UNITED STATESSECURITIES 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, 2007



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 number: 000-22190



VERSO TECHNOLOGIES, INC.

(Exact name of registrant as specified in its charter)



Minnesota
        41-1484525


(State of incorporation)
        (I.R.S. Employer


Identification No.)






400 Galleria Parkway, Suite 200

Atlanta, GA 30339

(Address of principal executive offices, including zip code)



678.589.3500

(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. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):



Large Accelerated filer  [   ]
        
        Accelerated filer  [   ]
        
        Non-Accelerated filer [ X ]




Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [   ] No [ X ]



The number of shares outstanding of the issuer's common stock as ofNovember 14, 2007was66,747,829.



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VERSO TECHNOLOGIES, INC.

FORM 10-Q

INDEX



Page No.

Part I.
        FINANCIAL INFORMATION




Item 1.
        Financial Statements




Condensed Consolidated Balance Sheets as of September 30, 2007 (unaudited) and December 31, 2006
        2




Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2007    and 2006 (unaudited)
        3




Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2007 and 2006    (unaudited)
        4




Notes to Condensed Consolidated Financial Statements (unaudited)
        5




Item 2.
        Managements Discussion and Analysis of Financial Condition and Results of Operations
        26




Item 3.
        Quantitative and Qualitative Disclosures about Market Risk
        41




Item 4.
        Controls and Procedures
        41






Part II.
        OTHER INFORMATION




Item 1.
        Legal Proceedings
        42




Item 1A.
        Risk Factors
        43




Item 2.
        Unregistered Sales of Equity Securities and Use of Proceeds
        44




Item 6.
        Exhibits
        45






Signature Page
        
        46




Exhibit Index
        
        47




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VERSO TECHNOLOGIES, INC. CONDENSED CONSOLIDATED
BALANCE SHEETS (in thousands, except share data)(Unaudited)







|                                                                                                                        |  |  |  | September 30,2007 |          | December 31, 2006
|----------------------------------------------------------------------------------------------------------------------- |  |  |  | ----------------- | -------- | -----------------
|ASSETS:                                                                                                                 |  |  |  |                   |          |                  
|Current
assets:                                                                                                         |  |  |  |                   |          |                  
|Cash and cash
equivalents                                                                                               |  |  |  | $                 | 5,407    |                  
|Restricted
cash                                                                                                         |  |  |  |                   | 503      |                  
|Accounts
receivable, net                                                                                                |  |  |  |                   | 11,013   |                  
|Inventories                                                                                                             |  |  |  |                   | 6,305    |                  
|Other current
assets                                                                                                    |  |  |  |                   | 900      |                  
|Current
portion of note receivable                                                                                      |  |  |  |                   |         |                  
|Total current
assets                                                                                                    |  |  |  |                   | 24,128   |                  
|                                                                                                                       
|Property and
equipment, net                                                                                             |  |  |  |                   | 1,564    |                  
|Loan issuance
costs, net                                                                                                |  |  |  |                   | 2,277    |                  
|Investment                                                                                                              |  |  |  |                   | 629      |                  
|Note receivable,
net of current portion                                                                                 |  |  |  |                   |         |                  
|Other
intangibles, net                                                                                                  |  |  |  |                   | 6,866    |                  
|Goodwill                                                                                                                |  |  |  |                   | 5,675    |                  
|Total
assets                                                                                                            |  |  |  | $                 | 41,139   |                  
|                                                                                                                       
|LIABILITIES
AND SHAREHOLDERS EQUITY:                                                                                   |  |  |  |                   |          |                  
|Current
liabilities:                                                                                                    |  |  |  |                   |          |                  
|Credit
facility                                                                                                         |  |  |  | $                 | 8,140    |                  
|Accounts
payable                                                                                                        |  |  |  |                   | 3,388    |                  
|Accrued
compensation                                                                                                    |  |  |  |                   | 2,127    |                  
|Accrued
expenses                                                                                                        |  |  |  |                   | 4,813    |                  
|Purchase
price payable for acquisition                                                                                  |  |  |  |                   |         |                  
|Current
portion of accrued loss on sublease                                                                             |  |  |  |                   | 544      |                  
|Current
portion of liabilities of discontinued operations                                                               |  |  |  |                   | 1,087    |                  
|Current
portion of notes payable                                                                                        |  |  |  |                   | 2,957    |                  
|Current
portion of convertible debentures                                                                               |  |  |  |                   | 5,063    |                  
|Unearned
revenue and customer deposits                                                                                  |  |  |  |                   | 2,347    |                  
|Total current
liabilities                                                                                               |  |  |  |                   | 30,466   |                  
|                                                                                                                       
|Accrued loss on
sublease, net of current portion                                                                        |  |  |  |                   | 485      |                  
|Credit facility,
net of current portion                                                                                 |  |  |  |                   | 2,250    |                  
|Liabilities of
discontinued operations, net of current portion                                                          |  |  |  |                   | 220      |                  
|Notes payable,
net of current portion                                                                                   |  |  |  |                   |         |                  
|Convertible
subordinated debentures, net of discount                                                                    |  |  |  |                   | 2,278    |                  
|Total
liabilities                                                                                                       |  |  |  |                   | 35,699   |                  
|                                                                                                                       
|Shareholders equity:                                                                                                   |  |  |  |                   |          |                  
|Common stock,
$.01 par value, authorized shares of 120,000,000; 65,896,815 and 41,691,911 shares issued and outstanding |  |  |  |                   | 637      |                  
|Additional
paid-in capital                                                                                              |  |  |  |                   | 371,472  |                  
|Deferred
compensation                                                                                                   |  |  |  |                   | (166     | )                
|Accumulated
deficit                                                                                                     |  |  |  |                   | (366,251 | )                
|Accumulated
other comprehensive income (loss)  foreign currency translation                                            |  |  |  |                   | (252     | )                
|Total
shareholders equity                                                                                              |  |  |  |                   | 5,440    |                  
|Total
liabilities and shareholders equity                                                                              |  |  |  | $                 | 41,139   |                  

Page 2

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VERSO TECHNOLOGIES, INC. CONDENSED CONSOLIDATED
STATEMENTS OF OPERATIONS (In thousands, except share data)(Unaudited)







|                                                                                                                                                                    |  |  |  | For the three months ended September
30, |            | For the nine months ended September
30, | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  | ---------------------------------------- | ---------- | --------------------------------------- | 
|
|Revenue:                                                                                                                                                            |  |  |  |                                          |            |                                         | 
|Products                                                                                                                                                            |  |  |  | $                                        | 9,744      |                                         | 
|Services                                                                                                                                                            |  |  |  |                                          | 3,392      |                                         | 
|Total
revenue                                                                                                                                                       |  |  |  |                                          | 13,136     |                                         | 
|                                                                                                                                                                   
|Cost of
revenue:                                                                                                                                                    |  |  |  |                                          |            |                                         | 
|Products:                                                                                                                                                           |  |  |  |                                          |            |                                         | 
|Product
costs                                                                                                                                                       |  |  |  |                                          | 5,168      |                                         | 
|Amortization
of intangibles                                                                                                                                         |  |  |  |                                          | 312        |                                         | 
|Total cost of
product                                                                                                                                               |  |  |  |                                          | 5,480      |                                         | 
|Services                                                                                                                                                            |  |  |  |                                          | 2,635      |                                         | 
|Total cost of
revenue                                                                                                                                               |  |  |  |                                          | 8,115      |                                         | 
|                                                                                                                                                                   
|Gross
profit:                                                                                                                                                       |  |  |  |                                          |            |                                         | 
|Products                                                                                                                                                            |  |  |  |                                          | 4,264      |                                         | 
|Services                                                                                                                                                            |  |  |  |                                          | 757        |                                         | 
|Total gross
profit                                                                                                                                                  |  |  |  |                                          | 5,021      |                                         | 
|                                                                                                                                                                   
|Operating
expenses:                                                                                                                                                 |  |  |  |                                          |            |                                         | 
|                                                                                                                                                                   
|General and
administrative                                                                                                                                          |  |  |  |                                          | 3,417      |                                         | 
|Sales and
marketing                                                                                                                                                 |  |  |  |                                          | 2,087      |                                         | 
|Research and
development                                                                                                                                            |  |  |  |                                          | 1,871      |                                         | 
|Depreciation
and amortization                                                                                                                                       |  |  |  |                                          | 708        |                                         | 
|Reorganization expense                                                                                                                                              |  |  |  |                                          | 362        |                                         | 
|Total
operating expenses                                                                                                                                            |  |  |  |                                          | 8,445      |                                         | 
|                                                                                                                                                                   
|Operating
loss from continuing operations                                                                                                                           |  |  |  |                                          | (3,424     | )                                       | 
|                                                                                                                                                                   
|Other
expense:                                                                                                                                                      |  |  |  |                                          |            |                                         | 
|Other
expense                                                                                                                                                       |  |  |  |                                          | (7         | )                                       | 
|                                                                                                                                                                   
|Equity in
loss of investment                                                                                                                                        |  |  |  |                                          | (37        | )                                       | 
|                                                                                                                                                                   
|Interest
expense, net, including $1,007, $1,288, $3,056 and $3,064 of amortization of loan fees and discount on convertible debentures in each period,
respectively |  |  |  |                                          | (1,539     | )                                       | 
|Other
expense                                                                                                                                                       |  |  |  |                                          | (1,583     | )                                       | 
|                                                                                                                                                                   
|Loss from
continuing operations before income taxes                                                                                                                 |  |  |  |                                          | (5,007     | )                                       | 
|                                                                                                                                                                   
|Income tax
benefit (expense)                                                                                                                                        |  |  |  |                                          |           |                                         | 
|                                                                                                                                                                   
|Loss from
continuing operations                                                                                                                                     |  |  |  |                                          | (5,007     | )                                       | 
|                                                                                                                                                                   
|Net
loss                                                                                                                                                            |  |  |  | $                                        | (5,007     | )                                       | 
|                                                                                                                                                                   
|Net loss per
common share  basic and diluted:                                                                                                                      |  |  |  |                                          |            |                                         | 
|Loss from
continuing operations                                                                                                                                     |  |  |  | $                                        | (0.08      | )                                       | 
|                                                                                                                                                                    |  |  |  | $                                        | (0.08      | )                                       | 
|Weighted
average shares outstanding  basic and diluted                                                                                                             |  |  |  |                                          | 59,809,128 |                                         | 

Page 3

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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES CONSOLIDATED
STATEMENTS OF CASH FLOWS (In thousands, except share data)







|                                                                                                                                 |  |  |  | For the nine months ended September 30, |        
|-------------------------------------------------------------------------------------------------------------------------------- |  |  |  | --------------------------------------- | -------
|
|Operating
Activities:                                                                                                            |  |  |  |                                         |        
|Continuing
operations:                                                                                                           |  |  |  |                                         |        
|Net loss from
continuing operations                                                                                              |  |  |  | $                                       | (16,484
|Adjustments
to reconcile net loss from continuing operations to net cash used in continuing operating activities                 |  |  |  |                                         |        
|Equity in
income of investment                                                                                                   |  |  |  |                                         | 115    
|Stock based
compensation                                                                                                         |  |  |  |                                         | 1,025  
|Non-cash
interest expense                                                                                                        |  |  |  |                                         | 576    
|Depreciation
and amortization                                                                                                    |  |  |  |                                         | 2,780  
|Provision for
doubtful accounts                                                                                                  |  |  |  |                                         | 307    
|Loss on
repayment of notes receivable                                                                                            |  |  |  |                                         | 231    
|Amortization
of loan fees and discount on convertible subordinated debentures                                                    |  |  |  |                                         | 3,390  
|Other                                                                                                                            |  |  |  |                                         | (32    
|Changes in
current operating assets and liabilities, net of effects of acquisitions:                                             |  |  |  |                                         |        
|Accounts
receivable                                                                                                              |  |  |  |                                         | (1,115 
|Inventories                                                                                                                      |  |  |  |                                         | 896    
|Other current
assets                                                                                                             |  |  |  |                                         | 65     
|Accounts
payable                                                                                                                 |  |  |  |                                         | 105    
|Accrued
compensation                                                                                                             |  |  |  |                                         | (179   
|Accrued
expenses                                                                                                                 |  |  |  |                                         | 515    
|Unearned
revenue and customer deposits                                                                                           |  |  |  |                                         | (396   
|Net cash used
in continuing operating activities                                                                                 |  |  |  |                                         | (8,201 
|Discontinued
operations:                                                                                                         |  |  |  |                                         |        
|Adjustment to
reconcile loss from discontinued operations to net cash used in discontinued operating activities, rental payments |  |  |  |                                         | (178   
|Net cash used
in discontinued operating activities                                                                               |  |  |  |                                         | (178   
|Net cash used
in operating activities                                                                                            |  |  |  |                                         | (8,379 
|Investing
Activities:                                                                                                            |  |  |  |                                         |        
|Continuing
operations:                                                                                                           |  |  |  |                                         |        
|Net cash used
in investing activities for continuing operations                                                                 |  |  |  |                                         |        
|Decrease in
restricted cash                                                                                                      |  |  |  |                                         | 538    
|Purchases of
property and equipment                                                                                              |  |  |  |                                         | (248   
|Purchase of
Verilink                                                                                                             |  |  |  |                                         |       
|Purchase of
iMarc                                                                                                                |  |  |  |                                         | (1,815 
|Purchase of
Sentito                                                                                                              |  |  |  |                                         | 937    
|Net cash used
in investing activities for continuing operations                                                                  |  |  |  |                                         | (588   
|Discontinued
operations:                                                                                                         |  |  |  |                                         |        
|Proceeds from
notes receivable                                                                                                   |  |  |  |                                         | 1,880  
|Net cash
provided by investing activities for discontinued operations                                                            |  |  |  |                                         | 1,880  
|Net cash
provided by investing activities                                                                                        |  |  |  |                                         | 1,292  
|Net cash used
in operating and investing activities                                                                              |  |  |  |                                         | (7,087 
|Financing
Activities:                                                                                                            |  |  |  |                                         |        
|Net
borrowings on line of credit                                                                                                 |  |  |  |                                         | 2,507  
|Proceeds from
convertible debentures, net                                                                                        |  |  |  |                                         |       
|Proceeds from
private placement, net                                                                                             |  |  |  |                                         | 8,815  
|Proceeds from
issuances of common stock in connection with the exercise of options and warrants, net                             |  |  |  |                                         | 9      
|Net cash
provided by financing activities                                                                                        |  |  |  |                                         | 11,331 
|Effect of
exchange rate changes on cash                                                                                          |  |  |  |                                         | 29     
|Increase
(decrease) in cash and cash equivalents                                                                                 |  |  |  |                                         | 4,273  
|Cash and cash
equivalents at beginning of period                                                                                 |  |  |  |                                         | 1,134  
|Cash and cash
equivalents at end of period                                                                                       |  |  |  | $                                       | 5,407  
|Supplemental
disclosure of cash flow information:                                                                                |  |  |  |                                         |        
|Cash
payments during the periods for:                                                                                            |  |  |  |                                         |        
|Interest                                                                                                                         |  |  |  | $                                       | 1,026  
|Income
taxes                                                                                                                     |  |  |  | $                                       | 7      
|Non-cash
investing and financing activities                                                                                      |  |  |  |                                         |        
|Stock
consideration for acquisitions:                                                                                            |  |  |  |                                         |        
|WSECI  
issuance of 70,504 and 103,129 shares of common stock                                                                   |  |  |  | $                                       | 71     
|Verilink  issuance of 2,900,000 shares of common stock                                                                          |  |  |  |                                         |       
|Verilink  issuance of 8,765.7122 shares of Class C preferred stock                                                              |  |  |  |                                         |       
|Sentito  Issuance of 7,631,465 shares of common stock                                                                           |  |  |  |                                         | 6,234  
|Issuance of
common stock and warrants in exchange for services                                                                   |  |  |  |                                         |       
|Issuance of
warrants in conjunction with credit facility                                                                         |  |  |  |                                         |        
|Issuance of
common stock for retirement of debt and accrued interest                                                             |  |  |  |                                         |        
|Compensatory
common stock and options issued                                                                                     |  |  |  |                                         | 1,034  
|Issuance of
common stock in lieu of principal                                                                                    |  |  |  |                                         | 2,531  
|Stock issued
for payment of note receivable                                                                                      |  |  |  |                                         | 70     
|Assets
acquired and liabilities assumed in conjunction with business acquisitions:                                               |  |  |  |                                         |        
|Fair value of
assets acquired, excluding cash and restricted cash                                                                |  |  |  |                                         | 6,403  
|Liabilities
assumed                                                                                                              |  |  |  |                                         | (1,038 

Page 4

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



1.
        BASIS OF PRESENTATION




Verso Technologies, Inc., a Minnesota corporation (we, our, us, or the Company), is a global technology company providing next generation communications network solutions offering a core-to-edge product portfolio to service providers and enterprises. Our product offerings include WiMAX, cellular backhaul, voice over broadband, voice over internet protocol (VoIP), integrated access devices, and internet usage solutions which are enabled by our hardware and software. These products enable customers to reduce communications costs, generate additional revenue, and secure and optimize network bandwidth.  We manufacture, deliver, and support these hardware, software, and service solutions primarily to large wireline, cellular, wireless, and satellite carriers and other customers. Our solutions are used by companies in several
industries and government, including mission critical satellite and wireless communications of all kinds.



Our operations include two separate business segments: (i) the Technologies Group, which includes our softswitching, I-Master, and NetPerformer divisions and our subsidiaries, Telemate.Net Software, Inc. (Telemate.Net), Verso Verilink, LLC (Verso Verilink), and sentitO Networks, Inc. (Sentito); and (ii) the Advanced Applications Services Group, which includes our technical applications support group and customer care center. The Technologies Group includes domestic and international sales of hardware and software, integration, applications and technical training and support.  The Technologies Group offers software-based solutions (which include hardware) for customers seeking to build converged packet-based voice and data networks.  In addition, the Technologies Group offers software-based solutions for internet access and usage management that include
call accounting and usage reporting for internet protocol (IP) network devices.  In 2006, the Technologies Group added the product suites from the Verilink Acquisition and the iMarc Acquisition (each defined below).  These products provide access, multiplexing and transport of voice and data services. In addition, these products have enhanced our technology offerings, provided substantial revenue to us, and delivered three large Tier-1 North American customers in AT&T, Inc., Verizon Communications, Inc. and Alcatel-Lucent. The Advanced Applications Services Group includes outsourced technical application services and application installation and training services to both customers of the Technologies Group and outside customers.



On April 17, 2007, we acquired Sentito, a provider of media and signaling gateway equipment to the telecommunications market (the Sentito Acquisition), by means of merger of SN Acquisition Corporation, a wholly-owned subsidiary of ours, into Sentito, pursuant to that certain Agreement and Plan of Merger, dated as of April 4, 2007, (the Merger Agreement).



On December 29, 2006, we purchased certain assets of Paradyne Networks, Inc. (Paradyne) related to the business of manufacturing, selling and supporting the iMarc product line (the iMarc Acquisition).  The iMarc product line is a family of asynchronous transfer mode (ATM), IP service units, and branch monitors that provide intelligent demarcation between carrier and enterprise networks, allowing for easier management.



On June 16, 2006, we acquired all of the outstanding equity interests (the Verilink Acquisition) of Winslow Asset Holdings, LLC (Holdings), now known as Verso Verilink, from Winslow Asset Group, LLC (Group) pursuant to that certain Securities Purchase Agreement dated as of June 15, 2006 among Verso, Holdings and Group (the Securities Purchase Agreement). At the time of the Verilink Acquisition, Holdings assets consisted of substantially all of the business assets of Verilink Corporation and Larscom Incorporated (together, the Verilink Sellers), other than the accounts receivable and certain fixed assets. Holdings assets were used by the Verilink Sellers in their business of developing, manufacturing, marketing, and selling broadband access solutions for computer networks.



In January 2005, we sold substantially all of the operating assets of our NACT Telecommunications, Inc., now known as Provo Pre-Paid (Delaware) Corp. (NACT), and MCK Communications, Inc., now known as Needham (Delaware) Corp. (MCK), businesses to better focus our capital and management resources on areas which we believe have greater potential given our strategies to focus on next-generation network and solutions and to improve cash utilization.  In addition, we disposed of our NACT business due to our new product strategy of an open-standards, pre-paid next-generation solution that could better address growing market opportunities and enable us to offer a competitive product for Tier-1 and Tier-2 carriers.



5



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|1. | BASIS OF PRESENTATION, Continued
|-- | --------------------------------



In March 2005, we acquired the I-Master platform from WSECI, Inc., a Delaware corporation formerly known as Jacksonville Technology Associates, Inc. (WSECI), after forming a strategic partnership with WSECI in the latter half of 2004.  We believe that this I-Master platform permits us to offer a solution that better addresses our growing market opportunities.



The consolidated financial statements include the accounts of Verso Technologies, Inc. and our wholly-owned subsidiaries, including Telemate.Net, Clarent Canada Ltd., now known as Verso Technologies Canada Inc. (Verso Canada), Verso Verilink, Sentito, MCK and NACT. MCK and NACT are reflected in discontinued operations. These subsidiaries were acquired and were all accounted for as purchases (see Note 2).



Certain prior year amounts in the condensed consolidated financial statements have been reclassified to conform with the current year presentation. These reclassifications had no effect on previously reported net losses.



The condensed consolidated quarterly financial statements are unaudited. These statements include all adjustments, including recurring adjustments, considered necessary by management to present a fair statement of the results of our operations, financial position and cash flows. The results reported in these condensed consolidated financial statements should not be regarded as necessarily indicative of results that may be expected for the entire year.



The year-end condensed consolidated balance sheet was derived from audited consolidated financial statements. The accompanying condensed consolidated unaudited quarterly financial statements are presented in accordance with the rules and regulations of the Securities and Exchange Commission (SEC) and do not include all disclosures normally required by accounting principles generally accepted in the United States of America. For further information, refer to the audited consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2006 (the Annual Report).



2.
        MERGERS AND ACQUISITIONS




Acquisition of Sentito



On April 17, 2007, we acquired Sentito, a provider of media and signaling gateway equipment to the
telecommunications market, by means of merger of SN Acquisition Corporation, a wholly-owned subsidiary of ours, into Sentito, pursuant to that certain Agreement and Plan of Merger, dated as of
April 4, 2007, among us, Sentito, SN Acquisition Corporation and Brett Hauser as the Stockholders Agent. As consideration for this merger, we became obligated to issue to the stockholders
of Sentito immediately prior to this merger: (i) an aggregate of 7,631,465 restricted shares of our common stock, par value $.01 per share, of which 984,721 shares are being held in escrow to
satisfy indemnification claims which we may make pursuant to the Merger Agreement and 1,230,902 shares are being held in escrow and will be released upon the completion of certain in-progress
Sentito customer activity; and (ii) five-year warrants to purchase an aggregate of 841,121 shares of common stock with an exercise price of $1.25 per share (the Sentito Warrants).
Furthermore, we may become obligated to issue to the former stockholders of Sentito a number of shares of common stock with an aggregate value of $3.0 million, to be valued at the time of such
issuance, if we recognize revenue of $12.0 million during the twelve-month period following the closing of this merger attributable to the Sentito business or customers (the Contingent
Consideration).



In July 2007, the Company reviewed certain balance sheet criteria as of the acquisition date and as a result of this review determined that Sentito was deficient with respect to such criteria.  As a result, Sentito is required to release 341,213 shares from the 984,721 shares being held in escrow for indemnification claims.  The value of the 341,213 shares returned from escrow was $346,000 and was recorded as a reduction to goodwill and stockholders equity in the Companys consolidated balance sheet at September 30, 2007.



In addition, in October 2007, as a result of the lack of completion of certain in-progress customer activity the Company is entitled to the release of the 1,230,902 shares held in escrow associated therewith and has requested the escrow agent to release such shares.



Pursuant to the Merger Agreement, we may pay such portion of the Contingent Consideration otherwise payable pursuant to the Merger Agreement in cash to the extent necessary to avoid violating the shareholder approval requirements of Marketplace Rule 4350 of The Nasdaq Stock Market, LLC (the Rule). For purposes of complying with the Rule, we have agreed to use commercially reasonable efforts to seek shareholder approval of the issuance in connection with this merger of a number of shares of common stock in excess of 20% of the number of shares of common stock outstanding prior to the execution of the Merger Agreement.



6



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2.
        MERGERS AND ACQUISITIONS, Continued




Acquisition of Sentito  (Continued)



The Sentito Acquisition was recorded under the purchase method of accounting. The total purchase price of $7.4 million consisted of (i) 7,288,451 shares of our common stock, (ii) 841,121 warrants to purchase shares of our common stock with an exercise price of $1.25 per share; and (iii) direct transaction costs of approximately $837,000. A summary of the total purchase consideration is as follows (in thousands):



Value of
common stock issued
     
     
     
     $
     5,652Value of
warrants issued
     
     
     
     
     582Direct
transaction costs
     
     
     
     
     837Total
purchase consideration
     
     
     
     $
     7,071




Under the purchase method of accounting, the total estimated purchase price is allocated to the net tangible and intangible assets based on their estimated fair values as of the date of acquisition. Based on managements estimate of fair values, the estimated purchase price was allocated as follows (in thousands):



Purchase Price AllocationTangible
assets:Cash
     
     
     
     $
     1,706Accounts
receivable
     
     
     
     
     484Inventories
     
     
     
     
     40Other
assets
     
     
     
     
     220Property and
equipment
     
     
     
     
     509Intangible
assets
     
     
     
     
     5,150Liabilities
assumed
     
     
     
     
     (1,038
     )Total
estimated purchase price allocation
     
     
     
     $
     7,071




Acquisition of iMarc Product Line Business



On December 29, 2006, we entered into an Asset Purchase Agreement (the Purchase Agreement) with Paradyne and, for certain limited purposes, Zhone Technologies, Inc., Paradynes parent (Zhone), pursuant to which we (i) purchased certain assets from, and assumed certain liabilities of, Paradyne relating to its business (the iMarc Business) of manufacturing, selling and supporting the iMarc product line for an aggregate purchase price of $2.5 million and (ii) agreed to purchase certain other remaining assets relating to the iMarc Business as provided in the Purchase Agreement. Since July 1, 2006, Verso Verilink has served pursuant to a Reseller Agreement (the Reseller Agreement) as a non-exclusive reseller within the United States for certain Zhone products. The amount of consideration paid by us pursuant to the Purchase Agreement was
determined as a result of arms length negotiations between us, Zhone and Paradyne.



The iMarc product line is closely aligned with our portfolio and distribution model, which we expanded as a result of the Verilink Acquisition. In particular, the iMarc product line strengthens our access offerings, substantially expands our Tier-1 customer base, and is complementary to the Verso Verilink WanSuite® product line. Prior to the iMarc Acquisition, we served as a reseller of Zhone products and therefore have a strong existing knowledge of the products and market, as well as long-term relationships with relevant senior management.



Pursuant to the Purchase Agreement, on December 29, 2006, we acquired from Paradyne certain engineering equipment and service contracts relating to the iMarc Business, assumed from Paradyne certain liabilities relating to the iMarc Business as specified in the Purchase Agreement and paid to Paradyne $1.0 million in cash in connection with the foregoing. We utilized our borrowing availability under our existing credit facility with Laurus Master Fund, Ltd., our primary lender (Laurus), to fund the $1.0 million paid on such date.



7



---



2.
        MERGERS AND ACQUISITIONS, Continued




Acquisition of iMarc product line business  (Continued)



On December 29, 2006, the Company and Paradyne also entered into (i) a license agreement pursuant to which Paradyne licensed to us rights to certain intellectual property relating to the iMarc Business on an exclusive basis (the Transferred IP) through January 19, 2007, and rights to certain other intellectual property relating to the iMarc Business on a non-exclusive basis for perpetuity (provided that we completed the purchase of the Transferred IP from Paradyne as provided in the Purchase Agreement) and (ii) an Adaptation of Reseller Agreement which modifies and supplements the Reseller Agreement to provide that Paradyne shall provide certain contract manufacturing services to us with respect to the iMarc products through June 30, 2007.



After the closing date, the Company, Zhone and Paradyne amended the Purchase Agreement by entering into Amendment No. 1 and Amendment No. 2 thereto on January 25, 2007 and February 7, 2007, respectively.  Pursuant to the Purchase Agreement, as amended, we agreed to pay Paradyne $1,250,000 in exchange for the assignment to us of the Transferred IP, of which $1.0 million was payable, and was paid, on January 31, 2007 and $250,000 was payable, and was paid, on March 31, 2007.  Upon receiving the payment on March 30, 2007, Paradyne assigned the Transferred IP to us. In accordance with the terms of Amendment No. 2 to the Purchase Agreement, we paid to Paradyne $250,000 on June 28, 2007 in exchange for Paradynes sale to us of certain manufacturing equipment previously required to be sold in connection with the payment for the Transferred IP. In addition, on June 28, 2007, we
purchased inventory related to the iMarc business totaling $315,000. Amendment No. 2 to the Purchase Agreement also amended the terms of the covenant not to compete to which Zhone and Paradyne (and their respective controlled affiliates) are bound in light of the amended payment terms described above.



The iMarc Acquisition was recorded under the purchase method of accounting, and the estimated purchase price was allocated based on the fair value of the assets acquired and liabilities assumed. The total purchase price of $2,575,000 consisted of (i) $1.0 million in cash at closing; (ii) three installments totaling $1.5 million; $1.0 million and $250,000 paid January 31, 2007, March 31, 2007, and June 28, 2007, respectively; and (iii) direct transaction costs of approximately $75,000. A summary of the total purchase consideration is as follows (in thousands):



Cash
paid
     
     
     
     $
     2,500Direct
transaction costs
     
     
     
     
     75Total
purchase consideration
     
     
     
     $
     2,575




Under the purchase method of accounting, the total estimated purchase price is allocated to the net tangible and intangible assets based on their estimated fair values as of the date of acquisition. Based on managements estimate of fair values, the estimated purchase price was allocated as follows (in thousands):



Purchase Price AllocationTangible
assets:Property
& equipment, net
     
     
     
     $
     180Other
assets
     
     
     
     
     15Goodwill
     
     
     
     
     710Other
intangible assets- customer relationship
     
     
     
     
     1,900Liabilities
assumed
     
     
     
     
     (230
     )Total
estimated purchase price allocation
     
     
     
     $
     2,575






8



---



2.
        MERGERS AND ACQUISITIONS, Continued




Acquisition of Business Assets of Verilink



On June 16, 2006, as a result of the Verilink Acquisition, we acquired substantially all of the business assets of the Verilink Sellers other than accounts receivable and certain fixed assets, and assumed certain liabilities, and issued (i) 2,900,000 shares of our common stock, and (ii) 8,766 shares of our newly-designated Series C preferred stock, which were subsequently converted in November 2006 into 2,900,000 shares of common stock. The Verilink Acquisition bolstered our product offerings and added several domestic Tier-1 relationships. The Verilink product suite includes products that provide access, multiplexing, and transport of voice and data services that extend legacy networks as well as next generation converged access solutions that deliver voice, data and video to business customers.



The Verilink Acquisition was recorded under the purchase method of accounting, and the estimated purchase price was allocated based on the fair value of the assets acquired and liabilities assumed. The total purchase price of $5,906,000 consisted of (i) 2,900,000 shares of our common stock issued upon consummation of the Verilink Acquisition and valued at approximately $2,784,000, using a fair value per share of $0.96; (ii) 8,766 shares of our Series C preferred stock issued upon consummation of the Verilink Acquisition and valued at approximately $2,784,000, which equaled the fair value of the common stock because the preferred shares were automatically convertible into 2,900,000 common shares upon the effectiveness of an amendment to our Articles of Incorporation to increase the number of our authorized shares of common stock to 120,000,000; and (iii) direct transaction costs of
approximately $338,000. The fair value of our common stock issued was determined using the eleven-trading-day average price surrounding the date the assets were sold by the Verilink Sellers (June 15, 2006). A summary of the total purchase consideration is as follows (in thousands):



Value of
common stock issued
     
     
     
     $
     2,784Value of
Series C preferred stock issued
     
     
     
     
     2,784Direct
transaction costs
     
     
     
     
     338Total
purchase consideration
     
     
     
     $
     5,906




We acquired the Verilink business assets as a result of the acquisition of Holdings, which acquired the business assets directly from the Verilink Sellers on June 15, 2006. In connection with the acquisition, Group appointed us as sole collection agent for the Verilink receivables that Group retained. In connection with this collection arrangement, we receive a collection fee equal to 50% of the initial $750,000 of Verilink receivables we collect and 25% of the remaining Verilink receivables that we collect. As of September 30, 2007, we had earned approximately $629,000 in collection fees upon collection of Verilink receivables. Such collection fees have been recorded as part of the net assets acquired. Under the purchase method of accounting, the total estimated purchase price is allocated to the net tangible and intangible assets based on their estimated fair values as of the date of
acquisition. Based on managements estimate of fair values, the estimated purchase price was allocated as follows (in thousands):



Purchase Price AllocationTangible
assets:Inventories
     
     
     
     $
     3,664Property
& equipment, net
     
     
     
     
     499Other
assets
     
     
     
     
     294Intangible
assets
     
     
     
     
     2,041Liabilities
assumed
     
     
     
     
     (592
     )Total
estimated purchase price allocation
     
     
     
     $
     5,906






9



---



2.
        MERGERS AND ACQUISITIONS, Continued




Acquisition of Assets ofWSECI, Inc.



On March 31, 2005, we acquired substantially all of the operating assets of WSECI pursuant to the Asset Purchase Agreement (WSECI Asset Purchase Agreement) dated as of February 23, 2005, by and among us, WSECI and all of the shareholders of WSECI.  WSECI is a provider of an internet protocol-based, revenue assurance platform which enables the deployment of multiple voice and next-generation services to the carrier market.  The fair value of the initial acquisition cost was approximately $1.1 million, consisting of 190,000 shares of our common stock with a fair value of $331,000, $50,000 in cash, the payment of certain liabilities of approximately $613,000, and acquisition costs of approximately $114,000.  The acquisition was accounted for as a purchase.



Pursuant to the WSECI Asset Purchase Agreement, we became obligated to issue to WSECI additional contingent consideration of $269,000 based on the sales of certain WSECI products and services. The contingent consideration was payable in cash or shares of our common stock at our election. Through the year ended December 31, 2006, under this provision, we issued an additional 139,136 shares of our common stock with a fair value of $199,000.  In addition, during the nine months ended September 30, 2007, under this provision, we issued an additional 62,950 shares of our common stock with a fair value of $70,000. The additional shares issued were recorded as an increase in other intangibles-current technology which is being amortized over the remaining estimated life of the original purchased technology.



The adjusted allocation of the costs of the acquisition of WSECI (initial cost plus contingent payments) is as follows (in thousands):






|                       |  |  |  | WSECI
|---------------------- |  |  |  | -----
|Property and
equipment |  |  |  | $    
|Accounts
receivable    |  |  |  |      
|Other
intangibles      |  |  |  |      
|Cost of
acquisition    |  |  |  | $    

The following unaudited pro forma information presents the results of our continuing operations as if the Verilink Acquisition, iMarc Acquisition and the Sentito Acquisition had taken place on January 1, 2006. Certain adjustments have been made to reflect the impact of the purchase transaction. These pro forma results have been prepared for comparative purposes only and are not indicative of what would have occurred had the acquisition been made at the beginning of the respective periods, or of the results which may occur in the future (in thousands, except per share amounts):



Three Months Ended
     
     Nine Months EndedSeptember 30, 2007
     
     September 30, 2006
     
     September 30, 2007
     
     September 30, 2006Net
sales
     
     
     
     $
     13,136
     
     
     $
     16,483
     
     
     $
     38,434
     
     
     $
     46,800Net
loss
     
     
     
     $
     (5,007
     )
     
     $
     (6,075
     )
     
     $
     (19,208
     )
     
     $
     (26,887
     )Earnings
(loss) per share, basic
     
     
     
     $
     (0.09
     )
     
     $
     (0.13
     )
     
     $
     (0.34
     )
     
     $
     (0.59
     )Earnings
(loss) per share, diluted
     
     
     
     $
     (0.09
     )
     
     $
     (0.13
     )
     
     $
     (0.34
     )
     
     $
     (0.59
     )






10



---



|3. | EQUITY INVESTMENT
|-- | -----------------



On October 1, 2002, we acquired a 51% interest in Shanghai BeTrue Infotech Co., Ltd. (BeTrue). The remaining 49% interest in BeTrue is owned by Shanghai Tangsheng Investments & Development Co. Ltd (Shanghai Tangsheng). The joint venture provides us with a distribution channel in China and the Asia-Pacific region for our application-based VoIP gateway solutions, billing systems, value-added applications and web filtering solutions. Due to the shared decision making between us and our equity partner, the results of BeTrue are treated as an equity investment rather than being consolidated. We evaluate our investments in partially owned entities in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 46 (R), Consolidation of Variable Interest Entities (FIN 46(R)) If the investment is a Variable
Interest Entity or a VIE and we are the primary beneficiary, as defined by FIN 46 (R), we account for such interest as if it were a consolidated subsidiary. We have determined that BeTrue is not a VIE.



We purchased the 51% interest in BeTrue for $100,000 from NeTrue Communications, Inc., Shanghai Tangshengs former joint venture partner. We also contributed to the joint venture certain next generation communication equipment and software valued at approximately $236,000 and cash in the amount of $100,000.



Summarized financial information reported by this affiliate for the three and nine months ended September 30, 2007 and 2006, respectively, are as follows (in thousands):






|                   |  |  |  | Three months endedSeptember 30, |     |   |  | Nine months ended September 30, |    
|------------------ |  |  |  | ------------------------------- | --- | - |  | ------------------------------- | ---
|
|Operating
results: |  |  |  |                                 |     |   |  |                                 |    
|Revenues           |  |  |  | $                               |    |   |  | $                               | 206
|Operating
loss     |  |  |  | $                               | (73 | ) |  | $                               | (39
|Net
loss           |  |  |  | $                               | (73 | ) |  | $                               | (39

4.
        DISCONTINUED OPERATIONS




In January 2005, we sold substantially all of the operating assets of our NACT and MCK businesses to better focus our capital and management resources on areas which we believe have greater potential given our strategy to focus on next-generation network solutions and to improve cash utilization. In addition, we disposed of our NACT business because we wanted to move toward an open-standards, pre-paid next-generation solution that could better address growing market opportunities and enable us to offer a competitive product for Tier-1 and Tier-2 carriers. We believe that the I-Master platform which we acquired from WSECI in March 2005, after forming a strategic partnership with WSECI in the latter half of 2004, permits us to offer a better solution. Further, we disposed of our MCK business because we intend to focus on next-generation solutions for service providers and the MCK products
did not fit that profile. The operations of NACT and MCK businesses have been reclassified as discontinued operations in our consolidated financial statements.



Assets and liabilities of discontinued operations (in thousands) are as follows:






|                                        |  |  |  | September 30,2007 |       | December 31,2006
|--------------------------------------- |  |  |  | ----------------- | ----- | ----------------
|
|Notes
receivable                        |  |  |  | $                 |      |                 
|Liabilities of
discontinued operations: |  |  |  |                   |       |                 
|Accrued
rent                            |  |  |  |                   | 801   |                 
|Other current
liabilities               |  |  |  |                   | 506   |                 
|Liabilities of
discontinued operations  |  |  |  | $                 | 1,307 |                 



11



---



4.
        DISCONTINUED OPERATIONS, Continued




In connection with the disposition of the MCK business, CITEL Technologies Limited (Citel U.K.) and CITEL Technologies, Inc. (Citel U.S. and together with CITEL U.K., CITEL) issued to us a convertible secured promissory note in principal amount of $3,500,000 (the Note). The outstanding principal under the Note accrued interest at an annual rate of 6%. Under certain circumstances described in the Note, all or any portion of the principal outstanding under the Note could be converted at our option into shares of the capital stock of Citel U.K. CITELs obligations under the Note are secured by a security interest in certain assets sold to CITEL.



On June 30, 2006, in connection with the completion of the admission (Admission) of Citel U.K.s entire issued share capital to the AIM market of the London Stock Exchange plc (AIM), the Company and CITEL amended the Note such that the principal balance of the Note became due and payable as follows: $870,000 to be paid within one business day of Admission, followed by six monthly installments of $75,000 commencing 12 months from the date of Admission, and all remaining outstanding principal and accrued interest under the Note being due and payable on January 21, 2008. The $870,000 was received in July, 2006. We agreed to irrevocably waive our rights to be prepaid on the Note in accordance with the terms of the Note as a result of (and limited to the transactions associated with) the Admission; however, the waiver given by us did not waive any subsequent right
to be prepaid under the Note in accordance with its terms.



On May 25, 2007, we entered into an agreement with CITEL and Citel PLC pursuant to which CITEL prepaid the Note, by making an immediate cash payment to us of approximately $1.9 million. In addition, Citel PLC was required to issue to us 62,424 shares of Citel PLCs capital stock (the Citel Shares), which Citel Shares had a market value of approximately $70,000 as of May 24, 2007 and, based upon representations made by CITEL to us, are fully tradable on the AIM market of the London Stock Exchange. We have agreed not to sell or transfer the Citel Shares prior to January 21, 2008, the original maturity date of the Note. Upon receipt of the prepayment and the Citel Shares, we canceled the Note and released our security interest in the collateral securing the Note. Prior to entering into this agreement, approximately $2.2 million of principal and interest was outstanding under
the Note. We recognized a loss of approximately $231,000 associated with the write-off of interest arising from the prepayment transaction.



Accrued rent relates primarily to several leases for buildings and equipment that are no longer being utilized in continuing operations. The accrual is for all remaining payments due on these leases, less estimated amounts to be paid by any sublessors. The accrual contains one lease with total payments remaining through January 31, 2010 of $984,000 and assumes that the building will be sub-leased for approximately 58% of the total lease liability over the remaining term of the lease.



The activity in the liabilities of discontinued operations (in thousands) for the three and nine months ended September 30, 2007 and 2006 was as follows:






|                                         |  |  |  | Three months ended Sept. 30, |       | Nine months ended Sept. 30, | 
|---------------------------------------- |  |  |  | ---------------------------- | ----- | --------------------------- | 
|
|Balance
beginning of period              |  |  |  | $                            | 1,364 |                             | 
|Lease
payments, net of sublease receipts |  |  |  |                              | 31    |                             | 
|Other
payments                           |  |  |  |                              | (63   | )                           | 
|Legal and
other costs of disposal        |  |  |  |                              | (25   | )                           | 
|Balance end
of period                    |  |  |  | $                            | 1,307 |                             | 



12



---



|5. | INVENTORIES
|-- | -----------



Inventories consist primarily of purchased electronic components, and are stated at the lower of cost or market. Cost is determined by using average cost. Inventories as of September 30, 2007 and December 31, 2006 are comprised of the following (in thousands):






|                  |  |  |  | September 30,2007 |       | December 31, 2006
|----------------- |  |  |  | ----------------- | ----- | -----------------
|Raw
materials     |  |  |  | $                 | 4,638 |                  
|Work in
process   |  |  |  |                   | 86    |                  
|Finished
goods    |  |  |  |                   | 1,581 |                  
|Total
Inventories |  |  |  | $                 | 6,305 |                  

On July 18, 2006, we entered into an agreement (the CM Agreement) with CM Solutions, Inc. (CM), the contract manufacturer of our Verilink product line. Pursuant to the CM Agreement, CM has purchased certain electrical components valued at $2.0 million from us for use in the manufacture of finished goods to be purchased by us. In addition, we have agreed to assign to CM an additional amount of unused electrical components valued at $2.0 million for which title will remain with us. We have an obligation under the CM Agreement to purchase during the first two years, products assembled by CM using electrical components valued at $2.0 million (the Assembled Products). Furthermore, we have agreed to submit purchase orders to CM in a minimum amount of $2.0 million per quarter for the next three years or until the obligation to purchase the
Assembled Products has been satisfied.



In connection with executing the CM Agreement, the Company and CM entered into a three-year Manufacturing Agreement which sets forth the terms and conditions under which CM shall manufacture the Assembled Products. As of September 30, 2007, CM had used $1,582,000 of electrical components in the manufacture of the Assembled Products, reducing the outstanding commitment to utilize $2.0 million of electrical components in the first two years of the agreements to approximately $418,000 which reduced the inventory currently assigned to CM to approximately $418,000. The remaining assigned inventory is reflected as inventory on the consolidated balance sheets as of September 30, 2007. The assigned inventory is not eligible for inclusion in the borrowing base under our credit agreement with Laurus.



The inventory amounts above are net of inventory reserves of $2.1 million at September 30, 2007 and $1.7 million at December 31, 2006.





13



---



6.
        GOODWILL AND OTHER INTANGIBLES




Intangible assets represent the excess of cost over the fair value of net tangible assets acquired and identified other intangible assets which consist of current technology and customer relationships which are amortized on a straight-line basis over their estimated useful life.Goodwill associated with acquisitions is not being amortized in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.








|                                        |  |  |  | AmortizationPeriod inmonths |  | September 30,2007 |        | December 31,2006
|--------------------------------------- |  |  |  | --------------------------- |  | ----------------- | ------ | ----------------
|                                        |  |  |  |                             |  |                   |        |                 
|Intangibles
subject to amortization:    |  |  |  |                             |  |                   |        |                 
|Current
technology                      |  |  |  | 36
months                   |  | $                 | 5,098  |                 
|Customer
relationship                   |  |  |  | 36-120 months               |  |                   | 6,344  |                 
|Weighted
average months                 |  |  |  | 36 months                   |  |                   | 11,442 |                 
|Accumulated
amortization:               |  |  |  |                             |  |                   |        |                 
|Current
technology                      |  |  |  |                             |  |                   | (2,395 | )               
|Customer
relationship                   |  |  |  |                             |  |                   | (2,181 | )               
|Net
intangibles subject to amortization |  |  |  |                             |  |                   | 6,866  |                 
|Goodwill                                |  |  |  |                             |  |                   | 5,675  |                 
|Total
goodwill and other intangibles    |  |  |  |                             |  | $                 | 12,541 |                 



7.
        LOAN FACILITIES




Our credit facility with Laurus consists of two tranches: (i) an $8.0 million tranche, the availability of which is subject to a borrowing base (Tranche A) and (ii) a $6.0 million tranche, of which $5.0 million is outstanding and the remainder of which is no longer available as a result of scheduled availability reduction by $187,500 per month beginning in Februrary 2007 (Tranche B). Borrowing availability under Tranche B is not subject to a borrowing base. Borrowing ability under Tranche A is determined pursuant to a formula which is based on the value of our eligible accounts receivables and inventory.  Borrowings under Tranche A accrue interest at a rate of prime rate plus 2%, provided that the interest rate shall not be less than 9% (9.75% at September 30, 2007). Borrowings under Tranche B accrue interest at a fixed rate of 15%.
Borrowings under the credit facility shall be made first under Tranche B to the extent of availability thereunder and then under Tranche A to the extent of availability thereunder.



As of September 30, 2007, we had outstanding borrowings including interest under Tranche A and Tranche B of $5,890,000 and $4,500,000, respectively. The remaining borrowing availability under the credit facility at September 30, 2007 was $2.1 million under Tranche A and $0 under Tranche B.



On December 29, 2006, in connection with the iMarc Acquisition, Laurus expanded our borrowing availability of Tranche B from $4.0 million to $5.0 million despite that we had not satisfied the EBITDA conditions. In connection with such increase, we issued a warrant to purchase 330,470 shares of common stock at an exercise price of $0.91 per share on December 29, 2006. This amount represents half of the additional warrants that are available under the terms of the credit facility and are issuable upon the earlier of (i) the date which is 18 months after the date of the closing of the credit facility and (ii) the date upon which the borrowing availability under Tranche B equals $6.0 million (without regard to the monthly deductions thereto commencing on February 1, 2007). Additionally, a perpetual warrant to purchase 150,000 shares of common stock at an exercise price of $0.01 per
share was issued in connection with this event.



14



---



7.
        LOAN FACILITIES, Continued




On July 3, 2007, August, 2, 2007, and September 4, 2007 Laurus was issued  65,943 shares,
442,716 shares, and 230,680 shares, respectively, of common stock  from the cashless exercise of  warrants with an exercise price of $0.01 per share .



Our obligations under the credit facility are secured by a first priority security interest in all of our assets and a pledge of all of the outstanding equity interests of Telemate.Net, Verso Verilink and Sentito.



Loan issuance costs are recognized in accordance with FASB Accounting Principles Board Opinion 21, Interest on Receivables and Payables, and are recorded as a deferred charge and included in prepaid loan issuance costs on our balance sheet.  We amortize these costs over the original term of the notes.  Amortization is calculated based on the interest method or straight line method based on an allocation of the costs over the relative fair values of the line of credit and term debt. During the three and nine months ended September 30, 2007 and 2006, we recorded interest expense from the amortization of the loan issuances costs of approximately $277,000 and $27,000 and $828,000 and $75,000, respectively. The unamortized loan issuance costs associated with the credit facility totaled approximately $1.9 million at September 30, 2007.



15



---





8.
        CONVERTIBLE DEBENTURES




Senior Unsecured Convertible Debentures



On February 4, 2005, we completed a private placement of senior unsecured convertible debentures and warrants pursuant to a securities purchase agreement with certain institutional investors. We issued $13,500,000 of senior unsecured convertible debentures, Series A warrants exercisable for 2,200,000 shares of our common stock and Series B warrants exercisable for 2,000,000 shares of our common stock. In connection with the private placement, we received net proceeds of approximately $12,500,000, including $1,600,000 in restricted cash, net of expenses. The debentures have been discounted to reflect the fair value of the warrants issued, totaling approximately $4,500,000. In addition, after allocation of the fair value of the warrants issued, the remaining fair value of the debentures resulted in a computed beneficial conversion feature with a fair value of $3,600,000. The amount was
recorded as a discount in the third quarter of 2005 as a result of additional analysis of the calculation of the beneficial conversion feature.



The discount is being amortized to interest expense over the life of the senior unsecured convertible debentures. The unamortized discount totaled approximately $2.2 million at September 30, 2007. The senior unsecured convertible debentures bear interest at a rate of 6.75%, are due February 2009 and are convertible into approximately 5,400,000 shares of our common stock at an initial conversion price of $2.50 per share, subject to anti-dilution adjustments and certain limitations. Interest is payable on a quarterly basis and principal became payable on a quarterly basis beginning in August 2006. The Series A warrants issued in connection with the private placement are exercisable for a period of five years commencing on February 4, 2005 and at an initial exercise price of $3.60 per share.



The Series B warrants issued in connection with the private placement were exercisable for a period of 90 days, commencing on June 16, 2005, and had an exercise price of $3.90 per share. The Series B warrants expired in September 2005. We paid certain private placement fees and attorneys fees totaling $993,000 and issued Series A warrants, on the same terms as disclosed above, exercisable for 302,400 shares of our stock with a value of $561,000, in connection with the private placement. The fees were recorded as loan issuance fees and are being amortized to interest expense over the term of the debentures. The unamortized fees totaled approximately $395,000 at September 30, 2007.



9.
        OTHER COMPREHENSIVE LOSS




Comprehensive loss for the three and nine months ended September 30, 2007 and 2006 is shown in the following table (in thousands):






|                             |  |  |  | Three months ended September 30, |        | Nine months ended September 30, | 
|---------------------------- |  |  |  | -------------------------------- | ------ | ------------------------------- | 
|
|Net
loss                     |  |  |  | $                                | (5,007 | )                               | 
|Other
comprehensive loss:    |  |  |  |                                  |        |                                 | 
|Foreign
currency translation |  |  |  |                                  | 21     |                                 | 
|Comprehensive
loss           |  |  |  | $                                | (4,986 | )                               | 



16



---



10.
        SEGMENT INFORMATION




We report on information for two segments, the Technologies Group and the Advanced Applications Services Group. Management evaluates the business segment performance based on contributions before unallocated items.  Inter-segment sales and transfers are not significant.



Technologies Group:


The Technologies Group includes our softswitching, I-Master, and NetPerformer divisions and our subsidiaries, Telemate.Net, Verso Verilink and Sentito. The Technologies Group includes domestic and international sales of hardware and software, integration, applications and technical training and support.  The Technologies Group offers software-based solutions (which include hardware) for companies seeking to build private, converged packet-based voice and data networks.  In addition, the Technologies Group offers software-based solutions for Internet access and usage management that include call accounting and usage reporting for IP network devices.  In 2006, the Technologies Group added the product suites from the Verilink Acquisition and the iMarc Acquisition.  These products provide access, multiplexing and transport of voice and data services.  In 2007, the Technologies Group added the
products and technology from the Sentito Acquisition.



Advanced Applications Services Group:


Our Advanced Applications Services Group consists of our technical applications support group and includes outsourced technical application services and application installation and training services to both customers of the Technologies Group and outside customers.



Summarized financial information concerning our reportable segments for the three months ended September 30, 2007 and 2006 is shown in the following table (in thousands):






|                                              |  |  |  | TechnologiesGroup |        | AdvancedApplicationServices Group |  | Total
|--------------------------------------------- |  |  |  | ----------------- | ------ | --------------------------------- |  | -----
|For the
Three Months Ended September 30, 2007 |  |  |  |                   |        |                                   |  |      
|Revenue                                       |  |  |  | $                 | 11,543 |                                   |  | $    
|(Loss)
contribution before unallocated items  |  |  |  |                   | (418   | )                                 |  |      
|                                              |  |  |  |                   |        |                                   |  |      
|At
September 30, 2007                         |  |  |  |                   |        |                                   |  |      
|Goodwill                                      |  |  |  |                   | 4,222  |                                   |  |      
|Total
assets                                  |  |  |  |                   | 28,000 |                                   |  |      
|                                              |  |  |  |                   |        |                                   |  |      
|For the
Three Months Ended September 30, 2006 |  |  |  |                   |        |                                   |  |      
|Revenue                                       |  |  |  |                   | 11,470 |                                   |  |      
|(Loss)
contribution before unallocated items  |  |  |  |                   | (484   | )                                 |  |      
|                                              |  |  |  |                   |        |                                   |  |      
|At
December 31, 2006                          |  |  |  |                   |        |                                   |  |      
|Goodwill                                      |  |  |  |                   | 1,771  |                                   |  |      
|Total
assets                                  |  |  |  |                   | 23,168 |                                   |  |      



17



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10.
        SEGMENT INFORMATION, Continued




The following table reconciles the contribution before unallocated items to the loss before discontinued operations for the three months ended September 30, 2007 and 2006 (in thousands):






|                                              |  |  |  | Three months ended September 30, |       
|--------------------------------------------- |  |  |  | -------------------------------- | ------
|
|Loss before
unallocated items, per above      |  |  |  | $                                | (323  
|Corporate
general and administrative expenses |  |  |  |                                  | (1,638
|Corporate
research and development            |  |  |  |                                  | (42   
|Depreciation and
amortization                 |  |  |  |                                  | (708  
|Stock based
compensation                      |  |  |  |                                  | (351  
|Reorganizaton
expense                         |  |  |  |                                  | (362  
|Other                                         |  |  |  |                                  | (1,583
|Loss from
continuing operations               |  |  |  | $                                | (5,007

Summarized financial information concerning our reportable segments for the nine months ended September 30, 2007 and 2006 is shown in the following table (in thousands):








|                                             |  |  |  | TechnologiesGroup |        | AdvancedApplicationServices Group |  | Total
|-------------------------------------------- |  |  |  | ----------------- | ------ | --------------------------------- |  | -----
|For the
Nine Months Ended September 30, 2007 |  |  |  |                   |        |                                   |  |      
|Revenue                                      |  |  |  | $                 | 32,558 |                                   |  | $    
|(Loss)
contribution before unallocated items |  |  |  |                   | (2,972 | )                                 |  |      
|                                             |  |  |  |                   |        |                                   |  |      
|For the
Nine Months Ended September 30, 2006 |  |  |  |                   |        |                                   |  |      
|Revenue                                      |  |  |  |                   | 23,008 |                                   |  |      
|(Loss)
contribution before unallocated items |  |  |  |                   | (3,127 | )                                 |  |      



The following table reconciles the contribution before unallocated items to the loss before discontinued operations for the nine months ended September 30, 2007 and 2006 (in thousands):






|                                              |  |  |  | Nine months ended September 30, |        
|--------------------------------------------- |  |  |  | ------------------------------- | -------
|
|Loss before
unallocated items, per above      |  |  |  | $                               | (2,242 
|Corporate
general and administrative expenses |  |  |  |                                 | (5,470 
|Corporate
research and development            |  |  |  |                                 | (103   
|Depreciation and
amortization                 |  |  |  |                                 | (2,070 
|Stock based
compensation                      |  |  |  |                                 | (885   
|Reorganization
expense                        |  |  |  |                                 | (751   
|Other                                         |  |  |  |                                 | (4,963 
|Loss from
continuing operations               |  |  |  | $                               | (16,484





18



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10.
        SEGMENT INFORMATION, Continued




The following table reconciles the segments total assets to our total assets (in thousands):








|                                                 |  |  |  | September 30,2007 |        | December 31, 2006
|------------------------------------------------ |  |  |  | ----------------- | ------ | -----------------
|Total assets
before unallocated items, per above |  |  |  | $                 | 31,473 |                  
|Corporate
assets:                                |  |  |  |                   |        |                  
|Cash and cash
equivalents                        |  |  |  |                   | 5,407  |                  
|Restricted
cash                                  |  |  |  |                   | 503    |                  
|Current
portion of notes receivable              |  |  |  |                   |       |                  
|Other current
assets                             |  |  |  |                   | 274    |                  
|Property and
equipment, net                      |  |  |  |                   | 576    |                  
|Loan issuance
costs                              |  |  |  |                   | 2,277  |                  
|Investment                                       |  |  |  |                   | 629    |                  
|Notes
receivable, net of current portion         |  |  |  |                   |       |                  
|                                                 |  |  |  | $                 | 41,139 |                  



Following the acquisition of substantially all the operating assets along with certain liabilities of Clarent Corporation in February 2003, we began conducting research and development in Canada. International sales of our products and services continue to originate only from the United States. The geographic distribution of our revenue and contribution before unallocated items (in thousands) are as follows:






|                                              |  |  |  | Canada |        | United States |  | Total |       
|--------------------------------------------- |  |  |  | ------ | ------ | ------------- |  | ----- | ------
|For the Three
Months ended September 30, 2007 |  |  |  |        |        |               |  |       |       
|Revenue                                       |  |  |  | $      |       |               |  | $     | 13,136
|(Loss)
contribution before unallocated Items  |  |  |  |        | (1,025 | )             |  |       | 702   
|                                              |  |  |  |        |        |               |  |       |       
|For the Three
Months ended September 30, 2006 |  |  |  |        |        |               |  |       |       
|Revenue                                       |  |  |  |        |       |               |  |       | 13,352
|Loss before
unallocated Items                 |  |  |  |        | (1,146 | )             |  |       | 738   
|                                              |  |  |  |        |        |               |  |       |       
|For the Nine
Months ended September 30, 2007  |  |  |  |        |        |               |  |       |       
|Revenue                                       |  |  |  |        |       |               |  |       | 38,191
|(Loss)
contribution before unallocated Items  |  |  |  |        | (3,272 | )             |  |       | 1,030 
|                                              |  |  |  |        |        |               |  |       |       
|For the Nine
Months ended September 30, 2006  |  |  |  |        |        |               |  |       |       
|Revenue                                       |  |  |  |        |       |               |  |       | 28,251
|Loss before
unallocated Items                 |  |  |  |        | (3,720 | )             |  |       | 868   
|                                              |  |  |  |        |        |               |  |       |       
|At September
30, 2007                         |  |  |  |        |        |               |  |       |       
|Total
Assets                                  |  |  |  |        | 321    |               |  |       | 40,818
|                                              |  |  |  |        |        |               |  |       |       
|At December
31, 2006                          |  |  |  |        |        |               |  |       |       
|Total
Assets                                  |  |  |  |        | 551    |               |  |       | 36,298



19



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|11. | REORGANIZATION COSTS
|--- | --------------------



In the third  quarter  of 2007,  we  initiated  certain  restructuring  plans to
improve operational  efficiencies and financial  performance and eliminated several
positions  held  by  employees.  As  a  result  of  these  actions  we  recorded
reorganization  costs of $362,000  during the quarter ended  September 30, 2007,
which included  severance and compensation costs of $275,000 and $87,000 related
to the closing of an office location in Acton, Massachusetts.



In the second quarter of 2007, we terminated a senior executive. As a result of this action, we recorded reorganization costs of $389,000 representing our severance obligation.



In the second quarter of 2005, we entered into a sublease agreement with an unrelated party to sublease excess office space at our facility in Atlanta, Georgia.  The excess space was primarily due to reductions in the corporate staffing in prior years.  As a result of these actions, we recorded an accrual of approximately $2,600,000 for all remaining payments due on this lease, less amounts to be paid by the sublessor, as well as write-offs for furniture and leasehold improvements. We expect to save approximately $1.6 million over the term of the sublease, which expires January 31, 2010.  The balance of the accrued loss on sublease is approximately $1.0 million at September 30, 2007.



12.
        STOCK OPTIONS AND WARRANTS




We have a stock incentive plan for employees, members of the board of directors, consultants, and other individual contributors to the Company which enables us to grant, as of September 30, 2007, up to 7,000,000 qualified and nonqualified incentive stock options as well as other stock-based awards. In addition, in connection with various financing and acquisition transactions, and for services provided to us, we have issued warrants to purchase our common stock. A summary of stock options and warrants outstanding at September 30, 2007 is as follows:



OPTIONS AND WARRANTS ISSUED TO EMPLOYEES






|             |  |  | 
|------------ |  |  | 
|
|$0.78$1.45  |  |  | 
|$1.46$2.50  |  |  | 
|$2.51$5.30  |  |  | 
|$5.31$7.50  |  |  | 
|$7.51$90.00 |  |  | 
|Total        |  |  | 



Options and warrants issued to employees generally terminate ten years from the date of grant. Termination dates for the options and warrants listed above range from January 3, 2008 to July 5, 2017.



20



---



|12. | STOCK OPTIONS AND WARRANTS, Continued
|--- | -------------------------------------



A summary of the status of stock options and warrants granted to employees, directors and consultants as of  September  30, 2007, and the changes during the nine months ended September 30, 2007 is presented below:








|                                   |  |  |  | Number ofShares ofUnderlyingOptions |           | Weighted Average Exercise Prices
|---------------------------------- |  |  |  | ----------------------------------- | --------- | --------------------------------
|Outstanding at
beginning of period |  |  |  |                                     | 4,638,493 |                                 
|Granted                            |  |  |  |                                     | 600,000   |                                 
|Exercised                          |  |  |  |                                     |          |                                 
|Forfeited                          |  |  |  |                                     | (960,000  | )                               
|Expired                            |  |  |  |                                     | (446,245  | )                               
|Outstanding at
end of period       |  |  |  |                                     | 3,832,248 |                                 
|Exercisable at
end of period       |  |  |  |                                     | 1,894,748 |                                 

The weighted  average grant date fair value for options granted during the three
and  nine  months   ended   September   30,  2007  was  $257,000  and   $346,000,
respectively.



A summary of warrants issued primarily in connection with financing transactions is as follows:













|Exercise Price |  |  |  | Outstanding Warrants |            | Exercise Price |  | Expiration Date
|-------------- |  |  |  | -------------------- | ---------- | -------------- |  | ---------------
|$0.68$1.25    |  |  |  |                      | 10,857,223 |                |  | $              
|$1.56          |  |  |  |                      | 5,614,692  |                |  |                
|$1.83.$2.45   |  |  |  |                      | 3,262,400  |                |  |                
|$4.26          |  |  |  |                      | 491,505    |                |  |                
|Total          |  |  |  |                      | 20,225,820 |                |  | $              

The exercise price and number outstanding for certain warrants previously issued have been adjusted according to their anti-dilution provisions.



21



---



|12. | STOCK OPTIONS AND WARRANTS, Continued
|--- | -------------------------------------



A summary of the status of warrants issued primarily in connection with financing as of September 30, 2007, and the changes during the nine months ended September 30, 2007 is presented below:











|                                   |  |  |  | Number ofOutstandingWarrants |            | Weighted Average Exercise Prices
|---------------------------------- |  |  |  | ---------------------------- | ---------- | --------------------------------
|Outstanding at
beginning of period |  |  |  |                              | 11,962,944 |                                 
|Granted                            |  |  |  |                              | 9,012,876  |                                 
|Exercised                          |  |  |  |                              | (750,000   | )                               
|Expired                            |  |  |  |                              |           |                                 
|Outstanding at
end of period       |  |  |  |                              | 20,225,820 |                                 
|Exercisable at
end of period       |  |  |  |                              | 14,754,065 |                                 



The warrants to purchase 2.7 million shares of our common stock issued in connection with the private placement in January and February 2007, are exercisable for a period of five years and at an exercise price of $1.24 per share.



The warrants to purchase 841,121 shares of our common stock issued in connection with the Sentito Merger in April 2007, are exercisable for a period of five years at an exercise price of $1.25.



The warrants to purchase 5,471,755 shares of our common stock issued in connection with the private placement in September 2007, are exercisable on March 6, 2008 for a period of five years at an exercise price of $0.90.



In December 2004, the FASB issued Statement of Financial Accounting Standards SFAS No. 123(R), Share-Based Payment (SFAS No. 123(R)), which is a revision of SFAS No. 123. Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Effective January 1, 2006, we adopted SFAS No. 123(R) using the modified prospective method. Under this transition method, compensation cost recognized in 2006 includes: (i) compensation costs for all share-based payments granted prior to, but not fully vested as of January 1, 2006, based on the grant date fair value as calculated under the pro forma
disclosure-only expense provisions of SFAS No. 123, and (ii) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with provisions of SFAS No. 123(R). The adoption of SFAS No. 123(R) primarily resulted in compensation expense being recorded for stock options. The results for prior periods have not been restated.



During the three months ended September 30, 2007 and 2006, we recorded compensation expense of $376,000 and $41,000, respectively, related to the expensing of our stock options.  During the nine months ended September 30, 2007 and 2006, we recorded compensation expense of $1,025,000 and $200,000, respectively, related to the expensing of our stock options.



22



---



|12. | STOCK OPTIONS AND WARRANTS, Continued
|--- | -------------------------------------





The fair value of options granted in the nine months ended September 30, 2007 and 2006, based on the Black-Scholes valuation model, used the following assumptions:








|                        |  |  |  | Nine Months EndedSeptember 30, 2007 |       | Nine Months EndedSeptember 30, 2006
|----------------------- |  |  |  | ----------------------------------- | ----- | -----------------------------------
|Risk-free
interest rate |  |  |  |                                     | 4.1   | %                                  
|Expected
life           |  |  |  |                                     | 4 yea | rs                                 
|Expected
volatility     |  |  |  |                                     | 89.77 | %                                  
|Expected
dividend yield |  |  |  |                                     | 0.0   | %                                  



As of September 30, 2007, there was $1.2 million of total unrecognized compensation cost related to unvested options. The cost is expected to be recognized over the weighted-average period of 2.44 years.



We define in-the-money stock options at September 30, 2007 as options that had exercise prices that were lower than the $0.67 market price of the common stock at that date.  As of September 30, 2007, there were no stock options outstanding that were in-the-money.



A summary of the status of nonvested stock options at September 30, 2007 and the changes during the nine months ended September 30, 2007 is presented below:













|Nonvested
shares at January 1, 2007    |  |  |  |  | 2,422,753 |  
|-------------------------------------- |  |  |  |  | --------- | -
|Granted                                |  |  |  |  | 600,000   |  
|Vested                                 |  |  |  |  | (125,253  | )
|Forfeited                              |  |  |  |  | (960,000  | )
|Nonvested
shares at September 30, 2007 |  |  |  |  | 1,937,500 |  



Our stock incentive plan also provides for stock purchase authorizations, stock bonus awards and issuance of restricted stock. In January 2007, restricted stock awards totaling 480,000 were granted under the stock incentive plan to our board of directors for their board services during 2007. The shares vest 25% on March 30, 2007, June 29, 2007, September 28, 2007 and December 31, 2007, respectively. Upon issuance we recorded deferred compensation of $547,000. In July, 50,000 of the director restricted stock shares issued in January 2007 were retired and 20,000 shares of restricted stock were issued due to the reorganization. For the three and nine months ended September 30, 2007, we recorded stock-based compensation, related to these restricted shares, of $114,000 and $387,000, respectively.  As of September 30, 2007, deferred compensation of $504,000 is recorded on our consolidated balance sheet.



During the first quarter of 2007, stock awards totaling 25,167, which were immediately vested, were granted under the stock incentive plan. For the three months ended March 31, 2007, we recorded stock-based compensation of $23,300 related to these shares.



During the second quarter of 2007, stock awards totaling 39,912, which were immediately vested, were granted under the stock incentive plan. For the three months ended June 30, 2007, we recorded stock-based compensation of $35,400 related to these shares. In addition, 85,000 restricted stock awards were granted to employees under the stock incentive plan and vest over a service period of approximately 3.5 years. For the three months ended June 30, 2007, we recorded stock-based compensation of $5,600 related to these shares.



During the third quarter of 2007, no stock awards were granted under the stock incentive plan. For the three months ended September 30, 2007, we recorded stock-based compensation of $8,367 related to shares that were issued during the six months ended June 30, 2007.



23



---





13.
        NET LOSS PER SHARE




Basic and diluted net loss per share are computed in accordance with SFAS No. 128, Earnings Per Share, using the weighted average number of common shares outstanding. The diluted net loss per share for the three and nine months ended September 30, 2007 and 2006 does not include the effect of the common stock equivalents, calculated by the treasury stock method, as their impact would be anti-dilutive. Using the treasury stock method, common stock equivalents are as follows:






|                                                              |  |  |  | For the three months endedSeptember 30, |         | For the nine months ended September 30, | 
|------------------------------------------------------------- |  |  |  | --------------------------------------- | ------- | --------------------------------------- | 
|
|Shares
issuable under conversion of preferred stock           |  |  |  |                                         |        |                                         | 
|Shares
issuable under stock options                           |  |  |  |                                         |        |                                         | 
|Shares
issuable pursuant to warrants to purchase common stock |  |  |  |                                         | 415,297 |                                         | 
|                                                              |  |  |  |                                         | 415,297 |                                         | 

14.
        PRIVATE PLACEMENT




On January 30, 2007, February 2, 2007, February 5, 2007, and February 9, 2007, we issued 2,000,000 shares, 2,000,000 shares, 250,000 shares, and 750,000 shares of our common stock, respectively, and warrants to purchase 1,080,000 shares, 1,080,000 shares, 135,000 shares, and 405,000 shares of our common stock, respectively, in a private placement transaction for an aggregate purchase price of approximately $5,000,000, or $1.00 per share. The warrants issued in connection with the private placement are exercisable for a period of five years at an exercise price of $1.25 per share. We received proceeds from the private placement of approximately $4,297,000, net of expenses.



On  September 5, 2007,  September 6, 2007,  and  September  10, 2007,  we issued
4,417,640  shares,  2,608,692  shares,  and 71,428  shares of our common  stock,
respectively,  and warrants to purchase 3,313,230 shares,  2,104,954 shares, and
53,571  shares  of  our  common  stock,  respectively,  in a  private  placement
transaction  for an aggregate  purchase price of  approximately  $4,850,000,  or
$0.68 per share.  The warrants issued in connection with the private  placement
are exercisable on March 6, 2008 for a period of five years at an exercise price
of $0.90  per  share.  We  received  proceeds  from  the  private  placement  of
approximately $4,547,000, net of expenses.



15.
        COMMON STOCK ISSUED IN CONNECTION WITH ACQUISITION OF BUSINESS ASSETS OF WSECI




As described in Note 2  Mergers and Acquisitions: WSECI, we issued during the quarter ended March 31, 2007 62,950 shares of our common stock, as contingent consideration pursuant to the WSECI Asset Purchase Agreement.



16.
        COMMON STOCK ISSUED IN CONNECTION WITH ACQUISITION OF SENTITO




As described in Note 2  Mergers and Acquisitions:  Acquisition of Sentito,
we issued during the quarter ended June 30, 2007, 7,631,465 restricted shares of
our common stock, pursuant to the Merger Agreement.



17.
        LITIGATION




Except as described in Note 18 to our audited consolidated financial statements included in the Annual Report, we are not a party to any material pending legal proceedings other than ordinary routine litigation incidental to our business, and we do not expect this ordinary litigation to have a material adverse effect on the Company. Except as otherwise provided in Part II, Item 1 Legal Proceedings of this Quarterly Report, there have been no material developments regarding the pending material legal proceedings described in Note 18 to our audited consolidated financial statements included in the Annual Report during the nine months ended September 30, 2007.



24



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|18. | INCOME TAXES
|--- | ------------



On January 1, 2007, we adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109 (FIN 48), with no impact on beginning retained earnings.  This statement clarifies the criteria that an individual tax position must satisfy for some or all of the benefits of that position to be recognized in a companys financial statements.  FIN 48 prescribes a recognition threshold of more-likely-than-not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those tax positions to be recognized in financial statements.  As of January 1, 2007, we had no unrecognized tax benefits.



We believe it is possible that a portion of our net operating losses may not be utilizable due to the operation of Internal Revenue Code section 382.  We have not performed a comprehensive analysis to determine any limitation.  Accordingly, upon completion of such an analysis, it may be necessary to record additional unrecognized tax benefits associated with our inability to fully utilize our net operating losses as a result of a section 382 limitation.



We recognize potential accrued interest and penalties related to unrecognized tax benefits within our income tax expense.  Due to our net operating loss carryforward position, we recognized no interest and penalties at January 1, 2007 associated with our uncertain tax positions.



Tax years 2003, 2004, 2005, and 2006 remain subject to examination by federal and state taxing authorities.  Our primary state tax jurisdictions are Alabama, California, Colorado, Georgia, Minnesota, Pennsylvania, Utah and our international jurisdictions are the United Kingdom and Canada.  Open tax years for all jurisdictions are for the tax years 2003 to 2006 with the exception of the United Kingdom, for which the open tax years are 2004 to 2006.



We do not currently anticipate that the total amount of unrecognized tax benefits will significantly increase or decrease during the twelve month period ended December 31, 2007.



19.
        RECENT ACCOUNTING PRONOUNCEMENTS




In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement. This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact the adoption of SFAS No. 157 will have on our consolidated financial statements.



19.
        SUBSQUENT EVENTS




On October 5, 2007, we implemented the Verso Technologies, Inc. 2007 Restricted Stock and Option Incentive Program (the Program), which is administered as a formulae award program under our stock incentive plan described in Note 12.  Under the Program our employees may elect to forgo up to 50% of the salary which becomes payable to them during the period from October 16, 2007 through March 31, 2008 (the Participation Period) and receive in lieu thereof restricted shares (the Restricted Shares) of the Companys common stock (the Common Stock) and non-qualified stock options (the Options) to purchase shares of Common Stock under our stock incentive plan.  For each dollar of salary forgone, a participating employee will receive (i) a dollars worth of Restricted Shares, with each such share valued at
the Fair Market Value (as defined in our stock incentive plan) of the Common Stock on the date of grant, and (ii) an Option to purchase an equal number of shares of Common Stock at an exercise price equal to the Fair Market Value of the Common Stock on the date of grant.



As a result of our employees participation in the Program, on October 16, 2007, we issued 423,000 Restricted Shares and 423,000 Options. The Restricted Shares will vest ratably at the end of each month during the Participation Period commencing on November 30, 2007, and the Options will vest based on the Company achieving certain performance criteria related to revenues, inventory management, and earnings before interest, taxes, depreciation,one-time charges and stock-based compensation.



25



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Item 2:
        
        Managements Discussion and Analysis of Financial Condition and Results of Operations




Certain statements in this Quarterly Report and in future filings by us with the SEC and in our written and oral statements that are not statements of historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words believe, expect, anticipate, intend, will and similar expressions are examples of words that identify forward-looking statements. Forward-looking statements include, without limitation, statements regarding our future financial position, business strategy and expected cost savings. These forward-looking statements are based on our current beliefs, as well as assumptions we have made based upon information currently available to us.



Each forward-looking statement reflects our current view of future events and is subject to risks, uncertainties and other factors that could cause actual results to differ materially from any results expressed or implied by our forward-looking statements. Important factors that could cause actual results to differ materially from the results expressed or implied by any forward-looking statements include:



-  the volatility of the price of our common stock;

-  the delisting of our common stock from the Nasdaq Capital Market if the bid price falls and remains below $1.00 per share for a specified period;

-  our obligation to pay liquidated damages to certain investors under certain circumstances;

-  our ability to fund future growth;

-  the risks associated with acquisitions;

-  our ability to be profitable;

-  our ability to attract and retain qualified personnel;

-  general economic conditions of the telecommunications market;

-  our research and development expenditures;

-  market demand for, and market acceptance of, our products;

-  legal claims against us, including, but not limited to, claims of patent infringement;

-  our ability to protect our intellectual property;

-  defects in our products;

-  our obligations to indemnify certain customers;

-  our exposure to risks inherent in international operations and emerging markets;

-  our dependence on contract manufacturers and suppliers;

-  general economic and business conditions; and

-  other risks and uncertainties disclosed in the Annual Report and in our other filings with the SEC.



All subsequent forward-looking statements relating to the matters described in this Quarterly Report and attributable to us or to persons acting on our behalf are expressly qualified in their entirety by such factors. We have no obligation to publicly update or revise these forward-looking statements to reflect new information, future events, or otherwise, except as required by applicable Federal securities laws, and we caution you not to place undue reliance on these forward-looking statements.



Overview



We are a communications technology and solutions provider for communications service providers and enterprises seeking to implement application-based telephony services, Internet usage management tools, and outsourced customer support services. Our continuing operations include two separate business segments: (i) the Technologies Group, which includes our softswitching and NetPerformer divisions (the two businesses acquired from Clarent Corporation in February 2003), our I-Master division (acquired from WSECI in March 2005) and our subsidiaries, Telemate.Net, Verso Verilink (acquired from Group in June 2006), and Sentito (acquired by merger in April 2007) and (ii) the Advanced Applications Services Group, which includes our technical applications support group. The Technologies Group includes domestic and international sales of hardware and software, integration, applications and
technical training and support. The Technologies Group offers hardware-based solutions (which include software) for companies seeking to build private, packet-based voice and data networks, and software-based solutions for Internet access and usage management that include call accounting and usage reporting for IP network devices, and the product suite acquired in the Verilink Acquisition that provides access, multiplexing and transport of voice and data services that extend legacy networks as well as next generation converged access solutions. The products and technology acquired in the Sentito



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Acquisition augment our softswitching divisions product offerings. The Advanced Applications Services Group includes outsourced technical application services and application installation and training services to outside customers, as well as customers of the Technologies Group.



Since 2001, we have been selling products to the carrier market and focusing our strategic direction on developing and marketing next-generation communications products. Our current business was built on acquisitions made by us leveraging the economic downturn in the telecommunications area. In the first quarter of 2003, we acquired substantially all of the operating assets of Clarent Corporation, which provided us with patented VoIP technologies for both the carrier and enterprise markets (primarily serving international markets) and significantly increased our market share in the worldwide softswitch market.



Our strategy through 2003 was to add next-generation communications products to our suite of products through strategic acquisitions and to leverage these operations through cost reductions to enhance cash flow. With the acquisition of substantially all of the operating assets of Clarent Corporation, we moved our growth strategy toward international markets. As the acquisition of substantially all of the operating assets of Clarent Corporation was funded primarily by short-term seller financing, generating cash flow from operations during 2003 was required to meet the debt repayment obligations. As such, we leveraged our combined operations, reducing sales, general and administrative costs (as compared to costs prior to the acquisition), while preserving the research and development expenditures, which are vital to our long-term growth and viability.



In 2004, we began moving towards an open standards platform, and we significantly increased our expenditures for sales and marketing to focus on long-term sustainable revenue growth. In the first quarter of 2004, we completed a private placement raising approximately $16.5 million, net of expenses, to fund the expanded sales and marketing programs. As expected, these additional expenditures significantly increased the operating loss from continuing operations in 2004.



In January 2005, we disposed of substantially all of the operating assets of our NACT and MCK businesses to better focus our capital and management resources on areas which we believe have greater potential given our strategy to focus on next-generation network and solutions to improve cash utilization. In addition, we disposed of our NACT business because we wanted to move toward an open-standards, pre-paid next-generation solution that could better address growing market opportunities and enable us to offer a competitive product for Tier 1 and Tier 2 carriers. We believe that the I-Master platform, which we acquired from WSECI in March 2005 after forming a strategic partnership with WSECI in the latter half of 2004, permits us to offer a better solution. Further, we disposed of our MCK business because we intend to focus on next-generation solutions for service providers and the MCK
products did not fit that profile. The operations of the NACT and MCK businesses have been reclassified as discontinued operations in our consolidated financial statements.



On June 16, 2006, we acquired all of the outstanding equity interests of Verso Verilink from Group pursuant to the Purchase Agreement. At the time of the Verilink Acquisition, Holdings assets consisted of substantially all of the business assets of the Verilink Sellers, other than the accounts receivable and certain fixed assets of the Verilink Sellers which were transferred to Group prior to the Verilink Acquisition. Holdings assets were used by the Verilink Sellers in their business of developing, manufacturing, marketing and selling broadband access solutions for computer networks.



On December 29, 2006, pursuant to the iMarc Acquisition, we purchased certain assets of Paradyne related to the iMarc Business. The iMarc product line is a family of ATM, IP service units, and branch monitors that provides intelligent demarcation between carrier and enterprise networks, allowing for easier management. The iMarc product line is complementary to the Verilink product line and is being integrated into the Verilink business.



On April 17, 2007, we acquired Sentito, a provider of media and signaling gateway equipment to the telecommunications market. The acquisition expands our product portfolio and further supports our strategy of providing fully integrated next generation communications solutions to the carrier market. In addition, the transaction is expected to enable us to take advantage of an active Russian and Eastern European distribution partnership.



We believe that the foregoing events significantly affect the comparability of our results of operations from year to year and period to period. You should read the following discussion of our results of operations and financial condition in conjunction with our consolidated financial statements and related notes thereto included in Part I, Item 1 of this Quarterly Report.



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Results of Operations



Three Months Ended September 30, 2007 Compared to Three Months Ended September 30, 2006



For the three months ended September 30, 2007, our net loss totaled $5,007,000, or $0.08 per share, compared with a net loss of $4,122,000, or $0.11 per share, for the same period in 2006.



|                                             |  |  | Packet-basedTechnologiesGroup |   | AdvancedApplicationsServices Group |   | Consolidated |  
|-------------------------------------------- |  |  | ----------------------------- | - | ---------------------------------- | - | ------------ | -
|
|Revenue                                      |  |  |                               | $ | 11,543                             |   |              | $
|Gross
profit                                 |  |  |                               |   | 4,709                              |   |              |  
|Gross
margin                                 |  |  |                               |   | 41                                 | % |              |  
|General and
administrative                   |  |  |                               |   | 1,300                              |   |              |  
|Sales and
marketing                          |  |  |                               |   | 1,972                              |   |              |  
|Research and
development                     |  |  |                               |   | 1,829                              |   |              |  
|Stock based
compensation                     |  |  |                               |   | 26                                 |   |              |  
|(Loss)
contribution before unallocated items |  |  |                               | $ | (418                               | ) |              | $
|Unallocated
items:                           |  |  |                               |   |                                    |   |              |  
|Corporate
general and administrative         |  |  |                               |   |                                    |   |              |  
|Corporate
research and development           |  |  |                               |   |                                    |   |              |  
|Depreciation
and amortization                |  |  |                               |   |                                    |   |              |  
|Stock based
compensation                     |  |  |                               |   |                                    |   |              |  
|Reorganization expense                       |  |  |                               |   |                                    |   |              |  
|Operating
loss                               |  |  |                               |   |                                    |   |              |  
|Other                                        |  |  |                               |   |                                    |   |              |  
|Loss before
income taxes                     |  |  |                               |   |                                    |   |              |  

Continuing Operations



For the three months ended September 30, 2007, our net loss from continuing operations totaled $5,007,000, or $0.08 per share, compared with a net loss of $4,122,000 or $0.11 per share, for the same period in 2006.



Total revenue was $13,136,000 in the three months ended September 30, 2007, reflecting a 2% decrease from the same period in 2006. Products revenue increased from $9,264,000 in the three months ended September 30, 2006 to $9,744,000 in the three months ended September 30, 2007. The increase in product revenue is attributable to the iMarc product line in the Technologies Group acquired in December 2006. Services revenue was $3,392,000 for the three months ended September 30, 2007, reflecting a 17% decrease from the same period in 2006, the decrease in revenue is due to declines in the Verilink professional services group and the Advanced Applications Services Group.



Gross profit was 38% of revenue for the three months ended September 30, 2007 and for the same period in 2006. The gross margin percentage remained stable as the sales mix between product lines in the Technology group revenue shifted from NetPerformer to SoftSwitch.



Total operating expenses incurred for the three months ended September 30, 2007, were $8,445,000, an increase of $888,000 compared with the same period in 2006. The operating expenses associated with Verilink, iMarc and Sentito, which were acquired in June 2006, December 2006, and April 2007, respectively, resulted in overall increased operating expenses compared with the third quarter of 2006. For the categories of operating expenses, the increase is primarily attributable to the following items: increase in general and administrative expenses of $358,000,  research and development expenses of $22,000, offset by a decrease of sales and marketing expenses of $362,000. In addition, we also incurred increased operating expenses associated with stock based compensation of $376,000, depreciation and amortization of $708,000, and reorganization expense of $362,000.



General and administrative expenses for the three months ended September 30, 2007, were $3,066,000, an increase of $358,000 compared to the same period in 2006. The increase is primarily attributable to Verilinks and Sentitos general and administrative expenses.



Sales and marketing expenses for the three months ended September 30, 2007 were $2,062,000, a decrease of $362,000 compared to the same period in 2006.  The decrease is primarily due to the reduction of other sales and marketing program expenses.



Research and development expenses for the three months ended September 30, 2007 were $1,871,000, an increase of $22,000 compared to the same period in 2006.  The increase in expense is primarily related to Sentito expenses of $253,000 offset by a reduction of other softswitching personnel and program costs.



The increase in depreciation and amortization expense is related to additional amortization associated with the acquired intangibles of the Verilink, iMarc, and Sentito businesses partially offset by the effect of fully depreciated assets and lower capital additions.



During the three months ended  September 30, 2007, we initiated a  restructuring
plan to improve operational efficiencies and financial performance. We eliminated several positions held by employees and closed a facility location in Acton, Massachusetts. As a result of this action,  we recorded  reorganization  costs associated
with this action of $362,000.



As a percent of revenue, operating expenses were 64% during the three months ended September 30, 2007 as compared with 57% for the same period in 2006.



Equity in loss of investment was $37,000 during the three months ended September 30, 2007, compared with a loss of $21,000 for the same period in 2006. This amount represents our portion of BeTrues losses or income.



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Net interest expense was $1,539,000  during the three months ended September 30,
2007, a decrease of $72,000  compared with the same period in 2006.  Included in
net interest  expenses was amortization of loan fees and discount on convertible
debentures  which were $1,007,000 for the three months ended September 30, 2007,
as compared to $1,228,000  for the three months ended  September  30, 2006.  The
decrease in the interest  expenses was  primarily  attributable  to interest and
amortization of debentures that were fully paid and amortized in 2006.



Business Unit Performance








Technologies Group



Total revenue from the Technologies Group was $11,543,000 in the three months ended September 30, 2007, a 1% increase from the same period in 2006. The increase was primarily attributable to the revenues related to the iMarc product suites acquired on December 29, 2006, and softswitching products, partially offset by a decline in revenue for the NetPerformer and Telemate.Net products.



Gross profit decreased by $88,000 in the three months ended September 30, 2007, and was 41% of revenue, compared with 42% in the same period in 2006. The gross margin percentage remained stable with the Technology Group revenue as the sales mix between product lines shifted from NetPerformer to softswitching products



Allocated operating expenses incurred in the Technologies Group for the three months ended September 30, 2007, were $5,127,000, a decrease of $154,000 compared to the same period in 2006. The increase in general and administrative expenses resulted primarily from the increase of $172,000 for Sentito expenses. The decrease in sales and marketing expenses from $2,332,000 to $1,972,000 is primarily attributable to a reduction in marketing personnel and programs and a reduction in other sales expenses.  The net increase in research and development expenses of $65,000 is attributable to the addition of Sentito offset by reductions in the softswitching division. As a percent of revenue, operating expenses for the Technologies Group were 44% during the three months ended September 30, 2007, a decrease from 46% during the same period in 2006.



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Advanced Applications Services Group



Total revenue for the Advanced Applications Services Group was $1,593,000 in the three months ended September 30, 2007, a 15% decrease from the same period in 2006. The decrease in revenue is related to a decrease in outsourced services for a significant hospitality related customer.



Gross profit increased by $33,000 in the three months ended September 30, 2007, and was 20% of revenue, compared with 15% of revenue in the same period in 2006. The increase in gross profit dollars and gross margin percentage was primarily attributable to enhanced utilization of the existing support infrastructure.



Allocated operating expenses incurred in Advanced Applications Services Group for the three months ended September 30, 2007, were $217,000 an increase of $14,000 compared to the same period in 2006.



Discontinued Operations



No discontinued operations were recorded in the three months ended September 30, 2007 since we disposed of substantially all of the operating assets of our NACT and MCK businesses in January 2005.



Nine Months Ended September 30, 2007, Compared to Nine Months Ended September 30, 2006



For the nine months ended September 30, 2007, our net loss totaled $16,484,000, or $0.31 per share, compared with a net loss of $13,420,000, or $0.40 per share, for the same period in 2006.



|                                             |  |  | Packet-basedTechnologiesGroup |   | AdvancedApplicationsServices Group |   | Consolidated |  
|-------------------------------------------- |  |  | ----------------------------- | - | ---------------------------------- | - | ------------ | -
|
|Revenue                                      |  |  |                               | $ | 32,558                             |   |              | $
|Gross
profit                                 |  |  |                               |   | 12,804                             |   |              |  
|Gross
margin                                 |  |  |                               |   | 39                                 | % |              |  
|General and
administrative                   |  |  |                               |   | 2,893                              |   |              |  
|Sales and
marketing                          |  |  |                               |   | 6,533                              |   |              |  
|Research and
development                     |  |  |                               |   | 6,231                              |   |              |  
|Stock based
compensation                     |  |  |                               |   | 119                                |   |              |  
|(Loss)
contribution before unallocated items |  |  |                               | $ | (2,972                             | ) |              | $
|Unallocated
items:                           |  |  |                               |   |                                    |   |              |  
|Corporate
general and administrative         |  |  |                               |   |                                    |   |              |  
|Corporate
research and development           |  |  |                               |   |                                    |   |              |  
|Depreciation
and amortization                |  |  |                               |   |                                    |   |              |  
|Stock based
compensation                     |  |  |                               |   |                                    |   |              |  
|Reorganization expense                       |  |  |                               |   |                                    |   |              |  
|Operating
loss                               |  |  |                               |   |                                    |   |              |  
|Other                                        |  |  |                               |   |                                    |   |              |  
|Loss before
income taxes                     |  |  |                               |   |                                    |   |              |  

Continuing Operations



For the nine months ended September 30, 2007, our net loss from continuing operations totaled $16,484,000, or $0.31 per share, compared with a net loss of $13,420,000 or $0.40 per share, for the same period in 2006.



Total revenue was $38,191,000 in the nine months ended September 30, 2007, reflecting a 34% increase from the same period in 2006. Products revenue increased from $18,017,000 in the nine months ended September 30, 2006 to $26,790,000 in the nine months ended September 30, 2007. The increase in product revenue in the Technologies Group is attributable to the Verilink product suite and the iMarc product line acquired in June 2006 and December 2006, respectively. Services revenue was $11,401,000 for the nine months ended September 30, 2007, reflecting a 9% increase from the same period in 2006, primarily due to the increase in revenue from Verilink professional services group, net of declines primarily in the other divisions of the Technologies Group product services.



Gross profit was 37% of revenue in the nine months ended September 30, 2007, compared to 39% of revenue for the same period in 2006. The decline in gross margin percentage is primarily due to the impact of the lower gross margins on the Verilink business, which we acquired in June 2006. Gross margin in the Verilink business is lower than our historical gross margin due to the significance of Verilinks professional services business in its overall revenue mix.



Total operating expenses incurred for the nine months ended September 30, 2007, were $25,466,000, an increase of $5,052,000 compared with the same period in 2006. Verilink, iMarc and Sentito operating expenses added approximately $4,051,000 to total operating expenses. On a functional basis, the increase is primarily attributable to the following items: increase in general and administrative expenses of $1,222,000, sales and marketing expenses of $874,000, and research and development expenses of $711,000. In addition, we also incurred increased operating expenses associated with stock based compensation of $824,000, depreciation and amortization of $670,000, and reorganization expenses of $751,000.



General and administrative expenses for the nine months ended September 30, 2007, were $8,431,000, an increase of $1,222,000 compared to the same period in 2006. The increase is primarily attributable to Verilink and Sentito general and administrative expenses of $1,009,000.



Sales and marketing expenses for the nine months ended September 30, 2007 were $6,855,000, an increase of $874,000 compared to the same period in 2006.  The increase is primarily due to the addition of Verilink and Sentito expenses of $1,462,000 partially offset by the reduction of other sales and marketing program expenses.



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Research and development expenses for the nine months ended September 30, 2007 were $6,334,000, an increase of $711,000 compared to the same period in 2006.  The increase in expense is attributed to Verilink and Sentito expenses of $1,584,000 partially offset by a reduction of softswitching division personnel and program costs.



The increase in depreciation and amortization expense is related to additional amortization associated with the acquired intangibles of the Verilink, iMarc, and Sentito businesses partially offset by the effect of fully depreciated assets and lower capital additions.



During the nine months ended September 30, 2007, we initiated a restructuring plan.  As a result of this action, we recorded reorganization costs associated with this action of $751,000.



As a percent of revenue, operating expenses were 67% during the nine months ended September 30, 2007 as compared with 72% for the same period in 2006.



Additional other expense of $253,000 was recorded during the nine months ended September 30, 2007 compared with other expense of $7,000 for the same period in 2006.  The increase for the nine months ended September 30, 2007 relates primarily to the $231,000 loss associated with write-off of interest arising from the prepayment of the Note from Citel PLC.



Equity in loss of investment was $115,000 during the nine months ended September 30, 2007, compared with a loss of $127,000 for the same period in 2006. This amount represents our portion of BeTrues losses or income.



Net interest expense was $4,595,000 during the nine months ended September 30, 2007, an increase of $460,000 compared with the same period in 2006. Included in net interest expenses was amortization of loan fees and discount on convertible debentures which were $3,056,000 for the nine months ended September 30, 2007 as compared to $3,064,000 for the nine months ended September 30, 2006. The increase in the interest expenses was primarily attributable to interest and amortization of the loan issuance costs associated with the credit facility.



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Business Unit Performance



Technologies Group



Total revenue from the Technologies Group was $32,558,000 in the nine months ended September 30, 2007, a 42% increase from the same period in 2006. The increase was attributable to the revenue related to the Verilink and iMarc product suites acquired on June 16, 2006 and December 29, 2006, respectively, net of decline in revenue for the other Technology Group products.



Gross profit increased by $2,417,000 in the nine months ended September 30, 2007, and was 39% of revenue, compared with 45% in the same period in 2006. The increase in gross profit is attributable to the increase in revenue. The most significant factor in the decline in gross margin percentage is due to the impact of the lower gross margins on Verilink business, which was acquired in June of 2006.  Gross margin in the Verilink business has been lower than our historical gross margin due to the effect of Verilinks professional services business in its overall revenue mix.



Allocated operating expenses incurred in the Technologies Group for the nine months ended September 30, 2007, were $15,776,000, an increase of $2,262,000 compared to the same period in 2006. The increase in general and administrative expenses resulted primarily from the increase of $1,009,000 for Verilink, iMarc, and Sentito net of decreases in Softswitch expense. The increase in sales and marketing expenses of $806,000 to $6,533,000 is primarily attributable to $1,462,000 increase for Verilink, and Sentito partially offset by a reduction in marketing personnel and programs and a reduction in other sales expense.  The increase in research and development expenses resulted from Verilink and Sentito expenses of $1,584,000 partially offset by reductions in Softswitch expense. As a percent of revenue, operating expenses for the Technologies Group were 48% during the nine months ended
September 30, 2007, a decrease from 59% during the same period in 2006.



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Advanced Applications Services Group



Total revenue for the Advanced Applications Services Group was $5,663,000 in the nine months ended September 30, 2007, a 2% increase from the same period in 2006. The increase in revenue is related to an increase in outsourced services for a significant hospitality related customer.



Gross profit increased by $265,000 in the nine months ended September 30, 2007, and was 20% of revenue, compared with 16% of revenue in the same period in 2006. The increase in gross profit dollars and gross margin percentage was primarily attributable to enhanced utilization of the existing support infrastructure.



Allocated operating expenses incurred in Advanced Applications Services Group for the nine months ended September 30, 2007, were $411,000, a decrease of $190,000 compared to the same period in 2006.



Discontinued Operations



No discontinued operations were recorded in the nine months ended September 30, 2007 since we disposed of substantially all of the operating assets of our NACT and MCK businesses in January 2005.



Critical Accounting Policies



The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. We base these estimates and assumptions on historical experience and evaluate them on an on-going basis to ensure they remain reasonable under current conditions. Factors that could affect our future operating results and cause actual results to vary from expectations include, but are not limited to, lower than anticipated growth from existing customers, an inability to attract new customers, an inability to successfully integrate acquisitions and technology changes, or a decline in the financial stability of our customers. Negative developments in these or other risk factors
could have a material adverse affect on our financial position and results of operations. Actual results could differ from management estimates. There were no changes to our critical accounting policies and estimates included in our Annual Report. A summary of our critical accounting policies follows:



Revenue Recognition



We recognize revenue when persuasive evidence of an agreement exists, delivery has occurred, the fee is fixed and determinable, and collection of the resulting receivable is reasonably assured. The determination of whether the ability to collect is reasonably assured is based upon an assessment of the creditworthiness of the customers. In instances where the collection of a receivable is not reasonably assured, the revenue and related costs are deferred.



Deferred revenue generally represents amounts collected for which revenue has not yet been recognized. It is principally comprised of deferred maintenance revenue.



We recognize revenue in accordance with Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements as updated by SAB No. 104 and in accordance with Emerging Issues Task Force 00-21, Revenue Arrangements with Multiple Deliverables, Statement of Position (SOP) No. 97-2, Software Revenue Recognition (SOP No. 97-2) and SOP No. 98-9, Software Revenue Recognition with Respect to Certain Transactions (SOP No. 98-9).



SOP No. 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on the evidence that is specific to the vendor. License revenue allocated to software products generally is recognized upon delivery of the products or deferred and recognized in future periods to the extent that an arrangement includes one or more elements to be delivered at a future date and for which fair values have not been established. Revenue allocated to maintenance is recognized ratably over the maintenance term which is typically twelve months and revenue allocated to training and other service elements, such as implementation and training, are recognized as the services are performed.



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Under SOP No. 98-9, if evidence of fair value of all undelivered elements exists, but evidence does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered element and recognized as revenue.



We routinely analyze and establish, as necessary, reserves at the time of shipment for product returns and allowances and warranty costs.



As a consequence of the Verilink Acquisition, we now have certain distributors who have the right to return product for stock rotation purposes. Every quarter, stock rotation rights are limited to a percentage of invoiced sales to the distributor in the prior quarter. The percentage of sales used to determine the stock rotation right is based upon the terms of the executed distributor agreements with us. We reduce revenue and maintain a reserve for an estimate of potential stock rotation returns related to the current period product revenue. Management analyzes historical returns, channel inventory levels, current economic trends and changes in customer demand for our products when evaluating the adequacy of the reserve for stock rotation returns.



Allowance for Doubtful Accounts



We are required to estimate the collectibility of our trade receivables. Considerable judgment is required in assessing the ultimate realization of these receivables, including the creditworthiness of each customer. The evaluation is based on credit information and collection history concerning the customer up and through the determination date. We determine the allowance for doubtful accounts based on a specific review of outstanding customer balances and a general reserve based upon aging of customer accounts and write-off history. Significant changes in required reserves have been recorded in recent periods and may occur in the future due to the current telecommunications and general economic environments and updates to customer credit information and collection activity.



Inventory Obsolescence



We are required to state our inventories at the lower of cost or market. In assessing the ultimate realization of inventories, we make judgments as to future demand requirements and compare that demand with the current and committed inventory levels. We have recorded changes in net realizable values in recent periods due to the impact of current and future technology trends and changes in strategic direction, such as discontinuances of product lines, as well as, changes in market conditions due to changes in demand requirements. Estimates of the future demand for inventory are based on historical usage for different products, as well as estimates of inventory required to fulfill maintenance requirements for products previously sold. It is possible that changes in the net realizable value of inventory may continue to occur in the future due to the current market conditions.



Liabilities of Discontinued Operations



In January 2005, we disposed of substantially all of the operating assets of our NACT and MCK businesses. As a result of these sales, certain liabilities of MCK are now classified as discontinued operations and netted against these liabilities are sublease payments to be received by us for one lease obligation through March 31, 2007.



During 2001, we initiated certain restructuring plans and discontinued operations of our legacy value-added reseller business. In conjunction with these restructuring plans, we established a restructuring reserve account for the estimated costs related to the plans. These costs primarily related to facilities closings, severance costs and other businesses exiting costs. For the facilities closings cost, a reserve was established for all remaining lease payments due on buildings and equipment that were no longer being utilized in continuing operations, less assumptions for sub-leases. The accrual for one of the leases with total payments remaining through January 31, 2010 of $984,000 is offset by sublease receipts to us totaling $375,000 through the end of the lease term and assumes an amount of $180,000 for the extension of one of the subleases through the end of the lease term.



As of September 30, 2007, we had a remaining balance of approximately $1,307,000 in liabilities of discontinued operations. We currently believe that this remaining estimated balance is sufficient to cover future obligations associated with the restructurings; however, changes in these estimates could occur based on changes in the financial condition of the subleases.



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Deferred Tax Asset Valuation Allowance



We currently have significant deferred tax assets, which are subject to periodic recoverability assessment. Realization of our deferred tax assets is principally dependant upon achievement of projected future taxable income. Our judgments regarding future profitability may change due to market conditions, our ability to continue to successfully execute our strategic plan and other factors. These changes, if any, may require possible material adjustments to these deferred tax asset balances. Due to the uncertainty of our ability to recognize the entire tax benefit, we established an offsetting provision for the tax assets.



Litigation and Related Contingencies



We are subject to proceedings, lawsuits and other claims related to labor, product, and other matters. We are required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as, potential ranges of probable losses. A determination of the amount of reserves required, if any, for these contingencies is made by us with assistance of our legal counsel after careful analysis of each individual issue based upon the then-current facts and circumstances. The required reserves may change in the future due to new developments in each matter or changes in approach such as a change in settlement strategy in dealing with these matters.



Goodwill, Intangible Assets and Long-Lived Assets



Goodwill represents the excess of costs over the fair value of net assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are tested for impairment at least annually in accordance with provisions of SFAS No. 142. Significant estimates are made with respect to the impairment testing. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144.



In accordance with SFAS No. 144, long-lived assets, such as property, plant and equipment and purchased assets subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Significant estimates are made with respect to recoverability and fair value assessments.



Liquidity and Capital Resources



Summary



Liquidity is the measurement of our ability to have adequate cash or access to cash at all times in order to meet financial obligations when due, as well as to fund corporate expansion and other activities. For the last three years, we have met our liquidity requirements through a combination of cash provided by debt from third party lenders, issuances of debt and equity securities and purchases and divestitures of other businesses.



At September 30, 2007, we had a negative working capital position (excess of current assets over current liabilities) of $6,338,000 compared to a negative working capital position of $768,000 at December 31, 2006. Our cash and restricted cash totaled $5,910,000 at September 30, 2007 and $2,175,000 at December 31, 2006. Total long-term debt, net of discount, was $5,233,000 at September 30, 2007 and $12,634,000 at December 31, 2006.



On September 20, 2006, we entered into the Security Agreement with our primary lender which provides for a three-year, $14.0 million revolving credit facility. The new credit facility replaced our prior $10.0 million credit facility.



The credit facility consists of two tranches: (i) Tranche A, an $8.0 million tranche, the availability of which is subject to a borrowing base, and (ii) Tranche B a $6.0 million tranche, of which $5.0 million is outstanding and the remainder of which is no longer available as a result of scheduled availability reduction by $187,500 per month beginning in February 2007. Borrowing availability under Tranche B is not subject to a borrowing base. Borrowing ability under




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Tranche A is determined pursuant to a formula which is based on the value of our eligible accounts receivables and inventory and borrowings under Tranche A accrue interest at a rate of prime rate plus 2%, provided that the interest rate shall not be less than 9% (9.75% at September 30, 2007). Borrowings under Tranche B accrue interest at a fixed rate of 15%. Borrowings under the credit facility shall
be made first under Tranche B to the extent of availability thereunder and then under Tranche A to the extent of availability thereunder. In June 2007, we purchased credit insurance on our international accounts receivable. We are now able to include our insured international accounts receivable in our borrowing base which has expanded our availability as previously we were restricted to only domestic accounts receivable in our borrowing base.



As of September 30, 2007, we had outstanding borrowings including interest under Tranche A and Tranche B of $5,890,000 and $4,500,000, respectively. The remaining borrowing availability under the credit facility at September 30, 2007 was $2.1 million under Tranche A and $0 under Tranche B.



On February 4, 2005, we completed a private placement of senior unsecured convertible debentures and warrants pursuant to a securities purchase agreement with certain institutional investors. We issued $13,500,000 of senior unsecured convertible debentures, Series A warrants exercisable for 2,200,000 shares of our common stock and Series B warrants exercisable for 2,000,000 shares of our common stock. The senior unsecured convertible debentures bear interest at 6.75% per annum, are due February 2009 and are convertible into approximately 5,400,000 shares of our common stock at an initial conversion price of $2.50 per share, subject to anti-dilution adjustments and certain limitations. Interest is payable on a quarterly basis and principal became payable on a quarterly basis beginning August 2006. The Series A warrants issued in connection with the private placement are exercisable for a
period of five years commencing on February 4, 2005 and at an exercise price of $3.60 per share. The Series B warrants issued in connection with the private placement were exercisable for a period of 90 days, commencing on June 16, 2005, and had an exercise price of $3.90 per share. The Series B warrants expired in September 2005. We received net proceeds of approximately $12,500,000, including $1,600,000 in restricted cash, net of expenses.



On February 12, 2003, we acquired substantially all the business assets and assumed certain related liabilities of Clarent Corporation for $9,800,000 in notes. At June 30, 2007, a $3,000,000 secured note due February 12, 2008, which bears interest at 5% per annum, remains outstanding. The assets we purchased from Clarent Corporation secure the note.



On February 17, 2006, we issued, in a private placement, 5,400,000 shares of our common stock and warrants to purchase 5,400,000 shares of our common stock for an aggregate purchase price of approximately $7,100,000, or $1.30 per share. The warrants issued in connection with the private placement are exercisable, after six months, for a period of five years at an exercise price of $1.56 per share. We received proceeds from the private placement of approximately $6,800,000, net of expenses.



On June 30, 2006, in connection with the completion of the Admission of Citel U.K.s entire issued share capital to AIM, the Company and CITEL amended the Note such that the principal balance of the Note became due and payable as follows: $870,000 to be paid within one business day of Admission; followed by six monthly installments of $75,000 commencing 12 months from the date of Admission; and all remaining outstanding principal and accrued interest under this note will be due and payable on January 21, 2008. In July 2006, we received the $870,000 as contemplated by the amendment to the Note.



On July 18, 2006, we entered into the CM Agreement with CM, our contract manufacturer of our Verilink product line. Pursuant to the CM Agreement, CM has purchased certain electrical components valued at $2.0 million from us for use in the manufacture of finished goods to be purchased by the Company. In addition, we have agreed to assign to CM an additional amount of unused electrical components valued at $2.0 million for which title will remain with us. We have an obligation under the CM Agreement to purchase during the first two years, products assembled by CM using electrical components valued at $2.0 million. Furthermore, we have agreed to submit purchase orders to CM in a minimum amount of $2.0 million per quarter for the next three years or until the obligation to purchase the Assembled Products has been satisfied.



In connection with executing the CM Agreement, the Company and CM entered into a three-year Manufacturing Agreement which sets forth the terms and conditions under which CM shall manufacture the Assembled Products. As of September 30, 2007 CM had used $1,582,000 of electrical components in the manufacture of the Assembled Products, reduced the outstanding commitment to utilize $2.0 million of electrical components in the first two years of the


36



agreements to approximately $418,000 which reduced the inventory currently assigned to CM to approximately $418,000. The remaining assigned inventory is reflected as inventory on the balance sheet as of September 30, 2007. The assigned inventory is not eligible for inclusion in the borrowing base under our credit facility



In January and February 2007, we issued 5,000,000 shares of common stock and warrants to purchase 2,700,000 shares of our common stock in private placement transactions for an aggregate purchase price of $5,000,000, or $1.00 per share. The warrants issued in connection with the private placement are exercisable for a period of five years at an exercise price of $1.25 per share. We received proceeds from the private placement of approximately $4.4 million, net of expenses.

On May 25, 2007, we entered into an agreement with CITEL and Citel PLC pursuant to which CITEL prepaid the Note, by making an immediate cash payment to us of approximately $1.9 million. In addition, Citel PLC was required to issue to us 62,424 Citel Shares which had a market value of approximately $70,000 as of May 24, 2007 and, based upon representations made by CITEL to us, are fully tradable on the AIM market of the London Stock Exchange. We have agreed not to sell or transfer the Citel Shares prior to January 21, 2008, the original maturity date of the Note. We received the Citel Shares, canceled the Note and released our security interest in the collateral securing the Note.



In September 2007, we issued 7,097,760 shares of our common stock, respectively,
and warrants to purchase 5,471,755 shares of our common stock, respectively,  in
a private placement transaction for an aggregate purchase price of approximately
$4,850,000,  or $0.68 per share.  The warrants  issued in  connection  with the
private placement are exercisable on March 6, 2008 for a period of five years at
an  exercise  price of $0.90 per share.  We received  proceeds  from the private
placement of approximately $4,547,000, net of expenses.



Cash Flow



Cash used in our continuing operations in the nine months ended September 30, 2007 totaled $8,201,000 compared with $8,107,000 in the same period in 2006. The cash used in continuing operations during the nine months ended September 30, 2007 resulted primarily from cash used by continuing operations of $8,092,000 (net loss from continuing operations of $16,484,000 reduced by net non-cash charges totaling $8,392,000, including depreciation and amortization of $2,780,000, amortization of loan fees and discount on convertible subordinated debentures of $3,390,000, provision for doubtful accounts of $307,000, interest expense of $576,000, equity in loss of investment of $115,000, loss on debt restructuring of $231,000, and stock based compensation of $1,025,000 offset by $32,000 in other) partially offset by the net increase in current operating assets and liabilities of $109,000. This
compares to cash used by continuing operations of $8,152,000 (net loss from continuing operations of $13,420,000, reduced by net non-cash charges totaling $5,267,000 including depreciation and amortization of $1,917,000, amortization of loan fees and discount on convertible subordinated debentures of $2,681,000, provision for doubtful accounts of $478,000, equity in loss of investment of $127,000, and stock based compensation of $200,000, offset by $136,000 in other) further reduced by the net decrease in current operating assets and liabilities of  $46,000 for the nine months ended September 30, 2006.



Cash used in our discontinued operations in the ninemonths ended September30, 2007 totaled $178,000 compared to $1,457,000 in the same period in 2006.



Cash used by investing activities for continuing operations in the nine months ended September 30, 2007 of $588,000 compares to cash used in investing activities for continuing operations in the nine months ended September 30, 2006 of $126,000. In the nine months ended September 30, 2007 we used $1,815,000 in cash related to the iMarc Acquisition and Sentito provided us $937,000 in cash related to the acquisition. During the nine months ended September 30, 2007 restricted cash decreased by $538,000 compared to $402,000 in the same period in 2006. We spent $248,000 and $286,000 on capital expenditures in the nine months ended September 30, 2007 and 2006, respectively.




Cash provided by investing  activities for  discontinued  operations in the nine
months ended  September 30, 2007 was  $1,880,000,  compared to $1,420,000 in the
same period of 2006 that relates to the collection of a note issued to us in the sale of the MCK
business.



Cash provided by financing activities totaled $11,331,000 in the ninemonths ended September30, 2007 compared to $8,219,000 in the same period of 2006. For the ninemonths ended September30, 2007, we received proceeds from a private placement of $8,815,000 (net of associated fees) and from borrowings on the line of credit of $2,507,000.  For the nine months ended September 30, 2006, the Company received proceeds from a private placement of



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$6,760,000 (net of associated fees) and net borrowings under the line of credit of $3,460,000, offset by a payment of $2,025,000 on the $4,647,000 convertible subordinated debentures.



Contractual Obligations and Commercial Commitments



The following summarizes our future contractual obligations at September 30, 2007 (in thousands) and excludes interest expense and sublease rentals and assumes that leases are not renewed.

|Contractual Obligations                   |  |  |  | Total |        | Less than1 year |  | 13 years |        | 45 years |  | After 5 years
|----------------------------------------- |  |  |  | ----- | ------ | --------------- |  | --------- | ------ | --------- |  | -------------
|Line of
credit                            |  |  |  | $     | 10,390 |                 |  | $         | 8,140  |           |  | $            
|Notes payable
for the purchase of Clarent |  |  |  |       | 3,000  |                 |  |           | 3,000  |           |  |              
|Senior
unsecured convertible debentures   |  |  |  |       | 9,562  |                 |  |           | 5,063  |           |  |              
|Operating
leases:                         |  |  |  |       |        |                 |  |           |        |           |  |              
|Continuing
operations                     |  |  |  |       | 4,944  |                 |  |           | 2,261  |           |  |              
|Discontinued
operations                   |  |  |  |       | 874    |                 |  |           | 384    |           |  |              
|Total
contractual cash obligations        |  |  |  | $     | 28,770 |                 |  | $         | 18,848 |           |  | $            

We remain a guarantor on a lease through December 2009 used in the operations of the NACT business, which we sold in January 2005. The total commitment related to this lease is approximately $1,403,000.



Sources of Cash



We have a history of incurring operating losses, and as a result, we have not yet been able to generate positive cash flow from operations.  For the remainder of 2007, we expect that our primary sources of cash will be from cash on hand and borrowings under our credit facility as well as other sources. We are currently working on several initiatives to continue to reduce the cash used in continuing operations and to ensure that it has sufficient liquidity to cover our needs for the next twelve months.



During January and February 2007,we issued through private placement transactions an aggregate of 5.0 million shares of common stock and warrants to acquire 2.7 million shares of our common stock for an aggregate purchase price of $5.0 million. The warrants are exercisable over a 5-year period commencing with their issuance at a per share exercise price equal to $1.25. We received approximately $4.4 million, net of expenses.



During  September  2007, we issued through  private  placement  transactions  an
aggregate  of 7.1  million  shares of common  stock and  warrants to acquire 5.5
million  shares of our  common  stock for an  aggregate  purchase  price of $4.9
million.  The warrants are exercisable over a 5-year period  commencing on March
6, 2008 at a per share exercise price equal to $0.90. We received  approximately
$4.5 million, net of expenses.



As previously mentioned, on September 20, 2006, we entered into a new credit facility which provides for a three-year, $14.0 million revolving credit facility. The new credit facility replaced our prior $10.0 million credit facility and thus increased our availability of working capital. As of September 30, 2007, we had outstanding borrowings including interest under Tranche A and Tranche B of $5,890,000 and $4,500,000, respectively. The remaining borrowing availability under the credit facility at September 30, 2007 was $2.1 million under Tranche A and none under Tranche B.



Availability for borrowings under Tranche A of our credit facility is subject to limitations as determined pursuant to a formula which is based on the value of our eligible accounts receivables and inventory. If we do not have sufficient eligible accounts receivable and inventories to support the level of borrowings we may need, then we may be unable to draw on the credit facility to the extent necessary. To the extent we do not have borrowing availability under the credit facility, we may be required to obtain additional sources of capital, sell assets, obtain an amendment to the Security Agreement or otherwise restructure our outstanding indebtedness.



Additional borrowings other than pursuant to the credit facility must be approved by our primary lender and may have to be approved by the holders of the secured note issued by us in connection with the acquisition of substantially all

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of the operating assets of Clarent Corporation, which note is due in 2008, and the holders of the convertible subordinated debentures. If we are unable to obtain additional capital, sell assets, obtain an amendment to the Security Agreement or otherwise restructure our outstanding indebtedness, then we may not be able to meet our obligations.



We have taken, and continue to take, steps that we believe will not only increase revenues and gross margins but also will make us more efficient and reduce operational expenses. The acquisition of Verilink, completed in June 2006, has contributed significantly to increased revenues and gross margin and reduced operating losses. In December 2006, we acquired the iMarc product line which is being integrated into the Verilink operations and also is expected to contribute to reductions in operating losses. These acquisitions have provided us with two new U.S. based Tier 1 carrier customers. In addition, our sources of revenues have transitioned from a majority of revenues being from international sources to a mix which is approximately equal between U.S. and international sources. This transition has substantially improved our cash flow through a reduction in days sales outstanding in
receivables. Revenue growth is viewed as the key driver to continue the improvement in the reduction of the operating losses and cash used from operations. During 2006, we introduced new products including product bundles comprised of two or more of our proprietary technology products; and shifted resources to focus on fewer but larger and more strategic OEM and distributor relationships. The reorganization of our sales and distribution network is expected to contribute to our future revenue growth as well as business acquisitions and strategic partnerships. Although gross margins are dependent on many different factors, including revenue volume, product mix and discounting, we believe that in general, gross margins should improve with revenue increases by leveraging departmental and other non-variable costs. In addition, we anticipate improved margins from higher value solution sales such as the product bundles.



In August 2007, we instituted a restructuring program which included a workforce reduction of approximately 12%. These restructuring activities are expected to yield up to $1.0 million in reduced operating costs on a quarterly basis. The savings from this program will begin in the third quarter of 2007 but will be more pronounced in the fourth quarter when we receive a full quarter of benefit. We recorded a restructuring charge in the third quarter of 2007 associated with this program.



Our business strategy calls for growth internally as well as through acquisitions. In connection with the recently acquired Sentito business, we have incurred certain incremental costs and expenses associated with the integration process. We have completed the integration process of Sentito and consolidated their operations from two facilities to one, reduced the staff level in the engineering group and have fully integrated the finance functions into our finance team in Atlanta.



Our short-term cash needs are for working capital, including cash operating losses, capital expenditures, payments on the convertible subordinated debentures of approximately $5.1 million in the next twelve months, to the extent that we do not elect to make these payments in stock, interest payments on debt outstanding, payments of the accrued loss on sublease and payments related to discontinued operations as well as payments related to prospective businesses we may acquire, if any. In addition we have scheduled payments of approximately $2.2 million on the Tranche B of the credit facility and $3.0 million on the note payable for the purchase of substantially all the operating assets of Clarent Corporation to be made in the next twelve months. We also expect to pay out approximately $2.2 million related to lease payments, net of sublease rental, in the next twelve months.



Our long-term cash needs are related to the costs of growing our current business as well as prospective businesses we may acquire, if any, including capital expenditures and working capital. Management also believes that maintaining sufficient research and development investments in product technologies is critical to the future success of our business plan. In addition, we will make required payments on our senior unsecured convertible debentures, to the extent that we do not elect to make these payments in stock, payments on Tranche B of our credit facility, the accrued loss on sublease, and liabilities of discontinued operations.



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We expect to meet these short-term and long-term cash needs through cash from operations, if any, cash on hand, borrowings under the credit facility or other debt facilities, if available, as well as through possible issuances of equity or debt securities or through the sale of assets or businesses. If sufficient borrowing capacity under a working capital line of credit is unavailable (or if we are unable to restructure our existing credit facility in the event that we require additional borrowing capacity), or if we are otherwise unable to obtain additional capital or sell assets, then we may not be able to meet our obligations and growth plans.



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Item 3:   Quantitative and Qualitative Disclosures About Market Risk



Market Risk



We are exposed to various market risks, including changes in interest rates and foreign currency exchange rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates and foreign currency exchange rates. We do not enter into derivatives or other financial instruments for trading or speculative purposes. We have also not entered into financial instruments to manage and reduce the impact of changes in interest rates and foreign currency exchange rates although we may enter into such transactions in the future.



Interest Rate Risks

Our notes payable and convertible subordinated debentures at September 30, 2007, carry interest rates which are fixed. Tranche A of our line of credit with Laurus carries interest rates which vary with the prime rate. Accordingly, if we have any indebtedness outstanding under Tranche A, then any increases in the prime rate will reduce our earnings. A 1% increase in the prime rate on the $5.8 million outstanding under Tranche A of our line of credit at September 30, 2007 would result in an annual interest expense increase of approximately $58,000.



Foreign Currency Risks



Products sold outside of the United States of America are transacted in U.S. dollars and, therefore, we are not exposed to foreign currency exchange risk on these transactions. Transactions with Verso Canada and Verso Technologies (UK) Limited, an indirect, wholly-owned subsidiary of ours, present foreign currency exchange risk. The principal transactions are personnel and related costs. The intercompany balance is denominated in U.S. dollars and changes in foreign currency rates would result in foreign currency gains and losses. Using the intercompany balance at September 30, 2007, a 10% strengthening of the U.S. dollar against the Canadian dollar and the British pound would result in a foreign currency transaction loss of approximately $59,000. To date, foreign exchange gains and losses have not been significant.



Item 4:   Controls and Procedures



Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) as of the end of the period covered by this Quarterly Report, as required by paragraph (b) of Rules 13(a)-15 or 15(d)-15 of the Exchange Act. Based on such evaluation, such officers have concluded that, as of the end of the period covered by this Quarterly Report, our disclosure controls and procedures are effective.



During the quarter ended September, 2007, there was not any change in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 or 15d-15 of the Exchange Act that has materially affected, or is reasonably likely to materially affect, our control over financial reporting.



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PART II - OTHER INFORMATION

Item 1.   Legal Proceedings



Except as described in Note 16 to our consolidated financial statements included in the Annual Report and as provided in our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2007 and June 30, 2007 and as set forth below, we are not a party to any material pending legal proceedings, other than ordinary routine litigation incidental to our business, and we do not expect this ordinary litigation to have a material adverse effect on us. There has been no material developments regarding the pending material legal proceedings described in Note 16 to our consolidated financial statements included in the Annual Report during the nine months ended September 30, 2007 except as noted in our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2007 and June 30, 2007  and as noted below:



In December 2001, a complaint was filed in the Southern District of New York seeking an unspecified amount of damages on behalf of an alleged class of persons who purchased shares of MCKs common stock between the date of MCKs initial public offering and December 6, 2000. The complaint named as defendants MCK and certain of its former officers and other parties as underwriters of its initial public offering (the MCK defendants). The plaintiffs allege, among other things, that MCKs prospectus, contained in the Registration Statement on Form S-1 filed with the SEC, was materially false and misleading because it failed to disclose that the investment banks which underwrote MCKs initial public offering of securities and others received undisclosed and excessive brokerage commissions, and required investors to agree to buy shares of securities after the
initial public offering was completed at predetermined prices as a precondition to obtaining initial public offering allocations. The plaintiffs further allege that these actions artificially inflated the price of MCKs common stock after the initial public offering. This case is one of many with substantially similar allegations known as the Laddering Cases filed before the Southern District of New York against a variety of unrelated issuers (the Issuers), directors and officers (the Laddering Directors and Officers) and underwriters (the Underwriters), and have been consolidated for pre-trial purposes before one judge to assist with administration. A motion to dismiss addressing issues common to the companies and individuals who have been sued in these actions was filed in July 2002. After a hearing on the motion to dismiss, the court, on February 19, 2003, denied dismissal of the claims against MCK as well as other Issuers.
Although MCK believes that the claims asserted are meritless, MCK and other Issuers negotiated a tentative settlement with the plaintiffs. The terms of the tentative settlement agreement provide, among other things, that (i) the insurers of the Issuers will deliver a surety undertaking in the amount of $1 billion payable to the plaintiffs to settle the actions against all Issuers and the Laddering Directors and Officers; (ii) each Issuer will assign to a litigation trust, for the benefit of the plaintiffs, any claims it may have against its Underwriters in the initial public offering for excess compensation in the form of fees or commissions paid to such Underwriters by their customers for allocation of initial public offering shares; (iii) the plaintiffs will release all claims against the Issuers and the Laddering Directors and Officers asserted or which could have been asserted in the actions arising out of the factual allegations of the amended complaints; and (iv) appropriate
releases and bar orders and, if necessary, judgment reductions, will be entered to preclude the Underwriters and any non-settling defendants from recovering any amounts from the settling Issuers or the Laddering Directors and Officers by way of contribution or indemnification. Prior to our acquisition of MCK, MCKs board of directors voted to approve the tentative settlement.  On February 15, 2005, the judge presiding over the Laddering Cases granted preliminary approval of the proposed settlement, subject to some changes, which were subsequently submitted.  The judge issued an order on August 31, 2005, further approving modifications to the settlement and certifying the class.  Notice of the settlement has been distributed to the settlement class members.  The deadline for filing objections to the settlement is March 24, 2006, and a fairness hearing was held April 26, 2006.  On December 5, 2006, the U.S. Court of Appeals for the Second Circuit issued a ruling reversing
class certification for purposes of the litigation. The plaintiffs petitioned for rehearing and rehearing en banc, and the Second Circuit Court denied the request on April 9, 2007. Because the settlement as agreed was not viable without the class certification, the parties stipulated to its termination without prejudicing their ability to apply to the court regarding a future settlement.  The court approved the stipulation in an order dated June 22, 2007. The plaintiffs are considering ways to define a new class in the case. No provision was recorded for this matter in the financial statements of MCK prepared prior to its acquisition by us because MCK believed that its portion of the proposed settlement would be paid by its insurance carrier. We agree with MCKs treatment of this matter.





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Item 1A.   Risk Factors



In addition to the other information set forth in this Quarterly Report, you should carefully consider the factors discussed in Part I, Item 1A. Risk Factors in the Annual Report and Part II, Item 1A. Risk Factors in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2007, which could materially affect our business, financial condition or future results. These risks are not the only risk factors facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.



The risk factors included in Part I, Item 1.A. Risk Factors in the Annual Report have not materially changed other than as set forth in Part II, Item 1A. Risk Factors in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2007, and as set forth below.



Our common stock may be delisted from The Nasdaq Capital Market.

Our common stock is currently quoted on The Nasdaq Capital Market.  We must satisfy certain minimum listing maintenance requirements to maintain such quotation, including a series of financial tests relating to shareholders equity or net income or market value, public float, number of market makers and shareholders, market capitalization, and maintaining a minimum bid price of $1.00 per share for the common stock.  In the past, we have experienced periods in which the minimum bid price for the common stock fell below $1.00 per share.

On June 26, 2007, The Nasdaq Stock Market, LLC notified us that for the 30 consecutive business days preceding June 26, 2007 the bid price for our common stock had closed below the minimum $1.00 per share requirement for continued inclusion of the common stock on The Nasdaq Capital Market as required by Marketplace Rule 4310(c)(4) (the Rule).  In accordance with Marketplace Rule 4310(c)(8)(D), we have 180 calendar days, or until December 24, 2007, to regain compliance with the Rule.  We may regain compliance with the Rule if the bid price of the common stock closes at $1.00 per share or more for a minimum of 10 consecutive business days at anytime before December 24, 2007.  If compliance with the Rule cannot be demonstrated by December 24, 2007 and, except for the bid price
requirement, we meet The Nasdaq Capital Market initial listing criteria set forth in Marketplace Rule 4310(c), then we will have an additional 180 calendar day compliance period in which to demonstrate compliance with the Rule.  If we do not regain compliance with the Rule prior to December 24, 2007 and we are not eligible for the additional compliance period, then The Nasdaq Stock Market, LLC will notify us that the common stock will be delisted.

If our common stock is delisted from The Nasdaq Capital Market, then the common stock may trade on the Over-the-Counter-Bulletin Board, which is viewed by most investors as a less desirable and less liquid market place.  Delisting from The Nasdaq Capital Market could make trading the common stock more difficult for our investors, leading to declines in share price. Delisting of our common stock would also make it more difficult and expensive for us to raise additional capital.  Furthermore, delisting of our common stock is an event of default under our credit facility with our primary lender, our outstanding senior unsecured convertible debentures and, through certain cross default provisions, the Loan and Security Agreement we entered into with Clarent Corporation in connection with our acquisition of substantially all of the business assets, and certain related liabilities, of Clarent
Corporation on February 12, 2003.

We may be required to pay liquidated damages to certain of our investors under certain circumstances.



Pursuant to the registration rights agreements we have entered into with the investors who purchased our securities in a private placement transaction conducted by us in January and February 2007, we have agreed to pay to such investors certain liquidated damages in the event we do not meet certain of our obligations under such registration rights agreements.  The registration statement filed on behalf of the investors was declared effective by the SEC on June 14, 2007. If this registration statement cease to remain continuously effective or the investors are not permitted to use the prospectus of which such registration statement is a part as required by the registration rights agreements for more than fifteen (15) consecutive calendar days or more than an aggregate of twenty (20) calendar days during any twelve (12)month period, then on the date of such event and each monthly
anniversary of such date until we are able to cure such event, we will be required to pay to the investors a cash payment equal to 1.5% of the aggregate purchase price paid by such investors for the securities purchased by them in the private placement; however, the maximum aggregate liquidated damages we may be obligated to pay may not exceed $1,200,000. If we are unable to satisfy our obligations under such registration rights agreements and we are obligated to pay liquidated damages, it may have a materially adverse effect on our cash flow and results of operations.



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We have significant market overhang which could adversely affect the trading price of our common stock.

As ofNovember  14, 2007, we had
(i)66,747,829shares of common
stock  outstanding,  (ii) approximately  4.2 million  shares of common
stock  issuable upon exercise of outstanding  options,  (iii) approximately
20.2 million  shares of common stock  issuable upon exercise of outstanding
warrants  and  (iv) approximately  5.7 million  shares of common stock
issuable upon conversion of the principal amount of our outstanding  convertible
debentures.  If all the outstanding options, warrants and convertible debentures
were exercised or converted, as applicable, by their holders, then approximately
an additional  30.1 million  shares of common stock would be  outstanding.  This
would represent an approximate45% increase in our outstanding common stock.  The convertible debentures are convertible, and a vast majority of the outstanding options and warrants are exercisable, at prices currently above the public trading prices of the common stock.  However, in the event that even a portion of these outstanding options and warrants were to be exercised, or a portion of the convertible debentures were to be converted, the resulting dilution could depress the trading price of the common stock.  We have registered all of the potential dilutive shares of common stock for resale pursuant to registration statements we have filed with the SEC.  If a significant portion of these shares are sold in the public marketplace by the selling shareholders identified in these registration statements, then such sales could also have a severe and adverse material affect on the trading price of the common stock.

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



On July 31, 2007, we issued an aggregate of 442,716 shares (the Shares) of our common stock to Laurus upon exercise by Laurus of a portion of a warrant to purchase shares of our common stock (the Laurus Warrant) issued to Laurus in connection with our credit agreement with Laurus. Pursuant to the terms of the Laurus Warrant, Laurus exercised the Laurus Warrant on a cashless basis and, in connection with such exercise, 6,324 shares of our common stock underlying the Laurus Warrant were cancelled in payment of the cashless exercise price. The Shares were issued without registration under the Securities Act of 1933 (the Securities Act) in reliance upon the exemption from registration set forth in Section 4(2) of the Securities Act. We based such reliance upon representations made by Laurus regarding its investment intent and sophistication, among other things.



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Item 6. Exhibits



The exhibits required to be furnished with this Quarterly Report are listed on the exhibit index attached hereto.



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SIGNATURE



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



VERSO TECHNOLOGIES, INC.





Date: November 14, 2007
        By:
        /s/ Martin D. Kidder                                        Chief Financial Officer (duly authorized signatory and Principal Financial and Accounting Officer)






























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EXHIBIT INDEX



Exhibit  No.
        Exhibit
        Method  of Filing4.1
        Form of Restricted Stock Award for restricted stock awarded pursuant to the Verso Technologies, Inc. 1999 Stock Incentive Plan, as amended.
        Filed herewith.4.2
        Form of Non-Qualified Stock Option Agreement for non-qualified stock options awarded pursuant to the Verso Technologies, Inc. 1999 Stock Incentive Plan, as amended.
        Filed herewith.4.3
        Option to purchase 16,438 shares of the Companys common stock issued to Martin D. Kidder on October 16, 2007.  Represents an executive compensation arrangement.
        Filed herewith.4.4
        Option to purchase 44,643 shares of the Companys common stock issued to Martin D. Kidder on October 18, 2007.  Represents an executive compensation arrangement.
        Filed herewith.4.5
        Option to purchase 21,825 shares of the Companys common stock issued to Mark H. Dunaway on October 16, 2007.  Represents an executive compensation arrangement.
        Filed herewith.4.6
        Option to purchase 32,738 shares of the Companys common stock issued to Steven A. Odom on October 16, 2007.  Represents an executive compensation arrangement.
        Filed herewith.4.7
        Option to purchase 89,286 shares of the Companys common stock issued to Steven A. Odom on October 18, 2007.  Represents an executive compensation arrangement.
        Filed herewith.4.8
        Restricted Stock Award Agreement dated October 16, 2007, between the Company and Martin D. Kidder with respect to 16,438 shares of the Companys common stock.  Represents an executive compensation arrangement.
        Filed herewith.4.9
        Restricted Stock Award Agreement dated October 16, 2007, between the Company and Mark H. Dunaway with respect to 21,825 shares of the Companys common stock.  Represents an executive compensation arrangement.
        Filed herewith.4.10
        Restricted Stock Award Agreement dated October 16, 2007, between the Company and Steven A. Odom with respect to 32,738 shares of the Companys common stock.  Represents an executive compensation arrangement.
        Filed herewith.4.11
        Form of Registration Rights Agreement entered into in connection with the Companys September 2007 private placement.
        Filed herewith.4.12
        Form of Warrant to purchase shares of the Companys common stock dated September 5, 2007, issued in connection with the Companys September 2007 private placement.
        Filed herewith.4.13
        Form of Warrant to purchase shares of the Companys common stock dated September 6, 2007, issued in connection with the Companys September 2007 private placement.
        Filed herewith.






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Exhibit  No.
        Exhibit
        Method  of Filing4.14
        Form of Warrant to purchase shares of the Companys common stock dated September 10, 2007, issued in connection with the Companys September 2007 private placement.
        Filed herewith.10.1
        Consulting and Separation Agreement between the Company and Montgomery Bannerman, dated June 30, 2007.
        Incorporated by reference to Exhibit 99.2 to the Companys Current Report on Form 8-K filed July 6, 2007.10.2
        Verso Technologies, Inc. 2007 Restricted Stock and Option Incentive Program.
        Incorporated by reference to Exhibit 99.1 to the Companys Current Report on Form 8-K filed October 12, 2007.31.1
        Rule 13a-14(a)/15d-14(a) Certification by the Registrants Chief Executive Officer.
        Filed herewith.31.2
        Rule 13a-14(a)/15d-14(a) Certification by the Registrants Chief Financial Officer.
        Filed herewith.32.1
        Section 1350 Certification by the Registrants Chief Executive Officer.
        Filed herewith.32.2
        Section 1350 Certification by the Registrants Chief Financial Officer.
        Filed herewith.






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