better
      align the interests of its employees with those of its shareholders. Option
      awards are generally granted with an exercise price equal to the market price
      of
      NeoMedia’s stock at the date of grant; those option awards generally vest over a
      period of 3 years and have 10-year contractual terms. Shares granted upon the
      exercise of stock options are newly issued shares. The fair value of each option
      award is estimated on the date of grant using the Black-Scholes valuation
      model that uses the assumptions noted in the following table. Because the Black-Scholes valuation
      model incorporates ranges of assumptions for inputs, those ranges are disclosed.
      Expected volatilities are based on the expected impact on future stock price
      of
      expected future revenue and earnings, historical volatility of NeoMedia’s stock,
      and other factors. NeoMedia uses historical data to estimate option exercise
      and
      employee termination within the valuation model. The expected term of options
      granted represents the period of time that options granted are expected to
      be
      outstanding.





**Three
                and Nine months ended September 30,****2006**
            
            **2005**Volatility
            
            
            56%
                - 28
            %
            
            431%
                - 449
            %Expected
                dividends
            
            
            —
            
            
            —Expected
                term (in years)
            
            
            3
            
            
            3Risk-free
                rate
            
            
            4.35
            %
            
            4.50
            %





37


As
      of
      January 1, 2006, NeoMedia reevaluated its volatility calculation to take into
      consideration the guidance outlined in Statement 123(R). Prior to January 1,
      2006, NeoMedia calculated volatility using only historical share price data.
      Under the provisions of Statement 123(R), from January 1, 2006 onward NeoMedia
      has considered historical volatility, as well expected future volatility. As
      a
      result, NeoMedia’s volatility decreased significantly for stock based
      compensation granted during the nine months ended September 30, 2006 as compared
      with stock based compensation granted prior to January 1, 2006. NeoMedia will
      evaluate its volatility on an ongoing basis using the most current information
      available. NeoMedia expects that, under the guidelines of Statement 123(R),
      future volatility will more closely resemble 2006 levels than previous years.





A
      summary
      of option activity under the Plans as of September 30, 2006, and changes during
      the nine months then ended is presented below:





**Weighted****Weighted**
            
            **Average****Average**
            
            **Remaining**
            
            **Aggregate****Exercise**
            
            **Contractual**
            
            **Intrinsic****Shares**
            
            **Price**
            
            **Term**
            
            **Value**(In
                thousands)
            
            
            
            (in
                years)
            
            (In
                thousands)Outstanding
                at January 1, 2006
            
            
            100,041
            
            $
            0.18Granted
            
            
            25,660
            
            $
            0.36Exercised
            
            
            (2,568
            )
            $
            0.14Forfeited
            
            
            (5,816
            )
            $
            0.25Outstanding
                at September 30, 2006
            
            
            117,317
            
            $
            0.22
            
            
            8.6
            
            $
            2,871Vested
                or expected to vest at September 30, 2006
            
            
            72,995
            
            $
            0.16
            
            
            8.2
            
            $
            2,842





The
      weighted-average grant-date fair value of options granted during the nine months
      ended September 30, 2006 was $0.11. The total intrinsic value of options
      exercised during the nine months ended September 30, 2006 was $425,000. Total
      cash received from options exercised was $350,000 and $903,000 for the nine
      months ended September 30, 2006 and 2005, respectively.





A
      summary
      of the status of NeoMedia’s nonvested shares as of September 30, 2006, and
      changes during the nine months ended September 30, 2006, is presented
      below:





**Weighted****Average****Grant
                Date****Nonvested
                Shares**
            
            **Shares**
            
            **Fair
                Value**(in
                thousands)Nonvested
                at January 1, 2006
            
            
            44,215
            
            $
            0.18Granted
            
            
            15,870
            
            $
            0.12Vested
            
            
            (11,929
            )
            $
            0.20Forfeited
            
            
            (3,834
            )
            $
            0.21Nonvested
                at September 30, 2006
            
            
            44,322
            
            $
            0.24





As
      of
      September 30, 2006, there was $7,973,000 of total unrecognized compensation
      cost
      related to nonvested share-based compensation arrangements granted under the
      Plans. That cost is expected to be recognized over a weighted-average period
      of
      1.2 years.




38




**Other
      Stock-based Compensation Expense**




On
      January 10, 2006, NeoMedia issued 52,632 fully vested shares to an employee
      as a sign-on bonus. The shares were valued at $0.309 per share, which was the
      last sale price of NeoMedia common stock on the date of issuance. The aggregate
      fair value of $16,000 was expensed during the nine months ended September 30,
      2006.




On
      April
      5, 2006, NeoMedia issued 115,681 fully vested shares to an employee as a
      sign-on bonus. The shares were valued at $0.389 per share, which was the last
      sale price of NeoMedia common stock on the date of issuance. The aggregate
      fair
      value of $45,000 was expensed during the nine months ended September 30, 2006.




On
      May
      30, 2006, June 30, 2006, and July 31, 2006, NeoMedia issued 6,977, 6,557, and
      36,000 fully vested shares, respectively, to an outside consultant for
      services rendered. The shares were valued at $0.215, $0.244, and $0.19 per
      share, respectively, which was the last sale price of NeoMedia common stock
      on
      the date of each issuance. The aggregate fair value of $10,000 was expensed
      during the nine months ended September 30, 2006.




On
      August
      8, 2006, NeoMedia issued 1,098,467 fully vested shares to an outside
      consultant as prepayment for one year of consulting services. The shares were
      valued at $0.163 per share, which was the last sale price of NeoMedia common
      stock on the date of issuance. The aggregate fair value of $179,000 was expensed
      during the nine months ended September 30, 2006.




On
      August
      29, 2006, NeoMedia issued 161,290 fully vested shares to an employee as a
      sign-on bonus. The shares were valued at $0.124 per share, which was the last
      sale price of NeoMedia common stock on the date of issuance. The aggregate
      fair
      value of $20,000 was expensed during the nine months ended September 30, 2006.




On
      August
      31, 2006, NeoMedia issued 4,975,000 fully vested shares to an employee in
      exchange for (i) an extension of the employee’s service agreement through
      December 31, 2007, and (ii) a waiver of certain of the employee’s rights to
      receive additional shares under a previous contract. The shares were valued
      at
      $0.132 per share, which was the last sale price of NeoMedia common stock on
      the
      date of issuance. The aggregate fair value of $657,000 was expensed during
      the
      nine months ended September 30, 2006.




On
      August
      31, 2006, NeoMedia issued 5,400,000 fully vested shares to an employee in
      exchange for (i) an extension of the employee’s service agreement through
      December 31, 2007, and (ii) a waiver of certain of the employee’s rights to
      receive additional shares under a previous contract. The shares were valued
      at
      $0.132 per share, which was the last sale price of NeoMedia common stock on
      the
      date of issuance. The aggregate fair value of $713,000 was expensed during
      the
      nine months ended September 30, 2006.




On
      September 12, 2006, NeoMedia issued 96,429 fully vested shares to an
      outside consultant for services rendered. The shares were valued at $0.14 per
      share, which was the last sale price of NeoMedia common stock on the date of
      issuance. The aggregate fair value of $14,000 was expensed during the nine
      months ended September 30, 2006.




**Subsequent
      Events**




On
      October 4, 2006, NeoMedia issued 94,340 fully vested shares to an employee
      as a sign-on bonus. The shares were valued at $0.106 per share, which was the
      last sale price of NeoMedia common stock on the date of issuance. The aggregate
      fair value of $10,000 will be expensed during the fourth quarter of 2006.




On
      October 17, 2006, NeoMedia issued 104,167 fully vested shares to an
      employee as a sign-on bonus. The shares were valued at $0.10 per share, which
      was the last sale price of NeoMedia common stock on the date of issuance. The
      aggregate fair value of $10,000 will be expensed during the fourth quarter
      of
      2006.




On
      October 18, 2006, NeoMedia issued 5,500,000 fully vested shares to an
      employee in exchange for an extension of the employee’s services. The shares
      were valued at $0.097 per share, which was the last sale price of NeoMedia
      common stock on the date of issuance. NeoMedia did not recognize any expense
      relating to this issuance during the three and nine month periods ended
      September 30, 2006 since the issuance occurred in October. NeoMedia will expense
      the aggregate fair value of $534,000 during the fourth quarter of 2006.




39




On
      October 20, 2006, NeoMedia issued 108,630 fully vested shares to an
      employee as severance payment. The shares were valued at $0.10 per share, which
      was the last sale price of NeoMedia common stock on the date of issuance. The
      aggregate fair value of $10,000 will be expensed during the fourth quarter
      of
      2006.




On
      October 23, 2006, NeoMedia issued 250,000 fully vested shares to an
      employee as a sign-on bonus. The shares were valued at $0.10 per share, which
      was the last sale price of NeoMedia common stock on the date of issuance. The
      aggregate fair value of $25,000 will be expensed during the fourth quarter
      of
      2006.




40




**10.** **SEGMENT
      REPORTING**




As
      of September 30,
      2006,
      NeoMedia was structured and evaluated by its Board of Directors and Management
      as three distinct business units:





-
            NeoMedia
                Mobile (NMM) - encompassing NeoMedia’s physical-world-to-internet and
                mobile marketing technologies branded under qode, 12Snap, Sponge,
                Gavitec
                and Mobot




-
            NeoMedia
                Micro Paint Repair (NMPR) - encompassing the micro paint and auto
                aftermarket accessories manufactured and distributed by
                NeoMedia





-
            NeoMedia
                Telecom Services (NTS) - encompassing the billing, clearinghouse
                and
                information management services of recently-acquired
                BSD




NeoMedia’s
      reportable segments are strategic business units that offer different technology
      and marketing strategies. NMM is headquartered in Ft. Myers, Florida, and
      operates principally in the United States and in Europe through the recent
      acquisitions of Sponge (United Kingdom), 12Snap (Germany) and Gavitec (Germany).
      NMPR is headquartered in Ft. Myers, Florida, and currently sells into Canada,
      the United States, Australia, New Zealand, Scandinavia, Mexico and China. NTS
      is
      headquartered in Calgary, Alberta, Canada and presently primarily operates
      within Canada.




On
      August
      30, 2006, NeoMedia signed a non-binding letter of intent to sell its NMPR
      business unit to Jose
      Sada, a technology partner of NeoMedia Micro Paint Repair, backed
      by Global
      Emerging Markets Group of New York City .
      The
      letter of intent calls for consummation
      of the transaction on or before **** November
      24, 2006. As
      a
      result of the letter of intent to sell NMPR, results of operations of NMPR
      are
      shown under the caption “Net loss from Micro Paint business to be sold” on the
      accompanying condensed consolidated financial statements, and as such are no
      longer included in this segment reporting.




41




Consolidated
      net sales and net loss from continuing operations for the three and nine month
      periods ended September 30, 2006 and 2005, and identifiable assets as of
      September 30, 2006 by geographic area were as follows:




(in
                  thousands)
              
              (in
                  thousands)**Three
                  Months Ended**
              
              **Nine
                  Months Ended****September
                  30,**
              
              **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005****Net
                  Sales:  (2)**United
                  States
              
              $
              298
              
              $
              193
              
              $
              819
              
              $
              762Germany
              
              
              1,424
              
              
              —
              
              
              3,713
              
              
              —United
                  Kingdom
              
              
              697
              
              
              —
              
              
              1,748
              
              
              —Canada
              
              
              3,205
              
              
              —
              
              
              6,374
              
              
              —Italy
              
              
              597
              
              
              —
              
              
              1,179
              
              
              —Other
              
              
              28
              
              
              —
              
              
              296
              
              
              —$
              6,249
              
              $
              193
              
              $
              14,129
              
              $
              762**Net
                  Loss From Continuing Operations: (2)**United
                  States
              
              
              ($28,981
              )
              
              ($1,569
              )
              
              ($23,593
              )
              
              ($4,162
              )Germany
              
              
              (150
              )
              
              —
              
              
              (759
              )
              
              —United
                  Kingdom
              
              
              (561
              )
              
              —
              
              
              (543
              )
              
              —Canada
              
              
              227
              
              
              —
              
              
              463
              
              
              —Italy
              
              
              (271
              )
              
              —
              
              
              (41
              )
              
              —Other
              
              
              447
              
              
              —
              
              
              205
              
              
              —($29,289
              )
              
              ($1,569
              )
              
              ($24,268
              )
              
              ($4,162
              )**Identifiable
                  Assets (2)**United
                  States (1)
              
              $
              80,429Germany
              
              
              1,672United
                  Kingdom
              
              
              676Canada
              
              
              1,594$
              84,371
  (1)
              For
                  segment reporting purposes, goodwill and intangible assets of acquired
                  subsidiaries are assumed to be located at NeoMedia headquarters
                  in the
                  United States.
  (2)
              Segment
                  reporting excludes the NeoMedia Micro Paint Repair business unit
                  discontinued operations and the assets held for
                  sale.
 
 42




Consolidated
      net sales, net operating losses for the three and nine month periods ended
      September 30, 2006 and 2005, and identifiable assets as of September 30, 2006,
      by business unit were as follows:


(in
                  thousands)
              
              (in
                  thousands)**Three
                  Months Ended**
              
              **Nine
                  Months Ended****September
                  30,**
              
              **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005****Net
                  Sales from Continuing Operations:**(4)NeoMedia
                  Mobile(1)
              
              $
              3,044
              
              $
              35
              
              $
              7,755
              
              $
              208NeoMedia
                  Telecom Services(2)
              
              
              3,205
              
              
              —
              
              
              6,374
              
              
              —NeoMedia
                  Consulting & Integration Services(3)
              
              
              —
              
              
              158
              
              
              —
              
              
              554$
              6,249
              
              $
              193
              
              $
              14,129
              
              $
              762**Net
                  Loss from Continuing Operations:**(4)NeoMedia
                  Mobile(1)
              
              
              ($3,276
              )
              
              ($433
              )
              
              ($8,123
              )
              
              ($1,298
              )NeoMedia
                  Telecom Services(2)
              
              
              214
              
              
              —
              
              
              31
              
              
              —NeoMedia
                  Consulting & Integration Services(3)
              
              
              —
              
              
              (463
              )
              
              —
              
              
              (1,388
              )Corporate
                  overhead
              
              
              (3,700
              )
              
              (673
              )
              
              (9,443
              )
              
              (1,476
              )Charges
                  related to convertible preferred stock, convertible debenture,
                  and
                  write-off of deferred financing costs
              
              
              (22,527
              )
              
              —
              
              
              (6,733
              )
              
              —($29,289
              )
              
              ($1,569
              )
              
              ($24,268
              )
              
              ($4,162
              )**Identifiable
                  Assets**(4)NeoMedia
                  Mobile(1)
              
              $
              76,110NeoMedia
                  Telecom Services(2)
              
              
              3,387NeoMedia
                  Consulting & Integration Services(3)
              
              
              —Corporate
              
              
              4,874$
              84,371
 
 (1)
              NeoMedia
                  Mobile consists of NeoMedia's qode® and patent business, Mobot, Sponge,
                  Gavitec, and 12Snap. Mobot operations are included in NeoMedia's
                  consolidated financial results for the period February 18, 2006
                  through
                  September 30, 2006. Gavitec and Sponge operations are included
                  in
                  NeoMedia's consolidated financial results for the period February
                  24, 2006
                  through September 30, 2006. 12Snap operations are included in NeoMedia's
                  consolidated financial results for the period March 1, 2006 through
                  September 30, 2006. Net loss of $8,123,000 for the nine months
                  ended
                  September 30, 2006 includes $1,149,000 of stock based compensation
                  recognized pursuant to SFAS 123.
 
 (2)
              NeoMedia
                  Telecom Services consists of the operations of BSD Software, Inc.,
                  acquired March 21, 2006, and included in NeoMedia's consolidated
                  financial
                  results for the period March 22, 2006 through September 30, 2006.
                  Net
                  income of $31,000 for the nine months ended September 30, 2006
                  includes
                  $432,000 of stock based compensation recognized pursuant to SFAS
                  123
 
 (3)
              NeoMedia
                  Consulting & Integration Services business unit was wound down during
                  the first quarter of 2006 and combined with the NeoMedia Mobile
                  business
                  unit. Results from operations previously included in this business
                  unit
                  are now included in the NeoMedia Mobile business
                  unit.
 
 (4)
              Segment
                  reporting excludes the Micro Paint Repair business unit discontinued
                  operations and the assets held for sale.





Operating
      costs included in one segment may benefit other segments, and therefore these
      segments are not designed to measure operating income or loss directly related
      to the products included in each segment.




43




**11.** **INVENTORY**





Inventories
      for continuing operations, consisting of material, material overhead, labor
      and
      processing costs, are stated at the lower of cost (first-in, first-out) or
      market and consist of the following at September 30, 2006:





September
                30,
              2006Raw
                materials
            
            $
            —Work-in-process
            
            
            —Finished
                goods
            
            
            53Total
            
            $
            53




**12.** **ACCRUED
      LIABILITIES**





Accrued
      liabilities for continuing operations consist of the following as of September
      30, 2006:





September
                30,
              2006Accruals
                related to silent partner agreements
            
            $
            1,507Accrued
                legal and accounting costs
            
            
            426Accruals
                for disputed services
            
            
            794Accrued
                operating expenses
            
            
            1,441Payroll
                related accruals
            
            
            442Accrued
                liquidated damages on Series C convertible
                preferred stock
            
            
            161Total
            
            $
            4,771




44


**13.** **COMMITMENTS
      AND CONTINGENCIES**





NeoMedia
      is party to various commitments and contingencies, such as:


·
              NeoMedia
                  and its subsidiaries lease office facilities and certain office
                  and
                  computer equipment under various operating
                  leases
 
 ·
              NeoMedia
                  is party to various payment arrangements with its vendors that
                  call for
                  fixed payments on past due
                  liabilities
 
 ·
              NeoMedia
                  is party to various consulting agreements that carry payment obligations
                  into future years.
 
 ·
              NeoMedia
                  issued Series C convertible preferred shares with face value of
                  $22,000,000 and convertible debentures with a face value of $5
                  million
                  that are subject to conversion at future
                  dates
 
 ·
              NeoMedia
                  holds notes payable to certain vendors and silent partners of an
                  acquired
                  subsidiary that mature at various dates in the future.
 
 ·
              NeoMedia’s
                  subsidiary Sponge has entered into purchase commitments to procure
                  the
                  functionality needed to support a sales agreement with a major
                  customer.
                  The purchase commitments require payments of $1,121,000 in the
                  fourth
                  quarter of 2006, and $2,200,000 in 2007. Revenues related to this
                  program
                  are expected to exceed the purchase commitments over the one-year
                  life of
                  the contract.




The
      following table sets forth NeoMedia’s future minimum payments due under
      operating leases, vendor and consulting agreements, convertible stock
      agreements, and debt agreements:





**Series
                C****Vendor
                &**
            
            
            
            
            
            **Convertible****Operating**
            
            **Consulting**
            
            **Notes**
            
            **Convertible**
            
            **Preferred****Leases**
            
            **Agreements**
            
            **Payable**
            
            **Debentures**
            
            **Stock**
            
            **Total**2006
                (remaining three months)
            
            $
            219
            
            $
            3,040
            
            $
            2,312
            
            $
            —
            
            $
            —
            
            $
            5,5702007
            
            
            743
            
            
            4,180
            
            
            27
            
            
            —
            
            
            —
            
            
            4,9502008
            
            
            571
            
            
            —
            
            
            —
            
            
            5,000
            
            
            —
            
            
            5,5712009
            
            
            323
            
            
            —
            
            
            —
            
            
            —
            
            
            22,000
            
            
            22,3232010
            
            
            206
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            206Thereafter
            
            
            198
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            198Total
            
            $
            2,260
            
            $
            7,220
            
            $
            2,339
            
            $
            5,000
            
            $
            22,000
            
            $
            38,818





It
      is not
      possible to predict the maximum potential amount of future payments under these
      or similar agreements due to the conditional nature of the Company’s obligations
      and the facts and circumstances involved in each particular agreement. The
      Company does not record a liability for claims related to indemnification unless
      the Company concludes that the likelihood of a material claim is probable and
      estimable. Historically, payments pursuant to these indemnifications have been
      immaterial. See Item 1 of Part II of this Form 10-Q for discussion of legal
      proceedings.





In
      the
      event that NeoMedia’s stock price, at the time the consideration shares issued
      in connection with the acquisitions of Mobot, Sponge, Gavitec, and 12Snap become
      saleable, is less than the contractual price (between $0.3839 and $0.3956),
      NeoMedia is obligated to compensate the sellers in cash for the difference
      between the price at the time the shares become saleable and the relevant
      contractual price. Assuming a stock price at the time the shares become saleable
      of $0.10, which was the last sale price on October 23, 2006, NeoMedia would
      have
      a cash liability of $32.7 million relating to the guarantees. On September
      11,
      2006, NeoMedia filed a registration statement on Form S-3 which included the
      consideration shares issued to acquire Mobot, Sponge, Gavitec, and 12Snap,
      among
      others. At current stock prices, NeoMedia does not believe that it will be
      able
      to generate enough cash to satisfy the purchase price guarantees if and when
      they become due, which is expected to occur upon effectiveness of the
      registration statement. As a result, NeoMedia is attempting to negotiate for
      payment of the purchase price guarantees in another form, including additional
      shares of common stock. There is no guarantee that NeoMedia will be successful
      in negotiating such an agreement with any or all of the parties involved.




45




**14.** **OTHER**





**Liabilities
      related to silent partnership arrangements**





12Snap,
      a
      wholly-owned subsidiary of NeoMedia, entered into three silent partnership
      arrangements in 2000 with principal borrowing amounts, totaling
      EUR 3,500,000 (approximately $4.2 million). Silent partnerships are a
      common form of investment in Germany. The purpose of a silent partnership is
      to
      financially support the Company in its efforts to research, design and develop
      its product and services, while allowing the lenders not to become a legal
      owner
      of the company and thus not become liable for the obligation of the company.
      The
      lenders are not involved in the management of 12Snap, but significant business
      decisions such as changes in the articles of incorporation, mergers and
      acquisitions or significant contractual matters are subject to their
      approval.




The
      partnership agreements regularly terminate on December 31, 2008 and 2009.
      However, due to the acquisition of all shares of 12Snap by NeoMedia, an early
      termination has been agreed on for all silent partnership agreements. Those
      silent partnerships have thus terminated as of February 28, 2006. According
      to
      the termination agreements EUR 1,750,000 (approximately $2.1 million) were
      repaid to the silent partners in March 2006. Another installment amounting
      to
      EUR 1,750,000 (approximately $2.1 million) plus interest will be due as of
      December 31, 2006.




In
      addition, one of the silent partners initiated arbitration proceedings during
      2006 claiming the amount of EUR 353,000 (approximately $443,000) plus interest
      of 5% per annum since March 1, 2006 arising out of a change in control clause
      of
      the silent partnership agreement. The matter has been subject to German
      arbitration proceedings during the third and fourth quarter 2006, and the
      parties are currently negotiating a settlement based on the arbitration
      proceedings.







**Debt
      of NeoMedia Telecom Services**





The
      NeoMedia Telecom Services business unit was formed in March 2006 with the
      acquisition of BSD Software, Inc. BSD was party to certain debt agreements
      prior
      to the acquisition which became obligations of NeoMedia upon completion of
      the
      acquisition, as follows:





Wayside
      Solutions, Inc., a corporation affiliated with BSD, provided financing services
      to BSD prior to the acquisition. Prior to the acquisition, NeoMedia reached
      an
      agreement with Wayside to pay the outstanding debt due to Wayside subsequent
      to
      completion of the acquisition. During June 2006, NeoMedia issued 3,721,698
      shares of its common stock in satisfaction of the debt and accrued interest.
      NeoMedia valued the stock at $0.227 per share, which was the last sale price
      on
      the date of issuance.




During
      June 2006, NeoMedia issued 1,512,093 shares of its common stock in satisfaction
      of the debt and accrued interest due to Guy Fietz, CEO, President and a
      shareholder of BSD, and now Vice President and General Manager of NeoMedia
      Telecom Services. NeoMedia valued the stock at $0.24 per share, which was the
      last sale price on the date of issuance.




NeoMedia
      also assumed amounts due to former BSD shareholders which bear interest at
      rates
      varying from 0%-10% per annum, are unsecured and due on demand and are subject
      to cash payment plans. Amounts due under such arrangements were $56,000 as
      of
      September 30, 2006.




46




**Micro
      Paint Developments in China**





On
      February 28, 2006, NeoMedia signed a 10-year exclusive supplier agreement with
      Automart, a Beijing-based joint venture operating under the laws of the People's
      Republic of China specializing in automobile sales, financing, insurance and
      repair. Automart is the brand name of Jinche Yingang Auto Technological Services
      Limited, with which NeoMedia signed a distribution agreement in August 2005.
      The
      new agreement expands on the previous agreement, giving Automart the exclusive
      rights to distribute NeoMedia’s micro paint repair products to their own stores
      and others throughout China, Hong Kong, Macao, and Taiwan, and also guaranteeing
      that Automart will purchase at least 70% of its non-micro paint products through
      NeoMedia as its distributor. NeoMedia has signed distribution agreements with
      DuPont and PPG, and intends to become a distributor of other automotive
      aftermarket products to Automart.





During
      the fourth quarter of 2005 and first quarter of 2006, NeoMedia shipped and
      invoiced $759,000 of Micro Paint Repair products to Automart that has not yet
      been recognized in revenue as of September 30, 2006. The amount of $573,000
      is
      included in deferred costs as of September 30, 2006.





In
      the
      third quarter of 2006, NeoMedia established a reserve for bad debt against
      the
      open accounts receivable, and wrote off the deferred revenue and deferred costs,
      incurring a net charge to income of $653,000. NeoMedia will recognize revenue
      on
      these shipments if and when collectibility is reasonably
      assured.





**Pick
      Ups Plus and Automotive Preservation**





On
      February 25, 2005, NeoMedia invested $250,000 in exchange for 8,333,333 shares
      of Pickups Plus, Inc. (“PUPS”)(OTCBB:PUPS) restricted common stock. PUPS is
      a
      retail operator and franchiser of retail automotive parts and accessories stores
      catering to the light truck market, and also provides new vehicle preparation,
      environmental protection packages, detailing and reconditioning products and
      services. In addition, on February 17, 2006, NeoMedia acquired an additional
      20,000,000 shares of PUPS common stock from Cornell Capital Partners acquired
      from the proceeds of the Series C convertible preferred stock sale. The total
      of
      28,333,333 shares owned represent approximately 19.75% of PUPS outstanding
      shares (based on 143,482,281 PUPS shares outstanding as of March 15, 2006).
      Because the investment represents less than 20% of PUPS outstanding shares,
      and
      because NeoMedia does not exercise significant influence over PUPS operations
      or
      decision making, NeoMedia has recorded the investment as available for sale
      securities and reported at fair value. As of September 30,
      2006, NeoMedia has recorded an unrealized holding loss of $384,000 due to the
      decrease in the quoted market price of PUPS common stock.





Also
      on
      February 25, 2005, NeoMedia signed two non-binding Letters of Intent to acquire
      up to 100% of Automotive Preservation, Inc. (“AP”), a distributor of automotive
      paint and accessory products, from AP’s parent company, PUPS. The first Letter
      of Intent calls for NeoMedia to initially acquire 30% of AP for $1,600,000,
      to
      be paid $600,000 in cash, $554,000 in shares of NeoMedia restricted common
      stock, and $446,000 through the assumption of AP debt by NeoMedia. Under the
      second Letter of Intent, upon completion of the acquisition of the initial
      30%
      of AP by NeoMedia, NeoMedia would have the option to acquire an additional
      30%
      of AP for $1,650,000, payable in shares of NeoMedia restricted common stock.
      The
      second Letter of Intent also gives NeoMedia the option to purchase the final
      40%
      of AP for either: (i) $2,200,000, payable in shares of NeoMedia restricted
      common stock, if NeoMedia exercises this right within 12 months of acquiring
      the
      second 30% of AP, or (ii) a price equivalent to AP’s previous quarter EBITDA
      multiplied by 8, payable in shares of NeoMedia restricted common stock. Both
      Letters of Intent are non-binding and subject to due diligence by NeoMedia
      and
      AP. On September 21, 2005, NeoMedia’s board of directors approved to change the
      deal structure for the acquisition of AP, so that the Company would acquire
      only
      30% of AP for a total purchase price of $1.6 million of which $600,000 would
      be
      paid in cash and $446,000 would be paid through the assumption of debt, and
      $554,000 through the issuance of restricted NeoMedia stock. NeoMedia will not
      acquire the remaining 70% of AP under the new structure.




47





During
      April 2006 ,
      NeoMedia announced its intention to issue a stock dividend with the distribution
      of common shares of PUPS common stock as a property dividend. NeoMedia intends
      to distribute 8,333,333 shares of PUPS common stock, which it acquired in
      February 2005, to NeoMedia shareholders of record as of April 28, 2006. The
      shares are to be distributed at such time as PUPS files and makes effective
      a
      registration statement registering the shares. As of September 30, 2006, PUPS
      had not filed a registration statement and is not legally obligated to file
      a
      registration statement.





**Patent
      Issuance**





During
      April 2006 ,
      the
      Instituto Mexicano de la Propiedad Industrial, the patent office in Mexico,
      awarded patent No. 233529 to NeoMedia, which corresponds to patents issued
      to
      the company by the U.S. Patent Office and the Canadian Intellectual Property
      Office, for a "Method and System for Accessing Electronic Resources via
      Machine-Readable Data on Intelligent Documents." Dr. Kevin Hunter, NeoMedia’s
      chief scientist, is the inventor of record. NeoMedia has also filed for patents
      for the process in Europe, Japan and Brazil. The patent deals with improved
      methods of storing information placed directly on physical objects as
      PC-readable data utilizing 2-dimensional bar codes and various data compression
      techniques.





**Change
      to Composition of Compensation Committee of Board of
      Directors**





On
      September 20, 2006, the Board of Directors approved a change in the composition
      of the Compensation Committee. Previously the Compensation Committee was
      comprised of Charles W. Fritz, Charles T. Jensen, and James J. Keil. Effective
      September 20, 2006 the Compensation Committee will be comprised of all outside
      directors, including James J. Keil, A. Hayes Barclay, and William E. Fritz.





**15.** **SUBSEQUENT
      EVENTS**




See
      Note 9.




48


**ITEM
              2.**
            **MANAGEMENT'S
                DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                OPERATIONS**





**NeoMedia
      in the Marketplace**





During
      the first quarter of 2006, NeoMedia implemented an aggressive growth strategy
      aimed at penetrating the rapidly evolving mobile marketing industry, through
      the
      acquisition of Mobot, Gavitec, 12Snap, and Sponge. Combining the brand name
      and
      innovative power of its new acquisitions with its patent portfolio and
      proprietary qode® suite of products, NeoMedia’s goal is to capture a significant
      portion of early adopting marketers and drive high volumes of
      physical-world-to-mobile-internet traffic through the NeoMedia engine.





As
      with
      any industry in its relative infancy, there have been bumps along the way.
      NeoMedia has experienced many of the problems normally associated with
      developing technologies and markets, such as slower than anticipated marketplace
      adoption, technical product development issues, the market’s unwillingness to
      find a standard pricing model, and increased competition, among others.





However,
      NeoMedia management believes that the Company has made significant inroads
      into
      this developing market. NeoMedia’s family of products and companies has run some
      of the most innovative and successful mobile marketing campaigns in the
      marketplace during 2006, such as:





·
            **qode®**technology will be featured in an interactive textbook published
                by
                Prentice Hall, in which students can link to mobile online content
                through
                the qode® reader on their mobile phones.





·
            **12Snap**designs and runs mobile marketing campaigns for a plethora of clients,
                most notably McDonald’s, Coca-Cola, Adidas, Nokia, Lufthansa, MTV, Kraft
                Foods, and Ferrero. 12snap enables millions of consumers throughout
                the
                EMEA (Europe, Middle East & Africa) region to participate in
                high-quality and entertaining mobile marketing
                campaigns.





·
            **Gavitec**has run mobile marketing solutions for clients such as McDonald’s
                Portugal, Amnesty International, Malaysian Railways, World
                Soccer Games 2006, EMT (Empresa Malagueña de Transportes, a
                Spanish public transport provider) Ströer, a large media company.
                Gavitec also ran a mobile couponing campaign for Bitburger beer focusing
                on World Cup events.





·
            **Sponge**media successes included increased activity for IPC magazines and
                News
                International, as well as television program Big Brother in Sweden
                and
                Norway. Sponge has also worked on a number of brand promotions, including:
                a major specialist motorcycle magazine; on-pack text-to-win mechanics
                for
                a major soft drinks brand to coincide with the World Cup as well
                as other
                drinks and confectionary brands. Also launched was a pan-European,
                eight-country trade promotion for TaylorMade®-adidas® Golf.





·
            **Mobot**expanded
                its relationship with Hachette Filipacchi Media and delivered a
                first-of-its-kind nationwide (U.S. & Canada) campaign for Starbucks.
                Mobot also helped launch an interactive shopping program called*EWish*with
                ELLE magazine, and provided a direct link campaign for Acura.




49


**NeoMedia
      Telecom**





During
      March 2006, NeoMedia acquired BSD Software, Inc. and created NeoMedia Telecom
      Services Business Unit. The acquisition of BSD did not contain the same purchase
      price guarantee provision as the other acquisitions.





NeoMedia
      Telecom is currently in the final stages of completing the successful transition
      of some of its key customers to a new Canadian interchange carrier network,
      which provides both 1010 dial-around and 900 service nationally. The company
      is
      already experiencing a positive impact from this transition in two
      ways: (1) several customers who were regional are expanding to a national
      billing strategy, and (2) NeoMedia Telecom has been able to reduce costs by
      moving from local exchange carriers (LEC’s) to the new interchange carrier
      network, which is a non-tariffed (regulated rates) national network.





Third
      quarter revenue from NeoMedia Telecom was $3,205,000, up from second quarter
      revenue of $2,937,000 million. The revenue growth is the result of transition
      to
      the new IXC, which lowers NeoMedia Telecom’s cost basis, as well as expansion of
      the NeoMedia Telecom’s billing solutions to U.S. carriers.





**Purchase
      Price Obligation**





From
      a
      capitalization perspective, NeoMedia was a relatively small player in the mobile
      marketing industry prior to its acquisitions of 12Snap, Gavitec, Sponge and
      Mobot. Many large advertising agencies, software providers, and other larger
      and
      better-funded companies were and continue to be in the market for acquisition
      of
      these cutting-edge start-ups. In order to induce companies of this caliber
      to
      merge with a smaller, unproven entity with fewer resources than competing
      bidders, NeoMedia agreed to a purchase price guarantee for the stock
      consideration issued in each transaction, essentially guaranteeing, with cash,
      that the value of the stock issued to acquire the companies would not decline
      between the closing of the acquisitions and the time the recipients could sell
      it. The stock price at the time the acquisitions closed was approximately $0.39
      per share. Since the closing of the acquisitions in February and March,
      NeoMedia’s stock price has gradually eroded. The last sale price on October 23,
      2006 was $0.10 per share, at which price the purchase price guarantee obligation
      would be approximately $32.7 million.





NeoMedia
      has neither sufficient operating capital nor contractually committed capital
      from outside sources to adequately fund the purchase price guarantee at these
      levels. As a result, NeoMedia has sought other means to satisfy or eliminate
      the
      obligations, including an offer to pay the obligation with shares of its common
      stock. As of the date of this filing, there have been no formal agreements
      put
      in place with respect to alternate payment of any of the obligations. In the
      event that the obligations are not satisfied through the issuance of common
      stock or other non-cash means, NeoMedia could be forced to sell or otherwise
      divest of some of its subsidiaries in the near future, or be subject to
      potential litigation by the shareholders of the acquired companies.





**Additional
      Cost Reductions**





During
      the third and fourth quarters of 2006, NeoMedia is implementing company wide
      cost reduction plans aimed at conserving its limited cash resources, including
      reductions of its workforce, termination of several month-to-month consulting
      arrangements, and other cost savings measures. NeoMedia will also realize
      additional cost reductions upon the sale of its Micro Paint Repair business
      unit, which has operated at a loss since its acquisition in February 2004.
      NeoMedia will continue to evaluate its cost base and reduce redundant or
      non-mission critical costs during the remainder of 2006 and into 2007.





**Sale
      of Micro Paint Business Unit**





On
      August
      30, 2006, NeoMedia signed a non-binding letter of intent to sell its Micro
      Paint
      Repair business unit to Jose
      Sada, a technology partner of NeoMedia Micro Paint Repair, backed
      by Global
      Emerging Markets Group of New York City .
      The
      letter of intent calls for consummation
      of the transaction on or before **** November
      24, 2006.




50





As
      a
      result of the pending sale, the operations of the NeoMedia
      Micro Paint Repair business unit have been classified as discontinued operations
      on the accompanying consolidated statements of operations for the three and
      nine
      months ended September 30, 2006 and 2005, and the
      assets and liabilities of the business unit have been classified as assets
      held
      for sale and liabilities held for sale on the accompanying consolidated balance
      sheets as of September 30, 2006 and December 31, 2005. Loss from these
      discontinued operations was $1,620,000 and $381,000 for the three
      months ended
      September 30, 2006 and 2005, respectively, and $2,826,000 and $1,307,000 for
      the
      nine months ended
      September 30, 2006 and 2005, respectively. The carrying value of assets held
      for
      sale was $3,451,000 (unaudited) and $4,058,000 as of September 30, 2006 and
      December 31, 2005, respectively. The carrying value of liabilities held for
      sale
      was $750,000 (unaudited) and $669,000 as of September 30, 2006 and December
      31, 2005, respectively. There have been no adjustments to the carrying value
      subsequent to September 30, 2006 and prior to this filing. NeoMedia will not
      recognize depreciation and amortization on the assets held for sale subsequent
      to September 30, 2006 through the date of sale. Depreciation and amortization
      on
      assets held for sale would be approximately $77,000 per quarter.





**Termination
      of Hip Cricket Acquisition**





On
      August
      24, 2006, NeoMedia terminated a non-binding letter of intent to acquire Hip
      Cricket, due to an inability of the parties to come to terms on a definitive
      purchase price. On February 16, 2006, NeoMedia and Hip Cricket signed the letter
      of intent, under which NeoMedia intended to acquire all of the outstanding
      shares of Hip Cricket in exchange for $500,000 cash and $4,000,000 of NeoMedia
      common stock, subject to due diligence and signing of a mutually agreeable
      definitive purchase agreement by both parties.




In
      addition to signing the letter of intent, NeoMedia loaned Hip Cricket the
      principal amount of $500,000 in the form of (a) a promissory note, dated
      February 16, 2006, in the amount of $250,000 and (b) that certain promissory
      note, dated March 20, 2006, in the amount of $250,000. The notes accrue interest
      at a rate of 8% per annum. The notes were to be applied toward the cash portion
      of the purchase price upon signing of a definitive purchase agreement for the
      acquisition of all of the outstanding shares of Hip Cricket by NeoMedia, as
      contemplated in the letter of intent. Due to the termination of the letter
      of
      intent, and pursuant to the terms of the notes, the face amount of the notes,
      plus any and all interest accrued thereon, will become payable and due on
      November 22, 2006. In the event the Notes are not repaid by November 22, 2006,
      the notes will convert into shares of Hip Cricket common stock using a valuation
      of $4.5 million for Hip Cricket.





**Consulting
      & Integration Services Business Unit**





As
      part
      of the acceleration of global expansion in the Mobile and Micro Paint business
      units, as well as the creation of the NeoMedia Telecom Services (NTS) business
      unit through the BSD acquisition, NeoMedia also decided in February 2006 to
      wind
      down its legacy NeoMedia Consulting & Integration Services (NCIS) business
      unit. The NCIS unit consisted of client-server equipment and related software
      resales. The resale market has been commoditized over the past several years,
      and NeoMedia believes its resources are better spent on the development and
      commercialization of its NMM, NMPR and NTS business units. Certain of the
      proprietary products associated with the NCIS business, such as PDF-417 and
      Maxicode print encoder software and WISP migration tools, will be retained
      by
      NeoMedia and consolidated with the NMM unit. NeoMedia does not intend to pursue
      additional resales of hardware and software or integration services not directly
      related to its other business units.





**Accounting
      Treatment of Series C Convertible Preferred Stock and Convertible
      Debenture**





In
      connection with the accounting treatment of the Series C convertible preferred
      stock sale (February 17, 2006) and Convertible Debentures (August 24, 2006),
      NeoMedia recognized a (loss) and gain on derivative financial instruments of
      $(9,271,000) and $6,503,000 during the three and nine month periods ended
      September 30, 2006, respectively. The gain and loss is due to the change in
      fair
      value of derivative financial instruments resulting from a decrease in
      NeoMedia's stock price from $0.389 per share on the date of the Series C
      convertible preferred stock sale (February 17, 2006) to $0.117 per share on
      September 30, 2006. The fair value of the derivative financial instruments
      at
      each measurement date correlates to NeoMedia's stock price at the same date.
      As
      a result, NeoMedia's net income varies significantly from its cash flow from
      operations during the three and six months ended June 30, 2006. In future
      periods, NeoMedia's earnings could fluctuate dramatically from quarter to
      quarter if its stock price is significantly different from the stock price
      at
      the end of the previous measurement period. Because NeoMedia cannot guarantee
      that it has enough authorized shares to net share settle the Series C
      convertible preferred stock, the change in fair value of derivative instruments
      will be recorded to NeoMedia's statement of operations each reporting period
      until the Series C convertible preferred stock is fully converted.




51





**Write-off
      of Deferred Financing Costs**





In
      the
      third quarter of 2006, NeoMedia incurred a non-cash charge to income in the
      amount of $13,256,000 to write off deferred equity financing costs related
      to
      its $100 million Standby Equity Distribution Agreement. The costs were
      originally recorded in March 2005 and represent the fair value of warrants
      issued as financing costs associated with the 2005 SEDA. The Company believes
      that it can no longer consider the 2005 SEDA a viable financing source due
      to
      the utilization of the preferred stock financing and the debenture financing.




**Critical
      Accounting Policies**





The
      United States Securities and Exchange Commission (the “SEC”) issued Financial
      Reporting Release No. 60, “ *Cautionary
      Advice Regarding Disclosure About Critical Accounting Policies* ”
(“FRR
      60”), suggesting companies provide additional disclosure and commentary on their
      most critical accounting policies. In FRR 60, the SEC defined the most critical
      accounting policies as the ones that are most important to the portrayal of
      a
      company’s financial condition and operating results, and require management to
      make its most difficult and subjective judgments, often as a result of the
      need
      to make estimates of matters that are inherently uncertain. Based on this
      definition, NeoMedia’s most critical accounting policies include: intangible
      asset valuation, which affects amortization and impairment of goodwill and
      other
      intangibles; financial instruments and concentrations of credit risk, which
      affects gains and losses from derivative financial instruments; allowance for
      doubtful accounts; inventory valuation, which affects cost of sales and gross
      margin; stock based compensation; estimate of litigation-based liability; and
      revenue recognition. NeoMedia also has other key accounting policies, such
      as
      policies for revenue recognition, including the deferral of a portion of
      revenues on sales to distributors, allowance for doubtful accounts, and
      stock-based compensation. The methods, estimates and judgments NeoMedia uses
      in
      applying these most critical accounting policies have a significant impact
      on
      the results it reports in its consolidated financial statements.





*Intangible
      Asset Valuation.* The
      determination of the fair value of certain acquired assets and liabilities
      is
      subjective in nature and often involves the use of significant estimates and
      assumptions. Determining the fair values and useful lives of intangible assets
      especially requires the exercise of judgment. While there are a number of
      different generally accepted valuation methods to estimate the value of
      intangible assets acquired, NeoMedia primarily uses the weighted-average
      probability method outlined in SFAS 144. This method requires significant
      management judgment to forecast the future operating results used in the
      analysis. In addition, other significant estimates are required such as residual
      growth rates and discount factors. The estimates NeoMedia has used are
      consistent with the plans and estimates that NeoMedia uses to manage its
      business, based on available historical information and industry averages.
      The
      judgments made in determining the estimated useful lives assigned to each class
      of assets acquired can also significantly affect NeoMedia’s net operating
      results.




52





According
      to SFAS 144, a long-lived asset should be tested for recoverability whenever
      events or changes in circumstances indicate that its carrying amount may not
      be
      recoverable. The following are examples of such events or changes in
      circumstances:




-
            A
                significant decrease in the market price of the
                asset 
 -
            A
                significant adverse change in the extent or manner in which the asset
                is
                being used, or in its physical condition 
 -
            A
                significant adverse change in legal factors or in the business climate
                that could affect the value of the asset, including an adverse action
                or
                assessment by a regulator 
 -
            An
                accumulation of costs significantly in excess of the amount originally
                expected 
 -
            A
                current-period operating or cash flow loss combined with a history
                of
                operating or cash flow losses or a projection or forecast that
                demonstrates continuing losses associated with the use of the
                asset 
 -
            A
                current expectation that, more likely than not,****the
                asset will be sold or otherwise disposed of significantly before
                the end
                of its previously estimated useful life.




NeoMedia
      follows the two-step process outlined in SFAS 144 for determining if an
      impairment charge should be taken: (1) the expected undiscounted cashflows
      from
      a particular asset or asset group are compared to the carrying value; if the
      expected undiscounted cashflows are greater than the carrying value, no
      impairment is taken, but if the expected undiscounted cashflows are less than
      the carrying value, then (2) an impairment charge is taken for the difference
      between the carrying value and the expected discounted cashflows. The
      assumptions used in developing expected cashflow estimates are similar to those
      used in developing other information used by NeoMedia for budgeting and other
      forecasting purposes. In instances where a range of potential future cashflows
      is possible, NeoMedia uses a probability-weighted approach to weigh the
      likelihood of those possible outcomes. NeoMedia used a rate of 10% for purposes
      of discounting cashflows in 2006 and 2005.





*Financial
      Instruments and Concentrations of Credit Risk.* The
      Company’s financial instruments consist of cash and cash equivalents, accounts
      receivable, accounts payable, accrued expenses, notes payable, derivative
      financial instruments, other current liabilities, convertible preferred stock,
      and convertible debenture financing. Management believes the carrying values
      of
      cash and cash equivalents, accounts receivable, accounts payable, accrued
      expenses, notes payable, and other current liabilities approximate their fair
      values due to their short-term nature. The fair value of the convertible
      preferred stock and convertible debenture financing is estimated on September
      30, 2006 to be approximately $1,515,000 and $72,692 respectively.





The
      Company generally does not use derivative financial instruments to hedge
      exposures to cash-flow risks or market-risks that may affect the fair values
      of
      its financial instruments. However, certain other financial instruments, such
      as
      warrants and embedded conversion features that are indexed to the Company’s
      common stock, are classified as liabilities when either (a) the holder possesses
      rights to net-cash settlement or (b) physical or net-share settlement is not
      within the control of the Company. In such instances, net-cash settlement is
      assumed for financial accounting and reporting, even when the terms of the
      underlying contracts do not provide for net-cash settlement. Such financial
      instruments are initially recorded at fair value and subsequently adjusted
      to
      fair value at the close of each reporting period.





The
      caption “Derivative Financial Instruments” consists of (i) the fair values
      associated with derivative features embedded in the Series C convertible
      preferred stock, (ii) the fair values of the detachable warrants that were
      issued in connection with the preferred stock financing arrangement, and (iii)
      the fair value of detachable warrants that were outstanding prior to the
      issuance of the Series C Preferred Shares..





*Allowance
      for Doubtful Accounts.* NeoMedia
      maintains an allowance for doubtful accounts for estimated losses resulting
      from
      the inability of its customers to make required payments. Allowance for doubtful
      accounts is based on NeoMedia’s assessment of the collectibility of specific
      customer accounts, the aging of accounts receivable, NeoMedia’s history of bad
      debts, and the general condition of the industry. If a major customer’s credit
      worthiness deteriorates, or NeoMedia’s customers’ actual defaults exceed
      historical experience, NeoMedia’s estimates could change and impact its reported
      results.




53





*Inventory.* Inventories are stated at lower of cost (using the first-in, first-out method)
      or market. NeoMedia continually evaluates the composition of its inventories
      assessing slow-moving and ongoing products and maintains a reserve for
      slow-moving and obsolete inventory as well as related disposal
      costs.





*Stock-based
      Compensation* .
      Beginning January 1, 2006, NeoMedia began to account for stock-based
      compensation in accordance with SFAS No. 123(R), *Share-Based
      Payment* .
      Under
      the fair value recognition provisions of this statement, share-based
      compensation cost is measured at the grant date based on the value of the award
      and is recognized as expense over the vesting period. Determining the fair
      value
      of share-based awards at the grant date requires judgment, including estimating
      expected dividends. In addition, judgment is also required in estimating the
      amount of share-based awards that are expected to be forfeited. If actual
      results differ significantly from these estimates, stock-based compensation
      expense and our results of operations could be materially impacted. Stock-based
      compensation expense is calculated using the Black Scholes option pricing model
      on the date of grant. This option valuation model requires input of highly
      subjective assumptions. Because NeoMedia’s employee stock options have
      characteristics significantly different from those of traded options, and
      because changes in the subjective input assumptions can materially affect the
      fair value estimate, in management's opinion, the existing model does not
      necessarily provide a reliable single measure of fair value of its employee
      stock options.





*Estimate
      of Litigation-based Liability* .
      From
      time to time, NeoMedia is defendant in certain litigation in the ordinary course
      of business (see the section entitled “Legal Proceedings”). NeoMedia accrues
      liabilities relating to these lawsuits on a case-by-case basis. NeoMedia
      generally accrues attorney fees and interest in addition to the liability being
      sought. Liabilities are adjusted on a regular basis as new information becomes
      available. NeoMedia consults with its attorneys to determine the viability
      of an
      expected outcome. The actual amount paid to settle a case could differ
      materially from the amount accrued.





*Revenue
      Recognition.* NeoMedia derives  revenues from the following  sources:  (1)
      license revenues relating to patents and internally-developed software, (2)
      hardware, software, and service revenues related to mobile marketing campaign
      design and implementation, and (3) sale of its proprietary Micro Paint Repair
      solution.


(1)
              Technology
                  license fees, including Intellectual Property licenses, represent
                  revenue
                  from the licensing of NeoMedia’s proprietary  software  tools
                  and  applications products.  NeoMedia licenses its 
                  development  tools and  application  products pursuant to
                  non-exclusive and  non-transferable  license agreements. 
                  The basis for license fee revenue recognition is substantially
                  governed by
                  American  Institute  of  Certified  Public 
                  Accountants  ("AICPA")  Statement of Position 97-2 "Software
                  Revenue  Recognition" ("SOP 97-2"), as amended, and Statement of
                  Position 98-9, Modification of SOP 97-2, “Software Revenue Recognition,
                  With Respect to Certain Transactions.”.  License revenue is
                  recognized if persuasive  evidence of an agreement 
                  exists,  delivery has occurred, pricing is fixed and determinable,
                  and collectibility is probable.  The Company defers revenue related
                  to license fees for which amounts have been collected but for which
                  revenue has not been recognized in accordance with the above, and
                  recognizes the revenue over the appropriate
                  period.





(2)
            Technology
                service and product revenue, which includes sales of software and
                technology equipment and service fee is recognized  based on
                guidance  provided in  SEC Staff  Accounting 
                Bulletin  (“SAB”) No. 104,  "Revenue  Recognition  in
                Financial Statements,"  as amended (SAB 104).  Software
                and technology equipment resale revenue is
                recognized when persuasive evidence of an arrangement exists, the
                price to the customer is fixed and determinable, delivery of the
                service
                has occurred and collectibility is reasonably assured.
                Service revenues including maintenance fees for
                providing system updates for software products, user documentation
                and
                technical support are recognized over the life of
                the contract.  Software  license revenue  from 
                long-term  contracts  has  been  recognized  on
                a  percentage  of completion  basis,  along with the
                 associated  services being  provided.  Telecom
                revenues are recognized at the time that calls are accepted by the
                clearing house for billing to customers. The Company’s recently acquired
                subsidiaries BSD, Mobot, and Gavitec follow this policy. The Company
                defers revenue related to technology service and product revenue
                for which
                amounts have been invoiced and or collected but for which the requisite
                service has not been provided. Revenue is then recognized over the
                matching service period.




54




(3)
            Technology
                service also includes mobile marketing services to its customers
                which
                mobile marketing projects are recognized after the completion of
                the
                project and accepted by the customer.  All response and messaging
                based revenues are recognized at the time such responses are received
                and
                processed and the Company recognizes its premium messaging revenues
                on a
                net basis based on guidance provided in Emerging Issues Task Force
                Issues
                No. 99-19 (EITF 99-19), “Reporting Revenue Gross as Principal or Net as an
                Agent” and No. 01-09 (EITF 01-09), “Accounting for Consideration Given by
                a Vendor to a Customer.”  Consulting and management revenues and
                revenues for periodic services are recognized as services are
                performed.  NeoMedia uses  stand-alone  pricing to
                determine an element's  vendor  specific  objective 
                evidence  (“VSOE”) in order to allocate an arrangement  fee
                amongst various pieces of a  multi-element  contract.  The
                Company’s recently acquired subsidiaries 12Snap and Sponge follow this
                policy. The Company defers revenue related to mobile marketing service
                fees for which amounts have been invoiced and/or collected but for
                which
                revenue has not been recognized. Revenue is then recognized over
                the
                matching service period.





(4)
            Revenue
                for licensing and exclusivity on NeoMedia’s Micro Paint Repair systems is
                recognized equally over the term of the contract, which is currently
                one
                year.  A portion of the initial fee paid by the customer is allocated
                to licensing, training costs and initial products sold with the system.
                Revenue is recognized upon completion of training and shipment of
                the
                products, provided there is VSOE in a multiple element arrangement. 
                Ongoing product and service revenue is recognized as products are
                shipped
                and services performed.  The Company defers revenue related to micro
                paint repair licensing for which amounts have been invoiced and/or
                collected and revenue is then recognized over the estimated contract
                period, which is currently one year.





In
      December 2003, the SEC issued SAB 104, “Revenue Recognition.” SAB 104
      supersedes SAB 101, “Revenue Recognition in Financial Statements.”
SAB 104’s primary purpose is to rescind accounting guidance contained in
      SAB 101 related to multiple element revenue arrangements, superseded as a
      result of the issuance of EITF 00-21, “Accounting for Revenue Arrangements
      with Multiple Deliverables.” Additionally, SAB 104 rescinds the SEC’s
      Revenue Recognition in Financial Statements Frequently Asked Questions and
      Answers (the “FAQ”) issued with SAB 101 that had been codified in SEC Topic
      13, Revenue Recognition. Selected portions of the FAQ have been incorporated
      into SAB 104. While the wording of SAB 104 has changed to reflect the
      issuance of EITF 00-21, the revenue recognition principles of SAB 101
      remain largely unchanged by the issuance of SAB 104, which was effective
      upon issuance. The adoption of SAB 104 did not impact NeoMedia’s
      consolidated financial statements.





*Income
      Tax Valuation Allowance.* Deferred
      tax assets are reduced by a valuation allowance when, in the opinion of
      management, it is more likely than not that some portion or all of the deferred
      tax assets will not be recognized. The Company has recorded a 100% valuation
      allowance as of September 30, 2006 and 2005.





*Foreign
      Currency Translation.* **** The
      local
      currency has been primarily used as the functional currency throughout the
      world. Translation gains and losses of those operations that use local currency
      as the functional currency are included in the consolidated balance sheets
      as
“Accumulated other comprehensive income (loss).” Where the U.S. dollar is used
      as the functional currency, foreign currency gains and losses are reflected
      in
      income.




55




**Stock-Based
      Compensation**




NeoMedia
      adopted Statement of Financial Accounting Standards No. 123 (“SFAS 123R”)
      on January 1, 2006, using the prospective method for stock option grants
      prior to January 1, 2006 and the modified-prospective transition method for
      stock option grants and restricted stock issued after January 1, 2006. As a
      result, the unamortized compensation expense from stock options granted prior
      to
      January 1, 2006 is not included in the statement of operations. SFAS 123R
      requires all share-based payments to employees to be recognized in the income
      statement based on their fair values. Under the modified-prospective transition
      method, compensation cost recognized for the three and nine months ended
      September 30, 2006 includes: (a) compensation cost for all share-based
      payments granted, but not yet vested as of January 1, 2006 based on the
      grant-date fair value estimated in accordance with the original provisions
      of
      SFAS 123, and (b) compensation cost for all share-based payments granted
      subsequent to January 1, 2006, based on the grant-date fair value estimated
      in accordance with the provisions of SFAS 123R. Such amounts
      are reduced by NeoMedia’s estimate of forfeitures of all unvested
      awards.




Prior
      to
      January 1, 2006, NeoMedia accounted for its stock-based compensation plans
      under the intrinsic-value method prescribed in Accounting Principles Board
      Opinion No. 25 “Accounting for Stock Issued to Employees,” (“APB 25”) and
      related interpretations as permitted by Statement of Financial Accounting
      Standards No. 123, “Accounting for Stock-Based Compensation.” (“SFAS 123”).
      Under APB 25, when the exercise price of options granted to employees equals
      the
      market price of the common stock on the date of grant, no compensation expense
      is recorded.  When the exercise price of options granted to employees is
      less than the market price of the common stock on the date of grant,
      compensation expense is recognized over the vesting period. Had NeoMedia
      accounted for stock based compensation under the fair value method during the
      three and nine months ended September 30, 2005, net loss would have been higher
      by $1.1 million and $2.8 million, respectively, during these periods, causing
      an
      increase to the reported net loss per share of $0.01 for each
      period.




SFAS
      123R
      requires share-based payments to employees to be measured at fair value.
      However, the valuation of employee stock options is an inherently subjective
      process, since market values are generally not available for long-term,
      non-transferable employee stock options. Accordingly, an option pricing model
      is
      utilized to derive an estimated fair value. NeoMedia uses the
      Black-Scholes-Merton pricing model in order to calculate the estimated fair
      value for its stock options.




Approximately
      56% and 37% of the stock-based compensation expense recorded in the three and
      nine months ended September 30, 2006 respectively, relates to the continued
      vesting of stock options that were granted prior to January 1, 2006. In
      accordance with the transition provisions of SFAS 123R, the grant date estimates
      for these options have not been changed.




As
      of
      September 30, 2006, there was $8.0 million of total stock-based compensation
      expense not yet recognized relating to non-vested awards granted under
      NeoMedia’s option plans and restricted stock agreements as calculated under SFAS
      123R. This expense is net of estimated forfeitures and is expected to be
      recognized over a weighted-average period of approximately 1.2 years. The
      amount of stock-based compensation expense to be recorded in any future period
      cannot be exactly predicted due to the uncertainty of future grant levels and
      actual forfeitures to be recorded. Additionally, changes to the assumptions
      used
      in the Black Scholes model could cause a material change in the amount of
      compensation expense to be recorded in future reporting periods.




One
      of
      the key components used in calculating the fair value of stock options is the
      volatility of the underlying stock. As of January 1, 2006, NeoMedia reevaluated
      its volatility calculation to take into consideration the guidance outlined
      in
      Statement 123(R). Prior to January 1, 2006, NeoMedia calculated volatility
      using
      only historical share price data. Under the provisions of Statement 123(R),
      from
      January 1, 2006 onward NeoMedia has considered historical volatility, as well
      expected future volatility. As a result, NeoMedia’s volatility decreased
      significantly for stock based compensation granted during the nine months ended
      September 30, 2006 as compared with stock based compensation granted prior
      to
      January 1, 2006. NeoMedia will evaluate its volatility on an ongoing basis
      using
      the most current information available. NeoMedia expects that, under the
      guidelines of Statement 123(R), future volatility will more closely resemble
      2006 levels than previous years.




56








**Effect
      Of Recently Issued Accounting Pronouncements**




A
      discussion of recent accounting pronouncements is included in Note 2 to the
      consolidated financial statements included in our Annual Report on Form 10-KSB
      for the year ended December 31, 2005.





Emerging
      Issues Task Force issue number 06-03 has been adopted early by NeoMedia in
      the
      first quarter of 2006. The implementation of EITF 06-03 had no impact on current
      or historical financial statements.





In
      June
      2006, the FASB issued FASB Interpretation (FIN) No. 48, “Accounting for
      Uncertainty in Income Taxes,” that provides guidance on the accounting for
      uncertainty in income taxes recognized in financial statements. The
      interpretation will be adopted by the Company on January 1, 2007. The Company
      is
      currently evaluating the impact of adopting FIN 48; however, does not expect
      the
      adoption of this provision to have a material effect on the financial position,
      results of operations or cash flows.





In
      July
      2006, the FASB issued FASB Staff Position (FSP) No. FAS 13-2, “Accounting for a
      Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes
      Generated by a Leveraged Lease Transaction,” that provides guidance on how a
      change or a potential change in the timing of cash flows relating to income
      taxes generated by a leveraged lease transaction affects the accounting by
      a
      lessor for the lease. This staff position will be adopted by the Company on
      January 1, 2007. The Company is currently evaluating the impact of adopting
      this
      FSP; however, the Company does not expect the adoption of this provision to
      have
      a material effect on its financial position, results of operations or cash
      flows.





In
      September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined
      Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements
      No. 87, 88, 106 and 132(R)" ("SFAS 158"). SFAS 158 requires an entity to
      recognize in its statement of financial position an asset for a defined benefit
      pension or postretirement plan's overfunded status or a liability for a plan's
      underfunded status, and to recognize changes in that funded status through
      other
      comprehensive income in the year in which the changes occur.  SFAS 158 will
      not change the amount of net periodic benefit expense recognized in an entity's
      results of operations. SFAS 158 is effective for fiscal years ending after
      December 15, 2006. The
      Company is currently evaluating the impact of adopting this FSP; however, the
      Company does not expect the adoption of this provision to have a material effect
      on its financial position, results of operations or cash flows.




In
      September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulletin No. 108 (“SAB 108”), *Financial
      Statements - Considering the Effects of Prior Year Misstatements when
      Quantifying Misstatements in Current Year Financial
      Statements.”* SAB 108
      provides guidance on how prior year misstatements should be taken into
      consideration when quantifying misstatements in current year financial
      statements for purposes of determining whether the current year’s financial
      statements are materially misstated. SAB 108 provides that once a current year
      misstatement has been quantified, the guidance in SAB No. 99, *Financial
      Statements - Materiality* ,
      should
      be applied to determine whether the misstatement is material and should result
      in an adjustment to the financial statements. Under certain circumstances,
      prior
      year financial statements will not have to be restated and the effects of
      initially applying SAB 108 on prior years will be recorded as a cumulative
      effect adjustment to beginning Retained Earnings on January 1, 2006, with
      disclosure of the items included in the cumulative effect. We will apply the
      provisions of SAB 108 with the preparation of our annual financial statements
      for the calendar year ending December 31, 2006. The Company is
      currently evaluating, but does not expect the application of the provisions
      of SAB
      108 to have
      a material impact, if any, on our financial statements for the calendar year
      ending December 31, 2006.




57


**Results
      Of Operations For The Three Months Ended September 30, 2006 As Compared To
      The
      Three Months Ended September 30, 2005**





*Net
      sales.* Total
      net
      sales from continuing operations for the three months ended September 30, 2006
      were $6,249,000, which represented a $6,056,000, or 3,138%, increase from
      $193,000 for the three months ended September 30, 2005.  This increase
      resulted from (i) $6,067,000 net sales from subsidiaries Mobot, Sponge, Gavitec,
      12Snap and BSD, all of which were acquired during the first quarter of 2006,
      offset by a (ii) decrease of $7,000 in net sales from the Company’s underlying
      business represented by qode® and NeoMedia’s legacy software products.





*Cost
      of sales.* Cost
      of
      technology services, products and licenses fees were $4,112,000 for the three
      months ended September 30, 2006 compared to $116,000 for the three months ended
      September 30, 2006, an increase of $3,996,000, or 3,445%.  This increase
      resulted from (i) $3,523,000 product and service related cost of sales from
      subsidiaries Mobot, Sponge, Gavitec, 12Snap and BSD, all of which were acquired
      during the first quarter of 2006, (ii) amortization of $519,000 of intangible
      assets relating to the acquisitions of Mobot, Sponge, Gavitec, 12Snap and BSD,
      offset by (iii) a decrease of $46,000 in cost of sales from the Company’s
      underlying business represented by qode® and NeoMedia’s legacy software
      products.





*Gross
      profit.* Gross profit was $2,137,000 for the three months ended September 30, 2006,
      an
      increase of $2,060,000, or 2,675%, compared with gross profit of $77,000 for
      the
      three months ended September 30, 2005.  This increase resulted from (i)
      $2,528,000 operational gross profit from subsidiaries Mobot, Sponge, Gavitec,
      12Snap and BSD, all of which were acquired during the first quarter of 2006,
      (ii) increased gross profit of $51,000 from the Company’s underlying business
      represented by qode® and NeoMedia’s legacy software products, offset by (iii)
      amortization of $519,000 of intangible assets relating to the acquisitions.





*Sales
      and marketing.* Sales
      and
      marketing expenses were $2,795,000 for the three months ended September 30,
      2006, compared to $589,000 for the three months ended September 30, 2005, an
      increase of $2,206,000 or 375%.  This increase resulted from (i) sales and
      marketing expenses of $2,420,000 from subsidiaries Mobot, Sponge, Gavitec,
      12Snap and BSD, all of which were acquired during the first quarter of 2006,
      offset by (ii) lower sales and marketing expense in the Company’s underlying
      business represented by qode® and NeoMedia’s legacy software products of
      $214,000 in 2006.





*General
      and administrative.* General
      and administrative expenses increased by $1,894,000, or 248%, to $2,659,000
      for
      the three months ended September 30, 2006, compared to $765,000 for the three
      months ended September 30, 2005. The increase resulted from (i) higher
      accounting, professional, and legal services of $1,215,000 due to Company’s
      implementation of Sarbanes Oxley, higher audit fees and accounting overhead
      resulting from a more complex reporting structure and transactions, actual
      and
      threatened lawsuits, and registration statements, and (ii) general and
      administrative expenses of $681,000 from subsidiaries Mobot, Sponge, Gavitec,
      12Snap and BSD, all of which were acquired during the first quarter of 2006.





*Research
      and development.* During
      the three months ended September 30, 2006, NeoMedia charged to expense
      $1,013,000 of research and development costs, an increase of $890,000 or 724%
      compared to $123,000 for the three months ended September 30, 2005.  The
      increase resulted from (i) research and development expenses of $746,000 from
      subsidiaries Mobot, Sponge, Gavitec, 12Snap and BSD, all of which were acquired
      during the first quarter of 2006, and (ii) increased research and development
      expense related to qode® products of $143,000.





*Stock
      based compensation expense.* Stock
      based compensation was $2,230,000 for the three months ended September 30,
      2006,
      as compared with $93,000 for the three months ended September 30, 2005, an
      increase of $2,227,000, or 2,395%.  The increase was due to the adoption of
      SFAS 123R (Share Based Payment) on January 1, 2006.





*Gain
      on extinguishment of debt.* Gain
      on
      extinguishment of debt was $0 for the three months ended September 30, 2006,
      a
      decrease of $1,000 or 100%, compared with a gain of $1,000 during the three
      months ended September 30, 2005.  The gain in 2005 resulted from the
      difference between the cash or market value of stock issued to settle debt
      and
      the carrying value of the debt at the time of settlement.




58





*Interest
      income (expense).* Interest
      income (expense) consists primarily of interest accrued for creditors as part
      of
      financed purchases, past due balances, and notes payable, net of interest earned
      on cash equivalent investments and notes receivable.  Interest expense for
      the three months ended September 30, 2006 was $112,000, as compared to interest
      expense of $77,000 for the three months ended September 30, 2005, a change
      of
      $35,000 or 45%. The change resulted from $123,000 of interest expense during
      the
      three months ended September 20, 2005 related to a note payable that was paid
      off during the first quarter of 2006 and accrued liquidated damages related
      to
      the preferred stock of $161,000 in 2006.





*Write-off
      of deferred equity financing costs* .
      During
      the three months ended September 30, 2006, NeoMedia incurred a charge of
      $13,256,000 to write off deferred equity financing costs related to the 2005
      SEDA. No
      comparable charges were taken during the three months ended September 30,
      2005.




*Change
      in fair value from revaluation of warrants and embedded conversion
      features.* Loss
      from
      the change in fair value from revaluation of warrants and
      embedded conversion features was $9,271,000 for the three months ended
      September 30, 2006.  The gain is on the derivatives and embedded conversion
      features associated with the preferred stock sale on February 17, 2006 and
      the
      convertible debenture financing dated August 24, 2006.  Certain derivatives
      and embedded conversion features were created at the time of each offering
      and those derivatives are recorded at fair value on the accompanying balance
      sheet. ** The
      gain
      for the three months ended September 30, 2006 is driven by a reduction in
      NeoMedia’s stock price from June 30, 2006 to September 30, 2006. 
 There was no such gain or loss on derivative financial instruments for the
      three months ended September 30, 2005.





*Loss
      from discontinued business unit* . 
      During the three months ended September 30, 2006, NeoMedia entered into a letter
      of intent to sell its NMPR business unit. As a result, the Company has
      classified the operations of the NMPR business unit into this line item. Loss
      from the discontinued business unit represents direct operations of the NMPR
      business during the three months ended September 30, 2006. The net loss from
      the
      NMPR business unit for the three months ended September 30, 2006 was $1,620,000,
      an increase of $1,239,000 and 325% from the loss of $381,000 for the three
      months ended September 30, 2005. The increased loss is due to the fixed overhead
      costs related to the expansion into the US and China markets and the
      establishment of a bad debt reserve on the sales to a customer in
      China.





*Net
      loss* . 
      The net loss for the three months ended September 30, 2006 was $30,909,000,
      which represented a $28,959,000, or 1,485% increase from a $1,950,000 loss for
      the three months ended September 30, 2005.  This increased net loss
      resulted from (i) $9,271,000 expense from the change in fair value from
      revaluation of warrants and embedded conversion features associated with
      the preferred stock and convertible debenture financing, (ii) $13,256,000
      charge to write off deferred equity financing costs associated with the 2005
      SEDA, (iii) $2,390,000 increase to stock based compensation expense as a result
      of the adoption of SFAS 123(R) on January 1, 2006, (iv) $1,105,000 loss from
      subsidiaries Mobot, Sponge, Gavitec, 12Snap and BSD, all of which were acquired
      during the first quarter of 2006, (v) $653,000 bad debt reserve for the Micro
      Paint customer in China, and (vi) $2,284,000 increased loss from the Company’s
      underlying business represented by qode®, NeoMedia’s legacy software products,
      and corporate administration.





*Known
      trends, demands, commitments, or uncertainties.* In the
      event that NeoMedia’s stock price at the time the consideration shares issued in
      connection with the acquisitions of Mobot, Sponge, Gavitec, and 12Snap become
      saleable is less than the contractual price (between $0.3839 and $0.3956),
      NeoMedia is obligated to compensate the sellers in cash for the difference
      between the price at the time the shares become saleable and the relevant
      contractual price. Assuming a stock price at the time the shares become saleable
      of $0.10, which was the last sale price on October 23, 2006, NeoMedia would
      have
      a cash liability of $32.7 million relating to the guarantees. On September
      11,
      2006, NeoMedia filed a registration statement on Form S-3 which included the
      consideration shares issued to acquire Mobot, Sponge, Gavitec, and 12Snap,
      among
      others. At current stock prices, NeoMedia does not believe that it will be
      able
      to generate enough cash to satisfy the purchase price guarantees if and when
      they become due, which is expected to occur upon effectiveness of the
      registration statement. As a result, NeoMedia is attempting to negotiate for
      payment of the purchase price guarantees in another form, including additional
      shares of common stock. There is no guarantee that NeoMedia will be successful
      in negotiating such an agreement with any or all of the parties involved. In
      the
      event that NeoMedia is not able to negotiate another form of payment, NeoMedia
      could be forced to divest of certain of the acquisitions. In the event that
      one
      or more of these subsidiaries is divested (which divestiture would be subject
      to
      approval by Cornell Capital Partners), NeoMedia would expect its sales, cost
      of
      sales, gross profit, and operating expenses over the next 12 months to decrease
      materially compared with its 2006 results which reflect operations of all
      acquisitions.





59





**Results
      Of Operations For The Nine months Ended September 30, 2006 As Compared To The
      Nine Months Ended September 30, 2005**





*Net
      sales.* Total
      net
      sales for the nine months ended September 30, 2006 were $14,129,000, which
      represented a $13,367,000, or 1,754%, increase from $762,000 for the nine months
      ended September 30, 2005.  This increase resulted from (i) $13,876,000 net
      sales from subsidiaries Mobot, Sponge, Gavitec, 12Snap and BSD, all of which
      were acquired during the first quarter of 2006, (ii) an increase of $45,000
      in
      net sales from the Company’s underlying business represented by qode® and
      intellectual property licensing, offset by (iii) a decrease in net sales of
      $554,000 from NeoMedia’s Consulting and Integration Services business unit.





*Cost of sales.* Cost
      of
      technology services, products and licenses fees were $8,887,000 for the nine
      months ended September 30, 2006 compared to $440,000 for the nine months ended
      September 30, 2005, an increase of $8,447,000, or 1,920%.  This increase
      resulted from (i) $7,385,000 product and service related cost of sales from
      subsidiaries Mobot, Sponge, Gavitec, 12Snap and BSD, all of which were acquired
      during the first quarter of 2006, (ii) amortization of $1,241,000 of intangible
      assets relating to the acquisitions of Mobot, Sponge, Gavitec, 12Snap and BSD,
      offset by (iii) a decrease of $249,000 in cost of sales from the Company’s
      underlying business represented by qode® and NeoMedia’s legacy software
      products.





*Gross profit.* Gross profit was $5,242,000 for the nine months ended September 30, 2006, an
      increase of $4,920,000, or 1,528%, compared with gross profit of $322,000 for
      the nine months ended September 30, 2005.  This increase resulted from (i)
      $6,491,000 operational gross profit from subsidiaries Mobot, Sponge, Gavitec,
      12Snap and BSD, all of which were acquired during the first quarter of 2006,
      offset by (ii) decreased gross profit of $330,000 from the Company’s underlying
      business represented by qode®, NeoMedia’s legacy software products, and
      NeoMedia’s discontinued Consulting and Integration Services business unit, and
      (iii) amortization of $1,241,000 of intangible assets relating to the
      acquisitions.





*Sales
      and marketing.* Sales
      and
      marketing expenses were $6,719,000 for the nine months ended September 30,
      2006,
      compared to $1,332,000 for the nine months ended September 30, 2005, an increase
      of $5,387,000 or 404%.  This increase resulted from (i) sales and marketing
      expenses of $4,597,000 from subsidiaries Mobot, Sponge, Gavitec, 12Snap and
      BSD,
      all of which were acquired during the first quarter of 2006, and (ii) higher
      sales and marketing expense in the Company’s underlying business represented by
      qode® and NeoMedia’s legacy software products of $790,000 in 2006.





*General
      and administrative.* General
      and administrative expenses increased by $4,609,000, or 215%, to $6,752,000
      for
      the nine months ended September 30, 2006, compared to $2,143,000 for the nine
      months ended September 30, 2005. The increase resulted from (i) higher
      accounting, professional, and legal services of $2,482,000 due to Company’s
      implementation of Sarbanes Oxley, higher audit fees resulting from a more
      complex reporting structure and transactions, actual and threatened lawsuits,
      and registration statements, and (ii) general and administrative expenses of
      $2,128,000 from subsidiaries Mobot, Sponge, Gavitec, 12Snap and BSD, all of
      which were acquired during the first quarter of 2006.





60




*Research
      and development.* During
      the nine months ended September 30, 2006, NeoMedia charged to expense $2,309,000
      of research and development costs, an increase of $1,944,000 or 533% compared
      to
      $365,000 for the three months ended September 30, 2005.  The increase
      resulted from (i) research and development expenses of $1,481,000 from
      subsidiaries Mobot, Sponge, Gavitec, 12Snap and BSD, all of which were acquired
      during the first quarter of 2006, and (ii) increased research and development
      expense related to qode® products of $462,000.





*Stock
      based compensation expense.* Stock
      based compensation was $4,948,000 for the nine months ended September 30, 2006,
      as compared with $593,000 for the nine months ended September 30, 2005, an
      increase of $4,355,000, or 743%.  The increase was due to the adoption of
      SFAS 123R (Share Based Payment) on January 1, 2006.





*Gain
      (loss) on extinguishment of debt.* NeoMedia
      incurred a loss on extinguishment of debt of $1,858,000 for the nine months
      ended September 30, 2006, primarily resulting from debt retired in connection
      with the Series C preferred stock issued and sold to Cornell on February 17,
      2006. ** A
      loss
      was incurred on the surrender  of a certain promissory note to Cornell
      dated March 30, 2005 in connection with the preferred stock sale. During the
      nine months ended September 30, 2005, NeoMedia recognized a gain on
      extinguishment of debt of $172,000, resulting from the payment of debt at a
      discount to its book value.





*Interest
      income (expense).* Interest
      income (expense) consists primarily of interest accrued for creditors as part
      of
      financed purchases, past due balances, and notes payable, net of interest earned
      on cash equivalent investments.  Interest expense decreased by $32,000, or
      14%, to $191,000 for the nine months ended September 30, 2006 from $223,000
      for
      the nine months ended September 30, 2005. The change resulted from $319,000
      of
      interest expense during the nine months ended September 30, 2005 related to
      a
      note payable that was paid off during the first quarter of 2006, offset by
      interest earned on notes receivable in 2006, and the accrual of $161,000 of
      liquidated damages related to the preferred stock in 2006.





*Write-off
      of deferred equity financing costs* .
      During
      the nine months ended September 30, 2006, NeoMedia incurred a charge of
      $13,256,000 to write off deferred equity financing costs related to the 2005
      SEDA. No comparable charges were taken during the nine months ended
      September 30, 2005.




*Change
      in fair value from revaluation of warrants and embedded conversion
      features.* Gain
      from
      the change in fair value from the revaluation of warrants and embedded
      conversion features was $6,523,000 for the nine months ended September 30,
      2006.  The gain is on the derivatives and embedded conversion
      features associated with the preferred stock sale on February 17, 2006 and
      the convertible debenture financing dated August 24, 2006.  Certain
      derivatives and embedded conversion features were created at the time of
      each offering and those derivatives are recorded at fair value on the
      accompanying balance sheet *.* The
      gain
      for the nine months ended September 30, 2006 is the reduction in value of the
      derivatives and embedded conversion features from the inception of each
      financing to September 30, 2006 and is due almost entirely to a reduction in
      NeoMedia’s stock price from the inception of each financing to September 30,
      2006.  There was no such gain or loss on derivative financial instruments
      for the nine months ended September 30, 2005.





*Loss
      from discontinued business unit* . 
      During the nine months ended September 30, 2006, NeoMedia entered into a letter
      of intent to sell its NMPR business unit. As a result, the Company has
      classified the operations of the NMPR business unit into this line item. Loss
      from the discontinued business unit represent direct operations of the NMPR
      business during the nine months ended September 30, 2006. The net loss from
      the
      NMPR business unit for the nine months ended September 30, 2006 was $2,826,000,
      an increase of $1,519,000 and 116% from the loss of $1,307,000 for the nine
      months ended September 30, 2005. The increased loss is due to the fixed overhead
      costs related to the expansion into the US and China markets and the
      establishment of a bad debt reserve on the amount owed by a customer
      in China.




61





*Net
      loss* . 
      The net loss for the nine months ended September 30, 2006 was $27,094,000,
      which
      represented a $21,625,000, or 395% increase from a $5,469,000 loss for the
      nine
      months ended September 30, 2005.  This increased net loss resulted from (i)
      $4,499,000 increase to stock based compensation expense as a result of the
      adoption of SFAS 123(R) on January 1, 2006, (ii) $1,715,000 loss from
      subsidiaries Mobot, Sponge, Gavitec, 12Snap and BSD, all of which were acquired
      during the first quarter of 2006, (iii) $13,256,000 charge to write off deferred
      equity financing costs associated with the 2005 SEDA, (iv) $1,858,000 loss
      on
      the extinguishment of debt, (v) $1,034,000 increased losses from the expansion
      of the Micro Paint business unit held for sale, and (vi) $5,786,000 increased
      loss from the Company’s underlying business represented by qode®, NeoMedia’s
      legacy software products, and corporate administration including audit and
      legal
      fees, offset by (vii) $6,523,000 gain from the change in fair value from
      revaluation of warrants and embedded conversion features associated with the
      preferred stock and convertible debenture financing.





*Known
      trends, demands, commitments, or uncertainties.* In the
      event that NeoMedia’s stock price at the time the consideration shares issued in
      connection with the acquisitions of Mobot, Sponge, Gavitec, and 12Snap become
      saleable is less than the contractual price (between $0.3839 and $0.3956),
      NeoMedia is obligated to compensate the sellers in cash for the difference
      between the price at the time the shares become saleable and the relevant
      contractual price. Assuming a stock price at the time the shares become saleable
      of $0.10, which was the last sale price on October 23, 2006, NeoMedia would
      have
      a cash liability of $32.7 million relating to the guarantees. On September
      11,
      2006, NeoMedia filed a registration statement on Form S-3 which included the
      consideration shares issued to acquire Mobot, Sponge, Gavitec, and 12Snap,
      among
      others. At current stock prices, NeoMedia does not believe that it will be
      able
      to generate enough cash to satisfy the purchase price guarantees if and when
      they become due, which is expected to occur upon effectiveness of the
      registration statement. As a result, NeoMedia is attempting to negotiate for
      payment of the purchase price guarantees in another form, including additional
      shares of common stock. There is no guarantee that NeoMedia will be successful
      in negotiating such an agreement with any or all of the parties involved. In
      the
      event that NeoMedia is not able to negotiate another form of payment, NeoMedia
      could be forced to divest of certain of the acquisitions. In the event that
      one
      or more of these subsidiaries is divested (which divestiture would be subject
      to
      approval by Cornell Capital Partners), NeoMedia would expect its sales, cost
      of
      sales, gross profit, and operating expenses over the next 12 months to decrease
      materially compared with its 2006 results which reflect operations of all
      acquisitions.




**Liquidity
      and Capital Resources**





**Current
      Period Activity**





*Net
      cash from operations.* Net cash used in continuing operating activities
      (net of cash used from operations of discontinued business unit) was $8,381,000
      for the nine months ended September 30, 2006, compared with $4,323,000 for
      the
      nine months ended September 30, 2005. NeoMedia’s net cash used in continuing
      operating activities increased substantially during the nine months ended
      September 30, 2006. The increase was driven by the following factors (1)
      additional sales, marketing, research and development resources employed to
      complete the technical requirements for a 2006 qode® launch in the U.S. and
      Europe; (2) increased general and administrative costs associated with
      supporting the new acquisitions and other administrative initiatives such as
      Sarbanes Oxley; and (3) negative operational cashflow during the nine months
      ended September 30, 2006 from newly-acquired subsidiaries Mobot, Gavitec,
      Sponge, and 12Snap.





*Net
      used in investing.* NeoMedia’s net cash flow used in investing activities (net of cash used in
      investing of discontinued business unit) for the nine months ended September
      30,
      2006 and 2005 was $14,687,000 and $4,117,000, respectively. The increase
      resulted from the investment of $11,891,000 in the acquisitions of Mobot,
      Sponge, Gavitec and 12Snap. NeoMedia also advanced $500,000 to Hip Cricket
      in
      the form of promissory notes, and increased capital expenditures on equipment
      and software required for the qode® launch.





*Net
      cash provided by financing activities* .
      Net
      cash provided by financing activities for the nine months ended September 30,
      2006 and 2005 was $25,165,000 and $10,292,000, respectively. NeoMedia received
      $14,066,000 from the sale of Series C convertible stock during February 2006,
      and an additional $5,000,000 from the sale of convertible debentures during
      August 2006. NeoMedia also received $8,419,000 from the exercise of warrants
      and
      employee stock options during the nine months ended September 30, 2006.





62




*Net
      cash used in discontinued operations* .
      Net
      cash used in the Company’s discontinued Micro Paint Repair operations for the
      nine months ended September 30, 2006 was $2,020,000, of which $1,980,000 was
      used in operations, $56,000 was used in investing activities, and $16,000 was
      generated as a result of the effect of exchange rates on cash. Net cash used
      in
      the Company’s discontinued Micro Paint Repair operations for the nine months
      ended September 30, 2005 was $1,737,000, of which $1,628,000 was used in
      operations, $133,000 was used in investing activities, and $24,000 was generated
      as a result of the effect of exchange rates on cash. The negative cashflow
      from
      operations of the discontinued Micro Paint Repair business will cease upon
      the
      pending sale of the business unit, which will reduce NeoMedia’s consolidated
      cash used in operations.





As
      of
      September 30, 2006, NeoMedia has a working capital deficiency of $30,222,000,
      of
      which $26,667,000 relates to the fair value of derivative financial instruments.
      NeoMedia intends to fund its working capital deficiency as described in “Sources
      of Cash and Projected Cash Requirements”.





**Significant
      Liquidity Events**





In
      the
      event that NeoMedia’s stock price at the time the consideration shares issued in
      connection with the acquisitions of Mobot, Sponge, Gavitec, and 12Snap become
      saleable is less than the contractual price (between $0.3839 and $0.3956),
      NeoMedia is obligated to compensate the sellers in cash for the difference
      between the price at the time the shares become saleable and the relevant
      contractual price. Assuming a stock price at the time the shares become saleable
      of $0.10, which was the last sale price on October 23, 2006, NeoMedia would
      have
      a cash liability of $32.7 million relating to the guarantees. On September
      11,
      2006, NeoMedia filed a registration statement on Form S-3 which included the
      consideration shares issued to acquire Mobot, Sponge, Gavitec, and 12Snap,
      among
      others. At current stock prices, NeoMedia does not believe that it will be
      able
      to generate enough cash to satisfy the purchase price guarantees if and when
      they become due, which is expected to occur upon effectiveness of the
      registration statement. As a result, NeoMedia is attempting to negotiate for
      payment of the purchase price guarantees in another form, including additional
      shares of common stock. There is no guarantee that NeoMedia will be successful
      in negotiating such an agreement with any or all of the parties
      involved.





During
      the nine months ended September
      30, 2006, NeoMedia made cash payments totaling $2.1 million to silent partners
      of 12Snap, as partial payment under silent partner agreements put in place
      prior
      to the acquisition of 12Snap by NeoMedia. The agreements call for additional
      cash payments of approximately $2.3million on or before December 31, 2006.





During
      the fourth quarter of 2005 and first quarter of 2006, NeoMedia shipped and
      invoiced $757,000 of Micro Paint Repair products to Automart for which payment
      has not been received. The accounts receivable related to this transaction
      have
      been fully reserved. Recognition of revenue on this transaction has been
      deferred since this is a new customer in a new territory. If and when payment
      is
      made, NeoMedia expects to recognize revenue for these shipments, and would
      also
      receive a material cash infusion. In the absence of payment, NeoMedia would
      not
      recognize revenue related to these products and would not recoup its cost of
      goods sold which have already been paid. These assets could be sold in
      connection with the proposed sale of the NMPR business unit.





**Sources
      of Cash and** **Projected
      Cash Requirements**





NeoMedia
      intends to fund its growth and working capital deficiencies from the following
      sources during the remainder of 2006 and beyond:





*Exercise
      of options and warrants.* In
      connection with the convertible debenture financing, NeoMedia issued 175,000,000
      warrants to purchase shares of common stock at exercise prices between $0.05
      -
      $0.25 per share. NeoMedia also repriced 85,000,000 previously issued warrants
      to
      prices between $0.10 - $0.15. NeoMedia can force conversion of the warrants
      if
      its stock price is more than $0.10 higher than the exercise price of the
      warrants once the shares underlying the warrants are registered. If all of
      these
      warrants were exercised, NeoMedia would receive $38.5 million proceeds. Based
      on
      its current stock price, NeoMedia would not realize any proceeds from these
      warrants. In addition, the warrants contain a provision that, if
      at the time of exercise, the shares underlying the warrant are not subject
      to an
      effective registration statement or if NeoMedia is in default of the warrant
      agreement, the holder can perform a “cashless” exercise of the warrants and in
      lieu of making payment of the exercise price in cash, elect instead withhold
      shares as consideration for the exercise price. In the event of such a
“cashless” exercise, NeoMedia would not receive any cash proceeds upon the
      exercise of such warrants.




63





In
      addition, certain outstanding employee stock options are in-the-money and could
      be exercised at the holders’ discretion from time to time. As of September 30,
      2006, NeoMedia had 117 million outstanding employee stock options, of which
      42
      million were in-the-money based on the closing price on September 30, 2006
      of
      $0.117 per share. Total potential proceeds from exercise of all in-the-money
      options is $2.1 million.





*Sale
      of Micro Paint Repair business unit.* During
      August 2006, NeoMedia announced its intent to sell its Micro Paint Repair
      business unit. Any cash proceeds realized from the sale of the Micro Paint
      Repair business will be used to fund the operations of the NeoMedia Mobile
      and
      NeoMedia Telecom Services businesses.





*$100
      Million SEDA.* On March
      30, 2005, NeoMedia and Cornell Capital Partners entered into a Standby Equity
      Distribution Agreement under which Cornell Capital Partners agreed to purchase
      up to $100 million of NeoMedia’s common stock over a two-year period, with the
      timing and amount of the purchase at NeoMedia’s discretion. The maximum amount
      of each purchase would be $2,000,000 with a minimum of five business days
      between advances. Based on NeoMedia’s current market capitalization and other
      outstanding securities, NeoMedia does not believe that the 2005 SEDA is
      currently a viable source of financing.





NeoMedia’s
      reliance on Cornell Capital Partners as its primary financing source has certain
      ramifications that could affect future liquidity and business operations. For
      example, pursuant to the terms of the convertible debenture agreement between
      NeoMedia and Cornell signed in connection with the convertible debenture sale,
      without Cornell’s consent NeoMedia cannot (i ) issue
      or sell any shares of Common Stock or preferred stock without consideration
      or
      for consideration per share less than the closing bid price immediately prior
      to
      its issuance, (ii) issue or sell any preferred stock, warrant, option,
      right, contract, call, or other security or instrument granting the holder
      thereof the right to acquire common stock for consideration per share less
      than
      the closing bid price immediately prior to its issuance, (iii)
      enter into any security instrument granting the holder a security interest
      in
      any of its assets of, or
      (iv) file any
      registration statements on Form S-8 .
      In
      addition, pursuant to a security agreement between NeoMedia and Cornell signed
      in connection with the convertible debenture, Cornell has a security interest
      in
      all of NeoMedia’s assets. Such covenants could severely harm NeoMedia’s ability
      to raise additional funds from sources other than Cornell, and would likely
      result in a higher cost of capital in the event funding were secured.





Additionally,
      pursuant to the terms of the investment agreement between NeoMedia and Cornell
      signed in connection with the Series C convertible preferred stock sale,
      NeoMedia cannot (i) enter into any debt arrangements in which it is the
      borrower, (ii) grant any security interest in any of its assets, or (iii) grant
      any security below market price.





In
      addition, NeoMedia has incurred both cash and non-cash costs associated with
      the
      financing arrangements with Cornell Capital Partners, as follows:





·
            In
                connection with the convertible debenture, NeoMedia issued 175 million
                warrants to Cornell with exercise prices between $0.05 and $0.25,
                repriced
                75 million warrants that had been issued in connection with the Series
                C
                convertible preferred stock sale, and repriced an additional 10 million
                warrants that had been issued in connection with the 2005 SEDA.





64


·
            In
                connection with the $27 million Series C convertible preferred stock
                sale,
                NeoMedia incurred the following costs: (i) Cornell held back a $2.7
                million cash fee from the proceeds of the sale, (ii) NeoMedia issued
                75
                million warrants to Cornell with exercise prices between $0.35 and
                $0.50,
                which were subsequently repriced in connection with the convertible
                debenture, and (iii) NeoMedia issued 2 million warrants with an exercise
                price of $0.328 to another party for structuring and consulting fees
                associated with the sale.





·
            In
                connection with the 2005 SEDA, NeoMedia incurred the following costs:
                (i)
                NeoMedia issued 75 million warrants to Cornell with an exercise price
                of
                $0.20, 10 million of which were subsequently repriced in connection
                with
                the convertible debenture, and (ii) NeoMedia issued 4 million warrants
                with an exercise price of $0.227 to another party for structuring
                and
                consulting fees associated with the 2005 SEDA. The fair value of
                these
                warrants in the amount of $13,256,000 was written off during the
                three
                months ended September 30, 2006.




NeoMedia’s
      cash flow used in operations was $8.4 million (net of cash used in operations
      of
      discontinued Micro Paint Repair business unit of $2.0 million) for the nine
      months ended September 30, 2006. In the event that NeoMedia’s stock price does
      not increase to levels where NeoMedia can force exercise of enough of its
      outstanding warrants to generate material operating capital, or if the market
      for NeoMedia’s stock will not support the sale of shares underlying such
      warrants or other funding sources, or NeoMedia does not realize a material
      increase in revenue during the next 12 months, NeoMedia will have to seek
      additional cash sources. There can be no assurances that such funding sources
      will be available. If necessary funds are not available, NeoMedia’s business and
      operations would be materially adversely affected and in such event, NeoMedia
      would attempt to reduce costs and adjust its business plan, and could be forced
      to sell certain of its assets, including its subsidiaries.





**Contractual
      Obligations**





NeoMedia
      is party to various commitments and contingencies, such as:





·
            NeoMedia
                and its subsidiaries lease office facilities and certain office and
                computer equipment under various operating
                leases


·
            NeoMedia
                is party to various payment arrangements with its vendors that call
                for
                fixed payments on past due
                liabilities


·
            NeoMedia
                is party to various consulting agreements that carry payment obligations
                into future years.


·
            NeoMedia
                issued Series C convertible preferred shares with face value of
                $22,000,000 and convertible debentures with a face value of $5 million
                that are subject to conversion at future
                dates


·
            NeoMedia
                holds notes payable to certain vendors and silent partners of an
                acquired
                subsidiary that mature at various dates in the future.


·
            NeoMedia’s
                subsidiary Sponge has entered into purchase commitments to procure
                the
                functionality needed to support a sales agreement with a major customer.
                The purchase commitments require payments of $1,121,000 in the fourth
                quarter of 2006, and $2,200,000 in 2007. Revenues related to this
                program
                are expected to exceed the purchase commitments over the one-year
                life of
                the contract.




65


The
      following table sets forth NeoMedia’s future minimum payments due under
      operating leases, vendor and consulting agreements, convertible stock
      agreements, and debt agreements:





**Series
                C****Vendor
                &**
            
            
            
            
            
            **Convertible****Operating**
            
            **Consulting**
            
            **Notes**
            
            **Convertible**
            
            **Preferred****Leases**
            
            **Agreements**
            
            **Payable**
            
            **Debentures**
            
            **Stock**
            
            **Total**2006
                (remaining three months)
            
            $
            219
            
            $
            3,040
            
            $
            2,312
            
            $
            —
            
            $
            —
            
            $
            5,5712007
            
            
            743
            
            
            4,180
            
            
            27
            
            
            —
            
            
            —
            
            
            4,9502008
            
            
            571
            
            
            —
            
            
            —
            
            
            5,000
            
            
            —
            
            
            5,5712009
            
            
            323
            
            
            —
            
            
            —
            
            
            —
            
            
            22,000
            
            
            22,3232010
            
            
            206
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            206Thereafter
            
            
            198
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            198Total
            
            $
            2,260
            
            $
            7,220
            
            $
            2,339
            
            $
            5,000
            
            $
            22,000
            
            $
            38,819





In
      addition to contractually obligated amounts above, NeoMedia has also guaranteed
      the value of stock consideration issued in connection with certain acquisitions,
      the amount of which will not be determinable until the shares issued for such
      acquisitions are registered. In the event that NeoMedia’s stock price at the
      time the consideration shares issued in connection with the acquisitions of
      Mobot, Sponge, Gavitec, and 12Snap become saleable is less than the contractual
      price (between $0.3839 and $0.3956), NeoMedia is obligated to compensate the
      sellers in cash for the difference between the price at the time the shares
      become saleable and the relevant contractual price. Assuming a stock price
      at
      the time the shares become saleable of $0.10, which was the last sale price
      on
      October 23, 2006, NeoMedia would have a cash liability of $32.7 million relating
      to the guarantees.




**Going
      Concern**




The
      accompanying condensed consolidated financial statements have been prepared
      in
      conformity with accounting principles generally accepted in the United States
      of
      America, which contemplate continuation of the Company as a going concern. Net
      loss
      for the nine months ended September 30, 2006, was $27,094,000, which includes
      a
      net gain on derivative financial instruments of $6,523,000 and a charge to
      write
      off deferred equity financing costs related to the 2005 SEDA of $13,256,000.
      NeoMedia also reported net losses of $9,147,000 and $7,230,000 for the years
      ended December 31, 2005 and 2004, respectively, and has an accumulated deficit
      of $119,618,000 and a working capital deficit of $30,222,000 as of September
      30,
      2006.





In
      addition, NeoMedia has material liquidity events that could adversely affect
      its
      ability to continue as a going concern, primarily:





·
            In
                the event that NeoMedia’s stock price at the time the consideration shares
                issued in connection with the acquisitions of Mobot, Sponge, Gavitec,
                and
                12Snap become saleable is less than the contractual price (between
                $0.3839
                and $0.3956), NeoMedia is obligated to compensate the sellers in
                cash for
                the difference between the price at the time the shares become saleable
                and the relevant contractual price. Assuming a stock price at the
                time the
                shares become saleable of $0.10, which was the last sale price on
                October
                23, 2006, NeoMedia would have a cash liability of $32.7 million relating
                to the guarantees.





·
            During
                the nine months ended September 30, 2006, NeoMedia made cash payments
                totaling $2.1 million to silent partners of 12Snap, as partial payment
                under silent partner agreements in place prior to the acquisition
                of
                12Snap by NeoMedia. The agreements call for additional cash payments
                of
                $2.1million plus accrued interest and penalties totaling $0.4 million
                on
                or before December 31, 2006.





66




NeoMedia
      had cash balances of $3,133,000 as of September 30, 2006. As disclosed above
      under the caption “Sources of Cash and Projected
      Cash Requirements,” NeoMedia could receive cash at future dates as follows: (1)
      from the exercise of stock options, to the extent that the exercise price of
      such stock options is less than the market price of NeoMedia’s common stock, (2)
      from the exercise of stock warrants, to the extent that the warrants become
      registered for resale and the exercise price of such stock warrants is less
      than
      the market price of NeoMedia’s common stock at the time of exercise, and to the
      extent that the holder of such warrants does not elect to perform a “cashless”
exercise, in which case NeoMedia would not receive any cash proceeds from the
      exercise, and (3) from the sale of its Micro Paint Repair business unit.





However,
      none of these events is contractually obligated as of the date of this filing.
      Based on cash currently available, and in the absence of any additional funding,
      NeoMedia expects to be able to sustain operations through December 31, 2006.
      In
      order to maintain operations for a 12-month period, and in the absence of a
      material increase in revenues, NeoMedia estimates that it would need to raise
      at
      least an additional $7-10 million to sustain operations. NeoMedia expects that,
      while not contractually committed, it could receive cash from one or more of
      the
      sources outlined above. The most likely source of cash in the short term is
      from
      the sale of the Micro Paint business unit. To the extent that funds are not
      available from these sources, NeoMedia will seek alternate financing in another
      form, or attempt to sell its assets to meet its obligations.





During
      the third quarter of 2006, NeoMedia was using capital at a rate of approximately
      $2 million per quarter from its continuing operations. During the third quarter
      and continuing into the fourth quarter, NeoMedia has instituted cost-cutting
      measures, including the sale of the Micro Paint business unit, which operated
      at
      a loss an a quarter-over-quarter basis, and the reduction of its remaining
      workforce and overhead expenses.





NeoMedia
      plans to address its working capital deficiency by completing the sale of the
      Micro Paint Repair business unit and continuing to reduce its workforce and
      overhead expenses in non-critical areas. In addition, NeoMedia will attempt
      to
      generate additional revenue and profit from the launch of its qode® products,
      the commercialization of its patent portfolio, and from increased revenue and
      profit from its 12Snap, Gavitec, and NeoMedia Telecom businesses.





In
      the
      event that these financing sources do not materialize, or that NeoMedia is
      unsuccessful in increasing its revenues and profits, NeoMedia will be forced
      to
      further reduce its costs, may
      be
      unable to repay its debt obligations as they become due, or respond to
      competitive pressures, any of which circumstances would have a material adverse
      effect on its business, prospects, financial condition and results of
      operations. Additionally, if these funding sources or increased revenues and
      profits do not materialize, and NeoMedia is unable to secure additional
      financing, NeoMedia could be forced to reduce or curtail its business operations
      unless it is able to engage in a merger or other corporate finance transaction
      with a better capitalized entity.


67


**ITEM
      3.** **QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK** **.**





NeoMedia
      previously filed its periodic reports as a small business issuer through the
      period ended December 31, 2005. The information required by Item 305 of
      Regulation S-K was not required under the disclosure requirements for small
      business issuers. Pursuant to Item 305 of Regulation S-K, disclosure of
      quantitative and qualitative information about market risk is required in the
      first annual report. Information relating to interim financial statements is
      not
      required until after the first fiscal year end in which Item 305 is applicable.
      Accordingly, NeoMedia anticipates providing a quantitative and qualitative
      analysis regarding market risk in its Form 10-K for the year ending December
      31,
      2006.





**ITEM
      4. CONTROLS AND PROCEDURES**





There
      were no policy reviews, improvements of documentation or general improvement
      in
      the state of internal controls that led to any change during the fiscal quarter,
      or subsequent to the end of the fiscal quarter through the date of this Form
      10-Q, that materially affected or were reasonably likely to materially affect,
      internal controls over financial reporting.




***Evaluation
      of Disclosure Controls and Procedures*** .
      As of
      the end of the period covered by this report, the Company carried out an
      evaluation, under the supervision and with the participation of the Company’s
      Principal Executive Officer and Principal Financial Officer, of the
      effectiveness of the design and operation of the Company’s disclosure controls
      and procedures. The Company’s disclosure controls and procedures are designed to
      provide a reasonable level of assurance of achieving the Company’s disclosure
      control objectives. The Company’s Principal Executive Officer and Principal
      Financial Officer have concluded that the Company’s disclosure controls and
      procedures are, in fact, effective at this reasonable assurance level as of
      the
      end of period covered. In addition, the Company reviewed its internal controls
      and there have been no significant changes in its internal controls or in other
      factors that could significantly affect those controls subsequent to the date
      of
      their last evaluation or from the end of the reporting period to the date of
      this Form 10-Q.





***Changes
      in Internal Controls*** .
      In
      connection with the evaluation of the Company’s internal controls during the
      Company’s nine months ended September 30, 2006, the Company’s Principal
      Executive Officer and Principal Financial Officer have determined that there
      were no changes to the Company’s internal controls over financial reporting that
      have materially affected, or are reasonably likely to materially effect, the
      Company’s internal controls over financial reporting during the nine months
      ended September 30, 2006, or subsequent to the date of their last evaluation,
      or
      from the end of the reporting period to the date of this Form 10-Q.




68


**PART
      II —OTHER
      INFORMATION**





**ITEM
      1. LEGAL PROCEEDINGS**





The
      Company is involved in various legal actions arising in the normal course of
      business, both as claimant and defendant. While it is not possible to determine
      with certainty the outcome of these matters, it is the opinion of management
      that the eventual resolution of the following legal actions could have a
      material adverse effect on the Company’s financial position or operating
      results. The following outlined legal proceedings for which the potential
      outcome could be in excess of $50,000.




**Scanbuy,
      Inc.**




On
      January 23, 2004, NeoMedia filed suit against Scanbuy, Inc. (“Scanbuy”) in the
      Northern District of Illinois, claiming that Scanbuy has manufactured, or has
      manufactured for it, and has used, or actively induced others to use, technology
      which allows customers to use a built-in UPC bar code scanner to scan individual
      items and access information, thereby infringing NeoMedia’s patents.  The
      complaint stated that on information and belief, Scanbuy had actual and
      constructive notice of the existence of the patents-in-suit, and, despite such
      notice, failed to cease and desist their acts of infringement and continue
      to
      engage in acts of infringement of the patents-in-suit.  On April 15, 2004,
      the court dismissed the suits against Scanbuy for lack of personal
      jurisdiction.





On
      April
      20, 2004, NeoMedia re-filed its suit against Scanbuy in the Southern District
      of
      New York alleging patent infringement. Scanbuy filed its answer on June 2,
      2004.
      NeoMedia filed its answer and affirmative defenses on July 23, 2004. On
      February 13, 2006, Scanbuy filed an amended answer to the complaint. NeoMedia
      filed its reply to Scanbuy’s amended answer on March 6, 2006. Discovery
      is ongoing.





**Former
      Mobot Shareholders**





On
      June
      8, 2006, Mark Freitas (“Plaintiff”), a former Mobot shareholder, filed a
      complaint in Massachusetts state court against NeoMedia alleging that NeoMedia
      breached the merger agreement between NeoMedia and Mobot by failing to file
      a
      registration statement with the SEC that included his shares by May 9,
      2006.  Plaintiff's complaint requested that the Court issue a preliminary
      injunction prohibiting NeoMedia from:  (1) causing its charter to be
      amended so as to increase the number of shares of authorized common stock in
      excess of one billion shares; (2) entering into any contract, agreement, or
      other undertaking in which NeoMedia shares are used as payment; (3) issuing
      a
      warrant or option to acquire NeoMedia common stock with an exercise price of
      less than $0.3839; and (4) filing a registration statement with the SEC that
      does not include the Mobot shareholder's shares.  Plaintiff also seeks
      costs and attorney's fees in his complaint.





A
      hearing
      on the request for preliminary injunctive relief was held on June 21,
      2006.  During the hearing, Plaintiff changed his request for relief by
      asking that the Court enjoin NeoMedia from amending the Registration Statement
      it filed on June 21, 2006 to add any additional shares or from filing any
      further registration statements until the one filed on June 21, 2006 becomes
      effective.  On June 26, 2006, the Court issued a Memorandum of Decision
      and Order on Plaintiff's Request for Preliminary Injunction and denied
      Plaintiff's request for a preliminary injunction.





NeoMedia plans
      to file a motion to dismiss the complaint, but the parties have agreed to
      extend the deadline for the submission of those papers to the Court. 
NeoMedia may also join Plaintiff's request that the action be transferred to
      the
      Business Litigation Session of the Suffolk Superior Court. NeoMedia
      intends to defend the lawsuit vigorously.





69




**12Snap
      Silent Partners**





On
      April
      18, 2006, 12Snap AG, a wholly-owned subsidiary of NeoMedia acquired on February
      28, 2006, received a letter of Technologie Beteiligungsfonds Bayern GmbH &
Co. KG, Munich, to initiate arbitration proceedings. Technologie
      Beteiligungsfonds claims for a final payment in the amount of EUR 353,000
      (approximately $443,000) plus interest of 5% per annum since March 1, 2006
      arising out of a silent partnership agreement with 12Snap. The matter was
      subject to a German arbitration proceeding during the third and fourth quarter
      2006, and the parties are currently negotiating a settlement based on the
      arbitration proceedings.





**12
      Snap Rent Dispute**





NeoMedia’s
      subsidiary 12Snap is involved in a dispute with its landlord regarding rent
      due
      for office space previously used by 12Snap in Italy. The dispute was heard
      in
      court on May 23, 2006, whereby the judge ruled for the parties to reach a
      settlement. The parties were unable to reach a settlement, and the case is
      being
      sent back to the courts. The opposing party is seeking approximately $140,000.
      The Company believes the actual settlement will be less than the amount
      sought.





**Threatened
      Litigation**





On
      March
      15, 2006, NeoMedia received a letter from an unrelated third party alleging
      that
      the party performed independent consulting services leading up to the closing
      of
      the merger between NeoMedia and Mobot on February 17, 2006. The letter contends
      that NeoMedia and Mobot breached a consulting agreement whereby the party was
      to
      be paid $300,000, equal to 3% of the merger consideration paid by NeoMedia
      to
      Mobot. NeoMedia believes the claim is without merit and intends to vigorously
      defend.




70


**ITEM
      1A. RISK FACTORS**





**Risks
      Related to NeoMedia’s Business**




**NeoMedia
      Has Historically Lost Money And Losses May Continue**




NeoMedia
        has incurred substantial operating losses since inception, and anticipates
        continuing to incur substantial losses for the foreseeable future. Net loss
        for
        the nine months ended September 30, 2006, was $27,094,000 (unaudited), which
        includes a $6,523,000 (unaudited) gain
        from the change in fair value from revaluation of warrants and embedded
        conversion features associated with the preferred stock and convertible
        debenture financing and a $13,256,000 (unaudited) charge
        to write off deferred equity financing costs associated with the 2005
        SEDA .
        NeoMedia also reported net losses of $9,147,000 and $7,230,000 for the years
        ended December 31, 2005 and 2004, respectively. NeoMedia’s accumulated losses
        were approximately $119,618,000 (unaudited) and $92,524,000 as of September
        30,
        2006 and December 31, 2005, respectively. As of September 30, 2006 NeoMedia
        had
        a working capital deficit of approximately $30,222,000 (unaudited). NeoMedia
        had
        stockholders’ equity of $40,854,000 (unaudited), $4,227,000 and $4,392,000 as of
        September 30, 2006 and December 31, 2005 and 2004, respectively. NeoMedia
        generated revenues of $14,129,000 (unaudited) and $762,000 (unaudited) for
        the nine months ended September 30, 2006 and 2005, respectively. In addition,
        during the nine months ended September 30, 2006 and 2005 NeoMedia recorded
        negative cash flows from continuing operations of $8,381,000 (unaudited)
        and $4,323,000 (unaudited), respectively. To succeed, NeoMedia must develop
        new client and customer relationships and substantially increase its revenue
        derived from improved products and additional value-added services. NeoMedia
        has
        expended, and to the extent it has available financing, NeoMedia intends
        to
        continue to expend, substantial resources to develop and improve its products,
        increase its value-added services and to market its products and services.
        These
        development and marketing expenses must be incurred well in advance of the
        recognition of revenue. As a result, NeoMedia may not be able to achieve
        or
        sustain profitability.




**NeoMedia’s
      Independent Registered Public Accounting Firm Have Added Going Concern Language
      To Their Report On NeoMedia’s Consolidated Financial Statements, Which Means
      That NeoMedia May Not Be Able To Continue Operations**




The
      report of Stonefield Josephson, Inc., NeoMedia’s independent registered public
      accounting firm, with respect to NeoMedia’s consolidated financial statements
      and the related notes for the years ended December 31, 2005 and 2004, indicates
      that, at the date of their report, NeoMedia had suffered significant recurring
      losses from operations and its working capital deficit raised substantial doubt
      about its ability to continue as a going concern. NeoMedia’s consolidated
      financial statements do not include any adjustments that might result from
      this
      uncertainty.




**NeoMedia
      Has Guaranteed The Value Of Stock Issued In Connection With Recent Mergers
      Through The Registration Of The Shares, Which Could Result In A Material Cash
      Liability**




Pursuant
      to the terms of the merger agreements with Mobot, Sponge, Gavitec, and 12Snap,
      in the event that NeoMedia’s stock price at the time the consideration shares
      issued in connection with each acquisition are saleable is less than the price
      at which they were valued for purposes of the merger agreement (between $0.3839
      and $0.3956 per share), NeoMedia is obligated to compensate the sellers in
      cash
      for the difference between the price at the time the shares become saleable
      and
      the price the shares were valued for purposes of the merger agreement.
      Subsequent to the closing of the acquisitions and through October 23, 2006,
      NeoMedia’s stock has closed as low as $0.07 per share. Assuming a stock price at
      the time the shares become saleable of $0.10, which was the last sale price
      on
      October 23, 2006, NeoMedia would have a cash liability of $32.7 million
      resulting from these clauses. As a result, NeoMedia is attempting to negotiate
      for payment of the purchase price guarantees in another non-cash form, including
      additional shares of common stock. There is no guarantee that NeoMedia will
      be
      successful in negotiating such an agreement with any or all of the parties
      involved.




71




**NeoMedia
      Has Contractual Commitments To Pay Silent Partners**




Resulting
      from the acquisition of 12 Snap, NeoMedia has a commitment to pay approximately
      $2.1 million plus accrued interest and penalties of approximately $0.4 million,
      at the end of 2006 to the Silent Partners of 12Snap. If NeoMedia’s financial
      resources are insufficient, NeoMedia may require additional financing in order
      to meet this obligation.  There is no guarantee that NeoMedia will be able
      to obtain the necessary additional capital to meet this obligation on a timely
      basis, on acceptable terms, or at all.  In any of these events, NeoMedia
      may be unable to repay this obligation when it becomes due.




**NeoMedia
      Could Identify Material Internal Control Weaknesses As Part Of Its
      Sarbanes-Oxley Internal Control Review For Its Fiscal Year Ended December 31,
      2006,**




The
      regulations implementing Section 404 of the Sarbanes-Oxley Act of 2002 require
      an assessment of the effectiveness of the Company’s internal controls over
      financial reporting beginning with our Annual Report on Form 10-K for the fiscal
      year ending December 31, 2006. The Company’s independent auditors will be
      required to confirm in writing whether management’s assessment of the
      effectiveness of the internal controls over financial reporting is fairly stated
      in all material respects, and separately report on whether they believe
      management maintained, in all material respects, effective internal control
      over
      financial reporting as of December 31, 2006. As part of the assessment of
      our internal controls in connection with the process required by Section 404
      of
      the Sarbanes-Oxley Act of 2002, management intends to continue to review,
      evaluate and strengthen our controls and processes. Management cannot state
      that
      material weaknesses in internal controls will not be determined. Management
      also
      cannot state that the process of evaluation and the auditor’s attestation will
      be completed on time. If a material weakness is discovered, corrective action
      may be time consuming, costly and further divert the attention of management.
      The disclosure of a material weakness, even if quickly remedied, could reduce
      the market’s confidence in the Company’s financial statements and harm the
      Company’s stock price, especially if a restatement of financial statements for
      past periods is required.




**There
      Is Limited Information Upon Which Investors Can Evaluate NeoMedia’s Business
      Because The Physical-World-To-Internet Market Has Existed For Only A Short
      Period Of Time**




The
      physical-world-to-Internet market in which NeoMedia operates is a recently
      developed market. Further, NeoMedia has conducted operations in this market
      only
      since March 1996. Consequently, NeoMedia has a relatively limited operating
      history upon which an investor may base an evaluation of NeoMedia’s primary
      business and determine NeoMedia’s prospects for achieving its intended business
      objectives. To date, NeoMedia has sold its physical-world-to-Internet products
      to only 12 companies. NeoMedia is prone to all of the risks inherent to the
      establishment of any new business venture, including unforeseen changes in its
      business plan. An investor should consider the likelihood of NeoMedia’s future
      success to be highly speculative in light of its limited operating history
      in
      its primary market, as well as the limited resources, problems, expenses, risks,
      and complications frequently encountered by similarly situated companies in
      new
      and rapidly evolving markets, such as the physical-world-to-Internet space.
      To
      address these risks, NeoMedia must, among other things:




·
            maintain
                and increase its client base;


·
            implement
                and successfully execute its business and marketing
                strategy;


·
            continue
                to develop and upgrade its
                products;


·
            continually
                update and improve service offerings and
                features;


·
            respond
                to industry and competitive developments;
                and


·
            attract,
                retain, and motivate qualified
                personnel.




NeoMedia
      may not be successful in addressing these risks. If NeoMedia is unable to do
      so,
      its business, prospects, financial condition, and results of operations would
      be
      materially and adversely affected.





**NeoMedia’s
      Future Success Depends On The Timely Introduction Of New Products And The
      Acceptance Of These New Products In The Marketplace.**





72




Rapid
      technological change and frequent new product introductions are typical for
      the
      markets NeoMedia serves. NeoMedia’s future success will depend in large part on
      continuous, timely development and introduction of new products that address
      evolving market requirements. To the extent that NeoMedia fails to introduce
      new
      and innovative products, it may lose market share to its competitors, which
      may
      be difficult to regain. Any inability, for technological or other reasons,
      to
      successfully develop and introduce new products could materially and adversely
      affect NeoMedia’s business.




**NeoMedia’s
      Common Stock Is Deemed To Be “Penny Stock,” Which May Make It More Difficult For
      Investors To Sell Their Shares Due To Suitability
      Requirements**




NeoMedia’s
      common stock is deemed to be “penny stock” as that term is defined in
      Rule 3a51-1 promulgated under the Securities Exchange Act of 1934, as
      amended. These requirements may reduce the potential market for NeoMedia’s
      common stock by reducing the number of potential investors. This may make it
      more difficult for investors in NeoMedia’s common stock to sell shares to third
      parties or to otherwise dispose of them. This could cause NeoMedia’s stock price
      to decline. Penny stocks are stock:





·
            with
                a price of less than $5.00 per
                share;





·
            that
                are not traded on a “recognized” national exchange;





·
            whose
                prices are not quoted on the NASDAQ automated quotation system (NASDAQ
                listed stock must still have a price of not less than $5.00 per share);
                or





·
            in
                issuers with net tangible assets less than $2 million (if the issuer
                has
                been in continuous operation for at least three years) or $10 million
                (if in continuous operation for less than three years), or with average
                revenues of less than $6 million for the last three
                years.





Broker-dealers
      dealing in penny stocks are required to provide potential investors with a
      document disclosing the risks of penny stocks. Moreover, broker-dealers are
      required to determine whether an investment in a penny stock is a suitable
      investment for a prospective investor.





**Existing
      Shareholders Will Experience Significant Dilution When Certain Investors
      Convert Their Preferred Stock to Common Stock, Convert Outstanding Convertible
      Debentures, Or When the Investors Exercise Their Warrants and Receive Common
      Stock Shares Under The Investment Agreement With The
      Investors**





The
      issuance of shares of common stock pursuant to the conversion of Series C
      convertible preferred stock or the conversion of convertible debentures pursuant
      to our transactions with Cornell Capital Partners will have a dilutive impact
      on
      our stockholders. As a result, our net income or loss per share could decrease
      in future periods, and the market price of our common stock could decline. 
In addition, the lower our stock price is, the more shares of common stock
      we
      will have to issue pursuant to the conversion of our preferred stock or the
      convertible debentures.  If our stock price is lower, then our
      existing stockholders would experience greater dilution.




**Due
      To The Accounting Treatment Of Certain Convertible Preferred Stock And
      Convertible Debenture Instruments Issued By NeoMedia, A Fluctuation In
      NeoMedia’s Stock Price Could Have A Material Impact On NeoMedia’s Results Of
      Operations**




During
        the three months ended March 31, 2006, June 30, 2006, and September 30, 2006,
        NeoMedia recognized income (expense) in the amount of $4,768,000, $11,026,000,
        and ($9,271,000), respectively, from adjustments recorded to reflect the
        change
        in fair value from revaluation of warrants and embedded conversion features
        in
        connection with its Series C convertible preferred shares and its convertible
        debenture. NeoMedia will adjust the carrying value of its derivative instruments
        to market at each balance sheet date. As a result, NeoMedia could experience
        significant fluctuations in its net income (loss) in future periods from
        such
        charges based on corresponding movement in NeoMedia’s share
        price.




73




**NeoMedia
      Is Uncertain Of The Success Of Its NeoMedia Mobile Business Unit And The Failure
      Of This Unit Would Negatively Affect The Price Of NeoMedia’s
      Stock**




NeoMedia
      provides products and services that provide a link from physical objects,
      including printed material, to the mobile Internet. NeoMedia can provide no
      assurance that:





·
            its
                NeoMedia Mobile business unit will ever achieve
                profitability;


·
            its
                current product offerings will not be adversely affected by the focusing
                of its resources on the physical-world-to-Internet space;
                or


·
            the
                products NeoMedia develops will obtain market
                acceptance.




In
      the
      event that the NeoMedia
      Mobile business
      unit should never achieve profitability, that NeoMedia’s current product
      offerings should so suffer, or that NeoMedia’s products fail to obtain market
      acceptance, NeoMedia’s business, prospects, financial condition, and results of
      operations would be materially adversely affected.




**A
      Large Percentage Of NeoMedia’s Assets Are Intangible Assets, Which Will Have
      Little Or No Value If NeoMedia’s Operations Are
      Unsuccessful**




At
      September 30, 2006 and December 31, 2005 and 2004, approximately 81%, 48% and
      49%, respectively, of NeoMedia’s total assets were intangible assets, consisting
      primarily of rights related to NeoMedia’s patents, other intellectual property,
      and excess of purchase price over fair market value paid for Mobot, Sponge,
      Gavitec, 12Snap, BSD, and CSI International, Inc. If NeoMedia’s operations are
      unsuccessful, these assets will have little or no value, which would materially
      adversely affect the value of NeoMedia’s stock and the ability of NeoMedia’s
      stockholders to recoup their investments in NeoMedia’s capital stock.





NeoMedia reviews
      its amortizable intangible assets for impairment when events or changes in
      circumstances indicate the carrying value may not be recoverable. Goodwill
      is
      required to be tested for impairment at least annually. NeoMedia may be required
      to record a significant charge to earnings in its financial statements during
      the period in which any impairment of our goodwill or amortizable intangible
      assets is determined, resulting in an impact on results of operations.




**Certain
      Of NeoMedia’s Emerging Products And Services Have Limited History And May Not
      Result In Success**




To
      date,
      NeoMedia has conducted limited marketing efforts directly relating to its
      emerging technology products, consisting primarily of the Qode suite of
      products, and certain products of recent acquisitions Mobot and Gavitec. Many
      of
      NeoMedia’s marketing efforts with respect to these emerging technologies have
      been largely untested in the marketplace, and may not result in materially
      increased sales of these emerging products and services. To penetrate the
      emerging markets in which it competes, NeoMedia expects that it will have to
      exert significant efforts to create awareness of, and demand for, its emerging
      products and services. NeoMedia intends to continue to expand its sales and
      marketing resources as the market continues to mature. NeoMedia’s failure to
      further develop its sales and marketing capabilities and successfully market
      its
      emerging products and services would have a material adverse effect on its
      business, prospects, financial condition, and results of
      operations.




74




**NeoMedia’s
      Internally Developed Systems Are Inefficient And May Put NeoMedia At A
      Competitive Disadvantage**




NeoMedia
      uses internally developed technologies for a portion of its systems integration
      services, as well as the technologies required to interconnect its clients’ and
      customers’ physical-world-to-Internet systems and hardware with its own. As
      NeoMedia develops these systems in order to integrate disparate systems and
      hardware on a case-by-case basis, these systems are inefficient and require
      a
      significant amount of customization. Such client and customer-specific
      customization is time consuming and costly and may place NeoMedia at a
      competitive disadvantage when compared to competitors with more efficient
      systems.




**NeoMedia
      Could Fail To Attract Or Retain Key Personnel**




NeoMedia’s
      future success will depend in large part on its ability to attract, train,
      and
      retain additional highly skilled executive level management, creative,
      technical, and sales personnel. Competition is intense for these types of
      personnel from other technology companies and more established organizations,
      many of which have significantly larger operations and greater financial,
      marketing, human, and other resources than NeoMedia has. NeoMedia may not be
      successful in attracting and retaining qualified personnel on a timely basis,
      on
      competitive terms, or at all. NeoMedia’s failure to attract and retain qualified
      personnel could have a material adverse effect on its business, prospects,
      financial condition, and results of operations.




**NeoMedia
      Depends Upon Its Senior Management And Their Loss Or Unavailability Could Put
      NeoMedia At A Competitive Disadvantage**




NeoMedia’s
      success depends largely on the skills of certain key management and technical
      personnel, including Charles T. Jensen, NeoMedia’s President and Chief Executive
      Officer, Charles W. Fritz, NeoMedia’s founder and Chairman of the Board of
      Directors, Martin N. Copus, NeoMedia’s Chief Operating Officer and head of the
      NMM business unit, and David A. Dodge, NeoMedia’s Chief Financial Officer. The
      loss of the services of Messrs. Jensen, Fritz, Copus, or Dodge could materially
      harm NeoMedia’s business because of the cost and time necessary to replace and
      train a replacement. Such a loss would also divert management attention away
      from operational issues. NeoMedia does not presently maintain a key-man life
      insurance policy on Messrs. Jensen, Fritz, Copus, or Dodge.




**NeoMedia
      May Be Unsuccessful In Integrating Its Recently Completed and Pending
      Acquisitions With Its Current Business**




The
      success of the acquisitions of Mobot, 12Snap, Sponge, Gavitec, and BSD could
      depend on the ability of NeoMedia’s executive management to integrate the
      business plan of each company with NeoMedia’s overall business plan. Failure to
      properly integrate the business could have a material adverse effect on the
      expected revenue and operations of the acquisitions, as well as the expected
      return on investment for NeoMedia.




**NeoMedia
      May Be Unable To Protect Its Intellectual Property Rights And May Be Liable
      For
      Infringing The Intellectual Property Rights Of Others**




NeoMedia’s
      success in the physical-world-to-Internet market is dependent upon its
      proprietary technology, including patents and other intellectual property,
      and
      on the ability to protect proprietary technology and other intellectual property
      rights. In addition, NeoMedia must conduct its operations without infringing
      on
      the proprietary rights of third parties. NeoMedia also intends to rely upon
      unpatented trade secrets and the know-how and expertise of its employees, as
      well as its patents. To protect its proprietary technology and other
      intellectual property, NeoMedia relies primarily on a combination of the
      protections provided by applicable patent, copyright, trademark, and trade
      secret laws as well as on confidentiality procedures and licensing arrangements.
      Although NeoMedia believes that it has taken appropriate steps to protect its
      unpatented proprietary rights, including requiring that its employees and third
      parties who are granted access to NeoMedia’s proprietary technology enter into
      confidentiality agreements, NeoMedia can provide no assurance that these
      measures will be sufficient to protect its rights against third parties. Others
      may independently develop or otherwise acquire patented or unpatented
      technologies or products similar or superior to NeoMedia’s.




75





NeoMedia
      licenses from third parties certain software tools that are included in
      NeoMedia’s services and products. If any of these licenses were terminated,
      NeoMedia could be required to seek licenses for similar software from other
      third parties or develop these tools internally. NeoMedia may not be able to
      obtain such licenses or develop such tools in a timely fashion, on acceptable
      terms, or at all. Companies participating in the software and Internet
      technology industries are frequently involved in disputes relating to
      intellectual property. NeoMedia may in the future be required to defend its
      intellectual property rights against infringement, duplication, discovery,
      and
      misappropriation by third parties or to defend against third party claims of
      infringement. Likewise, disputes may arise in the future with respect to
      ownership of technology developed by employees who were previously employed
      by
      other companies. Any such litigation or disputes could result in substantial
      costs to, and a diversion of effort by, NeoMedia. An adverse determination
      could
      subject NeoMedia to significant liabilities to third parties, require NeoMedia
      to seek licenses from, or pay royalties to, third parties, or require NeoMedia
      to develop appropriate alternative technology. Some or all of these licenses
      may
      not be available to NeoMedia on acceptable terms or at all, and NeoMedia may
      be
      unable to develop alternate technology at an acceptable price or at all. Any
      of
      these events could have a material adverse effect on NeoMedia’s business,
      prospects, financial condition, and results of operations.




**NeoMedia
      Is Exposed To Product Liability Claims And An Uninsured Claim Could Have A
      Material Adverse Effect On NeoMedia’s Business, Prospects, Financial Condition,
      And Results Of Operations, As Well As The Value Of NeoMedia’s
      Stock**




Many
      of
      NeoMedia’s projects are critical to the operations of its clients’ businesses.
      Any failure in a client’s information system could result in a claim for
      substantial damages against NeoMedia, regardless of NeoMedia’s responsibility
      for such failure. NeoMedia could, therefore, be subject to claims in connection
      with the products and services that it sells. NeoMedia currently maintains
      product liability insurance. There can be no assurance that:





·
            NeoMedia
                has contractually limited its liability for such claims adequately
                or at
                all; or


·
            NeoMedia
                would have sufficient resources to satisfy any liability resulting
                from
                any such claim.




The
      successful assertion of one or more large claims against NeoMedia could have
      a
      material adverse effect on its business, prospects, financial condition, and
      results of operations.




**NeoMedia
      Will Not Pay Cash Dividends And Investors May Have To Sell Their Shares In
      Order
      To Realize Their Investment**




NeoMedia
      has not paid any cash dividends on its common stock and does not intend to
      pay
      cash dividends in the foreseeable future. NeoMedia intends to retain future
      earnings, if any, for reinvestment in the development and marketing of
      NeoMedia’s products and services. As a result, investors may have to sell their
      shares of common stock to realize their investment.




**Some
      Provisions Of NeoMedia’s Certificate of Incorporation And bylaws May Deter
      Takeover Attempts, Which May Limit The Opportunity Of NeoMedia’s Stockholders To
      Sell Their Shares At A Premium To The Then-Current Market
      Price**




Some
      of
      the provisions of NeoMedia’s Certificate of Incorporation and bylaws could make
      it more difficult for a third party to acquire NeoMedia, even if doing so might
      be beneficial to NeoMedia’s stockholders by providing them with the opportunity
      to sell their shares at a premium to the then-current market price. On December
      10, 1999, NeoMedia’s Board of Directors adopted a stockholders rights plan and
      declared a non-taxable dividend of one right to acquire Series A Preferred
      Stock
      of NeoMedia, par value $0.01 per share, on each outstanding share of NeoMedia’s
      common stock to stockholders of record on December 10, 1999 and each share
      of
      common stock issued thereafter until a pre-defined hostile takeover date. The
      stockholder rights plan was adopted as an anti-takeover measure, commonly
      referred to as a “poison pill.” The stockholder rights plan was designed to
      enable all stockholders not engaged in a hostile takeover attempt to receive
      fair and equal treatment in any proposed takeover of NeoMedia and to guard
      against partial or two-tiered tender offers, open market accumulations, and
      other hostile tactics to gain control of NeoMedia. The stockholders rights
      plan
      was not adopted in response to any effort to acquire control of NeoMedia at
      the
      time of adoption. This stockholders rights plan may have the effect of rendering
      more difficult, delaying, discouraging, preventing, or rendering more costly
      an
      acquisition of NeoMedia or a change in control of NeoMedia. Certain of
      NeoMedia’s directors, officers and principal stockholders, Charles W. Fritz,
      William E. Fritz and The Fritz Family Limited Partnership and their holdings
      were exempted from the triggering provisions of NeoMedia’s “poison pill” plan,
      as a result of the fact that, as of the plan’s adoption, their holdings might
      have otherwise triggered the “poison pill”.




76





In
      addition, NeoMedia’s Certificate of Incorporation authorizes the Board of
      Directors to designate and issue preferred stock, in one or more series, the
      terms of which may be determined at the time of issuance by the Board of
      Directors, without further action by stockholders, and may include voting
      rights, including the right to vote as a series on particular matters,
      preferences as to dividends and liquidation, conversion, redemption rights,
      and
      sinking fund provisions.




NeoMedia
      is authorized to issue a total of 25,000,000 shares of Preferred Stock, par
      value $0.01 per share. The issuance of any preferred stock could have a material
      adverse effect on the rights of holders of NeoMedia’s common stock, and,
      therefore, could reduce the value of shares of NeoMedia’s common stock. In
      addition, specific rights granted to future holders of preferred stock could
      be
      used to restrict NeoMedia’s ability to merge with, or sell NeoMedia’s assets to,
      a third party. The ability of the Board of Directors to issue preferred stock
      could have the effect of rendering more difficult, delaying, discouraging,
      preventing, or rendering more costly an acquisition of NeoMedia or a change
      in
      NeoMedia’s control thereby preserving control by the current stockholders.




**All
      Of The Company’s Assets Are Pledged To Secure Certain Debt Obligations, Which
      The Company Could Fail To Repay**




Pursuant
      to secured convertible debentures, dated as of August 24, 2006 in the principal
      amount of $5,000,000 issued to Cornell Capital Partners, LP, the Company was
      required to secure such secured convertible debentures’ repayment with
      substantially all of its assets.
      In the event the Company is unable to repay the secured convertible debentures,
      it could lose all of its assets and be forced to cease its operations. If the
      Company is found to be in default under the debentures, the full principal
      amount of the debentures, together with interest and other amounts owing, may
      become immediately due and payable.




77




**Risks
      Relating To NeoMedia’s Industry**




**The
      Security Of The Internet Poses Risks To The Success Of NeoMedia’s Entire
      Business**




Concerns
      over the security of the Internet and other electronic transactions, and the
      privacy of consumers and merchants, may inhibit the growth of the Internet
      and
      other online services generally, especially as a means of conducting commercial
      transactions, which may have a material adverse effect on NeoMedia’s
      physical-world-to-Internet business.




**NeoMedia
      Will Only Be Able To Execute Its Physical-World-To-Internet Business Plan If
      Internet Usage and Electronic Commerce Continue To Grow**




NeoMedia’s
      future revenues and any future profits are substantially dependent upon the
      widespread acceptance and use of the Internet and camera devices on mobile
      telephones. If use of the Internet and camera devices on mobile telephones
      does
      not continue to grow or grows more slowly than expected, or if the
      infrastructure for the Internet and camera devices on mobile telephones does
      not
      effectively support the growth that may occur, or does not become a viable
      commercial marketplace, NeoMedia’s physical-world-to-Internet business, and
      therefore NeoMedia’s business, prospects, financial condition, and results of
      operations, could be materially adversely affected. Rapid growth in the use
      of,
      and interest in, the Internet and camera devices on mobile telephones is a
      recent phenomenon, and may not continue on a lasting basis. In addition,
      customers may not adopt, and continue to use mobile telephones as a medium
      of
      information retrieval or commerce. Demand and market acceptance for recently
      introduced services and products over the mobile Internet are subject to a
      high
      level of uncertainty, and few services and products have generated profits.
      For
      NeoMedia to be successful, consumers and businesses must be willing to accept
      and use novel and cost efficient ways of conducting business and exchanging
      information.





In
      addition, the public in general may not accept the use of the Internet and
      camera devices on mobile telephones as a viable commercial or information
      marketplace for a number of reasons, including potentially inadequate
      development of the necessary network infrastructure or delayed development
      of
      enabling technologies and performance improvements. To the extent that mobile
      phone Internet usage continues to experience significant growth in the number
      of
      users, their frequency of use, or in their bandwidth requirements, the
      infrastructure for the mobile Internet may be unable to support the demands
      placed upon them. In addition, the mobile Internet and mobile interactivity
      could lose its viability due to delays in the development or adoption of new
      standards and protocols required to handle increased levels of mobile Internet
      activity, or due to increased governmental regulation. Significant issues
      concerning the commercial and informational use of the mobile Internet, and
      online networks technologies, including security, reliability, cost, ease of
      use, and quality of service, remain unresolved and may inhibit the growth of
      Internet business solutions that utilize these technologies. Changes in, or
      insufficient availability of, telecommunications services to support the
      Internet, the Web or other online services also could result in slower response
      times and adversely affect usage of the Internet, the Web and other online
      networks generally and NeoMedia’s physical-world-to-Internet product and
      networks in particular.




**NeoMedia
      May Not Be Able To Adapt As The Internet, Physical-World-To-Internet, And
      Customer Demands Continue To Evolve**




NeoMedia
      may not be able to adapt as the mobile Internet and physical-world-to-Internet
      markets and consumer demands continue to evolve. NeoMedia’s failure to respond
      in a timely manner to changing market conditions or client requirements would
      have a material adverse effect on its business, prospects, financial condition,
      and results of operations. The mobile Internet and physical-world-to-Internet
      markets are characterized by:





·
            rapid
                technological change;






78




·
            changes
                in user and customer requirements and
                preferences;


·
            frequent
                new product and service introductions embodying new technologies;
                and


·
            the
                emergence of new industry standards and practices that could render
                proprietary technology and hardware and software infrastructure
                obsolete.





NeoMedia’s
      success will depend, in part, on its ability to:




·
            enhance
                and improve the responsiveness and functionality of its products
                and
                services;





·
            license
                or develop technologies useful in its business on a timely
                basis;





·
            enhance
                its existing services, and develop new services and technologies
                that
                address the increasingly sophisticated and varied needs of NeoMedia’s
                prospective or current customers;
                and





·
            respond
                to technological advances and emerging industry standards and practices
                on
                a cost-effective and timely basis.




**NeoMedia
      May Not Be Able To Compete Effectively In Markets Where Its Competitors Have
      More Resources**




While
      the
      market for physical-world-to-Internet technology is relatively new, it is
      already highly competitive and characterized by an increasing number of entrants
      that have introduced or developed products and services similar to those offered
      by NeoMedia. NeoMedia believes that competition will intensify and increase
      in
      the near future. NeoMedia’s target market is rapidly evolving and is subject to
      continuous technological change. As a result, NeoMedia’s competitors may be
      better positioned to address these developments or may react more favorably
      to
      these changes, which could have a material adverse effect on NeoMedia’s
      business, prospects, financial condition, and results of
      operations.





Some
      of
      NeoMedia’s competitors have longer operating histories, larger customer bases,
      longer relationships with clients, and significantly greater financial,
      technical, marketing, and public relations resources than NeoMedia. NeoMedia
      may
      not successfully compete in any market in which it conducts or may conduct
      operations. NeoMedia may not be able to penetrate markets or market its products
      as effectively as NeoMedia’s better-funded more-established competitors.




**In
      The Future There Could Be Government Regulations** **And
      Legal Uncertainties Which Could Harm NeoMedia’s Business**




Any
      new
      legislation or regulation, the application of laws and regulations from
      jurisdictions whose laws do not currently apply to NeoMedia’s business, or the
      application of existing laws and regulations to the Internet and other online
      services, could have a material adverse effect on NeoMedia’s business,
      prospects, financial condition, and results of operations. Due to the increasing
      popularity and use of the Internet, the Web and other online services, federal,
      state, and local governments may adopt laws and regulations, or amend existing
      laws and regulations, with respect to the Internet or other online services
      covering issues such as taxation, user privacy, pricing, content, copyrights,
      distribution, and characteristics and quality of products and services. The
      growth and development of the market for electronic commerce may prompt calls
      for more stringent consumer protection laws to impose additional burdens on
      companies conducting business online. The adoption of any additional laws or
      regulations may decrease the growth of the Internet, the Web or other online
      services, which could, in turn, decrease the demand for NeoMedia’s services and
      increase NeoMedia’s cost of doing business, or otherwise have a material adverse
      effect on NeoMedia’s business, prospects, financial condition, and results of
      operations. Moreover, the relevant governmental authorities have not resolved
      the applicability to the Internet, the Web and other online services of existing
      laws in various jurisdictions governing issues such as property ownership and
      personal privacy and it may take time to resolve these issues
      definitively.





79


Certain
      of NeoMedia’s proprietary technology allows for the storage of demographic data
      from NeoMedia’s users. In 2000, the European Union adopted a directive
      addressing data privacy that may limit the collection and use of certain
      information regarding Internet users. This directive may limit NeoMedia’s
      ability to collect and use information collected by NeoMedia’s technology in
      certain European countries. In addition, the Federal Trade Commission and
      several state governments have investigated the use by certain Internet
      companies of personal information. NeoMedia could incur significant additional
      expenses if new regulations regarding the use of personal information are
      introduced or if NeoMedia’s privacy practices are investigated.





Certain
      of NeoMedia’s micro paint solutions could be subject to environmental
      regulations.




80




**Item
      2. Unregistered Sales of Equity Securities and Use of Proceeds
      (** **a),
      (b), (c** **)
      and (** **d** **)**




None.




**Item
      3. Default upon Senior Securities**




None.




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




None.




**Item
      5. Other Information**




None.




81


**Item
      6. Exhibits and reports on form 8-K**




**(a)**  **Exhibits** **:**




**Exhibit
                No.**
            
            **Description**
            
            **Location**31.1
            
            Certification
                by Chief Executive Officer pursuant to 15 U.S.C. Section 7241, as
                adopted
                pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
            
            Provided
                herewith31.2
            
            Certification
                by Chief Financial Officer pursuant to 15 U.S.C. Section 7241, as
                adopted
                pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
            
            Provided
                herewith32.1
            
            Certification
                by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
                adopted
                pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
            
            Provided
                herewith32.2
            
            Certification
                by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
                adopted
                pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
            
            Provided
                herewith




**(b)**
            **Reports
                on Form 8-K****:**




NeoMedia
      filed a report on Form 8-K on July 27, 2006, with respect to Item 1.01,
      reporting that it had signed
      a
      an operating agreement with Shang Fang Wei Ye Technology Development Limited
      Company (“Shang
      Fang”) ,
      a
      subsidiary of Beijing Sino-U.S. Jinche Yingyang Auto Technological Services
      Ltd., to introduce and market NeoMedia’s patented qode direct-to-Web technology in key
      markets in  Asia .





NeoMedia
      filed a report on Form 8-K on August 30, 2006, with respect to Item 1.01 and
      Item 3.02, reporting that it had sold
      a $5
      million secured convertible debenture.





NeoMedia
      filed a report on Form 8-K on August 30, 2006, with respect to Item 8.01,
      reporting that it had terminated
      a non-binding letter of intent to acquire Hip Cricket, Inc.





NeoMedia
      filed a report on Form 8-K on August 31, 2006, with respect to Item 8.01,
      reporting that it had signed
      a
      non-binding letter of intent to sell its Micro Paint Repair business unit.


82


**SIGNATURES**





In
      accordance with the requirements of the Securities Exchange Act of 1934, the
      Registrant has caused this report to be signed on its behalf by the undersigned,
      thereunto duly authorized.


**NEOMEDIA
                TECHNOLOGIES, INC.**
                RegistrantDate:November
                9, 2006
            By:
            */s/
              Charles T. Jensen*Charles
                T. Jensen, President, Chief Executive Officer, and
                Director




Date:November
                9, 2006
            By:
            */s/
              David A. Dodge*David
                A. Dodge, Vice President,Chief
                Financial Officer and Principal Accounting
                Officer


83