##### Table of Contents



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, 2005
 o
    
    TRANSITION REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT
 For
the transition period from

to
  
 VERSO TECHNOLOGIES, INC.
  MINNESOTA
    
    41-1484525(State or other jurisdiction
    
    (I.R.S. Employer Identification No.)of incorporation or organization)
 
 
 
 þ o
 þ o
 o þ




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Page No.Part I. FINANCIAL INFORMATIONItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of September 30, 2005 and
December 31, 2004
    
    
    2Condensed Consolidated Statements of Operations for the three months
and the nine months ended September 30, 2005 and 2004
    
    
    3Condensed Consolidated Statements of Cash Flows for the nine months
ended September 30, 2005 and 2004
    
    
    4Notes to Condensed Consolidated Financial Statements
    
    
    5Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    22Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    35Item 4. Controls and Procedures
    
    
    36PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    37Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    37Item 6. Exhibits
    
    
    37Signature Page
    
    
    38Exhibit Index
    
    
    39EX-31.1 SECTION 302 CERTIFICATION OF THE CEOEX-31.2 SECTION 302 CERTIFICATION OF THE CFOEX-32.1 SECTION 906 CERTIFICATION OF THE CEOEX-32.2 SECTION 906 CERTIFICATION OF THE CFO
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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
 September 30,
    
    
    December 31,2005
    
    
    2004(Unaudited)ASSETS:Current assets:Cash and cash equivalents
    
    $
    5,055
    
    
    $
    4,234Restricted cash
    
    
    1,620
    
    
    
    Accounts receivable, net of allowance for doubtful accounts of $561
and $255, respectively
    
    
    5,154
    
    
    
    3,961Inventories
    
    
    4,429
    
    
    
    5,362Other current assets
    
    
    2,060
    
    
    
    1,451Current portion of note receivable
    
    
    541
    
    
    
    Assets held for sale
    
    
    
    
    
    
    8,995Total current assets
    
    
    18,859
    
    
    
    24,003Property and equipment, net of accumulated depreciation and amortization
of $6,475 and $7,047, respectively
    
    
    2,562
    
    
    
    3,879Investment
    
    
    735
    
    
    
    729Note receivable, net of current portion
    
    
    2,919
    
    
    
    Other intangibles, net of accumulated amortization
of $1,486 and $921, respectively
    
    
    3,047
    
    
    
    2,304Goodwill
    
    
    2,514
    
    
    
    2,514Total assets
    
    $
    30,636
    
    
    $
    33,429LIABILITIES AND SHAREHOLDERS EQUITY:Current liabilities:Accounts payable
    
    $
    2,272
    
    
    $
    2,095Accrued compensation
    
    
    1,222
    
    
    
    1,356Accrued expenses
    
    
    1,955
    
    
    
    1,973Current portion of accrued loss on sublease
    
    
    621
    
    
    
    Current portion of liabilities of discontinued operations
    
    
    2,092
    
    
    
    1,568Liabilities held for sale
    
    
    
    
    
    
    1,985Current portion of convertible debentures
    
    
    2,622
    
    
    
    4,254Unearned revenue and customer deposits
    
    
    2,577
    
    
    
    3,157Total current liabilities
    
    
    13,361
    
    
    
    16,388Accrued loss on sublease, net of current portion
    
    
    1,241
    
    
    
    Liabilities of discontinued operations, net of current portion
    
    
    782
    
    
    
    1,461Other long-term liabilities
    
    
    82
    
    
    
    229Notes payable
    
    
    2,766
    
    
    
    2,711Convertible debentures, net of current portion
    
    
    6,087
    
    
    
    Total liabilities
    
    
    24,319
    
    
    
    20,789Shareholders equity:Preferred
stock, no par value, 1,000,000 shares authorized;
780,000 shares issued and none outstanding
    
    
    
    
    
    
    Common
stock, $.01 par value, authorized shares of 60,000,000 and 40,000,000;
27,180,146 and 26,648,641 shares issued and outstanding
    
    
    272
    
    
    
    1,332Additional paid-in capital
    
    
    334,530
    
    
    
    322,971Stock payable
    
    
    67
    
    
    
    128Accumulated deficit
    
    
    (328,430
    )
    
    
    (311,931
    )Deferred compensation
    
    
    
    
    
    
    (7
    )Accumulated other comprehensive income (loss)  foreign currency translation
    
    
    (122
    )
    
    
    147Total shareholders equity
    
    
    6,317
    
    
    
    12,640Total liabilities and shareholders equity
    
    $
    30,636
    
    
    $
    33,429
 The accompanying notes are an integral part of these condensed consolidated financial statements.
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VERSO TECHNOLOGIES, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except share data)
 For the three months ended September 30,
    
    
    For the nine months ended September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Revenue:Products
    
    $
    4,697
    
    
    $
    2,978
    
    
    $
    12,038
    
    
    $
    11,669Services
    
    
    3,584
    
    
    
    3,988
    
    
    
    11,363
    
    
    
    13,027Total revenue
    
    
    8,281
    
    
    
    6,966
    
    
    
    23,401
    
    
    
    24,696Cost of revenue:Products:Product costs
    
    
    2,132
    
    
    
    1,376
    
    
    
    5,730
    
    
    
    4,934Amortization of intangibles
    
    
    170
    
    
    
    68
    
    
    
    385
    
    
    
    206Total cost of product
    
    
    2,302
    
    
    
    1,444
    
    
    
    6,115
    
    
    
    5,140Services
    
    
    2,261
    
    
    
    2,473
    
    
    
    6,951
    
    
    
    7,660Total cost of revenue
    
    
    4,563
    
    
    
    3,917
    
    
    
    13,066
    
    
    
    12,800Gross profit:Products
    
    
    2,395
    
    
    
    1,534
    
    
    
    5,923
    
    
    
    6,529Services
    
    
    1,323
    
    
    
    1,515
    
    
    
    4,412
    
    
    
    5,367Total gross profit
    
    
    3,718
    
    
    
    3,049
    
    
    
    10,335
    
    
    
    11,896Operating expenses:General and administrative
    
    
    2,592
    
    
    
    3,284
    
    
    
    7,646
    
    
    
    9,102Sales and marketing
    
    
    1,948
    
    
    
    2,583
    
    
    
    6,143
    
    
    
    6,948Research and development
    
    
    1,655
    
    
    
    1,754
    
    
    
    5,076
    
    
    
    5,141Depreciation and amortization
    
    
    527
    
    
    
    746
    
    
    
    1,768
    
    
    
    2,193Reorganization costs
    
    
    340
    
    
    
    
    
    
    
    464
    
    
    
    584Reorganization costs  loss on sublease
    
    
    
    
    
    
    
    
    
    
    2,550
    
    
    
    Reorganization costs  stock related
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    570Total operating expenses
    
    
    7,062
    
    
    
    8,367
    
    
    
    23,647
    
    
    
    24,538Operating loss from continuing
operations
    
    
    (3,344
    )
    
    
    (5,318
    )
    
    
    (13,312
    )
    
    
    (12,642
    )Other income (expense), net:Other income (expense)
    
    
    (41
    )
    
    
    72
    
    
    
    (58
    )
    
    
    196Equity in income (loss) of investment
    
    
    58
    
    
    
    (56
    )
    
    
    6
    
    
    
    (119
    )Interest expense, net,
including $1,025, $125, $1,869, and $400
of amortization of loan fees and
discount on convertible
debentures in each period, respectively
    
    
    (1,272
    )
    
    
    (255
    )
    
    
    (2,569
    )
    
    
    (787
    )(1,255
    )
    
    
    (239
    )
    
    
    (2,621
    )
    
    
    (710
    )Loss from continuing operations before
income taxes
    
    
    (4,599
    )
    
    
    (5,557
    )
    
    
    (15,933
    )
    
    
    (13,352
    )Income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Loss from continuing operations
    
    
    (4,599
    )
    
    
    (5,557
    )
    
    
    (15,933
    )
    
    
    (13,352
    )Loss from discontinued operations
    
    
    
    
    
    
    (1,764
    )
    
    
    (566
    )
    
    
    (3,986
    )Net loss
    
    $
    (4,599
    )
    
    $
    (7,321
    )
    
    $
    (16,499
    )
    
    $
    (17,338
    )Net loss per common share  basic and
diluted:Loss from continuing operations
    
    $
    (0.17
    )
    
    $
    (0.21
    )
    
    $
    (0.59
    )
    
    $
    (0.51
    )Loss from discontinued operations
    
    
    
    
    
    
    (0.06
    )
    
    
    (0.02
    )
    
    
    (0.15
    )$
    (0.17
    )
    
    $
    (0.27
    )
    
    $
    (0.61
    )
    
    $
    (0.66
    )Weighted average shares outstanding  basic
and diluted
    
    
    27,034,569
    
    
    
    26,626,667
    
    
    
    26,868,392
    
    
    
    26,198,953
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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands, except share data)
(Unaudited)
 For the nine months ended September 30,2005
    
    
    2004Operating Activities:Continuing operations:Net loss from continuing operations
    
    $
    (15,933
    )
    
    $
    (13,352
    )Adjustments to reconcile net loss from continuing operations to net
cash used in continuing operating activities:Equity in (income) loss of investment
    
    
    (6
    )
    
    
    119Depreciation and amortization
    
    
    2,153
    
    
    
    2,399Provision for doubtful accounts
    
    
    228
    
    
    
    311Amortization of loan fees and discount on convertible subordinated debentures
    
    
    1,869
    
    
    
    400Reorganization costs  loss on sublease
    
    
    2,550
    
    
    
    Reorganization costs  stock related
    
    
    
    
    
    
    570Other
    
    
    (27
    )
    
    
    41Changes in current operating assets and liabilities, net of effects of acquisitions:Accounts receivable
    
    
    (1,328
    )
    
    
    1,025Inventories
    
    
    933
    
    
    
    (1,477
    )Other current assets
    
    
    137
    
    
    
    (278
    )Accounts payable
    
    
    177
    
    
    
    (1,113
    )Accrued compensation
    
    
    (134
    )
    
    
    548Accrued expenses
    
    
    (867
    )
    
    
    (229
    )Unearned revenue and customer deposits
    
    
    (580
    )
    
    
    (295
    )Net cash used in continuing operating activities
    
    
    (10,828
    )
    
    
    (11,331
    )Discontinued operations:Loss from discontinued operations
    
    
    (566
    )
    
    
    (3,986
    )Adjustment to reconcile loss from discontinued operations
to net cash used in discontinued operating activities
    
    
    (772
    )
    
    
    6,101Net cash (used in) provided by discontinued operating activities
    
    
    (1,338
    )
    
    
    2,115Net cash used in operating activities
    
    
    (12,166
    )
    
    
    (9,216
    )Investing Activities:Continuing operations:Net cash (used in) provided by investing activities for continuing operations -Purchases of property and equipment
    
    
    (529
    )
    
    
    (1,760
    )Purchase of WSECI
    
    
    (268
    )
    
    
    (Increase) decrease in restricted cash
    
    
    (1,620
    )
    
    
    2,290Net cash (used in) provided by investing activities for continuing operations
    
    
    (2,417
    )
    
    
    530Discontinued operations:Purchases of property and equipment
    
    
    
    
    
    
    (287
    )Proceeds from notes receivable
    
    
    180
    
    
    
    Proceeds from sale of discontinued operations
    
    
    4,015
    
    
    
    Acquisition of MCK Communications, Inc., net of cash acquired
    
    
    
    
    
    
    (4,063
    )Net cash provided by (used in) investing activities for discontinued operations
    
    
    4,195
    
    
    
    (4,350
    )Net cash provided by (used in) investing activities
    
    
    1,778
    
    
    
    (3,820
    )Financing Activities:Proceeds from convertible debentures, net
    
    
    12,757
    
    
    
    Payments of convertible debentures
    
    
    (1,575
    )
    
    
    Payments of notes payable
    
    
    
    
    
    
    (350
    )Proceeds from private placement, net
    
    
    
    
    
    
    16,474Proceeds from issuances of common stock in connection with the
exercise of options and warrants, net
    
    
    39
    
    
    
    128Net cash provided by financing activities
    
    
    11,221
    
    
    
    16,252Effect of exchange rate changes on cash
    
    
    (12
    )
    
    
    (5
    )Increase in cash and cash equivalents
    
    
    821
    
    
    
    3,211Cash and cash equivalents at beginning of period
    
    
    4,234
    
    
    
    7,654Cash and cash equivalents at end of period
    
    $
    5,055
    
    
    $
    10,865Supplemental disclosure of cash flow information:Cash payments (receipts) during the periods for:Interest
    
    $
    578
    
    
    $
    272Income taxes
    
    $
    (9
    )
    
    $
    (80
    )Non-cash investing and financing activitiesCommon stock consideration for acquisitions:WSECI  issuance of 441,960 shares of common stock
    
    $
    676
    
    
    $
    Issuance of note receivable in disposition of MCK
    
    
    
    
    
    
    3,500Common stock and compensatory options issued in reorganization
    
    
    
    
    
    
    570Issuance of warrants in conjunction with convertible debentures
    
    
    8,113
    
    
    
    Issuance of warrants in subordinated debenture restructuring
    
    
    
    
    
    
    877Issuance of common stock and warrants in exchange for services
    
    
    794
    
    
    
    133Assets
acquired and liabilities assumed in conjunction with business acquisitions:Fair value of assets acquired, excluding cash and restricted cash
    
    
    1,453
    
    
    
    Liabilities assumed
    
    $
    
    
    
    $
    
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1.
    
    BASIS OF PRESENTATIONVerso 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 (i) the Packet-based Technologies Group, which includes the Companys
softswitching division, the Companys Netperformer division, the Companys subsidiary
Telemate.Net Software, Inc. (Telemate.Net) and the Companys I-Master division; and (ii)
the Advanced Applications Services Group, which includes the Companys technical
applications support group. The Packet-based Technologies Group includes domestic and
international sales of hardware and software, integration, applications and technical
training and support. The Packet-based Technologies Group offers hardware and software for
companies seeking to build private, packet-based voice and data networks. Additionally, the
Packet-based Technologies Group offers software-based solutions for Internet access and
usage management that include call accounting and usage reporting for Internet protocol
network devices. The Advanced Applications Services Group includes outsourced technical
application services and application installation and training services to outside
customers, as well as customers of the Packet-based Technologies Group.In January 2005, the Company sold substantially all of the operating assets of its NACT
Telecommunications, Inc., now known as Provo Pre-Paid (Delaware) Corp. (NACT) and MCK
Communications, Inc., now known as Needham (Delaware) Corp. (MCK) businesses to better
focus the Companys capital and management resources on areas which the Company believes
have greater potential given its strategy to focus on next-generation network and solutions
to improve cash utilization. In addition, the Company disposed of its NACT business
because the Company wanted to move toward an open-standards, pre-paid next-generation
solution that could better address growing market opportunities and enable the Company to
offer a competitive product for Tier 1 and Tier 2 carriers. The Company believes that the
I-Master platform which the Company acquired from WSECI, Inc., a Delaware corporation
formerly known as Jacksonville Technology Associates, Inc. (WSECI), in March 2005 after
forming a strategic partnership with WSECI in the latter half of 2004 permits the Company to
offer a better solution. Further the Company disposed of its MCK business because the
Company intends to focus on next-generation solutions for service providers and the products
of the MCK business did not fit that profile. The operations of NACT and MCK businesses
have been reclassified as discontinued operations in the Companys consolidated financial
statements.On October 11, 2005, the Company effected a 1-for-5 reverse stock split of the Companys
outstanding common stock, pursuant to which every five (5) shares of the Companys common
stock outstanding on such date were converted into one (1) share of the Companys common
stock (the Reverse Split). No fractional shares of common stock were issued as a result
of the Reverse Split, and shareholders otherwise entitled to receive fractional shares as a
result of the Reverse Split will be paid cash in lieu thereof.The consolidated financial statements include the accounts of Verso Technologies, Inc. and
its wholly-owned subsidiaries, including Telemate.Net Software, Inc. (Telemate.Net);
Clarent Canada Ltd., now known as Verso Technologies Canada Inc. (Verso Canada), MCK and
NACT are reflected in discontinued operations. These subsidiaries were acquired and were
all accounted for as purchases (see Note 2).Certain prior year amounts in the 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.
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1.
    
    BASIS OF PRESENTATION, ContinuedThe year-end condensed consolidated balance sheet was derived from audited consolidated
financial statements. The accompanying condensed consolidated unaudited quarterly financial
statements are presented in accordance with the rules and regulations of the Securities and
Exchange Commission (SEC) and do not include all disclosures normally required by
accounting principles generally accepted in the United States of America. For further
information, refer to the audited consolidated financial statements and footnotes thereto
included in the Companys Annual Report on Form 10-K for the year ended December 31, 2004
(the Annual Report).2.
    
    MERGERS AND ACQUISITIONSWSECI, Inc.On March 31, 2005, the Company acquired substantially all of the operating assets of WSECI
pursuant to the Asset Purchase Agreement (Asset Purchase Agreement) dated as of February
23, 2005 by and among the Company, WSECI and all of the shareholders of WSECI. WSECI is a
provider of an internet protocol-based, revenue assurance platform which enables the
deployment of multiple voice and next-generation services to the carrier market. The fair
value of the initial acquisition cost was approximately $1.1 million, consisting of 190,000
shares of the Companys common stock (950,000 before the Reverse Split) with a fair value of
$331,000, $50,000 in cash, the payment of certain liabilities of approximately $613,000 and
acquisition costs of approximately $114,000. The acquisition is accounted for as a
purchase. During the quarter ended September 30, 2005, under this provision, the Company
issued an additional 251,960 shares of the Companys common stock (1,259,799 before the
Reverse Split) with a fair value of $345,000. The additional shares issued were recorded as
an increase in other intangibles-current technology which is being amortized over the
remaining estimated life of the original purchased technology.Pursuant to the Asset Purchase Agreement, the Company may become obligated to issue to WSECI
additional contingent consideration of up to $5.0 million based on the sales of certain
WSECI products and services. The initial $500,000 of such contingent consideration earned
by WSECI is based upon specific customer transactions the Company completes with respect to
the WSECI assets, and the remaining $4.5 million of the contingent consideration may be
earned by WSECI based on the revenue generated from the WSECI assets during the 18-month
period following the acquisition, which revenue must equal a minimum of $88.0 million during
such period in order for all of such remaining contingent consideration to be earned. The
contingent consideration is payable in cash or shares of the Companys common stock at the
election of the Company. It is not possible to estimate what, if any, additional stock
payment would be due as additional contingent consideration at this time. When the
additional contingent consideration is determined, it will further increase the amount of
the purchase price allocated to other intangible assets and will be amortized over the
remaining useful life of the asset.The adjusted allocation of the costs of the acquisition of WSECI (initial cost plus first
contingent payment) are as follows (in thousands):
 WSECIProperty and equipment
    
    $
    52Accounts receivable
    
    
    93Other intangibles
    
    
    1,308Cost of acquisition
    
    $
    1,453
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2.
    
    MERGERS AND ACQUISITIONS, ContinuedPro Forma Effect of WSECI, Inc.
  Three months ended
    
    Nine months endedSeptember 30,2004
    
    September 30, 2004Revenues
    
    $
    7,084
    
    
    $
    24,996Net loss from continuing operations
    
    $
    (5,610
    )
    
    $
    (13,422
    )Net loss from continuing operations per common share  basic and diluted
    
    $
    (0.21
    )
    
    $
    (0.50
    )Weighted average shares outstanding
 basic and diluted
    
    
    27,068,627
    
    
    
    26,640,913
 3.
    
    EQUITY INVESTMENTOn October 1, 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 a distribution channel in the China and Asia-Pacific region for the Companys
application-based Voice over Internet Protocol (VoIP) 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 are treated as an equity
investment rather than being consolidated. The Company determined that since BeTrue was a
business, BeTrue did not fall under the scope of the Financial Accounting Standards Board
Interpretation No. 46 R, Consolidation of Variable Interest Entities and there was no
impact on the Companys financial position or results of 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 cash in the amount of $100,000.Summarized financial information reported by this affiliate for the three and nine months
ended September 30, 2005 and 2004 (in thousands) are as follows:
 Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Operating results:Revenues
    
    $
    1,092
    
    
    $
    
    
    
    $
    1,756
    
    
    $
    534Operating loss
    
    $
    113
    
    
    $
    (110
    )
    
    $
    13
    
    
    $
    (233
    )Net loss
    
    $
    113
    
    
    $
    (110
    )
    
    $
    13
    
    
    $
    (233
    )
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4.
    
    DISCONTINUED OPERATIONSIn January 2005, the Company sold substantially all of the operating assets of its NACT and
MCK businesses to better focus the Companys capital and management resources on areas which
the Company believes have greater potential given its strategy to focus on next-generation
network and solutions to improve cash utilization. In addition, the Company disposed of
its NACT business because the Company wanted to move toward an open-standards, pre-paid
next-generation solution that could better address growing market opportunities and enable
the Company to offer a competitive product for Tier 1 and Tier 2 carriers. The Company
believes that the I-Master platform which the Company acquired from WSECI in March 2005,
after forming a strategic partnership with WSECI in the latter half of 2004, permits the
Company to offer a better solution. Further, the Company disposed of its MCK business
because the Company intends to focus on next-generation solutions for service providers and
the products of the MCK business did not fit that profile. The operations of NACT and MCK
businesses have been reclassified as discontinued operations in the Companys consolidated
financial statements.The loss on the sale of the NACT business totaled
$11.4 million which was recognized in December 2004. The loss includes a
reduction in net asset values of approximately $10.9 million and a provision for estimated
closing costs and expenses of approximately $500,000. The loss on the sale of the MCK
business totaled $3.4 million which was recognized in
December 2004. The loss includes a reduction in net asset values of
approximately $2.9 million and a provision for estimated closing costs and expenses of
approximately $500,000.Summary operating results of the discontinued operations (in thousands) are as follows:
 Three months ended September 30,
    
    
    Nine months ended September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Revenue
    
    $
    
    
    
    $
    4,280
    
    
    $
    212
    
    
    $
    14,447Gross (loss) profit
    
    
    
    
    
    
    1,441
    
    
    
    (27
    )
    
    
    6,243Operating loss
    
    
    
    
    
    
    (1,764
    )
    
    
    (566
    )
    
    
    (4,015
    )Loss from discontinued operations
    
    $
    
    
    
    $
    (1,764
    )
    
    $
    (566
    )
    
    $
    (3,986
    )
 The operating loss from discontinued operations in the three months ended September 30, 2004
includes general and administrative costs of $698,000, sales and marketing costs of
$917,000, research and development costs of $1.3 million and depreciation and amortization
of $310,000.The operating loss from discontinued operations in the nine months ended September 30, 2005
includes general and administrative costs of $97,000, sales and marketing costs of $104,000,
research and development costs of $275,000 and depreciation and amortization of $61,000.The operating loss from discontinued operations in the nine months ended September 30, 2004
includes general and administrative costs of $2.2 million, sales and marketing costs of $3.3
million, research and development costs of $3.8 million, depreciation and amortization of
$978,000 and other income of $30,000.
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4.
    
    DISCONTINUED OPERATIONS, ContinuedThe assets and liabilities of NACT and MCK were classified as assets held for sale at
December 31, 2004 and the significant components (in thousands) were as follows:
 Accounts receivable, net
    
    $
    3,085Inventory
    
    
    2,901Other current assets
    
    
    419Furniture and equipment, net
    
    
    977Goodwill and other intangibles
    
    
    1,613Assets held for sale
    
    $
    8,995Accounts payable
    
    $
    163Accrued compensation
    
    
    465Unearned revenue and customer deposits
    
    
    1,127Other current liabilities
    
    
    230Liabilities held for sale
    
    $
    1,985
 Assets and liabilities of discontinued operations (in thousands) are as follows:
 September 30,
    
    
    December 31,2005
    
    
    2004Assets of discontinued operations:Notes receivable
    
    $
    3,460
    
    
    $
    Liabilities of discontinued operations:Accrued rent
    
    $
    1,874
    
    
    $
    2,384Other current liabilities
    
    
    1,000
    
    
    
    629Liabilities of discontinued operations
    
    $
    2,874
    
    
    $
    3,013
 In connection with the disposition of the MCK business, CITEL Technologies Limited (Citel
U.K.) and CITEL Technologies, Inc. (Citel U.S. and together with CITEL U.K., CITEL)
issued to the Company a convertible secured promissory note in principal amount of $3.5
million (the Note). The outstanding principal under the Note accrues interest at an
annual rate of 6% and has remaining payments with all interest accrued thereon of eleven
monthly payments of $60,000 followed by sixteen monthly payments of $75,000, with all
remaining outstanding principal and interest under the Note payable on January 21, 2008.
Under certain circumstances described in the Note, all or any portion of the principal
outstanding under the Note may be converted at the Companys option into shares of the
capital stock of CITEL U.K. CITEL U.K.s and CITEL U.S. obligations under the Note are
secured by a security interest in certain assets sold to CITEL.Accrued rent relates primarily to several leases for buildings and equipment that are no
longer being utilized in continuing operations. The accrual is for all remaining payments
due on these leases, less estimated amounts to be paid by any sublessors. The accrual
contains one lease with total payments remaining through January 31, 2010 of $1.8 million
and assumes that the building will be sub-leased for approximately 58% of the total lease
liability over the remaining term of the lease and one lease with total payments remaining
through March 31, 2007 of $2.0 million, discounted at 6%, which has been sub-leased for
approximately 66% of the total lease liability over the remaining term of the lease.
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4.
    
    DISCONTINUED OPERATIONS, ContinuedThe activity in the liabilities of discontinued operations (in thousands) for the three and
nine months ended September 30, 2005 and 2004 was as follows:
 Three months ended September 30,
    
    
    Nine months ended September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Balance beginning of period
    
    $
    3,241
    
    
    $
    3,837
    
    
    $
    3,013
    
    
    $
    4,579Lease payments, net of sublease receipts
    
    
    (165
    )
    
    
    (246
    )
    
    
    (508
    )
    
    
    (419
    )Other payments
    
    
    (72
    )
    
    
    (161
    )
    
    
    (192
    )
    
    
    (730
    )Estimated costs of disposal of discontinued operations
    
    
    
    
    
    
    
    
    
    
    1,000
    
    
    
    Legal and other costs of disposal
    
    
    (130
    )
    
    
    
    
    
    
    (439
    )
    
    
    Balance September 30
    
    $
    2,874
    
    
    $
    3,430
    
    
    $
    2,874
    
    
    $
    3,430
 5.
    
    INVENTORIESInventories consist primarily of purchased electronic components, and are stated at the
lower of cost or market. Cost is determined by using average cost.Inventories as of September 30, 2005 and December 31, 2004 are comprised of the following (in
thousands):
 September 30,
    
    
    December 31,2005
    
    
    2004Raw materials
    
    $
    2,810
    
    
    $
    3,315Work in process
    
    
    17
    
    
    
    9Finished goods
    
    
    1,602
    
    
    
    2,038Total inventories
    
    $
    4,429
    
    
    $
    5,362
 The inventory amounts noted are net of allowance of $1.2 million and $2.7 million at
September 30, 2005 and December 31, 2004, respectively.
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6.
    
    GOODWILL AND OTHER INTANGIBLESIntangible assets represent the excess of cost over the fair value of net tangible assets
acquired and identified other intangible assets which consist of current technology and a
customer relationship. The current technology is amortized on a straight-line basis over
its 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 associated with
acquisitions is not being amortized in accordance with Statement of Financial Accounting
Standards (SFAS) No. 142, Goodwill and Other Intangible Assets (SFAS No. 142).Goodwill and other intangible assets consist of the following (in thousands):
 Amortization
    
    
    September 30,
    
    
    December 31,Period in months
    
    
    2005
    
    
    2004Intangibles subject to amortization:Current technology
    
    36 months
    
    $
    2,130
    
    
    $
    821Customer relationship
    
    120 months
    
    
    2,403
    
    
    
    2,403Weighted average months
    
    85 months
    
    
    4,533
    
    
    
    3,224Accumulated amortization:Current technology
    
    
    
    
    
    
    (825
    )
    
    
    (440
    )Customer relationship
    
    
    
    
    
    
    (661
    )
    
    
    (480
    )Net intangibles subject to amortization
    
    
    
    
    
    
    3,047
    
    
    
    2,304Goodwill
    
    
    
    
    
    
    2,514
    
    
    
    2,514Total goodwill and other intangibles
    
    
    
    
    
    $
    5,561
    
    
    $
    4,818
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7.
    
    LOAN FACILITY WITH SILICON VALLEY BANKIn March 2005, the Company and Silicon Valley Bank
(Silicon), the Companys primary lender, renewed,
and in June and July 2005 further amended, the Companys credit facility with Silicon in
connection with the disposition of the MCK and NACT businesses, the sublease of the
Companys facilities in Atlanta, Georgia and the restructuring of the Companys 7.5%
convertible subordinated debentures (as amended, the Amended Credit Agreement). The
Amended Credit Agreement provided for a credit line of $7.5 million through September 30,
2005 at which time it increased to $10.0 million after the Company met certain financial
criteria. The working capital line includes 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s borrowings under the Amended Credit
Agreement are secured by substantially all of the assets of the Company. Interest on
borrowings under the Amended Credit Agreement is computed at 2.25% above Silicons Base
Rate, with a minimum Base Rate of 4.25% (6.75% at September 30, 2005). 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 March 2006. The Amended Credit Agreement
includes a loan fee of $130,000 and .375% per annum on unused available borrowings. The
loan fees will be amortized to interest expense over the term of the Amended Credit
Agreement. Under the terms of the Amended Credit Agreement, the Company must maintain a
minimum cash and excess availability covenant, 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, 2005.The Company had no borrowings under the Amended Credit Agreement as of September 30, 2005.
The availability under the Amended Credit Agreement at September 30, 2005 was $6.5 million.
The Company has outstanding letters of credit in the amount of $1.6 million at September 30,
2005, which would reduce borrowing capacity under the Amended Credit Agreement.8.
    
    CONVERTIBLE DEBENTURESSenior Unsecured Convertible DebenturesOn February 4, 2005, the Company completed a private placement of senior unsecured
convertible debentures and warrants pursuant to a securities purchase agreement with certain
institutional investors. The Company issued $13.5 million of senior unsecured convertible
debentures, Series A warrants exercisable for 2.2 million shares (10.8 million before the
Reverse Split) of the Companys common stock and Series B warrants exercisable for 2.0
million shares (10.0 million before the Reverse Split) of the Companys common stock. The
debentures have been discounted to reflect the fair value of the warrants issued, totaling
approximately $4.5 million. In addition, after allocation of the fair value of the warrants
issued, the remaining fair value of the debentures resulted in a computed beneficial
conversion feature with a fair value of $3.6 million. This
amount was recorded as a discount in the third quarter as a result of
additional analysis of the calculation of the beneficial conversion
feature. The impact of this additional discount is immaterial to the
statement of operations for the first and second quarters. The discount is being amortized to interest expense
over the life of the senior unsecured convertible debentures. The unamortized discount
totaled approximately $7.0 million at September 30, 2005. The senior unsecured convertible
debentures bear interest at a rate of 6% per annum increasing to 6.75% at February 4, 2006,
if the Fed Funds Rate is equal to or greater than 3.25% and are due February 2009 and are
convertible into approximately 5.4 million shares (27.0 million before the Reverse Split) of
the Companys common stock at an initial conversion price of $2.50 per share ($0.50 before
the Reverse Split), subject to anti-dilution adjustments and certain limitations. Interest
is payable on a quarterly basis beginning April 2005 and principal is payable on a quarterly
basis beginning August 2006. The Series A warrants issued in connection with the private
placement are exercisable for a period of five years commencing on February 4, 2005 and at
an exercise price of $3.60 ($0.72 before the Reverse Split) per share.
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8.
    
    CONVERTIBLE DEBENTURES, ContinuedSenior Unsecured Convertible Debentures, ContinuedThe Series B warrants issued in connection with the private placement were exercisable for a
period of 90 days, commencing on June 16, 2005, and had an exercise price of $3.90 per share
($0.78 before the Reverse Split). The Series B warrants expired in September 2005. The
Company paid certain private placement fees and attorneys fees totaling $993,000 and issued
Series A warrants, on the same terms as disclosed above, exercisable for 302,4000 shares
(1.5 million before the Reverse Split) of the Companys stock with a value of $561,000, in
connection with the private placement. The fees were recorded as prepaid loan origination
fees and are being amortized to interest expense over the term of the debentures. The
unamortized fees totaled approximately $1.3 million at September 30, 2005. In connection
with the private placement, the Company received net proceeds of approximately $12.5
million, including $1.6 million in restricted cash, net of expenses.Convertible Subordinated DebenturesOn July 25, 2005, the Company announced that it had restructured its outstanding 7.5%
convertible debenture with an aggregate principal amount of $4.5 million due November 22,
2005. Pursuant to the restructuring, $1.6 million of the aggregate principal amount has
been paid as of September 30, 2005, $225,000 will be paid on October 1, 2005, $450,000 will
be paid on November 22, 2005, and the remaining principal amount of $2.3 million will be
paid in equal monthly installments starting January 2006 and continuing through October
2006. The outstanding balance of the debentures totaled $2.9 million at September 30, 2005.
The interest rate on the unpaid principal remains at the current rate of 7.5% through
November 22, 2005 and then increases to 12% through the remaining term of the amended
debentures.In connection with the restructuring, the Company issued warrants to purchase an aggregate
of 800,000 shares (4.0 million before the Reverse Split) of the Companys common stock at an
exercise price of $2.50 ($0.50 before the Reverse Split) per share exercisable beginning on
November 22, 2005. Of these warrants, 600,000 (3.0 million before the Reverse Split) expire
January 1, 2007 and are cancelable if the debentures are repaid by November 22, 2005. The
remaining 200,000 (1.0 million before the Reverse Split) are not cancelable and have a five
year term. The fair value of the warrants issued, totaled approximately $877,000 and was
recorded as additional discount on the debentures. The discount is being amortized to
interest expense over the remaining life of the debentures. The unamortized discount
totaled approximately $669,000 at September 30, 2005.9.
    
    OTHER COMPREHENSIVE LOSSComprehensive loss for the three and nine months ended September 30, 2005 and 2004 is shown
in the following table (in thousands):
 Three months ended September 30,
    
    
    Nine months ended September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Net loss
    
    $
    (4,599
    )
    
    $
    (7,321
    )
    
    $
    (16,499
    )
    
    $
    (17,338
    )Other comprehensive loss:Foreign currency translation
    
    
    (42
    )
    
    
    52
    
    
    
    (269
    )
    
    
    (59
    )Comprehensive loss
    
    $
    (4,641
    )
    
    $
    (7,269
    )
    
    $
    (16,768
    )
    
    $
    (17,397
    )
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10.
    
    SEGMENT INFORMATIONThe Company reports information for two segments, the Packet-based Technologies Group and
the Advanced Applications Services Group. Previously the Company reported two segments, the
Carrier Solutions Group and the Enterprise Solutions Group. Following the dispositions of
the NACT and MCK businesses, the Company re-evaluated its internal reporting and
decision-making and segregated the activity of the Advanced Applications Services Group and
combined the remaining operations of the Carrier Solutions Group and Enterprise Solutions
Group into the Packet-based Technologies Group. Management evaluates the business segment
performance based on contributions before unallocated items. Inter-segment sales and
transfers are not significant.Packet-based
Technologies
Group:
 The Packet-based Technologies Group consists of the operations of the Companys
softswitching, I-Master and Netperformer divisions and the Companys subsidiary
Telemate.Net. The Packet-based Technologies Group includes domestic and international
sales of hardware and software, integration, applications and technical training and
support. The Packet-based Technologies Group offers hardware and software based
solutions for companies seeking to build private, packet-based voice and data networks.
Additionally, the Packet-based Technologies Group offers software-based solutions for
Internet access and usage management that include call accounting and usage reporting
for Internet protocol network devices.
 Advanced Applications
Services
Group:
 The Advanced Applications Services Group, consists of the Companys technical
applications support group which was previously included as part of the Enterprise
Solutions Group, and includes outsourced technical application services and application
installation and training services to outside customers, as well as customers of the
Packet-based Technologies Group.
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10.
    
    SEGMENT INFORMATION, ContinuedSummarized financial information concerning the Companys reportable segments is shown in
the following table (in thousands):
 Packet-based
    
    AdvancedTechnologies
    
    ApplicationGroup
    
    Services Group
    
    TotalFor the Three Months Ended September 30,
2005Revenue
    
    $
    6,139
    
    
    $
    2,142
    
    
    $
    8,281(Loss) contribution before unallocated items
    
    
    (970
    )
    
    
    335
    
    
    
    (635
    )At September 30, 2005Goodwill
    
    
    1,061
    
    
    
    1,453
    
    
    
    2,514Total assets
    
    
    12,239
    
    
    
    3,773
    
    
    
    16,012For the Three Months Ended September 30,
2004Revenue
    
    $
    4,140
    
    
    $
    2,826
    
    
    $
    6,966(Loss) contribution before unallocated items
    
    
    (2,588
    )
    
    
    633
    
    
    
    (1,955
    )At December 31, 2004Goodwill
    
    
    1,061
    
    
    
    1,453
    
    
    
    2,514Total assets
    
    
    11,104
    
    
    
    4,027
    
    
    
    15,131
 The following table reconciles the contribution before unallocated items to the loss before
discontinued operations (in thousands):
 Three months ended September 30,2005
    
    
    2004Loss before unallocated items, per above
    
    $
    (635
    )
    
    $
    (1,955
    )Corporate general and administrative expenses
    
    
    (1,747
    )
    
    
    (2,462
    )Corporate research and development
    
    
    (95
    )
    
    
    (155
    )Depreciation and amortization
    
    
    (527
    )
    
    
    (746
    )Reorganization costs
    
    
    (340
    )
    
    
    Other
    
    
    (1,255
    )
    
    
    (239
    )Income taxes
    
    
    
    
    
    
    Loss from continuing operations
    
    $
    (4,599
    )
    
    $
    (5,557
    )
 15




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10.
    
    SEGMENT INFORMATION, ContinuedSummarized financial information concerning the Companys reportable segments is shown in
the following table (in thousands):
 Packet-based
    
    AdvancedTechnologies
    
    ApplicationGroup
    
    Services Group
    
    TotalFor the Nine Months Ended September 30, 2005Revenue
    
    $
    16,194
    
    
    $
    7,207
    
    
    $
    23,401(Loss) contribution before unallocated items
    
    
    (4,493
    )
    
    
    1,472
    
    
    
    (3,021
    )For the Nine Months Ended September 30, 2004Revenue
    
    $
    15,443
    
    
    $
    9,253
    
    
    $
    24,696(Loss) contribution before unallocated items
    
    
    (4,753
    )
    
    
    2,358
    
    
    
    (2,395
    )
 The following table reconciles the contribution before unallocated items to the loss before
discontinued operations (in thousands):
 Nine months ended September 30,2005
    
    
    2004Loss before unallocated items, per above
    
    $
    (3,021
    )
    
    $
    (2,395
    )Corporate general and administrative expenses
    
    
    (5,308
    )
    
    
    (6,588
    )Corporate research and development
    
    
    (201
    )
    
    
    (312
    )Depreciation and amortization
    
    
    (1,768
    )
    
    
    (2,193
    )Reorganization costs
    
    
    (464
    )
    
    
    (584
    )Reorganization costs  loss on sublease
    
    
    (2,550
    )
    
    
    Reorganization costs-stock related
    
    
    
    
    
    
    (570
    )Other
    
    
    (2,621
    )
    
    
    (710
    )Income taxes
    
    
    
    
    
    
    Loss from continuing operations
    
    $
    (15,933
    )
    
    $
    (13,352
    )
 16




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10.
    
    SEGMENT INFORMATION, Continued
 The following table reconciles the segment total assets to the Companys total
assets:
 September 30,
    
    
    December 31,2005
    
    
    2004Total assets before unallocated items, per above
    
    $
    16,012
    
    
    $
    15,131Corporate assets:Cash and cash equivalents
    
    
    4,936
    
    
    
    4,234Restricted cash
    
    
    1,620
    
    
    
    Current portion of notes receivable
    
    
    541
    
    
    
    Other current assets
    
    
    1,821
    
    
    
    1,253Assets held for sale
    
    
    
    
    
    
    8,995Property and equipment, net
    
    
    2,052
    
    
    
    3,087Investment
    
    
    735
    
    
    
    729Notes receivable, net of current portion
    
    
    2,919
    
    
    
    $
    30,636
    
    
    $
    33,429
 Following the acquisition of substantially all the operating assets along with certain
liabilities of Clarent Corporation 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, 2005Revenue
    
    $
    
    
    
    $
    8,281
    
    
    $
    8,281(Loss) contribution before unallocated items
    
    
    (1,026
    )
    
    
    391
    
    
    
    (635
    )For the Three Months Ended September 30, 2004Revenue
    
    $
    
    
    
    $
    6,966
    
    
    $
    6,966Loss before unallocated items
    
    
    (504
    )
    
    
    (1,451
    )
    
    
    (1,955
    )For the Nine Months Ended September 30, 2005Revenue
    
    $
    
    
    
    $
    23,401
    
    
    $
    23,401(Loss) contribution before unallocated items
    
    
    (3,378
    )
    
    
    357
    
    
    
    (3,021
    )For the Nine Months Ended September 30, 2004Revenue
    
    $
    
    
    
    $
    24,696
    
    
    $
    24,696(Loss) contribution before unallocated items
    
    
    (2,671
    )
    
    
    276
    
    
    
    (2,395
    )At September 30, 2005Total Assets
    
    
    559
    
    
    
    30,077
    
    
    
    30,636At December 31, 2004Total Assets
    
    
    704
    
    
    
    32,725
    
    
    
    33,429
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11.
    
    REORGANIZATION COSTSIn the third quarter of 2005, the Company terminated a senior executive. As a result of
this action, the Company recorded reorganization costs of $340,000, consisting of severance
costs, during the three months ended September 30, 2005.In the second quarter of 2005, the Company entered into a sublease agreement with an
unrelated party to sublease excess office space at its facility in Atlanta, Georgia. The
excess space was primarily due to reductions in the corporate staffing over the past year.
As a result of these actions, the Company recorded an accrual for all remaining payments due
on this lease, less amounts to be paid by the sublessor. Total payments remaining through
January 31, 2010 are $3.3 million and the sublease total payments are $1.6M over the
remaining term of the lease. The Company recorded reorganization costs of $2.6 million
during the three months ended June 30, 2005. The charge represents the difference between
the lease and the sublease for the entire remaining term, as well as write-offs for
furniture and leasehold improvements. The Company expects to save approximately $1.6
million over the term of the sublease, which expires January 31, 2010. The balance of the
accrued loss on sublease is $1.9 million at September 30, 2005.In January 2005, the Company disposed of substantially all of the operating assets of NACT
and MCK, which resulted in six corporate positions being eliminated. The Company recorded
reorganization costs of $124,000 during the three months ended March 31, 2005.In the first quarter of 2004, the Company terminated a senior executive. As a result of
this action, the Company recorded reorganization costs of $1.2 million during the three
months ended March 31, 2004. The reorganization costs consist of severance costs of
$584,000 and non-cash stock compensation of $570,000 related to the write-off of unamortized
deferred compensation.12.
    
    STOCK OPTIONS AND WARRANTSThe Company has a stock option plan for employees, members of the board of directors,
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, 2005 is as follows:OPTIONS AND WARRANTS ISSUED TO EMPLOYEES
 Options and Warrants Outstanding
    
    
    Options and Warrants ExercisableRange of Exercise
    
    Outstanding at
    
    
    Weighted Average
    
    
    Exercisable at
    
    
    Weighted AveragePrices
    
    September 30, 2005
    
    
    Exercise Price
    
    
    September 30, 2005
    
    
    Exercise Price$0.95-$2.50
    
    
    1,337,183
    
    
    $
    1.88
    
    
    
    605,633
    
    
    $
    1.87$2.51-$5.00
    
    
    250,545
    
    
    $
    3.28
    
    
    
    157,695
    
    
    $
    3.22$5.01-$7.50
    
    
    109,185
    
    
    $
    6.54
    
    
    
    96,063
    
    
    $
    6.59$7.51-$10.69
    
    
    93,088
    
    
    $
    8.76
    
    
    
    83,813
    
    
    $
    8.81$10.70-$10.70
    
    
    752,500
    
    
    $
    10.70
    
    
    
    752,500
    
    
    $
    10.70$10.71-$15.25
    
    
    54,394
    
    
    $
    13.79
    
    
    
    54,294
    
    
    $
    13.80$15.26-$20.00
    
    
    266,545
    
    
    $
    17.01
    
    
    
    242,820
    
    
    $
    16.99$20.01-$25.00
    
    
    212,921
    
    
    $
    20.92
    
    
    
    212,596
    
    
    $
    20.92$25.01-$90.00
    
    
    117,093
    
    
    $
    33.52
    
    
    
    117,093
    
    
    $
    33.52Total
    
    
    3,193,454
    
    
    $
    8.32
    
    
    
    2,322,507
    
    
    $
    10.55
 18




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##### Table of Contents



12.
    
    STOCK OPTIONS AND WARRANTS, ContinuedOptions and warrants issued to employees generally terminate ten years from the date of
grant. Termination dates on the options and warrants listed above range from October 1,
2005 to September 30, 2015.A summary of the status of stock options and warrants granted to employees as of September
30, 2005, and the changes during the nine months ended September 30, 2005 is presented
below :
 Number of
    
    
    WeightedShares of
    
    
    AverageUnderlying
    
    
    ExerciseOptions
    
    
    PricesOutstanding at
beginning of the period
    
    
    3,242,185
    
    
    $
    10.18Granted
    
    
    895,650
    
    
    
    1.79Exercised
    
    
    (16,364
    )
    
    
    0.97Forfeited
    
    
    (928,017
    )
    
    
    8.68Expired
    
    
    
    
    
    
    Outstanding at end of period
    
    
    3,193,454
    
    
    $
    8.32Exercisable at end of period
    
    
    2,322,507
    
    
    $
    10.55
 A summary of warrants issued primarily in connection with financing is as follows:
 Number of
    
    
    Weighted AverageExercise Price
    
    Outstanding Warrants
    
    
    Exercise Price
    
    
    Expiration Date$0.05
    
    
    5,000
    
    
    $
    0.05
    
    
    October 2006$2.50-$3.60
    
    
    3,262,400
    
    
    $
    3.33
    
    
    January 2007-July 2010$6.70-$9.05
    
    
    789,792
    
    
    $
    8.18
    
    
    January 2006-February 2011$20.15-$20.40
    
    
    404,069
    
    
    $
    20.38
    
    
    November 2005$26.25-$30.00
    
    
    50,000
    
    
    $
    28.50
    
    
    October 2006Total
    
    
    4,511,261
    
    
    $
    5.98
 All warrants are vested.The exercise price and number outstanding for certain warrants previously issued have been
adjusted according to their antidilution provisions.
 19




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##### Table of Contents



12.
    
    STOCK OPTIONS AND WARRANTS, ContinuedA summary of the status of warrants issued primarily in connection with financing as of
September 30, 2005, and the changes during the nine months ended September 30, 2005 is
presented below :
 Number of
    
    
    WeightedShares of
    
    
    AverageUnderlying
    
    
    ExerciseWarrants
    
    
    PricesOutstanding at beginning of period
    
    
    2,110,361
    
    
    $
    19.03Granted
    
    
    5,262,399
    
    
    
    3.55Exercised
    
    
    (2,506
    )
    
    
    0.05Expired
    
    
    (3,040,520
    )
    
    
    11.61Effects of anti-dilutive provisions
    
    
    181,527Outstanding and exercisable at end of period
    
    
    4,511,261
    
    
    $
    5.98
 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, over the vesting period, based
on the fair value of options at the date of grant, then the pro-forma net loss and net loss
per common share would have been as follows (in thousands, except for per share amounts):
 Three months ended September 30,
    
    
    Nine months ended September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Net loss, as reported
    
    $
    (4,599
    )
    
    $
    (7,321
    )
    
    $
    (16,499
    )
    
    $
    (17,338
    )Add: Stock-based compensation
expense included in net loss
    
    
    
    
    
    
    90
    
    
    
    7
    
    
    
    346Less: Total stock-based employee
compensation expense determined
under fair value based method
for all awards
    
    
    (392
    )
    
    
    (714
    )
    
    
    (301
    )
    
    
    (1,944
    )Pro forma net loss
    
    $
    (4,991
    )
    
    $
    (7,945
    )
    
    $
    (16,793
    )
    
    $
    (18,936
    )Net loss per common shareAs reported
    
    $
    (0.17
    )
    
    $
    (0.27
    )
    
    $
    (0.61
    )
    
    $
    (0.66
    )Pro forma
    
    
    (0.18
    )
    
    
    (0.30
    )
    
    
    (0.63
    )
    
    
    (0.72
    )
 20




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##### Table of Contents



13.
    
    NET LOSS PER SHAREBasic 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 months ended September 30, 2005 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 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Shares issuable under stock options
    
    
    93,089
    
    
    
    468,731
    
    
    
    55,728
    
    
    
    643,210Shares issuable pursuant to warrants
to purchase common stock
    
    
    6,283
    
    
    
    7,437
    
    
    
    6,961
    
    
    
    7,99699,372
    
    
    
    476,169
    
    
    
    62,689
    
    
    
    651,205
 14.
    
    SUBSEQUENT EVENTSOn October 3, 2005, the Board of Directors approved an amendment to the Companys Articles
of Incorporation effecting the Reverse Split of the Companys common stock and reducing the
number of authorized shares of common stock from 300 million to 60 million.On the effective date of October 11, 2005, each holder of record was deemed to hold one
share of common stock for every five shares held immediately prior to the effective date.
The Company will make cash payments for fractional shares to holders who have a number of
shares not divisible by five.Following the effective date of the Reverse Split, the par value of the common stock
remained at $.01 per share. As a result, the Company reduced the common stock in its
Consolidated Balance Sheet as of the effective date by approximately $1.1 million, with a
corresponding increase in additional paid-in capital. All per share amounts have been
retroactively adjusted for all periods presented to reflect Reverse Split.15.
    
    LITIGATIONExcept for the pending matters described in Note 16 to the Companys audited consolidated
financial statements included in the Annual Report, 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 ordinary routine claims and proceedings,
either individually or in the aggregate, to have a material adverse effect on the Company.
There have been no material developments regarding the pending matters described in Note 16
to the Companys
audited consolidated financial statements included in the Annual Report during the nine
months ended September 30, 2005.
 21




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##### Table of Contents



ITEM 2: Managements Discussion and Analysis of Financial Condition and Results of Operations
   
    
    the volatility of the price of the Companys common stock;
    
    the Company may be unable to fund future growth;
    
    the Companys ability to be profitable;
    
    the Companys ability to attract and retain qualified personnel;
    
    economic conditions of the telecommunications market;
    
    market demand for and market acceptance of the Companys products;
    
    legal claims against the Company, including, but not limited to, claims of patent infringement;
    
    the Companys ability to protect the Companys intellectual property;
    
    defects in the Companys products;
    
    the Companys obligations to indemnify certain customers;
    
    the Companys exposure to risks inherent in international operations;
    
    the Companys dependence on contract manufacturers and suppliers;
    
    general economic and business conditions; and
    
    other risks and uncertainties disclosed in the Annual Report and in the Companys other filings
with the SEC.
  Overview
  22




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##### Table of Contents



Results of Operations
 Three Months Ended September 30, 2005, compared to Three Months Ended September 30, 2004
  23




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##### Table of Contents



Continuing Operations
             24




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##### Table of Contents



Business Unit Performance
 Packet-based
    
    
    AdvancedTechnologies
    
    
    ApplicationsDollars in thousands
    
    Group
    
    
    Services Group
    
    
    ConsolidatedFor the Three MonthsEnded September 30,
    
    2005
    
    
    2004
    
    
    2005
    
    
    2004
    
    
    2005
    
    
    2004Revenue
    
    $
    6,139
    
    
    $
    4,140
    
    
    $
    2,142
    
    
    $
    2,826
    
    
    $
    8,281
    
    
    $
    6,966Gross profit
    
    
    3,184
    
    
    
    2,119
    
    
    
    534
    
    
    
    930
    
    
    
    3,718
    
    
    
    3,049Gross margin
    
    
    52
    %
    
    
    51
    %
    
    
    25
    %
    
    
    33
    %
    
    
    45
    %
    
    
    44
    %General and administrative
    
    
    671
    
    
    
    549
    
    
    
    174
    
    
    
    273
    
    
    
    845
    
    
    
    822Sales and marketing
    
    
    1,923
    
    
    
    2,559
    
    
    
    25
    
    
    
    24
    
    
    
    1,948
    
    
    
    2,583Research and development
    
    
    1,560
    
    
    
    1,599
    
    
    
    
    
    
    
    
    
    
    
    1,560
    
    
    
    1,599(Loss) contribution before
unallocated items
    
    $
    (970
    )
    
    $
    (2,588
    )
    
    $
    335
    
    
    $
    633
    
    
    
    (635
    )
    
    
    (1,955
    )Unallocated items:Corporate general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,747
    
    
    
    2,462Corporate research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    95
    
    
    
    155Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    527
    
    
    
    746Reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    340
    
    
    
    Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,344
    )
    
    
    (5,318
    )Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,255
    )
    
    
    (239
    )Loss before income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (4,599
    )
    
    $
    (5,557
    )
 Packet-based Technologies Group
    25




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Advanced Applications Services Group
    Discontinued Operations
   For the three months ended September 30,2005
    
    
    2004Revenue
    
    $
    
    
    
    $
    4,280Gross profit
    
    
    
    
    
    
    1,441Operating loss
    
    
    
    
    
    
    (1,764
    )Loss from discontinued operations
    
    $
    
    
    
    $
    (1,764
    )
  Nine months Ended September 30, 2005, Compared to Nine months Ended September 30, 2004
  26




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##### Table of Contents



Continuing Operations
          27




---



##### Table of Contents



Business Unit Performance
 Packet-based
    
    
    AdvancedTechnologies
    
    
    ApplicationsDollars in thousands
    
    Group
    
    
    Services Group
    
    
    ConsolidatedFor the Nine MonthsEnded September 30,
    
    2005
    
    
    2004
    
    
    2005
    
    
    2004
    
    
    2005
    
    
    2004Revenue
    
    $
    16,194
    
    
    $
    15,443
    
    
    $
    7,207
    
    
    $
    9,253
    
    
    $
    23,401
    
    
    $
    24,696Gross profit
    
    
    8,196
    
    
    
    8,665
    
    
    
    2,139
    
    
    
    3,231
    
    
    
    10,335
    
    
    
    11,896Gross margin
    
    
    51
    %
    
    
    56
    %
    
    
    30
    %
    
    
    35
    %
    
    
    44
    %
    
    
    48
    %General and administrative
    
    
    1,745
    
    
    
    1,742
    
    
    
    593
    
    
    
    772
    
    
    
    2,338
    
    
    
    2,514Sales and marketing
    
    
    6,069
    
    
    
    6,847
    
    
    
    74
    
    
    
    101
    
    
    
    6,143
    
    
    
    6,948Research and development
    
    
    4,875
    
    
    
    4,829
    
    
    
    
    
    
    
    
    
    
    
    4,875
    
    
    
    4,829(Loss) contribution before
unallocated items
    
    $
    (4,493
    )
    
    $
    (4,753
    )
    
    $
    1,472
    
    
    $
    2,358
    
    
    
    (3,021
    )
    
    
    (2,395
    )Unallocated items:Corporate general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,308
    
    
    
    6,588Corporate research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    201
    
    
    
    312Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,768
    
    
    
    2,193Reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    464
    
    
    
    584Reorganization costs-loss on sublease
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,550Reorganization costs-stock related
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    570Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (13,312
    )
    
    
    (12,642
    )Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,621
    )
    
    
    (710
    )Loss before income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (15,933
    )
    
    $
    (13,352
    )
 28




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##### Table of Contents



Packet-based Technologies Group
    Advanced Applications Services Group
    Discontinued Operations
  29




---



##### Table of Contents



For the nine months ended September 30,2005
    
    
    2004Revenue
    
    $
    212
    
    
    $
    14,447Gross (loss) profit
    
    
    (27
    )
    
    
    6,243Operating loss
    
    
    (566
    )
    
    
    (4,015
    )Loss from discontinued operations
    
    $
    (566
    )
    
    $
    (3,986
    )
   Critical Accounting Policies
   Revenue Recognition
     30




---



##### Table of Contents



Allowance for Doubtful Accounts
  Inventory Obsolescence
  Liabilities of Discontinued Operations
    Deferred Tax Asset Valuation Allowance
  31




---



##### Table of Contents



Litigation and Related Contingencies
  Goodwill, Intangible Assets and Long-Lived Assets
   Recent Accounting Pronouncements
  32




---



##### Table of Contents



Liquidity and Capital Resources
 Summary
      Cash Flow
  33




---



##### Table of Contents



Contractual Obligations and Commercial Commitments
  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
    
    
    276
    
    
    
    194
    
    
    
    82
    
    
    
    
    
    
    
    Notes payable for the purchase of Clarent
    
    
    3,000
    
    
    
    
    
    
    
    3,000
    
    
    
    
    
    
    
    Convertible subordinated debentures
    
    
    2,925
    
    
    
    2,700
    
    
    
    225
    
    
    
    
    
    
    
    Senior unsecured convertible debentures
    
    
    13,500
    
    
    
    563
    
    
    
    9,000
    
    
    
    3,937
    
    
    
    Operating leases:Continuing operations
    
    
    7,810
    
    
    
    2,133
    
    
    
    3,625
    
    
    
    2,052
    
    
    
    Discontinued operations
    
    
    3,698
    
    
    
    1,734
    
    
    
    1,442
    
    
    
    522
    
    
    
    Total contractual cash obligations
    
    $
    31,209
    
    
    $
    7,324
    
    
    $
    17,374
    
    
    $
    6,511
    
    
    $
    
  Sources of Cash
  34




---



##### Table of Contents



,
  
 ITEM 3: Quantative and Qualitative Disclosures About Market Risk
       35




---



##### Table of Contents



ITEM 4: Controls and Procedures
   36




---



##### Table of Contents



PART II  OTHER INFORMATION
 
 Legal Proceedings
  
 Unregistered Sales of Equity Securities and Use of Proceeds
   
 Exhibits
  37




---



##### Table of Contents



SIGNATURE
  VERSO TECHNOLOGIES, INC.Date: November 8, 2005
    
    /s/ Juliet M. ReisingExecutive Vice President and Chief Financial Officer(duly authorized signatory and Principal Financial and Accounting Officer)
 38




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##### Table of Contents



EXHIBIT INDEX
 Exhibit No.
    
    Exhibit
    
    Method of Filing3.1
    
    Amended and Restated Articles of Incorporation
of the Company.
    
    Incorporated by reference to Exhibit 3.1 to the
Companys Registration Statement on Form S-18
(File No. 33-51456).3.2
    
    Amendment to the Amended and Restated Articles of
Incorporation of the Company, as amended.
    
    Incorporated by reference
to Exhibit 3.1 to the
Companys Current Report on
Form 8-K filed October 2,
2000.3.3
    
    Amendment to the Amended and Restated Articles of
Incorporation of the Company, as amended.
    
    Incorporated by reference to Exhibit 4.1 to the
Companys Current Report on Form 8-K filed November 19,
2001.3.4
    
    Amendment to the Amended and Restated Articles of
Incorporation of the Company, amended.
    
    Incorporated by reference to Exhibit 3.4 to the
Companys Quarterly Report on Form 10-Q for the quarter ended June 30,
2005.3.5
    
    Articles of Amendment to
the Companys Articles of Incorporation, effective as
of October 11, 2005.
    
    Incorporated by reference
to Exhibit 3.1 to the Companys Current Report on
Form 8-K filed October 7, 2005.3.6
    
    The Companys Amended and
Restated Bylaws, adopted October 24, 2005.
    
    Incorporated by reference
to Exhibit 3.1 to the Companys Current Report on
Form 8-K filed October 7, 2005.4.1
    
    Warrant issued July 25,
2005 to Mainfield Enterprises Inc. to
purchase 1,500,000 shares of Common Stock.
    
    Incorporated by reference
to Exhibit 4.1 to the Companys Current Report on
Form 8-K filed July 29, 2005.4.2
    
    Warrant issued July 25,
2005 to Heimdall Investments, Ltd. to purchase 1,500,000 shares
of Common Stock.
    
    Incorporated by reference to Exhibit 4.2 to the
Companys Current Report on Form 8-K filed July 29, 2005.4.3
    
    Warrant issued July 25, 2005 to Mainfield
Enterprises Inc. to purchase 500,000 shares of Common Stock.
    
    Incorporated by reference to Exhibit 4.3 to the
Companys Current Report on Form 8-K filed July 29, 2005.4.4
    
    Warrant issued July 25, 2005 to Heimdall
Investments, Ltd. to purchase 500,000 shares of Common Stock.
    
    Incorporated by reference to Exhibit 4.4 to the
Companys Current Report on Form 8-K filed July 29, 2005.4.5
    
    Registration Rights Agreement dated as of July
25, 2005, among the Company and the investors signatory thereto.
    
    Incorporated by reference to Exhibit 4.5 to the
Companys Current Report on Form 8-K filed July 29, 2005.10.1
    
    Sublease dated July 1, 2005, between the Company
and Digital Insurance, Inc.
    
    Incorporated by reference to Exhibit 99.1 to the
Companys Current Report on Form 8-K filed July 8, 2005.10.2
    
    Bill of Sale dated July 1, 2005, executed by the
Company in favor of Digital Insurance, Inc.
    
    Incorporated by reference to Exhibit 99.2 to the
Companys Current Report on Form 8-K filed July 8, 2005.10.3
    
    Security Agreement entered into on July 1, 2005,
between the Company and Digital Insurance, Inc.
    
    Incorporated by reference to Exhibit 99.3 to the
Companys Current Report on Form 8-K filed July 8, 2005.10.4
    
    Amendment to the 7.5% Convertible Debentures
dated as of July 25, 2005 among the Company,
Mainfield Enterprises Inc. and Heimdall Investments, Ltd.
    
    Incorporated by reference to Exhibit 99.1 to the
Companys Current Report on Form 8-K filed July 29, 2005.10.5
    
    Limited Waiver and Amendment to Loan Documents
dated July 25, 2005 between the Company and Silicon
Valley Bank.
    
    Incorporated by reference to Exhibit 99.2 to the
Companys Current Report on Form 8-K filed July 29, 2005.10.6
    
    Limited Waiver and Amendment to Loan Documents
(Exim Program) dated July 25, 2005 between the Company and Silicon Valley Bank.
    
    Incorporated by reference to Exhibit 99.3 to the
Companys Current Report on Form 8-K filed July 29, 2005.10.7
    
    Separation Agreement between the Company and
Lewis Jaffe entered into on August 16, 2005.
    
    Incorporated by reference to Exhibit 99.1 to the
Companys Current Report on Form 8-K filed August 22, 2005.10.8
    
    Verso Technologies, Inc. 1999 Stock Incentive Plan,
as amended September 22, 2005.
    
    Incorporated by reference to Exhibit 99.1 to the
Companys Current Report on Form 8-K filed September 28, 2005.10.9
    
    Amendment #1 to Secured Convertible Promissory Note
among the Company, CITEL Technologies Limited and CITEL Technologies, Inc.
entered into on September 23, 2005.
    
    Incorporated by reference to Exhibit 99.2 to the
Companys Current Report on Form 8-K filed September 28, 2005.10.10
    
    Subordination Agreement dated as of September 23,
2005, between the Company and Bridge Bank, National Association.
    
    Incorporated by reference to Exhibit 99.3 to the
Companys Current Report on Form 8-K filed September 28, 2005.10.10
    
    Executive Employment Agreement executed on
October 24, 2005, but effective as of October 1, 2005 between the Company
and Montgomery Bannerman. (Represents an executive compensatory plan or arrangement.)
    
    Incorporated by reference to Exhibit 99.2 to the
Companys Current Report on Form 8-K filed October 27, 2005.10.11
    
    Amended and Restated Executive Employment
Agreement executed on October 24, 2005, but effective as of October 1,
2005 between the Company and Steven A. Odom. (Represents an executive
compensatory arrangement or plan.)
    
    Incorporated by reference to Exhibit 99.1 to the
Companys Current Report on Form 8-K filed October 27, 2005.10.12
    
    Amended and Restated Executive Employment
Agreement executed on October 24, 2005, but effective as of October 1,
2005 between the Company and Juliet M. Reising. (Represents an executive
compensatory arrangement or plan.)
    
    Incorporated by reference to Exhibit 99.2 to the
Companys Current Report on Form 8-K filed October 27, 2005.31.1
    
    Rule 13a-14(a)/15d-14(a) Certification by the
Companys Chief Executive Officer.
    
    Filed herewith.31.2
    
    Rule 13a-14(a)/15d-14(a) Certification by the
Companys Chief Financial Officer.
    
    Filed herewith.32.1
    
    Section 1350 Certification by the Companys Chief
Executive Officer.
    
    Filed herewith.32.2
    
    Section 1350 Certification
by the Companys Chief Financial Officer.
    
    Filed herewith.
 39