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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


FORM 10-Q

þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2003

o   TRANSITION REPORT UNDER SECTION 13 OR 15(d)
OF THE EXCHANGE ACT

For the transition period from _______________ to _________

Commission file number 0-22190



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VERSO TECHNOLOGIES, INC.

(Exact Name of Registrant as Specified in its Charter)


MINNESOTA
(State or Other Jurisdiction
of Incorporation or Organization)
    
    41-1484525
(I.R.S. Employer Identification No.)


400 Galleria Parkway, Suite 300, Atlanta, GA 30339
(Address of Principal Executive Offices)

(678) 589-3500
(Registrants Telephone Number, Including Area Code)



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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 o No x.

Indicated by check mark whether registrant is an accelerated filer (as defined
in Rule 12b-2 of the Exchange Act) Yes o No x.

Shares of the registrants common stock, par value $.01 per share, outstanding
as of November 13, 2003: 119,726,803.





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|                                 |  |  |  |  |  |  |  | 
|-------------------------------- |  |  |  |  |  |  |  | 
|EX-31.1 302 CERTIFICATION OF CEO
|EX-31.2 302 CERTIFICATION OF CFO
|EX-32.1 906 CERTIFICATION OF CEO
|EX-32.2 906 CERTIFICATION OF CFO



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##### Table of Contents



VERSO TECHNOLOGIES, INC.
FORM 10-Q

INDEX

Page No.Part I
    
    FINANCIAL INFORMATIONItem 1
    
    Financial StatementsCondensed Consolidated Balance Sheets as of September 30, 2003 andDecember 31, 2002
    
    2Condensed Consolidated Statements of Operations for the three monthsand the nine months ended September 30, 2003 and 2002
    
    3Condensed Consolidated Statements of Cash Flows for the nine monthsended September 30, 2003 and 2002
    
    4Notes to Condensed Consolidated Financial Statements
    
    5Item 2
    
    Management's Discussion and Analysis of Financial Condition andResults of Operations
    
    20Item 3
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    35Item 4
    
    Controls and Procedures
    
    35PART II
    
    OTHER INFORMATIONItem 1
    
    Legal Proceedings
    
    36Item 2
    
    Changes in Securities and Use of Proceeds
    
    37Item 6
    
    Exhibits and Reports on Form 8-K
    
    37Signature Page
    
    39Exhibit Index
    
    40


1



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

September 30,
    
    December 31,2003
    
    2002ASSETS:Current assets:Cash and cash equivalents
    
    $
    9,781
    
    
    $
    1,294Restricted cash
    
    
    2,445
    
    
    
    300Accounts receivable, net of allowance for doubtful accounts of $2,857
and $1,853 at September 30, 2003 and December 31, 2002, respectively
    
    
    17,247
    
    
    
    10,909Inventories
    
    
    9,317
    
    
    
    4,733Other current assets
    
    
    1,703
    
    
    
    681Total current assets
    
    
    40,493
    
    
    
    17,917Property and equipment, net
    
    
    5,901
    
    
    
    4,962Investment
    
    
    539
    
    
    
    600Other intangibles, net
    
    
    7,303
    
    
    
    3,671Goodwill
    
    
    14,599
    
    
    
    12,685Total assets
    
    $
    68,835
    
    
    $
    39,835LIABILITIES AND SHAREHOLDERS EQUITY:Current liabilities:Line of credit
    
    $
    
    
    
    $
    800Current portion of notes payable
    
    
    4,235
    
    
    
    Accounts payable
    
    
    3,299
    
    
    
    1,993Accrued compensation
    
    
    2,265
    
    
    
    1,586Accrued expenses
    
    
    3,472
    
    
    
    4,473Current portion of accrued costs of MCK Communications, Inc. acquisition
    
    
    4,173
    
    
    
    Unearned revenue and customer deposits
    
    
    6,716
    
    
    
    5,387Current portion of liabilities of discontinued operations
    
    
    1,278
    
    
    
    1,829Total current liabilities
    
    
    25,438
    
    
    
    16,068Liabilities of discontinued operations, net of current portion
    
    
    879
    
    
    
    1,302Other long-term liabilities
    
    
    1,722
    
    
    
    1,128Notes payable, net of discount, net of current portion
    
    
    2,643
    
    
    
    Convertible subordinated debentures, net of discount
    
    
    3,910
    
    
    
    3,703Total liabilities
    
    
    34,592
    
    
    
    22,201Shareholders equity:Common stock, $.01 par value, 200,000,000 shares authorized;
115,052,738 and 89,077,846 shares issued and outstanding
    
    
    1,151
    
    
    
    891Additional paid-in capital
    
    
    302,360
    
    
    
    275,040Notes receivable from shareholders
    
    
    
    
    
    
    (1,623
    )Accumulated deficit
    
    
    (267,980
    )
    
    
    (254,857
    )Deferred compensation
    
    
    (1,205
    )
    
    
    (1,797
    )Accumulated other comprehensive loss  foreign currency translation
    
    
    (83
    )
    
    
    (20
    )Total shareholders equity
    
    
    34,243
    
    
    
    17,634Total liabilities and shareholders equity
    
    $
    68,835
    
    
    $
    39,835


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

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 30,2003
    
    2002
    
    2003
    
    2002Revenue:Products
    
    $
    9,573
    
    
    $
    5,156
    
    
    $
    26,697
    
    
    $
    17,846Services
    
    
    5,741
    
    
    
    5,256
    
    
    
    17,473
    
    
    
    16,231Total revenue
    
    
    15,314
    
    
    
    10,412
    
    
    
    44,170
    
    
    
    34,077Cost of revenue:Products
    
    
    3,671
    
    
    
    1,936
    
    
    
    10,198
    
    
    
    6,541Services
    
    
    2,686
    
    
    
    2,624
    
    
    
    7,910
    
    
    
    7,761Total cost of revenue
    
    
    6,357
    
    
    
    4,560
    
    
    
    18,108
    
    
    
    14,302Gross profit:Products
    
    
    5,902
    
    
    
    3,220
    
    
    
    16,499
    
    
    
    11,305Services
    
    
    3,055
    
    
    
    2,632
    
    
    
    9,563
    
    
    
    8,470Total gross profit
    
    
    8,957
    
    
    
    5,852
    
    
    
    26,062
    
    
    
    19,775Operating expenses:General and administrative
    
    
    2,897
    
    
    
    2,316
    
    
    
    10,146
    
    
    
    8,424Sales and marketing
    
    
    2,402
    
    
    
    1,631
    
    
    
    6,493
    
    
    
    5,262Research and development
    
    
    2,382
    
    
    
    1,455
    
    
    
    6,661
    
    
    
    4,593Depreciation and amortization of property and equipment
    
    
    867
    
    
    
    607
    
    
    
    2,062
    
    
    
    2,086Amortization of intangibles
    
    
    263
    
    
    
    159
    
    
    
    688
    
    
    
    448Amortization of deferred compensation, related to
sales, general and administrative
    
    
    194
    
    
    
    272
    
    
    
    587
    
    
    
    920Write-down of goodwill
    
    
    10,930
    
    
    
    
    
    
    
    10,930
    
    
    
    Reorganization costs
    
    
    232
    
    
    
    131
    
    
    
    426
    
    
    
    131Total operating expenses
    
    
    20,167
    
    
    
    6,571
    
    
    
    37,993
    
    
    
    21,864Operating loss from continuing operations
    
    
    (11,210
    )
    
    
    (719
    )
    
    
    (11,931
    )
    
    
    (2,089
    )Other (expense) income, net:Other income
    
    
    
    
    
    
    22
    
    
    
    18
    
    
    
    453Equity in loss of investment
    
    
    (9
    )
    
    
    
    
    
    
    (61
    )
    
    
    Interest expense, net
    
    
    (388
    )
    
    
    (322
    )
    
    
    (1,149
    )
    
    
    (841
    )Other expense, net
    
    
    (397
    )
    
    
    (300
    )
    
    
    (1,192
    )
    
    
    (388
    )Loss from continuing operations before income taxes
    
    
    (11,607
    )
    
    
    (1,019
    )
    
    
    (13,123
    )
    
    
    (2,477
    )Income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Loss from continuing operations
    
    
    (11,607
    )
    
    
    (1,019
    )
    
    
    (13,123
    )
    
    
    (2,477
    )Loss from discontinued operations, net of income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (331
    )Net loss
    
    $
    (11,607
    )
    
    $
    (1,019
    )
    
    $
    (13,123
    )
    
    $
    (2,808
    )Net loss per common share  basic and diluted:Loss from continuing operations
    
    $
    (0.12
    )
    
    $
    (0.01
    )
    
    $
    (0.14
    )
    
    $
    (0.03
    )Loss from discontinued operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.01
    )Net loss per common share  basic and diluted
    
    $
    (0.12
    )
    
    $
    (0.01
    )
    
    $
    (0.14
    )
    
    $
    (0.04
    )Weighted average shares outstanding  basic and diluted
    
    
    96,507,282
    
    
    
    78,970,101
    
    
    
    92,361,308
    
    
    
    78,373,925


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

3



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VERSO TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

For the nine months ended September 30,2003
    
    2002Operating
Activities:Continuing operations:Net loss from continuing operations
    
    $
    (13,123
    )
    
    $
    (2,477
    )Adjustments to reconcile net loss from continuing operations to net
cash provided by (used in) continuing operating activities:Equity in loss of investment
    
    
    61
    
    
    
    Depreciation
    
    
    2,062
    
    
    
    2,086Amortization of intangibles
    
    
    688
    
    
    
    448Amortization of deferred compensation
    
    
    587
    
    
    
    920Writedown of goodwill
    
    
    10,930
    
    
    
    Provision for doubtful accounts
    
    
    1,573
    
    
    
    1,150Amortization of loan fees and discount on notes and convertible subordinated debentures
    
    
    415
    
    
    
    452Other
    
    
    (112
    )
    
    
    86Changes in current operating assets and liabilities, net of effects of acquisition:Accounts receivable
    
    
    (3,709
    )
    
    
    (3,397
    )Inventories
    
    
    2,547
    
    
    
    (492
    )Other current assets
    
    
    (155
    )
    
    
    (262
    )Accounts payable
    
    
    708
    
    
    
    512Accrued compensation
    
    
    552
    
    
    
    (1,684
    )Accrued expenses
    
    
    (2,591
    )
    
    
    (154
    )Unearned revenue and customer deposits
    
    
    316
    
    
    
    8Net cash provided by (used in) continuing operating activities
    
    
    749
    
    
    
    (2,804
    )Discontinued operations:Loss from discontinued operations
    
    
    
    
    
    
    (331
    )Adjustment to reconcile loss from discontinued operations
to net cash used in discontinued operating activities
    
    
    (710
    )
    
    
    (566
    )Net cash used in discontinued operating activities
    
    
    (710
    )
    
    
    (897
    )Net cash provided by (used in) operating activities
    
    
    39
    
    
    
    (3,701
    )Investing
Activities:Purchases of property and equipment
    
    
    (977
    )
    
    
    (648
    )Software development costs capitalized
    
    
    (481
    )
    
    
    (267
    )Purchase of Clarent Corporation assets, net of cash acquired
    
    
    (1,122
    )
    
    
    Purchase of MCK Communications, Inc., net of cash acquired
    
    
    9,915
    
    
    
    Net cash provided by (used in) investing activities
    
    
    7,335
    
    
    
    (915
    )Financing
Activities:Payments of note payable for the purchase of NACT
    
    
    
    
    
    
    (2,000
    )Payments of notes payable
    
    
    (2,550
    )
    
    
    Shareholder note repayments
    
    
    1,771
    
    
    
    24Net repayments under line of credit
    
    
    (800
    )
    
    
    Proceeds from issuances of common stock, net
    
    
    2,744
    
    
    
    289Net cash provided by (used in) financing activities
    
    
    1,165
    
    
    
    (1,687
    )Effect of exchange rate changes on cash
    
    
    (52
    )
    
    
    Increase (decrease) in cash and cash equivalents
    
    
    8,487
    
    
    
    (6,303
    )Cash and cash equivalents at beginning of period
    
    
    1,294
    
    
    
    7,745Cash and cash equivalents at end of period
    
    $
    9,781
    
    
    $
    1,442Supplemental
disclosure of cash flow information:Cash payments during the period for:Interest
    
    $
    609
    
    
    $
    244Income taxes
    
    $
    11
    
    
    $
    45Non-cash investing and financing activitiesCommon stock consideration for MCK Communications, Inc.
issuance of 18,280,000 shares of common stock
    
    $
    24,130
    
    
    $
    Common stock and compensatory
options issued in reorganization
    
    
    264
    
    
    
    Issuance of common stock in arbitration settlement
    
    
    264
    
    
    
    403Issuance of warrants in exchange for services
    
    
    119
    
    
    
    211Assets acquired and liabilities assumed in conjunction with business acquisitions:Fair value of assets acquired, excluding cash
    
    $
    33,175
    
    
    $
    Consideration paid, including common stock
    
    
    15,337
    
    
    
    Liabilities assumed
    
    $
    17,838
    
    
    $
    


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

4



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VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2003

(Unaudited)



|1. |  | BUSINESS AND BASIS OF PRESENTATION
|-- |  | ----------------------------------



| |  | Verso Technologies, Inc. and subsidiaries (the Company) is 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. The Companys continuing operations include
two separate business segments, the Carrier Solutions Group, which the
Company formerly referred to as its Gateway Solutions business, which
includes the Companys Clarent softswitching division and the Companys
subsidiary NACT Telecommunications, Inc. (NACT), and the Enterprise
Solutions Group, which the Company formerly referred to as its
Applications and Services business, which includes the Companys Clarent
Netperformer division, the Companys subsidiaries Telemate.Net Software,
Inc. (Telemate.Net) and MCK Communications, Inc. (MCK) and the
Companys customer response center operations. The Carrier Solutions
Group includes domestic and international sales of hardware and software,
integration, applications and technical training and support. The
Enterprise Solutions Group offers hardware-based solutions (which include
software) for companies seeking to build private, packet-based voice
and
data networks. Additionally, the Enterprise Solutions Group offers software-based
solutions for Internet access and usage management that include call
accounting and usage reporting for Internet protocol network devices.
These solutions are supported by the Companys customer response center
services, which include outsourced technical support and application
installation and training services. The Company acquired MCK in September
2003, substantially all the business assets of Clarent Corporation
(Clarent) in February 2003, NACT in July 2001 and Telemate.Net in
November 2001. The Companys discontinued operations include the
Companys value-added reseller business and associated consulting practice
(legacy VAR business) and the Companys hospitality services group
(HSG), all of which were inactive by the end of the first quarter of
2002.
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The condensed consolidated financial statements include the accounts of
Verso Technologies, Inc. and its wholly-owned subsidiaries, including MCK,
Telemate.Net, NACT and Clarent Canada Ltd. Since the Companys
acquisition of MCK closed at the end of the third quarter of 2003, MCKs
operating results will not be included in the Companys consolidated results
until the fourth quarter of 2003.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  | 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 the Companys 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 the
Companys audited consolidated financial statements. The accompanying
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 the Companys Annual Report
on Form 10-K for the year ended December 31, 2002.
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|2. |  | MERGERS AND ACQUISITIONS
|-- |  | ------------------------



| |  | MCK Communications, Inc.
| |  | ------------------------



| |  | On September 26, 2003, to increase capital, which strengthened the
Companys balance sheet, and to enhance the Companys ability to provide
technology that allows enterprises the ability to migrate to
next-generation environments, the Company acquired all of the outstanding
capital stock of MCK by means of a subsidiary merger. The fair value of
the acquisition cost was approximately $25.1 million, consisting of
18,280,000 shares of the Companys common stock with a fair value of $24.1
million and acquisition costs of approximately $1.0 million.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|2. |  | MERGERS AND ACQUISITIONS, Continued
|-- |  | -----------------------------------



| |  | MCK Communications, Inc.  Continued
| |  | ------------------------------------



| |  | The acquisition was treated as a purchase for accounting purposes, and
accordingly, the assets and liabilities were recorded at their fair value
at the date of the acquisition.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Company has prepared an initial allocation of the purchase price based
on the estimated fair values of certain assets, including receivables, and
liabilities. The Company continues to obtain information as to the
valuation of inventories, certain acquired assets and certain estimated
liabilities. The Company anticipates the fair value assessments and
allocation of the purchase price to be finalized in 2003.
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In April 2003, the Company negotiated the original agreement to purchase
MCK in which the MCK stockholders would be entitled to receive
approximately 20.0 million shares of the Companys common stock which was
valued at $13.0 million, based on the volume weighted average closing
price per share of the Companys common stock as reported on the Nasdaq
SmallCap Market for the twenty trading day period beginning March 19, 2003
and ending April 15, 2003. As part of the original agreement, the Company
was to receive $7.5 million in cash. The terms of the agreement were
amended on June 13, 2003. Under the amended terms, MCK stockholders were
entitled to receive approximately 18.3 million shares of the Companys
common stock and the cash MCK was required to have at the closing of the
merger was reduced from $7.5 million to approximately $6.4 million.
Although the number of shares of the Companys common stock to be issued
in the merger was reduced by the amendment, the amendment changed the
measurement date for valuing such shares. As a result of the increase in
the price of the Companys common stock prior to June 13, 2003, the
revised valuation for the shares of the Companys common stock to be
issued in the merger increased to $24.1 million. As a result of this
increase in value, the goodwill recorded in the merger was impaired upon
closing the merger. The Company completed an impairment analysis in
accordance with Statement of Financial Accounting Standards (SFAS) No.
142, Goodwill and Other Intangible Assets (SFAS No. 142). Based upon
this analysis, the Company recorded a write-off of approximately $10.9
million during the quarter ended September 30, 2003.
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Clarent Corporation
| |  | -------------------



| |  | On February 12, 2003, to enhance the Companys position in the
next-generation networking and technology market, the Company acquired
substantially all the business assets and certain related liabilities of
Clarent. The purchase consideration was approximately $10.8 million,
consisting of $9.3 million in discounted seller notes issued by the
Company and acquisition costs of approximately $1.5 million. At the
closing of the acquisition, the Company issued three promissory notes to
Clarent: a $5.0 million secured note due February 13, 2004, which bears
interest at 10% per annum, of which $1.8 million was paid through
September 30, 2003, and the remainder of which is due in monthly
installments continuing in October 2003 of $500,000 and increasing to
$750,000 in December 2003; a $1.8 million non-interest bearing unsecured
note due February 13, 2004, discounted at 6.25% per annum, of which
$800,000 was paid through September 30, 2003 and the remainder of which is
due in quarterly installments of $500,000; and a $3.0 million secured note
due February 12, 2008, which bears interest at 5% per annum, discounted at
7.5% per annum. The unamortized discount totaled approximately $372,000
at September 30, 2003. The assets the Company purchased from Clarent
secure the secured notes.
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The acquisition was treated as a purchase for accounting purposes, and
accordingly, the assets and liabilities were recorded at their fair value
at the date of the acquisition.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Company has prepared an initial allocation of the purchase price based
on the estimated fair values of certain assets, including receivables, and
liabilities. The Company continues to obtain information as to the
valuation of inventories, certain acquired assets being held for sale and
certain estimated liabilities. The Company anticipates the fair value
assessments and allocation of the purchase price to be finalized in 2003.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|2. |  | MERGERS AND ACQUISITIONS, Continued
|-- |  | -----------------------------------



| |  | The preliminary allocations of the costs of acquisitions of MCK and the
net assets of Clarent, as adjusted, are as follows (in thousands):
| |  | ------------------------------------------------------------------------------------------------------------------------------------------

MCK
    
    ClarentCash and cash equivalents
    
    $
    10,575
    
    
    $
    350Restricted cash
    
    
    2,015
    
    
    
    115Accounts receivable
    
    
    1,264
    
    
    
    2,938Inventories
    
    
    1,039
    
    
    
    6,092Other current assets
    
    
    395
    
    
    
    613Property and equipment
    
    
    372
    
    
    
    1,650Other intangible assets
    
    
    3,600
    
    
    
    240Goodwill
(including $10.9 million written-off)
    
    
    12,843
    
    
    
    Accounts payable
    
    
    (495
    )
    
    
    (103
    )Accrued compensation
    
    
    (193
    )
    
    
    (198
    )Current portion of accrued costs of MCK acquisition
    
    
    (4,173
    )
    
    
    Accrued expenses
    
    
    (918
    )
    
    
    (377
    )Deferred revenue
    
    
    (533
    )
    
    
    (480
    )Accrued costs of MCK acquisition, net of current portion
    
    
    (661
    )
    
    
    Cost
of acquisition
    
    $
    25,130
    
    
    $
    10,840




| |  | Pro Forma Effect of MCK and Clarent Transactions
| |  | ------------------------------------------------



| |  | The condensed consolidated statements of operations reflect only the
write-down of goodwill related to the acquisition of MCK; the results of
MCKs operations will be included beginning October 1, 2003. The results
of Clarents operations have been included in the consolidated results
subsequent to February 12, 2003. The following unaudited pro forma
information presents the results of continuing operations of the Company
for the three and nine months ended September 30, 2003 and 2002, as if the
acquisitions of MCK and the net assets of Clarent had taken place on
January 1, 2002 (the write-down of goodwill totaling $10.9
million is reflected only in the pro forma information for the nine
months ended September 30, 2002) (in thousands, except per share amounts):
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Three months ended September 30,
    
    Nine months ended September 30,2003
    
    2002
    
    2003
    
    2002Revenues
    
    $
    18,366
    
    
    $
    20,867
    
    
    $
    54,997
    
    
    $
    71,813Loss from continuing operations
    
    $
    (1,289
    )
    
    $
    (10,195
    )
    
    $
    (9,423
    )
    
    $
    (51,471
    )Net loss
    
    $
    (1,289
    )
    
    $
    (10,195
    )
    
    $
    (9,423
    )
    
    $
    (51,802
    )Loss from continuing operations per common share
- basic and diluted
    
    $
    (0.01
    )
    
    $
    (0.10
    )
    
    $
    (0.09
    )
    
    $
    (0.53
    )Net loss per common share  basic and diluted
    
    $
    (0.01
    )
    
    $
    (0.10
    )
    
    $
    (0.09
    )
    
    $
    (0.54
    )Weighted average shares outstanding
- basic and diluted
    
    
    114,787
    
    
    
    97,250
    
    
    
    110,641
    
    
    
    96,654


7



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VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|3. |  | UNCONSOLIDATED AFFILIATES
|-- |  | -------------------------



| |  | Shanghai BeTrue Infotech Co., Ltd.
| |  | ----------------------------------



| |  | In October 2002, the Company 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 the Company with an immediate
distribution channel into the China and Asia-Pacific region for the
Companys application-based Voice over Internet Protocol gateway
solutions, billing systems, value-added applications and web filtering
solutions. Due to the shared decision making between the Company and its
equity partner, the results of BeTrues operations are accounted for under
the equity method rather than being consolidated with the Companys
operations.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  | Summarized financial information reported by this affiliate for the three
month and nine months ended September 30, 2003 (in thousands) are as
follows:
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

Operating results:September 30, 2003Three months ended
    
    Nine months endedRevenue
    
    $
    152
    
    
    $
    812Operating loss
    
    $
    (18
    )
    
    $
    (134
    )Net loss
    
    $
    (18
    )
    
    $
    (121
    )




|4. |  | DISCONTINUED OPERATIONS
|-- |  | -----------------------



| |  | Following the acquisition of NACT in July 2001, the Company determined
that its legacy VAR business was not strategic to the Companys ongoing
objectives and thus discontinued its capital and human resource investment
in its legacy VAR business. Accordingly, the Company elected to report its
legacy VAR business as discontinued operations by early adoption of SFAS
No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets
(SFAS No. 144).
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Summary operating results of the discontinued operations for the three and
nine months ended September 30, 2003 and 2002 (in thousands) were as
follows:
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------

Three
months endedSeptember 30,
    
    Nine
months endedSeptember 30,2003
    
    2002
    
    2003
    
    2002Revenue
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    223Gross loss
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    (331
    )Operating loss
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    (331
    )Loss from discontinued operations
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    (331
    )


8



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VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|4. |  | DISCONTINUED OPERATIONS, Continued
|-- |  | ----------------------------------



| |  | Liabilities of discontinued operations (in thousands) are as follows:
| |  | ---------------------------------------------------------------------

September 30,
    
    December 31,2003
    
    2002Accrued restructuring costs
    
    $
    1,666
    
    
    $
    2,010Other current liabilities
    
    
    491
    
    
    
    1,121Liabilities of discontinued operations
    
    $
    2,157
    
    
    $
    3,131




| |  | Accrued restructuring costs relate primarily to several leases for
buildings and equipment that were utilized by the discontinued operations
and 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 for one of the leases with total
payments remaining of $2.4 million assumes that the building will be
sub-leased for approximately 43% of the total lease liability over the
remaining term of the lease.
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The 2003 activity in the restructuring accrual under discontinued
operations (in thousands) was as follows:
| |  | -----------------------------------------------------------------------------------------------------------

Balance December 31, 2002
    
    $
    2,010Lease payments
    
    
    (545
    )Additional restructuring accrual
    
    
    201Balance September 30, 2003
    
    $
    1,666




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



| |  | Inventories consist primarily of purchased electronic components, and are
stated at the lower of cost or market. Cost is determined by using the
first-in, first-out method.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Inventories as of September 30, 2003 and December 31, 2002, are comprised
of the following (in thousands):
| |  | ----------------------------------------------------------------------------------------------------------

September 30,
    
    December 31,2003
    
    2002Raw materials
    
    $
    6,971
    
    
    $
    1,566Work in process
    
    
    1,192
    
    
    
    2,380Finished goods
    
    
    1,154
    
    
    
    787Total inventories
    
    $
    9,317
    
    
    $
    4,733


9



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VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|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 purchased software development, channels of distribution,
strategic licenses, current technology and a customer relationship.
Purchased software development is amortized on a straight-line
basis over an estimated useful life of three years once the projects are
placed in service. The channels of distribution, strategic licenses and
current technology are amortized on a straight-line basis over their
estimated useful life of three years. The customer relationship is
amortized on a straight-line basis over its estimated useful life of ten
years.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Goodwill and other intangible assets consist of the following (in
thousands):
| |  | -----------------------------------------------------------------------------

September 30,
    
    December 31,2003
    
    2002Intangibles subject to amortization:Purchased software development
    
    $
    2,576
    
    
    $
    2,096Channels of distribution
    
    
    900
    
    
    
    Strategic licenses
    
    
    1,800
    
    
    
    Current technology
    
    
    1,140
    
    
    
    Customer relationship
    
    
    2,403
    
    
    
    2,4038,819
    
    
    
    4,499Accumulated amortization
    
    
    (1,516
    )
    
    
    (828
    )Net intangibles subject to amortization
    
    
    7,303
    
    
    
    3,671Goodwill
    
    
    14,599
    
    
    
    12,685Total goodwill and other intangibles
    
    $
    21,902
    
    
    $
    16,356




| |  | In April 2003, the Company negotiated the original agreement to purchase
MCK in which the MCK stockholders would be entitled to receive
approximately 20.0 million shares of the Companys common stock which was
valued at $13.0 million, based on the volume weighted average closing
price per share of the Companys common stock as reported on the Nasdaq
SmallCap Market for the twenty trading day period beginning March 19, 2003
and ending April 15, 2003. As part of the original agreement, the Company
was to receive $7.5 million in cash. The terms of the agreement were
amended on June 13, 2003. Under the amended terms, MCK stockholders were
entitled to receive approximately 18.3 million shares of the Companys
common stock and the cash MCK was required to have at the closing of the
merger was reduced from $7.5 million to approximately $6.4 million.
Although the number of shares of the Companys common stock to be issued
in the merger was reduced by the amendment, the amendment changed the
measurement date for valuing such shares. As a result of the increase in
the price of the Companys common stock prior to June 13, 2003, the
revised valuation for the shares of the Companys common stock to be
issued in the merger increased to $24.1 million. As a result of this
increase in value, the goodwill recorded in the merger was impaired upon
closing the merger. The Company completed an impairment analysis in
accordance with SFAS No. 142. Based upon this analysis, the Company
recorded a write-off of approximately $10.9 million during the quarter
ended September 30, 2003.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

10



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VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|6. |  | GOODWILL AND OTHER INTANGIBLES, Continued
|-- |  | -----------------------------------------



| |  | Estimated future annual amortization expense is as follows (in
thousands):
| |  | --------------------------------------------------------------------------

AnnualAmortizationremaining 2003
    
    $
    5332004
    
    
    1,9682005
    
    
    1,8382006
    
    
    1,4502007
    
    
    311Thereafter
    
    
    1,203$
    7,303




|7. |  | LOAN FACILITY WITH SILICON VALLEY BANK
|-- |  | --------------------------------------



| |  | In February 2003, the Company amended its original credit agreement (the
Original Credit Agreement) with its primary lender, Silicon Valley Bank
(Silicon) to increase the Companys credit line with Silicon from $5.0
million to $10.0 million, subject to borrowing availability. The Company
also entered into certain additional arrangements with Silicon including
an export-import (EX-IM) facility that will provide for working capital
based on the Companys international accounts receivable and inventories
related to export sales. The Company and Silicon further amended the
credit facility in connection with the acquisition of MCK and the
acquisition of substantially all of the business assets along with related
liabilities of Clarent (as amended, the Amended Credit Agreement). The
Companys borrowings under the Amended Credit Agreement are secured by
substantially all of the assets of the Company. Interest is incurred at
2.0% above Silicons Base Rate, with a minimum Base Rate of 4.25% (6.25%
at September 30, 2003). The Amended Credit Agreement provides for up to
$2.5 million in letters of credit. Advances are limited by a formula
based on eligible receivables, inventories, certain cash balances,
outstanding letters of credit and certain subjective limitations.
Interest payments are due monthly, and the Amended Credit Agreement
expires in August 2004. The Amended Credit Agreement includes a loan fee
of $170,000 and .375% on unused available borrowings. Under the terms of
the Amended Credit Agreement, the Company must maintain a minimum EBITDA
(earnings before interest, taxes, depreciation and amortization), computed
monthly, and may not declare dividends or incur any additional
indebtedness without the consent of Silicon, and must comply with other
financial covenants, as defined in the Amended Credit Agreement. The
Company was in compliance with these covenants as of September 30, 2003.
Pursuant to the loan commitment letter with Silicon, on February 12, 2003,
the Company issued to Silicon a warrant to purchase 350,000 shares of the
Companys common stock at an exercise price of $0.44 per share. The fair
value of the warrant issued totaled approximately $119,000, using the
Black-Scholes option pricing method based on the following
weighted-average assumptions: expected volatility  104%;
expected life  five years; risk-free interest rate  3.0%;
and expected dividend yield  0%. The loan fees and fair value of the warrants issued are being
amortized to interest expense over the term of the Amended Credit
Agreement.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Company had no borrowings under the Amended Credit Agreement as of
September 30, 2003. The availability under the Amended Credit Agreement
at September 30, 2003 was $10.0 million. The Company has an outstanding
stand-by letter of credit in the amount of $200,000 at
September 30, 2003 which would reduce borrowing capacity under
the Amended Credit Agreement.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

11



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VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|8. |  | CONVERTIBLE SUBORDINATED DEBENTURES
|-- |  | -----------------------------------



| |  | In connection with the acquisition of MessageClick, Inc. in November 2000
(MessageClick) certain investors of MessageClick purchased $4.5 million
of the Companys 7.5% convertible subordinated debentures and warrants to
purchase an aggregate of 1,275,970 shares of the Companys common stock at
an exercise price of $5.88 per share. The debentures are convertible into
the Companys common stock at a conversion price of $3.57 per share. The
convertible subordinated debentures are due November 22, 2005. The
debentures have been discounted to reflect the fair value of the warrants
issued, totaling approximately $1.4 million, using the Black-Scholes
option pricing method based on the following weighted-average assumptions:
expected volatility  88%; expected life  five years; risk-free interest
rate  5.5%; and expected dividend yield  0%. The unamortized discount
totaled approximately $590,000 and $797,000 at September 30, 2003 and
December 31, 2002, respectively. In addition, the Company paid certain
private placement fees and attorneys fees in connection with the sale of
the debentures totaling $50,000. The fees are being amortized to interest
expense over the term of the debentures.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|9. |  | OTHER COMPREHENSIVE LOSS
|-- |  | ------------------------



| |  | Comprehensive loss for the three and nine months ended September 30, 2003 and 2002
is shown in the following table (in thousands):
| |  | ----------------------------------------------------------------------------------------------------------------------------------

Three months ended September 30,
    
    Nine months ended September 30,2003
    
    2002
    
    2003
    
    2002Net loss
    
    $
    (11,607
    )
    
    $
    (1,019
    )
    
    $
    (13,123
    )
    
    $
    (2,808
    )Other comprehensive income (loss):Foreign currency translation
    
    
    (36
    )
    
    
    1
    
    
    
    (63
    )
    
    
    (2
    )Comprehensive loss
    
    $
    (11,643
    )
    
    $
    (1,018
    )
    
    $
    (13,186
    )
    
    $
    (2,810
    )




|10. |  | SEGMENT INFORMATION
|--- |  | -------------------



| |  | The Company reports information for two segments, Carrier Solutions Group,
which the Company formerly referred to as its Gateway Solutions business,
and Enterprise Solutions Group, which the Company formerly referred to as
its Applications and Services business.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

CarrierSolutionsGroup:
    
    The Companys Carrier Solutions Group consists of the operations of
the Companys Clarent softswitching division and the Companys
switching subsidiary, NACT. The Companys Carrier Solutions Group
includes hardware and software, integration, applications and
technical training and support.EnterpriseSolutionsGroup:
    
    The Companys Enterprise Solutions Group consists of the operations
of the Companys Clarent Netperformer division, the Companys
subsidiary, Telemate.Net and the Companys customer response center
services. The Enterprise Solutions Group offers hardware-based
solutions (which include software) for companies seeking to build
private, packet-based voice and data networks. Additionally, the
Enterprise Group offers software-based solutions for Internet access
and usage management that include call accounting and usage reporting
for Internet protocol network devices. These solutions are supported
by the Companys customer response center services, which include
outsourced technical support and application installation and
training services.


12



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##### Table of Contents



VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|10. |  | SEGMENT INFORMATION, Continued
|--- |  | ------------------------------



| |  | Management evaluates the business segment performance based on
contributions before unallocated items. Inter-segment sales and transfers
are not significant.
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Summarized financial information concerning the Companys reportable
segments is shown in the following table (in thousands):
| |  | -----------------------------------------------------------------------------------------------------------------------------

Carrier
    
    EnterpriseSolutions
    
    SolutionsGroup
    
    Group
    
    TotalFor the Three Months Ended September 30,2003Revenue
    
    $
    7,575
    
    
    $
    77,739
    
    
    $
    15,314Contribution before unallocated items
    
    
    86
    
    
    
    2,990
    
    
    
    3,0762002Revenue
    
    $
    5,665
    
    
    $
    4,747
    
    
    $
    10,412Contribution before unallocated items
    
    
    180
    
    
    
    1,655
    
    
    
    1,835


The following table reconciles the total contribution before unallocated
items to the loss from continuing operations (in thousands):

Three Months Ended September 30,2003
    
    2002Contribution before unallocated items, per above
    
    $
    3,076
    
    
    $
    1,835Corporate and administrative expenses
    
    
    (1,800
    )
    
    
    (1,385
    )Depreciation
    
    
    (867
    )
    
    
    (607
    )Amortization of intangibles
    
    
    (263
    )
    
    
    (159
    )Deferred compensation
    
    
    (194
    )
    
    
    (272
    )Write-down of goodwill
    
    
    (10,930
    )
    
    
    Reorganization costs
    
    
    (232
    )
    
    
    (131
    )Other income
    
    
    
    
    
    
    22Equity in loss of investment
    
    
    (9
    )
    
    
    Interest expense, net
    
    
    (388
    )
    
    
    (322
    )Loss from continuing operations before income taxes
    
    $
    (11,607
    )
    
    $
    (1,019
    )


13



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##### Table of Contents



VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|10. |  | SEGMENT INFORMATION, Continued
|--- |  | ------------------------------

Carrier
    
    EnterpriseSolutions
    
    SolutionsGroup
    
    Group
    
    TotalFor the Nine Months Ended September 30,2003Revenue
    
    $
    23,427
    
    
    $
    20,743
    
    
    $
    44,170Contribution before unallocated items
    
    
    1,940
    
    
    
    6,687
    
    
    
    8,6272002Revenue
    
    $
    20,270
    
    
    $
    13,807
    
    
    $
    34,077Contribution before unallocated items
    
    
    2,449
    
    
    
    4,461
    
    
    
    6,910




| |  | The following table reconciles the total contribution before unallocated
items to the loss from continuing operations (in thousands):
| |  | -------------------------------------------------------------------------------------------------------------------------------------

Nine Months Ended September 30,2003
    
    2002Contribution before unallocated items, per above
    
    $
    8,627
    
    
    $
    6,910Corporate and administrative expenses
    
    
    (5,865
    )
    
    
    (5,414
    )Depreciation
    
    
    (2,062
    )
    
    
    (2,086
    )Amortization of intangibles
    
    
    (688
    )
    
    
    (448
    )Deferred compensation
    
    
    (587
    )
    
    
    (920
    )Write-down of goodwill
    
    
    (10,930
    )
    
    
    Reorganization costs
    
    
    (426
    )
    
    
    (131
    )Other income
    
    
    18
    
    
    
    453Equity in loss of investment
    
    
    (61
    )
    
    
    Interest expense, net
    
    
    (1,149
    )
    
    
    (841
    )Loss from continuing operations before income taxes
    
    $
    (13,123
    )
    
    $
    (2,477
    )




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

Canada
    
    United States
    
    TotalFor the Three Months Ended September 30,2003Revenue
    
    $
    
    
    
    $
    15,314
    
    
    $
    15,314Contribution before unallocated items
    
    
    (745
    )
    
    
    3,821
    
    
    
    3,076For the Nine Months Ended September 30,2003Revenue
    
    $
    
    
    
    $
    44,170
    
    
    $
    44,170Contribution before unallocated items
    
    
    (2,113
    )
    
    
    10,740
    
    
    
    8,627


14



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##### Table of Contents



VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



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



| |  | In the third quarter of 2003, the Company initiated a reorganization as a
part of its effort to consolidate functions and improve operational
efficiencies and eliminated 11 employee positions. As a result of these
actions, the Company recorded reorganization costs of $232,000 during the
three and nine months ended September 30, 2003. The reorganization costs
consist of severance costs and non-cash stock compensation expense related
primarily to the acceleration of vesting of options. The balance of the accrued
severance costs as of September 30, 2003 is $16,000.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In the first quarter of 2003, the Company initiated a reorganization to
accommodate the acquisition of the assets of Clarent and eliminated 14
positions held by employees. As a result of these actions, the Company
recorded reorganization costs of $194,000 during the nine months ended
September 30, 2003. The reorganization costs consist of severance costs
and all amounts due have been paid as of September 30, 2003.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In the third quarter of 2002, the Company announced a reorganization as a
part of its effort to improve operational efficiencies and financial
performance and eliminated 19 positions held by employees. As a result of
these actions, the Company recorded reorganization costs of $131,000
during the nine months ended September 30, 2002. The reorganization costs
consist of severance costs.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  | The Company has a stock option plan for employees, consultants, and other
individual contributors to the Company. In addition, in connection with
various financing and acquisition transactions, and for services provided
to the Company, the Company has issued warrants to purchase the Companys
common stock. A summary of stock options and warrants outstanding at
September 30, 2003, is as follows:
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Options and warrants issued to employees:
| |  | -----------------------------------------

Options and Warrants Outstanding
    
    Options and Warrants ExercisableRange of Exercise
    
    Outstanding at
    
    Weighted Average
    
    Exercisable
    
    Weighted AveragePrices
    
    September 30, 2003
    
    Exercise Price
    
    at September 30, 2003
    
    Exercise Price$
0.19 to $0.50
    
    
    3,841,536
    
    
    $
    0.42
    
    
    
    2,145,244
    
    
    $
    0.40$
0.51 to $1.19
    
    
    2,161,801
    
    
    $
    0.96
    
    
    
    1,007,146
    
    
    $
    0.86$
1.20 to $1.50
    
    
    480,750
    
    
    $
    1.43
    
    
    
    425,750
    
    
    $
    1.45$
1.51 to $2.14
    
    
    4,632,793
    
    
    $
    2.14
    
    
    
    3,527,981
    
    
    $
    2.14$
2.25 to $3.90
    
    
    2,087,934
    
    
    $
    3.38
    
    
    
    1,014,095
    
    
    $
    3.26$
4.14
to $5.13
    
    
    1,512,291
    
    
    $
    4.31
    
    
    
    1,153,016
    
    
    $
    4.34$
5.22
to $18.00
    
    
    616,819
    
    
    $
    7.03
    
    
    
    612,663
    
    
    $
    7.03$
    0.19 to $18.00
    
    
    15,333,924
    
    
    $
    2.10
    
    
    
    9,885,895
    
    
    $
    2.28




| |  | Options and warrants issued to employees generally expire ten years
from the date of grant and vesting periods are typically four years from
the date of grant. Expiration dates of the options and warrants listed
above range from October 18, 2003 to September 26, 2013.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

15



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##### Table of Contents



VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



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



| |  | Warrants issued primarily in connection with financing:
| |  | -------------------------------------------------------

Number of
    
    Weighted AverageExercise Price
    
    Outstanding Warrants
    
    Exercise Price
    
    Expiration Date$0.01
    
    
    37,532
    
    
    $
    0.01
    
    
    September 2005-October 2006$0.31
    
    
    5,938,585
    
    
    $
    0.31
    
    
    October 2007$0.44-$1.64
    
    
    2,187,459
    
    
    $
    1.22
    
    
    November 2004-February 2008$1.82-$3.09
    
    
    441,862
    
    
    $
    2.83
    
    
    August 2004-August 2005$4.03-$5.00
    
    
    662,413
    
    
    $
    4.07
    
    
    January 2004-November 2005$5.25-$5.65
    
    
    4,659,839
    
    
    $
    5.64
    
    
    February 2005-October 2006$5.88-$6.00
    
    
    1,425,970
    
    
    $
    5.89
    
    
    November 2005-October 2006Total
    
    
    15,353,660
    
    
    $
    2.81




| |  | Most of the warrants were vested when issued.
| |  | ---------------------------------------------



| |  | The total number of options and warrants outstanding as of September 30,
2003 was 30,687,584.
| |  | ---------------------------------------------------------------------------------------------



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



| |  | If the Company had used the fair value-based method of accounting for its
stock option and incentive plans and charged compensation cost against
income, then over the vesting period, based on the fair value of options
at the date of grant, the net loss and net loss per common share would
have been increased to the following pro forma amounts (in thousands,
except for per share amounts):
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Three months ended September 30,
    
    Nine months ended September 30,2003
    
    2002
    
    2003
    
    2002Net loss, as reported
    
    $
    (11,607
    )
    
    $
    (1,019
    )
    
    $
    (13,123
    )
    
    $
    (2,808
    )Add: Stock-based compensation
expense included in net loss
    
    
    194
    
    
    
    272
    
    
    
    587
    
    
    
    920Less: Total stock-based employee
compensation expense determined
under fair value based method
for all awards
    
    
    (844
    )
    
    
    (824
    )
    
    
    (2,450
    )
    
    
    (2,472
    )Pro forma net loss
    
    $
    (12,257
    )
    
    $
    (1,571
    )
    
    $
    (14,986
    )
    
    $
    (4,360
    )Net loss per common shareAs reported
    
    $
    (0.12
    )
    
    $
    (0.01
    )
    
    $
    (0.14
    )
    
    $
    (0.04
    )Pro forma
    
    
    (0.13
    )
    
    
    (0.02
    )
    
    
    (0.16
    )
    
    
    (0.06
    )


16



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##### Table of Contents



VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|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, 2003 and 2002 does not include the
effect of the common stock equivalents, calculated by the treasury stock
method, as their impact would be antidilutive. Using the treasury stock
method, common stock equivalents are as follows:
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

For the three months ended
    
    For the nine months endedSeptember, 30
    
    September, 302003
    
    2002
    
    2003
    
    2002Shares issuable under stock options
    
    
    7,061,632
    
    
    
    833,216
    
    
    
    4,768,705
    
    
    
    2,616,516Shares issuable pursuant to warrants
to purchase common stock
    
    
    7,674,188
    
    
    
    36,570
    
    
    
    7,685,705
    
    
    
    188,54814,735,820
    
    
    
    869,786
    
    
    
    12,454,410
    
    
    
    2,805,064




|14. |  | LITIGATION
|--- |  | ----------



| |  | In December 2001, a complaint was filed in the Southern District of New
York seeking an unspecified amount of damages on behalf of a class of
persons who allegedly purchased shares of the MCKs common stock between
the date of MCKs initial public offering and December 6, 2000. The
complainants 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 and investment bankers 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 the companies
and individuals, including the MCK defendants. On June 26, 2003, a
proposed partial global settlement was announced between the securities
issuers and their directors and officers and the plaintiffs. Under the
terms of the settlement, the insurers of the issuers would deliver a
surety undertaking in the amount of $1 billion payable to the plaintiffs
to settle the actions against all issuers, directors and officers. Prior
to the Companys acquisition of MCK, the Board of Directors of MCK voted
to approve the proposed settlement. The proposed settlement is subject to
acceptance by the other securities issuers and court approval. No
provision was recorded for this matter in the financial statements of MCK
prepared prior to its acquisition by the Company because MCK believed that
its portion of the proposed settlement would be paid by its insurance
carrier.
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

17



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##### Table of Contents



VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|14. |  | LITIGATION, Continued
|--- |  | ---------------------



| |  | MCK has been named a defendant in a lawsuit filed in Norfolk County,
Massachusetts by Entrata Communications, Inc. (Entrata). Entrata
Communications Inc. v. Superwire.com. Inc. and MCK, Inc. arises out of a
dispute between Entrata and one of its largest shareholders,
Superwire.com, Inc. (Superwire). Pursuant to a contract with Entrata,
MCK was obligated to pay Entrata $750,000 in early 2002. In order to take
advantage of a $100,000 discount offered for early payment, MCK paid
Entrata $650,000 in November 2001, in full satisfaction of its contractual
obligations. The funds were placed in escrow with Superwires California
law firm, Jeffers, Shaff & Falk, LLP (JSF), which agreed not to disburse
the funds until the dispute between Entrata and Superwire had been
resolved. Nevertheless, Entrata contends that it never received the funds
from MCK and that the funds were diverted to Superwire and JSF. Through
the lawsuit, Entrata seeks to recover from both MCK and Superwire the full
$750,000 that MCK would have owed in 2002. MCK has asserted counterclaims
against Entrata, and cross-claims against Superwire, for fraud and breach
of contract. On October 11, 2002, Superwire and Entrata filed
cross-motions for summary judgment against each other. The court denied
both motions on March 13, 2003. Following denial of the cross-motions for
summary judgment, MCK filed a motion to add JSF and two of its partners,
Barry D. Falk and Mark R. Ziebell, as third-party defendants. The motion
is unopposed and is likely to be allowed. The court has given the
parties until March 17, 2004
to complete discovery. The Company intends to defend
the claims against MCK and prosecute its counterclaims, cross-claims and
third-party claims. No amounts, other than the original payment, were
provided for this matter in the financial statements of MCK prepared prior
to its acquisition by the Company. The Company believes that the claim
against MCK is without merit.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Company believes that there will be no
material financial statement impact related to the above listed
litigation and therefore no provision has been recorded in the
Companys financial statements.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|15. |  | RECENT ACCOUNTING PRONOUNCEMENTS
|--- |  | --------------------------------



| |  | In April 2002, the Financial Accounting Standards Board (FASB) issued
SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment
of FASB Statement No. 13, and Technical Corrections (SFAS No. 145),
which eliminates the requirement to report gains and losses related to
extinguishments of debt as extraordinary items. The statement also
included other amendments and technical corrections, which will not have a
material impact on the Company. The provisions of the statement related
to the treatment of debt extinguishments are required to be applied in
fiscal years beginning after May 15, 2002. Upon adoption of SFAS No. 145
in January 2003, previously recorded extraordinary items for debt
extinguishments were reclassified to continuing operations.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In June 2002, the FASB issued SFAS No. 146, Accounting for Costs
Associated with Exit or Disposal Activities (SFAS No. 146). SFAS No.
146 addresses financial accounting and reporting for costs associated with
exit or disposal activities and nullifies Emerging Issues Task Force
(EITF) Issue No. 94-3, Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring) (EITF No. 94-3). SFAS No.
146 requires that a liability for costs associated with an exit or
disposal activity be recognized when the liability is incurred rather than
when a company commits to such an activity and also establishes fair value
as the objective for initial measurement of the liability. The Company
adopted SFAS No. 146 in January 2003.
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In December 2002, the FASB issued SFAS No. 148, Accounting for Stock
Based Compensations  Transition and Disclosure (SFAS No. 148). SFAS
No. 148 is an amendment to SFAF No. 123 providing alternative methods of
transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. Amendments are effective
for financial statements for fiscal years ended after December 15, 2002
and for interim periods beginning after December 15, 2002. The Company
has currently chosen not to adopt the voluntary change to the fair value
based method of accounting for stock-based employee compensation, pursuant
to SFAS No. 148, which, if adopted, could have a material effect on the
Companys financial position or results of operations.
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

18



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##### Table of Contents



VERSO TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2003

(Unaudited)



|15. |  | RECENT ACCOUNTING PRONOUNCEMENTS, Continued
|--- |  | -------------------------------------------



| |  | In February 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of Liabilities and Equity
(SFAS No. 150), which is effective at the beginning of the first interim
period beginning after June 15, 2003. SFAS No. 150 establishes standards
for the Companys classification of liabilities in the financial
statements that have characteristics of both liabilities and equity. In
November 2003, the FASB issued Staff Position No. 150-3 delaying the
effective date for certain instruments and entities. The adoption of SFAS
No. 150 did not have a material adverse effect on the Companys financial
condition or results of operations.
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In November 2002, the EITF of the FASB reached a consensus on EITF No.
00-21, Accounting for Revenue Arrangements with Multiple Element
Deliverables (EITF No. 00-21). The issue addresses how to account for
arrangements that may involve multiple revenue-generating activities,
i.e., the delivery or performance of multiple products, services, and/or
rights to use assets. In applying this guidance, separate contracts with
the same party, entered into at or near the same time, will be presumed to
be a package, and the consideration will be measured and allocated to the
separate units based on their relative fair values. This consensus
guidance is applicable to agreements executed in quarters beginning after
June 15, 2003. The Company adopted this accounting effective July 1,
2003. The adoption of EITF 00-21 did not have a material effect on the
Companys financial condition or results of operations.
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In May 2003, the EITF of the FASB reached a consensus on Issue 01-08,
Determining Whether an Arrangement Contains a Lease (EITF No. 01-08).
If an arrangement contains a lease in accordance with the EITF guidance,
the timing of the expense and recognition in the balance sheet (if a
capital lease) and disclosures could be affected. The EITF is effective
for all arrangements agreed to or modified in fiscal periods after May 28,
2003. The adoption of EITF 01-08 did not have a material effect on the
Companys financial condition or results of operations.
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In November 2002, the FASB issued FASB Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others (Interpretation No. 45), which
clarifies the disclosure and recognition/measurement requirements related
to certain guarantees. The disclosure requirements are effective for
financial statements issued after December 15, 2002 and the
recognition/measurement requirements are effective on a prospective basis
for guarantees issued or modified after December 31, 2002. The Company
typically grants its customers a warranty, which guarantees that its
products will substantially conform to its current specifications for
twelve months from the delivery date. Historically, costs related to
these guarantees have not been significant.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities, an interpretation of Accounting Research
Bulletin No. 51 (Interpretation No. 46). Interpretation No. 46 applies
immediately to variable interests in variable interest entities created
after January 31, 2003, and to variable interests in variable interest
entities obtained after January 31, 2003. For public enterprises with a
variable interest in a variable interest entity created before February l,
2003, this interpretation applies to that enterprise no later than the
ending of the first interim or annual reporting period beginning after
December 15, 2003. The Company is currently determining the impact of the
application of this Interpretation on the Companys financial condition
and results of operations.
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

19



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##### Table of Contents



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

Certain statements in this Quarterly Report on Form 10-Q and in future filings
by the Company with the SEC and in the Companys 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:



| |  |  | our ability to fund future growth;
| | - |  | ----------------------------------



| |  |  | our ability to become profitable;
| | - |  | ---------------------------------



| |  |  | the volatility of the price of our common stock;
| | - |  | ------------------------------------------------



| |  |  | market demand for and market acceptance for our products;
| | - |  | ---------------------------------------------------------



| |  |  | our ability to protect our intellectual property rights;
| | - |  | --------------------------------------------------------



| |  |  | our current level of indebtedness;
| | - |  | ----------------------------------



| |  |  | new regulation and legislation;
| | - |  | -------------------------------



| |  |  | trends for the continued growth of our business and other businesses we may
acquire;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | our ability to successfully market existing products and services and
develop and market new products and services;
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to integrate our business with entities we have recently
acquired and may subsequently acquire;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | our ability to expand our market for existing products and services;
| | - |  | --------------------------------------------------------------------



| |  |  | the effects of our accounting policies and general changes in accounting
principles generally accepted in the United States of America;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | general economic conditions of the telecommunications market, including
the new and evolving market for next-generation communications solutions;
and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | other risks and uncertainties disclosed in our Annual Report on Form 10-K
for the year ended December 31, 2002 and in our other filings with the SEC.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------

All subsequent forward-looking statements relating to the matters described in
this document 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.

20



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##### Table of Contents



General

The Company is 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. The Companys continuing operations include two separate business
segments, the Carrier Solutions Group, which the Company formerly referred to
as its Gateway Solutions business, which includes the Companys Clarent
softswitching division and the Companys subsidiary NACT, and the Enterprise
Solutions Group, which the Company formerly referred to as its Applications and
Services business, which includes the Companys Clarent Netperformer division,
the Companys subsidiaries Telemate.Net and MCK and the Companys customer
response center operations. The Company acquired MCK on September 26, 2003 and
will include MCKs operations beginning October 1, 2003. The Company formed
its Clarent softswitching division and Clarent Netperformer division subsequent
to the Companys acquisition of Clarents business assets in February 2003.
The Companys discontinued operations include its legacy VAR business and HSG.

The consolidated financial statements include the accounts of Verso
Technologies, Inc. and its wholly-owned subsidiaries, including MCK,
Telemate.Net, NACT and Clarent Canada Ltd.

The Company believes that the foregoing events significantly affect the
comparability of the Companys results of operations from year to year. You
should read the following discussion of the Companys results of operations and
financial condition in conjunction with the Companys consolidated financial
statements and related notes thereto included in Item 14 of the Companys
Annual Report on Form 10-K for the year ended December 31, 2002.

Results of Operations

Three Months Ended September 30, 2003, Compared to Three Months Ended September 30, 2002

For the three months ended September 30, 2003, the Companys net loss totaled
$11.6 million, or $.12 per share, compared with net loss of $1.0 million, or
$.01 per share, for the same period in 2002. The 2003 results include a
write-down of goodwill of $10.9 million or $.11 per share.

Total revenue was $15.3 million in the three months ended September 30, 2003,
reflecting a 47% increase from the same period in 2002. Product revenue was
$9.6 million in the three months ended September 30, 2003, reflecting an 86%
increase from the same period in 2002. The $4.4 million increase in product
revenue is comprised of $1.3 million net increase for the Carrier Solutions
Group and $3.1 million increase for the Enterprise Solutions Group,
attributable to Clarent product sales offset by a decrease in NACT product
sales. With the Companys strategy of focusing on next generation
communications solutions, it expects more growth in the Clarent products than
the NACT products because there is a greater market for the Clarent products
and because some customer needs previously filled by NACT products can now be
better served by Clarent products or a combination of both. Service revenue
was $5.7 million in the three months ended September 30, 2003, reflecting a 9%
increase from the same period in 2002. Gross profit increased by $3.1 million
in the three months ended September 30, 2003, and was 58% of revenue in 2003,
compared with 56% of revenue in the same period of 2002. The increase in gross
profit dollars resulted primarily from the increase in revenue. The increase
in gross profit percentage was primarily a result of the increase in the
proportion of product revenue to total revenue from 50% for the three months
ended September 30, 2002 compared to 63% for the same period in 2003, which
carries a higher gross profit percentage. This shift is primarily due to the
acquisition of assets from Clarent.

Total operating expenses incurred for the three months ended September 30,
2003, were $20.2 million, an increase of $13.6 million compared to the same
period in 2002. The increase is primarily attributable to the following items:
increases in general and administrative expenses of $581,000, sales and
marketing expenses of $771,000, research and development expenses of $927,000,
depreciation expense of $260,000, amortization of intangibles of $104,000, the
write-down of goodwill of $10.9 million and reorganization costs of $101,000
offset by a decrease amortization of deferred compensation of $78,000.

The increase in general and administrative expenses resulted from the addition
of personnel and related costs related to the acquisition of assets from
Clarent in February 2003, offset by overall decreased expenses related to
on-going cost reduction initiatives resulting in reduced personnel,
professional fees and other general and administrative expenses.

The increase in sales and marketing expenses resulted from the addition of
personnel and related costs related to the acquisition of assets from Clarent
in February 2003, offset by overall decreased expenses related to on-going cost
reduction initiatives.

The increase in research and development is primarily related to research and
development activities at the Companys Clarent softswitching division and
Clarent Netperformer division.

21



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##### Table of Contents



The increase in depreciation expense is primarily related to the additional
fixed assets recorded in connection with the acquisition of substantially all of the business assets of
Clarent and the increases related to the purchase of furniture and equipment of
approximately $977,000 and $241,000 during the first nine months of 2003 and
for the
last three months of 2002, respectively. Capital expenditures are primarily
depreciated on a straight-line basis over their estimated useful lives of three
years.

The increase in intangible amortization is primarily related to the
amortization of the customer relationship costs related to the acquisition of
Encore Systems, Inc., Global Systems and Support, Inc. and Five Star
Systems, Inc. (collectively, the Encore Group), recorded in the fourth quarter of 2002, and the amortization of
current technology related to the acquisition of substantially all the assets
of Clarent.

The write-down of goodwill relates to the acquisition of MCK. In April 2003,
the Company negotiated the original agreement to purchase MCK in which the MCK
stockholders would be entitled to receive approximately 20.0 million shares of
the Companys common stock which was valued at $13.0 million, based on the
volume weighted average closing price per share of the Companys common stock
as reported on the Nasdaq SmallCap Market for the twenty trading day period
beginning March 19, 2003 and ending April 15, 2003. As part of the original
agreement, the Company was to receive $7.5 million in cash. The terms of the
agreement were amended on June 13, 2003. Under the amended terms, MCK
stockholders were entitled to receive approximately 18.3 million shares of the
Companys common stock and the cash MCK was required to have at the closing of
the merger was reduced from $7.5 million to approximately $6.4 million.
Although the number of shares of the Companys common stock to be issued in the
merger was reduced by the amendment, the amendment changed the measurement date
for valuing such shares. As a result of the increase in the price of the
Companys common stock, prior to June 13, 2003, the revised valuation for the
shares of the Companys common stock to be issued in the merger increased to
$24.1 million. As a result of this increase in value, the goodwill recorded in
the merger was impaired upon closing the merger. The Company completed an
impairment analysis in accordance with SFAS No. 142. Based upon this analysis,
the Company recorded a write-off of approximately $10.9 million during the
quarter ended September 30, 2003.

In the third quarter of 2003, the Company initiated a reorganization as a part
of its effort to consolidate functions and improve operational efficiencies and
eliminated 11 employee positions. As a result of these actions, the Company
recorded reorganization costs of $232,000 during the three months ended
September 30, 2003. The reorganization costs consist of severance costs and
non-cash stock compensation expense related primarily to the acceleration of
vesting of options. Annualized savings beginning in the fourth quarter of 2003 are
expected to be approximately $925,000.

In the third quarter of 2002, the Company announced a reorganization as a part
of its effort to improve operational efficiencies and financial performance and
eliminated 19 employee positions. As a result of these actions, the Company
recorded reorganization costs of $131,000 during the three months ended
September 30, 2002. The reorganization costs consist of severance costs.
Annualized savings were expected to be approximately $1.1 million.

The $78,000 decrease in amortization of deferred compensation primarily related
to the termination of certain options and full vesting of other options
outstanding since the Companys acquisitions of Telemate.Net in November 2001
and Cereus Technology Partners, Inc. (Cereus) in September 2000. The
deferred compensation represents the intrinsic value of the Telemate.Net and
Cereus unvested options outstanding at the date of the acquisitions of
Telemate.Net and Cereus and is amortized over the remaining vesting period of
the options.

As a percent of revenue, operating expenses from continuing operations, were
132% during the three months ended September 30, 2003, compared to 63% for the
same period in 2002. Excluding the write-down of goodwill, operating expenses
from continuing operations as a percent of revenue would have been 60% during
the three months ended September 30, 2003.

Equity in loss of investment was $9,000 during the three months ended September
30, 2003. This amount represents the Companys 51% portion of BeTrues losses
for the quarter. The Company acquired a 51% interest in BeTrue during the
fourth quarter of 2002. Due to the shared decision making between the Company
and its equity partner, the results of BeTrues operations are accounted for
under the equity method rather than being consolidated with the Companys
operations.

Net interest expense was $388,000 during the three months ended September 30,
2003, an increase of $66,000 compared to the same period in 2002. The increase
was attributable to increased borrowings on the Companys line of credit and
notes payable for the acquisition of assets from Clarent, net of reductions
related to the interest on the deferred payment due for the purchase of NACT
and interest income on notes receivable from shareholders.

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Business Unit Performance

Dollars in thousands
    
    Carrier Solutions
    
    Enterprise Solutions
    
    ConsolidatedFor the
Three Months Ended
    
    Group
    
    GroupSeptember 30,
    
    2003
    
    2002
    
    2003
    
    2002
    
    2003
    
    2002Revenue
    
    $
    7,575
    
    
    $
    5,665
    
    
    $
    7,739
    
    
    $
    4,747
    
    
    $
    15,314
    
    
    $
    10,412Gross profit
    
    
    4,025
    
    
    
    3,312
    
    
    
    4,932
    
    
    
    2,540
    
    
    
    8,957
    
    
    
    5,852Gross margin
    
    
    53
    %
    
    
    58
    %
    
    
    64
    %
    
    
    54
    %
    
    
    58
    %
    
    
    56
    %General and administrative
    
    
    988
    
    
    
    870
    
    
    
    425
    
    
    
    233
    
    
    
    1,413
    
    
    
    1,103Sales and marketing
    
    
    1,096
    
    
    
    908
    
    
    
    990
    
    
    
    551
    
    
    
    2,086
    
    
    
    1,459Research and development
    
    
    1,855
    
    
    
    1,354
    
    
    
    527
    
    
    
    101
    
    
    
    2,382
    
    
    
    1,455Contribution before unallocated items
    
    $
    86
    
    
    $
    180
    
    
    $
    2,990
    
    
    $
    1,655
    
    
    
    3,076
    
    
    
    1,835Unallocated items:Corporate, sales, general and
administrative expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,800
    
    
    
    1,385Depreciation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    867
    
    
    
    607Amortization of intangibles
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    263
    
    
    
    159Amortization of deferred compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    194
    
    
    
    272Write-down of goodwill
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,930
    
    
    
    Reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    232
    
    
    
    131Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (11,210
    )
    
    
    (719
    )Other income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    22Equity in loss of investment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9
    )
    
    
    Interest expense, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (388
    )
    
    
    (322
    )Loss from continuing operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (11,607
    )
    
    $
    (1,019
    )


Carrier Solutions Group

Total Carrier Solutions Group revenue was $7.6 million in the three months
ended September 30, 2003, a 34% increase from the same period in 2002. The net
increase in revenue is attributable to Clarent product sales offset by a
decrease in NACT product sales. With Companys strategy of focusing on next
generation communications solutions, it expects more growth in the Clarent
products than the NACT products as there is a greater market for the Clarent
products and as some customer needs previously filled by NACT products can now
be better served by Clarent products or a combination of both.

Gross profit increased by $713,000 in the three months ended September 30,
2003, and was 53% percent of revenue, compared to 58% in the same period in
2002. The increase in gross profit dollars is related to the increase in
revenue. The decrease in gross profit percentage was a result of lower margins
on sales of NACT products and the Companys Clarent softswitching products.

Allocated operating expenses incurred in the Carrier Solutions Group for the
three months ended September 30, 2003, were $3.9 million, an increase of
$807,000 compared to the same period in 2002. The increase in general and
administrative expenses reflects the Companys acquisition of Clarents
business assets in February 2003 offset by a decrease in general and
administrative expenses at NACT. The increase in sales and marketing expenses
and research and development expenses reflect the increases related to the Companys
acquisition of Clarents business assets in February 2003 offset by cost
savings in the operations of NACT. As a percent of revenue, operating expenses
for the Carrier Solutions Group were 52% during the three months ended
September 30, 2003, down from 55% during the same period in 2002.

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Enterprise Solutions Group

Total Enterprise Solutions Group revenue was $7.7 million in the three months
ended September 30, 2003, a 63% increase from the same period in 2002. The
increase in revenue is primarily related to the Companys Clarent Netperformer
division business assets purchased in February 2003.

Gross profit increased by $2.4 million in the three months ended September 30,
2003, and was 64% percent of revenue, compared with 54% of revenue in the same
period in 2002. The Companys addition of Clarents Netperformer division in
February 2003 was the primary cause of the increase in gross profit dollars and
percentage.

Allocated operating expenses incurred in Enterprise Solutions Group for the
three months ended September 30, 2003, were $1.9 million, an increase of $1.1
million compared to the same period in 2002. The increases in general and
administrative expenses, sales and marketing expenses and research and
development expenses relates to the addition of the Clarents Netperformer
division in February 2003. As a percent of revenue, allocated operating
expenses for Enterprise Solutions Group were 25% during the three months ended
September 30, 2003 up from 19% during the same period in 2002. The increase is
attributable to the increase in research and development expenses as a
percentage of revenue related to the operations of the Companys Clarent
Netperformer division.

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Nine Months Ended September 30, 2003, Compared to Nine Months Ended September 30, 2002

For the nine months ended September 30, 2003, the Companys net loss totaled
$13.1 million, or $.14 per share, compared with net loss of $2.8 million, or
$.04 per share, for the same period in 2002. The 2003 results include a
write-down of goodwill of $10.9 million or $.12 per share. The 2002 results
included a loss from discontinued operations of $331,000 or $.01 per share.

Continuing Operations

For the nine months ended September 30, 2003, the Companys net loss from
continuing operations totaled $13.1 million, or $.14 per share, compared with a
net loss of $2.5 million, or $.03 per share, for the same period in 2002. The
2003 results include a write-down of goodwill of $10.9 million or $.12 per
share.

Total revenue was $44.2 million in the nine months ended September 30, 2003,
reflecting a 30% increase from the same period in 2002. Product revenue was
$26.7 million in the nine months ended September 30, 2003, reflecting a 50%
increase from the same period in 2002. The $8.9 million increase in product
revenue is comprised of $2.2 million net increase from the Carrier Group and
$6.7 million increase from the Enterprise Group, primarily attributable to
Clarent product sales offset by a decrease in NACT product sales. With the
Companys strategy of focusing on next generation communications solutions, it
expects more growth in the Clarent products than the NACT products because
there is a greater market for the Clarent products and because some customer
needs previously filled by NACT products can now be better served by Clarent
products or a combination of both. Services revenue was $17.5 million in the
nine months ended September 30, 2003, reflecting a 8% increase from the same
period in 2002. Gross profit increased by $6.3 million in the nine months
ended September 30, 2003, and was 59% of revenue in 2003, compared with 58% of
revenue in the same period of 2002. The increase in gross profit dollars
resulted primarily from the increase in revenues. The increase in gross profit
percentage is related to the purchase of substantially all the assets of
Clarent in February 2003.

Total operating expenses incurred in continuing operations for the nine months
ended September 30, 2003, were $38.0 million, an increase of $16.1 million
compared to the same period of 2002. The increase is primarily attributable to
the following items: increases in general and administrative expenses of $1.7
million, sales and marketing expenses of $1.2 million, research and development
expenses of $2.1 million, amortization of intangibles of $240,000, the
write-down of goodwill of $10.9 million and reorganization costs of $295,000
offset by decreases in depreciation expense of $24,000 and amortization of
deferred compensation of $333,000.

The increase in general and administrative expenses resulted from the addition
of personnel and related costs related to the acquisition of assets from
Clarent in February 2003 and an increase in general and administrative expenses
at NACT, offset by overall decreased expenses related to on-going cost
reduction initiatives resulting in reduced personnel, telecom and other general
and administrative expenses.

The increase in sales and marketing expenses resulted from the addition of
personnel and related costs related to the acquisition of assets from Clarent
in February 2003, offset by overall decreased expenses related to on-going cost
reduction initiatives.

The increase in research and development is primarily related to research and
development activities at the Companys Clarent softswitching division and
Clarent Netperformer division.

The increase in intangible amortization is primarily related to the
amortization of the customer relationship costs related to the acquisition of
Encore Group, recorded in the fourth quarter of 2002 and the amortization of
current technology related to the acquisition of substantially all the business
assets of Clarent.

The write-down of goodwill relates to the acquisition of MCK. In April 2003,
the Company negotiated the original agreement to purchase MCK in which the MCK
stockholders would be entitled to receive approximately 20.0 million shares of
the Companys common stock which was valued at $13.0 million, based on the
volume weighted average closing price per share of the Companys common stock
as reported on the Nasdaq SmallCap Market for the twenty trading day period
beginning March 19, 2003 and ending April 15, 2003. As part of the original
agreement, the Company was to receive $7.5 million in cash. The terms of the
agreement were amended on June 13, 2003. Under the amended terms, MCK
stockholders were entitled to receive approximately 18.3 million shares of the
Companys common stock and the cash MCK was required to have at the closing of
the merger was reduced from $7.5 million to approximately $6.4 million.
Although the number of shares of the Companys common stock to be issued in the
merger was reduced by the amendment, the amendment changed the measurement date
for valuing such shares. As a result of the increase in the price of the
Companys common stock, prior to June 13, 2003, the revised valuation for the
shares of the Companys common stock to be issued in the merger increased to
$24.1 million. As a result of this increase in value, the goodwill recorded in
the merger was impaired upon closing the merger. The Company completed an
impairment analysis in accordance with SFAS No. 142. Based upon this analysis,
the Company recorded a write-off of approximately $10.9 million during the
quarter ended September 30, 2003.

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In the first and third quarters of 2003, the Company announced
reorganizations
to accommodate the acquisition of the assets of Clarent and as a part of its
effort to consolidate functions and improve operational efficiencies and
eliminated 25 employees
positions. As a result of these actions, the Company recorded reorganization
costs of $426,000 during the nine months ended September 30, 2003. The
reorganization costs consist of severance costs and non-cash stock compensation
expense related primarily to the acceleration of vesting of option. Annualized savings
are expected to be approximately $1.9 million.

In the third quarter of 2002, the Company announced a reorganization as a part
of its effort to consolidate functions and improve operational efficiencies to
improve operational efficiencies and financial performance and eliminated 19
employee positions. As a result of these actions, the Company recorded
reorganization costs of $131,000 during the nine months ended September 30,
2002. The reorganization costs consist of severance costs. Annualized savings
were expected to be approximately $1.1 million.

The decrease in depreciation expense is primarily related to fully depreciated
assets net of additional fixed assets recorded in connection with the
acquisition of substantially all of the business assets of Clarent and the
increases related to the purchase of furniture and equipment of approximately
$977,000 and $241,000 during the first nine months of 2003 and for the last
three months of 2002, respectively. Capital expenditures are primarily
depreciated on a straight-line basis over their estimated useful lives of three
years.

The $333,000 decrease in amortization of deferred compensation primarily
related to the termination of certain options and full vesting of other options
outstanding since the Companys acquisitions of Telemate.Net in November 2001
and Cereus in September 2000. The deferred compensation represents the
intrinsic value of the Telemate.Net and Cereus unvested options outstanding at
the date of the acquisitions of Telemate.Net and Cereus and is amortized over
the remaining vesting period of the options.

As a percent of revenue, operating expenses from continuing operations, were
86% during the nine months ended September 30, 2003, compared to 64% for the
same period in 2002. Excluding the write-down of goodwill, operating expenses
from continuing operations as a percent of revenue would have been 61% during
the nine months ended September 30, 2003.

Other income was $18,000 during the nine months ended September 30, 2003,
compared with $453,000 for the same period in 2002. Included in other income
during the nine months ended September 30, 2002 was $254,000 of non-recurring
transactions related to insurance proceeds and the gain on sale of
non-operating assets.

Equity in loss of investment was $61,000 during the nine months ended September
30, 2003. This amount represents the Companys 51% portion of BeTrues losses
for the nine months ended September 30, 2003. The Company acquired a 51%
interest in BeTrue during the fourth quarter of 2002. Due to the shared
decision making between the Company and its equity partner, the results of
BeTrue are treated as an equity investment rather than being consolidated.

Net interest expense was $1.1 million during the nine months ended September
30, 2003, an increase of $308,000 compared to the same period in 2002. The
increase was attributable to increased borrowings on the Companys line of
credit and notes payable for the acquisition of assets from Clarent, net of
reductions related to the interest on the deferred payment due for the purchase
of NACT and interest income on notes receivable from shareholders.

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Business Unit Performance

Carrier Solutions
    
    Enterprise SolutionsDollars in thousands
    
    Group
    
    Group
    
    ConsolidatedFor the Nine Months EndedSeptember 30,
    
    2003
    
    2002
    
    2003
    
    2002
    
    2003
    
    2002Revenue
    
    $
    23,427
    
    
    $
    20,270
    
    
    $
    20,743
    
    
    $
    13,807
    
    
    $
    44,170
    
    
    $
    34,077Gross profit
    
    
    13,824
    
    
    
    12,333
    
    
    
    12,238
    
    
    
    7,442
    
    
    
    26,062
    
    
    
    19,775Gross margin
    
    
    59
    %
    
    
    61
    %
    
    
    59
    %
    
    
    54
    %
    
    
    59
    %
    
    
    58
    %General and administrative
    
    
    3,748
    
    
    
    2,891
    
    
    
    1,309
    
    
    
    938
    
    
    
    5,057
    
    
    
    3,829Sales and marketing
    
    
    3,077
    
    
    
    2,724
    
    
    
    2,640
    
    
    
    1,719
    
    
    
    5,717
    
    
    
    4,443Research and development
    
    
    5,059
    
    
    
    4,269
    
    
    
    1,602
    
    
    
    324
    
    
    
    6,661
    
    
    
    4,593Contribution before unallocated items
    
    $
    1,940
    
    
    $
    2,449
    
    
    $
    6,687
    
    
    $
    4,461
    
    
    
    8,627
    
    
    
    6,910Unallocated items:Corporate, sales, general and
administrative expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,865
    
    
    
    5,414Depreciation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,062
    
    
    
    2,086Amortization of intangibles
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    688
    
    
    
    448Amortization of deferred compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    587
    
    
    
    920Write-down of goodwill
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,930
    
    
    
    Reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    426
    
    
    
    131Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (11,931
    )
    
    
    (2,089
    )Other income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18
    
    
    
    453Equity in loss of investment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (61
    )
    
    
    Interest expense, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,149
    )
    
    
    (841
    )Loss from continuing operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (13,123
    )
    
    $
    (2,477
    )


Carrier Solutions Group

Total Carrier Solutions Group revenue was $23.4 million in the nine months
ended September 30, 2003, a 16% increase from the same period in 2002. The net
increase in revenue is attributable to Clarent product sales offset by a
decrease in NACT product sales. With the Companys strategy of focusing on
next generation communications solutions, it expects more growth in the Clarent
products than the NACT products as there is a greater market for the Clarent
products and as some customer needs previously filled by NACT products can now
be better served by Clarent products or a combination of both.

Gross profit increased by $1.5 million in the nine months ended September 30,
2003, and was 59% percent of revenue, compared to 61% in the same period in
2002. The increase in gross profit dollars is related to increased revenue.

Allocated operating expenses incurred in the Carrier Solutions Group for the
nine months ended September 30, 2003, were $11.9 million, an increase of $2.0
million compared to the same period in 2002. The increase in general and
administrative expenses reflects the Companys acquisition of Clarents
business assets in February 2003. The increase in sales and marketing expenses
and research and development expenses reflect increases related to the
Companys acquisition of Clarents business assets in February 2003 offset by
cost savings in the operations of NACT. As a percent of revenue, operating
expenses for the Carrier Solutions Group were 51% during the nine months ended
September 30, 2003 up from 49% during the same period in 2002.

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Enterprise Solutions Group

Total Enterprise Solutions Group revenue was $20.7 million in the nine months
ended September 30, 2003, a 50% increase from the same period in 2002. The
increase in revenue is primarily related to the formation of the Companys
Clarent Netperformer division subsequent to the Companys acquisition of
Clarents business assets in February 2003.

Gross profit increased by $4.8 million in the nine months ended September 30,
2003, and was 59% percent of revenue, compared with 54% of revenue in the same
period in 2002. All divisions in the Enterprise Solutions Group experienced
improvement in gross profit dollars and margin compared to the same period in
2002. The Companys addition of Clarents Netperformer division in February
2003 was the primary cause of the increase in gross profit dollars and its
margin was higher than the overall percentage of the Enterprise Solutions
Group.

Allocated operating expenses incurred in Enterprise Solutions Group for the
nine months ended September 30, 2003, were $5.6 million, an increase of $2.6
million compared to the same period in 2002. The increases in general and
administrative expenses, sales and marketing expenses and research and
development expenses relates to the addition of the Clarents Netperformer
division in February 2003. As a percent of revenue, allocated operating
expenses for Enterprise Solutions Group were 27% during the nine months ended
September 30, 2003 up from 22% during the same period in 2002. The increase is
attributable to the increase in research and development expenses as a
percentage of revenue related to the operations of the Companys Clarent
Netperformer division.

Discontinued Operations

Following the acquisition of NACT in July of 2001, the Company determined that
its legacy VAR business was not strategic to the Companys ongoing objectives
and discontinued capital and human resource investment in its legacy VAR
business. Accordingly, the Company elected to report its legacy VAR business
as discontinued operations by early adoption of SFAS No. 144. The condensed
consolidated financial statements have been reclassified to segregate the net
assets and operating results of this business segment.

There were no results of discontinued operations for the nine months ended
September 30, 2003. Summary operating results of the discontinued operations
for the nine months ended September 30, 2002 (in thousands) were as follows:

Revenue
    
    $
    223Gross loss
    
    $
    (331
    )Operating loss
    
    $
    (331
    )Loss from discontinued operations
    
    $
    (331
    )


Critical and Significant 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 condensed consolidated financial statements and
accompanying notes. Factors that could affect the Companys 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, and inability to successfully integrate acquisitions,
technology changes, or a decline in the financial stability of the Companys
customers. Negative developments in these or other risk factors could have a
material adverse affect on the Companys financial position and results of
operations.

A summary of the Companys critical and significant accounting policies
follows:

Allowance for Doubtful Accounts

The Company is required to estimate the collectibility of its trade
receivables. Considerable judgment is required in assessing the ultimate
realization of these receivables, including the creditworthiness of each
customer. The Company determines the allowance for doubtful accounts based on
a specific review of outstanding customer balances and a general reserve based
upon the 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.

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Inventory Obsolescence

The Company is required to state its inventories at the lower of cost or
market. In assessing the ultimate realization of inventories, the Company is
required to make judgments as to future demand requirements and compare them
with the current or committed inventory levels. The Company has 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. 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.

Revenue Recognition

The Companys principal sources of revenues are from sales of hardware and
software, integration, applications and technical training and support. The
Companys revenue recognition policies are in compliance with Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial Statements, issued by the
SEC and EITF No. 00-21 and Statement of Position No. 97-2, Software Revenue
Recognition. The Company recognizes revenue when (i) there is an agreement
with the customer, (ii) product is shipped and title has passed, (iii) the
amount due from the customer is fixed and determinable, and (iv) collectibility
is reasonably assured. Revenue is also recognized only when the Company has no
significant future performance obligation. At the time of the transaction, the
Company assesses whether the amount due from the customer is fixed and
determinable and collection of the resulting receivable is reasonably assured.
The Company assesses whether the amount due from the customer is fixed and
determinable based on the terms of the agreement with the customer, including,
but not limited to, the payment terms associated with the transaction. The
Company assesses collectibility based on a number of factors, including past
transaction history with the customer and credit-worthiness of the customer. If
the Company determines that collection of an amount due is not reasonably
assured, then the Company defers recognition of revenue until collection
becomes reasonably assured. Furthermore, in accordance with EITF No. 00-21, in
addition to other requirements, the Company must determine if revenue is
contingent, and, if so, the Company must defer the revenue. The Company reviews payment
terms and other factors in determining if revenue is contingent.

The Companys right of return policy, which is standard for virtually all
sales, allows a customer the right to return product for refund only if the
product does not conform to product specifications; the non-conforming product
is identified by the customer; and the customer rejects the non-conforming
product and notifies the Company within ten days of receipt. If an agreement
contains a non-standard right of return, the Company defers recognizing revenue
until the conditions of the agreement are met. From time to time, the Companys
agreements include acceptance clauses. If an agreement includes an acceptance
clause, the revenue is recorded at the time of acceptance.

Restructuring Accruals

Continuing Operations:

In the first and third quarters of 2003, the Company announced reorganizations
to accommodate the acquisition of the assets of Clarent and as a part of its
effort to consolidate functions and improve operational efficiencies and
eliminated 25 employee positions. As a result of these actions, the Company
recorded reorganization costs of $426,000 during the nine months ended
September 30, 2003. The reorganization costs consist of severance costs and
non-cash stock compensation expense related primarily to the acceleration of
vesting of options. The balance of the accrued severance costs as of September 30, 2003
is $16,000.

Discontinued Operations:

During the second and third quarters of 2001, the Company initiated certain
restructuring plans. In conjunction with these restructuring plans, the
Company established a restructuring reserve account for the estimated costs
related to the plans. These costs primarily related to facilities closings,
severance costs and MessageClick ASP service 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 of $2.5 million assumes that the building will be
sub-leased for 43% of the total lease liability over the remaining term of the
lease. As of September 30, 2003, the Company had a remaining reserve balance
of approximately $1.7 million, which is included in liabilities of discontinued
operations. The Company currently believes that this remaining estimated
balance is appropriate to cover future obligations associated with the
restructurings.

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Deferred Tax Asset Valuation Allowance

The Company currently has significant deferred tax assets, which are subject to
periodic recoverability assessment. Realization of the Companys deferred tax
assets is principally dependant upon achievement of projected future taxable
income. The
Companys judgments regarding future profitability may change due to market
conditions, its ability to continue to successfully execute its 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
the Companys ability to recognize the tax benefit, the Company has provided a
valuation allowance against all of its deferred income tax assets.

Litigation and Related Contingencies

The Company is subject to proceedings, lawsuits and other claims related to
labor, product and other matters. The Company is 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 the Company with
assistance of its legal counsel after careful analysis of each individual issue
based upon the then-current facts and circumstances and discussions with legal
counsel. 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.

Intangible Assets

The Company has significant intangible assets related to goodwill and other
acquired intangibles. The determination of related estimated useful lives and
whether or not these assets are impaired involves significant judgments.
Changes in strategy and/or market conditions could significantly impact these
judgments and require adjustments to recorded asset balances. The Company
assesses the recoverability of its intangible assets subject to amortization by
determining whether the value of intangible assets subject to amortization over
their remaining life can be recovered through undiscounted future operating
cash flows of the acquired operation. The amount of impairment, if any, is
measured based on projected discounted future operating cash flows using a
discount rate reflecting the Companys average cost of funds. For goodwill and
unamortized intangible assets, the Company performs an annual impairment test
that requires a comparison of the fair value of goodwill and unamortized
intangible assets with their carrying amounts. If the carrying amount of
goodwill or unamortized intangible asset exceeds its fair value, then an
impairment loss shall be recognized.

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Liquidity and Capital Resources

Summary

Liquidity is the measurement of the Companys 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. Historically, the
Company has met its liquidity requirements through a combination of cash
provided by debt from third party lenders, issuances of debt and equity
securities, sale of discontinued businesses and acquisitions.

At September 30, 2003, the Company had a positive working capital position
(excess of current assets over current liabilities) of $15.1 million compared
to a positive working capital position of $1.8 million at December 31, 2002.
The Companys cash and cash equivalents totaled $9.8 million at September 30,
2003, and $1.3 million at December 31, 2002. Total long-term debt, net of
discount, was $6.6 million at September 30, 2003 and $3.7 million at December
31, 2002. At September 30, 2003, the Company had no borrowings under its $10.0
million Amended Credit Agreement with Silicon. The Companys borrowing
availability under the Amended Credit Agreement at September 30, 2003 was $10.0
million. The Company has an outstanding stand-by letter of credit in the
amount of $200,000 at September 30, 2003 which would reduce
borrowing capacity under the Amended Credit Agreement.

On February 12, 2003, in connection with the Companys acquisition of the
assets of Clarent, the Company amended its existing Original Credit Agreement
with Silicon, and in connection therewith, the Company and Silicon entered into
certain amendments to the existing credit facility and certain additional
credit agreements. Such amendments and additional agreements increased the
Companys asset-based revolving credit line from $5.0 million to $10.0 million
and include an EX-IM facility that will provide for working capital based on
the Companys international accounts receivable and inventories related to
export sales primarily associated with Clarents assets. The amendments and
additional agreements also extended the term of the Original Credit Agreement
for 18 months (through August 13, 2004). The Company and Silicon further
amended the credit facility in connection with the acquisition of MCK and the
acquisition of substantially all of the business assets along with related
liabilities of Clarent.

On February 12, 2003, the Company acquired substantially all the business
assets and assumed certain related liabilities of Clarent for $9.8 million in
notes. At the closing of the acquisition, the Company issued three promissory
notes to Clarent: a $5.0 million secured note due February 13, 2004, which
bears interest at 10% per annum, of which $1.8 million was paid through
September 30, 2003, and the remainder of which is due in monthly installments
continuing in October 2003 at $500,000 and increasing to $750,000 in December
2003; a $1.8 million non-interest bearing unsecured note due February 13, 2004,
discounted at 6.25% per annum, of which $800,000 was paid through September 30,
2003 and the remainder of which is due in quarterly installments of $500,000;
and a $3.0 million secured note due February 12, 2008, which bears interest at
5% per annum, discounted at 7.5% per annum. The assets the Company purchased
from Clarent secure the secured notes.

Cash Flow

Cash provided by the Companys continuing operations in the nine months ended
September 30, 2003 totaled approximately $749,000 compared with cash used in
continuing operations of $2.8 million in the same period in 2002. The
Companys source of cash in continuing operations during the nine months ended
September 30, 2003 resulted primarily from cash provided from continuing
operations of $3.0 million (net loss from continuing operations of $13.1
million reduced by non-cash charges totaling $16.1 million, including
depreciation and amortization of $3.8 million, write-off of goodwill of $10.9
million and provision for doubtful accounts of $1.6 million) offset by cash
used for changes in current operating assets and liabilities of approximately
$2.3 million.

Cash used in the Companys discontinued operations in the nine months ended
September 30, 2003 totaled $710,000 compared with cash used in discontinued
operations of $897,000 in the same period in 2002.

The Company received cash from investing activities in the nine months ended
September 30, 2003 of approximately $7.3 million, compared to cash used in
investing activities of $915,000 in the same period of 2002. In the nine months
ended September 30, 2003, the Company received $9.9 million in cash, net of
acquisition costs, related to the acquisition of MCK and used $1.1 million in
cash, net of cash acquired, related to the acquisition of the assets of
Clarent. The Company spent $977,000 and $648,000 on capital expenditures in
the nine months ended September 30, 2003 and 2002, respectively. The Company
also invested $481,000 and $267,000 on purchased software development costs in
the nine months ended September 30, 2003 and 2002, respectively.

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Cash provided by financing activities totaled approximately $1.2 million in the
nine months ended September 30, 2003, compared to cash used of $1.7 million in
the same period of 2002. The Company received $1.8 million in payments of
notes receivable from shareholders, received proceeds from the issuance of the
Companys common stock totaling $2.7 and paid $800,000 on the Companys credit
line and $2.6 million on the notes payable for the purchase of the assets of
Clarent in the nine months ended September 30, 2003. The Company received
$24,000 in payments of notes receivable from shareholders and proceeds from the
issuance of the Companys common stock totaling $289,000 and paid $2.0 million
on the notes payable for the purchase of NACT in the nine months ended
September 30, 2002.

Contractual Obligations and Commercial Commitments

The following summarizes the Companys future contractual obligations at
September 30, 2003 (in thousands):

Less than
    
    
    
    
    
    
    
    
    
    AfterContractual Obligations
    
    Total
    
    1 year
    
    1-3 years
    
    4-5 years
    
    5 yearsLine of credit
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Additional payments for the acquisition of
Encore Group
    
    
    1,293
    
    
    
    620
    
    
    
    574
    
    
    
    99
    
    
    
    Notes payable
    
    
    7,250
    
    
    
    4,250
    
    
    
    
    
    
    
    3,000
    
    
    
    Convertible subordinated debentures
    
    
    4,500
    
    
    
    
    
    
    
    4,500
    
    
    
    
    
    
    
    Accrued costs of MCK acquisition
    
    
    7,660
    
    
    
    4,402
    
    
    
    2,600
    
    
    
    658
    
    
    
    Operating leases:Continuing operations
    
    
    14,213
    
    
    
    2,642
    
    
    
    4,862
    
    
    
    4,128
    
    
    
    2,581Discontinued operations
    
    
    3,127
    
    
    
    965
    
    
    
    849
    
    
    
    798
    
    
    
    515Total contractual cash obligations
    
    $
    38,043
    
    
    $
    12,879
    
    
    $
    13,385
    
    
    $
    8,683
    
    
    $
    3,096


Note, this table excludes interest expense and sublease rentals and assumes
that leases are not renewed .

Sources of Cash

For the next year, the Company expects that its primary sources of cash will be
from cash on hand, working capital provided by operating activities, borrowings
under its Amended Credit Agreement with Silicon and other possible sources,
including issuances of equity or debt securities, and proceeds from the
exercise of options and warrants. The Company believes that, with its current
operations, which generated positive income from continuing operations before
interest, taxes, depreciation, amortization of intangibles and amortization of
deferred compensation (EBITDA), excluding the write-down of goodwill, for the
last eight quarters, it will have sufficient liquidity from these sources to
meet its current financial obligations for the next year. Additionally, in
October and November 2003, the Company received cash proceeds of $2.6 million
(4,674,065 shares of common stock) from the exercise of options and warrants,
which was used to reduce the short-term portion of the secured and unsecured
notes made by the Company in connection with the acquisition of Clarents
assets. The Amended Credit Agreement with Silicon, however, is subject to
certain financial covenants and limitations on the Companys ability to access
funds under the Amended Credit Agreement. The Company was in compliance with
these covenants as of September 30, 2003. If the Company is in violation of
the Amended Credit Agreement, or does not have sufficient eligible accounts
receivable and inventory to support the level of borrowings it may need, then
the Company may be unable to draw on the Amended Credit Agreement to the extent
necessary. To the extent the Company does not have borrowing availability
under the Amended Credit Agreement, the Company may be required to obtain
additional sources of capital, sell assets, obtain an amendment to the Amended
Credit Agreement or otherwise restructure its outstanding indebtedness. If the
Company is unable to obtain additional capital, sell assets, obtain an
amendment to the Amended Credit Agreement or otherwise restructure its
outstanding indebtedness, then the Company may not be able to meet its
obligations.

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The Companys short-term cash needs are for working capital, including cash
operating losses, if any, capital expenditures, transaction costs related to
the acquisition of Clarents assets and MCK, severance and retention payments
related to the acquisition of MCK totaling approximately $3.1 million, payments
on the secured and unsecured notes made by the Company
in connection with the acquisition of Clarents assets, totaling approximately
$4.3 million plus interest due February 13, 2004 and payments related to
discontinued operations. At September 30, 2003, accrued costs of MCK
acquisition and other long-term liabilities include $1.7 million in lease
payments related to lease obligations for excess space at the date of
acquisition. The Company expects to pay out approximately $513,000 related to
these obligations in the next twelve months. At September 30, 2003,
liabilities of discontinued operations included $1.7 million in lease payments
related to discontinued operations. The Company expects to pay out
approximately $492,000 related to discontinued operations in the next twelve
months.

The Companys long-term cash needs are related to the costs of growing its
current business as well as prospective businesses to be acquired, including
capital expenditures and working capital. The Company expects to meet these
cash needs through cash from operations, if any, cash on hand, borrowings under
the Amended Credit Agreement or other debt facilities, if available, as well as
through possible issuances of equity or debt securities. If sufficient
borrowing capacity under a working capital line of credit is unavailable (or if
the Company is unable to restructure its existing Amended Credit Agreement in
the event that the Company requires additional borrowing capacity), or if the
Company is otherwise unable to obtain additional capital or sell assets, then
the Company may not be able to meet its obligations and growth plans.

Recent Accounting Pronouncements

In April 2002, the FASB issued SFAS No. 145, which eliminates the requirement
to report gains and losses related to extinguishments of debt as extraordinary
items. The statement also included other amendments and technical corrections,
which will not have a material impact on the Company. The provisions of the
statement related to the treatment of debt extinguishments are required to be
applied in fiscal years beginning after May 15, 2002. Upon adoption of SFAS
No. 145 in January 2003, previously recorded extraordinary items for debt
extinguishments were reclassified to continuing operations.

In June 2002, the FASB issued SFAS No. 146. SFAS No. 146 addresses financial
accounting and reporting for costs associated with exit or disposal activities
and nullifies EITF Issue No. 94-3. SFAS No. 146 requires that a liability for
costs associated with an exit or disposal activity be recognized when the
liability is incurred rather than when a company commits to such an activity
and also establishes fair value as the objective for initial measurement of the
liability. The Company adopted SFAS No. 146 in January 2003.

In December 2002, the FASB issued SFAS No. 148. SFAS No. 148 is an amendment
to SFAF No. 123 providing alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. Amendments are effective for financial statements for fiscal
years ended after December 15, 2002 and for interim periods beginning after
December 15, 2002. The Company has currently chosen not to adopt the voluntary
change to the fair value based method of accounting for stock-based employee
compensation, pursuant to SFAS No. 148, which, if adopted, could have a
material effect on the Companys financial position or results of operations.

In February 2003, the FASB issued SFAS No. 150, which is effective at the
beginning of the first interim period beginning after June 15, 2003. SFAS No.
150 establishes standards for the Companys classification of liabilities in
the financial statements that have characteristics of both liabilities and
equity. In November 2003, the FASB issued Staff Position No. 150-3 delaying
the effective date for certain instruments and entities. The adoption of SFAS
No. 150 did not have a material adverse effect on the Companys financial
condition or results of operations.

In November 2002, the EITF of the FASB reached a consensus on EITF No. 00-21.
The issue addresses how to account for arrangements that may involve multiple
revenue-generating activities, i.e., the delivery or performance of multiple
products, services, and/or rights to use assets. In applying this guidance,
separate contracts with the same party, entered into at or near the same time,
will be presumed to be a package, and the consideration will be measured and
allocated to the separate units based on their relative fair values. This
consensus guidance is applicable to agreements executed in quarters beginning
after June 15, 2003. The Company adopted this accounting effective July 1,
2003. The adoption of EITF No. 00-21 did not have a material effect on the
Companys financial condition or results of operations.

In May 2003, the EITF of the FASB reached a consensus on Issue 01-08. If an
arrangement contains a lease in accordance with the EITF guidance, the timing
of the expense and recognition in the balance sheet (if a capital lease) and
disclosures could be affected. The EITF is effective for all arrangements
agreed to or modified in fiscal periods after May 28, 2003. The adoption of
EITF 01-08 did not have a material effect on the Companys financial condition
or results of operations.

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In November 2002, the FASB issued FASB Interpretation No. 45, which clarifies
the disclosure and recognition/measurement requirements related to certain
guarantees. The disclosure requirements are effective for financial statements
issued after December 15, 2002 and the recognition/measurement requirements are
effective on a prospective basis for guarantees issued or modified after
December 31, 2002. The Company typically grants its customers a warranty,
which guarantees that its products
will substantially conform to its current specifications for twelve months from
the delivery date. Historically, costs related to these guarantees have not
been significant.

In January 2003, the FASB issued Interpretation No. 46. Interpretation No. 46
applies immediately to variable interests in variable interest entities created
after January 31, 2003, and to variable interests in variable interest entities
obtained after January 31, 2003. For public enterprises with a variable
interest in a variable interest entity created before February l, 2003, this
interpretation applies to that enterprise no later than the beginning of the
first interim or annual reporting period ending after December 15, 2003. The
Company is currently determining the impact of the application of this
Interpretation on the Companys financial condition and results of operations.

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Item 3: Quantitative and Qualitative Disclosures about Market Risk

Market Risk

The Company is 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. The Company does not enter into
derivatives or other financial instruments for trading or speculative purposes.
The Company has also not entered into financial instruments to manage and
reduce the impact of changes in interest rates and foreign currency exchange
rates although the Company may enter into such transactions in the future.

Interest Rate Risks

The Companys notes payable and convertible subordinated debentures at
September 30, 2003, carry interest rates, which are fixed. The Companys line
of credit pursuant to the Amended Credit Agreement carries interest rates,
which vary with the prime rate. Accordingly, any increases in Silicons prime
rate will reduce the Companys earnings. The Company has no borrowings under
the Amended Credit Agreement at September 30, 2003.

Foreign Currency Risks

Products sold outside of the United States of America are transacted in U.S.
dollars and therefore the Company is not exposed to foreign currency exchange
risk. Transactions with Clarent Canada Ltd., the Companys Canadian subsidiary
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, 2003, a 10%
strengthening of the U.S. dollar against the Canadian dollar would result in a
foreign currency transaction loss of approximately $112,000. To date, foreign
exchange gains and losses have not been significant.

Item 4: Controls and Procedures

The Companys Chief Executive Officer and Chief Financial Officer have
evaluated the effectiveness of the Companys 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 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 report, the
Companys disclosure controls and procedures are effective in alerting them on
a timely basis to material information relating to the Company (including its
consolidated subsidiaries) required to be included in the Companys periodic
filings under the Exchange Act.

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PART II  OTHER INFORMATION

Item 1: Legal Proceedings



| |  | Except as set forth below, the Company is not a party to any material
legal proceedings other than ordinary routine claims and proceedings
incidental to its business, and the Company does not expect these claims
and proceedings, either individually or in the aggregate, to have a
material adverse effect on the Company. At the time the Company acquired
MCK, it was a party to certain pending legal proceedings which are
described below.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In December 2001, a complaint was filed in the Southern District of New
York seeking an unspecified amount of damages on behalf of a class of
persons who allegedly purchased shares of the MCKs common stock between
the date of MCKs initial public offering and December 6, 2000. The
complainants 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 and investment bankers 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 the companies
and individuals, including the MCK defendants. On June 26, 2003, a
proposed partial global settlement was announced between the securities
issuers and their directors and officers and the plaintiffs. Under the
terms of the settlement, the insurers of the issuers would deliver a
surety undertaking in the amount of $1 billion payable to the plaintiffs
to settle the actions against all issuers, directors and officers. Prior
to the Companys acquisition of MCK, the Board of Directors of MCK voted
to approve the proposed settlement. The proposed settlement is subject to
acceptance by the other securities issuers and court approval. No
provision was recorded for this matter in the financial statements of MCK
prepared prior to its acquisition by the Company because MCK believed that
its portion of the proposed settlement would be paid by its insurance
carrier.
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | MCK has been named a defendant in a lawsuit filed in Norfolk County,
Massachusetts by Entrata Communications, Inc. (Entrata). Entrata
Communications Inc. v. Superwire.com. Inc. and MCK, Inc. arises out of a
dispute between Entrata and one of its largest shareholders,
Superwire.com, Inc. (Superwire). Pursuant to a contract with Entrata,
MCK was obligated to pay Entrata $750,000 in early 2002. In order to take
advantage of a $100,000 discount offered for early payment, MCK paid
Entrata $650,000 in November 2001, in full satisfaction of its contractual
obligations. The funds were placed in escrow with Superwires California
law firm, Jeffers, Shaff & Falk, LLP (JSF), which agreed not to disburse
the funds until the dispute between Entrata and Superwire had been
resolved. Nevertheless, Entrata contends that it never received the funds
from MCK and that the funds were diverted to Superwire and JSF. Through
the lawsuit, Entrata seeks to recover from both MCK and Superwire the full
$750,000 that MCK would have owed in 2002. MCK has asserted counterclaims
against Entrata, and cross-claims against Superwire, for fraud and breach
of contract. On October 11, 2002, Superwire and Entrata filed
cross-motions for summary judgment against each other. The court denied
both motions on March 13, 2003. Following denial of the cross-motions for
summary judgment, MCK filed a motion to add JSF and two of its partners,
Barry D. Falk and Mark R. Ziebell, as third-party defendants. The motion
is unopposed and is likely to be allowed. The court has given the
parties until March 17, 2004 to complete discovery. The Company intends to defend
the claims against MCK and prosecute its counterclaims, cross-claims and
third-party claims. No amounts, other than the original payment, were
provided for this matter in the financial statements of MCK prepared prior
to its acquisition by the Company. The Company believes that the claim
against MCK is without merit.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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Item 2: Changes in Securities and Use of Proceeds



| |  | In the quarter ended September 30, 2003, the Company issued to 13
individuals an aggregate of 1,524,000 shares of the Companys common stock
upon exercise by such individuals of warrants to purchase shares of the
Companys common stock issued in connection with the private placement of
securities conducted by the Company in October 2002. The shares issued to
the individuals were issued without registration under the Securities Act
of 1933, as amended (the Securities Act), in reliance upon the exemption
from registration set forth in Regulation D promulgated pursuant to
Section 4(2) of the Securities Act (Regulation D). The Company based
such reliance upon factual representations made to the Company by each
individual as to such individuals investment intent, sophistication, and
status as an accredited investor, as that term is defined in Rule 501 of
Regulation D, among other things.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Item 6: Exhibits and Reports on Form 8-K

(a)
    
    Exhibits2.1
    
    Agreement and Plan of Merger dated as of April 21,
2003, among the Company, Mickey Acquiring Sub, Inc. and MCK
Communications, Inc. (The schedules to the Agreement and Plan
of Merger have been omitted from this Report pursuant to Item
601(b)(2) of Regulation S-K, and the Company agrees to furnish
copies of such omitted schedules supplementally to the
Securities and Exchange Commission upon request.)*2.2
    
    First Amendment to the Agreement and Plan of Merger
dated as of April 21, 2003, among the Company, Mickey Acquiring
Sub, Inc. and MCK Communications, Inc.*2.3
    
    Second Amendment to the Agreement and Plan of
Merger dated as of June 13, 2003, among the Company, Mickey
Acquiring Sub, Inc. and MCK Communications, Inc.**31.1
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Executive Officer.31.2
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Financial Officer.32.1
    
    Section 1350 Certification by the Companys Chief Executive Officer.32.2
    
    Section 1350 Certification by the Companys Chief Financial Officer.99.1
    
    Form of Affiliate Agreement executed in connection
with the Companys acquisition of MCK Communications, Inc.***




---

|*   |  | Incorporated by reference to the Companys Current Report on Form 8-K
filed on April 23, 2003.                            
|--- |  | --------------------------------------------------------------------------------------------------------------------------
|   
|**  |  | Incorporated by reference to the Companys Current Report on Form 8-K
filed on June 17, 2003.                             
|   
|*** |  | Incorporated by reference to Exhibit B to Exhibit 2.1 of the Companys
Current Report on Form 8-K filed on April 23, 2003.



|(b) |  | Reports on Form 8-K.
|--- |  | --------------------

During the quarter ended September 30, 2003, the Company filed with
or furnished to the SEC the following Current Reports on Form 8-K:

(i)
    
    Current Report on Form 8-K/A filed with the SEC on
July 1, 2003, setting forth pursuant to Item 7 thereof the
following financial statements, together with the notes
thereto: the audited consolidated financial statements of
Clarent Corporation for the years ended December 30, 2001 and
2000; the unaudited financial statements of Clarent Corporation
for the nine months ended September 30, 2002 and 2001; the
unaudited pro forma condensed consolidated balance sheet of the
Company as of September 30, 2002; and the unaudited pro forma
condensed consolidated statement of operations of the Company
for the year ended December 31, 2001 and for the nine months
ended September 30, 2002;


37



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##### Table of Contents



(ii)
    
    Current Report on Form 8-K furnished to the SEC on
August 6, 2003, reporting under Item 12 of such report
information regarding the Companys results of operations and
financial condition for the second quarter of 2003; and(iii)
    
    Current Report on Form 8-K filed with the SEC on
September 30, 2003, reporting under Item 2 of such report the
consummation of the Companys acquisition of MCK Communications
on September 26, 2003.


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##### Table of Contents



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 13, 2003
    
    /s/ Juliet M. ReisingExecutive Vice President and Chief Financial Officer
(duly authorized signatory and
Principal Financial and Accounting Officer)


39



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##### Table of Contents



EXHIBIT INDEX

2.1
    
    Agreement and Plan of Merger dated as of April 21, 2003, among the
Company, Mickey Acquiring Sub, Inc. and MCK Communications, Inc. (The
schedules to the Agreement and Plan of Merger have been omitted from this
Report pursuant to Item 601(b)(2) of Regulation S-K, and the Company
agrees to furnish copies of such omitted schedules supplementally to the
Securities and Exchange Commission upon request.)*2.2
    
    First Amendment to the Agreement and Plan of Merger dated as of April 21,
2003, among the Company, Mickey Acquiring Sub, Inc. and MCK
Communications, Inc.*2.3
    
    Second Amendment to the Agreement and Plan of Merger dated as of June 13,
2003, among the Company, Mickey Acquiring Sub, Inc. and MCK
Communications, Inc.**31.1
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Executive Officer.31.2
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Financial Officer.32.1
    
    Section 1350 Certification by the Companys Chief Executive Officer.32.2
    
    Section 1350 Certification by the Companys Chief Financial Officer.99.1
    
    Form of Affiliate Agreement executed in connection with the Companys
acquisition of MCK Communications, Inc.***




---

|*   |  | Incorporated by reference to the Companys Current Report on Form 8-K
filed on April 23, 2003.                           
|--- |  | -------------------------------------------------------------------------------------------------------------------------
|   
|**  |  | Incorporated by reference to the Companys Current Report on Form 8-K
filed on June 17, 2003.                            
|   
|*** |  | Incorporated by reference to Exhibit B to Exhibit 2.1 of the Companys
Current Report on Form 8-K filed on April 23, 2003

40