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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 March 31, 2006
 o
    
    TRANSITION REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT
 For
the transition period from

to
 Commission file number 0-22190
 
 VERSO TECHNOLOGIES, INC.
  MINNESOTA
    
    41-1484525(State or other jurisdiction
    
    (I.R.S. Employer Identification No.)of incorporation or organization)
 
 
 
 þ o
 o o þ
 o þ




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Page No.Part I. FINANCIAL INFORMATIONItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of March 31, 2006 and
December 31, 2005
    
    
    2Condensed Consolidated Statements of Operations for the three months
ended March 31, 2006 and 2005
    
    
    3Condensed Consolidated Statements of Cash Flows for the three months
ended March 31, 2006 and 2005
    
    
    4Notes to Condensed Consolidated Financial Statements
    
    
    5Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    24Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    34Item 4. Controls and Procedures
    
    
    34PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    35Item 1A. Risk Factors
    
    
    35Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    35Item 5. Other Information
    
    
    35Item 6. Exhibits
    
    
    35Signature Page
    
    
    36Exhibit Index
    
    
    37EX-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)
 March 31,
    
    
    December 31,2006
    
    
    2005(Unaudited)ASSETS:Current assets:Cash and cash equivalents
    
    $
    1,996
    
    
    $
    1,079Restricted cash
    
    
    1,671
    
    
    
    1,656Accounts receivable, net of allowance for doubtful accounts of $767
and $742, respectively
    
    
    6,892
    
    
    
    7,336Inventories
    
    
    5,717
    
    
    
    4,259Other current assets
    
    
    1,921
    
    
    
    1,954Current portion of note receivable
    
    
    649
    
    
    
    655Total current assets
    
    
    18,846
    
    
    
    16,939Property and equipment, net of accumulated depreciation and amortization
of $4,957 and $4,671, respectively
    
    
    1,991
    
    
    
    2,305Investment
    
    
    679
    
    
    
    745Note receivable, net of current portion
    
    
    2,552
    
    
    
    2,736Other intangibles, net of accumulated amortization of $1,983 and $1,729,
respectively
    
    
    2,624
    
    
    
    2,859Goodwill
    
    
    2,514
    
    
    
    2,514Total assets
    
    $
    29,206
    
    
    $
    28,098LIABILITIES AND SHAREHOLDERS EQUITY:Current liabilities:Line of credit
    
    $
    
    
    
    $
    1,269Accounts payable
    
    
    2,729
    
    
    
    2,309Accrued compensation
    
    
    923
    
    
    
    1,111Accrued expenses
    
    
    2,638
    
    
    
    2,231Current portion of accrued loss on sublease
    
    
    503
    
    
    
    543Current portion of liabilities of discontinued operations
    
    
    1,844
    
    
    
    1,921Current portion of convertible debentures
    
    
    3,631
    
    
    
    3,262Unearned revenue and customer deposits
    
    
    2,272
    
    
    
    2,391Total current liabilities
    
    
    14,540
    
    
    
    15,037Accrued loss on sublease, net of current portion
    
    
    1,055
    
    
    
    1,150Liabilities of discontinued operations, net of current portion
    
    
    478
    
    
    
    610Other long-term liabilities
    
    
    25
    
    
    
    50Notes payable, net of current portion
    
    
    2,805
    
    
    
    2,785Convertible debentures, net of current portion
    
    
    5,337
    
    
    
    5,627Total liabilities
    
    
    24,240
    
    
    
    25,259Shareholders equity:Preferred stock,no par value, 200,000 shares authorized;
156,000 shares issued and none outstanding
    
    
    
    
    
    
    Common stock, $.01 par value, 60,000,000 shares authorized;
32,910,078 and 27,310,524 shares issued and outstanding
    
    
    329
    
    
    
    273Additional paid-in capital
    
    
    341,751
    
    
    
    334,650Stock payable
    
    
    
    
    
    
    67Accumulated deficit
    
    
    (336,931
    )
    
    
    (331,991
    )Accumulated other comprehensive income (loss)  foreign currency translation
    
    
    (183
    )
    
    
    (160
    )Total shareholders equity
    
    
    4,966
    
    
    
    2,839Total liabilities and shareholders equity
    
    $
    29,206
    
    
    $
    28,098
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VERSO TECHNOLOGIES, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share data)
 For the three months ended March 31,2006
    
    
    2005Revenue:Products
    
    $
    3,597
    
    
    $
    2,738Services
    
    
    3,191
    
    
    
    3,868Total revenue
    
    
    6,788
    
    
    
    6,606Cost of revenue:Products:Product costs
    
    
    1,657
    
    
    
    1,383Amortization of intangibles
    
    
    194
    
    
    
    68Total cost of product
    
    
    1,851
    
    
    
    1,451Services
    
    
    2,096
    
    
    
    2,335Total cost of revenue
    
    
    3,947
    
    
    
    3,786Gross profit:Products
    
    
    1,746
    
    
    
    1,287Services
    
    
    1,095
    
    
    
    1,533Total gross profit
    
    
    2,841
    
    
    
    2,820Operating expenses:General and administrative
    
    
    2,433
    
    
    
    2,478Sales and marketing
    
    
    1,774
    
    
    
    2,211Research and development
    
    
    1,779
    
    
    
    1,684Depreciation and amortization
    
    
    463
    
    
    
    660Reorganization costs
    
    
    
    
    
    
    124Total operating expenses
    
    
    6,449
    
    
    
    7,157Operating loss from continuing operations
    
    
    (3,608
    )
    
    
    (4,337
    )Other income (expense), net:Other income
    
    
    1
    
    
    
    6Equity in loss of investment
    
    
    (66
    )
    
    
    (29
    )Interest expense, net including $903 and $349
of amortization of loan fees and discount on convertible
debentures in each period, respectively
    
    
    (1,267
    )
    
    
    (574
    )Other expense, net
    
    
    (1,332
    )
    
    
    (597
    )Loss from continuing operations before income taxes
    
    
    (4,940
    )
    
    
    (4,934
    )Income taxes
    
    
    
    
    
    
    Loss from continuing operations
    
    
    (4,940
    )
    
    
    (4,934
    )Loss from discontinued operations
    
    
    
    
    
    
    (566
    )Net loss
    
    $
    (4,940
    )
    
    $
    (5,500
    )Net loss per common share  basic and diluted:Loss from continuing operations
    
    $
    (0.17
    )
    
    $
    (0.18
    )Loss from discontinued operations
    
    
    
    
    
    
    (0.02
    )$
    (0.17
    )
    
    $
    (0.20
    )Weighted average shares outstanding  basic and diluted
    
    
    29,933,805
    
    
    
    26,683,713
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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands, except share data)
(Unaudited)
 For the three months ended March 31,2006
    
    
    2005Operating Activities:Continuing operations:Net loss from continuing operations
    
    $
    (4,940
    )
    
    $
    (4,934
    )Adjustments to reconcile net loss from continuing operations to net
cash used in continuing operating activities:Equity in loss of investment
    
    
    66
    
    
    
    29Stock based compensation
    
    
    55
    
    
    
    Depreciation and amortization
    
    
    658
    
    
    
    728Provision for doubtful accounts
    
    
    80
    
    
    
    59Amortization of loan fees and discount on convertible subordinated debentures
    
    
    903
    
    
    
    349Other
    
    
    9
    
    
    
    (14
    )Changes in current operating assets and liabilities, net of effects of acquisitions:Accounts receivable
    
    
    364
    
    
    
    583Inventories
    
    
    (1,458
    )
    
    
    519Other current assets
    
    
    27
    
    
    
    (249
    )Accounts payable
    
    
    420
    
    
    
    (452
    )Accrued compensation
    
    
    (188
    )
    
    
    (306
    )Accrued expenses
    
    
    247
    
    
    
    (197
    )Unearned revenue and customer deposits
    
    
    (119
    )
    
    
    457Net cash used in continuing operating activities
    
    
    (3,876
    )
    
    
    (3,428
    )Discontinued operations:Loss from discontinued operations
    
    
    
    
    
    
    (566
    )Adjustment to reconcile loss from discontinued operations
to net cash used in discontinued operating activities
    
    
    (259
    )
    
    
    (142
    )Net cash used in discontinued operating activities
    
    
    (259
    )
    
    
    (708
    )Net cash used in operating activities
    
    
    (4,135
    )
    
    
    (4,136
    )Investing Activities:Continuing operations:Net cash used in investing activities for continuing operations -
Purchases of property and equipment
    
    
    (123
    )
    
    
    (299
    )Purchase of WSECI
    
    
    
    
    
    
    (244
    )Increase in restricted cash
    
    
    (15
    )
    
    
    (1,620
    )Net cash used in investing activities for continuing operations
    
    
    (138
    )
    
    
    (2,163
    )Discontinued operations:Proceeds from notes receivable from Citel
    
    
    240
    
    
    
    Proceeds from sale of discontinued operations
    
    
    
    
    
    
    4,015Net cash provided by investing activities for discontinued operations
    
    
    240
    
    
    
    4,015Net cash provided by investing activities
    
    
    102
    
    
    
    1,852Financing Activities:Net payments on line of credit
    
    
    (1,269
    )
    
    
    Payments of convertible debentures
    
    
    (675
    )
    
    
    Proceeds from convertible debentures, net
    
    
    
    
    
    
    12,757Proceeds from private placement, net
    
    
    6,888
    
    
    
    Proceeds from the issuances of common stock in connection with the
exercise of options, net
    
    
    6
    
    
    
    Net cash provided by financing activities
    
    
    4,950
    
    
    
    12,757Effect of exchange rate changes on cash
    
    
    
    
    
    
    (7
    )Increase in cash and cash equivalents
    
    
    917
    
    
    
    10,466Cash and cash equivalents at beginning of period
    
    
    1,079
    
    
    
    4,234Cash and cash equivalents at end of period
    
    $
    1,996
    
    
    $
    14,700Supplemental disclosure of cash flow information:Cash payments during the periods for:Interest
    
    $
    110
    
    
    $
    177Income taxes
    
    $
    (4
    )
    
    $
    (70
    )Non-cash investing and financing activitiesCommon stock consideration for acquisitions:WSECI  issuance of 950,000 shares of common stock
    
    $
    20
    
    
    $
    331Issuance of note receivable in disposition of MCK
    
    
    
    
    
    
    3,500Issuance of warrants in conjunction with convertible debentures
    
    
    
    
    
    
    4,523Issuance of common stock and warrants in exchange for services
    
    
    123
    
    
    
    694Assets
acquired and liabilities assumed in conjunction with business acquisitions:Fair value of assets acquired, excluding cash and restricted cash
    
    
    
    
    
    
    1,084Liabilities assumed
    
    $
    
    
    
    $
    
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1.
    
    BASIS OF PRESENTATION
       5




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1.
    
    BASIS OF PRESENTATION, Continued
  2.
    
    MERGERS AND ACQUISITIONS
 WSECI, Inc.
    WSECIProperty and equipment
    
    $
    52Accounts receivable
    
    
    93Other intangibles
    
    
    1,383Cost of acquisition
    
    $
    1,528
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2.
    
    MERGERS AND ACQUISITIONS, Continued
  3.
    
    EQUITY INVESTMENT
    Three months endedMarch 31,2006
    
    2005Operating results:Revenues
    
    $
    
    
    
    $
    469Operating loss
    
    $
    (67
    )
    
    $
    (56
    )Net loss
    
    $
    (67
    )
    
    $
    (56
    )
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4.
    
    DISCONTINUED OPERATIONS
   Three months ended March 31,2006
    
    
    2005Revenue
    
    $
    
    
    
    $
    212Gross loss
    
    
    
    
    
    
    (27
    )Operating loss
    
    
    
    
    
    
    (566
    )Loss from discontinued operations
    
    $
    
    
    
    $
    (566
    )
  8




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4.
    
    DISCONTINUED OPERATIONS, Continued
  March 31,
    
    
    December 31,2006
    
    
    2005Assets of discontinued operations:Notes receivable
    
    $
    3,201
    
    
    $
    3,391Liabilities of discontinued operations:Accrued rent
    
    $
    1,547
    
    
    $
    1,707Other current liabilities
    
    
    775
    
    
    
    824Liabilities of discontinued operations
    
    $
    2,322
    
    
    $
    2,531
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4.
    
    DISCONTINUED OPERATIONS, ContinuedThe activity in the liabilities of discontinued operations (in thousands) for the three
months ended March 31, 2006 and 2005 was as follows:
 Three months ended March 31,2006
    
    
    2005Balance beginning of period
    
    $
    2,531
    
    
    $
    3,013Lease payments, net of sublease receipts
    
    
    (160
    )
    
    
    (219
    )Other payments
    
    
    (38
    )
    
    
    (111
    )Estimated costs of disposal of discontinued operations
    
    
    
    
    
    
    1,000Legal and other costs of disposal
    
    
    (11
    )
    
    
    (179
    )Balance end of period
    
    $
    2,322
    
    
    $
    3,504
 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 March 31, 2006 and December 31, 2005 are comprised of the following (in
thousands):
 March 31,
    
    
    December 31,2006
    
    
    2005Raw materials
    
    $
    4,168
    
    
    $
    3,026Work in process
    
    
    4
    
    
    
    5Finished goods
    
    
    1,545
    
    
    
    1,228Total inventories
    
    $
    5,717
    
    
    $
    4,259
 The inventory amounts noted are net of allowance of $1.2 million at March 31, 2006 and
December 31, 2005.
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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
    
    March 31,
    
    
    December 31,Period in months
    

2006
    
    

2005Intangibles subject to amortization:Current technology
    
    36 months
    
    $
    2,204
    
    
    $
    2,185Customer relationship
    
    120 months
    
    
    2,403
    
    
    
    2,403Weighted average months
    
    80 months
    
    
    4,607
    
    
    
    4,588Accumulated amortization:Current technology
    
    
    
    
    
    
    (1,202
    )
    
    
    (1,008
    )Customer relationship
    
    
    
    
    
    
    (781
    )
    
    
    (721
    )Net intangibles subject to amortization
    
    
    
    
    
    
    2,624
    
    
    
    2,859Goodwill
    
    
    
    
    
    
    2,514
    
    
    
    2,514Total goodwill and other intangibles
    
    
    
    
    
    $
    5,138
    
    
    $
    5,373
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7.
    
    LOAN FACILITY WITH SILICON VALLEY BANKIn March 2006, the Company and Silicon Valley Bank (Silicon), the Companys primary
lender, renewed the Companys credit facility with Silicon (the Credit Agreement).
The Credit Agreement provided for a credit line of $10.0 million. 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 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% (10.0% at
March 31, 2006). The 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 Credit Agreement expires in March 2007. The Credit
Agreement includes a loan fee of $135,000 and .375% per annum on unused available
borrowings. The loan fees will be amortized to interest expense over the term of the Credit
Agreement. Under the terms of the Credit Agreement, the Company must (i) satisfy certain
financial covenants with respect to minimum cash/excess availability and tangible net worth,
which are computed monthly; (ii) may not declare dividends or incur any additional
indebtedness without the consent of Silicon; and (iii) must comply with other financial
covenants, as defined in the Credit Agreement. Although the Company was not in compliance
with the tangible net worth covenant at March 31, 2006, Silicon waived compliance with such
covenant.The Company had no borrowings under the Credit Agreement as of March 31, 2006. The total
borrowing availability under the Credit Agreement at March 31, 2006 was $7.1 million. The
Company has outstanding letters of credit in the amount of $1.6 million at March 31, 2006,
which reduce borrowing capacity under the Credit Agreement.
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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 of the Companys common
stock and Series B warrants exercisable for 2.0 million shares 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. The 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
was immaterial to the statement of operations for the first and second quarters. If the
entry for the additional discount would have been recorded in February 2005, the impact of
this additional discount on the balance sheets as of March 31, 2005 and June 30, 2005 would
have been as follows (in thousands):
 As filed
    
    AdjustedMarch 31, 2005:Convertible debentures
    
    $
    9,171
    
    
    $
    5,607Total liabilities
    
    
    28,322
    
    
    
    24,783Total shareholders equity
    
    
    12,404
    
    
    
    15,959June 30, 2005:Convertible debentures
    
    $
    9,440
    
    
    $
    6,006Total liabilities
    
    
    30,202
    
    
    
    26,768Total shareholders equity
    
    
    6,044
    
    
    
    9,519
 The discount is being amortized to interest expense over the life of the senior unsecured
convertible debentures. The unamortized discount totaled approximately $5.9 million at
March 31, 2006. The senior unsecured convertible debentures bear interest at a rate of
6.75%, and are due February 2009 and are convertible into approximately 5.4 million shares of the Companys common stock at an initial conversion price of $2.50 per share,
subject to anti-dilution adjustments and certain limitations. Interest is payable on a
quarterly basis and principal 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 per
share.The Series B warrants issued in connection with the private placement were exercisable for a
period of 90 days, commencing on June 16, 2005, and had an exercise price of $3.90 per
share. The Series B warrants expired in September 2005. 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 302,400 shares 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 $1.1 million at March 31, 2006.
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.
 13




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8.
    
    CONVERTIBLE DEBENTURES, ContinuedConvertible 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, $2.9 million of the aggregate principal amount has
been paid as of March 31, 2006, and the remaining principal amount of $1.6 million will be
paid in equal monthly installments through October 2006. The interest rate on the unpaid
principal increased to 12% at November 22, 2005 through the term of the amended debentures.In connection with the restructuring, the Company issued warrants to purchase an aggregate
of 800,000 shares of the Companys common stock at an exercise price of $2.50 per share
exercisable beginning on November 22, 2005. Of these warrants, 600,000 expire January 1,
2007. The remaining 200,000 have a five year term. Notwithstanding the foregoing, the
expiration date of the warrants issued in connection with the restructuring will be extended
for each day following November 22, 2005 on which a registration statement covering the
resale of the shares of the Companys common stock issuable upon exercise of such warrants
has not been declared effective by the SEC. As of March 31, 2006, such registration
statement has not been declared effective. 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 $194,000 at March 31, 2006.9.
    
    OTHER COMPREHENSIVE LOSSComprehensive loss for the three months ended March 31, 2006 and 2005 is shown in the
following table (in thousands):
 Three months ended March 31,2006
    
    
    2005Net loss
    
    $
    (4,940
    )
    
    $
    (5,500
    )Other comprehensive loss:Foreign currency translation
    
    
    (23
    )
    
    
    (191
    )Comprehensive loss
    
    $
    (4,963
    )
    
    $
    (5,691
    )
 14




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10.
    
    SEGMENT INFORMATIONThe Company reports information for two segments, the Packet-based Technologies Group and
the Advanced Applications Services Group. Management evaluates the business segment
performance based on contributions before unallocated items. Inter-segment sales and
transfers are not significant.
 Packet-basedTechnologies
Group:
    
    The Companys Packet-based Technologies Group consists of the
operations of the Companys softswitch, I-Master and
NetPerformer divisions and the Companys subsidiary
Telemate.Net. The Packet-based Technologies Group includes
international and domestic 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 ApplicationsServicesGroup:
    
    The Companys 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 Companys Packet-based Technologies Group.
 15




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##### Table of Contents



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 March 31, 2006Revenue
    
    $
    4,881
    
    
    $
    1,907
    
    
    $
    6,788(Loss) contribution before unallocated items
    
    
    (1,577
    )
    
    
    200
    
    
    
    (1,377
    )At March 31, 2006Goodwill
    
    
    1,061
    
    
    
    1,453
    
    
    
    2,514Total assets
    
    
    14,838
    
    
    
    3,683
    
    
    
    18,521For the Three Months Ended March 31, 2005Revenue
    
    $
    4,071
    
    
    $
    2,535
    
    
    $
    6,606(Loss) contribution before unallocated items
    
    
    (2,275
    )
    
    
    592
    
    
    
    (1,683
    )At December 31, 2005Goodwill
    
    
    1,061
    
    
    
    1,453
    
    
    
    2,514Total assets
    
    
    14,437
    
    
    
    3,655
    
    
    
    18,092
 The following table reconciles the contribution before unallocated items to the loss before
discontinued operations (in thousands):
 Three months ended March 31,2006
    
    
    2005Loss before unallocated items, per above
    
    $
    (1,377
    )
    
    $
    (1,683
    )Corporate general and administrative expenses
    
    
    (1,742
    )
    
    
    (1,813
    )Corporate research and development
    
    
    (26
    )
    
    
    (57
    )Depreciation and amortization
    
    
    (463
    )
    
    
    (660
    )Reorganization costs
    
    
    
    
    
    
    (124
    )Other
    
    
    (1,332
    )
    
    
    (597
    )Income taxes
    
    
    
    
    
    
    Loss from continuing operations
    
    $
    (4,940
    )
    
    $
    (4,934
    )
 16




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##### Table of Contents



10.
    
    SEGMENT INFORMATION, ContinuedThe following table reconciles the segment total assets to the Companys total
assets:
 March 31,
    
    
    December 31,2006
    
    
    2005Total assets before unallocated items, per above
    
    $
    18,521
    
    
    $
    18,092Corporate assets:Cash and cash equivalents
    
    
    1,862
    
    
    
    706Restricted cash
    
    
    1,671
    
    
    
    1,656Current portion of notes receivable
    
    
    649
    
    
    
    655Other current assets
    
    
    1,577
    
    
    
    1,594Property and equipment, net
    
    
    1,695
    
    
    
    1,914Investment
    
    
    679
    
    
    
    745Notes receivable, net of current portion
    
    
    2,552
    
    
    
    2,736$
    29,206
    
    
    $
    28,098
 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 March 31, 2006Revenue
    
    $
    
    
    
    $
    6,788
    
    
    $
    6,788(Loss) contribution before unallocated items
    
    
    (1,294
    )
    
    
    (83
    )
    
    
    (1,377
    )For the Three Months Ended March 31, 2005Revenue
    
    $
    
    
    
    $
    6,606
    
    
    $
    6,606Loss before unallocated items
    
    
    (1,025
    )
    
    
    (658
    )
    
    
    (1,683
    )At March 31, 2006Total Assets
    
    
    530
    
    
    
    28,676
    
    
    
    29,206At December 31, 2005Total Assets
    
    
    715
    
    
    
    27,383
    
    
    
    28,098
 17




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##### Table of Contents



11.
    
    REORGANIZATION COSTSIn 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, 2005.12.
    
    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 which
enables the Company to grant up to 3.5 million qualified and
nonqualified incentive stock options as well as other stock-based
awards. In addition, in connection
with various financing and acquisition transactions, and for services provided to the
Company, the Company has issued warrants to purchase the Companys common stock. A summary
of stock options and warrants outstanding at March 31, 2006 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
    
    March 31, 2006
    
    
    Exercise Price
    
    
    March 31, 2006
    
    
    Exercise Price$0.95-$1.45
    
    
    560,923
    
    
    $
    1.44
    
    
    
    521,173
    
    
    $
    1.43$1.45-$2.50
    
    
    821,770
    
    
    $
    2.20
    
    
    
    670,020
    
    
    $
    2.16$2.51-$5.00
    
    
    223,858
    
    
    $
    3.26
    
    
    
    183,358
    
    
    $
    3.22$5.01-$7.50
    
    
    150,625
    
    
    $
    6.47
    
    
    
    100,625
    
    
    $
    6.59$7.51-$90.00
    
    
    1,444,221
    
    
    $
    15.09
    
    
    
    1,443,346
    
    
    $
    15.09Total
    
    
    3,201,397
    
    
    $
    8.16
    
    
    
    2,918,522
    
    
    $
    8.65
 Options and warrants issued to employees generally terminate ten years from the date of grant.
Termination dates on the options
for the options and warrants listed above range from April 3, 2006 to March 15, 2016.
 18




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##### Table of Contents



12.
    
    STOCK OPTIONS AND WARRANTS, ContinuedA summary of the status of stock options and warrants granted to employees as of March 31,
2006, and the changes during the three months ended March 31, 2006 is presented below:
 Number of
    
    
    WeightedShares of
    
    
    AverageUnderlying
    
    
    ExerciseOptions
    
    
    PricesOutstanding at
beginning of the period
    
    
    3,201,096
    
    
    $
    8.23Granted
    
    
    50,000
    
    
    
    6.25Exercised
    
    
    (4,060
    )
    
    
    1.45Forfeited
    
    
    (45,639
    )
    
    
    11.59Expired
    
    
    
    
    
    
    Outstanding at end of period
    
    
    3,201,397
    
    
    $
    8.16Exercisable at end of period
    
    
    2,918,522
    
    
    $
    8.65
 The weighted average grant date fair value for options
granted during the three months ended March 31, 2006 was $58,000.
 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$1.56
    
    
    5,614,692
    
    
    $
    1.56
    
    
    August 2011$2.17
    
    
    800,000
    
    
    $
    2.17
    
    
    January 2007-July 2010$2.91
    
    
    2,462,400
    
    
    $
    2.19
    
    
    February 2010$6.82
    
    
    491,505
    
    
    $
    6.82
    
    
    February 2011$26.25-$30.00
    
    
    50,000
    
    
    $
    28.50
    
    
    October 2006Total
    
    
    9,423,597
    
    
    $
    3.59
 The exercise price and number outstanding for certain warrants previously issued have been
adjusted according to their anti-dilution 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
March 31, 2006, and the changes during the three months ended March 31, 2006 is presented
below:
 Number of
    
    WeightedShares of
    
    AverageUnderlying
    
    ExerciseWarrants
    
    PricesOutstanding at beginning of period
    
    
    4,107,192
    
    
    $
    3.82Granted
    
    
    5,614,692
    
    
    
    1.56Exercised
    
    
    
    
    
    
    Expired
    
    
    (298,287
    )
    
    
    6.74Outstanding at end of period
    
    
    9,423,597
    
    
    $
    2.38Exercisable at end of period
    
    
    3,808,905
    
    
    $
    3.59
   20




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12.
    
    STOCK OPTIONS AND WARRANTS, Continued
    Three Months EndedMarch 31, 2006Risk-free interest rate
    
    
    4.8
    %Expected life
    
    4 yearsExpected volatility
    
    
    106.00
    %Expected dividend yield
    
    
    0.0
    %
  21




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##### Table of Contents



12.
    
    STOCK OPTIONS AND WARRANTS, Continued
  Net loss, as reported
    
    $
    (5,500
    )Add: Stock-based compensation
expense included in net loss
    
    
    7Total stock-based employee
compensation expense determined
under fair value based method
for all awards
    
    
    278Pro forma net loss
    
    $
    (5,215
    )Net loss per common shareAs reported
    
    $
    (0.04
    )Pro forma
    
    
    (0.04
    )
  Three Months EndedMarch 31, 2005Risk-free interest rate
    
    
    3.9
    %Expected life
    
    4 yearsExpected volatility
    
    
    110.00
    %Expected dividend yield
    
    
    0.0
    %
 22




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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 March 31, 2006 does not include the effect of the
common stock equivalents, calculated by the treasury stock method, as their impact would be
anti-dilutive. Using the treasury stock method, common stock equivalents are as follows:
 For the three months endedMarch 31,2006
    
    2005Shares issuable under stock options
    
    
    12,290
    
    
    
    58,098Shares issuable pursuant to warrants
to purchase common stock
    
    
    4,830
    
    
    
    7,34317,120
    
    
    
    65,441
 14.
    
    PRIVATE PLACEMENTOn February 17, 2006, the Company issued 5.4 million shares of its common stock and warrants
to purchase 5.4 million shares of its common stock in a private placement transaction for
an aggregate purchase price of approximately $7.1 million, or $1.30 per share. The warrants
issued in connection with the private placement are exercisable, after six months, for a
period of five years and at an exercise price of $1.56 per share. The Company received
proceeds from the private placement of approximately $6.8 million, net of expenses.15.
    
    LITIGATIONExcept as 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 pending legal
proceedings other than ordinary routine litigation incidental to its business, and the
Company does not expect this ordinary litigation to have a material adverse effect on the
Company. There have been no material developments regarding the pending material legal
proceedings described in Note 16 to the Companys audited consolidated financial statements
included in the Annual Report during the three months ended March 31, 2006.
 23




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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;-
    
    general economic conditions of the telecommunications market;-
    
    the Companys research and development expenditures-
    
    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 and emerging markets;-
    
    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
  24




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25




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Results of Operations
 Three Months Ended March 31, 2006, Compared to Three Months Ended March 31, 2005
  Continuing Operations
             26




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##### Table of Contents



Business Unit Performance
 Packet-based
    
    
    AdvancedTechnologies
    
    
    ApplicationsDollars in thousands
    
    Group
    
    
    Services Group
    
    
    ConsolidatedFor the Three MonthsEnded March 31,
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Revenue
    
    $
    4,881
    
    
    $
    4,071
    
    
    $
    1,907
    
    
    $
    2,535
    
    
    $
    6,788
    
    
    $
    6,606Gross profit
    
    
    2,439
    
    
    
    1,993
    
    
    
    402
    
    
    
    827
    
    
    
    2,841
    
    
    
    2,820Gross margin
    
    
    50
    %
    
    
    49
    %
    
    
    21
    %
    
    
    33
    %
    
    
    42
    %
    
    
    43
    %General and administrative
    
    
    565
    
    
    
    519
    
    
    
    126
    
    
    
    146
    
    
    
    691
    
    
    
    665Sales and marketing
    
    
    1,698
    
    
    
    2,122
    
    
    
    76
    
    
    
    89
    
    
    
    1,774
    
    
    
    2,211Research and development
    
    
    1,753
    
    
    
    1,627
    
    
    
    
    
    
    
    
    
    
    
    1,753
    
    
    
    1,627(Loss) contribution before
unallocated items
    
    $
    (1,577
    )
    
    $
    (2,275
    )
    
    $
    200
    
    
    $
    592
    
    
    
    (1,377
    )
    
    
    (1,683
    )Unallocated items:Corporate general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,742
    
    
    
    1,813Corporate research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    26
    
    
    
    57Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    463
    
    
    
    660Reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    124Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,608
    )
    
    
    (4,337
    )Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,332
    )
    
    
    (597
    )Loss before income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (4,940
    )
    
    $
    (4,934
    )
 Packet-based Technologies Group
    27




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##### Table of Contents



Advanced Applications Services Group
    Discontinued Operations
   For the three months ended March 31,2006
    
    
    2005Revenue
    
    $
    
    
    
    $
    212Gross loss
    
    
    
    
    
    
    (27
    )Operating loss
    
    
    
    
    
    
    (566
    )Loss from discontinued operations
    
    $
    
    
    
    $
    (566
    )
  Critical Accounting Policies
   28




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##### Table of Contents



Revenue Recognition
       Allowance for Doubtful Accounts
  Inventory Obsolescence
  Liabilities of Discontinued Operations
  29




---



##### Table of Contents



Deferred Tax Asset Valuation Allowance
  Litigation and Related Contingencies
  Goodwill, Intangible Assets and Long-Lived Assets
   30




---



##### Table of Contents



Liquidity and Capital Resources
 Summary
       Cash Flow
  31




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##### 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
    
    
    180
    
    
    
    155
    
    
    
    25
    
    
    
    
    
    
    
    Notes payable for the purchase of Clarent
    
    
    3,000
    
    
    
    
    
    
    
    3,000
    
    
    
    
    
    
    
    Convertible subordinated debentures
    
    
    1,575
    
    
    
    1,575
    
    
    
    
    
    
    
    
    
    
    
    Senior unsecured convertible debentures
    
    
    13,500
    
    
    
    2,250
    
    
    
    11,250
    
    
    
    
    
    
    
    Operating leases:Continuing operations
    
    
    6,867
    
    
    
    2,091
    
    
    
    3,561
    
    
    
    1,215
    
    
    
    Discontinued operations
    
    
    2,832
    
    
    
    1,738
    
    
    
    766
    
    
    
    328
    
    
    
    Total contractual cash obligations
    
    $
    27,954
    
    
    $
    7,809
    
    
    $
    18,602
    
    
    $
    1,543
    
    
    $
    
   Sources of Cash
  32




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,
  33




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##### Table of Contents



Item 3: Quantative and Qualitative Disclosures About Market Risk
       
 Item 4: Controls and Procedures
   34




---



##### Table of Contents



PART II  OTHER INFORMATION
 
 Legal Proceedings
  
 Risk Factors
  
 Unregistered Sales of Equity Securities and Use of Proceeds
  
 Other Information
  
 Exhibits
  35




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##### Table of Contents



SIGNATURE
  VERSO TECHNOLOGIES, INC.Date: May 12, 2006
    
    /s/ Juliet M. ReisingExecutive Vice President and Chief Financial Officer(duly authorized signatory andPrincipal Financial and Accounting Officer)
 36




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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
    
    Registration Rights
Agreement dated March 20,
2006, between the
Registrant and Joseph Noel.
    
    Incorporated by reference
to Exhibit 4.4 to the
Registrants Registration
Statement on Form S-3 (No.
333-133373).4.2
    
    Registration Rights
Agreement dated March 20,
2006, between the
Registrant and J.P. Turner
& Company, L.L.C.
    
    Incorporated by reference
to Exhibit 4.5 to the
Registrants Registration
Statement on Form S-3 (No.
333-133373).4.3
    
    Registration Rights
Agreement dated March 20,
2006, between the
Registrant and Croft &
Bender.
    
    Incorporated by reference
to Exhibit 4.6 to the
Registrants Registration
Statement on Form S-3 (No.
333-133373).4.4
    
    Form of Warrant issued in
the Registrants February
2006 Private Placement.
    
    Incorporated by reference
to Exhibit 4.53 to the
Registrants Annual Report
on Form 10-K for the year
ended December 31, 2005.
 37




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##### Table of Contents



Exhibit No.
    
    Exhibit
    
    Method of Filing4.5
    
    Form of Registration Rights
Agreement entered into in
connection with the
Registrants February 2006
Private Placement.
    
    Incorporated by reference
to Exhibit 4.54 to the
Registrants Annual Report
on Form 10-K for the year
ended December 31, 2005.10.1
    
    Amended and Restated
Promissory Note made by the
Registrant, Provo Prepaid
(Delaware) Corp.,
Telemate.Net Software, Inc.
and Needham (Delaware)
Corp. dated March 24, 2006.
    
    Incorporated by reference
to Exhibit 10.113 to the
Registrants Annual Report
on Form 10-K for the year
ended December 31, 2005.10.2
    
    Export-Import Bank of the
United States Working
Capital Guarantee Program
Borrower Agreement dated as
of March 24, 2006 among the
Registrant, Provo Prepaid
(Delaware) Corp.,
Telemate.Net Software, Inc.
Needham (Delaware) Corp.
and Silicon Valley Bank.
    
    Incorporated by reference
to Exhibit 10.114 to the
Registrants Annual Report
on Form 10-K for the year
ended December 31, 2005.10.3
    
    Amendment to Loan Documents
dated January 27, 2006
among the Registrant, Provo
Prepaid (Delaware) Corp.,
Telemate.Net Software, Inc.
Needham (Delaware) Corp.
and Silicon Valley Bank.
    
    Incorporated by reference
to Exhibit 10.115 to the
Registrants Annual Report
on Form 10-K for the year
ended December 31, 2005.10.4
    
    Amendment to Loan Documents
(EXIM Program) dated as of
March 24, 2006 among the
Registrant, Provo Prepaid
(Delaware) Corp.,
Telemate.Net Software, Inc.
Needham (Delaware) Corp.
and Silicon Valley Bank.
    
    Incorporated by reference
to Exhibit 10.116 to the
Registrants Annual Report
on Form 10-K for the year
ended December 31, 2005.10.5
    
    Amendment to Loan Documents
dated as of March 24, 2006
among the Registrant, Provo
Prepaid (Delaware) Corp.,
Telemate.Net Software, Inc.
Needham (Delaware) Corp.
and Silicon Valley Bank.
    
    Incorporated by reference
to Exhibit 10.117 to the
Registrants Annual Report
on Form 10-K for the year
ended December 31, 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.
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