UNITED
STATES


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, 2008,
  or





[   ]
            Transition
      Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934 for the transition period from ______________ to
      _____________.





Commission
File No. 0-23862


Fonix
Corporation


(Exact
name of registrant as specified in its charter)





Delaware
            22-2994719(State
      or other jurisdiction of incorporation or organization)
            (I.R.S.
      Employer Identification No.)





387
South 520 West, Suite 110


Lindon,
Utah 84042


(Address
of principal executive offices with zip code)





(801)
553-6600


(Registrant's
telephone number, including area code)





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 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] No[ ].





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer, or a smaller reporting
company.  (Check one):


Large
accelerated filer [  ]  Accelerated filer
[  ]  Non-accelerated filer
[  ]  Smaller reporting company [X]





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-25 of the Exchange Act).  Yes __ No X





As of
November 14, 2008, there were issued and outstanding 16,615,553,852 shares of
our Class A common stock.





1





FONIX
CORPORATION


FORM
10-Q








TABLE
OF CONTENTS





PART
I - FINANCIAL INFORMATION





PageItem
      1.
            Financial
      Statements (Unaudited)Condensed
      Consolidated Balance Sheets – As of September 30, 2008, and December 31,
      2007
            3Condensed
      Consolidated Statements of Operations and Comprehensive Loss for
      theThree
      and Nine Months Ended September 30, 2008 and 2007
            4Condensed
      Consolidated Statements of Cash Flows for the Nine Months
      EndedSeptember
      30, 2008 and 2007
            5Notes
      to Condensed Consolidated Financial Statements (Unaudited)
            7Item
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            19Item
      3.
            Quantitative
      and Qualitative Disclosures About Market Risk
            34Item
      4T.
            Controls
      and Procedures
            34PART
      II - OTHER INFORMATIONItem
      1.
            Legal
      Proceedings
            35Item
      1A.
            Risk
      Factors
            35Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            36Item
      6.
            Exhibits
            36







2





Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED BALANCE SHEETS


(Unaudited)




September
      30,
              
              
              December
      31,2008
              
              
              2007ASSETSCurrent
      assetsCash
      and cash equivalents
              
              $
              10,000
              
              
              $
              26,000Prepaid
      expenses and other current assets
              
              
              60,000
              
              
              
              61,000Total
      current assets
              
              
              70,000
              
              
              
              87,000Property and equipment,
      net of accumulated depreciation of $1,301,000 and $1,293,000,
      respectively
              
              
              28,000
              
              
              
              16,000Deposits
      and other assets
              
              
              12,000
              
              
              
              108,000Total
      assets
              
              $
              110,000
              
              
              $
              211,000LIABILITIES
      AND STOCKHOLDERS' DEFICITCurrent
      liabilitiesAccrued
      liabilities
              
              $
              4,666,000
              
              
              $
              4,505,000Accounts
      payable
              
              
              1,682,000
              
              
              
              1,532,000Derivative
      liability
              
              
              33,886,000
              
              
              
              20,742,000Accrued
      payroll and other compensation
              
              
              211,000
              
              
              
              211,000Accrued
      settlement obligation
              
              
              85,000
              
              
              
              540,000Deferred
      revenues
              
              
              445,000
              
              
              
              445,000Notes
      payable - related parties
              
              
              940,000
              
              
              
              902,000Series
      E debentures
              
              
              -
              
              
              
              1,754,000Current
      portion of notes payable
              
              
              -
              
              
              
              3,833,000Deposits
      and other
              
              
              7,000
              
              
              
              7,000Total
      current liabilities
              
              
              41,922,000
              
              
              
              34,471,000Long-term
      notes payable, net of current portion
              
              
              -
              
              
              
              3,556,000Total
      liabilities
              
              
              41,922,000
              
              
              
              38,027,000Commitments
      and contingenciesStockholders'
      deficitPreferred
      stock, $0.0001 par value;  50,000,000 shares
      authorized;Series
      A, convertible; 166,667 shares outstanding (aggregate liquidation
      preference of $6,055,000)
              
              
              500,000
              
              
              
              500,000Series
      L, convertible; 1,501 shares and 1,535 shares outstanding ,
      respectively
              
              
              -
              
              
              
              -Common
      stock, $0.0001 par value; 20,000,000,000 shares
authorized;Class
      A voting, 14,900,043,852 shares and 4,287,119,186 shares outstanding,
      respectively
              
              
              1,490,000
              
              
              
              429,000Class
      B non-voting, none outstanding
              
              
              -
              
              
              
              -Additional
      paid-in capital
              
              
              239,183,000
              
              
              
              238,714,000Outstanding
      warrants to purchase Class A common stock
              
              
              474,000
              
              
              
              474,000Cumulative
      foreign currency translation adjustment
              
              
              10,000
              
              
              
              10,000Accumulated
      deficit
              
              
              (283,469,000
              )
              
              
              (277,943,000
              )Total
      stockholders' deficit
              
              
              (41,812,000
              )
              
              
              (37,816,000
              )Total
      liabilities and stockholders' deficit
              
              $
              110,000
              
              
              $
              211,000


See
accompanying notes to condensed consolidated financial
statements.





3





Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS


(Unaudited)


Three
      Months Ended September 30,
              
              
              Nine
      Months Ended September 30,2008
              
              
              2007
              
              
              2008
              
              
              2007Revenues
              
              $
              223,000
              
              
              $
              339,000
              
              
              $
              1,069,000
              
              
              $
              1,344,000Cost
      of revenues
              
              
              3,000
              
              
              
              54,000
              
              
              
              53,000
              
              
              
              133,000Gross
      profit
              
              
              220,000
              
              
              
              285,000
              
              
              
              1,016,000
              
              
              
              1,211,000Expenses:Selling,
      general and administrative
              
              
              343,000
              
              
              
              502,000
              
              
              
              1,431,000
              
              
              
              1,966,000Product
      development and research
              
              
              300,000
              
              
              
              338,000
              
              
              
              992,000
              
              
              
              1,263,000Total
      expenses
              
              
              643,000
              
              
              
              840,000
              
              
              
              2,423,000
              
              
              
              3,229,000Other
      income (expense):Interest
      expense
              
              
              (1,686,000
              )
              
              
              (476,000
              )
              
              
              (2,723,000
              )
              
              
              (1,393,000
              )Gain
      on forgiveness of liabilities
              
              
              -
              
              
              
              199,000
              
              
              
              -
              
              
              
              199,000Gain
      on derivative liability
              
              
              408,000
              
              
              
              247,000
              
              
              
              95,000
              
              
              
              776,000Other
      income (expense), net
              
              
              (1,278,000
              )
              
              
              (30,000
              )
              
              
              (2,628,000
              )
              
              
              (418,000
              )Net
      loss from continuing operations
              
              
              (1,701,000
              )
              
              
              (585,000
              )
              
              
              (4,035,000
              )
              
              
              (2,436,000
              )Net
      loss
              
              
              (1,701,000
              )
              
              
              (585,000
              )
              
              
              (4,035,000
              )
              
              
              (2,436,000
              )Preferred
      stock dividends
              
              
              (466,000
              )
              
              
              (436,000
              )
              
              
              (1,491,000
              )
              
              
              (1,278,000
              )Loss
      attributable to common stockholders
              
              $
              (2,167,000
              )
              
              $
              (1,021,000
              )
              
              $
              (5,526,000
              )
              
              $
              (3,714,000
              )Basic
      and diluted loss per common share from continuing
    operations
              
              $
              (0.00
              )
              
              $
              (0.00
              )
              
              $
              (0.00
              )
              
              $
              (0.00
              )Net
      loss
              
              $
              (1,701,000
              )
              
              $
              (585,000
              )
              
              $
              (4,035,000
              )
              
              $
              (2,436,000
              )


See
accompanying notes to condensed consolidated financial statements.




4





Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)


Nine
      Months Ended September 30,
                  
                  2008
                  
                  
                  2007Cash
      flows from operating activitiesNet
      income (loss)
                  
                  $
                  (4,035,000
                  )
                  
                  $
                  (2,436,000
                  )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Gain
      on derivative liability
                  
                  
                  (95,000
                  )
                  
                  
                  (776,000
                  )Accretion
      of discount on notes payable
                  
                  
                  2,124,000
                  
                  
                  
                  774,000Issuance
      of shares for employee grants
                  
                  
                  709,000
                  
                  
                  
                  -Gain
      on forgiveness of liabilities
                  
                  
                  -
                  
                  
                  
                  (199,000
                  )Depreciation
                  
                  
                  8,000
                  
                  
                  
                  29,000Changes
      in assets and liabilitiesPrepaid
      expenses and other current assets
                  
                  
                  134,000
                  
                  
                  
                  2,000Other
      assets
                  
                  
                  96,000
                  
                  
                  
                  -Accounts
      payable
                  
                  
                  274,000
                  
                  
                  
                  (130,000
                  )Accrued
      payroll and other compensation
                  
                  
                  -
                  
                  
                  
                  44,000Other
      accrued liabilities
                  
                  
                  576,000
                  
                  
                  
                  581,000Deferred
      revenues
                  
                  
                  -
                  
                  
                  
                  (14,000
                  )Net
      cash used in operating activities
                  
                  
                  (209,000
                  )
                  
                  
                  (2,125,000
                  )Cash
      flows from investing activitiesPurchase
      of property and equipment
                  
                  
                  (20,000
                  )
                  
                  
                  -Net
      cash used in investing activities
                  
                  
                  (20,000
                  )
                  
                  
                  -Cash
      flows from financing activitiesProceeds
      from related party note payable
                  
                  
                  59,000
                  
                  
                  
                  102,000Proceeds
      from Series B Preferred Stock
                  
                  
                  -
                  
                  
                  
                  1,250,000Proceeds
      from Series N Preferred Stock
                  
                  
                  -
                  
                  
                  
                  915,000Advance
      on Series N Preferred Stock
                  
                  
                  -
                  
                  
                  
                  10,000Proceeds
      from issuance of Series O Preferred Stock
                  
                  
                  609,000
                  
                  
                  
                  -Proceeds
      from notes payable
                  
                  
                  -
                  
                  
                  
                  450,000Payments
      on accrued settlement obligation
                  
                  
                  (455,000
                  )
                  
                  
                  (594,000
                  )Net
      cash provided by financing activities
                  
                  
                  213,000
                  
                  
                  
                  2,133,000Net
      increase (decrease) in cash and cash equivalents
                  
                  
                  (16,000
                  )
                  
                  
                  8,000Cash
      and cash equivalents at beginning of period
                  
                  
                  26,000
                  
                  
                  
                  5,000Cash
      and cash equivalents at end of period
                  
                  $
                  10,000
                  
                  
                  $
                  13,000


See
accompanying notes to condensed consolidated financial statements.




5





Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)


(Unaudited)








Supplemental
schedule of noncash investing and financing activities





For
the Nine Months Ended September 30, 2008:





Issued
3,228,481,781 shares of Class A common stock upon conversion of 34 shares of
Series L Convertible Preferred Stock.





Issued  4,483,938,874
shares of Class A common stock for employee stock grants





Issued
624,705,379 shares of Class A common stock for unpaid legal fees.





Issued
726,126,126 shares of Class A common stock for consulting services.




Issued
1,339,746,008 shares of Class A common stock upon conversion of $162,000 in
accrued interest.


Issued
209,926,500 shares of Class A common stock upon conversion of $21,000 in notes
payable – related parties.





Accrued
$1,040,000 of dividends on Series L Preferred Stock.





Accrued
$103,000 of dividends on Series M Preferred Stock.





Accrued
$105,000 of dividends on Series N Preferred Stock.





Accrued
$23,000 of dividends on Series O Preferred Stock.





Accrued
$86,000 of dividends on Fonix Speech Series B Preferred Stock.





For
the Nine Months Ended September 30, 2007:





Issued
1,502,304,306 shares of Class A common stock upon conversion of 141 shares of
Series L Convertible Preferred Stock.





Accrued
$1,144,000 of dividends on Series L Preferred Stock.





Accrued
$67,000 of dividends on Series M Preferred Stock.





Accrued
$7,000 of dividends on Series N Preferred Stock.





Accrued
$56,000 of dividends on Fonix Speech Series B Preferred Stock.





Issued
150 shares of Series M Convertible Preferred Stock with a face value of
$1,500,000 in exchange for 150 shares of Series L Preferred Stock with a face
value of $1,500,000.





Issued
915 shares of Series N Convertible Preferred Stock with a face value of
$915,000.






See
accompanying notes to condensed consolidated financial
statements.





6





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)





1.  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES





Basis of
Presentation – The accompanying unaudited condensed consolidated
financial statements ofFonixCorporation and
subsidiaries (collectively, the “Company” or “Fonix”) have been prepared by the
Company pursuant to the rules and regulations of the Securities and Exchange
Commission (the “SEC”).  Certain information and footnote disclosures
normally included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America have been
condensed or omitted pursuant to such rules and regulations, although the
Company believes that the following disclosures are adequate to make the
information presented not misleading.  The Company suggests that these
condensed consolidated financial statements be read in conjunction with the
consolidated financial statements and the notes thereto included in the
Company’s 2007 Annual Report on Form 10-K.





These
condensed consolidated financial statements reflect all adjustments (consisting
only of normal recurring adjustments) that, in the opinion of management, are
necessary to present fairly the financial position and results of operations of
the Company for the periods presented.  The Company’s business
strategy is not without risk, and readers of these condensed consolidated
financial statements should carefully consider the risks set forth under the
heading “Certain Significant Risk Factors” in the Company’s 2007 Annual Report
on Form 10-K.





Operating
results for the nine months ended September 30, 2008, are not necessarily
indicative of the results that may be expected for the year ending December 31,
2008.




Nature of
Operations–Fonix
Corporation (“the Company” or “Fonix”) provides value-added speech technologies
through its subsidiary, Fonix Speech, Inc. (“Fonix Speech”).  The
Company offers speech-enabling technologies including automated speech
recognition (“ASR”) and text-to-speech (“TTS”) through Fonix Speech to markets
for wireless and mobile devices, computer telephony, server solutions and
personal software for consumer applications.  The Company has received
various patents for certain elements of its core technologies and has filed
applications for other patents covering various aspects of its
technologies.  The Company seeks to develop relationships and
strategic alliances with third-party developers and vendors in
telecommunications, computers, electronic devices and related industries,
including producers of application software, operating systems, computers and
microprocessor chips.  Revenues are generated through licensing of
speech-enabling technologies, maintenance contracts and services.
 
 Business
Condition-For
the three months ended September 30, 2008 and 2007, the company generated
revenues of $223,000 and $339,000, respectively, and incurred net losses of
$1,701,000 and $585,000, respectively.  For the nine months ended
September 30, 2008 and 2007, the company generated revenues of $1,069,000 and
$1,344,000, respectively, incurred net losses of $4,035,000 and $2,436,000,
respectively, and had negative cash flows from operating activities of $209,000
and $2,125,000, respectively.  As of September 30, 2008, we had an
accumulated deficit of $283,469,000; negative working capital of $41,852,000;
derivative liabilities of $33,886,000 related to the issuance of Series L
Preferred Stock,  Series M Preferred Stock, Series N Preferred Stock,
Series O Preferred Stock and   Series P Preferred Stock of the
Company and Series B Preferred Stock of our subsidiary; accrued liabilities and
accrued settlement obligation of $4,751,000; accounts payable of
$1,682,000;  notes payable to related parties of $940,000; accrued
payroll and other compensation of $211,000; and deferred revenues of
$445,000.  We expect to continue to incur significant losses and
negative cash flows from operating activities at least through December 31,
2008, primarily due to expenditure requirements associated with continued
marketing and development of our speech-enabling technologies.
 
 The
Company’s cash resources, limited to collections from customers, sales of our
equity and debt securities and loans, have not been sufficient to cover
operating expenses.  As a result, some payments to vendors have been
delayed.  On March 15, 2007, the New York State trial court entered
judgment against the Company and in favor of the Breckenridge Fund in the amount
of $1,602,000.  In February 2008, the Company entered into an amended
settlement agreement with Breckenridge under which the Company agreed to pay
Breckenridge $540,000, which amount was paid in full in November
2008.





7





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)








These
factors, as well as the risk factors set out elsewhere in the Company’s Annual
Report on Form 10-K,  raise substantial doubt about the Company’s
ability to continue as a going concern.  The accompanying financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.  Management plans to fund further operations of the
Company from cash flows from future license and royalty arrangements and with
proceeds from additional issuance of debt and equity
securities.  There can be no assurance that management’s plans will be
successful.





Net Loss Per
Common Share –Basic and diluted net
loss per common share are calculated by dividing net loss attributable to common
stockholders by the weighted average number of shares of common stock
outstanding during the period.  As of September 30, 2008 and 2007,
there were outstanding common stock equivalents to purchase 233,964,681,280and
42,840,665,606 shares of common stock, respectively, that were not included in
the computation of diluted net loss per common share as their effect would have
been anti-dilutive, thereby decreasing the net loss per common
share.





The
following table is a reconciliation of the net loss numerator of basic and
diluted net loss per common share for the three and nine months ended September
30, 2008 and 2007:





Three
      Months Ended September 30,2008
            
            
            2007Per
            
            
            
            
            
            PerShare
            
            
            
            
            
            ShareAmount
            
            
            Amount
            
            
            Amount
            
            
            AmountNet
      loss
            
            $
            (1,701,000
            )
            
            
            
            
            $
            (585,000
            )Preferred
      stock dividends
            
            
            (466,000
            )
            
            
            
            
            
            (436,000
            )Loss
      attributable to common stockholders
            
            $
            (2,167,000
            )
            
            $
            (0.00
            )
            
            $
            (1,021,000
            )
            
            $
            (0.00
            )Weighted-average
      common shares outstanding
            
            
            12,733,212,844
            
            
            
            
            
            
            
            2,517,230,627







Nine
      Months Ended September 30,2008
            
            
            2007Per
            
            
            
            
            
            PerShare
            
            
            
            
            
            ShareAmount
            
            
            Amount
            
            
            Amount
            
            
            AmountNet
      loss
            
            $
            (4,035,000
            )
            
            
            
            
            $
            (2,436,000
            )Preferred
      stock dividends
            
            
            (1,491,000
            )
            
            
            
            
            
            (1,278,000
            )Loss
      attributable to common stockholders
            
            $
            (5,526,000
            )
            
            $
            (0.00
            )
            
            $
            (3,714,000
            )
            
            $
            (0.00
            )Weighted-average
      common shares outstanding
            
            
            8,028,530,486
            
            
            
            
            
            
            
            2,003,817,026








Imputed Interest
Expense–Interest
is imputed on long-term debt obligations where management has determined that
the contractual interest rates are below the market rate for instruments with
similar risk characteristics.





Comprehensive
Loss–Other
comprehensive loss as presented in the accompanying condensed consolidated
financial statements consists of cumulative foreign currency translation
adjustments.





Revenue
Recognition– The Company recognizes revenue when pervasive evidence of
an arrangement exists; services have been rendered or products have been
delivered; the price to the buyer is fixed and determinable; and collectibility
is reasonably assured.  Revenues are recognized by the Company based
on the various types of transactions generating the revenue.  For
software sales, the Company recognizes revenues in accordance with the
provisions of Statement of Position No. 97-2, “Software Revenue Recognition,”
and related interpretations.The Company
generates revenues from licensing the rights to its software products to end
users and from royalties.





8





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




For Fonix
Speech, revenue of all types is recognized when acceptance of functionality,
rights of return, and price protection are confirmed or can be reasonably
estimated, as appropriate.  Revenues from development and consulting
services are recognized on a completed-contract basis when the services are
completed and accepted by the customer.  The completed-contract method
is used because the Company’s contracts are typically either short-term in
duration or the Company is unable to make reasonably dependable estimates of the
costs of the contracts.  Revenue for hardware units delivered is
recognized when delivery is verified and collection assured.





Revenue
for products distributed through wholesale and retail channels and through
resellers is recognized upon verification of final sell-through to end users,
after consideration of rights of return and price
protection.  Typically, the right of return on such products has
expired when the end user purchases the product from the retail
outlet.  Once the end user opens the package, it is not returnable
unless the medium is defective.





When
arrangements to license software products do not require significant production,
modification or customization of software, revenue from licenses and royalties
are recognized when persuasive evidence of a licensing arrangement exists,
delivery of the software has occurred, the fee is fixed or determinable, and
collectibility is probable.  Post-contract obligations, if any,
generally consist of one year of support including such services as customer
calls, bug fixes, and upgrades.  Related revenue is recognized over
the period covered by the agreement.  Revenues from maintenance and
support contracts are also recognized over the term of the related
contracts.





Revenues
applicable to multiple-element fee arrangements are bifurcated among the
elements such as license agreements and support and upgrade obligations using
vendor-specific objective evidence of fair value.  Such evidence
consists primarily of pricing of multiple elements as if sold as separate
products or arrangements.  These elements vary based upon factors such
as the type of license, volume of units licensed, and other related
factors.





Deferred
revenue as of September 30, 2008, and December 31, 2007, consisted of the
following:





Description
            Criteria
      for Recognition
            
            September
      30, 2008
            
            
            December
      31, 2007Deferred
      unit royalties and license fees
            Delivery
      of units to end users or expiration of contract
            
            $
            445,000
            
            
            $
            445,000





Cost of Revenues– Cost of revenues from license, royalties, and maintenance consists of
costs to distribute the product, installation and support personnel
compensation, amortization and impairment of capitalized speech software costs,
licensed technology, and other related costs.  Cost of service
revenues consists of personnel compensation and other related
costs.





Software
Technology Development and Production Costs– All costs incurred to
establish the technological feasibility of speech software technology to be
sold, leased, or otherwise marketed are charged to product development and
research expense.  Technological feasibility is established when a
product design and a working model of the software product have been completed
and confirmed by testing.  Costs to produce or purchase software
technology incurred subsequent to establishing technological feasibility are
capitalized.  Capitalization of software costs ceases when the product
is available for general release to customers.  Costs to perform
consulting or development services are charged to cost of revenues in the period
in which the corresponding revenues are recognized.  The cost of
maintenance and customer support is charged to expense when related revenue is
recognized or when these costs are incurred, whichever occurs
first.




2.  NOTES
PAYABLE





In
connection with the acquisition of the capital stock of LTEL Holdings in 2004,
the Company issued a 5%, $10,000,000, secured, six-year note (the “Note”)
payable to McCormack Avenue, Ltd. (“McCormack”).  Under the terms of
the Note, quarterly interest-only payments were required through January 15,
2005, with quarterly principal and interest payments of $319,000 beginning April
2005 and continuing through January 2010.  Interest on the Note is
payable in cash or, at the Company’s option, in shares of the Company’s Class A
common stock.  The Note is secured by the capital stock and all of the
assets of LTEL Holdings and its subsidiaries.  The Note was originally
valued at $4,624,000 based on an imputed interest rate of 25 percent per
annum.








9





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




On
September 8, 2006, the Company received a default notice (the “Default Notice”)
from McCormack in respect of the Note  In the Default Notice,
McCormack stated that it intended to exercise its rights, including any and all
rights set forth in the Note, as amended.  McCormack has taken no
action to collect amounts due under the Note.
 
 On
September 30, 2008, the Company entered into a Series P 9% Convertible Preferred
Stock Exchange Agreement (the “Exchange Agreement”) with McCormack and Sovereign
Partners, LP (“Sovereign”), whereby McCormack exchanged the Note, along with
other promissory notes and the Series E debenture (discussed in Note 5), and
Sovereign exchanged two promissory notes, for shares of the Company’s Series P
9% Convertible Preferred Stock (the Series P Preferred Stock”).  A
table listing the obligations exchanged and the number of shares of Series P
Preferred Stock issued is included at the end of this Note 2.
 
 During
the fourth quarter of 2006, the Company entered into two promissory notes with
McCormack Avenue, Ltd., in the aggregate amount of $330,000. These notes accrue
interest at 10% annually and were due and payable during the second quarter of
2007.  These promissory notes were exchanged for shares of the
Company’s Series P Preferred Stock.  See table below.
 
 
 During
the quarter ended March 31, 2007, the Company entered into five promissory notes
with McCormack Avenue, Ltd. and Sovereign Partners LP., in the aggregate amount
of $450,000.  These notes accrue interest at 10% annually and were due
and payable during the third quarter of 2007.  These promissory notes
were exchanged for shares of the Company’s Series P Preferred
Stock.  See table below.







Purchaser
            Nature
      of Obligation Exchanged
            
            Amount
      of Obligation Exchanged
            
            
            Number
      of Series P Preferred Shares to be IssuedSovereign
      Partners LP
            Promissory
      Note, dated February 22, 2007, in the principal amount of $100,000, and
      interest of $16,278
            
            $
            116,278
            
            
            
            11.6278Sovereign
      Partners LP
            Promissory
      Note, dated March 13, 2007, in the principal amount of $100,000, and
      interest of $15,750
            
            $
            115,750
            
            
            
            11.575McCormack
      Avenue, Ltd.
            Promissory
      Note, dated January 11, 2007, in the principal amount of $50,000, and
      interest of $8,722
            
            $
            58,722
            
            
            
            5.8722McCormack
      Avenue, Ltd.
            Promissory
      Note, dated January 19, 2007, in the principal amount of $100,000, and
      interest of $17,222
            
            $
            117,222
            
            
            
            11.7222McCormack
      Avenue, Ltd.
            Promissory
      Note, dated January 26, 2007, in the principal amount of $100,000, and
      interest of $17,028
            
            $
            117,028
            
            
            
            11.7028McCormack
      Avenue, Ltd.
            Promissory
      Note, dated December 28, 2006, in the principal amount of $95,000, and
      16,942
            
            $
            111,942
            
            
            
            11.1942McCormack
      Avenue, Ltd.
            Promissory
      Note, dated December 15, 2006, in the principal amount of $235,000, and
      interest of $42,701
            
            $
            277,701
            
            
            
            27.7701McCormack
      Avenue, Ltd.
            Note
      Payable, dated February, 2004, in the principal amount of $8,732,620, and
      interest of $1,311,105
            
            $
            10,043,725
            
            
            
            1,004.3725McCormack
      Avenue, Ltd.
            Series
      E Debenture, dated December 7, 2007, in the principal amount of
      $1,754,464, and interest of $291,763
            
            $
            2,046,227
            
            
            
            204.6227








10





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)





3.  RELATED-PARTY
NOTES PAYABLE





During
2002, two executive officers of the Company (the “Lenders”) sold shares of the
Company’s Class A common stock owned by them and advanced the resulting proceeds
amounting to $333,000 to the Company under the terms of a revolving line of
credit and related promissory note.  The funds were advanced for use
in Company operations.  The advances bear interest at 12 percent per
annum, which interest is payable on a semi-annual basis.  The entire
principal, along with unpaid accrued interest and any other unpaid charges or
related fees, was originally due and payable on June 10, 2003.  The
Company and the Lenders have agreed to postpone the maturity date on several
occasions.  The note was due September 30, 2006.  As of June
30, 2008, the Company had not made payment against the outstanding balance due
on the note.  All or part of the outstanding balance and unpaid
interest may be converted at the option of the Lenders into shares of Class A
common stock of the Company at any time.  The conversion price was the
average closing bid price of the shares at the time of the
advances.  To the extent the market price of the Company’s shares is
below the conversion price at the time of conversion, the Lenders are entitled
to receive additional shares equal to the gross dollar value received from the
original sale of the shares.  A beneficial conversion option of
$15,000 was recorded as interest expense in connection with this
transaction.  The Lenders may also receive additional compensation as
determined appropriate by the Board of Directors.





During
the year ended December 31, 2005, the Company received an additional advance of
$50,000 against the promissory note.  The balance due at December 31,
2005 was $486,000.  During the year ended December 31, 2006, the
Company received additional advances and other consideration from the Lenders in
the aggregate amount of $419,000 and made principal payments to the Lenders
against the note of $105,000.  During the year ended December 31,
2007, the Company received additional advances of $102,000.  During
the nine months ended September 30, 2008, the Company received additional
advances of $59,000.  The balance due at September 30, 2008, was
$940,000.





The
balance due of $940,000 is secured by the Company’s intellectual property rights
and common stock of Fonix Speech.  For the nine months ended September
30, 2008, the Lenders converted $21,000 of the principal balance into
209,926,500 shares common stock, and also converted $107,000 of accrued interest
into 694,173,415 shares of common stock for the benefit of one of the Lenders,
Thomas A. Murdock, a former officer and director of the Company.





4.  PREFERRED
STOCK





The
Company’s certificate of incorporation allows for the issuance of preferred
stock in such series and having such terms and conditions as the Company’s board
of directors may designate.





Series A
Convertible Preferred Stock – As of September 30, 2008, there were
166,667 shares of Series A convertible preferred stock
outstanding.  Holders of the Series A convertible preferred stock have
the same voting rights as common stockholders, have the right to elect one
person to the board of directors and are entitled to receive a one time
preferential dividend of $2.905 per share of Series A convertible preferred
stock prior to the payment of any dividend on any class or series of
stock.  At the option of the holders, each share of Series A
convertible preferred stock is convertible into one share of Class A common
stock and in the event that the common stock price has equaled or exceeded $10
per share for a 15 day period, the shares of Series A convertible preferred
stock will automatically be converted into Class A common stock.  In
the event of liquidation, the holders are entitled to a liquidating distribution
of $36.33 per share and a conversion of Series A convertible preferred stock at
an amount equal to .0375 shares of common stock for each share of Series A
convertible preferred stock.





11





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




Series L
Preferred Stock – On September 7, 2006, the Company entered into a Series
L 9% Convertible Preferred Stock Exchange Agreement (the "Exchange Agreement")
with McCormack and Kenzie Financial (“Kenzie”), a British Virgin Islands
company.  Pursuant to the Exchange Agreement, McCormack and Kenzie
exchanged all 2,000 shares of Series H Preferred Stock that they acquired from
the sale of LTEL Holdings, for 1,960.8 and 39.2 shares,
respectively,  of the Company's Series L 9% Convertible Preferred
Stock (the "Series L Preferred Stock").





Because
the shares of Series L Preferred Stock were issued in exchange for the remaining
outstanding shares of Series H Preferred Stock, the Company did not receive any
proceeds in connection with the issuance of the Series L Preferred
Stock.





The
Series L Preferred Stock entitles McCormack and Kenzie to receive dividends in
an amount equal to 9% of the then-outstanding balance of shares of Series L
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.





The
Series L Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price which was 80% of the average of
the two (2) lowest closing bid prices for the twenty-day trading period prior to
the conversion date.





Redemption
of the Series L Preferred Stock, whether at the Company’s option or that of
McCormack or Kenzie, requires the Company to pay, as a redemption price, the
stated value of the outstanding shares of Series L Preferred Stock to be
redeemed, together with any accrued but unissued dividends thereon, multiplied
by one hundred ten percent (110%).





The
Company accounted for the exchange as redemption of the outstanding Series H
Preferred Stock as the Series H Preferred Stock was not convertible into shares
of common stock of the Company.  The Series L Preferred Stock is
convertible into shares of common stock of the Company.  The Company
followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$30,991,000 due to the value of the conversion feature of the Series L Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 140%, risk-free rate of 3.75% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
L Preferred Stock, no value was prescribed to the Series L Preferred
Stock.  Also in connection with the redemption, the Company recognized
a preferred stock dividend of $16,000,000, equal to the original discount the
Company had assigned to the Series H Preferred Stock.  At September
30, 2008, the fair value of the Series L Preferred Stock derivative liability
was $15,359,000.





For the
nine months ended September 30, 2008, the Company issued 3,228,481,781 shares of
its Class A common stock in conversion of 34 shares of its Series L Preferred
Stock.  At September 30, 2008, 1,501 shares of Series L Preferred
Stock remained outstanding.  (See Note 9 for discussion of conversions
subsequent to September 30, 2008.)





Series M
Preferred Stock– On April 4, 2007, the Company entered into a Series M
9% Convertible Preferred Stock Exchange Agreement with Sovereign Partners, LP
(“Sovereign”).  Pursuant to the exchange agreement, Sovereign
exchanged 150 shares of the Company’s Series L Preferred Stock for 150 shares of
the Company’s Series M 9% Convertible Preferred Stock (the “Series M Preferred
Stock”).





12





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




The
Series M Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series M Preferred Stock.  The dividends are payable in cash or shares
of the Company’s Class A common stock, at the Company’s option.





The
Series M Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which shall be the lower of
(i) 80% of the average of the two lowest closing bid prices for the twenty-day
trading period prior to the conversion date, or (ii) $0.004.





Redemption
of the Series M Preferred Stock, whether at the Company’s option or that of
Sovereign, requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series M Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





Because
the shares of Series M were issued in exchange for the outstanding shares of
Series L Preferred Stock, the Company did not receive any proceeds in connection
with the issuance of the Series M Preferred Stock.





The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$1,603,000 due to the value of the conversion feature of the Series M Preferred
Stock, which was previously recorded as part of the Series L Preferred Stock
derivative liability.  The liability was calculated using the
Black-Scholes valuation model with the following assumptions: dividend yield of
0%, expected volatility of 134%, risk-free rate of 5% and expected life of 4
years.  As the value of the derivative liability was greater than the
face value of the Series M Preferred Stock, no value was prescribed to the
Series M Preferred Stock.  At September 30, 2008, the fair value of
the Series M Preferred Stock derivative liability was $1,535,000.





As of
September 30, 2008, there were 150 shares of Series M Preferred Stock
convertible preferred stock outstanding.





Series N
Convertible Preferred Stock – On August 24, 2007, the Company entered
into a Securities Purchase Agreement with Trillium Partners, LP and other
unnamed future investors relating to the issuance and sale of the Company’s
Series N 9% Convertible Preferred Stock.





Pursuant
to the agreement, the Company agreed to issue up to 2,400 shares of its Series N
9% Convertible Preferred Stock (the “Series N Preferred Stock”) at a per share
price of $1,000 to Trillium Partners, LP and other unnamed future investors, for
gross proceeds of up to $2,400,000.  As of the date of this report,
the Company had issued 1,755 shares of the Series N Preferred Stock, for cash
proceeds of $1,350,000.





The
Series N Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series N
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.





The
Series N Preferred Stock is convertible into Class A common stock of the Company
at the option of the holder by using a conversion price equal to 80% of the
average of the two lowest closing bid prices for the twenty-day trading period
prior to the conversion date.





Redemption
of the Series N Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series N Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).








13





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)





The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$957,000 due to the value of the conversion feature of the Series N Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 128%, risk-free rate of 5.0% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
N Preferred Stock, no value was prescribed to the Series N Preferred
Stock.  At September 30, 2008, the fair value of the Series N
Preferred Stock derivative liability was $1,795,000.





As of
September 30, 2008, there were 1,755 shares of Series N Preferred Stock
convertible preferred stock outstanding.





Series O
Convertible Preferred Stock – Between January 25, 2008, and September 30,
2008, the Company received advances from three entities in connection with the
purchase agreements related to the Company’s Series O 9% Convertible Preferred
Stock (“Series O Preferred Stock”). On May 20, 2008, the Company entered into
Securities Purchase Agreements with Southridge Partners LP, Southshore Capital
Fund LTD, Sovereign Partners LP (collectively, the “Series O Purchasers”) for
the sale of an aggregate of 609 shares of Series O Preferred Stock for gross
proceeds of $609,000.  The material terms of the purchase agreements
had been agreed upon prior to receipt of the advances.  Therefore, the
Series O Preferred Stock was accounted for as discussed below on the dates cash
proceeds were received by the Company.  The Company also began
accruing dividends upon receiving the advances.





The
Series O Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series O
Preferred Stock. The dividends are payable in cash or shares of the Company's
Class A common stock, at the Company's option.





The
Series O Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price, equal to 80% of the average of
the two lowest closing bid prices for the twenty-day trading period prior to the
conversion date.





Redemption
of the Series O Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series O Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity,” SFAS
133 “Accounting for Derivative Instruments and Hedging Activities” and EITF
00-19 “Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company’s Own Stock.” The Company recognized a
derivative liability upon the redemption of $290,000 due to the value of the
conversion feature of the Series O Preferred Stock. The liability was calculated
using the Black-Scholes valuation model with the following assumptions: dividend
yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected
life of 4 years. As the value of the derivative liability was greater than the
face value of the Series O Preferred Stock, no value was prescribed to the
Series O Preferred Stock. At September 30, 2008, the fair value of the Series O
Preferred Stock derivative liability was $623,000.




As of
September 30, 2008, there were 609 shares of Series O Preferred Stock
convertible preferred stock outstanding.





14





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)





Series P
Convertible Preferred Stock – On September 30, 2008, the Company entered
into a Series P 9% Convertible Preferred Stock Exchange Agreement (the “Exchange
Agreement”) with Sovereign Partners, LP (“Sovereign”), and McCormack Avenue Ltd.
(“McCormack”).  Pursuant to the Exchange Agreement, Sovereign and
McCormack exchanged certain debt obligations, discussed more fully below, for
shares of the Company’s Series P 9% Convertible Preferred Stock (the “Series P
Preferred Stock”).


The
Series P Preferred Stock entitles the holders to receive dividends in an amount
equal to 9% of the then-outstanding balance of shares of Series P Preferred
Stock.  The dividends are payable in cash or shares of the Company’s
Class A common stock, at the Company’s option.





The
Series P Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which shall be 80% of the
average of the two (2) lowest closing bid prices for the twenty-day trading
period prior to the conversion date.





Redemption
of the Series P Preferred Stock, whether at our option or that of the holder,
requires us to pay, as a redemption price, the stated value of the outstanding
shares of Series P Preferred Stock to be redeemed, together with any accrued but
unissued dividends thereon, multiplied by one hundred ten percent
(110%).




Because
the shares of Series P were issued in exchange for certain outstanding debt
obligations, the Company, we did not receive any proceeds in connection with the
issuance of the Series P Preferred Stock to McCormack and
Sovereign.
 
 In
connection with the issuance of the Series P Preferred Stock, on September 26,
2008, the Company filed with the State of Delaware a Certificate of Designation
and Series P 9% Convertible Stock Terms (the “Series P Terms”), which become a
part of its Certificate of Incorporation, as amended.
 
 The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity,” SFAS
133 “Accounting for Derivative Instruments and Hedging Activities” and EITF
00-19 “Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company’s Own Stock.” The Company recognized a
derivative liability upon the redemption of $13,,000 due to the value of the
conversion feature of the Series P Preferred Stock. The liability was calculated
using the Black-Scholes valuation model with the following assumptions: dividend
yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected
life of 4 years. As the value of the derivative liability was greater than the
face value of the Series P Preferred Stock, no value was prescribed to the
Series P Preferred Stock. At September 30, 2008, the fair value of the Series P
Preferred Stock derivative liability was $13,304,000.


As of
September 30, 2008, there were 1,300 shares of Series P Preferred Stock
convertible preferred stock outstanding.





Fonix Speech,
Inc. Series B Convertible Preferred Stock – On April 4, 2007, the Company
entered into a Securities Purchase Agreement by and among the Company, Fonix
Speech, Inc. (“FSI”), and Sovereign Partners, LP (“Sovereign”).  FSI
is a wholly owned subsidiary of the Company.





Pursuant
to the FSI purchase agreement, FSI sold 125 shares of its Series B 9%
Convertible Preferred Stock (the “Series B Preferred Stock”) at a per share
price of $10,000 to Sovereign, for gross proceeds of $1,250,000.





The
shares of Series B Preferred Stock are convertible into shares of the Company’s
Class A common stock.  The Series B Preferred Stock may be converted
into common stock of the Company at the option of the holder by using a
conversion price which shall be the lower of (i) 80% of the average of the two
lowest closing bid prices for the twenty-day trading period prior to the
conversion date, or (ii) $0.004.





The
Series B Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series B Preferred Stock.  The dividends are payable in cash or shares
of the Company's Class A common stock, at the Company's option





The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the issuance of
$1,336,207 due to the value of the conversion feature of the Series B Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 134%, risk-free rate of 5% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
B Preferred Stock, no value was prescribed to the Series B Preferred
Stock.  At September 30, 2008, the fair value of the Series B
Preferred Stock derivative liability was $1,279,000.





As of
September 30, 2008, there were 125 shares of Series B Preferred Stock
convertible preferred stock outstanding.





15





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)








5.  CONVERTIBLE
DEBENTURES





On
December 7, 2006, the Company entered into a Securities Purchase Agreement,
dated as of December 1, 2006 (the “Agreement”), with Southridge Partners, LP
(“Southridge”) relating to the purchase and sale of a Series E 9% Secured
Subordinated Convertible Debenture (the “Debenture”) in the principal amount of
$850,000.





Pursuant
to the Agreement, Southridge paid the purchase price by tendering a prior
debenture in the aggregate amount (including principal and interest) of
$641,000, and agreed that an advance to the Company in the amount of $75,000
made in November 2006 would also constitute part of the purchase
price.  Southridge agreed to fund the remaining $134,000 upon the
effectiveness of a registration statement, to be filed by the Company, to
register the resales of shares issuable to Southridge upon conversion of the
Debenture.  The Company received no new capital in connection with the
issuance and sale of the Debenture.





The
Debenture is convertible into shares of our Class A common stock.  The
number of shares issuable is determined by dividing the amount of the Debenture
being converted by the conversion price, which is the average of the two lowest
per share market values for the twenty trading days immediately preceding the
conversion date multiplied by seventy percent. The conversion price is subject
to adjustment as set forth in the Debenture.  Southridge has agreed
not to convert the Debenture to the extent that such conversion would cause
Southridge to beneficially own in excess of 4.999% of the then-outstanding
shares of Class A common stock of the Company except in the case of a merger by
the Company or other organic change.





The
Company also entered into a Registration Rights Agreement (the “Registration
Agreement”) with Southridge pursuant to which the Company agreed to file a
registration statement to register the resale by Southridge of shares of the
Company’s Class A common stock issuable upon conversion of the
Debenture.   As of the date of this Report, no registration
statement has been filed.





In
addition to the Debenture issued to Southridge described above, on December 7,
2006, the Company entered into a Securities Purchase Agreement, dated as of
December 1, 2006 (the “McCormack Agreement”), with McCormack, relating to the
purchase and sale of a Series E 9% Secured Subordinated Convertible Debenture
(the “McCormack Debenture”) in the principal amount of $1,039,000.





Pursuant
to the McCormack Agreement, McCormack paid the purchase price by tendering
outstanding promissory notes in the amounts of $300,000 and $350,000, together
with combined interest thereon of $64,000, and agreed that advances to the
Company in the amount of $325,000, made in September, October, and November
2006, would also constitute part of the purchase price.





The
McCormack Debenture is convertible into shares of the Company’s Class A common
stock on the same terms as the Debenture.





The
Company also entered into a Registration Rights Agreement (the “McCormack
Registration Agreement”) with McCormack pursuant to which the Company agreed to
file a registration statement to register the resale by McCormack of shares of
the Company’s common stock issuable upon conversion of the
Debenture.  As of the date of this Report, no registration statement
had been filed.




This
debenture was exchanged for shares of the Company’s Series P Preferred
Stock.  See Note 2.


16





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




6.  COMMON
STOCK, STOCK OPTIONS AND WARRANTS





Class A Common
Stock – During the nine months ended September 30, 2008, 3,228,481,781
shares of Class A common stock were issued in conversion of 34 shares of Series
L Preferred Stock, 4,483,938,874 shares were issued for employee stock grants,
624,705,379 shares were issued for payment of unpaid legal fees, 726,126,126
shares were issued for consulting services, 694,173,415 shares were issued in
conversion of interest on the related party note, 209,926,500 shares were issued
in conversion of the outstanding balance on the related party note and
645,572,593 shares were issued in payment of interest on the Series L Preferred
Stock.





Stock Options
– As of September 30, 2008, the Company had a total of 198,000 options to
purchase Class A common stock outstanding.  During the nine months
ended September 30, 2008 no options were granted.





Warrants –
As of September 30, 2008, the Company had warrants to purchase a total of 15,000
shares of Class A common stock outstanding that expire through
2010.





7.  LITIGATION,
COMMITMENTS AND CONTINGENCIES




The Breckenridge
Fund – On June 6, 2006, Breckenridge filed a complaint against the
Company in the Supreme Court of the State of New York, County of Nassau (the
“Court”), in connection with a settlement agreement between the Company and
Breckenridge entered into in September 2005.  On February 2, 2007, the
Court granted Breckenridge’s motion for summary judgment, denied the Company’s
summary judgment motion, and directed that a hearing be held to determine the
amount owed by the Company to Breckenridge.  The Company and
Breckenridge entered into a stipulation that the Company owed Breckenridge
$1,530,000 plus interest at a rate of 9% from September 15, 2006 to the date of
entry of judgment.
 
 The
Court’s judgment dated as of March 15, 2007 states that the Company owes an
aggregate of $1,602,000 to Breckenridge.  The Company has accrued for
this settlement in the accompanying financial statements.  In February
2008, the Company entered into an amended settlement agreement with Breckenridge
under which the Company agreed to pay Breckenridge $540,000.  The
Company has paid Breckenridge $455,000 and is obligated to pay the balance of
$85,000 at the rate of $42,500 per month.  This obligation was satisfied in
November 2008.
 
 Hite Development
Corporation –  In January 2007, Hite Development Corporation
(“Hite”) brought a lawsuit against the Company claiming breach of contract and
breach of the covenant of good faith and fair dealing, alleging that the Company
failed to make certain payments under a settlement agreement with Hite dating
from March 2005.  The complaint seeks approximately $33,000 plus
interest.  The Company filed its answer in May 2007.  On May
8, 2008, Hite filed a motion for summary judgment, which the Court
granted.  To date, Hite has not attempted to collect its judgment
against the Company.





RR Donnelley
Receivables Inc– In July 2007, RR
Donnelley Receivables Inc. (“Donnelly”) brought a lawsuit against the Company
for alleged failure to pay for services provided.  The complaint seeks
approximately $21,000 plus interest.  The Company filed its answer in
August 2007, and filed a motion to dismiss the action in December
2007.  That motion is currently pending before the
court.  If the Company’s motion to dismiss is denied, the Company
intends to defend against the claims in the complaint.




Perpetual
Storage, Inc. -  Perpetual Storage, Inc., brought suit,
claiming breach of contract and unjust enrichment, and seeking damages of
approximately $12,300 plus attorneys’ fees and costs.  The Company
filed its answer in July 2008, and no further developments had occurred as of
the date of this report.





17





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)





8.  SUBSEQUENT
EVENTS





Subsequent
to September 30, 2008, the Company has issued 300,000,000 shares of its Class A
common stock in conversion of 3 shares of Series L Preferred Stock.





Subsequent
to September 30, 2008, the Company has issued 57,510,000 shares of its Class A
common stock in payment of interest on the Series L Preferred
Stock.





Subsequent
to September 30, 2008, the Company has issued 394,000,000 shares of its Class A
common stock in payment of principal and interest on related party notes
payable.





Subsequent
to September 30, 2008, the Company has issued 1,000,000,000 shares of its Class
A common stock for employee stock grants.




Subsequent
to September 30, 2008, the Company paid The Breckenridge Fund the sum of
$85,000, which was the balance due and owing Breckenridge under a settlement
agreement with the Company (see note 7 above).





18





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





This
report on Form 10-Q contains, in addition to historical information,
forward-looking statements that involve substantial risks and
uncertainties.  All forward-looking statements contained herein are
deemed by Fonix to be covered by and to qualify for the safe harbor protection
provided by Section 21E of the Private Securities Litigation Reform Act of
1995.  When used in this report, words such as “believes,” “expects,”
“intends,” “plans,” “anticipates,” “estimates,” and similar expressions are
intended to identify forward-looking statements, although there may be certain
forward-looking statements not accompanied by such
expressions.  Statements relating to the future performance, business
strategies and implementation, availability of outside financing, financial
performance, market acceptance of our products, and similar statements may also
include forward looking statements.  Actual results could differ
materially from the results anticipated by Fonix and discussed in the
forward-looking statements.    Factors that could cause or
contribute to such differences are discussed in the Company’s Annual Report on
Form 10-K for the year ended December 31, 2007.  The Company disclaims
any obligation or intention to update any forward-looking
statements.





To
date, we have earned only limited revenue from operations and intend to continue
to rely primarily on financing through the sale of our equity and debt
securities to satisfy future capital requirements.





The following Management’s Discussion
and Analysis of Financial Condition and Results of Operations (“MD&A”) is
intended to help the reader understand Fonix Corporation, our operations and our
present business environment.  MD&A is provided as a supplement
to, and should be read in conjunction with, our condensed consolidated financial
statements and the accompanying notes thereto.  This overview
summarizes MD&A, which includes the following sections:





·
            Overview
      – a general description of our business and the markets in which we
      operate; our objective; our areas of focus; and challenges and risks of
      our business.





·
            Significant
      Accounting Policies– a discussion of
      accounting policies that require critical judgments and
      estimates.





·
            Results of
      Operations– an analysis of
      our Company’s consolidated results of operations for the three years
      presented in our consolidated financial statements.  Except to
      the extent that differences among our operating segments are material to
      an understanding of our business as a whole, we present the discussion in
      the MD&A on a consolidated
basis.





·
            Liquidity
      and Capital Resources– an analysis of
      cash flows; off-balance sheet arrangements and aggregate contractual
      obligations; the impact of foregoing exchange; an overview of financial
      position; and the impact of inflation and changing
  prices.





We intend for this discussion to
provide the reader with information that will assist in understanding our
financial statements, the changes in certain key items in those financial
statements from year to year, and the primary factors that accounted for those
changes, as well as how certain accounting principles affect our financial
statements.  The discussion also provides information about the
financial results of the various segments of our business to provide a better
understanding of how those segments and their results affect the financial
condition and results of operations of the Company as a whole.  This
discussion should be read in conjunction with our financial statements as of
December 31, 2007, and the year then ended and the notes accompanying those
financial statements.





Overview





We are engaged in providing value-added
speech technologies through Fonix Speech, Inc. (“Fonix Speech”).  We
offer speech-enabling technologies including automated speech recognition
(“ASR”) and text-to-speech (“TTS”) through Fonix Speech.  We offer our
speech-enabling technologies to markets for wireless and mobile devices,
computer telephony, server solutions and personal software for consumer
applications.  We have received various patents for certain elements
of our core technologies and have filed applications for other patents covering
various aspects of our technologies.  We seek to develop relationships
and strategic alliances with third-party developers and vendors in
telecommunications, computers, electronic devices and related industries,
including producers of application software, operating systems, computers and
microprocessor chips.  Revenues are generated through licensing of
speech-enabling technologies, maintenance contracts and services.








19





For the three months ended September
30, 2008 and 2007, the company generated revenues of $223,000 and $339,000,
respectively, and incurred net losses of $1,701,000 and $585,000,
respectively.  For the nine months ended September 30, 2008 and 2007,
the company generated revenues of $1,069,000 and $1,344,000, respectively,
incurred net losses of $4,035,000 and $2,436,000, respectively, and had negative
cash flows from operating activities of $209,000 and $2,125,000,
respectively.  As of September 30, 2008, we had an accumulated deficit
of $283,469,000; negative working capital of $41,852,000; derivative liabilities
of $33,886,000 related to the issuance of Series L Preferred
Stock,  Series M Preferred Stock, Series N Preferred Stock, Series O
Preferred Stock,  Series P Preferred Stock and Series B Preferred
Stock of our subsidiary; accrued liabilities and accrued settlement obligation
of $4,751,000; accounts payable of $1,682,000; notes payable to related parties
of $940,000; accrued payroll and other compensation of $211,000; and deferred
revenues of $445,000.  We expect to continue to incur significant
losses and negative cash flows from operating activities at least through
December 31, 2008, primarily due to expenditure requirements associated with
continued marketing and development of our speech-enabling
technologies.





We are continually developing new
product offerings in the ASR businesses in an effort to increase our revenue
stream, and we are continuing to work with our existing customers to increase
sales.  We have also experienced operating expense decreases through
headcount reductions and overall cost reduction measures.  Through the
combination of increased recurring revenues and the overall operating cost
reduction strategies we have implemented, we hope to achieve positive cash flow
from operations in the next 18-24 months.  However, there can be no
assurance that we will be able to achieve positive cash flow from operations
within this time frame.





Historically, our cash resources,
limited to collections from customers, draws on equity lines of credit and
loans, have not been sufficient to cover operating expenses.  We
periodically engage in discussions with various sources of financing to
facilitate our cash requirements including buyers of both debt and equity
securities.  To date, no additional sources of funding offering terms
superior to those available under equity lines have been implemented, and we
rely on first, cash generated from operations, and second, cash provided through
convertible debt financing arrangements.  We will need to generate
approximately $2 to $3 million to continue operations for the next twelve
months.  There can be no assurance that we will be able to obtain such
financing or that, if we can obtain such financing, it will be on terms
favorable to us.





Significant
Accounting Policies





The discussion and analysis of our
financial condition and results of operations are based upon our consolidated
financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States.  The preparation
of these financial statements requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of sales and expenses during the reporting
period.  Significant accounting policies and areas where substantial
judgments are made by management include:





Accounting
estimates-The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
the disclosures of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses during
the reporting period.  Actual results could differ from those
estimates.





Valuation of
long-lived assets - The carrying values of our long-lived assets are
reviewed for impairment whenever events or changes in circumstances indicate
that they may not be recoverable.  When such an event occurs, we
project undiscounted cash flows to be generated from the use of the asset and
its eventual disposition over the remaining life of the asset.  If
projections indicate that the carrying value of the long-lived asset will not be
recovered, the carrying value of the long-lived asset, other than software
technology, is reduced by the estimated excess of the carrying value over the
projected discounted cash flows.







20





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




Goodwill
–
Goodwill represents the excess of the cost over the fair value of net assets of
acquired businesses. Goodwill is not amortized, but is tested for impairment
quarterly or when a triggering event occurs.  The testing for
impairment requires the determination of the fair value of the asset or entity
to which the goodwill relates (the reporting unit).  The fair value of
a reporting  unit is determined based upon a weighting of the quoted
market price of our common stock and present value techniques based upon
estimated future cash flows of the reporting unit, considering future revenues,
operating costs, the risk-adjusted discount rate and other
factors.  Impairment is indicated if the fair value of the reporting
unit is allocated to the assets and liabilities of that unit, with the excess of
the fair value of the reporting unit over the amounts assigned to its assets and
liabilities assigned to the fair value of goodwill.  The amount of
impairment of goodwill is measured by the excess of the goodwill’s carrying
value over its fair value.





Revenue
recognition – We recognize revenue when pervasive evidence of an
arrangement exists, services have been rendered or products have been delivered,
the price to the buyer is fixed and determinable and collectibility is
reasonable assured.  Revenues are recognized by us based on the
various types of transactions generating the revenue.  For software
sales, we recognize revenues in accordance with the provisions of Statement of
Position No. 97-2, “Software Revenue Recognition” and related
interpretations.We generate
revenues from licensing the rights to its software products to end users and
from royalties.





For Fonix Speech, revenue of all types
is recognized when acceptance of functionality, rights of return, and price
protection are confirmed or can be reasonably estimated, as
appropriate.  Revenues from development and consulting services are
recognized on a completed-contract basis when the services are completed and
accepted by the customer.  The completed-contract method is used
because our contracts are typically either short-term in duration or we are
unable to make reasonably dependable estimates of the costs of the
contracts.  Revenue for hardware units delivered is recognized when
delivery is verified and collection assured.





Revenue for products distributed
through wholesale and retail channels and through resellers is recognized upon
verification of final sell-through to end users, after consideration of rights
of return and price protection.  Typically, the right of return on
such products has expired when the end user purchases the product from the
retail outlet.  Once the end user opens the package, it is not
returnable unless the medium is defective.





When arrangements to license software
products do not require significant production, modification or customization of
software, revenue from licenses and royalties are recognized when persuasive
evidence of a licensing arrangement exists, delivery of the software has
occurred, the fee is fixed or determinable, and collectibility is
probable.  Post-contract obligations, if any, generally consist of one
year of support including such services as customer calls, bug fixes, and
upgrades.  Related revenue is recognized over the period covered by
the agreement.  Revenues from maintenance and support contracts are
also recognized over the term of the related contracts.





Revenues applicable to multiple-element
fee arrangements are bifurcated among the elements such as license agreements
and support and upgrade obligations using vendor-specific objective evidence of
fair value.  Such evidence consists primarily of pricing of multiple
elements as if sold as separate products or arrangements.  These
elements vary based upon factors such as the type of license, volume of units
licensed, and other related factors.





Deferred revenue as of September 30,
2008, and December 31, 2007, consisted of the following:


Description
            Criteria
      for Recognition
            
            September
      30,
              2008
            
            
            December
      31,
              2007Deferred
      unit royalties and license fees
            Delivery
      of units to end users or expiration of contract
            
            $
            445,000
            
            
            $
            445,000





Cost of
revenues-  Cost of revenues from license, royalties, and maintenance
consists of costs to distribute the product, installation and support personnel
compensation, amortization and impairment of capitalized speech software costs,
licensed technology, and other related costs.  Cost of service
revenues consists of personnel compensation and other related
costs.








21





Software
Technology Development and Production Costs- All costs incurred to
establish the technological feasibility of speech software technology to be
sold, leased, or otherwise marketed are charged to product development and
research expense.  Technological feasibility is established when a
product design and a working model of the software product have been completed
and confirmed by testing.  Costs to produce or purchase software
technology incurred subsequent to establishing technological feasibility are
capitalized.  Capitalization of software costs ceases when the product
is available for general release to customers.  Costs to perform
consulting or development services are charged to cost of revenues in the period
in which the corresponding revenues are recognized.  Costs of
maintenance and customer support are charged to expense when related revenue is
recognized or when these costs are incurred, whichever occurs
first.





Capitalized software technology costs
were amortized on a product-by-product basis.  Amortization was
recognized from the date the product was available for general release to
customers as the greater of (a) the ratio that current gross revenue for a
product bears to total current and anticipated future gross revenues for that
product or (b) the straight-line method over the remaining estimated economic
life of the products.  Amortization was charged to cost of
revenues.





We assessed unamortized capitalized
software costs for possible write down on a quarterly basis based on net
realizable value of each related product.  Net realizable value was
determined based on the estimated future gross revenues from a product reduced
by the estimated future cost of completing and disposing of the product,
including the cost of performing maintenance and customer
support.  The amount by which the unamortized capitalized costs of a
software product exceeded the net realizable value of that asset was written
off.





Imputed Interest
Expense and Income - Interest is imputed on long-term debt obligations
and notes receivable where management has determined that the contractual
interest rates are below the market rate for instruments with similar risk
characteristics.





Foreign Currency
Translation-The
functional currency of our Korean subsidiary is the South Korean
won.  Consequently, assets and liabilities of the Korean operations
are translated into United States dollars using current exchange rates at the
end of the year.  All revenue is invoiced in South Korean won and
revenues and expenses are translated into United States dollars using
weighted-average exchange rates for the year.





Comprehensive
Income-Other
comprehensive income presented in the accompanying consolidated financial
statements consists of cumulative foreign currency translation
adjustments.





Recently Enacted
Accounting Standards





Business
Combinations - In December 2007, the Financial Accounting Standards Board
(“FASB”) issued Statement of Financial Accounting Standards No. 141 (revised
2007) (“SFAS 141”),“Business Combinations.” This accounting principle requires the
fundamental requirements of acquisition accounting (purchase accounting) be
applied to all business combinations in which control is obtained regardless of
consideration and for an acquirer to be identified for each business
combination. Additionally, this accounting principle requires
acquisition-related costs and restructuring costs at the date of acquisition to
be expensed rather than allocated to the assets acquired and the liabilities
assumed; minority interests, including goodwill, to be recorded at fair value at
the acquisition date; recognition of the fair value of assets and liabilities
arising from contractual contingencies and contingent consideration (payments
conditioned on the outcome of future events) at the acquisition date;
recognition of bargain purchase (acquisition-date fair value exceeds
consideration plus any noncontrolling interest) as a gain; and recognition of
changes in deferred taxes. This accounting principle will be adopted January
2009. The accounting requirements will be adopted prospectively. Earlier
adoption is prohibited. Adoption of SFAS 141is not expected to have an impact on
our consolidated financial position, results of operations or cash
flows.





Noncontrolling
Interests in Consolidated Financial Statements - In December 2007, the
FASB issued Statement of Financial Accounting Standard No. 160,
“Noncontrolling Interests in Consolidated Financial Statements.”  This
accounting principle eliminates noncomparable accounting for minority interests.
Specifically, minority interests are presented as a component of shareholders’
equity; consolidated net income includes amounts attributable to both the parent
and minority interest and is disclosed on the face of the income statement;
changes in the ownership interest are accounted for as equity transactions if
ownership remains controlling; elimination of purchase accounting for
acquisitions of noncontrolling interests and acquisitions of additional
interests; and recognition of deconsolidated controlling interest based on fair
value consistent with SFAS No. 141 (revised 2007),Business Combinations. This
accounting principle will be adopted January 2009. The accounting requirements
will be adopted prospectively, however presentation and disclosure will be
adopted retrospectively for all periods presented. Earlier adoption is
prohibited. Adoption of SFAS 160 is not expected to have an impact on our
consolidated financial position, results of operations or cash
flows.








22





Fair Value
Measurements-In September 2006, the FASB issued SFAS No. 157, “Fair Value
Measurements” (“SFAS 157”). SFAS 157 provides guidance for using fair value to
measure assets and liabilities. The standard also responds to investors’ request
for expanded information about the extent to which a company measures assets and
liabilities at fair value, the information used to measure fair value, and the
effect of fair value measurements on earnings. SFAS 157 took effect for the
Company’s fiscal year beginning January 1, 2008. We are currently reviewing the
effect that the adoption of SFAS 157 will have on our financial
statements.





Results
of Operations




Three
months ended September 30, 2008, compared with three months ended September 30,
2007







During
the three months ended September 30, 2008, we recorded revenues of $223,000, a
decrease of $116,000 from $339,000 for the same period in 2007. The decrease was
primarily due to decreased royalty revenues of $99,000, decreased non-recurring
engineering (“NRE”) speech revenues of $13,000, and decreased licensing revenue
of $4,000.




Selling,
general and administrative expenses were $343,000 for the three months ended
September 30, 2008, a decrease of $159,000 from $502,000 for the same period in
2007. The decrease is primarily due to decreased salary and wage related
expenses of $145,000, decreased occupancy related expenses of $41,000, decreased
other expenses of $40,000 and decreased travel expenses of $19,000, partially
offset by increased consulting expenses $79,000, and increased legal and
accounting fees of $7,000.
 
 We
incurred research and product development expenses of $300,000 for the three
months ended September 30, 2008, a decrease of $38,000 from $338,000 for the
same period in 2007. The decrease was primarily due to an overall decrease
occupancy expenses of $30,000, decreased other operating expenses of $11,000,
decreased travel expenses of $10,000, decreased consulting expenses of $10,000,
partially offset by an increase in wage related expenses of
$23,000.


Net
interest and other expense was $1,278,000 for the three months ended September
30, 2008, an increase of $1,248,000 from net other expense of $30,000 for the
same period in 2007.  The overall increase was due to an increase in
interest expense of $1,210,000, decreased gain on forgiveness of liabilities of
$199,000 and an increase in the gain recognized on the derivative liability of
$161,000.




Nine
months ended September 30, 2008, compared with nine months ended September 30,
2007




During
the nine months ended September 30, 2008, we recorded revenues of $1,069,000, a
decrease of $275,000 from $1,344,000 for the same period in 2007. The decrease
was primarily due to decreased royalty revenues of $226,000, decreased licensing
revenue of $51,000 and decreased non-recurring engineering (“NRE”) speech
revenues of $27,000, partially offset by increased support fees of
$29,000





Selling,
general and administrative expenses were $1,431,000 for the nine months ended
September 30, 2008, a decrease of $535,000 from $1,966,000 for the same period
in 2007. The decrease is primarily due to decreased salary and wage related
expenses of $589,000, decreased other expenses of $60,000, decreased taxes,
licenses and permits of $12,000, decreased travel expenses of $9,000 and
decreased depreciation expenses of $9,000, partially offset by increased
consulting expenses $73,000, increased investor relations related expenses of
$37,000, increased occupancy related expenses of $27,000, increased legal and
accounting fees of $5,000 and increased advertising expenses of
$2,000.








23





We
incurred research and product development expenses of $992,000 for the nine
months ended September 30, 2008, a decrease of $271,000 from $1,263,000 for the
same period in 2007. The decrease was primarily due to an overall decrease in
wage related expenses of $133,000, decreased consulting expenses of $41,000,
decreased occupancy expenses of $41,000, decreased travel expenses of $35,000,
decreased depreciation expenses of 11,000 and a decrease in other operating
expenses of $10,000.





Net
interest and other expense was $2,628,000 for the nine months ended September
30, 2008, an increase of $2,210,000 from net other expense of $418,000 in
2007.  The overall increase was due to the change of $681,000 in the
derivative liability and an increase in interest expense of $1,330,000 and
decreased gain on forgiveness of liabilities of $199,000.





Liquidity
and Capital Resources





We must raise additional funds to be
able to satisfy our cash requirements during the next 12 months.  It
is anticipated that we will need to raise approximately $2.5 to $5 million over
the next 12 months to meet obligations and continue our product development,
corporate operations and marketing expenses.  Because we presently
have only limited revenue from operations, we intend to continue to rely
primarily on financing through the sale of our equity and debt securities to
satisfy future capital requirements until such time as we are able to enter into
additional third-party licensing, collaboration, or co-marketing arrangements
such that we will be able to finance ongoing operations from license, royalty,
and sales revenue.  We are working with game developers and other
potential licensors of our speech product offerings to develop additional
revenue streams for our speech technologies.  There can be no
assurance that we will be able to enter into such
agreements.  Furthermore, the issuance of equity or debt securities
which are or may become convertible into equity securities of Fonix in
connection with such financing could result in substantial additional dilution
to the stockholders of Fonix.





Our cash resources are limited to
collections from customers, proceeds from the issuance of preferred stock, and
loan proceeds, and are not sufficient to cover current operating expenses and
payments of current liabilities.  At September 30, 2008, negative
working capital of $41,852,000; derivative liabilities of $33,886,000 related to
the issuance of Series L Preferred Stock,  Series M Preferred Stock,
Series N Preferred Stock, Series O Preferred Stock,  Series P
Preferred Stock and Series B Preferred Stock of our subsidiary; accrued
liabilities and accrued settlement obligation of $4,751,000; accounts payable of
$1,682,000;  notes payable to related parties of $940,000; accrued
payroll and other compensation of $211,000 and deferred revenues of
$445,000.





We had $1,069,000 in revenue and a loss
of $4,035,000 for the nine months ended September 30, 2008.  Net cash
used in operating activities of $209,000 for the nine months ended September 30,
2008, resulted principally from the net loss incurred of $4,035,000, non-cash
accretion of discount on notes payable of $2,124,000, issuance of shares for
employee stock grants of $709,000, increased accrued liabilities of
$576,000,  non-cash gain recognized on the derivative liability of
$95,000, increased accounts payable of $274,000, decreased other assets of
$96,000,  decreased prepaid expenses and other current assets of
$134,000 and depreciation expense of $8,000.  Net cash used in
investing activities of $20,000 for the nine months ended September 30, 2008,
consisted of the purchase of property and equipment of $20,000.  Net
cash provided by financing activities of $668,000 consisting primarily of the
proceeds on the Series O Preferred Stock of $609,000 and proceeds from the
related party note of $59,000.





We had negative working capital of
$41,852,000 at September 30, 2008, compared to negative working capital of
$34,384,000 at December 31, 2007.  Current assets decreased by $17,000
to $70,000 from $87,000 from December 31, 2007, to September 30,
2008.  Current liabilities increased by $7,451,000 to $41,922,000 from
$34,471,000 during the same period.  The change in working capital
from December 31, 2007, to September 30, 2008, reflects, in part, increased
accrued liabilities of $161,000, increased accounts payable of $150,000,
increased derivative liability of $13,144,000 and increased notes payable to
related parties of $38,000, partially offset by a decrease in accrued settlement
obligation of $455,000, decreased current portion of notes payable of
$3,833,000 and decreased Series E debenture of $1,754,000.  Total
assets were $110,000 at September 30, 2008, compared to $211,000 at December 31,
2007.





24





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)





Notes
Payable - Related Parties





During 2002, two executive officers of
the Company (the “Lenders”) sold shares of the Company’s Class A common stock
owned by them and advanced the resulting proceeds amounting to $333,000 to the
Company under the terms of a revolving line of credit and related promissory
note.  The funds were advanced for use in Company
operations.  The advances bear interest at 12 percent per annum, which
interest is payable on a semi-annual basis.  The entire principal,
along with unpaid accrued interest and any other unpaid charges or related fees,
was originally due and payable on June 10, 2003.  The Company and the
Lenders have agreed to postpone the maturity date on several
occasions.  The note was due September 30, 2006.  As of
September 30, 2008, the Company had not made payment against the outstanding
balance due on the note.  All or part of the outstanding balance and
unpaid interest may be converted at the option of the Lenders into shares of
Class A common stock of the Company at any time.  The conversion price
was the average closing bid price of the shares at the time of the
advances.  To the extent the market price of the Company’s shares is
below the conversion price at the time of conversion, the Lenders are entitled
to receive additional shares equal to the gross dollar value received from the
original sale of the shares.  A beneficial conversion option of
$15,000 was recorded as interest expense in connection with this
transaction.  The Lenders may also receive additional compensation as
determined appropriate by the Board of Directors.





During the year ended December 31,
2005, the Company received an additional advance of $50,000 against the
promissory note.  The balance due at December 31, 2005 was
$486,000.  During the year ended December 31, 2006, the Company
received additional advances and other consideration from the Lenders in the
aggregate amount of $419,000 and made principal payments to the Lenders against
the note of $105,000.  During the year ended December 31, 2007, the
Company received additional advances of $102,000.  During the nine
months ended September 30, 2008, the Company received additional advances of
$59,000.  The balance due at September 30, 2008, was
$940,000.





The
balance due of $940,000 is secured by the Company’s intellectual property rights
and common stock of Fonix Speech.  For the nine months ended September
30, 2008, the Lenders converted $21,000 of the principal balance into
209,926,500 shares common stock, and also converted $107,000 of accrued interest
into 694,173,415 shares of common stock for the benefit of one of the Lenders,
Thomas A. Murdock, a former officer and director of the Company.






Notes
Payable





In connection with the acquisition of
the capital stock of LTEL Holdings in 2004, we issued a 5%, $10,000,000,
secured, six-year note (the “Note”) payable to McCormack Avenue, Ltd.
(“McCormack”).  Under the terms of the Note, quarterly interest-only
payments were required through January 15, 2005, with quarterly principal and
interest payments beginning April 2005 and continuing through January
2010.  Interest on the Note is payable in cash or, at our option, in
shares of our Class A common stock.  The Note is secured by the
capital stock and all of the assets of LTEL Holdings and its
subsidiaries.  The Note was valued at $4,624,000 based on an imputed
interest rate of 25 percent per annum.





The discount on the Note is based on an
imputed interest rate of 25%.  The carrying amount of the Note of
$5,542,000 at December 31, 2006, was net of unamortized discount of
$3,191,000.  As of the date of this Report, we had not made any
scheduled payments for 2006 or 2007.




On
September 8, 2006, we received a default notice (the “Default Notice”) from
McCormack in respect of the Note.  In the Default Notice, McCormack
stated that it intended to exercise its rights, including any and all rights set
forth in the Note as amended.  McCormack has taken no action to
collect amounts due under the note.


25





On
September 30, 2008, the Company entered into a Series P 9% Convertible Preferred
Stock Exchange Agreement (the “Exchange Agreement”) with McCormack and Sovereign
Partners, LP (“Sovereign”) whereby McCormack exchanged the Note, along with
other promissory notes, and Series E debenture, and Sovereign exchanged two
promissory notes for shares of the Company’s Series P 9% Convertible Preferred
Stock (the Series P Preferred Stock”).  A table listing the
obligations exchanged and the number of shares of Series P Preferred Stock
issued is included.





Purchaser
            Nature
      of Obligation Exchanged
            
            Amount
      of Obligation Exchanged
            
            
            Number
      of Series P Preferred Shares to be IssuedSovereign
      Partners LP
            Promissory
      Note, dated February 22, 2007, in the principal amount of $100,000, and
      interest of $16,278
            
            $
            116,278
            
            
            
            11.6278Sovereign
      Partners LP
            Promissory
      Note, dated March 13, 2007, in the principal amount of $100,000, and
      interest of $15,750
            
            $
            115,750
            
            
            
            11.575McCormack
      Avenue, Ltd.
            Promissory
      Note, dated January 11, 2007, in the principal amount of $50,000, and
      interest of $8,722
            
            $
            58,722
            
            
            
            5.8722McCormack
      Avenue, Ltd.
            Promissory
      Note, dated January 19, 2007, in the principal amount of $100,000, and
      interest of $17,222
            
            $
            117,222
            
            
            
            11.7222McCormack
      Avenue, Ltd.
            Promissory
      Note, dated January 26, 2007, in the principal amount of $100,000, and
      interest of $17,028
            
            $
            117,028
            
            
            
            11.7028McCormack
      Avenue, Ltd.
            Promissory
      Note, dated December 28, 2006, in the principal amount of $95,000, and
      16,942
            
            $
            111,942
            
            
            
            11.1942McCormack
      Avenue, Ltd.
            Promissory
      Note, dated December 15, 2006, in the principal amount of $235,000, and
      interest of $42,701
            
            $
            277,701
            
            
            
            27.7701McCormack
      Avenue, Ltd.
            Note
      Payable, dated February, 2004, in the principal amount of $8,732,620, and
      interest of $1,311,105
            
            $
            10,043,725
            
            
            
            1,004.3725McCormack
      Avenue, Ltd.
            Series
      E Debenture, dated December 7, 2007, in the principal amount of
      $1,754,464, and interest of $291,763
            
            $
            2,046,227
            
            
            
            204.6227




McCormack
notified us that notwithstanding the Series L Exchange Agreement between us and
McCormack discussed above, McCormack had not waived any of its rights in
connection with the Note, the Modification Agreement, the Security Agreement, or
the Supplemental Security Agreement.
 
 During
the fourth quarter of 2006, we entered into two promissory notes with an
unrelated third party in the aggregate amount of $330,000. These notes accrue
interest at 10% annually and are due and payable during the second quarter of
2007.  These promissory notes were exchanged for shares of the
Company’s Series P Preferred Stock.  See table above.
 
 During
the quarter ended March 31, 2007, we entered into five promissory notes with an
unrelated third party in the aggregate amount of $450,000.  These
notes accrue interest at 10% annually and are due and payable during the third
quarter of 2007.  These promissory notes were exchanged for shares of
the Company’s Series P Preferred Stock.  See table
above.





26





Series A
Convertible Preferred Stock





As of September 30, 2008, there
were 166,667 shares of Series A convertible preferred stock
outstanding.  Holders of the Series A convertible preferred stock have
the same voting rights as common stockholders, have the right to elect one
person to the board of directors and are entitled to receive a one time
preferential dividend of $2.905 per share of Series A convertible preferred
stock prior to the payment of any dividend on any class or series of
stock.  At the option of the holders, each share of Series A
convertible preferred stock is convertible into one share of Class A common
stock and in the event that the common stock price has equaled or exceeded $10
per share for a 15 day period, the shares of Series A convertible preferred
stock will automatically be converted into Class A common stock.  In
the event of liquidation, the holders are entitled to a liquidating distribution
of $36.33 per share and a conversion of Series A convertible preferred stock at
an amount equal to .0375 shares of common stock for each share of Series A
convertible preferred stock.





Series L
Preferred Stock





On September 7, 2006, the Company
entered into a Series L 9% Convertible Preferred Stock Exchange Agreement (the
"Exchange Agreement") with McCormack and Kenzie Financial (“Kenzie”), a British
Virgin Islands company.  Pursuant to the Exchange Agreement, McCormack
and Kenzie exchanged all 2,000 shares of Series H Preferred Stock that
they  acquired from the sale of LTEL Holdings, for 1,960.8 and 39.2
shares, respectively,  of the Company's Series L 9% Convertible
Preferred Stock (the "Series L Preferred Stock").





Because the shares of Series L
Preferred Stock were issued in exchange for the remaining outstanding shares of
Series H Preferred Stock, the Company did not receive any proceeds in connection
with the issuance of the Series L Preferred Stock.





The
Series L Preferred Stock entitles McCormack and Kenzie to receive dividends in
an amount equal to 9% of the then-outstanding balance of shares of Series L
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.





The
Series L Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price which was 80% of the average of
the two (2) lowest closing bid prices for the twenty-day trading period prior to
the conversion date.





Redemption
of the Series L Preferred Stock, whether at the Company’s option or that of
McCormack or Kenzie, requires the Company to pay, as a redemption price, the
stated value of the outstanding shares of Series L Preferred Stock to be
redeemed, together with any accrued but unissued dividends thereon, multiplied
by one hundred ten percent (110%).





The Company accounted for the exchange
as redemption of the outstanding Series H Preferred Stock as the Series H
Preferred Stock was not convertible into shares of common stock of the
Company.  The Series L Preferred Stock is convertible into shares of
common stock of the Company.  The Company followed the accounting
treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$30,991,000 due to the value of the conversion feature of the Series L Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 140%, risk-free rate of 3.75% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
L Preferred Stock, no value was prescribed to the Series L Preferred
Stock.  Also in connection with the redemption, the Company recognized
a preferred stock dividend of $16,000,000, equal to the original discount the
Company had assigned to the Series H Preferred Stock.  At September
30, 2008, the fair value of the Series L Preferred Stock derivative liability
was $15,359,000.





For the nine months ended September 30,
2008, the Company issued 3,228,481,781 shares of its Class A common stock in
conversion of 34 shares of its Series L Preferred Stock.  At September
30, 2008, 1,501 shares of Series L Preferred Stock remained
outstanding.  (See Note 9 for discussion of conversions subsequent to
September 30, 2008.)






27




Series
M Preferred Stock





On April 4, 2007, the Company
entered into a Series M 9% Convertible Preferred Stock Exchange Agreement with
Sovereign Partners, LP (“Sovereign”).  Pursuant to the exchange
agreement, Sovereign exchanged 150 shares of the Company’s Series L Preferred
Stock for 150 shares of the Company’s Series M 9% Convertible Preferred Stock
(the “Series M Preferred Stock”).





The Series M Preferred Stock entitles
Sovereign or its assignees to receive dividends in an amount equal to 9% of the
then-outstanding balance of shares of Series M Preferred Stock.  The
dividends are payable in cash or shares of the Company’s Class A common stock,
at the Company’s option.





The Series M Preferred Stock may be
converted into common stock of the Company at the option of the holder by using
a conversion price which shall be the lower of (i) 80% of the average of the two
lowest closing bid prices for the twenty-day trading period prior to the
conversion date, or (ii) $0.004.





Redemption
of the Series M Preferred Stock, whether at the Company’s option or that of
Sovereign, requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series M Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





Because
the shares of Series M were issued in exchange for the outstanding shares of
Series L Preferred Stock, the Company did not receive any proceeds in connection
with the issuance of the Series M Preferred Stock.





The Company followed the accounting
treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$1,603,000 due to the value of the conversion feature of the Series M Preferred
Stock, which was previously recorded as part of the Series L Preferred Stock
derivative liability.  The liability was calculated using the
Black-Scholes valuation model with the following assumptions: dividend yield of
0%, expected volatility of 134%, risk-free rate of 5% and expected life of 4
years.  As the value of the derivative liability was greater than the
face value of the Series M Preferred Stock, no value was prescribed to the
Series M Preferred Stock.  At September 30, 2008 the fair value of the
Series M Preferred Stock derivative liability was $1,535,000.





As of September 30, 2008, there were
150 shares of Series M Preferred Stock convertible preferred stock
outstanding.





Series N
Convertible Preferred Stock





On August 24, 2007, the Company
entered into a Securities Purchase Agreement with Trillium Partners, LP and
other unnamed future investors relating to the issuance and sale of the
Company’s Series N 9% Convertible Preferred Stock.





Pursuant to the agreement, the Company
agreed to issue up to 2,400 shares of its Series N 9% Convertible Preferred
Stock (the “Series N Preferred Stock”) at a per share price of $1,000 to
Trillium Partners, LP and other unnamed future investors, for gross proceeds of
up to $2,400,000.  As of the date of this report, the Company had
issued 1,350 shares of the Series N Preferred Stock, for cash proceeds of
$1,350,000.





The
Series N Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series L
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.





The
Series N Preferred Stock is convertible into Class A common stock of the Company
at the option of the holder by using a conversion price equal to 80% of the
average of the two lowest closing bid prices for the twenty-day trading period
prior to the conversion date.







28





Redemption
of the Series N Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series N Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





The Company followed the accounting
treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$957,000 due to the value of the conversion feature of the Series N Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 128%, risk-free rate of 5.0% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
N Preferred Stock, no value was prescribed to the Series N Preferred
Stock.  At September 30, 2008, the fair value of the Series N
Preferred Stock derivative liability was $1,795,000.





As of September 30, 2008, there were
1,755 shares of Series N Preferred Stock convertible preferred stock
outstanding.





Series O
Convertible Preferred Stock





Between
January 25, 2008, and September 30, 2008, the Company received advances from
three entities in connection with the purchase agreements related to the
Company’s Series O 9% Convertible Preferred Stock (“Series O Preferred Stock”).
On May 20, 2008, the Company entered into Securities Purchase Agreements with
Southridge Partners LP, Southshore Capital Fund LTD, Sovereign Partners LP
(collectively, the “Series O Purchasers”) for the sale of an aggregate of 609
shares of Series O Preferred Stock for gross proceeds of
$609,000.  The material terms of the purchase agreements had been
agreed upon prior to receipt of the advances.  Therefore, the Series O
Preferred Stock was accounted for as discussed below on the dates cash proceeds
were received by the Company.  The Company also began accruing
dividends upon receiving the advances.





The
Series O Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series O
Preferred Stock. The dividends are payable in cash or shares of the Company's
Class A common stock, at the Company's option.





The
Series O Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price, equal to 80% of the average of
the two lowest closing bid prices for the twenty-day trading period prior to the
conversion date.





Redemption
of the Series O Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series O Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity,” SFAS
133 “Accounting for Derivative Instruments and Hedging Activities” and EITF
00-19 “Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company’s Own Stock.” The Company recognized a
derivative liability upon the redemption of $290,000 due to the value of the
conversion feature of the Series O Preferred Stock. The liability was calculated
using the Black-Scholes valuation model with the following assumptions: dividend
yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected
life of 4 years. As the value of the derivative liability was greater than the
face value of the Series O Preferred Stock, no value was prescribed to the
Series O Preferred Stock. At September 30, 2008, the fair value of the Series O
Preferred Stock derivative liability was $623,000.





As of
September 30, 2008, there were 609 shares of Series O Preferred Stock
convertible preferred stock outstanding.  Please note: In our
quarterly report for the quarter ending June 30, 2008, we reported that the
number of shares of Series O Preferred Stock outstanding was 43.  The
number should have been 430.  The correct value was reflected in the
financials and disclosures; the number of shares outstanding was a typographical
error.





29




Series P
Convertible Preferred Stock




On
September 30, 2008, we entered into a Series P 9% Convertible Preferred Stock
Exchange Agreement (the “Exchange Agreement”) with Sovereign Partners, LP
(“Sovereign”), and McCormack Avenue Ltd. (“McCormack”).  Pursuant to
the Exchange Agreement, Sovereign and McCormack exchanged certain debt
obligations, discussed more fully below, for shares of the our Series P 9%
Convertible Preferred Stock (the “Series P Preferred Stock”).
 
 The Series P Preferred Stock entitles
the holders to receive dividends in an amount equal to 9% of the
then-outstanding balance of shares of Series P Preferred Stock.  The
dividends are payable in cash or shares of our Class A common stock, at our
option.
 
 The Series P Preferred Stock may be
converted into our common stock at the option of the holder by using a
conversion price which shall be 80% of the average of the two (2) lowest closing
bid prices for the twenty-day trading period prior to the conversion
date.


Redemption of the Series P Preferred
Stock, whether at our option or that of the holder, requires us to pay, as a
redemption price, the stated value of the outstanding shares of Series P
Preferred Stock to be redeemed, together with any accrued but unissued dividends
thereon, multiplied by one hundred ten percent (110%).





Because the shares of Series P were
issued in exchange for certain outstanding debt obligations of the Company, we
did not receive any proceeds in connection with the issuance of the Series P
Preferred Stock to McCormack and Sovereign.





In connection with the issuance of the
Series P Preferred Stock, on September 26, 2008, we filed with the State of
Delaware a Certificate of Designation and Series P 9% Convertible Stock Terms
(the “Series P Terms”), which become a part of our Certificate of Incorporation,
as amended.





Under the Exchange Agreement and the
Series P Terms, Sovereign and McCormack may convert shares of Series P Preferred
Stock into shares of our common stock.  Our issuances of shares of
common stock upon any conversion of the Series P Preferred Stock will be made
without registration under the securities Act of 1933 (the “1933 Act”) in
reliance on Section 4(2) of the 1933 Act and the rules and regulations
promulgated thereunder.





The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity,” SFAS
133 “Accounting for Derivative Instruments and Hedging Activities” and EITF
00-19 “Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company’s Own Stock.” The Company recognized a
derivative liability upon the redemption of $290,000 due to the value of the
conversion feature of the Series O Preferred Stock. The liability was calculated
using the Black-Scholes valuation model with the following assumptions: dividend
yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected
life of 4 years. As the value of the derivative liability was greater than the
face value of the Series P Preferred Stock, no value was prescribed to the
Series P Preferred Stock. At September 30, 2008, the fair value of the Series P
Preferred Stock derivative liability was $13,304,000.





As of September 30, 2008, there were
1,300 shares of Series P Preferred Stock convertible preferred stock
outstanding.





Fonix Speech,
Inc. Series B Convertible Preferred Stock





On April 4, 2007, the Company entered
into a Securities Purchase Agreement by and among the Company, Fonix Speech,
Inc. (“FSI”), and Sovereign Partners, LP (“Sovereign”).  FSI is a
wholly owned subsidiary of the Company.





Pursuant to the FSI purchase agreement,
FSI sold 125 shares of its Series B 9% Convertible Preferred Stock (the “Series
B Preferred Stock”) at a per share price of $10,000 to Sovereign, for gross
proceeds of $1,250,000.





30




The shares of Series B Preferred Stock
are convertible into shares of the Company’s Class A common
stock.  The Series B Preferred Stock may be converted into common
stock of the Company at the option of the holder by using a conversion price
which shall be the lower of (i) 80% of the average of the two lowest closing bid
prices for the twenty-day trading period prior to the conversion date, or (ii)
$0.004.





The Series B Preferred Stock entitles
Sovereign or its assignees to receive dividends in an amount equal to 9% of the
then-outstanding balance of shares of Series B Preferred Stock.  The
dividends are payable in cash or shares of the Company's Class A common stock,
at the Company's option





The Company followed the accounting
treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the issuance of
$1,336,207 due to the value of the conversion feature of the Series B Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 134%, risk-free rate of 5% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
B Preferred Stock, no value was prescribed to the Series B Preferred
Stock.  At September 30, 2008, the fair value of the Series B
Preferred Stock derivative liability was $1,279,000.





As of September 30, 2008, there were
125 shares of Series B Preferred Stock convertible preferred stock
outstanding.





Stock Options and
Warrants





During
the nine months ended September 30, 2008, we did not grant any stock
options.  As of September 30, 2008, we had a total of 198,000 options
to purchase Class A common stock outstanding.





During the nine months ended September
30, 2008, we issued 4,486,938,874 shares of Class A common stock for employee
stock grants.





As of September 30, 2008, we had
warrants to purchase a total of 15,000 shares of Class A common stock
outstanding that expire through 2010.





Other


We presently have no plans to purchase
new research and development.





Recent
Developments





Exchange
Agreement





In June
2008, the Company organized a subsidiary, Fonix GS Acquisition Group, Inc.
(“FGSA”).  The Company owns 100% of the issued and outstanding shares
of FGSA, which was formed for the purpose of acquiring 80% of the issued and
outstanding shares of Shanghai Gaozhi Software Systems Limited ("GaozhiSoft"), a
Hong Kong software developer and solutions provider in 2G (second-generation)
and 3G (third-generation) mobile networks in China and throughout the Asian
Pacific region




The
Company and FGSA subsequently entered into an exchange agreement dated as of
June 27, 2008 (the “Exchange Agreement”), with Southridge LLC (“Southridge”)
G-Soft, Limited, a Hong Kong corporation (“G-Soft”).  G-Soft, through
its wholly owned subsidiary, has the rights to acquire GaoshiSoft based on a
written agreement with all of the shareholders of GaozhiSoft. Pursuant to the
Exchange Agreement, FGSA agreed to purchase 80% of the issued and outstanding
shares of G-Soft from the Sellers, and Southridge agreed to purchase the
remaining 20% of the issued and outstanding G-Soft shares, concurrent with
G-Soft’s acquisition of all of the shares of GaozhiSoft.





31




As
consideration for the purchase of the G-Soft shares, Southridge agreed to
transfer shares of the Company’s Series L Convertible Preferred Stock (the
“Series L Preferred Stock”) in the amounts set forth in the
agreement.  In return for the purchase of the 80% of the outstanding
shares, the Company agreed to issue an aggregate of Two Thousand (2,000) shares
of a new series of preferred stock (the “Preferred
Stock”).  Additionally, the Company agreed to execute and deliver to
Haim Shafrir, acting as the Seller’s representative, a promissory note (the
“Note”) in the aggregate principal amount of $3,000,000, payable quarterly as a
percentage of EBITDA of GaozhiSoft, with the balance of principal due four (4)
years after the date of issuance.  The Note is secured by the assets
of FGSA (including the capital stock of G-Soft and its subsidiaries, including
GaozhiSoft).


The
Company cannot close the purchase of GaozhiSoft until it receives approval of
certain Chinese regulatory agencies, which approval has not yet been
received.  The Company does not know when it will receive the required
regulatory approvals.  Moreover, the Company is presently engaged in
discussions with the Sellers to modify the purchase price and
terms.  There can be no assurance that these discussions will result
in an improvement of the purchase price and terms, in which case the Company may
elect to terminate the Exchange Agreement.





The
foregoing summary of the terms and conditions of the Exchange Agreement does not
purport to be complete and is qualified in its entirety by reference to the full
text of the Exchange Agreement, attached as an exhibit to the Company’s Current
Report on Form 8-K, filed with the Commission on August 12, 2008.








Corporate
Outlook








Fonix’s
focus on providing competitive and value-added solutions for customers and
partners requires a broad set of technologies, service offerings and channel
capabilities.  Management anticipates and expects further development
of complementary technologies, added product and application developments,
access to market channels and additional opportunities for strategic alliances
in other industry segments.





We will
continue to leverage our research and development of speech technologies to
deliver software applications and engines to device manufacturers looking to
incorporate speech interfaces into end-user products.  Fonix Speech’s
award-wining technologies provide competitive embedded speech solutions for
mobile/wireless devices, videogames, telephony systems and products for the
assistive market based on Fonix’s proprietary and patented TTS and ASR
technologies.





As we proceed to implement our strategy
and to reach our objectives, we anticipate further development of complementary
technologies, added product and applications development expertise, access to
market channels and additional opportunities for strategic alliances in other
industry segments.  The strategy adopted by us has significant risks,
and shareholders and others interested in Fonix and our Class A common stock
should carefully consider the risks set forth below and under the heading
“Certain Significant Risk Factors” in Item 1, Part I, of our annual report on
Form 10-K for the year ended December 31, 2007.





As noted above, as of September 30,
2008, we had an accumulated deficit of $283,469,000; negative working capital of
$41,852,000; derivative liabilities of $33,886,000 related to the issuance of
Series L Preferred Stock,  Series M Preferred Stock, Series N
Preferred Stock, Series O Preferred Stock , Series P Preferred Stock and Series
B Preferred Stock of our subsidiary; accrued liabilities and accrued settlement
obligation of $4,751,000; accounts payable of $1,682,000; notes payable to
related parties of $940,000; accrued payroll and other compensation of $211,000;
and deferred revenues of $445,000.  Sales of products and revenue from
licenses based on our technologies have not been sufficient to finance ongoing
operations.  These matters raise substantial doubt about our ability
to continue as a going concern.  Our continued existence is dependent
upon several factors, including our success in (1) increasing speech license,
royalty and services revenues, (2) raising sufficient additional funding, and
(3) minimizing operating costs.  Until sufficient revenues are
generated from operating activities, we expected to continue to fund our
operations through debt instruments.  We are currently pursuing
additional sources of liquidity in the form of traditional commercial credit,
asset based lending, or additional sales of our equity securities to finance our
ongoing operations.  Additionally, we are pursuing other types of
commercial and private financing, which could involve sales of our assets or
sales of one or more operating divisions.  Our sales and financial
condition have been adversely affected by our reduced credit availability and
lack of access to alternate financing because of our significant ongoing losses
and increasing liabilities and payables.  As we have noted in our
previous annual reports and other public filings, if additional financing is not
obtained in the near future, we will be required to more significantly curtail
our operations or seek protection under bankruptcy laws.





32




Information
Concerning Forward-Looking Statements





Certain of the statements contained in
this report (other than the historical financial data and other statements of
historical fact) are forward-looking statements.  These statements
include, but are not limited to our expectations with respect to the development
of a diversified revenue base; delivery of our VoiceDial application; the market
volume of educational electronic dictionary devices; our ability to capitalize
in markets including toys, appliances, and other devices; the market demand for
videogames; our growth strategies and the implementation of our Core
Technologies and potential results; our payment of dividends on our common
stock; our ability to meet customer demand for speech technologies and
solutions; development of complementary technologies, products, marketing, and
strategic alliance opportunities; profitability of language learning tools; the
status of  traditional operator systems; our ability to continue
operations in the event we do not receive approval to amend our articles of
incorporation; the comparability of our speech-enabled Speech Products to other
products; our intentions with respect to strategic collaborations and marketing
arrangements; our intentions with respect to use of licenses; our plans with
respect to development and acquisition of speech solutions; our goals with
respect to supplying speech solutions for OEMs; our expectations with respect to
continued financial losses; and our intentions with respect to financing our
operations in the future.  Additional forward-looking statements may
be found in the “Certain Significant Risk Factors” Section of our 10-K for the
year ended December 31, 2007, together with accompanying explanations of the
potential risks associated with such statements.





Forward-looking statements made in this
report, are made based upon management’s good faith expectations and beliefs
concerning future developments and their potential effect upon
Fonix.  There can be no assurance that future developments will be in
accordance with such expectations, or that the effect of future developments on
Fonix will be those anticipated by management.  Forward-looking
statements may be identified by the use of words such as “believe,” “expect,”
“plans,” “strategy,” “prospects,” “estimate,” “project,” “anticipate,” “intends”
and other words of similar meaning in connection with a discussion of future
operating or financial performance.





You are cautioned not to place undue
reliance on these forward looking statements, which are current only as of the
date of this Report.  We disclaim any intention or obligation to
update or revise any forward-looking statements, whether as a result of new
information, future events, or otherwise.  Many important factors
could cause actual results to differ materially from management’s expectations,
including those listed in the “Certain Significant Risk Factors” Section of our
10-K for the year ended December 31, 2007, as well as the
following:





•           unpredictable
difficulties or delays in the development of new products and
technologies;





•
            changes
      in U.S. or international economic conditions, such as inflation, interest
      rate fluctuations, foreign exchange rate fluctuations or recessions in
      Fonix's markets;





•
            pricing
      changes to our supplies or products or those of our competitors, and other
      competitive pressures on pricing and
sales;





•
            difficulties
      in obtaining or retaining the management, engineering, and other human
      resource competencies that we need to achieve our business
      objectives;





•
            the
      impact on Fonix or a subsidiary from the loss of a significant customer or
      a significant number of customers;





•
            risks
      generally relating to our international operations, including
      governmental, regulatory or political
changes;





•
            transactions
      or other events affecting the need for, timing and extent of our capital
      expenditures; and





•           the
extent to which we reduce outstanding debt.





33




Item
3.            Quantitative
and Qualitative Disclosures About Market Risk





Foreign Currency
Exposure





To date, all of our revenues have been
denominated in United States dollars and received primarily from customers in
the United States.  Our exposure to foreign currency exchange rate
changes has been insignificant.  We expect, however, that future
product license and services revenue may also be derived from international
markets and may be denominated in the currency of the applicable
market.  As a result, operating results may become subject to
significant fluctuations based upon changes in the exchange rate of certain
currencies in relation to the U.S. dollar.  Furthermore, to the extent
that we engage in international sales denominated in U.S. dollars, an increase
in the value of the U.S. dollar relative to foreign currencies could make our
products less competitive in international markets.  Although we will
continue to monitor our exposure to currency fluctuations, we cannot assure that
exchange rate fluctuations will not adversely affect financial results in the
future.





Item
4T.          Controls and
Procedures




Management's Report on Internal
Control Over Financial Reporting




Evaluation of Disclosure
Controls and Procedures.  Our Chief Executive Officer who is
also our Chief Financial Officer, after evaluating the effectiveness of the
Company’s “disclosure controls and procedures” (as defined in the Securities
Exchange Act of 1934 (Exchange Act) Rules 13a-15(e) or 15d-15(e)) as of the end
of the period covered by this annual  report, has concluded that our
disclosure controls and procedures are effective based on his evaluation of
these controls and procedures required by paragraph (b) of Exchange Act Rules
13a-15 or 15d-15.





Changes in Internal Control
Over Financial Reporting.  There were no changes in our
internal control over financial reporting identified in connection with the
evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that
occurred during our last fiscal quarter that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.





Section 404
Assessment.  Section 404 of the Sarbanes-Oxley Act of 2002
required management’s annual review and evaluation of our internal controls
beginning with our Form 10-K for the fiscal year ending December 31, 2007, and
an attestation of the effectiveness of these controls by our independent
registered public accounting firm beginning with our Form 10-K for the fiscal
year ending on December 31, 2009.  We are dedicating significant
resources, including management time and effort, and incurring substantial costs
in connection with our ongoing Section 404 assessment.  We are
continue to document and test our internal controls and consider whether any
improvements are necessary for maintaining an effective control environment at
our company.  The evaluation of our internal controls is being
conducted under the direction of our senior management.  In addition,
our management is regularly discussing the results of our testing and any
proposed improvements to our control environment with our Board of
Directors.  We will continue to work to improve our controls and
procedures, and to educate and train our employees on our existing controls and
procedures in connection with our efforts to maintain an effective controls
infrastructure at our Company.





Limitations on Effectiveness
of Controls.  A system of controls, however well designed and
operated, can provide only reasonable, and not absolute, assurance that the
system will meet its objectives.  The design of a control system is
based, in part, upon the benefits of the control system relative to its
costs.  Control systems can be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of
the control.  In addition, over time, controls may become inadequate
because of changes in conditions, or the degree of compliance with the policies
or procedures may deteriorate.  In addition, the design of any control
system is based in part upon assumptions about the likelihood of future
events.








34




PART
II - OTHER INFORMATION





Item
1.            Legal
Proceedings





The Breckenridge Fund – On
June 6, 2006, the Breckenridge Fund filed a complaint against the Company in the
Supreme Court of the State of New York, County of Nassau (the “Court”), in
connection with a settlement agreement between the Company and Breckenridge
entered into in September 2005. In the Complaint, Breckenridge alleged that the
Company failed to pay certain amounts due under the settlement agreement in the
amount of $450,000. The Company denied the allegations of Breckenridge’s
complaint and filed a motion for summary judgment.  Breckenridge also
filed for summary judgment on its complaint.


On
February 2, 2007, the Court granted Breckenridge’s motion for summary judgment,
denied the Company’s summary judgment motion, and directed that a hearing be
held to determine the amount owed by the Company to Breckenridge.  The
Company and Breckenridge entered into a stipulation that the Company owed
Breckenridge $1,530,000 plus interest at a rate of 9% from September 15, 2006 to
the date of entry of judgment.


The
Court’s judgment dated as of March 15, 2007 states that the Company owes an
aggregate of $1,602,000 to Breckenridge.  The Company has accrued for
this settlement in the accompanying financial statements.  In February
2008, the Company entered into an amended settlement agreement with Breckenridge
under which the Company agreed to pay Breckenridge $540,000.  The
Company has paid Breckenridge $455,000 and is obligated to pay the balance of
$85,000 at the rate of $42,500 per month.  This obligation was satisfied in
November 2008.




Hite Development
Corporation  In January 2007, Hite Development Corporation
(“Hite”) brought a lawsuit against the Company claiming breach of contract and
breach of the covenant of good faith and fair dealing, alleging that the Company
failed to make certain payments under a settlement agreement with Hite dating
from March 2005.  The complaint seeks approximately $33,000 plus
interest.  The Company filed its answer in May
2007.   On May 8, 2008, Hite filed a motion for summary judgment,
which the Court granted.
 
 RR Donnelley Receivables Inc. v.
Fonix Corporartion,  In July 2007, RR Donnelley Receivables
Inc. (“Donnelly”) brought a lawsuit against the Company for alleged failure to
pay for services provided.  The complaint seeks approximately $21,000
plus interest.  The Company filed its answer in August 2007, and filed
a motion to dismiss the action in December 2007.  That motion is
currently pending before the court.  If the Company’s motion to
dismiss is denied, the Company intends to defend against the claims in the
complaint.
 
 Perpetual Storage, Inc.Perpetual
Storage, Inc., brought suit, claiming breach of contract and unjust enrichment,
and seeking damages of approximately $12,300 plus attorneys’ fees and
costs.  The Company filed its answer in July 2008, and no further
developments had occurred as of the date of this report.
  Item
1A.         Risk
Factors





We
attempt to identify, manage and mitigate the risks and uncertainties associated
with our business to the extent practical.  However, some level of
risk and uncertainty will always be present.  The section of our
Annual Report on Form 10-K for the fiscal year ended December 31, 2007, entitled
“Certain Significant Risk Factors” describes some of the risks and uncertainties
associated with our business. These risks and uncertainties have the potential
to materially affect our business, financial condition, results of operations,
cash flows, projected results and future prospects. We have revised the
following risk factors which were previously disclosed in our Annual Report on
Form 10-K for the fiscal year ended December 31, 2007.








35





Our
substantial and continuing losses since inception, coupled with significant
ongoing operating expenses, raise doubt about our ability to continue as a going
concern.





Since inception, we have sustained
substantial losses.  Such losses continue due to ongoing operating
expenses and a lack of revenues sufficient to offset operating
expenses.  We have raised capital to fund ongoing operations by
private sales of our securities, some of which sales have been highly dilutive
and involve considerable expense.  In our present circumstances, there
is substantial doubt about our ability to continue as a going concern absent
significant sales of our products and telecommunication services, substantial
revenues from new licensing or co-development contracts, or continuing large
sales of our securities.





We had net income of $14,959,000 for
December 31, 2007, and net losses $21,943,000 and $22,631,000 for the years
ended December 31, 2006 and 2005, respectively.  We incurred a net
loss of $1,701,000 for the three months ended September 30, 2008 and $4,035,000
for the nine months ended September 30, 2008 As of September 30, 2008, we had an
accumulated deficit of $283,469,000; negative working capital of $41,852,000;
derivative liabilities of $33,886,000 related to the issuance of Series L
Preferred Stock,  Series M Preferred Stock, Series N Preferred Stock,
Series O Preferred Stock,  Series P Preferred Stock and Series B
Preferred Stock of our subsidiary; accrued liabilities and accrued settlement
obligation of $4,751,000; accounts payable of $1,682,000;  notes
payable to related parties of $940,000; accrued payroll and other compensation
of $211,000; and deferred revenues of $445,000.





We expect to continue to spend
significant amounts to enhance our Speech Products and technologies and fund
further Product development.  As a result, we will need to generate
significant additional revenue to achieve profitability.  Even if we
do achieve profitability, we may not be able to sustain or increase
profitability on a quarterly or annual basis.  If we do not achieve
and maintain profitability, the market price for our common stock may further
decline, perhaps substantially, and we may have to curtail or cease our
operations.





Continuing
debt obligations could impair our ability to continue as a going
concern.





As of September 30, 2008, we had debt
obligations of $940,000, accrued liabilities and accrued settlement obligation
of $4,751,000 and vendor accounts payable of approximately
$1,682,000.  At present, our revenues from existing licensing
arrangements and Speech Product sales are not sufficient to offset our ongoing
operating expenses or to pay in full our current debt obligations.





There is substantial risk, therefore,
that the existence and extent of the debt obligations described above could
adversely affect our business, operations and financial condition, and we may be
forced to curtail our operations, sell part or all of our assets, or seek
protection under bankruptcy laws.  Additionally, there is substantial
risk that the current or former employees or our vendors could bring lawsuits to
collect the unpaid amounts.  In the event of lawsuits of this type, if
we are unable to negotiate settlements or satisfy our obligations, we could be
forced into bankruptcy.




General
economic conditions may affect our revenue and harm our business.
  As widely
reported, financial markets in the United States, Europe and Asia have been
experiencing extreme disruption in recent months.  Unfavorable changes in
economic conditions, including declining consumer confidence, inflation,
recession or other changes, may lead our customers to delay or reduce purchases
of our products and our results of operations and financial condition could be
adversely affected thereby.  Challenging economic conditions also may
impair the ability of our customers or distributors to pay for products they
have purchased, and as a result, our reserves for doubtful accounts and
write-offs of accounts receivable could increase.  Our cash flows may be
adversely affected by delayed payments or underpayments by our customers. 
We are unable to predict the duration and severity of the current disruption in
financial markets and adverse economic conditions in the U.S. and other
countries.





Item
2.            Unregistered
Sales of Equity Securities and Use of Proceeds





During
the nine months ended September 30, 2008, we issued 3,228,481,781 shares of our
common stock in connection with conversions of 34 shares of our Series L
Preferred Stock for which we received no proceeds.    The
shares of common stock were issued without registration under the 1933 Act in
reliance on Section 4(2) of the 1933 Act and the rules and regulations
promulgated thereunder.





We
received no proceeds from the issuance of shares upon conversion of our series
of preferred stock.





Item
6.            Exhibits





a.
            Exhibits:
      The following Exhibits are filed with this Form 10-Q pursuant to Item
      601(a) of Regulation S-K:




4
              Certificate of Designation of
      Rights and Preferences for Series P 9% Convertible Preferred
      Stock10
              Exchange
      Agreement, dated as of September 30, 200831
              Certification of President and
      Chief Financial Officer32
              Certification of President and
      Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
      of 2002





36





SIGNATURES





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








Fonix
      CorporationDate:
      November 19, 2008
            /s/  Roger
      D.DudleyRoger
      D.  Dudley, Chief Executive Officer,
  President,Chief
      Financial Officer, and Director(Principal
      Executive Officer, Principal Financial
Officer)




37