**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

**(Mark One)**

**x**                                 ANNUAL REPORT PURSUANT TO SECTION 13OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe fiscal year ended September 30, 2006**

**OR**

** ̈**                                   TRANSITION REPORT PURSUANT TOSECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the transition periodfrom                  to                  **

**Commission File Number 000-27427**

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**ALTIGEN COMMUNICATIONS,INC.**

(Exactname of Registrant as specified in its charter)

| **DELAWARE**                                                                                              |   | **94-3204299**                           |
|-----------------------------------------------------------------------------------------------------------|--------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)                                          |   | (I.R.S. Employer  Identification Number) |
| **4555 Cushing Parkway  Fremont, CA**                                                                     |   | **94538**(Zip Code)                      |
| (Address of  principal executive offices)                                                                 |   |                                     |
| Registrant’s  telephone number, including area code: **(510) 252-9712**                         |
| Securities  registered pursuant to Section 12(b) of the Act: **None**                           |
| Securities  registered pursuant to Section 12(g) of the Act: **Common Stock, $0.001 par value** |
| (Title of Class)                                                                                          |

 

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Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes  o  No  x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes   ̈  No  x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for thepast 90 days. Yes  x  No   ̈

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K.   ̈

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act). Yes   ̈  No  x

Indicate by check whetherthe registrant is a shell company as defined in Rule 12b-2 of theExchange Act. Yes   ̈  No  x

The aggregate market valueof the common stock held by non-affiliates of the registrant was approximately$25,115,815 as of March 31, 2006, based on the closing price of our commonstock as reported on The Nasdaq Global Market on such date. Shares of commonstock held by each officer and director and by each person known to own 5% ormore of our outstanding common stock have been excluded in that such personsmay be deemed to be affiliates. This determination of affiliate status is notnecessarily a conclusive determination for other purposes. As of March 31,2006, there were 14,954,954 shares of our common stock issued and outstanding.

As of December 21,2006, there were 15,149,669 shares of our common stock issued and outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Certainsections of AltiGen Communications, Inc.’s definitive Proxy Statement forthe 2006 Annual Meeting of Stockholders to be held on March 5, 2007 areincorporated by reference in Part III of this Form 10-K to theextent stated herein.

 

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**TABLEOF CONTENTS**

|                | ** ** | ** **                                                                                                         | ** ** | **Page** |
|----------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I    |
| Item 1.        |       | Business                                                                                                           |       | 3        |   |
| Item 1A.       |       | Risk Factors                                                                                                       |       | 13       |   |
| Item 1B.       |       | Unresolved Staff Comments                                                                                          |       | 22       |   |
| Item 2.        |       | Properties                                                                                                         |       | 22       |   |
| Item  3.       |       | Legal  Proceedings                                                                                                 |       | 22       |   |
| Item 4.        |       | Submission of Matters to a Vote of Security Holders                                                                |       | 22       |   |
| PART II   |
| Item 5.        |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 23       |   |
| Item 6.        |       | Selected Financial Data                                                                                            |       | 24       |   |
| Item 7.        |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |       | 25       |   |
| Item 7A.       |       | Quantitative and Qualitative Disclosures About Market  Risk                                                        |       | 33       |   |
| Item 8.        |       | Financial Statements and Supplementary Data                                                                        |       | 34       |   |
| Item 9.        |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                              |       | 34       |   |
| Item 9A.       |       | Controls and Procedures                                                                                            |       | 34       |   |
| Item  9B.      |       | Other  Information                                                                                                 |       | 34       |   |
| PART III  |
| Item 10.       |       | Directors and Executive Officers of the Registrant                                                                 |       | 35       |   |
| Item 11.       |       | Executive Compensation                                                                                             |       | 36       |   |
| Item 12.       |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |       | 36       |   |
| Item 13.       |       | Certain Relationships and Related Transactions                                                                     |       | 36       |   |
| Item 14.       |       | Principal Accountant Fees and Services                                                                             |       | 36       |   |
| PART IV   |
| Item 15.       |       | Exhibits and Financial Statement Schedules                                                                         |       | 38       |   |
| SIGNATURES     |       | 61                                                                                                                 |       |
| CERTIFICATIONS |       |                                                                                                               |       |

 

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**PART I**

**Item 1. Business**

**INTRODUCTION**

**AltiGenCommunications, Inc.**(NASDAQ: ATGN)****is a pioneer and market leader in Voice over InternetProtocol (VoIP) telephone systems. We design and manufacture advanced phonesystems and call center products that use both the Internet and the publictelephone network.

AltiGen Communications, or AltiGen, was founded bycurrent CEO and President Gilbert Hu in 1994, and the first products beganshipping in 1996. Our telephony products are primarily sold to small-to-mediumsized businesses, multi-site businesses, corporate branch offices, callcenters, credit unions and community banks.

AltiGen’s products enable an array of applicationslike VoIP phones and servers, voicemail, call recording, call activityreporting, and mobility solutions that take advantage of the convergence ofvoice and data communications to achieve cost reduction. Our systems aredesigned with an open architecture and are built on an industry standardplatform. This adherence to widely-used standards allows our products tointegrate with and leverage a company’s existing technology investment.

AltiGen Communications products are available fromindependent authorized resellers and strategic partners. AltiGen’s family oftelephony solutions has been recognized for excellence with more than 40industry awards since 1996. Most recently, AltiGen’s IP710 VoIP phone wasawarded a 2005 Product of the Year award from TMC’s Internet Telephonymagazine.

We generated net revenue of $17.9 million with anet loss of $12,000 during fiscal year 2006. As of September 30, 2006, wehad an accumulated deficit of $51.2 million. Net cash provided in operatingactivities was $570,000 for fiscal year 2006.

Our principal executive offices are located at 4555Cushing Parkway, Fremont, California 94538. Our telephone number is(510) 252-9712. We were incorporated in California in May 1994,and we reincorporated into Delaware in June 1999.

We maintain an Internetwebsite at *http://www.altigen.com*.Our most recent annual report on Form 10-K and certain of our otherfilings with the Securities and Exchange Commission (SEC) are available throughthe Investor Relations section of our website. Our annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-Kand other required filings and amendments to these filings are available on theSEC website at *http:/ /www.sec.gov*,which can be reached from our Investor Relations website. In addition, you mayread and copy any material we file with the SEC at the SEC’s Public Reference Room at450 Fifth Street, NW, Washington, DC 20549. You may obtain information on theoperation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

**INDUSTRY BACKGROUND**

We focus on thesmall-to-medium sized business and mid-sized enterprise business market, whichrepresents approximately 14 million businesses in the United States. Ourtelephony products primarily are sold to small-to-medium sized businesses,multi-site businesses, corporate branch offices, call centers, credit unionsand community banks.

*Convergence ofVoice and Data*

Traditionally, businesses have supported two separate,incompatible networks to handle their communications needs. The first networkhas been the traditional telephone network, which relies on a technology called“circuit-switching.” A circuit-switched network establishes andmaintains a dedicated 

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(i.e. not shared) linebetween calling parties for the duration of a call. The second type of networkon which businesses have traditionally relied is a “packet-switched”network, such as an internal local area network or an external network, likethe Internet, where voice, video, images or data is divided into small Internetprotocol packets of information for transmission that are simultaneouslycombined with other unrelated packets of information and routed to a finaldestination where this process is reversed. Packet-switched networks aremore efficient than the traditional circuit-switched telephone network, becausenetwork paths are not dedicated to a single user, but instead are available tobe shared by all users. As a result, network capacity is allocated moreefficiently. It is commonplace for networks installed today to be able tosupport both voice and data usage with Internet protocol packet-switching.

Most telecommunicationssystems do not address the needs of businesses that need to transmit voicecommunications over both traditional telephone networks and packet-switchingnetworks. For example, businesses may wish to route internal calls over their existingvoice network and route calls between offices over packet-switched networks,all using the same telecommunications system. We believe a significantopportunity exists to provide small-to-medium sized and mid-enterprisebusinesses with an integrated phone system that delivers the benefits ofintegrated, multi-function telecommunications systems using Internet protocolpacket switching networks as well as traditional circuit-switched telephonenetworks.

**THE ALTIGEN PRODUCTOFFERING**

AltiServTM Office systems are complete businesstelephone systems that are installed on custom designed and manufacturedindustrial server platforms. The systems include a comprehensive bundle ofAltiGen software applications to provide a high value, all-in-one solution. Thesystems include software and licensing necessary to support analog and Voiceover Internet Protocol (VoIP) telephones, operator software, and desktop callcontrol software for each extension on the system. By providing a bundledapproach, we are able to maintain quality and reliability while providing foreasy deployment of our products.

The AltiGen phone systems work with digital, analogand internet protocol trunks, and internet protocol and analog telephoneextensions. The systems can be configured with digital, analog or voice overinternet protocol, or a combination of the three. By allowing the customer tochoose what best fits their current and future requirement, we provide apractical and cost effective solution to future growth.

Each system includes as standard PBX functionality, acomprehensive voicemail system with over 2,000 hours of storage, 255 autoattendant menus with unlimited levels, automatic call distribution and calldetail reporting. The system also provides intuitive and easy to use systemadministration software to allow for customer self-administration or remoteadministration by our authorized reseller partners.

The AltiServTM Office family of telephone systems canbe implemented for businesses requiring as few as eight extensions andsupporting up to 400 users per individual system. Individual systems can beaffordably scaled to customer needs, and multiple systems may be networkedtogether for greater expansion. These networked systems can be at a singlesite, a campus environment or multiple locations throughout the world usingInternet protocol technology to link them. The AltiServTM Office product allowsan affordable entry point while maintaining logical system growth.

For customers with more advanced requirements, weprovide AltiContact Manager. The product is available as a software upgrade toan existing AltiServTM Office system. This product is capable of skills-basedrouting, priority queuing, centralized call recording and advanced monitoringand reporting. This capability may be added on a per agent/supervisor basis asthe customer grows. This allows a smaller business or branch office to enjoythe same capability as a large professional call center organization. If acustomer has more than one location, call center calls can automatically berouted to other locations based on conditions the customer chooses.

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As a follow up to the release of the IP710 IP Phone in2005, we released the IP705 IP Phone in June of 2006. The IP705 is AltiGen’sentry level IP Phone with a subset of the IP710 features at a lower price point.It is also a standard based VoIP telephone that is feature rich whilemaintaining our tradition of intuitive, easy to use technology. The phone wasdesigned and developed based on several years of input from our customers andpartners.

We have continued to refine our innovative and costeffective product family. We provide a comprehensive, manageable and costeffective option for each of our customers.

Key features of ourphone systems include:

·       **Measurable Information to Ensure Best Business Practices.  **Weprovide a complete view into individual and group performance. The amount, typeand duration of calls can be tracked an analyzed. An individual can record acall for later review, or a company can centrally record all or a percentage ofcalls for quality control.

·       **Reduced Administration Costs.  **Oureasy to use self administration software allows customers to manage their owntelephone system. This reduces or eliminates ongoing operating cost of anybusiness telephone system typically referred to as adds, moves and changes. OurAltiServTM systems allow system administrators to perform many of these tasks onsite or remotely without assistance from third parties.

·       **Lower Toll Costs.  **By routing voiceover data networks, our systems reduce toll charges associated withlong-distance calls between locations. Using our products, businesses can sendand receive voice communications over the Internet or a private data network.

·       **Unified Company Locations.  **Forcompanies with AltiGen systems in multiple locations, we provide a seamlessdialing plan. Customers calling into one location can automatically be routedto the correct group or individual. This allows a multi-site business tooperate under a unified dialing plan and allows users in different sites tooperate as if they were supported by a single system rather than an individualsystem for each location.

·       **Survivability Options.  **Our systems allow practical and cost efficient options for disasterrecovery planning.  Redundant system hard drives allow allvoicemail and configuration information to be copied to a spare hard drive. Thesystem allows nightly backup to another network drive. If weather or otherproblems prevent employees from reaching the office, ExtensionAnywhereTM, One Number Access and VoIP telephonescan be utilized to keep operations running. We provide multiple options basedupon what best fits the customer environment.

·       **Innovative Desktop Productivity Software****.**   Our systems provide desktop software applications toincrease user productivity. Call control, changes in extension configurationand the ability to view and manage voicemail messages improve an employee’s abilityto process calls. In addition, we provide software for group supervisors,agents, system administrators and operators. Applications are centrallyupgraded from the phone system to allow for quick and efficient deployment.

·       **Integration with Customer Relationship ManagementSoftware.  **The AltiView and AltiAgent desktop interfaceprovides automatic contact record retrieval and “screen pops” of contactrecords to a user’s desktop. Microsoft Outlook users can type in a name toautomatically retrieve telephone numbers and click and dial from an integratedcontact record directory. Certified integration to Microsoft customerrelationship management software is provided as standard with the system. Weprovide built-in integration with other Microsoft software applications likeMicrosoft customer relationship management, Microsoft Outlook and MicrosoftExchange.

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·       **Ease of Installation, Use and Maintenance.  **TheAltiServTM Office phone systems allow easy installation and system maintenance.Administrators can manage call routing, extension management, voice messaging,email and Internet features of our products through a single AltiWareadministrator interface. By using industry standards we believe that AltiServTMsystems make it easier for resellers and end-user customers to implement andmaintain systems.

·       **Improved Customer Service Capabilities.  **TheAltiServTM Office systems provide integrated call center functionality. For moreadvanced call center or centralized call recording requirements, we offer theAltiContact Manager software application. Both contact center applications aredesigned to enhance our customers’ communications with their customers by employingcomprehensive contact center and call center routing, reporting and recordingtechnologies.

·       **Integrated Centralized Call Recording.  **Voicecalls can be recorded on demand by employees, agents and supervisors orautomatically centrally recorded by the phone system. Traditional phone systemsrequire a separate system to be tied to a PBX to centrally record calls. Modularfeature licensing allows businesses to add capabilities on a per-feature orper-user basis offering a reduced up-front investment.

·       **TrueEmployee****Mobility.  **We provide flexible and useable mobilityoptions while retaining accountability. We provide several powerful options. ExtensionAnywhereallows any phone with a direct telephone number to be enabled as a liveextension on the system. Call handling, call transfer, conferencing andvoicemail capability are retained. Our “OneNumber Access” feature allows the system to search and then transfer a call atup to four numbers. For remote employees, we offer a VoIP telephone to connectto an employee’s high speed Internet access. Our mobility options are flexibleand simple to use.

**PRODUCTS**

Thefollowing is a list of our products that are material to our current operationsfrom a financial standpoint:
| Product               | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | ** ** | **Description** |
|-----------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| AltiServTM Office |       | AltiServTM Office systems are complete business  telephone systems that are installed on custom designed and manufactured  industrial server platforms. The systems include a comprehensive bundle of  AltiGen software applications to provide a high value, all-in-one solution.  The systems include software and licensing necessary to support analog and VoIP  telephones, operator software, and desktop call control software for each  extension on the system. By providing a bundled approach, we maintain quality  and reliability while providing for easy deployment. The platforms are  scaleable, and are packaged according to the size of the customer. |
| AltiContact  Manager  |       | AltiContact Manager is  available as a software upgrade to an existing AltiServTM Office system. This product is capable  of skills-based routing, priority queuing, centralized call recording and advanced  monitoring and reporting. This capability may be added on a per  agent/supervisor basis as a company’s needs grow. This allows a smaller  business or branch office to enjoy the same capability as a large  professional call center organization. If a company has more than one  location, call center calls can automatically be routed to other locations  based on conditions the customer chooses.                                              |

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| AltiTouch 510 Analog Telephone |   | The AltiTouch 510 telephone is an executive level  analog phone with a high quality speaker, a large (7.4 square inch) backlit  LCD display with adjustable viewing angle, and LED voicemail waiting  indicator. One-touch buttons provide access to features and call control  including: volume, mute, voicemail, voice mail greeting management, do not  disturb, intercom, headset answering, conference, hold, transfer, redial,  call release, speed dial, call directory, extension management, line pickup,  account codes and much more. |
|-------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| IP710 Voice over  IP Telephone |   | The IP710 is a fully  featured IP telephone designed to empower the user. Bringing stylish form and  functionality to the desktop, the IP710 makes sophisticated features simple  and intuitive to use. Users have single button access to voicemail,  activity/presence selection, voicemail greeting selections, call recording,  call conferencing, call transferring, and even placing calls to employees in  other countries. Our IP710 Telephone was  recognized in Internet Telephony  Magazine as Product of Year for 2005.               |
| IP705 Voice over  IP Telephone |   | The IP705 provides a  subset of the flagship IP710 VoIP telephone’s features while offering the  same level of voice quality at a reduced price.                                                                                                                                                                                                                                                                                                                                                                                             |
| AltiView                            |   | AltiView is a  Windows-based desktop application that provides call control and visual voice  mail management to the desktop. It allows users to receive and place calls,  listen to voicemail messages, identify the caller phone number and manage  extension configuration. AltiView is standard with the system.                                                                                                                                                                                                                              |
| AltiAgent                           |   | AltiAgent is a  Windows-based desktop application to bring call control and workgroup  information to call center agents. Users can view a call queue, monitor work  group status, check caller identification, measure performance, review log-on  history, receive and place calls and listen to and manage voicemail messages.                                                                                                                                                                                                                 |
| AltiSupervisor                      |   | AltiSupervisor is a  Windows-based desktop application for call center supervisors. The  application allows a call center or workgroup supervisor to effectively  manage a workgroup. AltiSupervisor provides four major real time module views  for workgroup management: agent status, agent statistics, group statistics,  and queue status with a quality of services capability. AltiSupervisor allows  silent monitoring of agents with barge-in call participation and call  recording functionality.                                      |
| Triton IP Board                     |   | The Triton IP Board is a  microprocessor-controlled board supporting VoIP communications. This  allows voice conversations to be carried over public and private data  networks that support Internet protocol. The Triton IP Board is a 12-port  board that can be software configured to 30 ports. The Triton IP Board can be  used for Internet protocol trunks connecting multiple networked AltiServTM  systems or to support voice over Internet protocol telephones extensions and  VoIP agent extensions.                             |
| Triton T1, E1,  T1/PRI Board   |   | The Triton T1, E1,  T1/PRI Board is a microprocessor-controlled board that allows AltiServTM  systems to connect to T1, E1 or T1/PRI digital high-capacity central  office telephone lines. This board can be configured with software to support  provisioning for T1, E1 or T1/PRI communication protocols.                                                                                                                                                                                                                                 |

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| Triton Trunk Board      |   | The Triton Trunk Board is an 8 or 12 port,  microprocessor-controlled board that allows AltiServTM systems to  connect to analog central office telephone lines. This allows outbound and  inbound calls to be carried over traditional analog central office telephone  lines. |
|-------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Triton Extension  Board |   | The Triton Extension  Board is a 12 port, microprocessor-controlled board that allows  AltiServTM systems to support 12 analog telephone extensions with each Triton  Extension Board.                                                                                          |

 

*AltiGen Hardwareand Firmware*

We have developed a single base circuit board withhigh performance digital signal processing technology, which means that thecircuit board has an integrated computer built on it that can run special,high-speed software programs, called firmware. Firmware can receive, send andmodify digital information for communications with network services. Our Tritonfamilies of digital signal processing boards are designed to allow us to createdifferent circuit boards to meet many communication requirements by simplyadding a few hardware and/or software components to the basic board. Forexample, the Triton digital signal processing board can become a T1, E1 orIntegrated Services Digital Network communication circuit board or a circuitboard supporting VoIP with simple changes in on-board software and, in somecases, new circuits.

This modular design notonly enables us to provide new capabilities, but we also believe that itenables our products to achieve a high degree of reliability and cost reductionsince the underlying technology is consistent across our products.

*AltiGen ModularSoftware*

Our software products are based on modular softwarecomponents similar to the concept described above for our hardware andfirmware. The service provider layer of software is composed of separatesoftware components, each of which communicates with a hardware circuit boardwithin the AltiServTM system. The middleware layer interacts with all the serviceproviders in the system and manages their resources. This middleware layercommunicates with the hardware and allows application programs to providespecific features. The application program layer consists of components thatimplement the application logic, such as voicemail and auto attendant menus.These applications do not depend on any particular hardware integration.

We believe that thelayered architectural structure of our AltiServTM products provides importantbenefits:

·       Newfeatures can be developed without changing hardware.

·       Developmenttime is generally shorter.

·       Newhardware and software features can be added to installed systems.

·       Changing one component inthe system does not require other components to be changed.

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NetRevenue by Products:

| ** ** | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|------------|------------|-----------------------------------------------------|------------|
| ** ** | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Hardware   |       |                                                | 92         | % |   |   | 86 | % |   |   | 84 | % |   |
| Software   |       |                                                | 8          | % |   |   | 14 | % |   |   | 16 | % |   |
|       |       |                                                | 100        | % |   |   | 100 | % |   |   | 100 | % |   |

 

**MARKETING, SALESAND CUSTOMER SUPPORT**

*Marketing*

Our marketing efforts currently focus on increasingdemand for our products in the Americas, Europe and Asia Pacific. We areworking to increase market awareness of our technology and demand for ourproducts in the small-to-medium sized business and call center markets throughpublic relations, print, email and web campaigns.

To assist ourdistributors, dealers and strategic partners, we provide market developmentfunds, marketing tools and technical and sales training developed specificallyfor our products. We expect that these programs will allow us to leverage theexpertise and contacts of the local and regional reseller channels to createstrong lead generation.

*Sales*

Our banking vertical market strategy, initiated in January 2005,continues to grow. In fiscal 2006, AltiGen systems were installed in 76 newbank and credit union locations throughout the United States. As of September 30,2006, AltiGen systems have been installed in 231 bank and credit union offices.We believe our focus and expertise in this vertical market will allow us toshow continued growth in 2007. In China, we continue to see increasedgovernment spending and expect revenue from the region to increase again infiscal 2007.

Our business is organizedinto two operating segments, Americas and Asia. Our revenue is primarilygenerated from one geographic area, the Americas.

NetRevenue by Geographic Area:

| ** **    | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Americas      |       |                                                | 90         | % |   |   | 90 | % |   |   | 90 | % |   |
| International |       |                                                | 10         | % |   |   | 10 | % |   |   | 10 | % |   |
|          |       |                                                | 100        | % |   |   | 100 | % |   |   | 100 | % |   |

 

We currently have salesand support staff in New York, Illinois, Nevada, Florida, Virginia, China andin our headquarters in Fremont, California. Our inside sales force answersincoming calls from end users and refers new leads to a qualified dealer near eachend user’s location. The inside sales force also is responsible for accountmanagement of our smaller resellers. Our outside sales force, which isprimarily based in the Americas, includes regional sales managers andtechnology solutions managers who work with our larger resellers and recruitnew reseller partners. In fiscal 2006, we continued our expansion to a morescalable reseller community by signing on an increasing number of resellersthat currently sell traditional and Internet protocol telephone systemsmanufactured by companies such as Avaya Communications (Avaya), 3ComCorporation (3Com), Nortel Networks Inc., (Nortel) and NEC Corporation (NEC).

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*Customers*

Our direct customersprimarily are distributors and resellers who sell our products to end-users. Wehave distribution agreements with AltiSys, Graybar and Synnex in the Americas.Our agreements with AltiSys, Graybar and Synnex have initial terms of one yearand are renewed automatically for additional one-year terms, provided that eachparty shall have the right to terminate the agreement for convenience upon90 days’ written notice prior to the end of the initial term or anysubsequent term of the agreement. In addition, our agreements with AltiSys,Graybar and Synnex also provide for termination, with or without cause, byeither party upon 30 days’ written notice to the other party withoutpenalty, or upon insolvency or bankruptcy. For a period of 60 days’following termination of the agreement, AltiSys, Graybar and Synnex maydistribute any products in their possession at the time of termination or, attheir option, return any products to us that are in their inventories. Upontermination of the distribution agreement, all outstanding invoices for theproducts will become due and payable within 30 days’ of the termination.

NetRevenue by Customers:

| ** **    | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| AltiSys       |       |                                                | 15         | % |   |   | 16 | % |   |   | 14 | % |   |
| Ingram Micro* |       |                                                | —     |   |   |   | 2 | % |   |   | 14 | % |   |
| Synnex        |       |                                                | 55         | % |   |   | 53 | % |   |   | 46 | % |   |
| Graybar       |       |                                                | 14         | % |   |   | 11 | % |   |   | 8 | % |   |

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*                    On July 20,2005, we terminated our distribution agreement with Ingram Micro. Thetermination of our relationship with Ingram Micro did not have a materialimpact on our business.

We also have over 200authorized resellers who sell our products directly to end-users. We review ourresellers’ performance quarterly and discontinue distribution for those who donot meet our revenue or technical standards.

*Customer Support*

We believe thatconsistent, high-quality service and support are key factors in attracting andretaining customers. Our customer support groups, located in California, Texas,Colorado, and Shanghai, China coordinate service and technical support of ourproducts and provide service twenty-four hours a day, seven days a week. Our supportpersonnel assist our distributors and resellers in resolving installation andsupport issues that arise from their sales to end users and also providelimited support to end-users to supplement dealer support. Resellers andend-user customers also can access technical information and receive technicalsupport through our web site.

**RESEARCH ANDDEVELOPMENT**

The market for our products is characterized byrapidly changing technology, evolving industry standards and frequent productintroductions. We believe that our future success depends in large part uponour ability to continue to enhance the functionality and uses of our coretechnology. We intend to extend the functionality and uses of our hardware andsoftware technology and develop new products by continuing to invest inresearch and development.

We are currently developing enhancements to ourproducts to provide greater functionality and increased capabilities that weexpect will enable us to enhance our position in the Internet protocol phone systemmarket space, enter new geographical markets, and allow us to continue topenetrate the call center market for small-to-medium sized businesses.

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We currently conduct the majority of our productdevelopment in-house. We also use a small number of independent contractors toassist with certain product development and testing activities. We intend tocontinue working with our strategic partners to enhance our products. As of September 30,2006, we employed 46 individuals in engineering, research and development andsupport.

During fiscal years 2006,2005, and 2004, our research and development expense was approximately $3.7million, $3.5 million, and $3.3 million, respectively.

**COMPETITION**

The markets for our products are intensely competitive,continually evolving and subject to changing technologies. We currently competewith companies providing traditional telephone systems and attempting to launchcompetitive Internet protocol enabled solutions, principally Avaya, NEC andNortel. We also compete against companies providing only Internet protocol andInternet protocol-enabled telecommunications systems, such as 3Com,Shoretel, and Cisco Systems, Inc. Many of our competitors aresubstantially larger than us and have significantly greater name recognition,financial, sales and marketing, technical, customer support, manufacturing andother resources. These competitors also may have more established distributionchannels and stronger relationships with local, long distance and Internet serviceproviders. These competitors may be able to respond more rapidly to new oremerging technologies and changes in customer requirements or to devote greaterresources to the development, promotion and sale of their products.

These competitorsmay enter our existing or future markets with products that may be lessexpensive, that may provide higher performance or additional features or thatmay be introduced more quickly than our products. In fiscal 2006, we believethat we continued to be both feature and price competitive. Additionally, webelieve we provide a low ongoing cost of ownership. We believe that ourprincipal competitive advantages include:

·       Systemdesigned for small-to-medium sized business budgets;

·       Abilityto reduce communications costs;

·       Easeof system manageability;

·       Easeof use;

·       Simpledeployment in single and multi-site implementations;

·       Strongproduct development;

·       Experiencein service and technical support of Internet protocol telephony;

·       Completecall center application now standard with all AltiServTM systems;

·       Completecall processing and voice processing resources in every telephony board

·       Decentralizedvoice processing support for advanced and integrated telephony application;

·       Innovativemobility capabilities supporting mobile telephone devices as telephone systemextensions; and

·       Highly reliable redundantconfigurations supported.

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**INTELLECTUALPROPERTY**

We generally rely upon patent, copyright, trademarkand trade secret laws to protect and maintain our proprietary rights for ourtechnology and products. As of September 30, 2006, we have been issuedthree registered trademarks, “AltiGenTM,” “AltiServTM” and “ZoomerangTM.” Inaddition, the AltiGen logo is a trademark of ours in the United States andother jurisdictions. All other trademarks and trade names used in this Form 10-Kare the property of their respective owners.

We have filed several U.S.patent applications relating to various aspects of our client and serversoftware, mixed-media communications and computer telephony. As of September 30,2006, we have been issued fourteen U.S. patents and have one U.S. patentapplication pending. We expect to continue to file patent applications toprotect our technology and products. We cannot be sure that our patentapplications will result in the issuance of patents, or that any issued patentswill provide commercially significant protection for our technology.

**MANUFACTURING ANDASSEMBLY**

Our manufacturing operations consist of two phases. Inthe first phase, we send out components of our products to a third partyassembler. The third party assembler auto-inserts the components into theprinted circuit boards instead of manually inserting the components and returnsthe assembled circuit board back to us. In the second phase, we insert theassembled circuit boards into the burn-in process for a minimum of two weeksand after that we perform the final test of the circuit boards. In fiscal year2006, we engaged All Quality Services and Bestronics in San Jose as our thirdparty assemblers. During fiscal 2006, four suppliers, Advantech Corporation,BCM Communications, Inc., Fanstel Corporation, and Avnet Electronics,provided us with approximately 91% of our hardware product components. Wepurchase fully-assembled chassis from Advantech Corporation, Analogphones from Fanstel Corporation and Internet protocol phones from BCMCommunications, Inc. As of September 30, 2006, our in-housemanufacturing operations occupied approximately 7,000 square feet of ourcorporate headquarters in Fremont, California.

We test ourproducts after the assembly process using internally developed productassurance testing procedures, which include visual inspection, functionaltesting and final systems testing. Although we generally use standardcomponents for our products and try to maintain alternative sources of supply,we purchase some key components from sole source suppliers for whichalternative sources are not currently available. We incorporate the followingsole-sourced components in our products:

·       ZarlinkCorporation chips are included in all of our boards and are the means by whichour boards communicate with each other to enable our products to functioncorrectly.

·       TexasInstruments’ digital signal processor (“DSP”) chips are included in our Tritonfamily of boards. The DSP chip is designed to perform the mathematics, datacompression and other tasks required to manipulate voice communications thatare routed through our products.

·       Xilinx, Incprovides chips for our Triton family of boards which allow our boards to workwith digital communications lines.

·       InfineonTechnologies provides chips for our Triton Analog product line which allow ourboard to work with analog communications lines.

·       PMCSierra, Inc. provides chips for our Triton Digital product line whichallow our board to work with digital communications lines.

·       AdvantechCorporation provides the chassis for our AltiServTM Office products based on ourspecifications.

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·       BCMCommunications, Inc. manufactures our Internet protocol phone loaded withcustomized firmware to work with our system.

·       FanstelCorporation manufactures our analog phone loaded with customized firmware towork with our system.

Loss of any key componentsupplier would adversely impact our business.

**EMPLOYEES**

As of September 30,2006, we had 88 full-time employees, including 46 in research and developmentand support, 24 in marketing and sales, 7 in operations, and 11 in finance andadministration. Of these full-time employees, 49 were located in theUnited States and 39 in China. Our future success will depend, in part, on ourability to continue to attract, retain and motivate highly qualified technical,marketing, engineering and management personnel.

**Item1A. Risk Factors**

**CERTAIN FACTORS AFFECTING BUSINESS, OPERATING RESULTS,AND FINANCIAL CONDITION**

You should carefullyconsider the risks described below and all of the information contained in thisForm 10-K. If any of the following risks occur, our business,financial condition and result of operations could be harmed, the trading priceof our common stock could decline and you may lose all or part of yourinvestment in our common stock.

*Risks Related to Our Business*

***We have had a history of losses andmay incur future losses, which may prevent us from maintaining profitability.***

We have had a history ofoperating losses since our inception and, as of September 30, 2006, we hadan accumulated deficit of $51.2 million. We may incur operating losses in thefuture, and these losses could be substantial and impact our ability tomaintain profitability. We do not expect to increase expenditures for productdevelopment, general and administrative expenses, and sales and marketingexpenses; however, if we cannot maintain current revenue or revenue growth, wewill not achieve or sustain profitability or positive operating cash flows.Even if we achieve profitability and positive operating cash flows, we may notbe able to sustain or increase profitability or positive operating cash flowson a quarterly or annual basis.

***Our operating results vary, makingfuture operating results difficult to predict.***

Ourquarterly and annual operating results have varied significantly in the pastand likely will vary significantly in the future. A number of factors, many ofwhich are beyond our control, have caused and may cause our operating resultsto vary, including:

·       ourability to respond effectively to competitive pricing pressures;

·       ourability to establish or increase market acceptance of our technology, productsand systems;

·       oursuccess in expanding our network of distributors, dealers and companies thatbuy our products in bulk, customize them for particular applications orcustomers, and resell them under their own names;

·       marketacceptance of products and systems incorporating our technology andenhancements to our product applications on a timely basis;

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·       oursuccess in supporting our products and systems;

·       oursales cycle, which may vary substantially from customer to customer;

·       unfavorablechanges in the prices and delivery of the components we purchase;

·       thesize and timing of orders for our products, which may vary depending on theseason, and the contractual terms of the orders;

·       thesize and timing of our expenses, including operating expenses and expenses ofdeveloping new products and product enhancements;

·       deferralsof customer orders in anticipation of new products, services or productenhancements introduced by us or by our competitors; and

·       ourability to attain and maintain production volumes and quality levels for ourproducts.

Our future projectedbudgets and commitments are based in part on our expectations of future sales.If our sales do not meet expectations, it will be difficult for us to reduceour expenses quickly and, consequently, our operating results may suffer.

Our dealers often requireimmediate shipment and installation of our products. As a result, we havehistorically operated with limited backlog, and our sales and operating resultsin any quarter primarily depend on orders booked and shipped during thatquarter.

Any of the above factorscould harm our business, financial condition and results of operations. Webelieve that period-to-period comparisons of our results of operations are notmeaningful, and you should not rely upon them as indicators of our futureperformance.

***Our market is highly competitiveand we may not have the resources to adequately compete.***

The market for ourintegrated, multifunction telecommunications systems is new, rapidly evolvingand highly competitive. We expect competition to intensify in the future asexisting competitors develop new products and new competitors enter the market.We believe that a critical component to success in this market is the abilityto establish and maintain strong partner and customer relationships with a widevariety of domestic and international providers. If we fail to establish ormaintain these relationships, we will be at a serious competitive disadvantage.

We face competition fromcompanies providing traditional private telephone systems. Our principalcompetitors that produce these telephone systems are Avaya Communications, NECand Nortel Networks. We also compete against providers of multi-functiontelecommunications systems, including 3Com Corporation, and Cisco Systems, Inc.,as well as any number of future competitors. Many of our competitors aresubstantially larger than we are and have significantly greater namerecognition, financial resources, sales and marketing teams, technical andcustomer support, manufacturing capabilities and other resources. Thesecompetitors also may have more established distribution channels and strongerrelationships with service providers. These competitors may be able to respondmore rapidly to new or emerging technologies and changes in customerrequirements or to devote greater resources to the development, promotion andsale of their products. These competitors may enter our existing or futuremarkets with products that may be less expensive, provide higher performance oradditional features or be introduced earlier than our phone systems. We alsoexpect that other companies may enter our market with better products andtechnologies. If any technology that is competing with ours is more reliable,faster, less expensive or has other advantages over our technology, then thedemand for our products and services could decrease and harm our business.

We expect our competitorsto continue to improve the performance of their current products and introducenew products or new technologies. If our competitors successfully introduce newproducts or enhance their existing products, our sales or market acceptance ofour products and services could be 

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reduced,price competition could be increased or our products could become obsolete. Toremain competitive, therefore, we must continue to invest significant resourcesin research and development, sales and marketing and customer support. We maynot have sufficient resources to make these investments or to make thetechnological advances necessary to be competitive, which in turn will causeour business to suffer.

***We sell our products throughdealers and distributors, which limits our ability to control the timing of oursales, and which makes it more difficult to predict our revenue.***

We do not recognizerevenue from the sale of our products to our distributors until these productsare sold to either resellers or end-users. We have little control over thetiming of product sales to dealers and end users. Our lack of control over therevenue that we recognize from our distributors’ sales to resellers andend-users limits our ability to predict revenue for any given period. Our futureprojected budgets and commitments are based in part on our expectations offuture sales. If our sales do not meet expectations, it will be difficult forus to reduce our expenses quickly, and consequently our operating results maysuffer.

***We rely on resellers to promote,sell, install and support our products, and their failure to do so or ourinability to recruit or retain resellers may substantially reduce our sales andthus seriously harm our business.***

We rely on resellers whocan provide high quality sales and support services. As with our distributors,we compete with other telecommunications systems providers for our resellers’business as our resellers generally market competing products. If a resellerpromotes a competitor’s products to the detriment of our products or otherwisefails to market our products and services effectively, we could lose marketshare. In addition, the loss of a key reseller or the failure of resellers toprovide adequate customer service could cause our business to suffer. If we donot properly train our resellers to sell, install and service our products, ourbusiness will suffer.

***Software or hardware errors mayseriously harm our business and damage our reputation, causing loss ofcustomers and revenue.***

Users expect telephone systems to provide a high levelof reliability. Our products are inherently complex and may have undetectedsoftware or hardware errors. We have detected and may continue to detect errorsand product defects in our installed base of products, new product releases andproduct upgrades. End users may install, maintain and use our productsimproperly or for purposes for which they were not designed. These problems maydegrade or terminate the operation of our products, which could cause end usersto lose telephone service, cause us to incur significant warranty and repaircosts, damage our reputation and cause significant customer relations problems.Any significant delay in the commercial introduction of our products due toerrors or defects, any design modifications required to correct these errors ordefects or any negative effect on customer satisfaction as a result of errorsor defects could seriously harm our business, financial condition and resultsof operations.

Any claims brought becauseof problems with our products or services could seriously harm our business,financial condition and results of operations. We currently offer a one-yearhardware guarantee to end-users. If our products fail within the first year, weface replacement costs. Our insurance policies may not provide sufficient orany coverage should a claim be asserted. In addition, our introduction ofproducts and systems with reliability, quality or compatibility problems couldresult in reduced revenue, uncollectible accounts receivable, delays incollecting accounts receivable, warranties and additional costs. Our customers,end users or employees could find errors in our products and systems after wehave begun to sell them, resulting in product redevelopment costs and loss of,or delay in, their acceptance by the markets in which we compete. Further, wemay experience significant product returns in the future. Any of these eventscould have a material adverse effect on our business, financial condition andresults of operations.

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***Our market is subject to changingpreferences; failure to keep up with these changes would result in our losingmarket share, thus seriously harming our business, financial condition andresults of operations.***

Our customers and endusers expect frequent product introductions and have changing requirements fornew products and features. In order to be competitive, therefore, we need todevelop and market new products and product enhancements that respond to thesechanging requirements on a timely and cost-effective basis. Our failure to doso promptly and cost effectively would seriously harm our business, financialcondition and results of operations. Also, introducing new products couldrequire us to write-off existing inventory as obsolete, which could harm ourresults of operations.

***We depend on attracting andretaining qualified personnel to maintain and expand our business; our failureto promptly attract and retain qualified personnel may seriously harm ourbusiness, financial condition and results of operations.***

We depend, in large part,on our ability to attract and retain highly skilled personnel, particularlyengineers and sales and marketing personnel. We need highly trained technicalpersonnel to design and support our server-based telecommunications systems. Inaddition, we need highly trained sales and marketing personnel to expand ourmarketing and sales operations in order to increase market awareness of ourproducts and generate increased revenue. Competition for highly trainedpersonnel is intense, especially in the San Francisco Bay Area where most ofour operations are located. We cannot be certain that we will be successful inour recruitment and retention efforts. If we fail to attract or retainqualified personnel or suffer from delays in hiring required personnel, ourbusiness, financial condition and results of operations may be seriouslyharmed.

***FASB’s adoption of SFAS No. 123(R) hascaused, and changes to existing accounting pronouncements or taxation rules orpractices may cause, adverse fluctuation on operating income, affect ourreported results of operations or how we conduct our business.***

In December 2004, the FASB issued SFAS No. 123(R),Stock-Based Compensation, which establishes standards for transactions in whichan entity exchanges its equity instruments for goods or services. In March 2005,the SEC issued Staff Accounting Bulletin No. 107—Stock-Based Compensation,which provides interpretive guidance related to SFAS No. 123(R). SFAS No. 123(R) requiresa public entity to measure the cost of employee services received in exchangefor an award of equity instruments based on the grant-date fair value of theaward. This eliminates the exception to account for such awards using theintrinsic method previously allowable under APB Opinion No. 25. SFAS No. 123(R).This standard was adopted on October 1, 2005. This standard had materialimpact on our reported results of operations.

Also, a change inaccounting pronouncements or taxation rules or practices can have a significanteffect on our reported results and may even affect our reporting oftransactions completed before the change is effective. Other new accountingpronouncements or taxation rules and varying interpretations of accountingpronouncements or taxation practice have occurred and may occur in the future.This change to existing rules, future changes, if any, or the questioning ofcurrent practices may adversely affect our reported financial results or theway we conduct our business.

***If, as of the end of our 2008fiscal year, we are unable to assert that our internal control over financialreporting is effective, investors could lose confidence in our reportedfinancial information, and the trading price of our stock price and ourbusiness could be adversely affected.***

We are in the process ofdocumenting, and plan to test our internal control procedures in order tosatisfy the requirements of Section 404 of the Sarbanes-Oxley Act.Commencing on September 30, 2008, the end of our 2008 fiscal year, theSarbanes-Oxley Act requires annual management assessments of the effectivenessof our internal controls over financial reporting. During the course of ourtesting we may 

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identifydeficiencies which we may not be able to remediate in time to meet the deadlineimposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404.In addition, if we fail to achieve and maintain the adequacy of our internalcontrols, as such standards are modified, supplemented, or amended from time totime, we may not be able to ensure that we can conclude on an ongoing basisthat we have effective internal controls over financial reporting in accordancewith Section 404 of the Sarbanes-Oxley Act. Effective internalcontrols are important to help produce reliable financial reports and toprevent financial fraud. If we are unable to assert that our internal controlover financial reporting is effective as of the end of our 2008 fiscal year, wecould lose investor confidence in the accuracy and completeness of our financialreports, investors could lose confidence in our reported financial information,and the trading price of our stock and our business could be adverselyaffected.

***If we do not manage our growtheffectively, our business will suffer.***

We may not be successful in managing our futuregrowth. We have expanded our operations rapidly since our inception. In orderto manage this expansion and grow in the future, we will need to expand orenhance our management, manufacturing, research and development and sales andmarketing capabilities. We may not be able to hire the management, staff orother personnel required to do so.

We may not be able to install adequate control systemsin an efficient and timely manner, and our current or planned operationalsystems, procedures and controls may not be adequate to support our futureoperations. Difficulties in installing and implementing new systems, proceduresand controls may significantly burden our management and our internalresources. Delays in the implementation of new systems or operationaldisruptions when we transition to new systems would impair our ability toaccurately forecast sales demand, manage our product inventory and record andreport financial and management information on a timely and accurate basis.

Lead times for materialsand components used in the assembly of our products vary significantly, anddepend on factors such as the supplier, contract terms and demand for acomponent at a given time. If orders do not match forecasts, we may have excessor inadequate inventory of certain materials and components, which mayseriously harm our business, financial condition and results of operations.

***Losing any of our key distributorswould harm our business. We also need to establish and maintain relationshipswith additional distributors and original equipment manufacturers.***

Sales through our threekey distributors, Altisys, Graybar and Synnex, accounted for 84% of our netrevenue in the fiscal year ended September 30, 2006. Our business andoperating results will suffer if any one of these distributors does notcontinue distributing our products, fails to distribute the volume of ourproducts that it currently distributes or fails to expand our customer base. Wealso need to establish and maintain relationships with additional distributorsand original equipment manufacturers. We may not be able to establish, orsuccessfully manage, relationships with additional distribution partners. Inaddition, our agreements with distributors typically provide for termination byeither party upon written notice to the other party. For example, our agreementwith Synnex provides for termination, with or without cause, by either partyupon 30 days’ written notice to the other party, or upon insolvency orbankruptcy. Generally, these agreements are non-exclusive and distributors sellproducts that compete with ours. If we fail to establish or maintainrelationships with distributors and original equipment manufacturers, ourability to increase or maintain our sales and our customer base will besubstantially harmed.

***We rely on sole-sourced componentsand third party technology and products; if these components are not available,our business may suffer.***

We purchase technologyfrom third parties that is incorporated into many of our products, includingvirtually all of our hardware products. We order sole-sourced components usingpurchase orders and do 

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not havesupply contracts for them. One sole-sourced component, a TI DSP chip, isparticularly important to our business because it is included in virtually allof our hardware products. If we were unable to purchase an adequate supply ofthese sole-sourced components on a timely basis, we would be required todevelop alternative products, which could entail qualifying an alternative sourceor redesigning our products based on different components. Our inability toobtain these sole-sourced components, especially the TI DSP chip, couldsignificantly delay shipment of our products, which could have a negativeeffect on our business, financial condition and results of operations

***Compliance with changingregulations of corporate governance and public disclosure may result inadditional expenses.***

Changing laws, regulationsand standards relating to corporate governance and public disclosure, includingthe Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq National Marketrules, are creating uncertainty for companies such as ours. These new orchanged laws, regulations and standards are subject to varying interpretationsin many cases due to their lack of specificity, and as a result, theirapplication in practice may evolve over time as new guidance is provided byregulatory and governing bodies, which could result in continuing uncertaintyregarding compliance matters and higher costs necessitated by ongoing revisionsto disclosure and governance practices. As a result, our efforts to comply withevolving laws, regulations and standards have resulted in, and are likely tocontinue to result in, increased general and administrative expenses and adiversion of management time and attention from revenue-generating activitiesto compliance activities. In particular, our efforts to comply with Section 404of the Sarbanes-Oxley Act of 2002 and the related regulations regarding ourrequired assessment of our internal controls over financial reporting and ourexternal auditors’ audit of that assessment has required the commitment ofsignificant financial and managerial resources. We expect these efforts torequire the continued commitment of significant resources. Further, our boardmembers, chief executive officer, and chief financial officer could face anincreased risk of personal liability in connection with the performance oftheir duties. As a result, we may have difficulty attracting and retainingqualified board members and executive officers, which could harm our business.If our efforts to comply with new or changed laws, regulations and standardsdiffer from the activities intended by regulatory or governing bodies due toambiguities related to practice, our reputation may be harmed.

***Our facility is vulnerable todamage from earthquakes and other natural disasters and other businessinterruptions; any such damage could seriously or completely impair ourbusiness.***

We perform final assembly,software installation and testing of our products at our facility in Fremont,California. Our facility is located on or near known earthquake fault zones andmay be subject to rolling electrical blackouts and is vulnerable to damage orinterruption from fire, floods, earthquakes, power loss, telecommunicationsfailures and similar events. If such a disaster or interruption occurs, ourability to perform final assembly, software installation and testing of ourproducts at our facility would be seriously, if not completely, impaired. If wewere unable to obtain an alternative place or way to perform these functions,our business, financial condition and results of operations would suffer. Theinsurance we maintain may not be adequate to cover our losses against fires,floods, earthquakes and general business interruptions.

***Our strategy to outsource assemblyand test functions in the future could delay delivery of products, decreasequality or increase costs.***

We may begin outsource asubstantial amount of our product assembly and test functions. This outsourcingstrategy involves certain risks, including the potential lack of adequatecapacity and reduced control over delivery schedules, manufacturing yield,quality and costs. In the event that any significant subcontractors were tobecome unable or unwilling to continue to manufacture or test our products inthe 

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requiredvolumes, we would have to identify and qualify acceptable replacements. Findingreplacements could take time and we cannot be sure that additional sourceswould be available to us on a timely basis. Any delay or increase in costs inthe assembly and testing of products by third-party subcontractors couldseriously harm our business, financial condition and results of operations.

***Our expansion in internationalmarkets has been slow and steady. However, our plan is to accelerate thisgrowth rate and will involve new risks that our previous domestic operationshave not prepared us to address; our failure to address these risks could harmour business, financial condition and results of operations.***

For fiscal year2006, approximately 10% of our net revenue came from customers outside of theAmericas. We intend to expand our international sales and marketing efforts.Our efforts are subject to a variety of risks associated with conductingbusiness internationally, any of which could seriously harm our business,financial condition and results of operations. These risks include:

·       tariffs,duties, price controls or other restrictions on foreign currencies or tradebarriers, such as import or export licensing imposed by foreign countries,especially on technology;

·       potentialadverse tax consequences, including restrictions on repatriation of earnings;

·       fluctuationsin foreign currency exchange rates, which could make our products relativelymore expensive in foreign markets; and

·       conflictingregulatory requirements in different countries that may require us to investsignificant resources customizing our products for each country.

***Any failure by us to protect ourintellectual property could harm our business and competitive position.***

Our success depends, to a certain extent, upon ourproprietary technology. We currently rely on a combination of patent, tradesecret, copyright and trademark law, together with non-disclosure and inventionassignment agreements, to establish and protect the proprietary rights in thetechnology used in our products.

Although we have filedpatent applications, we are not certain that our patent applications willresult in the issuance of patents, or that any patents issued will providecommercially significant protection of our technology. In addition, otherindividuals or companies may independently develop substantially equivalentproprietary information not covered by patents to which we own rights, mayobtain access to our know-how or may claim to have issued patents that preventthe sale of one or more of our products. Also, it may be possible for thirdparties to obtain and use our proprietary information without our authorization.Further, the laws of some countries, such as those in Japan, one of our targetmarkets, may not adequately protect our intellectual property or suchprotection may be uncertain. Our success also depends on trade secrets thatcannot be patented and are difficult to protect. If we fail to protect ourproprietary information effectively, or if third parties use our proprietarytechnology without authorization, our competitive position and business willsuffer.

***If we are unable to raiseadditional capital when needed, we may be unable to develop or enhance ourproducts and services.***

We may seek additionalfunding in the future. If we cannot raise funds on acceptable terms, we may beunable to develop or enhance our products and services, take advantage offuture opportunities or respond to competitive pressures or unanticipatedrequirements. We also may be required to reduce operating costs throughlay-offs or reduce our sales and marketing or research and development efforts.If we issue equity securities, stockholders may experience additional dilutionor the new equity securities may have rights, preferences or privileges seniorto those of our common stock.

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***We may face infringement issuesthat could harm our business by requiring us to license technology onunfavorable terms or temporarily or permanently cease sales of key products.***

We may become parties to litigation in the normalcourse of our business. Litigation in general, and intellectual property andsecurities litigation in particular, can be expensive and disruptive to normalbusiness operations. Moreover, the results of complex litigation are difficultto predict.

On September 6, 2002, Vertical Networks, Inc.filed suit against us in the United States District Court for the NorthernDistrict of California, alleging infringement of Vertical Networks’ U.S.Patents Nos. 6,266,341; 6,289,025; 6,292,482; 6,389,009; and 6,396,849. OnOctober 28, 2002, Vertical Networks amended its complaint to addallegations of infringement of U.S. Patents Nos. 5,617,418 and 5,687,174.Vertical Networks filed a second amended complaint on November 20, 2002 toidentify our products and/or activities that allegedly infringe the sevenpatents-in-suit. Vertical Networks seeks a judgment of patent infringement andan award of damages, including treble damages for alleged willful infringement,and attorneys’ fees and costs. We filed an answer and counterclaims fordeclaratory relief on December 9, 2002. On December 26, 2002,Vertical Networks filed its answer to our counterclaims. Vertical Networksserved its preliminary infringement contentions on us on April 9, 2003 andwe served Vertical Networks our preliminary invalidity contentions on June 3,2003 and July 14, 2003. To date, the parties have exchanged somediscovery, but no depositions have been taken, and no motions are currentlypending. We believe we have strong defenses and arguments in this dispute andintend to vigorously defend our position. Management’s view is that any lossfrom this litigation is currently not probable or estimable. Therefore, we havenot established a reserve on our balance sheets as to any liability related tothe outcome of this action.

More generally, litigationrelated to these types of claims may require us to acquire licenses under thirdparty patents that may not be available on acceptable terms, if at all. Webelieve that an increasing portion of our revenue in the future will come fromsales of software applications for our hardware products. The software markettraditionally has experienced widespread unauthorized reproduction of productsin violation of developers’ intellectual property rights. This activity isdifficult to detect, and legal proceedings to enforce developers’ intellectualproperty rights are often burdensome and involve a high degree of uncertaintyand substantial costs.

***Our products may not meet the legalstandards required for their sale in some countries; if we cannot sell ourproducts in these countries, our results of operations may be seriously harmed.***

The United States and other countries in which weintend to sell our products have standards for safety and other certificationsthat must be met for our products to be legally sold in those countries. Wehave tried to design our products to meet the requirements of the countrieswhere we sell or plan to sell them. We also have obtained or are trying toobtain the certifications that we believe are required to sell our products inthese countries. We cannot, however, guarantee that our products meet all ofthese standards or that we will be able to obtain any certifications required.In addition, there is, and will likely continue to be, an increasing number oflaws and regulations pertaining to the products we offer and may offer in thefuture. These laws or regulations may include, for example, more stringentsafety standards, requirements for additional or more burdensome certificationsor more stringent consumer protection laws.

If our products do notmeet a country’s standards or we do not receive the certifications required bya country’s laws or regulations, then we may not be able to sell our productsin that country. This inability to sell our products may seriously harm ourresults of operation by reducing our sales or requiring us to investsignificant resources to conform our products to these standards.

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*Risks Related tothe Industry*

***Integrated, multifunctiontelecommunications systems may not achieve widespread acceptance.***

The market for integrated,multifunction telecommunications systems is relatively new and rapidlyevolving. Businesses have invested substantial resources in the existingtelecommunications infrastructure, including traditional private telephonesystems, and may be unwilling to replace these systems in the near term or atall. Businesses also may be reluctant to adopt integrated, multifunctiontelecommunications systems because of their concern about the currentlimitations of data networks, including the Internet. For example, end userssometimes experience delays in receiving calls and reduced voice quality duringcalls when routing calls over data networks. Moreover, businesses that begin toroute calls over the same networks that currently carry only their data alsomay experience these problems if the networks do not have sufficient capacityto carry all of these communications at the same time.

*Evolving standardsmay delay our product introductions, increase our product development costs orcause end users to defer or cancel plans to purchase our products, any of whichcould adversely affect our business.*

The standards in ourmarket are still evolving. These standards are designed to ensure thatintegrated, multifunction telecommunications products from differentmanufacturers can operate together. Some of these standards are proposed by otherparticipants in our market, including some of our competitors, and includeproprietary technology. In recent years, these standards have changed, and newstandards have been proposed, in response to developments in our market. Ourfailure to conform our products to existing or future standards may limit theiracceptance by market participants. We may not anticipate which standards willachieve the broadest acceptance in our market in the future, and we may take asignificant amount of time and expense to adapt our products to thesestandards. We also may have to pay additional royalties to developers ofproprietary technologies that become standards in our market. These delays andexpenses may seriously harm our results of operations. In addition, customersand users may defer or cancel plans to purchase our products due to concernsabout the ability of our products to conform to existing standards or to adaptto new or changed standards, and this could seriously harm our results of operations.

***Futureregulation or legislation could harm our business or increase our cost of doingbusiness.***

The Federal CommunicationsCommission (FCC) has submitted a report to Congress stating that it mayregulate certain Internet services if it determines that such Internet servicesare functionally equivalent to conventional telecommunications services. Theincreasing growth of the voice over data network market and the popularity ofsupporting products and services, heighten the risk that national governmentswill seek to regulate the transmission of voice communications over networkssuch as the Internet. In addition, large telecommunications companies maydevote substantial lobbying efforts to influence the regulation of this marketso as to benefit their interests, which may be contrary to our interests. Theseregulations may include, for example, assessing access or settlement charges,imposing tariffs or imposing regulations based on encryption concerns or thecharacteristics and quality of products and services. In February 2004,the FCC found that an entirely Internet based voice over Internet protocolservice was an unregulated information service. At the same time, the FCC begana broader proceeding to examine what its role should be in this new environmentof increased consumer choice and what can be done to meet its role ofsafeguarding the public interest. Future laws, legal decisions or regulations,as well as changes in interpretations of existing laws and regulations, couldrequire us to expend significant resources to comply with them. In addition,these future events or changes may create uncertainty in our market that couldreduce demand for our products.

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**Item 1B. UnresolvedStaff Comments**

Not applicable.

**Item 2. Properties**

As of September 30,2006, our headquarters for corporate administration, research and development,manufacturing and sales and marketing occupied 32,000 square feet of space inFremont, California. The lease expires on February 21, 2009. Outside theUnited States, we lease approximately 9,400 square feet of a facility inShanghai, China, where we conduct administration, research and development,sales and marketing, and another 1,600 square feet of a facility in Beijing,China to serve sales and marketing functions. We believe that our existingfacilities are adequate for our needs through at least the end of year 2007.

**Item 3. LegalProceedings**

On September 6, 2002, Vertical Networks, Inc.filed suit against us in the United States District Court for the NorthernDistrict of California, alleging infringement of Vertical Networks’ U.S.Patents Nos. 6,266,341; 6,289,025; 6,292,482; 6,389,009; and 6,396,849. OnOctober 28, 2002, Vertical Networks amended its complaint to addallegations of infringement of U.S. Patents Nos. 5,617,418 and 5,687,174.Vertical Networks filed a second amended complaint on November 20, 2002 toidentify our products and/or activities that allegedly infringe the sevenpatents-in-suit. Vertical Networks seeks a judgment of patent infringement andan award of damages, including treble damages for alleged willful infringement,and attorneys’ fees and costs. We filed an answer and counterclaims fordeclaratory relief on December 9, 2002. On December 26, 2002,Vertical Networks filed its answer to our counterclaims. Vertical Networksserved its preliminary infringement contentions on us on April 9, 2003 andwe served Vertical Networks our preliminary invalidity contentions on June 3,2003 and July 14, 2003. To date, the parties have exchanged somediscovery, but no depositions have been taken, and no motions are currentlypending. We believe we have strong defenses and arguments in this dispute andintend to vigorously defend our position. Management’s view is that any lossfrom this litigation is currently not probable or estimable; therefore, theCompany has not established a reserve on its balance sheets as to any liabilityrelated to the outcome of this action.

From time to time, we maybecome party to litigation and subject to claims arising in the ordinary course of our business. To date,these actions have not had a material adverse effect on our financial position,result of operations or cash flows. Although the results of litigation andclaims cannot be predicted with certainty, we believe that the final outcome ofsuch matters would not have a material adverse effect on our business,financial position, results of operation and cash flows.

**Item 4. Submissionof Matters to a Vote of Security Holders**

None.

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**PART II**

**Item 5. Market forRegistrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.**

From October 4, 1999, the date of our initialpublic offering, to June 11, 2002, our common stock was traded on theNasdaq National Market under the symbol “ATGN”. Since June 12, 2002, ourcommon stock has traded on the Nasdaq Capital Market under the symbol “ATGN.”The following table sets forth the range of high and low sales prices for ourcommon stock for the periods indicated:

| ** **  | ** ** | **Fiscal 2006** | ** ** | **Fiscal 2005** | ** ** |
|-------------|------------|----------------------|------------|----------------------|------------|
| ** **  | ** ** | **High**             | ** ** | **Low**              | ** ** | **High** | ** ** | **Low** | ** ** |
| 1st Quarter |       | $                    | 2.05       |                 | $          | 1.45 |   | $ | 4.00 |   | $ | 2.40 |   |
| 2nd Quarter |       | $                    | 1.90       |                 | $          | 1.53 |   | $ | 4.05 |   | $ | 2.51 |   |
| 3rd Quarter |       | $                    | 1.98       |                 | $          | 1.35 |   | $ | 2.75 |   | $ | 1.59 |   |
| 4th Quarter |       | $                    | 1.57       |                 | $          | 1.37 |   | $ | 2.10 |   | $ | 1.54 |   |

 

As of September 30, 2006, we had approximately 93stockholders of record of our Common Stock. We have never declared or paid anycash dividends on our capital stock. We currently expect to retain futureearnings, if any, to support operations and to finance the growth anddevelopment of our business. We do not expect to pay cash dividends in theforeseeable future.

We received aggregate net proceeds of approximately$33.3 million from the initial public offering of shares of our commonstock in October 1999. As of September 30, 2006, proceeds from ourinitial public offering have been used for working capital and generalcorporate purposes, including research and development of new products, salesand marketing efforts, general and administrative expenses and internationalexpansion. The remaining net proceeds have been invested in cash, cashequivalents and short-term investments.

| **Plan category**                                       | ** ** | ** ** | ** ** | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights  (a)** | ** ** | **Weighted-average exercise  price of outstanding  options, warrants  and rights  (b)** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected  in column (a))**1  (c) | ** ** |
|--------------------------------------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders |       |       | 3,559,170  |                                                                                                                                                      |       |                                                                                                             | $          | 3.76                                                                                                                                                                                                               |       |   |   | 2,821,795 |   |   |
| Equity  compensation plans not approved by security holders  |       |       | —     |                                                                                                                                                      |       |                                                                                                             | —     |                                                                                                                                                                                                               |       |   | — |   |   |
| Total                                                        |       |       | 3,559,170  |                                                                                                                                                      |       |                                                                                                             | $          | 3.76                                                                                                                                                                                                               |       |   |   | 2,821,795 |   |   |

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(1)          Thenumber of shares reserved for issuance under the Company’s 1999 Stock OptionPlan will be increased on the first day of the Company’s fiscal year by anamount equal to the lesser of: (i) 1,796,783 shares; (ii) 5% of theCompany’s outstanding shares on that date; or (iii) such lesser amount asdetermined by the Board of Directors. The number of shares reserved forissuance under the Company’s 1999 Employee Stock Purchase Plan will beincreased on the first day of each fiscal year by an amount equal to the lesserof: (i) 598,928 shares; (ii) 2% of the outstanding shares on thatdate; or (iii) such lesser amount as determined by the Board of Directors.

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**Item 6. SelectedFinancial Data**

This section presentsselected historical financial data of AltiGen Communications, Inc. Thissection should be read carefully in conjunction with “Management’s Discussionand Analysis of Financial Conditions and Results of Operations” and theconsolidated financial statements included in this Form 10-K,including the notes to the consolidated financial statements. The selected datain this section is not intended to replace our consolidated financialstatements.

| ** **                                                                        | ** ** | **Fiscal Year Ended September 30,**            | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                        | ** ** | **(in thousands, except per share data)** | ** ** |
| Consolidated Statements  of Operations Data:                                      |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Revenue, net                                                                      |       | $                                                                  | 17,896     |   | $ | 15,441 |   | $ | 14,842 |   | $ | 11,824 |   | $ | 9,896 |   | $ | 9,632 |   |
| Cost of revenue                                                                   |       | 8,082                                                              |       | 6,592 |   | 5,607 |   | 4,978 |   | 4,571 |   | 7,346 |   |
| Gross profit                                                                      |       | 9,814                                                              |       | 8,849 |   | 9,235 |   | 6,846 |   | 5,325 |   | 2,286 |   |
| Operating expenses:                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Research and  development                                                         |       | 3,740                                                              |       | 3,496 |   | 3,288 |   | 3,990 |   | 4,071 |   | 4,847 |   |
| Sales and  marketing                                                              |       | 4,353                                                              |       | 3,943 |   | 4,130 |   | 4,648 |   | 5,857 |   | 9,738 |   |
| General and  administrative                                                       |       | 2,058                                                              |       | 1,946 |   | 1,894 |   | 1,943 |   | 2,217 |   | 2,820 |   |
| Amortization of  deferred stock compensation                                      |       | —                                                             |       | — |   | — |   | 55 |   | 338 |   | 793 |   |
| Total operating  expenses                                                         |       | 10,151                                                             |       | 9,385 |   | 9,312 |   | 10,636 |   | 12,483 |   | 18,198 |   |
| Loss from  operations                                                             |       | (337                                                               | )          | (536 | ) | (77 | ) | (3,790 | ) | (7,158 | ) | (15,912 | ) |
| Equity in net  loss of investee                                                   |       | (36                                                                | )          | (12 | ) | — |   | — |   | — |   | — |   |
| Write-down of  long term investment                                               |       | —                                                             |       | — |   | — |   | — |   | (203 | ) | — |   |
| Interest and  other income, net                                                   |       | 380                                                                |       | 237 |   | 105 |   | 241 |   | 284 |   | 1,222 |   |
| Net income (loss)  before tax                                                     |       | 7                                                                  |       | (311 | ) | 28 |   | (3,549 | ) | (7,077 | ) | (14,690 | ) |
| Income taxes                                                                      |       | 19                                                                 |       | — |   | — |   | — |   | — |   | — |   |
| Net income (loss)                                                                 |       | $                                                                  | (12        | ) | $ | (311 | ) | $ | 28 |   | $ | (3,549 | ) | $ | (7,077 | ) | $ | (14,690 | ) |
| Basic and diluted net income (loss) per share                                |       | $                                                                  | (0.00      | ) | $ | (0.02 | ) | $ | 0.00 |   | $ | (0.26 | ) | $ | (0.53 | ) | $ | (1.07 | ) |
| Weighted average shares used in computing basic net  income (loss) per share |       | 14,964                                                             |       | 14,605 |   | 14,242 |   | 13,643 |   | 13,371 |   | 13,666 |   |
| Weighted average shares used in computing diluted  net income (loss) per share    |       | 14,964                                                             |       | 14,605 |   | 15,725 |   | 13,643 |   | 13,371 |   | 13,666 |   |
| Consolidated  Balance Sheets Data:                                                |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and short-term investments                                |       | $                                                                  | 9,922      |   | $ | 9,422 |   | $ | 10,034 |   | $ | 10,146 |   | $ | 12,148 |   | $ | 17,528 |   |
| Working capital                                                                   |       | 11,027                                                             |       | 10,133 |   | 10,314 |   | 9,850 |   | 12,488 |   | 19,234 |   |
| Total assets                                                                      |       | 14,644                                                             |       | 13,335 |   | 13,516 |   | 13,210 |   | 16,506 |   | 23,861 |   |
| Accumulated deficit                                                               |       | (51,158                                                            | )          | (51,146 | ) | (50,835 | ) | (50,863 | ) | (47,314 | ) | (40,237 | ) |
| Total stockholders’  equity                                                  |       | 11,837                                                             |       | 10,718 |   | 10,669 |   | 10,290 |   | 13,371 |   | 20,810 |   |

 

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**Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

**FORWARD-LOOKINGINFORMATION**

This report contains certain forward-lookingstatements (within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended) and information relating to us that are based on the beliefs of ourmanagement as well as assumptions made by and information currently availableto our management. Additional forward-looking statements may be identified bythe words “anticipate,” “believe,” “expect,” “intend,” “plan,” or the negativeof such terms, or similar expressions, as they relate to us or our management.

The forward-lookingstatements contained herein reflect our judgment as of the date of this reportwith respect to future events, the outcome of which is subject to certainrisks, that may have a significant impact on our business, operating results orfinancial condition. You are cautioned that these forward-lookingstatements are inherently uncertain. Should one or more of these risks oruncertainties materialize, or should underlying assumptions prove incorrect,actual results or outcomes may vary materially from those described herein.Although we believe that the expectations reflected in these forward-lookingstatements are reasonable, we cannot guarantee future results, levels ofactivity, performance or achievements. You should carefully review thecautionary statements contained in this Form 10-K, including the “CertainFactors Affecting Business, Operating Results and Financial Condition” below.

**OVERVIEW**

We are a market leader in Internet protocol telephonysystems for small-to-medium sized businesses. We design, manufacture and marketnext generation, Internet protocol phone systems and contact centers that useboth the Internet and the public telephone network to take advantage of theconvergence of voice and data communications. Unlike traditional proprietary phonesystems, our systems are designed with open architecture and are built on anindustry standard platform. This adherence to industry standards allows ourproducts to play an important role in the small-to-medium sized business marketby delivering phone systems that can integrate with other technologies andprovide integrated voice and data solutions. We believe this enables ourcustomers to implement communication systems that have an increased return oninvestment versus past technology investments. We generated net revenue of$17.9 million, for a net loss of $12,000, during fiscal year 2006. As of September 30,2006, we had an accumulated deficit of $51.2 million. Net cash provided byoperating activities was $570,000 for fiscal year 2006.

We derive our revenue from sales of our AltiServTMtelephone systems. Product revenue consist of sales to end-users (includingdealers) and to distributors. Revenue from product sales to end users andresellers are recognized upon shipment. We defer recognition of revenue for salesto distributors until they resell our products to their customers. Uponshipment, we also provide a reserve for the estimated cost that may be incurredfor product warranty. Under our distribution contracts, a distributor has theright, in certain circumstances, to return products it determines areoverstocked, so long as it provides an offsetting purchase order for productsin an amount equal to or greater than the dollar value of the returnedproducts. In addition, we provide distributors protection from subsequent pricereductions.

Our cost of revenue consists of component and materialcosts, direct labor costs, provisions for excess and obsolete inventory,warranty costs and overhead related to the manufacturing of our products.Several factors that have affected and will continue to affect our revenuegrowth are the state of economy, the market acceptance of our products, ourability to add new resellers and our ability to design, develop, and releasenew products. We engage third-party assemblers, which in fiscal year 2006were All Quality Services and Bestronics in San Jose, to insert the hardwarecomponents into the printed circuit board. We selected our manufacturingpartners with the goals of ensuring a reliable supply of high-quality finishedproducts and lowering per unit product costs as a result of manufacturingeconomies of scale. We cannot 

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assure you that we willmaintain the volumes required to realize these economies of scale or when or ifsuch cost reductions will occur. The failure to obtain such cost reductionscould materially adversely affect our gross margins and operating results.

As of September 30, 2006, we had net operatingloss carryforwards for federal income tax purposes of approximately$40.7 million that expire at various dates through 2025, and federalresearch and development tax credits of approximately $520,000 that expire atvarious dates through 2025. We also had net operating loss carryforwards forstate income tax purposes of approximately $13.8 million that expire at variousdates through 2015, and state research and development tax credits ofapproximately $565,000 which do not have an expiration date and may be carriedforward indefinitely. Under current tax law, net operating loss carry forwardsavailable for use in any given year may be limited upon the occurrence ofcertain events, including changes of ownership interest. We have not recognizedany future tax benefits of our cumulative net operating losses due touncertainty as to future realization.

We continue to focus oncreating and developing new product offerings and enhancements to our currentproducts to provide greater functionality and increased capabilities, based onour market research, customer feedback and our competitors’ product offerings.In particular, we focus on (i) developing products that allow us toenhance our position in our target market segment and (ii) entering newgeographical markets. Additionally, we intend to continue to focus on sellingour products to small-to-medium sized businesses, multi-site businesses,corporate branch offices, call centers, credit unions and community banks.Also, we plan to continue to recruit additional resellers and distributors thatfocus on selling phone systems to our target customers. We believe that theadoption rate for this Internet telephony is much faster with small-to-mediumsized businesses because they have no significant investment on their books fortraditional phone systems. Also we believe that small-to-medium sizedbusinesses are looking for call center-type administration to increase theproductivity and efficiency of their contacts with customers. Assuming thatcurrent market trends, including the continuing acceptance of the call centerproducts, continuing growth in the marketplaces of Asia, Latin America,Caribbean, and the status quo of the North American economy continues and thatwe are successful in enhancing our products, we expect to see continued revenuegrowth for fiscal year 2007.

**CRITICAL ACCOUNTINGPOLICIES**

*Revenuerecognition.**  *Revenueconsist of sales to end users, including resellers, and to distributors.Revenue from sales to end users are recognized upon shipment, when risk of losshas passed to the customer, collection of the receivable is reasonably assured,persuasive evidence of an arrangement exists, and the price is fixed anddeterminable. Sales to distributors are made under terms allowing certainrights of return and protection against subsequent price declines on ourproducts held by its distributors. Upon termination, any unsold products may bereturned by the distributor for a full refund. These agreements may be canceledby either party based on a specified notice. As a result of the aboveprovisions, we defer recognition of distributor revenue until such distributorsresell our products to their customers. The amounts deferred as a result ofthis policy are reflected as “deferred revenue” in the accompanyingconsolidated balance sheets. The related cost of revenue is also deferred andreported in the consolidated balance sheets as inventory. Our total deferredrevenue was $531,000 and $507,000 as of September 30, 2006 and September 30,2005, respectively.

*Allowancefor Doubtful Accounts.**  *Theallowance for doubtful accounts is based on our assessment of thecollectibility of specific customer accounts and the aging of the accountsreceivable. If there were a deterioration of a major customer’screditworthiness, or actual defaults were higher than our historicalexperience, we could be required to increase our allowance and our earningscould be adversely affected. Our allowance for doubtful accounts was $38,000and $40,000 as of September 30, 2006 and September 30, 2005,respectively.

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*Inventory.**  *Inventory is stated at the lower ofcost (first-in, first-out method) or market. Our inventory balance was $1.4million and $965,000 as of September 30, 2006 and September 30, 2005,respectively. We regularly review the value of our inventory in detail, withconsideration given to future customer demand for our products, obsolescencefrom rapidly changing technology, and other factors. If actual marketconditions are less favorable than those projected by management, and ourestimates prove to be inaccurate, we could be required to increase ourinventory provision and our gross margins could be adversely affected. As of December 2001,AltiGen had established a reserve to write off $3.5 million of excess inventorywhich management believed would not be sold. During 2002 through 2006, AltiGenreversed a portion of the reserve related to inventory which was sold. Theamount of such reversals were $301,000, $167,000 and $293,000 in fiscal yearsending 2006, 2005 and 2004, respectively.

*Warranty.**  *We accrue for warranty costs basedon estimated product return rates and the expected material and labor costs toprovide warranty services. If actual return rates and repair and replacementcosts differ significantly from our estimates, our gross margin could be adverselyaffected. The liability for product warranties was $263,000 and $264,000 as of September 30,2006 and September 30, 2005, respectively.

**Results ofOperations**

Thefollowing table sets forth consolidated statements of operations data for theperiods indicated as a percentage of net revenue.

| ** **                                   | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Consolidated Statements  of Operations Data: |       |                                                |       |   |   |   |   |
| Net revenue:                                 |       |                                                |       |   |   |   |   |
| Hardware                                     |       | 92.1                                                | %          | 86.5 | % | 84.0 | % |
| Software                                     |       | 7.9                                                 |       | 13.5 |   | 16.0 |   |
| Total net revenue                            |       | 100.0                                               |       | 100.0 |   | 100.0 |   |
| Cost of revenue:                             |       |                                                |       |   |   |   |   |
| Hardware                                     |       | 44.6                                                |       | 41.7 |   | 36.5 |   |
| Software                                     |       | 0.6                                                 |       | 1.0 |   | 1.3 |   |
| Total cost of revenue                        |       | 45.2                                                |       | 42.7 |   | 37.8 |   |
| Gross profit                                 |       | 54.8                                                |       | 57.3 |   | 62.2 |   |
| Operating  expenses:                         |       |                                                |       |   |   |   |   |
| Research and development                     |       | 20.9                                                |       | 22.6 |   | 22.2 |   |
| Sales and marketing                          |       | 24.3                                                |       | 25.5 |   | 27.8 |   |
| General and administrative                   |       | 11.5                                                |       | 12.6 |   | 12.8 |   |
| Total operating expenses                     |       | 56.7                                                |       | 60.7 |   | 62.8 |   |
| Income (loss) from operations                |       | (1.9                                                | )          | (3.4 | ) | (0.6 | ) |
| Equity in net  loss of investee              |       | (0.2                                                | )          | (0.1 | ) | — |   |
| Interest and  other income, net              |       | 2.1                                                 |       | 1.5 |   | 0.7 |   |
| Net income (loss)  before taxes              |       | —                                              |       | (2.0 | ) | 0.01 |   |
| Provision for income taxes                   |       | 0.1                                                 |       | — |   | — |   |
| Net income (loss)                            |       | (0.1                                                | )%         | (2.0 | )% | 0.1 | % |

 

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**Fiscal Year Ended September 30,2006 Compared to Fiscal Year Ended September 30, 2005**

**Revenue,net.****  **Revenueconsist of sales to end users (including resellers) and distributors.

Internationalis comprised of revenue primarily from China, the United Kingdom and Norway.Most significant long-lived assets are located in the United States. Ourhardware tooling used to develop the IP710 and the IP705 phones is located inTaiwan.

| ** **    | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Americas      |       |                                                | 90         | % |   |   | 90 | % |   |
| International |       |                                                | 10         | % |   |   | 10 | % |   |
|          |       |                                                | 100        | % |   |   | 100 | % |   |

 

Netrevenue by customers that individually accounted for more than 10% of ourrevenue for the twelve months ended September 30, 2006 and 2005,respectively, were as follows:

| ** **    | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **   2006   **        | ** ** | **   2005   ** | ** ** |
| AltiSys       |       |                                                | 15         | % |   |   | 16 | % |   |
| Ingram Micro* |       |                                                | —     |   |   |   | 2 | % |   |
| Synnex        |       |                                                | 55         | % |   |   | 53 | % |   |
| Graybar       |       |                                                | 14         | % |   |   | 11 | % |   |

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*                    On July 20,2005, we terminated our distribution agreement with Ingram Micro. Thetermination of our relationship with Ingram Micro did not have a materialimpact on our business.

For fiscal year ended September 30, 2006, weincurred a net loss of $12,000 as compared to a net loss of $311,000 for fiscalyear ended September 30, 2005. During the current fiscal year ended September 30,2006, we recognized $801,000 of non-cash stock based-compensation due to theadoption of SFAS No. 123(R). This standard was adopted on October 1,2005.

Net revenue increased 16% from $15.4 million infiscal year 2005 to $17.9 million in fiscal year 2006 primarily due tohigher sales of telephone systems in the Americas. Revenue generated in theAmericas accounted for $16.1 million or 90% of revenue in fiscal year 2006 and$13.9 million or 90% of revenue in fiscal year 2005. The number of systemshipped in fiscal year 2006 grew 22% over fiscal year 2005 as a result ofincreased customer acceptance of our new pricing and packaging strategy ofbundling the AltiView software, which offers more features than other productson the market, the penetration of our AltiContact Manager (ACM) in the callcenter market and the introduction of our internet protocol phones, the IP710and IP705 to the market.

**Costof revenue.****  **Costof revenue in fiscal year 2006 increased $1.5 million or 23% to $8.1 millionfrom approximately $6.6 million in fiscal year 2005 primarily due to anincrease in overall sales of products and the requisite increase in productcosts. Cost of revenue as a percentage of net revenue increased from 43% infiscal year 2005 to 45% in fiscal year 2006. This increase was primarily causedby a lower profit margin as a result of a price deduction on our smallertelephone system bundles in the second quarter of fiscal year 2005.

**Researchand development expenses.****  **Research and development expenses consist principallyof salaries and related personnel expenses, consultant fees and prototypeexpenses related to the design, development and testing of our products andenhancement of our converged telephone system software. Research anddevelopment expenses increased by approximately $244,000 or 7% from$3.5 million in fiscal 

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year 2005 to$3.7 million in fiscal year 2006. Research and development expenses as apercentage of revenue decreased from 23% in fiscal year 2005 to 21% in fiscalyear 2006. The increase in research and development expenses in absolutedollars was primarily attributable to a $279,000 increase of non-cash stockbased compensation recorded due to the adoption of SFAS No. 123(R) anda decrease of approximately $36,000 in legal expenses. We believe that research and developmentexpenses will increase in the future periods over the long term due todevelopment of new products and continued efforts in the improvement of thecurrent products. In the short term, we expect research and developmentexpenses to remain consistent as management continues to monitor expenses andplans to keep them in line with expected revenue opportunities.

**Salesand marketing expenses.****  **Sales and marketing expenses consist primarily ofsalaries, commissions and related expenses for personnel engaged in marketing,sales and customer support functions, as well as trade shows, advertising, andpromotional expenses. Sales and marketing expenses increased by approximately$410,000 or 10% from $3.9 million in fiscal year 2005 to $4.3 millionin fiscal year 2006. Sales and marketing expenses as a percentage of revenuedecreased from 26% in fiscal year 2005 to 24% in fiscal year 2006. This increase in absolute dollars was due to a$216,000 increase of non-cash stock-based compensation recorded due to theadoption of SFAS No. 123(R); an increase of approximately $42,000 inadvertising; headcount-related costs also increased by approximately $48,000 aswell as market development funds of approximately $108,000. We anticipate salesand marketing expenses to remain consistent; however, some expenses vary withrevenue, such as commissions. If we are successful in enhancing our products,we expect to see continued revenue growth for fiscal year 2007 and,consequently, expect an increase in sales and marketing expenses.

**Generaland administrative expenses.****  **General and administrative expenses consist of salariesand related expenses for (i) executive, finance, human resources andadministrative personnel, (ii) facilities, (iii) allowance fordoubtful accounts, (iv) legal, and (v) other general corporate expenses.General and administrative expenses increased by approximately $112,000 or 6%from $1.9 million in fiscal year 2005 to $2.0 million in fiscal year 2006.General and administrative expenses as a percentage of revenue decreased from13% in fiscal year 2005 to 12% in fiscal year 2006. The increase in absolutedollars was mainly the result of a $270,000 non-cash stock-based compensationexpense required by SFAS No. 123(R), and a reduction in insurance expensesof approximately $168,000. We expect general and administrative to increase dueto the cost associated with compliance with Section 404 of Sarbanes OxleyAct during fiscal year 2007.

**Equityinvestment in common stock of private company.****  **In July 2004, we purchased commonstock of a private Korean telecommunications company for $79,000. As a resultof this investment, we acquired approximately 23% of the voting power of thecompany and have the right to nominate and have elected one of the threemembers of the company’s current board of directors. We are accounting for thisinvestment using the equity method. We had revenue from product sales to thiscompany of $14,000 and $37,000 during fiscal years 2006 and 2005, respectively.Our accounts receivable from this company decreased to $30,000 in fiscal year2006 from $40,000 in fiscal year 2005. Thecompany has a 23% vested interest in AliGen Korea. The total equity innet losses of Korea investee was approximately $160,000 of which 23%, or$36,000 was recognized in fiscal 2006. In fiscal year 2005 equity in net lossesof Korea invetee was approximately $52,000 of which 23% or $12,000 wasrecognized in the fourth quarter of fiscal year 2005.

**Interest and other income,net.****  **Net interest andother income increased to $380,000 in fiscal year 2006 from $237,000 in fiscalyear 2005. The increase in netinterest and other income was primarily a result of higher interest rates oninvestments. We expect net interest andother income to remain relatively flat as we have limited cash reserves toinvest.

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**Fiscal Year Ended September 30,2005 Compared to Fiscal Year Ended September 30, 2004**

**Revenue,net.****  **Revenueconsist of sales to end users (including resellers) and distributors.

Net Revenueby Products:

| ** ** | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|------------|------------|-----------------------------------------------------|------------|
| ** ** | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| Hardware   |       |                                                | 86         | % |   |   | 84 | % |   |
| Software   |       |                                                | 14         | % |   |   | 16 | % |   |
|       |       |                                                | 100        | % |   |   | 100 | % |   |

 

NetRevenue by Geographic Area:

| ** **    | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| Americas      |       |                                                | 90         | % |   |   | 90 | % |   |
| International |       |                                                | 10         | % |   |   | 10 | % |   |
|          |       |                                                | 100        | % |   |   | 100 | % |   |

 

NetRevenue by Customers:

| ** **   | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|--------------|------------|-----------------------------------------------------|------------|
| ** **   | ** ** | **   2005   **        | ** ** | **   2004   ** | ** ** |
| AltiSys      |       |                                                | 16         | % |   |   | 14 | % |   |
| Ingram Micro |       |                                                | 2          | % |   |   | 14 | % |   |
| Synnex       |       |                                                | 53         | % |   |   | 46 | % |   |
| Graybar      |       |                                                | 11         | % |   |   | 8 | % |   |

 

Revenue generated in the Americas accounted for$13.9 million or 90% of revenue in fiscal year 2005 and $13.3 millionor 90% of revenue in fiscal year 2004. The number of system shipped in fiscalyear 2005 grew 20% over fiscal year 2004 as a result of increased customer acceptanceof our new pricing and packaging strategy for our product bundling by includingAltiView software, which offers more features than other products on themarket, the penetration of our AltiContact Manager (ACM) in the call centermarket and the introduction of our internet protocol phone IP710 to the market.However, net revenue only increased 4% from $14.8 million in fiscal year2004 to $15.4 million in fiscal year 2005 primarily due to price reductionon our low-end product bundles in the second quarter of fiscal year 2005.

**Costof revenue.****  **Costof revenue in fiscal year 2005 increased $985,000 or 18% to $6.6 millionfrom approximately $5.6 million in fiscal year 2004 primarily due to anincrease in overall sales of products and the requisite increase in productcosts. Cost of revenue as a percentage of net revenue increased from 38% infiscal year 2004 to 43% in fiscal year 2005. This increase primarily was causedby a lower profit margin as a result of a price deduction on our low-endproduct bundles in the second quarter of fiscal year 2005. No additionalprovision for excess or obsolete inventory was necessary in either fiscal year2005 and 2004.

**Researchand development expenses.****  **Research and development expenses consist principallyof salaries and related personnel expenses, consultant fees and prototypeexpenses related to the design, development and testing of our products andenhancement of our converged telephone system software. Research anddevelopment expenses increased by approximately $208,000 or 6% from$3.3 million in fiscal year 2004 to $3.5 million in fiscal year 2005.Research and development expenses as a percentage of revenue increased from 22%in fiscal year 2004 to 23% in fiscal year 2005. The increase in research and 

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development expenses inabsolute dollars was primarily a result of increases in headcount-relatedcosts of $108,000 resulting from an increase in salary and compensation of ourengineers; an increase in equipment expenses of $30,000; and an increase inresearch and development expenses related to the design of our internetprotocol phone (IP710) of $67,000.

**Salesand marketing expenses.****  **Sales and marketing expenses consist primarily ofsalaries, commissions and related expenses for personnel engaged in marketing,sales and customer support functions, as well as trade shows, advertising, andpromotional expenses. Sales and marketing expenses decreased by approximately$187,000 or 5% from $4.1 million in fiscal year 2004 to $3.9 millionin fiscal year 2005. Sales and marketing expenses as a percentage of revenuedecreased from 28% in fiscal year 2004 to 26% in fiscal year 2005. The decreasein absolute dollars was primarily a result of a decrease in service fee andconsulting expenses of $39,000, a decrease in trade show expense of $45,000, adecrease in relocation expense of $40,000 and a decrease in depreciation andamortization costs of $55,000.

**Generaland administrative expenses.****  **General and administrative expenses consist of salariesand related expenses for executive, finance and administrative personnel,facilities, bad debt, legal, and other general corporate expenses. General andadministrative expenses remained unchanged at $1.9 million for fiscal years2004 and 2005. General and administrative expenses as a percentage of revenueremained unchanged at 13% for fiscal years 2004 and 2005.

**Equityinvestment in common stock of private company.****  **In July 2004,we purchased common stock of a private Korean telecommunications company for $79,000.As a result of this investment, we acquired approximately 23% of the votingpower of the company and have the right to nominate and have elected one of thethree members of the company’s current board of directors. We are accountingfor this investment using the equity method. We had revenue from product salesto this company of $37,000 in fiscal 2005. Our accounts receivable from thiscompany was $40,000 at September 30, 2005. The company has a 23% vested interest in AliGen Korea. The totalequity in net losses of Korea investee was approximately $52,000 of which 23%,or $12,000, was recognized in the fourth quarter of fiscal year 2005.

**Interest and other income,net.****  **Netinterest and other income increased to $237,000 in fiscal year 2005 from$105,000 in fiscal year 2004. The increase was primarily due to an increase ininterest rates.

**Liquidity andCapital Resources**

Sinceinception, we have financed our operations primarily through the sale of equitysecurities. As of September 30, 2006, we had cash and short-terminvestments totaling $9.9 million consisting of cash and cash equivalentsof $5.0 million with a maturity of less than 90 days and $4.8 millionof short-term investment with a maturity of greater than 90 days.

| ** **                                               | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                                               | ** ** | **(dollars in thousands)** | ** ** |
| Cash and cash  equivalents                               |       | $                                    | 5,053      |     | $          | 3,963    |       | $ | 2,898 |   |
| Short-term  investments                                  |       | 4,869                                |       | 5,459    |       | 7,136    |       |
| Total cash, cash equivalents and short-term  investments |       | $                                    | 9,922      |     | $          | 9,422    |       | $ | 10,034 |   |
| Cash provided by (used in) operating activities          |       | $                                    | 570        |     | $          | (509     | )          | $ | (185 | ) |
| Cash provided by  (used in) investing activities         |       | $                                    | 191        |     | $          | 1,215    |       | $ | (5,818 | ) |
| Cash provided by  financing activities                   |       | $                                    | 329        |     | $          | 359      |       | $ | 353 |   |
| Net increase  (decrease) in cash and cash equivalents    |       | $                                    | 1,090      |     | $          | 1,065    |       | $ | (5,650 | ) |

 

*Changes in CashFlows*

During fiscal year 2006, net cash provided byoperating activities was $570,000, a $1.1 million increase over our reportedresults for fiscal year 2005. This was primarily due to a lower net loss of$12,000, an 

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increase in non-cash stockbased compensation expense of $801,000, $219,000 increase in depreciation andamortization as well as  an increase inaccounts payables of $184,000. These factors were partially offset by anincrease in accounts receivable of approximately $273,000, and increase in netinventories of $417,000. Theincrease in non-cash based compensation expense is the result of our adoptionof SFAS No. 123(R) starting on October 1, 2005. The net cashused in operating activities of $509,000 for the fiscal year 2005 was primarilydue to a net loss of $311,000. In fiscal year 2005, our use of cash fornon-operating activities was primarily attributable to the $207,000 of capitalspending for internet protocol phone (IP710) tooling development and $271,000of capital spending on equipment additions to support our operations.

Net accounts receivable increased to $2.3 million at September 30,2006 from $1.9 million for the fiscal year ended September 30, 2005. Theincrease in accounts receivable was primarily due to increases in sales of ourproducts. As we continue to focus on developing products that allow us toenhance our position in our target market segment and enter new markets, weexpect to see continued revenue growth for fiscal year 2007, and that growthwill be reflected in our accounts receivable.

We ended the fourth quarter of fiscal year 2006 with acash conversion cycle of 69 days as compared to 58 days for the fourth quarterof fiscal 2005. The cash conversion cycle is the duration between purchase ofinventories and services and the collection of the cash from the sale of ourproducts and services and is a metric on which we have focused as we continueto try to efficiently manage our assets. The cash conversion cycle results fromthe calculation of days of sales outstanding (DSO) added to days of supply ininventories (DOS), reduced by days of payable outstanding (DPO).

Inventories increased to $1.4 million at September 30,2006 from $965,000 at September 30, 2005 and our annualized inventory turnrate decreased to 5.9 as of September 30, 2006 as compared to 6.8 times asof September 30, 2005. Our annualized inventory turn rate represents thenumber of times inventory is replenished during the year. The increase ininventory is the result of higher finished goods and raw material. Inventorymanagement will continue to be an area of focus as we balance the need tomaintain strategic inventory levels to help ensure competitive lead times withthe risk of inventory obsolescence due to rapidly changing technology andcustomer requirements.

Accounts payable increased to $837,000 at September 30,2006 from $653,000 at September 30, 2005. This increase was primarilyattributable to an increase in the number of components purchased at the end offiscal year 2006 as compared to fiscal year 2005. Our accrued payroll-relatedliabilities increased to $328,000 at September 30, 2006 from $317,000 at September 30,2005, primarily as a result of an increase of $24,000 in accrued commission, adecrease of $10,000 in accrued vacation and a decrease  in the employee stock purchase plancontribution.

In fiscal year 2006, ournet cash provided by financing activities was primarily attributable to the$329,000 of proceeds from the exercise of employee stock options and employeestock purchase plan.

*Liquidity andCapital Resources*

We intend to invest our cash in excess of currentoperating requirements in short-term, interest bearing investment-grade securities.

Our cash needs depend on numerous factors, includingmarket acceptance of and demand for our products, our ability to develop andintroduce new products and enhancements to existing products, the prices atwhich we can sell our products, the resources we devote to developing,marketing, selling and supporting our products, the timing and expenseassociated with expanding our distribution channels, increases in manufacturingcosts and the prices of the components we purchase, as well as other factors.If we are unable to raise additional capital or if sales from our new productsor enhancements are lower than expected, we will be required to make additionalreductions in operating expenses and capital expenditures to ensure that wewill have adequate cash reserves to fund operations.

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Additional financing, if required, may not beavailable on acceptable terms, or at all. We also may require additionalcapital to acquire or invest in complementary businesses or products, or obtainthe right to use complementary technologies. If we cannot raise needed funds inthe future  if needed, on acceptableterms, we may not be able to further develop or enhance our products, takeadvantage of  opportunities, or respondto competitive pressures or unanticipated requirements, which could seriouslyharm our business. Even if additional financing is available, we may berequired to obtain the consent of our stockholders, which we may or may not beable to obtain. In addition, the issuance of equity or equity-related securitieswill dilute the ownership interest of our stockholders and the issuance of debtsecurities could increase the risk or perceived risk of investing in oursecurities.

We donot have any material commitments for capital expenditures as of September 30,2006. We have a commitment under our noncancellable capital and operating leasein the amount of $1.0 million as of September 30, 2006. We believe,we have sufficient cash reserves to allow us to continue operations for morethan a year. Our cash and short-term investments totaled $9.9 million asof September 30, 2006. The following table represents our futurecommitments as of September 30, 2006 (in thousands):

| ** **                       | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
| Operating leases  obligation     |       | $                                         | 824        |   |   | $ | 446 |   |   |   | $ | 378 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Capital leases  obligation       |       | 177                                       |       |   | 53 |   |   |   | 91 |   |   |   | 33 |   |   |   | — |   |   |
| Total                            |       | $                                         | 1,001      |   |   | $ | 499 |   |   |   | $ | 469 |   |   |   | $ | 33 |   |   |   | $ | — |   |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Recent AccountingPronouncements*

In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”)which replaces Accounting Principles Board Opinions No. 20 “AccountingChanges” and SFAS No. 3, “Reporting Accounting Changes in InterimFinancial Statements—An Amendment of APB Opinion No. 28.” SFAS 154provides guidance on the accounting for and reporting of accounting changes anderror corrections. It establishes retrospective application, or the latestpracticable date, as the required method for reporting a change in accountingprinciple and the reporting of a correction of an error. SFAS 154 iseffective for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005 is required to be adopted by us in thefirst quarter of fiscal year 2007. We are currently evaluating the effect thatthe adoption of SFAS 154 will have on our consolidated results ofoperations and financial condition but do not expect it to have a materialimpact.

**Item 7A.Quantitative and Qualitative Disclosures About Market Risk.**

At September 30, 2006, our investment portfolioconsisted primarily of fixed income securities. These securities are subject tointerest rate risk and will decline in value if market interest rates increase.Due to the short duration and conservative nature of these instruments, we donot believe that we have a material exposure to interest rate risk. Forexample, if market interest rates were to increase immediately and uniformly by10% from levels as of September 30, 2006, the decline in the fair value ofthe portfolio would not have a material effect on our results of operationsover the next fiscal year.

*InterestRate Risk.**  *Ourinterest income is sensitive to changes in the general level of U.S. interestrates, particularly since the majority of our investments are in cashequivalents and short-term instruments. Due to the short-term nature of ourcash equivalents and investments, we have concluded that a change in interestrates does not pose a material market risk to us.

*Foreign Currency ExchangeRisk.**  *We faceforeign exchange currency fluctuations with our subsidiary in China, however,due to the strength in China’s economy, we do not foresee foreign exchangecurrency fluctuations to pose a material market risk to us.

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**Item 8. FinancialStatements and Supplementary Data.**

The financial statementsrequired by this item are incorporated by reference from Part IV Item 15(a) 1and 2 hereof. The selected quarterly supplementary data is included as part ofItem 7, “Management’s Discussion and Analysis of Financial Condition andResults of Operations.”

**1.**                 INDEXTO CONSOLIDATED FINANCIAL STATEMENTS

Thefollowing Consolidated Financial Statements are filed as part of this report:

|                                                                                                                                             | ** ** | **Page** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Report of Independent Registered Public Accounting  Firm                                                                                    |       |     | 40         |   |   |
| Consolidated Balance Sheets as of September 30,  2006 and 2005                                                                         |       |     | 42         |   |   |
| Consolidated Statements of Operations for the years  ended September 30, 2006, 2005 and 2004                                           |       |     | 43         |   |   |
| Consolidated Statements of Stockholders’ Equity and  Comprehensive Income for the years ended September 30, 2006, 2005, and  2004 |       |     | 44         |   |   |
| Consolidated Statements of Cash Flows for the years  ended September 30, 2006, 2005, and 2004                                          |       |     | 45         |   |   |
| Notes to Consolidated Financial Statements                                                                                                  |       |     | 46         |   |   |
| Quarterly Financial Information                                                                                                             |       |     | 59         |   |   |

 

**2.**                 INDEXTO FINANCIAL STATEMENT SCHEDULE

The following financial statement schedule issubmitted herewith:

|                                               | ** ** | **Page** | ** ** |
|-----------------------------------------------|------------|----------|------------|
| Schedule II Valuation and Qualifying Accounts |       |     | 60         |   |   |
|                                               |            |          |            |  |  |

 

**Item 9. Changes inand Disagreements With Accountants on Accounting and Financial Disclosure**

None

**Item 9A. Controlsand Procedures**

*(a) Evaluation of disclosure controls and procedures.*   Ourmanagement evaluated, with the participation of our Chief Executive Officer andour Chief Financial Officer, the effectiveness of our disclosure controls andprocedures as of the end of the period covered by this Quarterly Report on Form 10-Q.Based on this evaluation, our Chief Executive Officer and our Chief FinancialOfficer have concluded that our disclosure controls and procedures areeffective to ensure that information we are required to disclose in reportsthat we file or submit under the Securities Exchange Act of 1934 is accumulatedand communicated to our management including our principal executive andprincipal financial officers, as appropriate, to allow timely decisionsregarding disclosure and that such information is  recorded, processed, summarized and reportedwithin the time periods specified in Securities and Exchange Commission rules andforms.

*(b)  Changes ininternal control over financial reporting.*   Therewas no change in our internal control over financial reporting that occurredduring the period covered by this Quarterly Report on Form 10-Q thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

**Item 9B. OtherInformation**

None.

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**PART III**

**Item 10. Directorsand Executive Officers of the Registrant**

The information required by this section with respectto our directors is incorporated by reference from the information in thesection entitled: “Election of Directors” in the Company’s definitive ProxyStatement for the Annual Meeting of Stockholders to be held on March 5,2007 (the “Proxy Statement”). The information required by this section withrespect to our executive officers is included in Part I of this Form 10-Kunder the section titled “Executive Officers of the Registrant.”

The information required by this section with respectto any known late filing or failure by an insider to file a reportrequired by Section 16 of the Exchange Act is incorporated by referencefrom the information in the section titled “Section 16(a) BeneficialOwnership Reporting Compliance” in our Proxy Statement.

Our board of directors adopted a Code of Conduct forall of directors, officers and employees on July 26, 2004. Our Code ofConduct is posted on our website at *http://www.altigen.com/company_investors-conduct.html*.We intend to disclose any amendment to, or waivers of, the provisions of ourCode of Conduct that apply specifically to our Chief Executive Officer, ChiefFinancial Officer, Controller or persons performing similar functions byposting such information on our website.

A copy of our Code of Conduct is also available uponwritten request and without charge to any stockholder by writing to: Secretary,AltiGen Communications, Inc., 4555 Cushing Parkway, Fremont, CA 94538.

The following table sets forth certain informationwith regard to our executive officers and their ages as of September 30,2006:

 

| **Name**              | ** ** | ** ** | ** ** | **Age**                                       | ** ** | **Position** |
|-----------------------|------------|------------|------------|-----------------------------------------------|------------|--------------|
| Gilbert Hu            |       | 49         |       | President, Chief  Executive Officer, Director |
| Philip M. McDermott   |       | 60         |       | Chief Financial  Officer                      |
| Michael Plumer        |       | 42         |       | Vice President of  Sales                      |
| Simon Chouldjian      |       | 53         |       | Vice President of  Hardware Engineering       |
| Tsyr-Yi (Shirley) Sun |       | 46         |       | Vice President of  Research and Development   |

 

Gilbert Hu founded AltiGen and has served as ourPresident, Chief Executive Officer and a director since May 1994. Beforefounding AltiGen, Mr. Hu was a founder, President and Chief ExecutiveOfficer of Centrum Communications, Inc., a networking company acquired by3Com Corporation in early 1994. Mr. Hu has also served in technical andmanagerial roles at Vitalink Communication Corporation, an internet workingequipment manufacturer. He received a Bachelor of Science degree in ElectricalEngineering from National Chiao-Tung University in Taiwan and a Master ofScience degree in Electrical Engineering from Arizona State University.

Philip M. McDermott has served as our Chief FinancialOfficer since June 1999. From October 1995 to May 1999, Mr. McDermottserved as Director of Finance for Americas Sales for 3Com Corporation. From October 1994to October 1995, Mr. McDermott served as Vice President of Finance,Operations and Administration for DAVID Systems, a division of ChipcomCorporation, a public networking company. Chipcom was subsequently acquired by3Com Corporation. Mr. McDermott received Certified Management Accountantaccreditation from The Society of Management Accounting in Montreal, Canada.

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Michael Plumer has served as our Vice President ofSales since July 2004. Mr. Plumer joined AltiGen in November 1996 to beginbuilding the AltiGen sales channel. In the past eight years he has held variouspositions including Senior Director of Sales and National Sales Director. FromJanuary 1994 until October 1996, Mr. Plumer worked for NetManage, Inc. Mr.Plumer received a Bachelor of Arts degree in Journalism and Public Relationsfrom Iowa State University.

Simon Chouldjian has served as our Vice President ofHardware Engineering since November 2001. He served as our Vice Presidentof Manufacturing from June 1997 to November 2001. From July 1984to June 1997, Mr. Chouldjian was the founder and Vice President ofEngineering of Luxcom, Inc., a manufacturer of communication hubequipment. Mr. Chouldjian has held supervisory and project manager positionsin engineering at the Hewlett Packard Company and TRW, Inc. He received aBachelor of Science degree in Electrical Engineering from the University ofCalifornia, Berkeley and a Master of Science degree in Electrical Engineeringfrom Stanford University.

Tsyr-Yi (Shirley) Sun hasserved as our Vice President of Research and Development since October 1999.Prior to that role, she served as our Director of Internet Protocol Telephonyfrom April 1998 to October 1999. From February 1994 to March 1998,Ms. Sun worked for 3Com Corporation as an engineering manager. From August 1991to February 1994, Ms. Sun was a founder and an engineering managerwith Centrum Communications, Inc., a networking company acquired by 3ComCorporation in early 1994. Ms. Sun received a Bachelor of Science degreein Mechanical Engineering from National Central University in Taiwan and aMaster of Science degree in Computer Science from Utah State University.

**Item 11. ExecutiveCompensation**

The information requiredby this section is incorporated by reference from the information in thesection titled “Executive Compensation and Other Matters” in our ProxyStatement.

**Item 12. Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters**

The information requiredby this section is incorporated by reference from the information in thesection titled: “Security Ownership of Certain Beneficial Owners and Management”in our Proxy Statement.

**Item 13. CertainRelationships and Related Transactions**

The information requiredby this item regarding certain relationships and related transactions isincorporated by reference to the information set forth in the section titled “CertainRelationships and Related Transactions” in our Proxy Statement.

**Item 14. Principal AccountantFees and Services**

*Audit Fees*

Moss Adams LLP’s fees for professional servicesrendered in connection with the audit of our annual financial statements andthe review of our financial statements included in our third quarterly reporton Form 10-Q were approximately $160,000 for the fiscal year ended September 30,2006. Moss Adams LLP did not render services in connection with the review ofour financial statements for our first and second quarterly reports on Form 10-Qfor the fiscal year ended September 30, 2006. We did not engage Moss AdamsLLP to provide advice regarding financial information systems design andimplementation during the fiscal years ended September 30, 2006 and 2005.

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Deloitte & ToucheLLP’s fees for professional services rendered in connection with the review ofour financial statements included in our first and second quarterly reports on Form 10-Qwere approximately $88,000 for fiscal year ended September 30, 2006.Deloitte & Touche LLP’s fees for professional services rendered inconnection with the audit of our annual financial statements and the review ofour financial statements included in our quarterly reports on Form 10-Qwere approximately $255,000 for the fiscal year ended September 30, 2005.We did not engage Deloitte & Touche LLP to provide advice regardingfinancial information systems design and implementation during the fiscal yearsended September 30, 2006 and 2005.

*Audit-Related Fees*

We did not incur anyadditional fees from our independent registered public accounting firm, MossAdams LLP during fiscal year 2006. During fiscal year 2005, we did not incurany additional fees from our independent registered public accounting firm,Deloitte & Touche LLP.

*Tax Fees*

Deloitte & ToucheLLP’s fees for all other services rendered to us, including tax relatedservices, totaled approximately $30,000 in each of the fiscal years ended September 30,2006 and 2005, respectively.

*All Other Fees*

During fiscal year 2006, Deloitte & ToucheLLP billed the company approximately $20,000 for services rendered inconnection with the SEC filing Form 8-K. During fiscal year 2005,Deloitte & Touche LLP did not bill the company for any otherservices.

The Audit Committeepre-approves all audit and permissible non-audit services provided by the independentregistered public accounting firm. These services may include audit services,audit-related services, tax services and other services. The AuditCommittee has adopted a policy for the pre-approval of services provided by theindependent auditors. Under the policy, pre-approval generally is provided forup to one year and any pre-approval is detailed as to the particular service orcategory of services and is subject to a specific budget. In addition, theAudit Committee may also pre-approve particular services on a case-by-casebasis. For each proposed service, the independent registered public accountingfirm is required to provide detailed back-up documentation at the time ofapproval. The Audit Committee may delegate pre-approval authority to one ormore of its members. Such member must report any decisions to the AuditCommittee at the next scheduled meeting.

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**PART IV**

**Item 15. Exhibitsand Financial Statement Schedules**

(a)   The following documents are filed as a partof this Annual Report on Form 10-K.

**1.****                 FINANCIALSTATEMENTS**

|                                                                                                                                             | ** ** | **Page** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent Registered Public Accounting  Firm                                                                                    |       | 40       |
| Consolidated Balance Sheets as of September 30,  2006 and 2005                                                                         |       | 42       |
| Consolidated  Statements of Operations for the years ended September 30, 2006, 2005  and 2004                                          |       | 43       |
| Consolidated Statements of Stockholders’ Equity and  Comprehensive Income for the years ended September 30, 2006, 2005, and  2004 |       | 44       |
| Consolidated Statements of Cash Flows for the years  ended September 30, 2006, 2005, and 2004                                          |       | 45       |
| Notes to Consolidated Financial Statements                                                                                                  |       | 46       |
| Quarterly Financial Information                                                                                                             |       | 59       |

 

**2.****                 FINANCIALSTATEMENT SCHEDULES**

Thefollowing financial statement schedule is submitted herewith:

|                                               | ** ** | **Page** |
|-----------------------------------------------|------------|----------|
| Schedule II Valuation and Qualifying Accounts |       | 60       |

 

(All other schedules areomitted because they are not applicable or the required information is shown inthe Consolidated Financial Statements or notes thereto.)

**3.****                 EXHIBITS**

Thefollowing exhibits are included in this Annual Report on Form 10-K(numbered in accordance with Item 601 of Regulation S-K):
| Exhibit   Number | ** ** | **Description**                                                                                                                                                   |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1*             |       | Amended and Restated Certificate of Incorporation.                                                                                                                |
| 3.2*****         |       | Second Amended and Restated Bylaws.                                                                                                                               |
| 4.2*             |       | Specimen common stock certificates.                                                                                                                               |
| 4.3*             |       | Third Amended and Restated Rights Agreement dated  May 7, 1999 by and among AltiGen Communications, Inc. and the  Investors and Founder named therein.  |
| 10.1*            |       | Form of Indemnification Agreement.                                                                                                                           |
| 10.2*            |       | 1994 Stock Option Plan, as amended, and form of  stock option agreement.                                                                                          |
| 10.3*            |       | 1998 Stock Purchase Plan.                                                                                                                                         |
| 10.4****         |       | 1999 Stock Plan, as amended, and form of stock  option agreement.                                                                                                 |
| 10.5***          |       | 1999 Employee Stock Purchase Plan, as amended, and  forms of subscription agreement and notice of withdrawal.                                                     |
| 10.8****         |       | Lease agreement: 4555 Cushing Parkway, Fremont,  California between VEF III Funding, LLC and AltiGen  Communications, Inc., dated October 1, 2003. |

38

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| 10.19*      |   | Employment Agreement by  and between the Registrant and Philip McDermott, dated June 8, 1999.                                                             |
|-------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.26**++   |   | OEM Agreement between  AltiSys Communications and AltiGen Communications, Inc., dated  January 18, 1999.                                             |
| 10.27****++ |   | Distribution Agreement  between Synnex Information Technologies, Inc. and AltiGen Communications, Inc.  dated December 22, 1999.                |
| 10.28****++ |   | Distribution Agreement between Graybar Electric  Company, Inc. and AltiGen Communications, Inc. dated June 12,  2003.                           |
| 21.1*       |   | Subsidiaries of the Registrant.                                                                                                                                |
| 23.1        |   | Consent of Independent Registered Public Accounting  Firm.                                                                                                     |
| 23.2        |   | Consent of Deloitte & Touche LLP,  Independent Registered Public Accounting Firm.                                                                     |
| 24.1        |   | Power of Attorney (included on signature page).                                                                                                                |
| 31.1        |   | Certification of Principal Executive Officer.                                                                                                                  |
| 31.2        |   | Certification of Principal Financial Officer.                                                                                                                  |
| 32.1        |   | Certification of Chief Executive Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2        |   | Certification of Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

----

| *     |   | Incorporated by reference to exhibit filed with the  Registrant’s Registration Statement on Form S-1 (No. 333-80037)  declared effective on October 4, 1999. |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **    |   | Incorporated by reference to exhibit filed with the  Registrant’s Quarterly Report on Form 10-Q for the quarter ended  December 31, 2001.                         |
| ***   |   | Incorporated by reference to exhibit filed with the  Registrant’s Annual Report on Form 10-K for the fiscal year ended  September 30, 2002.                       |
| ****  |   | Incorporated by reference to exhibit filed with the  Registrant’s Annual Report on Form 10-K for the fiscal year ended  September 30, 2003.                       |
| ***** |   | Incorporated by reference to exhibit filed with the  Registrant’s Quarterly Report on Form 10-Q for the quarter ended  March 31, 2004.                            |
| ++    |   | Confidential treatment was granted for certain  portions of this exhibit.                                                                                                        |

 

39

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders ofAltiGen Communications, Inc.Fremont, CA

We have audited the accompanying consolidated balancesheets of AltiGen Communications, Inc. and subsidiaries (the “Company”) asof September 30, 2006, and the related consolidated statements of operations,stockholders’ equity, and cash flows for the period ended September 30,2006. Our audit also included the financial statement schedule listed in theIndex at Item 15(a)(2). These financial statements and financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on the financial statements and financial statementschedule based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audit provides a reasonable basis for our opinion.

In our opinion, suchconsolidated financial statements present fairly, in all material respects, thefinancial position of AltiGen Communications, Inc. and subsidiaries as of September 30,2006, and the results of their operations and their cash flows for the periodended September 30, 2006, in conformity with accounting principlesgenerally accepted in the United States of America. Also, in our opinion, suchfinancial statement schedule, when considered in relation to the basicconsolidated financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.

/s/ MOSS ADAMS LLP

San Francisco, CaliforniaDecember 29, 2006

40

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders ofAltiGen Communications, Inc.Fremont, CA

We have audited the accompanying consolidated balancesheets of AltiGen Communications, Inc. and subsidiaries (the “Company”) asof September 30, 2005, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the two years in the periodended September 30, 2005. Our audits also included the financial statementschedule for the years ended September 30, 2005 and 2004 listed in theIndex at Item 15(a)(2). These financial statements and financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on the financial statements and financial statementschedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditsincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, suchconsolidated financial statements present fairly, in all material respects, thefinancial position of AltiGen Communications, Inc. and subsidiaries as ofSeptember 30, 2005, and the results of their operations and their cashflows for each of the two years in the period ended September 30, 2005, inconformity with accounting principles generally accepted in the United Statesof America. Also, in our opinion, such financial statement schedule for theyears ended September 30, 2005 and 2004, when considered in relation tothe basic consolidated financial statements taken as a whole, presents fairlyin all material respects the information set forth therein.

/s/ DELOITTE & TOUCHE LLP

San Jose, CaliforniaDecember 27, 2005

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**ALTIGENCOMMUNICATIONS, INC. AND SUBSIDIARYCONSOLIDATED BALANCE SHEETS(in thousands, except share and per share amounts)**

| ** **                                                                                                                                                                    | ** ** | **September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                    | ** ** | **2006**               | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                                    |       |                   |       |   |   |
| Current assets:                                                                                                                                                               |       |                   |       |   |   |
| Cash and cash  equivalents                                                                                                                                                    |       | $                      | 5,053      |   | $ | 3,963 |   |
| Short-term investments                                                                                                                                                        |       | 4,869                  |       | 5,459 |   |
| Accounts receivable, net  of allowances of $38 and $40 in 2006 and 2005, respectively                                                                                         |       | 2,230                  |       | 1,957 |   |
| Inventories                                                                                                                                                                   |       | 1,382                  |       | 965 |   |
| Prepaid expenses and  other current assets                                                                                                                                    |       | 123                    |       | 148 |   |
| Total current assets                                                                                                                                                          |       | 13,657                 |       | 12,492 |   |
| Property and equipment:                                                                                                                                                       |       |                   |       |   |   |
| Furniture and equipment                                                                                                                                                       |       | 1,783                  |       | 1,405 |   |
| Computer software                                                                                                                                                             |       | 920                    |       | 920 |   |
|                                                                                                                                                                          |       | 2,703                  |       | 2,325 |   |
| Less: Accumulated  depreciation                                                                                                                                               |       | (2,022                 | )          | (1,803 | ) |
| Net property and  equipment                                                                                                                                                   |       | 681                    |       | 522 |   |
| Other non-current assets:                                                                                                                                                     |       |                   |       |   |   |
| Long-term  investments                                                                                                                                                        |       | 211                    |       | 247 |   |
| Long-term deposit                                                                                                                                                             |       | 95                     |       | 74 |   |
| Total other non-current  assets                                                                                                                                               |       | 306                    |       | 321 |   |
| Total assets                                                                                                                                                                  |       | $                      | 14,644     |   | $ | 13,335 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                 |       |                   |       |   |   |
| Current liabilities:                                                                                                                                                          |       |                   |       |   |   |
| Accounts payable                                                                                                                                                              |       | $                      | 837        |   | $ | 653 |   |
| Accrued liabilities:                                                                                                                                                          |       |                   |       |   |   |
| Payroll and related  benefits                                                                                                                                                 |       | 328                    |       | 317 |   |
| Warranty                                                                                                                                                                      |       | 263                    |       | 264 |   |
| Marketing                                                                                                                                                                     |       | 68                     |       | 58 |   |
| Accrued expense                                                                                                                                                               |       | 263                    |       | 272 |   |
| Other                                                                                                                                                                         |       | 340                    |       | 288 |   |
| Deferred revenue                                                                                                                                                              |       | 531                    |       | 507 |   |
| Total current  liabilities                                                                                                                                                    |       | 2,630                  |       | 2,359 |   |
| Long-term deferred rent  and other                                                                                                                                            |       | 177                    |       | 258 |   |
| Commitments and contingencies (Note 4)                                                                                                                                        |       |                   |       |   |   |
| Stockholders’ equity:                                                                                                                                                    |       |                   |       |   |   |
| Convertible preferred  stock, $0.001 par value; Authorized—5,000,000 shares; Outstanding—none  at September 30, 2006 and 2005                             |       | —                 |       | — |   |
| Common stock, $0.001 par  value; Authorized—50,000,000 shares; Outstanding—16,157,364 and 15,782,071  shares at September 30, 2006 and 2005, respectively |       | 16                     |       | 16 |   |
| Treasury stock at  cost—1,063,895 shares at September 30, 2006 and 2005                                                                                             |       | (1,014                 | )          | (1,014 | ) |
| Additional paid-in  capital                                                                                                                                                   |       | 63,993                 |       | 62,863 |   |
| Accumulated other  comprehensive loss                                                                                                                                         |       | —                 |       | (1 | ) |
| Accumulated deficit                                                                                                                                                           |       | (51,158                | )          | (51,146 | ) |
| Total stockholders’  equity                                                                                                                                              |       | 11,837                 |       | 10,718 |   |
| Total liabilities and stockholders’ equity                                                                                                                               |       | $                      | 14,644     |   | $ | 13,335 |   |

 

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

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**ALTIGENCOMMUNICATIONS, INC. AND SUBSIDIARYCONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share amounts)**

| ** **                                                                     | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net revenue:                                                                   |       |                                                    |       |   |   |   |   |
| Hardware                                                                       |       | $                                                       | 16,486     |   | $ | 13,363 |   | $ | 12,470 |   |
| Software                                                                       |       | 1,410                                                   |       | 2,078 |   | 2,372 |   |
| Total net revenue                                                              |       | 17,896                                                  |       | 15,441 |   | 14,842 |   |
| Cost of revenue:                                                               |       |                                                    |       |   |   |   |   |
| Hardware                                                                       |       | 7,979                                                   |       | 6,442 |   | 5,417 |   |
| Software                                                                       |       | 103                                                     |       | 150 |   | 190 |   |
| Total cost of revenue                                                          |       | 8,082                                                   |       | 6,592 |   | 5,607 |   |
| Gross profit                                                                   |       | 9,814                                                   |       | 8,849 |   | 9,235 |   |
| Operating expenses:                                                            |       |                                                    |       |   |   |   |   |
| Research and development                                                       |       | 3,740                                                   |       | 3,496 |   | 3,288 |   |
| Sales and marketing                                                            |       | 4,353                                                   |       | 3,943 |   | 4,130 |   |
| General and administrative                                                     |       | 2,058                                                   |       | 1,946 |   | 1,894 |   |
| Total operating expenses                                                       |       | 10,151                                                  |       | 9,385 |   | 9,312 |   |
| Loss from  operations                                                          |       | (337                                                    | )          | (536 | ) | (77 | ) |
| Equity in net  loss of investee                                                |       | (36                                                     | )          | (12 | ) | — |   |
| Interest and  other income, net                                                |       | 380                                                     |       | 237 |   | 105 |   |
| Net income (loss)  before tax                                                  |       | 7                                                       |       | (311 | ) | 28 |   |
| Income taxes                                                                   |       | 19                                                      |       | — |   | — |   |
| Net income (loss)                                                              |       | $                                                       | (12        | ) | $ | (311 | ) | $ | 28 |   |
| Basic and diluted net income (loss) per share                                  |       | $                                                       | (0.00      | ) | $ | (0.02 | ) | $ | 0.00 |   |
| Weighted average shares used in computing basic net  income (loss) per share   |       | 14,964                                                  |       | 14,605 |   | 14,242 |   |
| Weighted average  shares used in computing diluted net income (loss) per share |       | 14,964                                                  |       | 14,605 |   | 15,725 |   |

 

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

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**ALTIGENCOMMUNICATIONS, INC. AND SUBSIDIARYCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME(in thousands, except share amounts)**

| ** **                                                                | ** ** | **Common Stock** | ** ** | **Treasury** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated** | ** ** | **Total  Stockholders’** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|-------------------------|------------|---------------------------------------|------------|-----------------|------------|-------------------------------|------------|
| ** **                                                                | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Stock**               | ** ** | **Capital**                           | ** ** | **Loss**        | ** ** | **Deficit**                   | ** ** | **Equity** | ** ** |
| BALANCE, SEPTEMBER 30, 2003                                          |       | 15,054,442            |       |         | $          | 15                      |       |                                  |       | $               | (1,014     | )                             |       |   | $ | 62,152 |   |   |   | $ | — |   |   |   | $ | (50,863 | ) |   |   | $ | 10,290 |   |   |
| Exercise of stock options                                                 |       | 229,075               |       |         | —     |                    |       |                                  | —     |            |       |                          | 241        |   |   |   | — |   |   |   | — |   |   |   | 241 |   |   |
| Issuance of common stock in connection with Employee  Stock Purchase Plan |       | 178,989               |       |         | —     |                    |       |                                  | —     |            |       |                          | 112        |   |   |   | — |   |   |   | — |   |   |   | 112 |   |   |
| Unrealized loss from investments                                          |       | —                |       |         | —     |                    |       |                                  | —     |            |       |                          | —     |   |   |   | (2 | ) |   |   | — |   |   |   | (2 | ) |   |
| Net income                                                                |       | —                |       |         | —     |                    |       |                                  | —     |            |       |                          | —     |   |   |   | — |   |   |   | 28 |   |   |   | 28 |   |   |
| Comprehensive income                                                      |       | —                |       |         | —     |                    |       |                                  | —     |            |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | 26 |   |   |
| BALANCE, SEPTEMBER 30, 2004                                          |       | 15,462,506            |       |         | 15         |                    |       |                                  | (1,014     | )               |       |                          | 62,505     |   |   |   | (2 | ) |   |   | (50,835 | ) |   |   | 10,669 |   |   |
| Exercise of stock options                                                 |       | 210,107               |       |         | 1          |                    |       |                                  | —     |            |       |                          | 199        |   |   |   | — |   |   |   | — |   |   |   | 200 |   |   |
| Issuance of common stock in connection with Employee  Stock Purchase Plan |       | 109,458               |       |         | —     |                    |       |                                  | —     |            |       |                          | 159        |   |   |   | — |   |   |   | — |   |   |   | 159 |   |   |
| Unrealized gain from investments                                          |       | —                |       |         | —     |                    |       |                                  | —     |            |       |                          | —     |   |   |   | 1 |   |   |   | — |   |   |   | 1 |   |   |
| Net loss                                                                  |       | —                |       |         | —     |                    |       |                                  | —     |            |       |                          | —     |   |   |   | — |   |   |   | (311 | ) |   |   | (311 | ) |   |
| Comprehensive income                                                      |       | —                |       |         | —     |                    |       |                                  | —     |            |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| BALANCE, SEPTEMBER 30, 2005                                          |       | 15,782,071            |       |         | 16         |                    |       |                                  | (1,014     | )               |       |                          | 62,863     |   |   |   | (1 | ) |   |   | (51,146 | ) |   |   | 10,718 |   |   |
| Exercise of stock options                                                 |       | 265,895               |       |         |       |                    |       |                                  | —     |            |       |                          | 186        |   |   |   | — |   |   |   | — |   |   |   | 186 |   |   |
| Issuance of common stock in connection with Employee  Stock Purchase Plan |       | 109,398               |       |         | —     |                    |       |                                  | —     |            |       |                          | 143        |   |   |   | — |   |   |   | — |   |   |   | 143 |   |   |
| Unrealized gain from investments                                          |       | —                |       |         | —     |                    |       |                                  | —     |            |       |                          | —     |   |   |   | 1 |   |   |   | — |   |   |   | 1 |   |   |
| Stock based compensation                                                  |       | —                |       |         | —     |                    |       |                                  | —     |            |       |                          | 801        |   |   |   | — |   |   |   | — |   |   |   | 801 |   |   |
| Net loss                                                                  |       | —                |       |         | —     |                    |       |                                  | —     |            |       |                          | —     |   |   |   | — |   |   |   | (12 | ) |   |   | (12 | ) |   |
| Comprehensive income                                                      |       | —                |       |         | —     |                    |       |                                  | —     |            |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| BALANCE, SEPTEMBER 30,  2006                                         |       | 16,157,364            |       |         | $          | 16                      |       |                                  |       | $               | (1,014     | )                             |       |   | $ | 63,993 |   |   |   | $ | — |   |   |   | $ | (51,158 | ) |   |   | $ | 11,837 |   |   |

 

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

44

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**ALTIGENCOMMUNICATIONS, INC. AND SUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)**

| ** **                                                                   | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                       |       |                                                    |       |   |   |   |   |
| Net income (loss)                                                            |       | $                                                       | (12        | ) | $ | (311 | ) | $ | 28 |   |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                                                    |       |   |   |   |   |
| Depreciation                                                                 |       | 219                                                     |       | 109 |   | 218 |   |
| Stock based compensation                                                     |       | 801                                                     |       | — |   | — |   |
| Equity in net loss of investee                                               |       | 36                                                      |       | 12 |   | — |   |
| Changes in  operating assets and liabilities:                                |       |                                                    |       |   |   |   |   |
| Accounts receivable                                                          |       | (273                                                    | )          | (100 | ) | (336 | ) |
| Inventories                                                                  |       | (417                                                    | )          | 93 |   | (148 | ) |
| Prepaid expenses and other current assets                                    |       | 25                                                      |       | (81 | ) | 126 |   |
| Accounts payable                                                             |       | 184                                                     |       | (145 | ) | (75 | ) |
| Accrued liabilities                                                          |       | 64                                                      |       | (188 | ) | (272 | ) |
| Deferred revenue                                                             |       | 24                                                      |       | (11 | ) | 106 |   |
| Long-term deferred rent and other                                            |       | (81                                                     | )          | 113 |   | 168 |   |
| Net cash provided by (used in) operating activities                          |       | 570                                                     |       | (509 | ) | (185 | ) |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                       |       |                                                    |       |   |   |   |   |
| Purchases of short-term investments                                          |       | (26,031                                                 | )          | (8,761 | ) | (11,599 | ) |
| Proceeds from sale of short-term investments                                 |       | 26,621                                                  |       | 10,440 |   | 6,061 |   |
| Changes in long-term investments                                             |       | —                                                  |       | 15 |   | (79 | ) |
| Changes in long-term deposits                                                |       | (21                                                     | )          | — |   | (74 | ) |
| Purchases of property and equipment                                          |       | (378                                                    | )          | (479 | ) | (127 | ) |
| Net cash provided by (used in) investing activities                          |       | 191                                                     |       | 1,215 |   | (5,818 | ) |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                       |       |                                                    |       |   |   |   |   |
| Proceeds from issuances of common stock, net of  issuance costs              |       | 329                                                     |       | 359 |   | 353 |   |
| Net cash provided by financing activities                                    |       | 329                                                     |       | 359 |   | 353 |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                         |       | 1,090                                                   |       | 1,065 |   | (5,650 | ) |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF YEAR                                |       | 3,963                                                   |       | 2,898 |   | 8,548 |   |
| CASH AND CASH  EQUIVALENTS, END OF YEAR                                      |       | $                                                       | 5,053      |   | $ | 3,963 |   | $ | 2,898 |   |

 

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

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**ALTIGENCOMMUNICATIONS, INC. AND SUBSIDIARYNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1. ORGANIZATION OFTHE COMPANY:**

We are a pioneer andmarket leader in Internet protocol telephony systems for small-to-medium sizedbusinesses. We design, manufacture and market next generation, Internetprotocol phone systems and contact centers that use both the Internet and thepublic telephone network to take advantage of the convergence of voice and datacommunications. Unlike traditional proprietary phone systems, our systems aredesigned with open architecture and are built on an industry standard platform.This adherence to industry standards allows our products to play an importantrole in the small-to-medium sized business market by delivering phone systemsthat can integrate with other technologies and provide integrated voice anddata solutions. We believe this enables our customers to implementcommunication systems that have an increased return on investment versus pasttechnology investments. We generated net revenue of $17.9 million, for anet loss of $12,000, during fiscal year 2006. As of September 30, 2006, wehad an accumulated deficit of $51.2 million. Net cash provided byoperating activities was $570,000 for fiscal year 2006. We were incorporated inCalifornia in May 1994 and we reincorporated into Delaware in June 1999.

**2. SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES:**

*Principles ofPresentation*

Our consolidated financial statements reflect theoperations of AltiGen Communications, Inc. and our wholly-ownedsubsidiary. The subsidiary is located in Shanghai, China and was incorporatedin November 1998. As of September 30, 2006, we had approximately$44,000 in long lived assets located in China. All significant intercompanytransactions and balances have been eliminated. Our fiscal year end is September 30.Unless otherwise stated, all references to fiscal years 2006, 2005, and 2004refer to the twelve months ended September 30 of that year. Certainreclassifications have been made to conform prior period amounts to the currentpresentation. The reclassifications did not impact previously reported revenue,total operating expense, operating income (loss), net income (loss), totalassets, total liabilities or stockholders’ equity.

In March 2005, the Company determined thatinvestments in Auction Rate Securities (“ARS”) should not be considered cashequivalents in prior periods. ARS generally have long-term stated maturities;however, these investments have characteristics similar to short-terminvestments because at pre-determined intervals, generally between 7 to49 days after the purchase, there is a new auction process. As of March 31,2005, the Company held $2.5 million of investments in ARS that were classifiedas short-term investments, available for sale. The Company reclassified$2.5 million of investments in ARS that were previously included in cash andcash equivalents as of September 30, 2004 to short-term investments,available for sale. The Company has included purchases and sales of ARS in itsconsolidated statements of cash flows as a component of its investingactivities.

Additionally, in March 2005,the Company revised the presentation of its consolidated statements ofoperations to separate net revenue and cost of revenue by source (hardware andsoftware).

*Use of Estimates inPreparation of Financial Statements*

The preparation of thefinancial statements in conformity with generally accepted accountingprinciples in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during the reportedperiods. Key estimates include provisions for excess and obsolete inventories,warranty, doubtful account reserve, valuation on tax assets and long-terminvestments. Actual results could differ from those estimates.

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*Concentration ofRisk*

Financial instruments that potentially subject us to aconcentration of credit risk consist principally of trade receivables. Weperform ongoing credit evaluations of our customers’ financial condition andrequire letters of credit whenever deemed necessary to help reduce our creditrisk. Additionally, we establish an allowance for doubtful accounts based uponfactors surrounding the credit risk of specific customers, historical trendsrelated to past losses and other information. As of September 30, 2006approximately 81% of our account receivable was concentrated with threedistributors, compared to approximately 84% concentrated with threedistributors as of September 30, 2005.

Our purchases areconcentrated with four suppliers and certain key chip components of ourproducts are sole sourced. For fiscal years 2006 and 2005 these four suppliersprovided 91% and 93%, respectively, of all raw materials purchased. Loss of oneof these suppliers could adversely impact our operations.

*Cash and CashEquivalents and Short-Term Investments*

We consider all highly liquid investments with anoriginal maturity of three months or less from the date of purchase to be cashequivalents. Short-term investments are in highly liquid financial instrumentswith original maturities greater than three months but less than one year andare classified as “available-for-sale” investments. Investments arereported at their fair value, with unrealized gains and losses excluded fromearnings and reported as a separate component of stockholders’ equity. As of September 30,2006, our cash and cash equivalents consisted of commercial paper and cashdeposited in checking and money market accounts. For fiscal years 2006, 2005,and 2004, we did not make any cash payments for interest or income taxes.

As of September 30, 2006, short-term investmentsconsisted of the following (in thousands):

Availablefor Sale Securities: 

| ** **                         | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gain** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Market  Value** | ** ** | **Accrued  Interest  Income** | ** ** | **Total  Value** | ** ** |
|------------------------------------|------------|---------------------|------------|-----------------------------|------------|-------------------------------|------------|-------------------|------------|-------------------------------|------------|------------------|------------|
| U.S. government  agency obligation |       |                | $          | 1,001                       |       |                          |       | $                 | —     |                          |       |             | $          | 1 |   |   | $ | 1,002 |   |   | $ | 2 |   |   | $ | 1,004 |   |
| Auction-rate  preferred stock      |       |                | —     |                        |       |                          | —     |              |       |                          | —     |             |       | — |   |   | — |   |   | — |   |
| Corporate bonds  and notes         |       |                | 3,835      |                        |       |                          | —     |              |       |                          | (1         | )                |       | 3,834 |   |   | 31 |   |   | 3,865 |   |
| Commercial paper                   |       |                | —     |                        |       |                          | —     |              |       |                          | —     |             |       | — |   |   | — |   |   | — |   |
|                               |       |                | $          | 4,836                       |       |                          |       | $                 | —     |                          |       |             | $          | — |   |   | $ | 4,836 |   |   | $ | 33 |   |   | $ | 4,869 |   |

 

As of September 30, 2005, short-term investmentsconsisted of the following (in thousands):

Availablefor Sale Securities: 

| ** **                         | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gain** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Market  Value** | ** ** | **Accrued  Interest  Income** | ** ** | **Total  Value** | ** ** |
|------------------------------------|------------|---------------------|------------|-----------------------------|------------|-------------------------------|------------|-------------------|------------|-------------------------------|------------|------------------|------------|
| U.S. government  agency obligation |       |                | $          | 3,018                       |       |                          |       | $                 | —     |                          |       |             | $          | — |   |   | $ | 3,018 |   |   | $ | 10 |   |   | $ | 3,028 |   |
| Auction-rate  preferred stock      |       |                | 850        |                        |       |                          | —     |              |       |                          | —     |             |       | 850 |   |   | — |   |   | 850 |   |
| Corporate bonds  and notes         |       |                | 1,271      |                        |       |                          | —     |              |       |                          | (1         | )                |       | 1,270 |   |   | 11 |   |   | 1,281 |   |
| Commercial paper                   |       |                | 300        |                        |       |                          | —     |              |       |                          | —     |             |       | 300 |   |   | — |   |   | 300 |   |
|                               |       |                | $          | 5,439                       |       |                          |       | $                 | —     |                          |       |             | $          | (1 | ) |   | $ | 5,438 |   |   | $ | 21 |   |   | $ | 5,459 |   |

 

The U.S. government agencyobligation includes bonds and discount notes with a maturity date of one to 30years at issuance for bonds and discount notes have maturities from oneday to one year at issuance. 

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The securities are issuedby such agencies as Fannie Mae (FNMA), Freddie Mac (FHLMC) andGovernment Sponsored Enterprises (GSEs).

Accrued interest is calculated on a 30-daymonth/360-day year for corporate bonds and municipal bonds, and onactual-calendar-days for Government bonds. Income bonds and bonds in defaulttrade without accrued interest. When calculating accrued interest on a bondthat is being sold, it is conventional to consider the time period from themost recent payment up to, but not including, the date on which the bond saleis settled.

For fiscal period ending September 30,2006, we did not have unrealized loss from short-term investment, however, atfiscal period ending September 30, 2005, unrealized loss from short-terminvestment was $1,000.

*Inventories*

Inventories(which include costs associated with components assembled by third-partyassembly manufacturers, as well as internal labor and allocable overhead) arestated at the lower of standard cost (which approximates actual cost on a first-in,first-out method) or market value. Provisions, when required, are made toreduce excess and obsolete inventories to their estimated net realizablevalues. We regularly monitor inventory quantities on hand and record aprovision for excess and obsolete inventories based primarily on our estimatedforecast of product demand and production requirements for the next six months.As of September 30, 2006, we recognized $122,000 of provision for excessand obsolete inventories offset by a $301,000 reversal of inventories fromprior year. We did not record any provision for excess and absolute inventoriesfor fiscal years 2005 and 2004. The components of inventories include (inthousands):

| ** **       | ** ** | **September 30,** | ** ** |
|------------------|------------|------------------------|------------|
| ** **       | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Raw materials    |       | $                      | 497        |   | $ | 144 |   |
| Work-in-progress |       | 75                     |       | 84 |   |
| Finished goods   |       | 810                    |       | 737 |   |
|             |       | $                      | 1,382      |   | $ | 965 |   |

 

*Property andEquipment*

Property and equipment are carried at cost lessaccumulated depreciation. Depreciation is provided using the straight-linemethod over the estimated useful lives of the assets, which is three yearsexcept for tooling which we depreciate using the greater value between the fiveyear straight-line method or the number of phones shipped in the period.Depreciation expense for fiscal years 2006, 2005, and 2004, was approximately$218,000, $109,000, and $218,000, respectively. All repairs and maintenancecosts are expensed as incurred.

Net book value ofequipment leased under capital leases was $118,000, $184,000 and $9,000 forfiscal years 2006, 2005 and 2004, respectively. Net of accumulated deprecationfor such equipment was $81,000, $15,000 and $15,000 for fiscal years 2006, 2005and 2004, respectively.

*Long-TermInvestments*

As of September 30, 2006, we held an investmentof common stock of private Taiwanese telecommunication company valued atapproximately $195,000 accounted for using the cost method. Our interest in thecompany is approximately 2%, which interest does not allow us to exercisesignificant influence.

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In July 2004, we purchased common stock of aprivate Korean telecommunications company for $79,000. As a result of thisinvestment, we acquired approximately 23% of the voting power of the companyand have the right to nominate and have elected one of the three members of thecompany’s current board of directors. We are accounting for this investmentusing the equity method and record our minority interest of their results inour results of operations. As of September 30, 2006, our investment in theKorean company had a remaining book value of approximately $16,000 compared to$63,000 at fiscal year end September 30, 2005.

We perform periodicreviews of our investments for impairment. Our investments are consideredimpaired when a review of the issuer’s operations and other indicators ofimpairment indicate that the carrying value of the investment is not likely tobe recoverable. Such indicators include, but are not limited to, limitedcapital resources, limited prospects of receiving additional financing, andlimited prospects for liquidity of the related securities. No write-downswere recorded during fiscal years 2006, 2005 or 2004.

*SoftwareDevelopment Costs*

In accordance withStatement of Financial Accounting Standards (“SFAS”) No. 86, “Accountingfor the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed,”the Company capitalizes eligible computer software development costs upon theestablishment of technological feasibility, which it has defined as completionof a working model. The amount of costs eligible for capitalization, after considerationof factors such as realizable value, were not material and, accordingly, allsoftware development costs have been charged to research and developmentexpense in the accompanying consolidated statements of operations.

*Stock-BasedCompensation*

Commencing October 1,2005 we adopted the provisions of Statement of Financial Accounting Standard (“SFAS”)No. 123(R), “Share Based Compensation” (“SFAS No. 123(R)”), whichrequires all share-based compensation, including grants of stock options, to berecognized in the income statement as an operating expense, based on their fairmarket values. During fiscal year 2006, stock compensation was accounted underSFAS No. 123(R) while during fiscal year 2005, stock-basedcompensation was accounted under Accounting Principles Board (APB), Opinion No. 25APB (25).

Prior to adopting SFAS No. 123(R), we accounted forstock-based employee compensation under Accounting Principles Board (“APB”)Opinion No. 25, “Accounting for Stock Issued to Employees,” as amended by SFAS No. 148, “Accounting forStock-Based Compensation-Transition and Disclosures.” We have appliedthe modified prospective method in adopting SFAS No. 123(R) and,accordingly, we recorded compensation costs as the requisite service wasrendered for the unvested portion of previously issued awards that remainoutstanding at the initial date of adoption. Periods prior to the adoption ofSFAS No. 123(R) have not been restated.

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The following table summarizes the total stock-basedcompensation expense for the twelve months ended September 30, 2006 and isincluded in the Audited Condensed Consolidated Statements of Operations (inthousands):

| ** **                                | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                            | ** ** |
| Cost of goods  sold                       |       |                                                | $          | 36 |   |   |
| Research and  development                 |       |                                                | 279        |   |   |
| Selling, general  and administrative      |       |                                                | 486        |   |   |
| Pre-tax  stock-based compensation expense |       |                                                | 801        |   |   |
| Income tax                                |       |                                                | —     |   |   |
| Net stock-based  compensation expense     |       |                                                | $          | 801 |   |   |

 

Thefollowing table illustrates the effects on net income and earnings per share ifthe fair value based method had been applied to the prior periods as requiredunder SFAS No. 123(R). The reported net income and earnings per share forfiscal year ended September 30, 2005 and September 30, 2004 have beenpresented below to reflect the impact had the Company been required to includethe amortization of the Black-Scholes option value as an expense (in thousands,except for per share data):

| ** **                                                                                                                                                 | ** ** | **Fiscal Year Ended  September 30,**      | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                                                                 | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| Net income (loss)                                                                                                                                          |       |                                                     | $          | (311 | ) |   |   | $ | 28 |   |   |
| Add: stock-based employee compensation expense  included in reported net loss under APB No. 25                                                   |       |                                                     | —     |   |   |   | — |   |   |
| Deduct: Total stock-based compensation  determined under fair value based method prior to adoption of SFAS  No. 123R, net of related tax effects |       |                                                     | (1,680     | ) |   |   | (1,161 | ) |   |
| Net loss—pro forma                                                                                                                                    |       |                                                     | $          | (1,991 | ) |   |   | $ | (1,133 | ) |   |
| Basic and diluted  net income (loss) per share:                                                                                                            |       |                                                     |       |   |   |   |   |   |   |
| As reported                                                                                                                                                |       |                                                     | $          | (0.02 | ) |   |   | $ | 0.00 |   |   |
| Pro forma                                                                                                                                                  |       |                                                     | $          | (0.14 | ) |   |   | $ | (0.08 | ) |   |

 

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model, and is not subject to revaluation asa result of subsequent stock price fluctuations. The following weighted-averageassumptions are used:

| ** **                | ** ** | **Employee Stock Option Plans  Fiscal Year  Ended September 30,** | ** ** | **Employee Stock Purchase Plan  Fiscal Year  Ended September 30,** | ** ** |
|---------------------------|------------|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                | ** ** | **2006**                                                                                        | ** ** | **2005**                                                                                         | ** ** | **2004** | ** ** | **  2006  ** | ** ** | **  2005  ** | ** ** | **  2004  ** | ** ** |
| Expected Life (in  years) |       | 5                                                                                               |       | 5                                                                                                |       | 5 |   |   | 0.5 |   |   |   | 0.5 |   |   |   | 0.5 |   |   |
| Risk-free  interest rate  |       | 4.35-5.4                                                                                        | %          | 3.5-4.0                                                                                          | %          | 3.3-3.7 | % |   | 5.15 | % |   |   | 4.3 | % |   |   | 1.3 | % |   |
| Volatility                |       | 95                                                                                              | %          | 100                                                                                              | %          | 105 | % |   | 94 | % |   |   | 99 | % |   |   | 103 | % |   |
| Expected dividend         |       | 0.0                                                                                             | %          | 0.0                                                                                              | %          | 0.0 | % |   | 0.0 | % |   |   | 0.0 | % |   |   | 0.0 | % |   |

 

The Black-Scholesoption pricing model was developed for use in estimating the fair value oftraded options that have no vesting restrictions and are fully transferable. Inaddition, option pricing models require the input of highly subjectiveassumptions, including the expected stock price volatility. We use projectedvolatility rates, which are based upon historical volatility rates since ourinitial public offering, trended into future years. Because our employee stockoptions have characteristics significantly different from those of tradedoptions and because changes in the subjective input assumptions can materiallyaffect 

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the fairvalue estimate, in management’s opinion, the existing models do not necessarilyprovide a reliable single measure of the fair value of our options.

*Revenue Recognition*

We account for the recognition of revenue inaccordance with Statement of Position (“SOP”) 97-2, “Software RevenueRecognition.” Revenue consist of sales to end-users, including resellers, andto distributors. Revenue from sales to end-users including resellers arerecognized upon shipment, when risk of loss has passed to the customer,collection of the receivable is reasonably assured, persuasive evidence of anarrangement exits, and the price is fixed and determinable. Sales todistributors are made under terms allowing certain rights of return andprotection against subsequent price declines on the Company’s products held byits distributors. Upon termination, any unsold products may be returned by thedistributor for a full refund. These agreements may be canceled by either partybased on a specified notice. As a result of the above provisions, we defer recognitionof distributor revenue until such distributors resell our products to theircustomers. The amounts deferred as a result of this policy are reflected as “deferredrevenue” in the accompanying consolidated balance sheets. The related cost ofrevenue is also deferred and reported in the consolidated balance sheets asinventory.

Software components are generally not sold separatelyfrom our hardware components. Software revenue consist of license revenue thatare recognized upon the delivery of application products. We provide limitedpost-contract customer support (“PCS”), consisting primarily of technicalsupport and “bug” fixes. In accordance with SOP 97-2, revenue earned onsoftware arrangements involving multiple elements is allocated to each elementbased upon the relative fair values of the elements. Although we provide PCS,the revenue allocated to this element is recognized together with the initiallicensing fee on delivery of the software because: (1) the PCS fee isincluded with the initial licensing fee; (2) the PCS included with theinitial license fee is for one year or less; (3) the estimated cost ofproviding PCS during the arrangement is insignificant; and (4) unspecifiedupgrades/enhancements offered for minimal or no cost during PCS arrangementshistorically have been and are expected to continue to be minimal andinfrequent. All estimated costs of providing the services, including upgradesand enhancements are accrued for at the time of delivery.

Forfiscal years 2006, 2005, and 2004, the following customers accounted forapproximately 84%, 82%, and 82% of net revenue, respectively:

| ** **    | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| AltiSys       |       |                                                | 15         | % |   |   | 16 | % |   |   | 14 | % |   |
| Ingram Micro* |       |                                                | —     |   |   |   | 2 | % |   |   | 14 | % |   |
| Synnex        |       |                                                | 55         | % |   |   | 53 | % |   |   | 46 | % |   |
| Graybar       |       |                                                | 14         | % |   |   | 11 | % |   |   | 8 | % |   |

----

*                    On July 20,2005, we terminated our distribution agreement with Ingram Micro. Thetermination of our relationship with Ingram Micro did not have a materialimpact on our business.

Revenue derived from salesto customers outside of the Americas, primarily in China, Norway and the UnitedKingdom accounted for approximately 10%, 10%, and 10% of our net revenue forfiscal years 2006, 2005 and 2004, respectively.

*Computation ofBasic and Diluted Net Income (Loss) Per Share*

Historicalnet income (loss) per share has been calculated under SFAS No. 128, “Earningsper Share.” SFAS No. 128 requires companies to compute earnings per shareunder two methods (basic and diluted). 

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Basic net income (loss) per share is calculated bydividing net income (loss) by the weighted average shares of common stockoutstanding during the period. Diluted earnings per share reflects thepotential dilution that could occur if securities or other contracts to issuecommon stock were exercised or converted into common stock.

Basicand diluted income (loss) per share for each of the three years in the periodended September 30, 2006 are as follows (in thousands):

| ** **                                                                | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income (loss)                                                         |       | $                                                   | (12        | ) | $ | (311 | ) | $ | 28 |   |
| Weighted average  shares outstanding—basic income (loss) per share   |       | 14,964                                              |       | 14,605 |   | 14,242 |   |
| Weighted average  dilutive potential shares                               |       | —                                              |       | — |   | 1,484 |   |
| Weighted average  shares outstanding—diluted income (loss) per share |       | 14,964                                              |       | 14,605 |   | 15,726 |   |
| Basic net income  (loss) per share                                        |       | $                                                   | (0.00      | ) | $ | (0.02 | ) | $ | 0.00 |   |
| Diluted net income  (loss) per share                                      |       | $                                                   | (0.00      | ) | $ | (0.02 | ) | $ | 0.00 |   |

 

Thefollowing common stock options and employee stock options were excluded fromthe computation of diluted net income (loss) per share for fiscal years 2006,2005 and 2004:

| ** **             | ** ** | **Fiscal Year Ended  September 30,**      | ** ** |
|------------------------|------------|----------------------------------------------------------|------------|
| ** **             | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| Common Stock  Options  |       |                                                     | —     |   |   |   | — |   |   |   | 1,412 |   |   |
| Employee stock options |       |                                                     | —     |   |   |   | — |   |   |   | 72 |   |   |

 

*ComprehensiveIncome (Loss)*

Comprehensiveincome (loss) consists of net income (loss) and net unrealized gains (losses)on available-for-sale investment. Comprehensive loss for fiscal years 2006,2005 and 2004, respectively, were as follows (in thousands):

| ** **              | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|-------------------------|------------|-----------------------------------------------------|------------|
| ** **              | ** ** | **   2006   **        | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** |
| Net income (loss)       |       |                                                | $          | (12 | ) |   |   | $ | (311 | ) |   |   | $ | 28 |   |   |
| Unrealized gain  (loss) |       |                                                | 1          |   |   |   | 1 |   |   |   | — |   |   |
|                    |       |                                                | $          | (11 | ) |   |   | $ | (310 | ) |   |   | $ | 28 |   |   |

 

*Segment Reporting*

We are organized and operate as two operatingsegments. We operate primarily in two geographic areas, the Americas and Asia.The Americas is comprised of the United States, Canada, Mexico, Central Americaand the Caribbean.

Netrevenue by geographic region based on customer location for fiscal years ending2006, 2005 and 2004, respectively, were as follows:

| ** **    | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Americas      |       |                                                | 90         | % |   |   | 90 | % |   |   | 90 | % |   |
| International |       |                                                | 10         | % |   |   | 10 | % |   |   | 10 | % |   |
|          |       |                                                | 100        | % |   |   | 100 | % |   |   | 100 | % |   |

 

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International is comprised of revenue primarily fromChina, the United Kingdom and Norway. Most significant long-lived assets arelocated in the United States. Our hardware tooling used to develop the IP710and the IP705 phones is located in Taiwan.

Net revenueby customers that individually accounted for more than 10% of our revenue forfiscal years ending 2006, 2005 and 2004, respectively, were as follows:

| ** **    | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| AltiSys       |       |                                                | 15         | % |   |   | 16 | % |   |   | 14 | % |   |
| Ingram Micro* |       |                                                | —     |   |   |   | 2 | % |   |   | 14 | % |   |
| Synnex        |       |                                                | 55         | % |   |   | 53 | % |   |   | 46 | % |   |
| Graybar       |       |                                                | 14         | % |   |   | 11 | % |   |   | 8 | % |   |

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*                    OnJuly 20, 2005, we terminated our distribution agreement with Ingram Micro.The termination of our relationship with Ingram Micro did not have a materialimpact on our business.

*Recent AccountingPronouncements*

In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”)which replaces Accounting Principles Board Opinions No. 20 “AccountingChanges” and SFAS No. 3, “Reporting Accounting Changes in InterimFinancial Statements—An Amendment of APB Opinion No. 28.” SFAS 154provides guidance on the accounting for and reporting of accounting changes anderror corrections. It establishes retrospective application, or the latestpracticable date, as the required method for reporting a change in accountingprinciple and the reporting of a correction of an error. SFAS 154 iseffective for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005 is required to be adopted by us in thefirst quarter of fiscal year 2007. We are currently evaluating the effect thatthe adoption of SFAS 154 will have on our consolidated results ofoperations and financial condition but do not expect it to have a materialimpact.

**3. WARRANTY**

The Company provides a one year warranty for hardwareproducts starting upon shipment to end users. We historically have experiencedminimal warranty costs. Factors that affect our warranty liability include the numberof installed units, historical experience and management’s judgment regardinganticipated rates of warranty claims and cost per claim. We assess the adequacyof our recorded warranty liability every quarter and make adjustments to theliability if necessary.

Changesin our warranty liability for the fiscal years ended September 30, 2006and 2005, respectively, are as follows (in thousands):

| ** **                                           | ** ** | **September 30,** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Beginning balance                                    |       | $                      | 264        |   | $ | 424 |   |
| Provisions for  warranty liability                   |       | 146                    |       | 103 |   |
| Other adjustments                                    |       | —                 |       | (102 | ) |
| Warranty cost  including labor, components and scrap |       | (147                   | )          | (161 | ) |
| Ending balance                                       |       | $                      | 263        |   | $ | 264 |   |

 

Other adjustments were theresult of a significant decline in the product return rate caused by changes inthe Company’s management of the return programs.

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**4. COMMITMENTS ANDCONTINGENCIES:**

*Commitments*

Welease our facilities under various operating lease agreements expiring onvarious dates through February 2009. In December 2003, we leasedapproximately 32,000 square feet to serve as our headquarters for corporateadministration, research and development, manufacturing, and sales andmarketing facility in Fremont, California. The lease for our headquartersexpires on February 21, 2009. Rent expense for all operating leasestotaled approximately $539,000, $486,000, and $510,000, for fiscal years 2006,2005, and 2004, respectively. In addition, we lease certain equipment undercapital lease arrangements. Minimum future lease payments under allnoncancellable capital and operating leases as of September 30, 2006 areas follows (in thousands):

| ** **                                               | ** ** | **Capital** | ** ** | **Operating** | ** ** |
|----------------------------------------------------------|------------|-------------|------------|---------------|------------|
| **Fiscal Year Ending September 30,** | ** ** | ** **  | ** ** | **Leases**    | ** ** | **Leases** | ** ** |
| 2007                                                     |       |        | 53         |          |       |   | 446 |   |   |
| 2008                                                     |       |        | 47         |          |       |   | 286 |   |   |
| 2009                                                     |       |        | 44         |          |       |   | 92 |   |   |
| 2010                                                     |       |        | 33         |          |       |   | — |   |   |
| Total minimum  lease payment                             |       |        | $          | 177           |       |   |   | $ | 824 |   |   |
| Amount  representing interest                            |       |        | $          | 27            |       |   |   |   |   |   |
| Present value of  minimum lease payment                  |       |        | 150        |          |       |   |   |   |   |
| Total minimum  lease payment                             |       |        | $          | 177           |       |   |   |   |   |   |
| Current portion  plus current portion of interest        |       |        | $          | 53            |       |   |   |   |   |   |
| Long-term portion  plus long-term portion of interest    |       |        | 124        |          |       |   |   |   |   |
| Total capital lease  commitments                         |       |        | $          | 177           |       |   |   |   |   |   |
|                                                          |            |             |            |               |            |  |  |  |  |  |  |  |  |

 

*Contingencies*

We may become party to litigation in the normal courseof our business. Litigation in general, and intellectual property andsecurities litigation in particular, can be expensive and disruptive to normalbusiness operations. Moreover, the results of complex litigation are difficultto predict.

On September 6, 2002,Vertical Networks, Inc. filed suit against us in the United StatesDistrict Court for the Northern District of California, alleging infringementof Vertical Networks’ U.S. Patents Nos. 6,266,341; 6,289,025; 6,292,482;6,389,009; and 6,396,849. On October 28, 2002, Vertical Networks amendedits complaint to add allegations of infringement of U.S. Patents Nos. 5,617,418and 5,687,174. Vertical Networks filed a second amended complaint on November 20,2002 to identify our products and/or activities that allegedly infringe theseven patents-in-suit. Vertical Networks seeks a judgment of patentinfringement and an award of damages, including treble damages for allegedwillful infringement, and attorneys’ fees and costs. We filed an answer andcounterclaims for declaratory relief on December 9, 2002. On December 26,2002, Vertical Networks filed its answer to our counterclaims. VerticalNetworks served its preliminary infringement contentions on us on April 9,2003 and we served Vertical Networks our preliminary invalidity contentions on June 3,2003 and July 14, 2003. To date, the parties have exchanged some discovery,but no depositions have been taken, and no motions are currently pending. Webelieve we have strong defenses and arguments in this dispute and intend tovigorously defend our position. Management’s view is that any loss from thislitigation is currently not probable or estimable. Therefore, we have notestablished a reserve on our balance sheets as to any liability related to theoutcome of this action.

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**5. CAPITAL STOCK:**

*Common Stock*

We areauthorized to issue 50,000,000 shares of common stock. At September 30,2006, we had reserved the following shares of common stock for future issuance:

| 1994 Stock Option  Plan            |   | 972,235   |   |
|------------------------------------|--------|-----------|--------|
| 1999 Employee  Stock Purchase Plan |   | 765,640   |   |
| 1999 Stock Option  Plan            |   | 4,643,090 |   |
|                               |   | 6,380,965 |   |

 

*Stock Option Plans*

In October 1994, we adopted the 1994 Stock OptionPlan (the “1994 Plan”) and authorized the issuance of 2,096,246 shares toemployees, directors, and consultants. As of September 30, 2006, therewere 180,525 vested shares outstanding from the 1994 Stock Option Plan (the “1994Plan”). In 1996, all shares under this plan vested and continue to remainoutstanding. During fiscal year 1999, we adopted the 1999 Stock Option Plan(the “1999 Plan”) and authorized the issuance of 2,096,247 shares to employees,directors and consultants. The number of shares will be increased on the firstday of our  Company’s fiscal year equalto the lesser of (i) 1,796,783 shares, (ii) 5% of the outstandingshares on that date or (iii) a lesser amount as determined by the Board ofDirectors. Under the Plans, the Board of Directors may grant incentive andnonqualified stock options to employees, directors and consultants of theCompany. The exercise price per share for an incentive stock option cannot beless than 100% of the fair market value, as determined by the Board ofDirectors, on the date of grant. The exercise price per share for anonqualified stock option cannot be less than 85% of the fair market value, asdetermined by the Board of Directors, on the date of grant. Also, the exerciseprice of options granted to a greater than 10% stockholder may not be less than110% of the fair market value on the date of grant. The value of common stocksubject to incentive stock options that become exercisable by any one employeein any calendar year may not exceed $100,000. Options under these Plansgenerally vest over a four-year period and generally expire ten years after thedate of grant.

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Optionactivity under the 1994 and 1999 Plans (“the Plans”) was as follows:

| ** **                                         | ** ** | **Options available  for grant** | ** ** | **Options outstanding** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------------------------|------------|
| Balance as of  September 30, 2003             |       |                                       | 2,616,961  |                         |       |                                           | 3,602,285  |   |   |   | $ | 3.88 |   |   |
| Authorized for grant                               |       |                                       | 699,527    |                         |       |                                           | —     |   |   |   |   |   |   |
| Granted (weighted average of fair value of $3.75)  |       |                                       | (808,000   | )                            |       |                                           | 808,000    |   |   |   | 3.75 |   |   |
| Exercised                                          |       |                                       | —     |                         |       |                                           | (229,075   | ) |   |   | 1.05 |   |   |
| Canceled                                           |       |                                       | 429,411    |                         |       |                                           | (429,396   | ) |   |   | 5.90 |   |   |
| Balance as of  September 30, 2004             |       |                                       | 2,937,899  |                         |       |                                           | 3,751,814  |   |   |   | $ | 3.79 |   |   |
| Authorized for grant                               |       |                                       | 719,931    |                         |       |                                           | —     |   |   |   |   |   |   |
| Granted (weighted average of fair value of $2.99)  |       |                                       | (831,000   | )                            |       |                                           | 831,000    |   |   |   | 2.99 |   |   |
| Exercised                                          |       |                                       | —     |                         |       |                                           | (210,107   | ) |   |   | 0.95 |   |   |
| Canceled                                           |       |                                       | 288,217    |                         |       |                                           | (288,217   | ) |   |   | 4.11 |   |   |
| Balance as of  September 30, 2005             |       |                                       | 3,115,047  |                         |       |                                           | 4,084,490  |   |   |   | $ | 3.75 |   |   |
| Authorized for  grant                              |       |                                       | —     |                         |       |                                           | —     |   |   |   |   |   |   |
| Granted (weighted  average of fair value of $1.76) |       |                                       | (58,000    | )                            |       |                                           | 58,000     |   |   |   | 1.76 |   |   |
| Exercised                                          |       |                                       | —     |                         |       |                                           | (265,895   | ) |   |   | 0.69 |   |   |
| Canceled                                           |       |                                       | 317,425    |                         |       |                                           | (317,425   | ) |   |   | 5.86 |   |   |
| Balance as of  September 30, 2006             |       |                                       | 3,374,472  |                         |       |                                           | 3,559,170  |   |   |   | $ | 3.76 |   |   |
| Exercisable at September 30, 2004             |       |                                       |       |                         |       |                                           | 2,494,920  |   |   |   | $ | 4.42 |   |   |
| Exercisable at  September 30, 2005            |       |                                       |       |                         |       |                                           | 2,829,037  |   |   |   | $ | 4.12 |   |   |
| Exercisable at  September 30, 2006            |       |                                       |       |                         |       |                                           | 2,992,428  |   |   |   | $ | 3.91 |   |   |

 

Thefollowing table summarizes information concerning outstanding and exercisableoptions at September 30, 2006:

| ** **               | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding**      | ** ** | **Weighted  Average  Remaining  Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $0.17-$0.59              |       |                         | 21,240     |                         |       |   | 3.21 |   |   |   | $ | 0.42 |   |   | 21,240 |   |   | $ | 0.42 |   |   |
|   0.60-0.60    |       |                         | 422,720    |                         |       |   | 6.12 |   |   |   | 0.60 |   |   | 402,825 |   |   | 0.60 |   |   |
|   0.61-0.78    |       |                         | 362,335    |                         |       |   | 4.86 |   |   |   | 0.78 |   |   | 362,335 |   |   | 0.78 |   |   |
|   0.79-1.83    |       |                         | 359,301    |                         |       |   | 5.12 |   |   |   | 1.08 |   |   | 307,218 |   |   | 0.97 |   |   |
|   1.84-2.13    |       |                         | 363,000    |                         |       |   | 4.49 |   |   |   | 2.11 |   |   | 343,647 |   |   | 2.12 |   |   |
|   2.14-2.89    |       |                         | 70,946     |                         |       |   | 5.58 |   |   |   | 2.68 |   |   | 52,300 |   |   | 2.73 |   |   |
|   2.90-2.98    |       |                         | 633,802    |                         |       |   | 8.12 |   |   |   | 2.98 |   |   | 347,806 |   |   | 2.98 |   |   |
|   2.99-3.81    |       |                         | 2,000      |                         |       |   | 4.02 |   |   |   | 3.81 |   |   | 2,000 |   |   | 3.81 |   |   |
|   3.82-3.82    |       |                         | 564,333    |                         |       |   | 7.27 |   |   |   | 3.82 |   |   | 402,314 |   |   | 3.82 |   |   |
|   3.83-12.69   |       |                         | 759,493    |                         |       |   | 3.23 |   |   |   | 9.80 |   |   | 750,743 |   |   | 9.87 |   |   |
|                     |       |                         | 3,559,170  |                         |       |   | 5.62 |   |   |   | $ | 3.76 |   |   | 2,992,428 |   |   | $ | 3.91 |   |   |
|                          |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*1999 Employee StockPurchase Plan*

Under the 1999 EmployeeStock Purchase Plan (the “1999 Purchase Plan”), 765,640 shares of common stockare reserved for issuance at September 30, 2006 to eligible employees at aprice of 85% of the lower of the fair market value of the common stock on thefirst day of the offering period or a specified exercise date (last trading dayin April or October). The number of reserved shares will be increased onthe first day of each fiscal year by the lesser of (i) 598,928 shares, (ii) 2%of the outstanding shares on that date or (iii) a lesser amount determinedby the Board of Directors. Participants under the 1999 Purchase Plan 

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generallymay not purchase shares on any exercise date to the extent that, immediatelyafter the grant, the participant would own stock totaling 5% or more of thetotal combined voting power of all stock of the Company, or greater than$25,000 worth of stock in any calendar year. In addition, no more than 5,989shares may be purchased by any participant during any offering period. In theevent of a sale or merger of us, the Board may accelerate the exercise date ofthe current purchase period to a date prior to the change of control, or theacquiring company may assume or replace the outstanding purchase rights underthe 1999 Purchase Plan. In fiscal year 2006, 109,398 shares were purchased by and distributed toemployees at a price of $1.31 per share.

**6. DEFERRED STOCKCOMPENSATION**

Amortizationof deferred stock compensation relates to the following items in theaccompanying consolidated statements of operations (in thousands):

| ** **                                | ** ** | **Fiscal Year Ended September 30,**  | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| Cost of goods  sold                       |       |                                                     | $          | 36 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Research and  development                 |       |                                                     | 279        |   |   |   | — |   |   |   | — |   |   |
| Selling, general  and administrative      |       |                                                     | 486        |   |   |   | — |   |   |   | — |   |   |
| Pre-tax  stock-based compensation expense |       |                                                     | 801        |   |   |   | — |   |   |   | — |   |   |
| Income tax                                |       |                                                     | —     |   |   |   | — |   |   |   | — |   |   |
| Net stock-based  compensation expense     |       |                                                     | $          | 801 |   |   |   | $ | — |   |   |   | $ | — |   |   |

 

**7. INCOME TAXES:**

Worldwideincome (loss) from continuing operations before provision for income taxesconsists of the following (in thousands):

| ** **                                | ** ** | **Fiscal Year Ended September 30,**  | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| United States                             |       |                                                     | $          | 114 |   |   |   | $ | (131 | ) |   |   | $ | 284 |   |   |
| Foreign                                   |       |                                                     | (107       | ) |   |   | (180 | ) |   |   | (256 | ) |   |
| Income (loss) from  continuing operations |       |                                                     | $          | 7 |   |   |   | $ | (311 | ) |   |   | $ | 28 |   |   |

 

Theprovision for income taxes consisted of the following (in thousands) and isattributable to federal and state minimum taxes:

| ** **           | ** ** | **Fiscal Year Ended September 30,**  | ** ** |
|----------------------|------------|----------------------------------------------------------|------------|
| ** **           | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| Federal              |       |                                                     | $          | 14 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| State                |       |                                                     | 5          |   |   |   | — |   |   |   | — |   |   |
| Foreign              |       |                                                     | —     |   |   |   | — |   |   |   | — |   |   |
| Income tax provision |       |                                                     | $          | 19 |   |   |   | $ | — |   |   |   | $ | — |   |   |

 

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Weaccount for income taxes pursuant to SFAS No. 109, “Accounting for IncomeTaxes.” SFAS No. 109 requires recognition of deferred tax liabilities andassets for the expected future tax consequences of events that have beenincluded in the financial statements or tax returns. The following is a summaryof the significant components of the deferred tax asset (in thousands):

| ** **                                          | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|
| ** **                                          | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Net operating  loss carryforwards                   |       | $                      | 15,056     |   | $ | 16,422 |   |
| Reserve and other  cumulative temporary differences |       | 1,860                  |       | 1,790 |   |
| Research and  development credit carryforward       |       | 1,085                  |       | 1,090 |   |
| Net capitalized  research and development expenses  |       | 490                    |       | 402 |   |
|                                                |       | 18,491                 |       | 19,704 |   |
| Valuation  allowance                                |       | (18,491                | )          | (19,704 | ) |
| Net deferred tax asset                              |       | $                      | —     |   | $ | — |   |

 

As of September 30, 2006, we had net operatingloss carryforwards for federal income tax purposes of approximately$40.7 million that expire at various dates through 2025, and federalresearch and development tax credits of approximately $520,000 that expire atvarious dates through 2025. We also had net operating loss carryforwards forstate income tax purposes of approximately $13.8 million that expire at variousdates through 2015, and state research and development tax credits ofapproximately $565,000 which do not have an expiration date and may be carriedforward indefinitely. Utilization of the Company’s net operating loss and taxcredit carryforwards may be subject to substantial annual limitation due to theownership change limitations provided by the Internal Revenue Code and similarstate provisions. Such an annual limitation could result in the expiration ofthe net operating loss carryforwards before utilization.

A valuation allowance has been recorded for the entiredeferred tax asset as a result of uncertainties regarding realization of theasset, including limited operating history of the Company, lack ofprofitability to date and uncertainty over future operating profitability andtaxable income. As of September 30, 2006 and 2005 we had no significantdeferred tax liabilities.

We did not incur any income tax expenses from ourforeign subsidiaries, AltiGen Korea and AltiGen China as of September 30,2006.

Reconciliationbetween the Company’s effective tax rate and the U.S. statutory rate is asfollows:

| ** **                      | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Tax at federal  statutory rate  |       | 35.0                                                    | %          | 35.0 | % | 35.0 | % |
| Change in  valuation allowance  |       | (4,098.5                                                | )          | (31.0 | ) | (94.0 | ) |
| State taxes                     |       | 543.7                                                   |       | — |   | — |   |
| Meals &  entertainment |       | 179.5                                                   |       | — |   | — |   |
| Unbenefitted  foreign loss      |       | 535.0                                                   |       | — |   | — |   |
| Stock based  compensation       |       | 3,067.8                                                 |       | — |   | — |   |
| Other                           |       | 8.3                                                     |       | (4.0 | ) | 59.0 |   |
| Provision for income taxes      |       | 270.8                                                   | %          | 0.0 | % | 0.0 | % |

 

**8. EQUITYINVESTMENT IN COMMON STOCK OF PRIVATE COMPANY**

TheCompany has a 23% vested interest in AltiGen “Korea”. The total equityin net losses of Korea investee was approximately $160,000 of which 23%, or$36,000 was recognized in fiscal 2006. In fiscal year 2005 equity in net lossesof Korea investee was approximately $52,000 of which 23% or $12,000 wasrecognized in the fourth quarter of fiscal year.

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**9. RELATED PARTYTRANSACTION**

In July 2004, we purchasedcommon stock of a private Korean telecommunications company for $79,000. As aresult of this investment, we acquired approximately 23% of the voting power ofthe company and have the right to nominate and have elected one of the threemembers of the company’s current board of directors. We are accounting for thisinvestment using the equity method. We had revenue from product sales to thiscompany of $14,000 and $37,000 during fiscal years 2006 and 2005, respectively.Our accounts receivable from this company decreased to $30,000 in fiscal year2006 from $40,000 in fiscal year 2005.

**10. SELECTEDQUARTERLY FINANCIAL DATA (UNAUDITED)**

Thefollowing is a summary of our unaudited quarterly financial results:

| ** **                                     | ** ** | **First Quarter**                                             | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **(in thousands, except per share data)** | ** ** |
| Fiscal Year Ended  September 30,          |       |                                                               |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| 2006:                                          |       |                                                               |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Revenue, net                                   |       |                                                               | $          | 4,403                   |       |                   |       | $                       | 4,174      |   |   |   | $ | 4,806 |   |   |   | $ | 4,513 |   |   |
| Gross profit                                   |       |                                                               | 2,385      |                    |       |                   | 2,239      |                    |       |   | 2,711 |   |   |   | 2,479 |   |   |
| Net income (loss)                              |       |                                                               | (218       | )                       |       |                   | (120       | )                       |       |   | 190 |   |   |   | 136 |   |   |
| Basic and diluted  net income (loss) per share |       |                                                               | (0.01      | )                       |       |                   | (0.01      | )                       |       |   | 0.01 |   |   |   | 0.01 |   |   |
| 2005:                                          |       |                                                               |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Revenue, net                                   |       |                                                               | $          | 4,275                   |       |                   |       | $                       | 2,801      |   |   |   | $ | 4,117 |   |   |   | $ | 4,248 |   |   |
| Gross profit                                   |       |                                                               | 2,608      |                    |       |                   | 1,541      |                    |       |   | 2,221 |   |   |   | 2,479 |   |   |
| Net income (loss)                              |       |                                                               | 342        |                    |       |                   | (858       | )                       |       |   | (96 | ) |   |   | 302 |   |   |
| Basic and diluted net  income (loss) per share |       |                                                               | 0.02       |                    |       |                   | (0.06      | )                       |       |   | (0.01 | ) |   |   | 0.02 |   |   |

 

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**ALTIGENCOMMUNICATIONS, INC. AND SUBSIDIARYSCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS**

| **Classification**               | ** ** | ** **              | ** ** | **Balance at  Beginning of  Fiscal Year** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Deductions** | ** ** | **Balance at  End of  Fiscal Year** | ** ** |
|----------------------------------|------------|-------------------------|------------|----------------------------------------------------------|------------|-----------------------------------------------|------------|----------------|------------|----------------------------------------------------|------------|
| ** **                       | ** ** | **(in thousands)** | ** ** |
| Allowance for doubtful accounts: |       |                    |       |                                                     |       |                                          |       |           |       |                                               |       |   |   |   |   |   |   |
| 2006                             |       |                    | $          | 40                                                       |       |                                          |       | $              | 1          |                                               |       |   | $ | (3 | ) |   |   | $ | 38 |   |   |
| 2005                             |       |                    | $          | 35                                                       |       |                                          |       | $              | 34         |                                               |       |   | $ | (29 | ) |   |   | $ | 40 |   |   |
| 2004                             |       |                    | $          | 60                                                       |       |                                          |       | $              | 35         |                                               |       |   | $ | (60 | ) |   |   | $ | 35 |   |   |
| Inventory reserve:               |       |                    |       |                                                     |       |                                          |       |           |       |                                               |       |   |   |   |   |   |   |
| 2006                             |       |                    | $          | 2,458                                                    |       |                                          |       | $              | 122        |                                               |       |   | $ | (301 | ) |   |   | $ | 2,279 |   |   |
| 2005                             |       |                    | $          | 2,625                                                    |       |                                          |       | $              | —     |                                               |       |   | $ | (167 | ) |   |   | $ | 2,458 |   |   |
| 2004                             |       |                    | $          | 2,918                                                    |       |                                          |       | $              | —     |                                               |       |   | $ | (293 | ) |   |   | $ | 2,625 |   |   |

 

The deductions are a result of sales of product thatwere recovered and we are currently using up this reserve as we sell ourproduct.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

| Date: December 29, 2006 | Altigen  Communications, Inc. |
|------------------------------|------------------------------------|
|                         | By:                                | /s/ GILBERT HU |
|                         |                               | Gilbert Hu |
|                         |                               | President and Chief Executive Officer |

 

**POWER OF ATTORNEY**

KNOW ALL PERSONS BY THESE PRESENT, that each personwhose signature appears below constitutes and appoints Gilbert Hu and Philip M.McDermott, jointly and severally, his attorneys-in-fact, each with the power ofsubstitution, for him in any and all capacities, to sign any amendments to thisreport on Form 10-K, and to file the same, with exhibits thereto andother documents in connection therewith with the Securities and ExchangeCommission, hereby ratifying and confirming all that each of saidattorneys-in-fact, or his substitute or substitutes may do or cause to be doneby virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant in thecapacities and on the dates indicated.

| Signature                | ** ** | **Title**                           | ** ** | **Date**               |
|--------------------------|------------|-------------------------------------|------------|------------------------|
| /s/ GILBERT HU           |       | Chief Executive Officer (principal  |       | December 29, 2006 |
| Gilbert Hu               |       | executive officer) and Director     |       |                   |
| /s/ PHILIP M. MCDERMOTT  |       | Chief Financial Officer  (principal |       | December 29, 2006 |
| Philip McDermott         |       | financial and accounting officer)   |       |                   |
| /s/ KENNETH TAI          |       | Director                            |       | December 29, 2006 |
| Kenneth Tai              |       |                                |       |                   |
| /s/ RICHARD BLACK        |       | Director                            |       | December 29, 2006 |
| Richard Black            |       |                                |       |                   |
| /s/ TACHENG CHESTER WANG |       | Director                            |       | December 29, 2006 |
| Tacheng Chester Wang     |       |                                |       |                   |
| /s/ MIKE MON YEN TSAI    |       | Director                            |       | December 29, 2006 |
| Mike Mon Yen Tsai        |       |                                |       |                   |

 

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**AltiGenCommunications, Inc.Exhibit Index**
| Exhibit  Number | ** ** | **Description**                                                                                                                                                  |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1*            |       | Amended  and Restated Certificate of Incorporation.                                                                                                              |
| 3.2*****        |       | Second Amended and Restated Bylaws.                                                                                                                              |
| 4.2*            |       | Specimen common stock certificates.                                                                                                                              |
| 4.3*            |       | Third Amended and Restated Rights Agreement dated  May 7, 1999 by and among AltiGen Communications, Inc. and the  Investors and Founder named therein. |
| 10.1*           |       | Form of Indemnification Agreement.                                                                                                                          |
| 10.2*           |       | 1994 Stock Option Plan, as amended, and form of  stock option agreement.                                                                                         |
| 10.3*           |       | 1998 Stock Purchase Plan.                                                                                                                                        |
| 10.4****        |       | 1999 Stock Plan, as amended, and form of stock  option agreement.                                                                                                |
| 10.5***         |       | 1999 Employee Stock Purchase Plan, as amended, and  forms of subscription agreement and notice of withdrawal.                                                    |
| 10.8****        |       | Lease agreement: 4555 Cushing Parkway, Fremont,  California between VEF III Funding, LLC. And AltiGen  Communications, Inc. dated October 1, 2003.     |
| 10.19*          |       | Employment Agreement by and between the Registrant  and Philip McDermott, dated June 8, 1999.                                                               |
| 10.26**++       |       | OEM Agreement between AltiSys Communications and  AltiGen Communications, Inc., dated January 18, 1999.                                                |
| 10.27****++     |       | Distribution Agreement between Synnex Information  Technologies, Inc. and AltiGen Communications, Inc. dated  December 22, 1999.                  |
| 10.28****++     |       | Distribution Agreement between Graybar Electric  Company, Inc. and AltiGen Communications, Inc. dated June 12,  2003.                             |
| 21.1*           |       | Subsidiaries of the Registrant.                                                                                                                                  |
| 23.1            |       | Consent of Independent Registered Public Accounting  Firm.                                                                                                       |
| 23.2            |       | Consent of Deloitte & Touche LLP,  Independent Registered Public Accounting Firm.                                                                       |
| 24.1            |       | Power of Attorney (included on signature page).                                                                                                                  |
| 31.1            |       | Certification of Principal Executive Officer.                                                                                                                    |
| 31.2            |       | Certification of Principal Financial Officer.                                                                                                                    |
| 32.1            |       | Certification of Chief Executive Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.   |
| 32.2            |       | Certification of Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.   |

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| *     |   | Incorporated by reference to exhibit filed with the  Registrant’s Registration Statement on Form S-1 (No. 333-80037)  declared effective on October 4, 1999. |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **    |   | Incorporated by reference to  exhibit filed with the Registrant’s Quarterly Report on Form 10-Q  for the quarter ended December 31, 2001.                         |
| ***   |   | Incorporated by reference to  exhibit filed with the Registrant’s Annual Report on Form 10-K for  the fiscal year ended September 30, 2002.                       |
| ****  |   | Incorporated by reference to  exhibit filed with the Registrant’s Annual Report on Form 10-K for  the fiscal year ended September 30, 2003.                       |
| ***** |   | Incorporated by reference to  exhibit filed with the Registrant’s Quarterly Report on Form 10-Q  for the quarter ended March 31, 2004.                            |
| ++    |   | Confidential treatment was  granted for certain portions of this exhibit.                                                                                                        |

 

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