**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, 2005**

**OR**

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

**Forthe transition periodfrom                   to                   **

**CommissionFile Number 000-27427**

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**ALTIGEN COMMUNICATIONS,INC.**

(Exact name of Registrantas 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  o  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 filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes  x  No  o

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.  o

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

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

The aggregate market valueof the common stock held by non-affiliates of the registrant was approximately$38,040,121 as of March 31, 2005, based on the closing price of our commonstock as reported on The Nasdaq Capital 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 31,2005, there were 14,635,022 shares of the our common stock issued andoutstanding.

As of December 19,2005, there were 14,902,501 shares of our common stock issued and outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Certainsections of AltiGen Communications, Inc.’s definitive Proxy Statement for the2006 Annual Meeting of Stockholders to be held on February 9, 2006 areincorporated by reference in Part III of this Form 10-K to theextent stated herein.

 

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**TABLE OF 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                                                                                                  |       |       | 23       |       |
| Item  4.       |       | Submission  of Matters to a Vote of Security Holders                                                                |       |       | 23       |       |
|           |       | PART II                                                                                                        |       |       |     |       |
| Item 5.        |       | Market  for Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |       |       | 24       |       |
| 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                                                         |       |       | 34       |       |
| 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                                                                                                  |       |       | 35       |       |
|           |       | PART III                                                                                                       |       |       |     |       |
| Item 10.       |       | Directors  and Executive Officers of the Registrant                                                                 |       |       | 36       |       |
| Item  11.      |       | Executive  Compensation                                                                                             |       |       | 37       |       |
| Item  12.      |       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    |       |       | 37       |       |
| Item  13.      |       | Certain  Relationships and Related Transactions                                                                     |       |       | 37       |       |
| Item  14.      |       | Principal  Accountant Fees and Services                                                                             |       |       | 37       |       |
|           |       | PART IV                                                                                                        |       |       |     |       |
| Item 15.       |       | Exhibits  and Financial Statement Schedules                                                                         |       |       | 39       |       |
| SIGNATURES     |       |                                                                                                                | 60         |       |
| CERTIFICATIONS |       |                                                                                                                |       |            |

 

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**PART I**

**Item 1. Business**

**INTRODUCTION**

**AltiGen Communications, Inc.**(NASDAQSC: ATGN) is a pioneer and market leader in Internet protocol telephonysystems for small-to-medium sized businesses. We design and manufactureadvanced phone systems and call center products that use both the Internet andthe public telephone network. Our systems are designed with an openarchitecture and are built on an industry standard platform. This adherence towidely-used standards allows our products to integrate with and leverage acompany’s existing technology investment.

We generated net revenues of $15.4 million with anet loss of $311,000 during fiscal year 2005. As of September 30, 2005, wehad an accumulated deficit of $51.1 million. Net cash used in operatingactivities was $509,000 for fiscal year 2005.

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 (i.e. not shared) line between calling parties for theduration of a call. The second type of network on which businesses havetraditionally relied is a “packet-switched” network, such as an internallocal area network or an external network, like the Internet, where voice,video, images or data is divided into small Internet protocol packets ofinformation for transmission that are simultaneously combined with otherunrelated packets of information and routed to a final destination where thisprocess is reversed. Packet-switched networks are more efficient than thetraditional circuit-switched telephone network, because network paths are notdedicated to a single user, but instead are available to be shared by allusers. As a result, network capacity is allocated more efficiently. It iscommonplace for networks installed today to be able to support both voice anddata 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, 

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businessesmay wish to route internal calls over their existing voice network and routecalls between offices over packet-switched networks, all using the sametelecommunications system. We believe a significant opportunity exists toprovide small-to-medium sized and mid-enterprise businesses with an integratedphone system that delivers the benefits of integrated, multi-functiontelecommunications systems using Internet protocol packet switching networks aswell as traditional circuit-switched telephone networks.

**THE ALTIGEN PRODUCT OFFERING**

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 turn-keyapproach, 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 companies with more advanced requirements, wemanufacture AltiContact Manager. The product is available preloaded as a PBXand call center, or as a software upgrade to an existing AltiServTM Officesystem. This product is capable of skills-based routing, priority queuing,centralized call recording and advanced monitoring and reporting. Thiscapability may be added on a per agent/supervisor basis as the company’s needsgrow. This allows a smaller business or branch office to enjoy the samecapability as a large professional call center organization. If a company hasmore than one location, call center calls can automatically be routed to otherlocations based on conditions the customer chooses.

In 2005, we released two significant additions to ourcall center capability. The first product, VR Manager, allows themanagement of centrally recorded calls. We have integrated voice processing onevery connection in and out of the phone system. This allows a company torecord some or all calls for quality assurance. Competitively, this gives us atechnological advantage over other products that require an external recordingsystem to be tied to a PBX at a much greater cost. This year we also released acomprehensive call center reporting package called AltiReports. This web-basedreporting application can generate up to 40 detailed reports based on callcenter agents or call routing groups.

In September of this year, we released our mostadvanced business telephone to date. The IP710 is a standard based VoIPtelephone that is feature rich while maintaining our tradition of intuitive,easy to use technology. The phone was designed and developed based on severalyears of input from our customers and partners. The phone has been wellreceived in the market.

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With the enhancements to our call center capabilityand addition of the IP710 phone, we have continued to refine our innovative andcost effective product family. We provide a comprehensive, manageable and costeffective option for customer-driven companies.

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. The associated expenses, typically referred to as adds, movesand changes, can be a significant percentage of the ongoing operating cost ofany business telephone system. Our AltiServTM systems allow systemadministrators to perform many of these tasks on site or remotely withoutassistance 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. Redundantsystem hard drives allow all voice mail and configuration information tobe copied to a spare hard drive. The system allows nightly backup to anothernetwork drive. If weather or other problems prevent employees from reaching theoffice, ExtensionAnywhere, One Number Access and VoIP telephones can beutilized to keep operations running.We provide multiple options based upon what best fits the customer environment.

·       **Innovative Desktop Productivity Software**.   Oursystems provide desktop software applications to increase user productivity. Callcontrol, changes in extension configuration and the ability to view and managevoicemail messages improve an employee’s ability to process calls. In addition,we provide unique software for group supervisors, agents, system administratorsand operators. Applications are centrally upgraded from the phone system toallow for quick and efficient deployment.

·       **Integration with Customer Relationship ManagementSoftware.  **The AltiView and AltiAgent desktop interfacesprovided 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.

·       **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.

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·       **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 byemploying comprehensive contact center and call center routing, reporting andrecording technologies.

·       **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**

The following is a list ofour products that are material to our current operations from a financialstandpoint:
| 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 turn-key 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 pre-loaded as a PBX and call center, or 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.      |
| 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.                                                                                                                              |

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| 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.                                                                                     |
|------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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 effectively manage a workgroup.  AltiSupervisor provides four major real time module views for workgroup  management: agent states, 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.                                                                                                                                                                                                     |
| Triton Trunk  Board                |   | The Triton Trunk Board  is a 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.                                                                                                                                                                                                                                                                                                                            |
| Quantum Board                      |   | The Quantum Board is a  12-port microprocessor-controlled board that comes in 2  combinations of trunk plus extension configurations on the same board. The  Quantum Board allows AltiServTM systems to connect to analog central office  telephone lines and to support analog telephone extensions with the same  board.                                                                                                                                                                                        |

 

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*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 Tritonfamily 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 theservice providers in the system and manages their resources. This middlewarelayer communicates 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 generally is shorter

·       Newhardware and software features can be added to installed systems

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

NetRevenues by Products:

| ** ** | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|------------|------------|-----------------------------------------------------|------------|
| ** ** | ** ** | **2005**                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Hardware   |       |                                                | 86         | % |   |   | 84 | % |   |   | 87 | % |   |
| Software   |       |                                                | 14         | % |   |   | 16 | % |   |   | 13 | % |   |

 

**MARKETING,SALES AND 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 through publicrelations, print, email and web campaigns.

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Among our marketinghighlights for fiscal 2005:

**·**      Best of Show at InternetTelephony Conference and Expo Fall 2005 **(IP710 TelephoneRecognized)**

·       CommwebTester’s Choice Award 2005 **(AltiWare 5.0 IP PBXSoftware Recognized)**

·       Bestof Call Center and Demo Conference Dallas 2005**(AltiContactManager Software Recognized)**

·       ChannelBusiness “SME Convergence Solution 2005” United Kingdom **(MicrosoftCRM Integration Recognized)**

·       CustomerInter@ction Solutions 2004 “Product of the Year Award **(AltiContactManager Software Recognized)**

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 inJanuary 2005, has resulted in an increase of business as well as newreseller partnerships. Between January and September, more than 50 bankand credit union installations occurred. We believe our advanced but affordabletechnology is well matched to this vertical market. In China, we see more favorablegovernment spending and expect revenue from the region to increase again in2006.

We are organized as oneoperating segment. Our revenues primarily are generated from one geographicarea, the Americas.

NetRevenues by Geographic Area: 

| ** **    | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2005**                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Americas      |       |                                                | 90         | % |   |   | 90 | % |   |   | 94 | % |   |
| International |       |                                                | 10         | % |   |   | 10 | % |   |   | 6 | % |   |

 

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 neareach end user’s location. The inside sales force also is responsible foraccount management 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 2005, 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).

*Customers*

Our direct customers primarily are distributors andresellers who sell our products to end-users. We have distribution agreementswith AltiSys, Graybar and Synnex in the Americas. Our agreements with AltiSys,Graybar and Synnex have initial terms of one year and are renewed automaticallyfor additional one-year terms, provided that each party shall have the right toterminate the agreement for convenience upon 90 days’ written notice priorto the end of the initial term or any subsequent term of the agreement. 

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In addition, ouragreements with AltiSys, Graybar and Synnex also provide for termination, withor without cause, by either party upon 30 days’ written notice to theother party without penalty, or upon insolvency or bankruptcy. For a period of60 days’ following termination of the agreement, AltiSys, Graybar andSynnex may distribute any products in their possession at the time oftermination or, at their option, return any products to us that are in theirinventories. Upon termination of the distribution agreement, all outstandinginvoices for the products will become due and payable within 30 days’ ofthe termination.

On July 20, 2005, weterminated our distribution agreement with Ingram Micro.

NetRevenues by Customers:

| ** **   | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|--------------|------------|-----------------------------------------------------|------------|
| ** **   | ** ** | **2005**                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| AltiSys      |       |                                                | 16         | % |   |   | 14 | % |   |   | 18 | % |   |
| Ingram Micro |       |                                                | 2          | % |   |   | 14 | % |   |   | 21 | % |   |
| Synnex       |       |                                                | 53         | % |   |   | 46 | % |   |   | 48 | % |   |
| Graybar      |       |                                                | 11         | % |   |   | 8 | % |   |   | — |   |   |

 

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,and Shanghai, China coordinate service and technical support of our productsand 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 AND DEVELOPMENT**

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. We alsoare developing products that we expect will enable us to enhance our positionin the Internet protocol phone system market space, enter new geographicalmarkets, and allow us to enter the call center market for small-to-medium sizedbusinesses.

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 ofSeptember 30, 2005, we employed 45 individuals in engineering, researchand development and support.

During fiscal years 2005,2004, and 2003, our research and development expense was approximately $3.5million, $3.3 million, and $4.0 million, respectively.

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**COMPETITION**

The markets for our products are intenselycompetitive, continually evolving and subject to changing technologies. Wecurrently compete with companies providing traditional telephone systems andattempting to launch competitive Internet protocol enabled solutions,principally Avaya, NEC and Nortel. We also compete against companies providingonly Internet protocol and Internet protocol-enabled telecommunicationssystems, such as 3Com 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 Internetservice providers. These competitors may be able to respond more rapidly to newor emerging technologies and changes in customer requirements or to devotegreater resources 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 2005, 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.

**INTELLECTUAL PROPERTY**

On September 19, 2005, we entered into aroyalty-free agreement with Adaptive Digital Technologies, Inc. (Adaptive)to acquire a limited, non exclusive, world wide right and license to use,reproduce and sublicense Adaptive’s object code and source code for the purposeof developing, manufacturing, integrating, marketing and selling our productincorporated with Adaptive’s software. The agreement commenced onSeptember 19, 2005, and continues until terminated by either party or ifthe other party commits a material breach of the agreement and fails to curethe breach within thirty days after the notice has been given by the otherparty. We paid a one time license fee of approximately $27,000 to use thesoftware. The software allows for Echo Cancellation on the telephone lines.

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On June 2, 2005, we entered into a softwaretesting authorization agreement with Microsoft Corporation (Microsoft) to allowMicrosoft to test our product for compatibility with Microsoft operatingsystems, Microsoft software products, and other Microsoft technologies. Theagreement became effective as of June 2, 2005, and may be terminated byeither party, with or without cause, upon thirty day prior written notice tothe other party.

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, 2005, we have been issuedthree registered trademarks, “AltiGen,” “AltiServTM” and “Zoomerang.” 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 30,2005, we have been issued ten U.S. patents that expire at various times between2016 and 2019 and have five U.S. patent applications which are pending. Weexpect to continue to file patent applications to protect our technology andproducts. We cannot be sure that our patent applications will result in theissuance of patents, or that any issued patents will provide commerciallysignificant protection for our technology.

**MANUFACTURING AND ASSEMBLY**

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 year2005, we engaged All Quality Services and Bestronics in San Jose as our thirdparty assemblers. During fiscal 2005, four suppliers, Advantech, BCM Computers,Fanstel Corporation, and Avnet Electronics, provided us with approximately 93%of our hardware product components. We purchase fully-assembled chassisfrom Advantech. As of September 30, 2005, our in-house manufacturingoperations occupied approximately 7,000 square feet of our corporateheadquarters in Fremont, California.

We test our productsafter the assembly process using internally developed product assurance testingprocedures, which include visual inspection, functional testing and finalsystems testing. Although we generally use standard components for our productsand try to maintain alternative sources of supply, we purchase some keycomponents from sole source suppliers for which alternative sources currentlyare not available. We incorporate the following sole-sourced components in ourproducts:

·       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 needed to manipulate voice communications that arerouted through our products. We expect that sales of our Triton family ofboards will represent an increasing percentage of our revenues in the future.

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

·       Legerity, Inc.provides chips for our Triton Analog product line which allow our board to workwith analog communications lines.

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

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

·       BCMComputers manufactures our Internet protocol phone loaded with customizedfirmware 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 30,2005, we had 91 full-time employees, including 45 in research and developmentand support, 25 in marketing and sales, 7 in operations, and 14 in finance andadministration. Of these full-time employees, 52 were located in the UnitedStates and 39 in China. Our future success will depend, in part, on our abilityto continue to attract, retain and motivate highly qualified technical,marketing, engineering and management personnel.

**Item 1A. Risk Factors**

**CERTAINFACTORS 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, financialcondition and result of operations could be harmed, the trading price of ourcommon stock could decline and you may lose all or part of your investment inour common stock.

*Risks Related toOur Business*

*We have had a history oflosses and may incur future losses, which may prevent us from maintainingprofitability.*

We have had a history ofoperating losses since our inception and, as of September 30, 2005, we hadan accumulated deficit of $51.1 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 revenues 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 resultsvary, making future operating results difficult to predict.*

Our quarterly and annual operating results have variedsignificantly in the past and likely will vary significantly in the future. Anumber of factors, many of which are beyond our control, have caused and maycause our operating results to vary, including:

our ability torespond effectively to competitive pricing pressures;

·       ourability to respond effectively to competitive pricing pressures;

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

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·       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;

·       ourability to respond effectively to competitive pressures;

·       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 projected budgets and commitments are basedin part on our expectations of future sales. If our sales do not meetexpectations, it will be difficult for us to reduce our expenses quickly and,consequently, our operating results may suffer.

Our dealers often require immediate shipment andinstallation of our products. As a result, we have historically operated withlimited backlog, and our sales and operating results in any quarter primarilydepend on orders booked and shipped during that quarter.

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 highlycompetitive and we may not have the resources to adequately compete.*

The market for our integrated, multifunctiontelecommunications systems is new, rapidly evolving and highly competitive. Weexpect competition to intensify in the future as existing competitors developnew products and new competitors enter the market. We believe that a criticalcomponent to success in this market is the ability to establish and maintainstrong partner and customer relationships with a wide variety of domestic andinternational providers. If we fail to establish or maintain theserelationships, we will be at a serious competitive disadvantage.

We face competition from companies providingtraditional private telephone systems. Our principal competitors that producethese telephone systems are Avaya Communications, NEC and Nortel Networks. Wealso compete against providers of multi-function telecommunications systems,including 3Com Corporation, and Cisco Systems, Inc., as well as any numberof future competitors. Many of our competitors are substantially larger than weare and have significantly greater name recognition, financial resources, salesand marketing teams, technical and customer support, manufacturing capabilitiesand other resources. These competitors also may have more established distributionchannels and stronger relationships with service providers. These competitorsmay be able to respond more rapidly to new or emerging technologies and changesin customer requirements or to devote greater resources to the 

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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 reduced, price competition could beincreased or make our products could become obsolete. To remain competitive,therefore, we must continue to invest significant resources in research anddevelopment, sales and marketing and customer support. We may not havesufficient resources to make these investments or to make the technologicaladvances necessary to be competitive, which in turn will cause our business tosuffer.

*We sell our products through dealers and distributors,which limits our ability to control the timing of our sales, and which makes itmore difficult to predict our revenues.*

We do not recognize revenue from the sale of ourproducts to our distributors until these products are sold to either resellersor end-users. We have little control over the timing of product sales todealers and end users. Our lack of control over the revenue that we recognizefrom our distributors’ sales to resellers and end-users limits our ability to predictrevenue for any given period. Our future projected budgets and commitments arebased in part on our expectations of future sales. If our sales do not meetexpectations, it will be difficult for us to reduce our expenses quickly, andconsequently our operating results may suffer.

*We rely on resellers to promote, sell, install andsupport our products, and their failure to do so may substantially reduce oursales and thus seriously harm our business.*

We rely on resellers who can provide high quality salesand support services. As with our distributors, we compete with othertelecommunications systems providers for our resellers’ business as ourresellers generally market competing products. If a reseller promotes acompetitor’s products to the detriment of our products or otherwise fails tomarket our products and services effectively, we could lose market share. Inaddition, the loss of a key reseller or the failure of resellers to provideadequate customer service could cause our business to suffer. If we do notproperly train our resellers to sell, install and service our products, ourbusiness will suffer.

*Software or hardware errors may seriously harm ourbusiness and damage our reputation, causing loss of customers and revenues.*

Users expecttelephone systems to provide a high level of reliability. Our products areinherently complex and may have undetected software or hardware errors. We havedetected and may continue to detect errors and product defects in our installedbase of products, new product releases and product upgrades. End users mayinstall, maintain and use our products improperly or for purposes for whichthey were not designed. These problems may degrade or terminate the operationof our products, which could cause end users to lose telephone service, causeus to incur significant warranty and repair costs, damage our reputation andcause significant customer relations problems. Any significant delay in thecommercial introduction of our products due to errors or defects, any design modificationsrequired to correct these errors or defects or any negative effect on customersatisfaction as a result of errors or defects could seriously harm ourbusiness, financial condition and results of operations.

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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 revenues, 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.

*Our market is subject tochanging preferences; failure to keep up with these changes would result in ourlosing market share, thus seriously harming our business, financial conditionand results 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 attractingand retaining qualified personnel to maintain and expand our business; ourfailure to promptly attract and retain qualified personnel may seriously harmour business, 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 revenues. 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 ofStatement 123R will cause, and changes to existing accounting pronouncements ortaxation rules or practices may cause, adverse revenue fluctuations,affect our reported results of operations or how we conduct our business.*

In December 2004 FASB adopted Statement No. 123(R),“Share-Based Payment.” In April 2005, the SEC announced a delay of theeffective date until the first interim or annual reporting period of a company’sfirst fiscal year beginning December 31, 2005. SFAS No. 123(R) willrequire us, starting in the first quarter of fiscal year 2006 which began on October 1,2005, to measure compensation costs for all stock based compensation (includingstock options and our employee stock purchase plan, as currently constructed)at fair value and take a compensation charge equal to that value. We expectthat this statement will have a material effect on our results from operations.

Also, a change inaccounting pronouncements or taxation rules or practices can have asignificant effect 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 

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toexisting rules, future changes, if any, or the questioning of current practicesmay adversely affect our reported financial results or the way we conduct ourbusiness.

*If, as of the end of our2007 fiscal year, we are unable to assert that our internal control overfinancial reporting is effective, or if our auditors are unable to confirm ourassessment, investors could lose confidence in our reported financialinformation, and the trading price of our stock price and our business could beadversely affected.*

We are in the process ofdocumenting, and plan to test during the current fiscal year, our internalcontrol procedures in order to satisfy the requirements of Section 404 ofthe Sarbanes-Oxley Act. Commencing on September 30, 2007, the end of our2007 fiscal year, the Sarbanes-Oxley Act requires annual management assessmentsof the effectiveness of our internal controls over financial reporting and areport by our independent registered public accounting firm addressing theseassessments. During the course of our testing we may identify deficiencieswhich we may not be able to remediate in time to meet the deadline imposed bythe 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 internal controlsare important to help produce reliable financial reports and to preventfinancial fraud. If we are unable to assert that our internal control overfinancial reporting is effective as of the end of our 2007 fiscal year, or ifour auditors are unable to attest that our management’s report is fairly statedor they are unable to express an opinion on our management’s evaluation or onthe effectiveness of the internal controls, we could lose investor confidencein the accuracy and completeness of our financial reports, investors could loseconfidence in our reported financial information, and the trading price of ourstock and our business could be adversely affected.

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

We may not be successful in managing our future growth.We have expanded our operations rapidly since our inception. In order to managethis expansion and grow in the future, we will need to expand or enhance ourmanagement, manufacturing, research and development and sales and marketingcapabilities. We may not be able to hire the management, staff or otherpersonnel 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 operational disruptionswhen we transition to new systems would impair our ability to accuratelyforecast sales demand, manage our product inventory and record and reportfinancial 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.

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*Losing any of our keydistributors would harm our business. We also need to establish and maintainrelationships with additional distributors and original equipmentmanufacturers.*

Sales through our threekey distributors, Altisys, Graybar and Synnex, accounted for 80% of our netrevenues in the fiscal year ended September 30, 2005. 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 distributors andoriginal 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. For example, our agreement with Ingram Micro wasterminated as of July 20, 2005, with no impact to our business.

*We rely on sole-sourcedcomponents and third party technology and products; if these components are notavailable, 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 not have supply contracts for them. One sole-sourcedcomponent, a TI DSP chip, is particularly important to our business because itis included in virtually all of our hardware products. If we were unable topurchase an adequate supply of these sole-sourced components on a timely basis,we would be required to develop alternative products, which could entailqualifying an alternative source or redesigning our products based on differentcomponents. Our inability to obtain these sole-sourced components, especiallythe TI DSP chip, could significantly delay shipment of our products, whichcould have a negative effect on our business, financial condition and resultsof 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, 

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regulationsand standards differ from the activities intended by regulatory or governingbodies due to ambiguities related to practice, our reputation may be harmed.

*Our facility is vulnerableto damage 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 outsourceassembly and test functions in the future could delay delivery of products,decrease quality or increase costs.*

Based on volume orcustomer requirements, we may begin outsourcing some assembly and testfunctions. In addition, we may determine that we need to establish assembly andtest operations overseas to better serve our international customers.Establishing overseas assembly and test operations may be more difficult ortake longer than we anticipate. This outsourcing strategy involves certainrisks, including the potential lack of adequate capacity and reduced controlover delivery schedules, manufacturing yield, quality and costs. In the eventthat any significant subcontractors were to become unable or unwilling tocontinue to manufacture or test our products in the required volumes, we wouldhave to identify and qualify acceptable replacements. Finding replacementscould take time and we cannot be sure that additional sources would beavailable to us on a timely basis. Any delay or increase in costs in theassembly and testing of products by third-party subcontractors could seriouslyharm our business, financial condition and results of operations.

*Our planned expansion ininternational markets will involve new risks that our previous domesticoperations have not prepared us to address; our failure to address these riskscould harm our business, financial condition and results of operations.*

For fiscal year2005, approximately 10% of our net revenues 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.

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*Any failure by us toprotect our intellectual property could harm our business and competitiveposition.*

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 will resultin 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 ourauthorization. Further, the laws of some countries, such as those in Japan, oneof our target markets, may not adequately protect our intellectual property orsuch protection may be uncertain. Our success also depends on trade secretsthat cannot 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.

*We may face infringementissues that 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. On October 7, 2003, the parties filed a stipulation to stay thisaction, pending the outcome of the reissue of some of the subject patentsbefore the U.S. Patent and Trademark Office. We believe we have strong defensesand arguments in this dispute and intend to vigorously defend our position.Management’s view is 

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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.

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 revenues in the future will come fromsales of software applications for our hardware products. The software markettraditionally has experienced widespread unauthorized reproduction of products inviolation 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 maynot meet the legal standards required for their sale in some countries; if wecannot sell our products in these countries, our results of operations may beseriously 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.

*Risks Related tothe Industry*

*Integrated,multifunction telecommunications 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, multifunction telecommunicationssystems because of their concern about the current limitations of datanetworks, including the Internet. For example, end users sometimes experiencedelays in receiving calls and reduced voice quality during calls when routingcalls over data networks. Moreover, businesses that begin to route calls overthe same networks that currently carry only their data also may experiencethese problems if the networks do not have sufficient capacity to carry all ofthese communications at the same time.

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*Evolving standards maydelay 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 byother participants in our market, including some of our competitors, andinclude proprietary technology. In recent years, these standards have changed,and new standards have been proposed, in response to developments in ourmarket. Our failure to conform our products to existing or future standards maylimit their acceptance by market participants. We may not anticipate whichstandards will achieve the broadest acceptance in our market in the future, andwe may take a significant amount of time and expense to adapt our products tothese standards. 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 ofoperations.

*Future regulation orlegislation could harm our business or increase our cost of doing business.*

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.

**Item 1B. Unresolved Staff Comments**

Not applicable.

**Item 2. Properties**

As of September 30,2005, 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 2006. Webelieve that any additional space we may need in the future will be availableon commercially reasonable terms.

22

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**Item 3. Legal Proceedings**

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. On October 7, 2003, the parties filed a stipulation to stay thisaction, pending the outcome of the reissue of some of the subject patents beforethe U.S. Patent and Trademark Office. We believe we have strong defenses andarguments in this dispute and intend to vigorously defend our position.Management’s view is that any loss from this litigation is currently notprobable or estimable; therefore, the Company has not established a reserve onits balance sheets as to any liability related to the outcome of this action.

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

**Item 4. Submission of Matters to a Vote of SecurityHolders**

None.

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**PART II**

**Item5. Market for Registrant’s Common Equity, Related Stockholder Matters andIssuer Purchases of Equity Securities.**

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

| ** **  | ** ** | **Fiscal 2005** | ** ** | **Fiscal 2004** | ** ** |
|-------------|------------|----------------------|------------|----------------------|------------|
| ** **  | ** ** | **High**             | ** ** | **Low**              | ** ** | **High** | ** ** | **Low** | ** ** |
| 1st Quarter |       | $ 4.00          |       | $ 2.40          |       | $ 4.00 |   | $ 2.49 |   |
| 2nd Quarter |       | $ 4.05          |       | $ 2.51          |       | $ 5.09 |   | $ 3.59 |   |
| 3rd Quarter |       | $ 2.75          |       | $ 1.59          |       | $ 3.81 |   | $ 2.43 |   |
| 4th Quarter |       | $ 2.10          |       | $ 1.54          |       | $ 3.43 |   | $ 2.35 |   |

 

As of September 30, 2005, we had approximately100 stockholders of record of our Common Stock. We have never declared or paidany cash 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.

Wereceived aggregate net proceeds of approximately $33.3 million from theinitial public offering of shares of our common stock in October 1999. Asof September 30, 2005, proceeds from our initial public offering have beenused for working capital and general corporate purposes, including research anddevelopment of new products, sales and marketing efforts, general andadministrative expenses and international expansion. The remaining net proceedshave been invested in cash, cash equivalents 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 |       |       | 4,084,490  |                                                                                                                                                      |       |                                                                                                             | $ 3.75 |                                                                                                                                                                                                               |       |   | 2,671,768 |   |   |
| Equity  compensation plans not approved by security holders  |       |       | —     |                                                                                                                                                      |       |                                                                                                             | —      |                                                                                                                                                                                                               |       |   | — |   |   |
| Total                                                        |       |       | 4,084,490  |                                                                                                                                                      |       |                                                                                                             | $ 3.75 |                                                                                                                                                                                                               |       |   | 2,671,768 |   |   |

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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.

**Item 6. Selected Financial Data**

Thissection presents selected historical financial data of AltiGen Communications, Inc.This section should be read carefully in conjunction with “Management’s Discussionand Analysis of Financial 

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

 

**Item 7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

**FORWARD-LOOKING INFORMATION**

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 by thewords “anticipate,” “believe,” “expect,” “intend,” “plan,” or the negative ofsuch 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 

25

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materialize,or should underlying assumptions prove incorrect, actual results or outcomesmay vary materially from those described herein. Although we believe that theexpectations reflected in these forward-looking statements arereasonable, we cannot guarantee future results, levels of activity, performanceor achievements. You should carefully review the cautionary statementscontained in this Form 10-K, including the “Certain FactorsAffecting Business, Operating Results and Financial Condition” below.

**OVERVIEW**

We are a pioneer and market leader in Internetprotocol telephony systems for small-to-medium sized businesses. We design,manufacture and market next generation, Internet protocol phone systems andcontact centers that use both the Internet and the public telephone network totake advantage of the convergence of voice and data communications. Unliketraditional proprietary phone systems, our systems are designed with openarchitecture and are built on an industry standard platform. This adherence toindustry standards allows our products to play an important role in thesmall-to-medium sized business market by delivering phone systems that canintegrate with other technologies and provide integrated voice and datasolutions. We believe this enables our customers to implement communicationsystems that have an increased return versus past technology investments. Wegenerated net revenues of $15.4 million, for a net loss of $311,000,during fiscal year 2005. As of September 30, 2005, we had an accumulateddeficit of $51.1 million. Net cash used in operating activities was$509,000 for fiscal year 2005.

We derive our revenues from sales of our AltiServTMtelephone systems. Product revenues consist of sales to end-users (includingdealers) and to distributors. Revenues from product sales to end users andresellers are recognized upon shipment. We defer recognition of revenue forsales to distributors until they resell our products to their customers. Upon shipment,we also provide a reserve for the estimated cost that may be incurred forproduct 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 revenues consists of component andmaterial costs, direct labor costs, provisions for excess and obsoleteinventory, warranty costs and overhead related to the manufacturing of ourproducts. Several factors that have affected and will continue to affect ourrevenue growth are the state of economy, the market acceptance of our products,our ability to add new resellers and our ability to design, develop, andrelease new products. We engage third-party assemblers, which in fiscalyear 2005 were All Quality Services and Bestronics in San Jose, to insert thehardware components into the printed circuit board. We selected ourmanufacturing partners with the goals of ensuring a reliable supply ofhigh-quality finished products and lowering per unit product costs as a resultof manufacturing economies of scale. We cannot assure you that we will maintainthe volumes required to realize these economies of scale or when or if suchcost reductions will occur. The failure to obtain such cost reductions couldmaterially adversely affect our gross margins and operating results.

As of September 30, 2005, we had cumulative netoperating loss carry forwards for federal and California income tax reportingpurposes of approximately $43.9 million and $18.3 million, respectively,available to offset income in future years. The cumulative net operating losscarry forwards will expire in various periods from 2010 to 2025 if they are notutilized. Under current tax law, net operating loss carry forwards available inany given year may be limited upon the occurrence of certain events, includingchanges of ownership interest. We have not recognized any future tax benefitsof our cumulative net operating losses due to uncertainty as to futurerealization.

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We continue to focus on developing enhancements to ourcurrent products to provide greater functionality and increased capabilities,based on our market research, customer feedback and our competitors’ productofferings and creating new product offerings. In particular, we focus(i) on developing products that allow us to enhance our position in ourtarget market segment and (ii) entering new geographical markets.Additionally, we intend to continue to focus on selling our products tosmall-to-medium sized businesses and branch offices of larger corporations.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 rate of at least 20% for fiscal year 2006.

**CRITICAL ACCOUNTINGPOLICIES**

*Revenuerecognition.**  *Revenuesconsist of sales to end users, including resellers, and to distributors.Revenues from sales to end users are recognized upon shipment, when risk ofloss has passed to the customer, collection of the receivable is reasonablyassured, persuasive evidence of an arrangement exists, and the price is fixedand determinable. Sales to distributors are made under terms allowing certainrights of return and protection against subsequent price declines on the 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 revenues 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 revenues is also deferred andreported in the consolidated balance sheets as inventory. Our total deferredrevenue was $507,000 and $518,000 as of September 30, 2005 and September 30,2004, 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 $40,000and $35,000 as of September 30, 2005 and September 30, 2004,respectively.

*Inventory.**  *Inventory is stated at the lower ofcost (first-in, first-out method) or market. Our inventory balance was $965,000and $1.1 million as of September 30, 2005 and September 30,2004, 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 2005, AltiGenreversed a portion of the reserve related to inventory which was sold. Theamount of such reversals were $167,000, $293,000 and $401,000 in fiscal yearsending 2005, 2004 and 2003, 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 

27

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product warrantieswas $264,000 and $424,000 as of September 30, 2005 and September 30,2004, respectively. The decrease in accrued warranty was the result ofdecreases in the product return rate.

**Results of Operations**

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

| ** **                                   | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Consolidated Statements  of Operations Data: |       |                                                |       |   |   |   |   |
| Net revenue:                                 |       |                                                |       |   |   |   |   |
| Hardware                                     |       | 86.5                                                | %          | 84.0 | % | 86.9 | % |
| Software                                     |       | 13.5                                                |       | 16.0 |   | 13.1 |   |
| Total net revenue                            |       | 100.0                                               |       | 100.0 |   | 100.0 |   |
| Cost of revenues:                            |       |                                                |       |   |   |   |   |
| Hardware                                     |       | 41.7                                                |       | 36.5 |   | 41.0 |   |
| Software                                     |       | 1.0                                                 |       | 1.3 |   | 1.1 |   |
| Total cost of revenues                       |       | 42.7                                                |       | 37.8 |   | 42.1 |   |
| Gross profit                                 |       | 57.3                                                |       | 62.2 |   | 57.9 |   |
| Operating  expenses:                         |       |                                                |       |   |   |   |   |
| Research and  development                    |       | 22.6                                                |       | 22.2 |   | 33.7 |   |
| Sales and  marketing                         |       | 25.5                                                |       | 27.8 |   | 39.3 |   |
| General and  administrative                  |       | 12.6                                                |       | 12.8 |   | 16.4 |   |
| Amortization of  deferred stock compensation |       | —                                              |       | — |   | 0.5 |   |
| Total operating  expenses                    |       | 60.7                                                |       | 62.8 |   | 89.9 |   |
| Loss from operations                         |       | (3.4                                                | )          | (0.6 | ) | (32.0 | ) |
| Equity in net  loss from investee            |       | (0.1                                                | )          | — |   | — |   |
| Interest and  other income, net              |       | 1.5                                                 |       | 0.7 |   | 2.0 |   |
| Net (loss) income                            |       | (2.0                                                | )%         | 0.1 | % | (30.0 | )% |

 

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

**Revenues,net.****  **Revenuesconsist of sales to end users (including resellers) and distributors.

Net Revenues by Products:

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

 

NetRevenues by Geographic Area:

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

 

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NetRevenues by Customers:

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

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*                    On July 20, 2005, weterminated our distribution agreement with Ingram Micro.

Revenues generated in the Americas accounted for $13.9 millionor 90% of revenues in fiscal year 2005 and $13.3 million or 90% ofrevenues in fiscal year 2004. The number of system shipped in fiscal year 2005grew 20% over fiscal year 2004 as a result of increasedcustomer acceptance of our new pricing and packaging strategy for our productbundling by including AltiView software, which offers more features than otherproducts on the market, the penetration of our AltiContact Manager (ACM) in thecall center market and the introduction of our internet protocol phone IP710 tothe market. However, net revenues only increased 4% from$14.8 million in fiscal year 2004 to $15.4 million in fiscal year2005primarily due to price reduction on our low-end product bundles in the secondquarter of fiscal year 2005.

**Costof revenues.****  **Costof revenues 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 revenues as a percentage of net revenues increased from 38% infiscal year 2004 to 43% in fiscal year 2005. This increase primarily wascaused by a lower profit margin as a result of a price deduction on our low-endproduct bundles in the second quarter of fiscal year 2005. Noadditional provision for excess or obsolete inventory was necessary in eitherfiscal year 2005 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 anddevelopment expenses in absolute dollars was primarily a result of increases inheadcount-related costs of $108,000 resulting from an increase in salaryand compensation of our engineers; an increase in equipment expenses of$30,000; and an increase in research and development expenses related to thedesign of our internet protocol phone (IP710) of $67,000. We expect researchand development expenses to remain relatively flat due to the uncertainty aboutcustomers’ spending patterns in the current economic environment. Managementcontinues to monitor research and development expenses to keep them in linewith 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 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. We expect sales and marketing expenses to remainrelatively flat due to the uncertainty about customers’ spending patterns inthe current economic environment, however, some expenses vary with revenues,such as commissions, which grow with increasing sales.

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**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. We expect general andadministrative expenses to increase due to the cost associated with compliancewith Section 404 of the Sarbanes Oxley Act during fiscal year 2006.

**Amortizationof deferred stock compensation.****  **We had no amortization of deferredstock compensation in fiscal year 2005 or 2004.

**Equityin net loss of investee.**   In July 2004, we purchased common stock of a privateKorean telecommunications company for $79,000. As a result of this investment,we acquired approximately 23% of the voting power of the company and have theright to nominate and have elected one of the three members of the company’scurrent board of directors. We are accounting for this investment using theequity method. We had revenue from product sales to this company of $37,000 infiscal 2005. Our accounts receivable from this company was $40,000 at September 30,2005. The company has a 23% vested interestin AliGen Korea. The total equity in net losses of Korea investee wasapproximately $52,000 of which 23%, or $12,000, is reflected in the fourthquarter 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. We expect net interest and other income to remain relativelyflat as we have limited cash reserves to invest.

**FiscalYear Ended September 30, 2004 Compared to Fiscal Year Ended September 30,2003**

**Revenues,net.****  **Revenuesconsist of sales to end users (including resellers) and distributors.

Net Revenues by Products:

| ** ** | ** ** | **Fiscal Year Ended  September 30,**      | ** ** |
|------------|------------|----------------------------------------------------------|------------|
| ** ** | ** ** | **    2004    ** | ** ** | **    2003    ** | ** ** |
| Hardware   |       |                                                     | 84         | % |   |   | 87 | % |   |
| Software   |       |                                                     | 16         | % |   |   | 13 | % |   |

 

Net Revenues by GeographicArea:

| ** **    | ** ** | **Fiscal Year Ended  September 30,**      | ** ** |
|---------------|------------|----------------------------------------------------------|------------|
| ** **    | ** ** | **    2004    ** | ** ** | **    2003    ** | ** ** |
| Americas      |       |                                                     | 90         | % |   |   | 94 | % |   |
| International |       |                                                     | 10         | % |   |   | 6 | % |   |

 

NetRevenues by Customers:

| ** **   | ** ** | **Fiscal Year Ended  September 30,**      | ** ** |
|--------------|------------|----------------------------------------------------------|------------|
| ** **   | ** ** | **    2004    ** | ** ** | **    2003    ** | ** ** |
| AltiSys      |       |                                                     | 14         | % |   |   | 18 | % |   |
| Ingram Micro |       |                                                     | 14         | % |   |   | 21 | % |   |
| Synnex       |       |                                                     | 46         | % |   |   | 48 | % |   |
| Graybar      |       |                                                     | 8          | % |   |   | 0 | % |   |

 

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Revenues generated in the Americas accounted for$13.3 million or 90% of revenues in fiscal year 2004 and$11.1 million or 94% of revenues in fiscal year 2003. Net revenuesincreased 25% from $11.8 million in fiscal year 2003 to $14.8 millionin fiscal year 2004 due to the increased sales in telephone systems as a resultof upgrading the quality of our authorized resellers, selling more productsinto the call center market space, the sales of larger systems and the doublingof our international revenues, especially in China.

**Costof revenues.****  **Costof revenues in fiscal year 2004 increased $0.6 million or 12% to$5.6 million from approximately $5.0 million in fiscal year 2003 dueto an increase in overall sales of products and the requisite increase inproduct costs. Cost of revenues as a percentage of net revenues decreased from42% in fiscal year 2003 to 38% in fiscal year 2004. The decrease was primarilycaused by the decrease in warranty reserve of $354,000 due to the decline inthe product return rate and the $240,000 adjustment of the inventory allowanceassociated with the sale of products which were previously reserved. Noadditional provision for excess or obsolete inventory was necessary in eitherfiscal year 2004 or fiscal year 2003.

**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 decreased by approximately $0.7 million or 18% from$4.0 million in fiscal year 2003 to $3.3 million in fiscal year 2004.Research and development expenses as a percentage of revenue decreased from 34%in fiscal year 2003 to 22% in fiscal year 2004 due in part to the increase insales volume and the decrease in absolute dollars. The decrease in research anddevelopment expenses in absolute dollars was primarily a result of decreases inheadcount-related costs of $536,000 resulting from a reduction in ourworkforce; a decrease in depreciation cost of $110,000; and a decrease inoffice rent expense of $181,000 associated with the facilities change inFremont, California.

**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$0.5 million or 11% from $4.6 million in fiscal year 2003 to$4.1 million in fiscal year 2004. Sales and marketing expenses as apercentage of revenue decreased from 39% in fiscal year 2003 to 28% in fiscalyear 2004 due in part to the increase in sales volume and the decrease inabsolute dollars. The decrease in absolute dollars was primarily a result of: adecrease in headcount-related costs of $428,000 due to workforcereduction in the sales and marketing group; a decrease in depreciation costs of$73,000, and a decrease in office rent expense of $117,000 associated with thefacilities change in Fremont, California.

**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 years2003 and 2004. General and administrative expenses as a percentage of revenuedecreased from 16% in fiscal year 2003 to 13% in fiscal year 2004 due to theincrease in sales volume. We expect to maintain general and administrativeexpenses at the same level.

**Amortizationof deferred stock compensation.   **Wehad no amortization of deferred stock compensation in fiscal year 2004.Amortization of deferred stock compensation was $55,000 in fiscal year 2003.Deferred stock compensation expense reflects the amortization of stockcompensation charges resulting from granting stock options prior to our initialpublic offering at exercise prices below the deemed fair value of our commonstock on the dates the options were granted. We amortize these deferred amountsusing the straight-line method over the vesting period of the related stockoptions. All remaining deferred stock compensation was amortized in fiscal year2003.

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**Interest and other income, net.  **Netinterest and other income decreased to $105,000 in fiscal year 2004 from$241,000 in fiscal year 2003. The decrease was primarily due to the recognitionof interest received from full repayment of an outstanding promissory note heldby our Chief Executive Officer, Gilbert Hu, in fiscal year 2003 and a decreasein invested principal due to cash being used in operations.

**Liquidity andCapital Resources**

Sinceinception, we have financed our operations primarily through the sale of equitysecurities. As of September 30, 2005, we had cash and short-terminvestments totaling $9.4 million consisting of cash and cash equivalentsof $4.0 million with a maturity of less than 90 days and $5.4 millionof short-term investment with a maturity of greater than 90 days.

| ** **                                               | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                                               | ** ** | **(dollars in thousands)** | ** ** |
| Cash and cash  equivalents                               |       | $                                    | 3,963      |     | $          | 2,898    |       | $ | 8,548 |   |
| Short-term  investments                                  |       | 5,459                                |       | 7,136    |       | 1,598    |       |
| Total cash, cash equivalents and short-term  investments |       | $                                    | 9,422      |     | $          | 10,034   |       | $ | 10,146 |   |
| Percentage of total assets                               |       | 70.7                                 | %          | 74.2     | %          | 76.8     | %          |
| Cash used in operating activities                        |       | $                                    | (509       | )        | $          | (185     | )          | $ | (2,681 | ) |
| Cash provided by  (used in) investing activities         |       | $                                    | 1,215      |     | $          | (5,818   | )          | $ | 3,263 |   |
| Cash provided by  financing activities                   |       | $                                    | 359        |     | $          | 353      |       | $ | 756 |   |
| Net increase (decrease)  in cash and cash equivalents    |       | $                                    | 1,065      |     | $          | (5,650   | )          | $ | 1,338 |   |

 

*Changes in CashFlows*

During fiscal year 2005, net cash used in operatingactivities was $509,000, which is $324,000 higher than the cash used in operatingactivities during fiscal year 2004 due to a net loss of $311,000 in fiscal year2005. In fiscal year 2005, our use of cash for non-operating activities wasprimarily attributable to the $207,000 of capital spending for internetprotocol phone (IP710) tooling development and $271,000 of capital spending onequipment additions to support our operations. As a result, during the twelvemonths ended September 30, 2005, our cash, cash equivalents and marketablesecurities decreased $612,000 as compared to September 30, 2004.

Net accounts receivable remained flat at$1.9 million for the fiscal year ended September 30, 2005 and 2004due to a slight increase in sales of our products.

We ended the fourth quarter of fiscal year 2005 with acash conversion cycle of 58 days as compared to 59 days for the fourthquarter of fiscal 2004. The cash conversion cycle is the duration betweenpurchase of inventories and services and the collection of the cash from thesale of our products and services and is a metric on which we have focused aswe continue to try to efficiently manage our assets. The cash conversion cycleresults from the calculation of days of sales outstanding (DSO) added to daysof supply in inventories (DOS), reduced by days of payable outstanding (DPO).

Inventories decreased to $965,000 at September 30,2005 from $1.1 million at September 30, 2004 and our annualizedinventory turn rate increased to 6.8 as of September 30, 2005 as comparedto 5.7 times as of September 30, 2004. Our annualized inventory turn raterepresents the number of times inventory is replenished during the year.Inventory management will continue to be an area of focus as we balance theneed to maintain strategic inventory levels to help ensure competitive leadtimes with the risk of inventory obsolescence due to rapidly changingtechnology and customer requirements.

Accounts payable decreased to $653,000 at September 30,2005 from $798,000 at September 30, 2004. This decrease primarily was dueto a decrease in the number of components purchased at the end of fiscal year2005 as compared to fiscal year 2004. Our accrued payroll-relatedliabilities decreased to $317,000 at 

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September 30, 2005from $330,000 at September 30, 2004, primarily as a result of a decreasein vacation accrual and employee stock purchase plan contribution.

In fiscal year 2005, ournet cash provided by financing activities was primarily attributable to the$361,000 of proceeds from the exercise of employee stock options and employeestock purchase plan.

*Liquidity and CapitalResources*

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

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.

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 acceptable terms, we may not be able to furtherdevelop or enhance our products, take advantage of opportunities, or respond tocompetitive pressures or unanticipated requirements, which could seriously harmour business. Even if additional financing is available, we may be required toobtain the consent of our stockholders, which we may or may not be able toobtain. 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 30,2005. We have a commitment under our noncancellable capital and operating leasein the amount of $1.4 million as of September 30, 2005. We believe,we have sufficient cash reserves to allow us to continue operations for morethan a year assuming our quarterly cash usage rate does not deteriorate overthat period. Our cash and short-term investments totaled $9.4 million asof September 30, 2005, and our quarter ended September 30, 2005generated $514,000 from operating activities.

| ** **                       | ** ** | **Payment Due by Period** | ** ** |
|----------------------------------|------------|------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                               | ** ** | **Total** | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
| Operating leases  obligation     |       | $                                        | 1,127      |   |   | $ | 403 |   |   |   | $ | 632 |   |   |   | $ | 92 |   |   |   | $ | — |   |   |
| Capital leases  obligation       |       | 229                                      |       |   | 53 |   |   |   | 99 |   |   |   | 77 |   |   |   | — |   |   |
| Total                            |       | $                                        | 1,356      |   |   | $ | 456 |   |   |   | $ | 731 |   |   |   | $ | 169 |   |   |   | $ | — |   |   |
|                                  |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Recent AccountingPronouncements*

In December 2004, the FASB issued SFAS No. 123(R),Share-Based Payment, which establishes standards for transactions in which anentity exchanges its equity instruments for goods or services. In March 2005,the SEC issued Staff Accounting Bulletin No. 107—Share-Based Payment,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) willbe effective beginning 

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with the first interim orannual reporting period of our fiscal year beginning December 31, 2005. Weare currently evaluating the provisions of SFAS No. 123(R) andhave not yet determined whether to use the modified prospective or the modifiedretrospective methods allowed by SFAS No. 123(R). We expect that the newstandards will have a material effect on or results of operations.

In December 2004, the FASB issued SFAS No. 153,Exchanges of Nonmonetary Assets, which eliminates the exception for nonmonetaryexchanges of similar productive assets and replaces it with a general exceptionfor exchanges of nonmonetary assets that do not have commercial substance. SFAS No. 153will be effective for nonmonetary asset exchanges occurring in fiscal periodsbeginning December 31, 2005. We are currently evaluating the provisions ofSFAS No. 153 and do not believe that its adoption will have amaterial impact on our financial condition, results of operations or liquidity.

In March 2005, the FASB issued FIN 47, “Accountingfor Conditional Asset Retirement Obligations, an interpretation of FASBStatement No. 143” (“FIN 47”), which requires an entity to recognizea liability for the fair value of a conditional asset retirement obligationwhen incurred if the liability’s fair value can be reasonably estimated.FIN 47 is effective for fiscal years ending after December 15, 2005.We are currently evaluating the effect that the adoption of FIN 47 willhave on our consolidated results of operations and financial condition but donot expect it to have a material impact.

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 154 provides guidance on the accounting for and reporting ofaccounting changes and error corrections. It establishes retrospectiveapplication, or the latest practicable date, as the required method forreporting a change in accounting principle and the reporting of a correction ofan error. SFAS 154 is effective for accounting changes and corrections oferrors made in fiscal years beginning after December 15, 2005 is requiredto be adopted by us in the first quarter of fiscal year 2007. We are currentlyevaluating the effect that the adoption of SFAS 154 will have on ourconsolidated results of operations and financial condition but do not expect itto have a material impact.

**Item 7A. Quantitative and Qualitative DisclosuresAbout Market Risk.**

*Market Risk.**  *Our interest income is sensitive tochanges in the general level of U.S. interest rates, particularly since themajority of our investments are in cash equivalents and short-term instruments.Due to the short-term nature of our cash equivalents and investments, we haveconcluded that a change in interest rates does not pose a material market riskto us. We face foreign exchange currency fluctuations with our subsidiary inChina, however, due to the strength in China’s economy, we do not foreseeforeign exchange currency fluctuations to pose a material market risk to us.

**Item 8. Financial Statements and SupplementaryData.**

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.”

**Item 9. Changes in and Disagreements WithAccountants on Accounting and Financial Disclosure**

None

**Item 9A. Controls and Procedures**

*(a) Evaluation of disclosure controls andprocedures.*   Our management evaluated, with theparticipation of our Chief Executive Officer and our Chief Financial Officer,the effectiveness of our 

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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 reported within the time periods specified in Securities andExchange Commission rules and forms.

*(b) Changes in internal 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. Other Information**

None.

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**PART III**

**Item10. Directors and 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 February 9,2006 (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.

Thefollowing table sets forth certain information with regard to our executiveofficers and their ages as of September 30, 2005:

| **Name**              | ** ** | ** ** | ** ** | **Age**                                       | ** ** | **Position** |
|-----------------------|------------|------------|------------|-----------------------------------------------|------------|--------------|
| Gilbert Hu            |       | 48         |       | President, Chief  Executive Officer, Director |
| Philip M. McDermott   |       | 59         |       | Chief Financial  Officer                      |
| Michael Plumer        |       | 41         |       | Vice President of  Sales                      |
| Simon Chouldjian      |       | 52         |       | Vice President of  Hardware Engineering       |
| Tsyr-Yi (Shirley) Sun |       | 45         |       | 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 1996to begin building the AltiGen sales channel. In the past eight years he hasheld various positions including Senior Director of Sales and National SalesDirector. From January 1994 until October 1996, Mr. Plumerworked for NetManage, Inc. Mr. Plumer received a Bachelor of Artsdegree in Journalism and Public Relations from 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.

**Item11. Executive Compensation**

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

**Item12. Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder 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..

**Item13. Certain Relationships 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.

**Item14. Principal Accountant Fees and Services**

*Audit Fees*

Deloitte & ToucheLLP’s fees for professional services rendered in connection with the audit ofour annual financial statements and the review of our financial statementsincluded in our quarterly reports on Form 10-Q were approximately$255,000 and $205,000 for the fiscal years ended September 30, 2005 and2004, respectively. We did not engage Deloitte & Touche LLP to provideadvice regarding financial information systems design and implementation duringthe fiscal years ended September 30, 2005 and 2004.

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*Audit-Related Fees*

We did not incur anyadditional fees from our independent registered public accounting firm,Deloitte & Touche LLP during fiscal year 2005.

*Tax Fees*

Deloitte & ToucheLLP’s fees for all other services rendered to us, including tax relatedservices, totaled approximately $30,000 and $28,000 for the fiscal years ended September 30,2005 and 2004, respectively.

*All Other Fees*

During fiscal year 2005, Deloitte & ToucheLLP did not bill the company for any other services.

The Audit Committee pre-approves all audit andpermissible non-audit services provided by the independent registered publicaccounting firm. These services may include audit services, audit-relatedservices, tax services and other services. The Audit Committee has adopted apolicy for the pre-approval of services provided by the independent auditors.Under the policy, pre-approval generally is provided for up to one year and anypre-approval is detailed as to the particular service or category of servicesand is subject to a specific budget. In addition, the Audit Committee may alsopre-approve particular services on a case-by-case basis. For each proposedservice, the independent registered public accounting firm is required to providedetailed back-up documentation at the time of approval. The Audit Committee maydelegate pre-approval authority to one or more of its members. Such member mustreport any decisions to the Audit Committee at the next scheduled meeting.

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**PART IV**

**Item 15. Exhibits and Financial Statement Schedules**

(a)   The following documents are filed as a part of this Annual Reporton Form 10-K.

**1.****                 FINANCIALSTATEMENTS**
|                                                                                                                                             | ** ** | **Page** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent  Registered Public Accounting Firm                                                                                    |       |     | 41 |   |
| Consolidated Balance Sheets as of  September 30, 2005 and 2004                                                                         |       |     | 42 |   |
| Consolidated Statements of  Operations for the years ended September 30, 2005, 2004 and 2003                                           |       |     | 43 |   |
| Consolidated Statements of  Stockholders’ Equity and Comprehensive Income for the years ended  September 30, 2005, 2004, and 2003 |       |     | 44 |   |
| Consolidated Statements of  Cash Flows for the years ended September 30, 2005, 2004, and 2003                                          |       |     | 45 |   |
| Notes to Consolidated  Financial Statements                                                                                                 |       |     | 46 |   |
| Quarterly  Financial Information                                                                                                            |       |     | 58 |   |

 

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

Thefollowing financial statement schedule is submitted herewith:
|                                                | ** ** | **Page** |
|------------------------------------------------|------------|----------|
| Schedule II Valuation and  Qualifying Accounts |       |     | 59 |   |

 

(All otherschedules are omitted because they are not applicable or the required informationis shown in the 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. |
| 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.                                                 |

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| 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.                                                                                                     |
| 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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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

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”) as of September30, 2005 and 2004, and the related consolidated statements of income,stockholders' equity, and cash flows for each of the three years in the periodended September 30, 2005.  Our auditsalso included the financial statement schedule listed in the Index at Item 15(a)(2).  These financial statements and financialstatement schedule are the responsibility of the Company's management.  Our responsibility is to express an opinionon the financial statements and financial statement schedule based on ouraudits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  The Company is not required to have, nor werewe engaged to perform, an audit of its internal control over financialreporting.  Our audits includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company'sinternal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable 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 September30, 2005 and 2004, and the results of their operations and their cash flows foreach of the three years in the period ended September 30, 2005, in conformitywith accounting principles generally accepted in the United States ofAmerica.  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/ DELOITTE & TOUCHE LLP

San Jose, CaliforniaDecember 27, 2005

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

| ** **                                                                                                                                                                     | ** ** | **September 30,**             | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                                                                     | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                                     |       |                               |       |   |   |
| Current assets:                                                                                                                                                                |       |                               |       |   |   |
| Cash and cash equivalents                                                                                                                                                      |       | $  3,963                 |       | $  2,898 |   |
| Short-term investments                                                                                                                                                         |       | 5,459                              |       | 7,136 |   |
| Accounts receivable, net  of allowances of $40 and $35 in 2005 and 2004,  respectively                                                                                         |       | 1,957                              |       | 1,857 |   |
| Inventories                                                                                                                                                                    |       | 965                                |       | 1,058 |   |
| Prepaid expenses and  other current assets                                                                                                                                     |       | 148                                |       | 67 |   |
| Total current assets                                                                                                                                                           |       | 12,492                             |       | 13,016 |   |
| Property and equipment:                                                                                                                                                        |       |                               |       |   |   |
| Furniture and equipment                                                                                                                                                        |       | 1,405                              |       | 987 |   |
| Computer software                                                                                                                                                              |       | 920                                |       | 915 |   |
|                                                                                                                                                                           |       | 2,325                              |       | 1,902 |   |
| Less: Accumulated  depreciation                                                                                                                                                |       | (1,803                             | )          | (1,750 | ) |
| Net property and  equipment                                                                                                                                                    |       | 522                                |       | 152 |   |
| Other non-current assets:                                                                                                                                                      |       |                               |       |   |   |
| Long-term  investments                                                                                                                                                         |       | 247                                |       | 274 |   |
| Long-term deposit                                                                                                                                                              |       | 74                                 |       | 74 |   |
| Total other non-current  assets                                                                                                                                                |       | 321                                |       | 348 |   |
| Total assets                                                                                                                                                                   |       | $ 13,335                      |       | $ 13,516 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                  |       |                               |       |   |   |
| Current liabilities:                                                                                                                                                           |       |                               |       |   |   |
| Accounts payable                                                                                                                                                               |       | $     653 |       | $     798 |   |
| Accrued liabilities:                                                                                                                                                           |       |                               |       |   |   |
| Payroll and related  benefits                                                                                                                                                  |       | 317                                |       | 330 |   |
| Warranty (Note 3)                                                                                                                                                              |       | 264                                |       | 424 |   |
| Marketing                                                                                                                                                                      |       | 58                                 |       | 139 |   |
| Accrued expense                                                                                                                                                                |       | 272                                |       | 261 |   |
| Other                                                                                                                                                                          |       | 288                                |       | 232 |   |
| Deferred revenue                                                                                                                                                               |       | 507                                |       | 518 |   |
| Total current liabilities                                                                                                                                                      |       | 2,359                              |       | 2,702 |   |
| Deferred Rent                                                                                                                                                                  |       | 258                                |       | 145 |   |
| Commitments and contingencies (Note 4)                                                                                                                                         |       |                               |       |   |   |
| Stockholders’ equity:                                                                                                                                                     |       |                               |       |   |   |
| Convertible preferred  stock, $0.001 par value; Authorized—5,000,000 shares; Outstanding—none at  September 30, 2005 and 2004                                   |       | —                             |       | — |   |
| Common stock, $0.001 par  value; Authorized—50,000,000 shares; Outstanding—15,782,071 and 15,462,506  shares at September 30, 2005 and 2004, respectively  |       | 16                                 |       | 15 |   |
| Treasury stock at  cost—1,063,895 shares at September 30, 2005 and 2004                                                                                              |       | (1,014                             | )          | (1,014 | ) |
| Additional paid-in  capital                                                                                                                                                    |       | 62,863                             |       | 62,505 |   |
| Accumulated other comprehensive  loss                                                                                                                                          |       | (1                                 | )          | (2 | ) |
| Accumulated deficit                                                                                                                                                            |       | (51,146                            | )          | (50,835 | ) |
| Total stockholders’  equity                                                                                                                                               |       | 10,718                             |       | 10,669 |   |
| Total liabilities and stockholders’ equity                                                                                                                                |       | $ 13,335                      |       | $ 13,516 |   |

 

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

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

| ** **                                                                     | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2005**                                                | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenue:                                                                   |       |                                                    |       |   |   |   |   |
| Hardware                                                                       |       | $ 13,363                                           |       | $ 12,470 |   | $ 10,277 |   |
| Software                                                                       |       | 2,078                                                   |       | 2,372 |   | 1,547 |   |
| Total net revenue                                                              |       | 15,441                                                  |       | 14,842 |   | 11,824 |   |
| Cost of revenues:                                                              |       |                                                    |       |   |   |   |   |
| Hardware                                                                       |       | 6,442                                                   |       | 5,417 |   | 4,854 |   |
| Software                                                                       |       | 150                                                     |       | 190 |   | 124 |   |
| Total cost of revenues                                                         |       | 6,592                                                   |       | 5,607 |   | 4,978 |   |
| Gross profit                                                                   |       | 8,849                                                   |       | 9,235 |   | 6,846 |   |
| Operating expenses:                                                            |       |                                                    |       |   |   |   |   |
| Research and development                                                       |       | 3,496                                                   |       | 3,288 |   | 3,990 |   |
| Sales and marketing                                                            |       | 3,943                                                   |       | 4,130 |   | 4,648 |   |
| General and administrative                                                     |       | 1,946                                                   |       | 1,894 |   | 1,943 |   |
| Amortization of deferred stock compensation (Note 6)                           |       | —                                                  |       | — |   | 55 |   |
| Total operating expenses                                                       |       | 9,385                                                   |       | 9,312 |   | 10,636 |   |
| Loss from  operations                                                          |       | (536                                                    | )          | (77 | ) | (3,790 | ) |
| Equity in net  loss of investee                                                |       | (12                                                     | )          | — |   | — |   |
| Interest and  other income, net                                                |       | 237                                                     |       | 105 |   | 241 |   |
| Net (loss) income                                                              |       | $  (311                                       | )          | $      28 |   | $ (3,549 | ) |
| Basic and diluted net (loss) income per share                                  |       | $ (0.02                                            | )          | $   0.00 |   | $ (0.26 | ) |
| Weighted average shares used in computing basic net  (loss) income per share   |       | 14,605                                                  |       | 14,242 |   | 13,643 |   |
| Weighted average  shares used in computing diluted net (loss) income per share |       | 14,605                                                  |       | 15,725 |   | 13,643 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

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**ALTIGENCOMMUNICATIONS, INC. AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME**

**(inthousands, except share amounts)**

| ** **                                                                | ** ** | **Common Stock** | ** ** | **Treasury** | ** ** | **Additional  Paid-In** | ** ** | **Deferred  Stock** | ** **    | **Accumulated  Other  Comprehensive ** | ** ** | **Accumulated** | ** **    | **Total  Stockholders’** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|-------------------------|------------|---------------------|---------------|---------------------------------------------|------------|-----------------|---------------|-------------------------------|------------|
| ** **                                                                | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Stock**               | ** ** | **Capital**         | ** **    | **Compensation**                            | ** ** | **Loss**        | ** **    | **Deficit**                   | ** ** | **Equity** | ** ** |
| BALANCE,  OCTOBER 1, 2002                                            |       | 14,543,606            |       |         | $ 14  |                    |       |                | $ (1,014 | )                                           |       |            | $ 61,740 |                          |       |   | $ (55 | ) |   |   | $ — |   |   |   | $ (47,314 | ) |   |   | $ 13,371 |   |   |   |
| Exercise of stock  options                                                |       | 365,431               |       |         | 1          |                    |       |                | —        |                                        |       |            | 347           |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 348 |   |   |   |
| Issuance of common  stock in connection with Employee Stock Purchase Plan |       | 145,405               |       |         | —     |                    |       |                | —        |                                        |       |            | 65            |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 65 |   |   |   |
| Amortization of  deferred stock compensation                         |       | —                |       |         | —     |                    |       |                | —        |                                        |       |            | —        |                          |       |   | 55 |   |   |   | — |   |   |   | — |   |   |   | 55 |   |   |   |
| Net loss                                                                  |       | —                |       |         | —     |                    |       |                | —        |                                        |       |            | —        |                          |       |   | — |   |   |   | — |   |   |   | (3,549 | ) |   |   | (3,549 | ) |   |   |
| Comprehensive  income                                                     |       | —                |       |         | —     |                    |       |                | —        |                                        |       |            | —        |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   |
| 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 |   |   |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

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

| ** **                                                                           | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                                                | ** ** | **2004** | ** ** | **2003** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                               |       |                                                    |       |   |   |   |   |
| Net (loss) income                                                                    |       | $  (311                                       | )          | $        28 |   | $ (3,549 | ) |
| Adjustments to  reconcile net (loss) income to net cash used in operating activities |       |                                                    |       |   |   |   |   |
| Depreciation                                                                         |       | 109                                                     |       | 218 |   | 427 |   |
| Amortization of deferred stock compensation                                          |       | —                                                  |       | — |   | 55 |   |
| Equity in net loss of investee                                                       |       | 12                                                      |       | — |   | — |   |
| Write-off of property and equipment                                                  |       | —                                                  |       | — |   | 40 |   |
| Changes in  operating assets and liabilities:                                        |       |                                                    |       |   |   |   |   |
| Accounts receivable                                                                  |       | (100                                                    | )          | (336 | ) | 135 |   |
| Inventories                                                                          |       | 93                                                      |       | (148 | ) | 353 |   |
| Prepaid expenses and other assets                                                    |       | (81                                                     | )          | 126 |   | 73 |   |
| Accounts payable                                                                     |       | (145                                                    | )          | (75 | ) | 335 |   |
| Accrued liabilities                                                                  |       | (188                                                    | )          | (272 | ) | (557 | ) |
| Deferred revenue                                                                     |       | (11                                                     | )          | 106 |   | 7 |   |
| Deferred rent                                                                        |       | 113                                                     |       | 168 |   | — |   |
| Net cash used in operating activities                                                |       | (509                                                    | )          | (185 | ) | (2,681 | ) |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                               |       |                                                    |       |   |   |   |   |
| Purchases of short-term investments                                                  |       | (8,761                                                  | )          | (11,599 | ) | (11,261 | ) |
| Proceeds from sale of short-term investments                                         |       | 10,440                                                  |       | 6,061 |   | 14,601 |   |
| Changes in long-term investments                                                     |       | 15                                                      |       | (79 | ) | — |   |
| Changes in long-term deposits                                                        |       | —                                                  |       | (74 | ) | — |   |
| Purchases of property and equipment                                                  |       | (479                                                    | )          | (127 | ) | (77 | ) |
| Net cash provided by (used in) investing activities                                  |       | 1,215                                                   |       | (5,818 | ) | 3,263 |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                               |       |                                                    |       |   |   |   |   |
| Proceeds from issuances of common stock, net of  issuance costs                      |       | 359                                                     |       | 353 |   | 413 |   |
| Collection of promissory note from  officer/stockholder                              |       | —                                                  |       | — |   | 343 |   |
| Net cash provided by financing activities                                            |       | 359                                                     |       | 353 |   | 756 |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                 |       | 1,065                                                   |       | (5,650 | ) | 1,338 |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF YEAR                                        |       | 2,898                                                   |       | 8,548 |   | 7,210 |   |
| CASH AND CASH  EQUIVALENTS, END OF YEAR                                              |       | $ 3,963                                            |       | $   2,898 |   | $   8,548 |   |

 

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

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**ALTIGEN COMMUNICATIONS, INC. AND SUBSIDIARYNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1. ORGANIZATION OF THE 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 versus past technologyinvestments. We generated net revenues of $15.4 million, for a net loss of$311,000, during fiscal year 2005. As of September 30, 2005, we had anaccumulated deficit of $51.1 million. Net cash used in operatingactivities was $509,000 for fiscal year 2005. We were incorporated inCalifornia in May 1994 and we reincorporated into Delaware in June 1999.

**2.SUMMARY OF SIGNIFICANT 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, 2005, we had approximately$35,000 in long lived assets 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 2005, 2004, and 2003refer 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 reportedrevenues, total operating expense, operating income (loss), net income (loss),total assets, 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 to 49 daysafter 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 classified asshort-term investments, available for sale. The Company reclassified $2.5million of investments in ARS that were previously included in cash and cashequivalents as of September 30, 2004 to short-term investments, availablefor 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 revenues and cost of revenues by source (hardwareand software).

*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 revenues and expenses during thereported periods. 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, 2005approximately 84% of our account receivable was concentrated with threedistributors, compared to approximately 88% concentrated with threedistributors as of September 30, 2004.

Our purchases areconcentrated with four suppliers and certain key chip components of ourproducts are sole sourced. For fiscal years 2005 and 2004 these four suppliersprovided 93% and 81%, 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 are reported attheir fair value, with unrealized gains and losses excluded from earnings andreported as a separate component of stockholders’ equity. As of September 30,2005, our cash and cash equivalents consisted of commercial paper and cashdeposited in checking and money market accounts. For fiscal years 2005, 2004,and 2003, we did not make any cash payments for interest or income taxes.

As of September 30, 2004, 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 |       |                | $ 3,586 |                        |       |                          | $ — |              |       |                          | $ (2  | )                |       | $ 3,584 |   |   | $ 8 |   |   | $ 3,592 |   |
| Auction-rate  preferred stock      |       |                | 2,282        |                        |       |                          | —        |              |       |                          | —     |             |       | 2,282 |   |   | — |   |   | 2,282 |   |
| Corporate bonds  and notes         |       |                | 952          |                        |       |                          | —        |              |       |                          | (1         | )                |       | 951 |   |   | 12 |   |   | 963 |   |
| Commercial paper                   |       |                | 299          |                        |       |                          | —        |              |       |                          | —     |             |       | 299 |   |   | — |   |   | 299 |   |
|                               |       |                | $ 7,119 |                        |       |                          | $ — |              |       |                          | $ (3  | )                |       | $ 7,116 |   |   | $ 20 |   |   | $ 7,136 |   |

 

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.

Unrealized loss fromshort-term investments were $1,000 and $2,000 at September 30, 2005 and2004, respectively.

*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 afirst-in, first-out method) or market value. Provisions, when required, aremade to reduce excess and obsolete inventories to their estimated netrealizable values. We regularly monitor inventory quantities on hand and recorda provision for excess and obsolete inventories based primarily on ourestimated forecast of product demand and production requirements for the nextsix months. We did not record any provision for excess and obsolete inventoriesfor fiscal years 2005, 2004, or 2003. The components of inventories include (inthousands):

| ** **       | ** ** | **September 30,** | ** ** |
|------------------|------------|------------------------|------------|
| ** **       | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Raw materials    |       | $ 144             |       | $    68 |   |
| Work-in-progress |       | 84                     |       | 95 |   |
| Finished goods   |       | 737                    |       | 895 |   |
|             |       | $ 965             |       | $ 1,058 |   |

 

*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 2005, 2004, and 2003, was approximately$109,000, $218,000, and $427,000, respectively. All repairs and maintenancecosts are expensed as incurred.

At September 30,2005, equipment with a net book value of $184,000 (net of accumulateddepreciation of $15,000), has been leased under capital leases compared to netbook value of $9,000 as of September 30, 2004 and (net of accumulateddepreciation of $15,000).

*Long-TermInvestments*

As of September 30, 2005, 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.

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 

48

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minority interest of theirresults in our results of operations. A As of September 30, 2005, ourinvestment in the Korean company had a remaining book value of approximately$63,000.

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 2005, 2004 or 2003.

*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, afterconsideration of factors such as realizable value, were not material and, accordingly,all software development costs have been charged to research and developmentexpense in the accompanying consolidated statements of operations.

*Stock-BasedCompensation*

We account for stock-based compensation inaccordance with the provisions of APB No. 25, “Accounting for Stock Issuedto Employees,” and comply with the disclosure provisions of SFAS No. 123as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transitionand Disclosures.” Deferred compensation recognized under APB No. 25 isamortized to expense using the graded vesting method. We account for stockoptions issued to non-employees in accordance with the provision of SFAS No. 123and EITF No. 96-18 under the fair value based method.

Weadopted the disclosure-only provisions of SFAS No. 123, and accordingly,no expense has been recognized for options granted to employees. We amortizedeferred stock-based compensation over the vesting periods of theapplicable stock purchase rights and stock options, generally four years. Hadcompensation expense been determined based on the fair value at the grant datefor awards, consistent with the provisions of SFAS No. 123, the Company’spro forma net loss and net loss per share would be as follows (in thousands,except per share data):

| ** **                                                                                                   | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                   | ** ** | **2005**                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Reported net income (loss)                                                                                   |       | $  (311                                   | )          | $      28 |   | $ (3,549 | ) |
| Add: stock-based employee compensation expense  included in reported net (loss) income under APB No. 25 |       | —                                              |       | — |   | 55 |   |
| Deduct: Total stock-based compensation  determined under fair value based method for all awards              |       | (1,680                                              | )          | (1,161 | ) | (2,047 | ) |
| Pro forma net loss under SFAS No. 123                                                                   |       | (1,991                                              | )          | (1,133 | ) | (5,541 | ) |
| Basic and diluted net  (loss) income per share:                                                              |       |                                                |       |   |   |   |   |
| As reported                                                                                                  |       | $ (0.02                                        | )          | $   0.00 |   | $ (0.26 | ) |
| Pro forma                                                                                                    |       | (0.14                                               | )          | (0.08 | ) | (0.41 | ) |

 

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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,** | ** ** |
|---------------------------|------------|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                | ** ** | **2005**                                                                                        | ** ** | **2004**                                                                                         | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Expected Life (in  years) |       | 5                                                                                               |       | 5                                                                                                |       | 5 |   |   | 0.5 |   |   |   | 0.5 |   |   | 0.5 |   |
| Risk-free  interest rate  |       | 3.5-4.0                                                                                         | %          | 3.3-3.7                                                                                          | %          | 2.9-3.4 | % |   | 4.3 | % |   |   | 1.3 | % |   | 1.0-2.1 | % |
| Volatility                |       | 100                                                                                             | %          | 105                                                                                              | %          | 111 | % |   | 99 | % |   |   | 103 | % |   | 111 | % |
| 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 traded optionsand because changes in the subjective input assumptions can materially affectthe fair value estimate, in management’s opinion, the existing models do notnecessarily provide a reliable single measure of the fair value of our options.

*Revenue Recognition*

We account for the recognition of revenues inaccordance with Statement of Position (“SOP”) 97-2, “Software RevenueRecognition.” Revenues consist of sales to end-users, including resellers, andto distributors. Revenues 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 deferrecognition of distributor revenues until such distributors resell our productsto their customers. The amounts deferred as a result of this policy arereflected as “deferred revenue” in the accompanying consolidated balancesheets. The related cost of revenue is also deferred and reported in theconsolidated balance sheets as inventory.

Software components are generally not sold separatelyfrom our hardware components. Software revenues consist of license revenuesthat are recognized upon the delivery of application products. We providelimited post-contract customer support (“PCS”), consisting primarily oftechnical support and “bug” fixes. In accordance with SOP 97-2, revenueearned on software arrangements involving multiple elements is allocated toeach element based upon the relative fair values of the elements. Although weprovide PCS, the revenue allocated to this element is recognized together withthe initial licensing fee on delivery of the software because: (1) the PCSfee is included with the initial licensing fee; (2) the PCS included withthe initial 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.

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Forfiscal years 2005, 2004, and 2003, the following customers accounted forapproximately 82%, 82%, and 87% of net revenues, respectively:

| ** **    | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2005**                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| AltiSys       |       |                                                | 16         | % |   |   | 14 | % |   |   | 18 | % |   |
| Ingram Micro* |       |                                                | 2          | % |   |   | 14 | % |   |   | 21 | % |   |
| Synnex        |       |                                                | 53         | % |   |   | 46 | % |   |   | 48 | % |   |
| Graybar       |       |                                                | 11         | % |   |   | 8 | % |   |   | — |   |   |

----

*                    On July 20, 2005, weterminated our distribution agreement with Ingram Micro.

Revenues derived fromsales to customers outside of the Americas, primarily in China, Norway and theUnited Kingdom accounted for approximately 10%, 10%, and 6% of our net revenuesfor fiscal years 2005, 2004 and 2003, respectively.

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

Historical net (loss) income per share has beencalculated under SFAS No. 128, “Earnings per Share.” SFAS No. 128requires companies to compute earnings per share under two methods (basic anddiluted). Basic net (loss) income per share is calculated by dividing net(loss) income by the weighted average shares of common stock outstanding duringthe period. Diluted earnings per share reflects the potential dilution thatcould occur if securities or other contracts to issue common stock wereexercised or converted into common stock. Fiscal years 2005 and 2003 basic anddiluted net loss per share numbers are identical as potential common stockresulting from the exercise of stock options are antidilutive.

Basicand diluted (loss) income per share for each of the three years in the periodended September 30, 2005 are as follows (in thousands):

| ** **                                                                    | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Reported net  (loss) income                                                   |       | $  (311                                   | )          | $      28 |   | $ (3,549 | ) |
| Computation of common  shares outstanding—basic (loss) income per share: |       |                                                |       |   |   |   |   |
| Weighted average common stock                                                 |       | 14,605                                              |       | 14,242 |   | 13,643 |   |
| Weighted average dilutive potential shares                                    |       | —                                              |       | 1,483 |   | — |   |
| Weighted average shares used in computation of  dilutive EPS                  |       | 14,605                                              |       | 15,725 |   | 13,643 |   |
| Basic net income  (loss) per share                                            |       | $ (0.02                                        | )          | $   0.00 |   | $ (0.26 | ) |
| Diluted net income  (loss) per share                                          |       | $ (0.02                                        | )          | $   0.00 |   | $ (0.26 | ) |

 

Thefollowing common stock options and employee stock options were excluded fromthe computation of diluted net income (loss) per share for fiscal years 2005,2004 and 2003:

| ** **             | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|------------------------|------------|-----------------------------------------------------|------------|
| ** **             | ** ** | **2005**                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Common Stock Options   |       |                                                | —     |   |   | 1,412 |   |   | — |   |   |
| Employee stock options |       |                                                | —     |   |   | 72 |   |   | — |   |   |

 

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*Comprehensive Loss*

Comprehensive loss for theCompany consists of net loss plus the effect of other unrealized gains andlosses from investments.

*Segment Reporting*

We are organized andoperate as one operating segment. We operate primarily in one geographic area,the Americas.

*Recent Accounting Pronouncements*

In December 2004, theFASB issued SFAS No. 123(R), Share-Based Payment, which establishesstandards for transactions in which an entity exchanges its equity instrumentsfor goods or services. In March 2005, the SEC issued Staff AccountingBulletin No. 107—Share-Based Payment, which provides interpretive guidancerelated to SFAS No. 123(R). SFAS No. 123(R) requires a publicentity to measure the cost of employee services received in exchange for anaward of equity instruments based on the grant-date fair value of the award.This eliminates the exception to account for such awards using the intrinsicmethod previously allowable under APB Opinion No. 25. SFAS No. 123(R) willbe effective beginning with the first interim or annual reporting period of ourfiscal year update beginning on or after December 31, 2005. We arecurrently evaluating the provisions of SFAS No. 123(R) and havenot yet determined whether to use the modified prospective or the modifiedretrospective methods allowed by SFAS No. 123(R). We expect that the newstandards will have a material effect on our results of operations.

In November 2004, theFASB issued SFAS No. 151, “Inventory Costs”. The Statement requires thatabnormal amounts of idle facility expense, freight handling costs and wastedmaterial be recognized as current-period expenses. In addition the statementrequires that the allocation of production overhead be based on normalcapacity. The adoption of this standard in October 2004 is not expected tohave a material impact on our consolidated financial statements.

In December 2004, theFASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, whicheliminates the exception for nonmonetary exchanges of similar productive assetsand replaces it with a general exception for exchanges of nonmonetary assetsthat do not have commercial substance. SFAS No. 153 will be effectivefor nonmonetary asset exchanges occurring in fiscal periods beginning after June 15,2005. We are currently evaluating the provisions of SFAS No. 153 anddo not believe that its adoption will have a material impact on our financialcondition, results of operations or liquidity.

In March 2005, theFASB issued FIN 47, “Accounting for Conditional Asset RetirementObligations, an interpretation of FASB Statement No. 143” (“FIN 47”),which requires an entity to recognize a liability for the fair value of aconditional asset retirement obligation when incurred if the liability’s fairvalue can be reasonably estimated. FIN 47 is effective for fiscal yearsending after December 15, 2005. We are currently evaluating the effectthat the adoption of FIN 47 will have on our consolidated results ofoperations and financial condition but do not expect it to have a materialimpact.

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 154 provides guidance on the accounting for and reporting ofaccounting changes and error corrections. It establishes retrospectiveapplication, or the latest practicable date, as the required method forreporting a change in accounting principle and the reporting of a correction ofan error. SFAS 154 is effective for accounting changes and corrections oferrors made in fiscal years beginning after December 15, 2005 and arerequired to be adopted by us in the first quarter of fiscal year 2007. We arecurrently evaluating the effect that the adoption of SFAS 154 will have onour consolidated results of operations and financial condition but do notexpect it to have a material impact.

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**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 thenumber of installed units, historical experience and management’s judgmentregarding anticipated rates of warranty claims and cost per claim. We assessthe adequacy of our recorded warranty liability every quarter and makeadjustments to the liability if necessary.

Changesin our warranty liability for the fiscal years ended September 30, 2005and 2004, respectively, are as follows (in thousands):

| ** **                                           | ** ** | **September 30,** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Beginning balance                                    |       | $                      | 424        |   | $ | 644 |   |
| Provisions for  warranty liability                   |       | 103                    |       | 147 |   |
| Other adjustments                                    |       | (102                   | )          | (193 | ) |
| Warranty cost  including labor, components and scrap |       | (161                   | )          | (174 | ) |
| Ending balance                                       |       | $                      | 264        |   | $ | 424 |   |

 

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

**4. COMMITMENTS AND CONTINGENCIES:**

*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 $486,000, $510,000, and $818,000, for fiscal years 2005,2004, and 2003, respectively. In addition, we lease certain equipment undercapital lease arrangements. Minimum future lease payments under allnoncancellable capital and operating leases as of September 30, 2005 areas follows (in thousands):

| ** **                                               | ** ** | **Capital** | ** ** | **Operating** | ** ** |
|----------------------------------------------------------|------------|-------------|------------|---------------|------------|
| **Fiscal Year Ending September 30,** | ** ** | ** **  | ** ** | **Leases**    | ** ** | **Leases** | ** ** |
| 2006                                                     |       |        | $          | 53            |       |   |   | $ | 403 |   |   |
| 2007                                                     |       |        | 52         |          |       |   | 361 |   |   |
| 2008                                                     |       |        | 47         |          |       |   | 271 |   |   |
| 2009                                                     |       |        | 44         |          |       |   | 92 |   |   |
| 2010                                                     |       |        | 33         |          |       |   | — |   |   |
| Total minimum  lease payment                             |       |        | 229        |          |       |   | $ | 1,127 |   |   |
| Amount  representing interest                            |       |        | 37         |          |       |   |   |   |   |
| Present value of  minimum lease payment                  |       |        | $          | 192           |       |   |   |   |   |   |
| Current portion                                          |       |        | $          | 52            |       |   |   |   |   |   |
| Long-term portion                                        |       |        | 177        |          |       |   |   |   |   |
| Total capital lease  commitments                         |       |        | $          | 229           |       |   |   |   |   |   |
|                                                          |            |             |            |               |            |  |  |  |  |  |  |  |  |

 

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*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 somediscovery, but no depositions have been taken, and no motions are currentlypending. On October 7, 2003, the parties filed a stipulation to stay thisaction, pending the outcome of the reissue of some of the subject patentsbefore the U.S. Patent and Trademark Office. We believe we have strong defensesand arguments in this dispute and intend to vigorously defend our position.Management’s view is that any loss from this litigation is currently notprobable or estimable. Therefore, we have not established a reserve on ourbalance sheets as to any liability related to the outcome of this action.

**5. CAPITAL STOCK:**

*Common Stock*

We areauthorized to issue 50,000,000 shares of common stock. At September 30,2005, we had reserved the following shares of common stock for future issuance:

| 1994 Stock Option  Plan            |   | 1,026,132 |   |
|------------------------------------|--------|-----------|--------|
| 1999 Employee  Stock Purchase Plan |   | 875,038   |   |
| 1999 Stock Option  Plan            |   | 4,855,088 |   |
|                               |   | 6,756,258 |   |

 

*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, 2005, therewere 237,000 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 equal to the lesser of (i) 1,796,783shares, (ii) 5% of the outstanding shares on that date or (iii) alesser amount as determined by the Board of Directors. Under the Plans, theBoard of Directors may grant incentive and nonqualified stock options toemployees, directors and consultants of the Company. The exercise price pershare for an incentive stock option cannot be less than 100% of the fair marketvalue, as determined by the Board of Directors, on the date of grant. Theexercise price per share for a nonqualified stock option cannot be less than85% of the fair market value, as determined by the Board of Directors, on thedate of grant. Also, the exercise price of options granted to a greater than10% stockholder may not be less than 110% of the fair market value on the dateof grant. The value of common stock subject to 

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incentive stock optionsthat become exercisable by any one employee in any calendar year may not exceed$100,000. Options under these Plans generally vest over a four-year period andgenerally expire ten years after the date of grant.

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  October 1, 2002               |       |                                       | 2,364,921  |                         |       |                                           | 3,545,771  |   |   |   | $ | 4.10 |   |   |
| Authorized for grant                              |       |                                       | 673,985    |                         |       |                                           | —     |   |   |   |   |   |   |
| Granted (weighted average of fair value of $0.51) |       |                                       | (873,000   | )                            |       |                                           | 873,000    |   |   |   | 0.64 |   |   |
| Exercised                                         |       |                                       | —     |                         |       |                                           | (365,431   | ) |   |   | 0.95 |   |   |
| Canceled                                          |       |                                       | 451,055    |                         |       |                                           | (451,055   | ) |   |   | 1.73 |   |   |
| 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 |   |   |
| Exercisable at September 30, 2003            |       |                                       |       |                         |       |                                           | 2,508,791  |   |   |   | $ | 5.02 |   |   |
| Exercisable at  September 30, 2004           |       |                                       |       |                         |       |                                           | 2,494,920  |   |   |   | $ | 4.42 |   |   |

 

Thefollowing table summarizes information concerning outstanding and exercisableoptions at September 30, 2005:

| ** **               | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding**      | ** ** | **Weighted  Average  Remaining  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0.17-$0.78              |       |                         | 998,188    |                         |       |   | 6.26 |   |   |   | $ | 0.66 |   |   | 835,441 |   |   | $ | 0.67 |   |   |
|   0.79-2.13    |       |                         | 795,033    |                         |       |   | 5.44 |   |   |   | 1.55 |   |   | 767,533 |   |   | 1.53 |   |   |
|   2.14-2.89    |       |                         | 71,446     |                         |       |   | 6.60 |   |   |   | 2.67 |   |   | 42,175 |   |   | 2.79 |   |   |
|   2.90-2.98    |       |                         | 687,000    |                         |       |   | 9.12 |   |   |   | 2.98 |   |   | 0 |   |   | 0.00 |   |   |
|   2.99-4.34    |       |                         | 734,987    |                         |       |   | 7.77 |   |   |   | 3.87 |   |   | 386,052 |   |   | 3.92 |   |   |
|   4.35-12.69   |       |                         | 797,836    |                         |       |   | 4.20 |   |   |   | 10.47 |   |   | 797,836 |   |   | 10.47 |   |   |
|                     |       |                         | 4,084,490  |                         |       |   | 6.46 |   |   |   | $ | 3.75 |   |   | 2,829,037 |   |   | $ | 4.12 |   |   |
|                          |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Deferred StockCompensation*

In connection with theissuance of certain stock options to employees in fiscal years 1999 and 1998,we recorded deferred stock compensation in the aggregate amount ofapproximately $3,892,000, representing the difference between the deemed fairvalue of our common stock and the exercise price of stock options at the dateof grant prior to our initial public offering. For fiscal year 2003,amortization of deferred stock compensation expense was approximately $55,000.We fully amortized the deferred stock compensation in fiscal year 2003.

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*1999 Employee StockPurchase Plan*

Under the 1999 EmployeeStock Purchase Plan (the “1999 Purchase Plan”), 875,038 shares of common stockare reserved for issuance at September 30, 2005 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 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 5,989 sharesmay be purchased by any participant during any offering period. In the event ofa sale or merger of us, the Board may accelerate the exercise date of thecurrent 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 2005, 109,458 shares were purchased byand distributed to employees at a price ranging from of $0.50 to $2.10 pershare.

*Stock RepurchaseProgram*

On April 24, 2001,our Board of Directors authorized a stock repurchase program to buy back ouroutstanding common stock in the open market. Under this repurchase program, werepurchased $909,490 and $105,009 during fiscal years 2002 and 2001,respectively, of common stock. The stock repurchased program ended on January 2002.

**6. DEFERRED STOCK COMPENSATION**

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

| ** **                  | ** ** | **Fiscal Year Ended  September 30,** | ** ** |
|-----------------------------|------------|-----------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Research and  development   |       |                                                | $          | — |   |   |   | $ | — |   |   |   | $ | 23 |   |   |
| Sales and  marketing        |       |                                                | —     |   |   |   | — |   |   |   | 27 |   |   |
| General and  administrative |       |                                                | —     |   |   |   | — |   |   |   | 5 |   |   |
|                        |       |                                                | $          | — |   |   |   | $ | — |   |   |   | $ | 55 |   |   |

 

**7. INCOME TAXES:**

Weaccount for income taxes pursuant to SFAS No. 109, “Accounting for IncomeTaxes.” SFAS No. 109 requires recognition of deferred tax liabilitiesand assets 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,** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|
| ** **                                          | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Net operating  loss carryforwards                   |       | $                      | 16,422     |   | $ | 15,752 |   |
| Reserve and other  cumulative temporary differences |       | 1,790                  |       | 2,100 |   |
| Research and  development credit carryforward       |       | 1,090                  |       | 1,087 |   |
| Net capitalized  research and development expenses  |       | 402                    |       | 698 |   |
|                                                |       | 19,704                 |       | 19,637 |   |
| Valuation  allowance                                |       | (19,704                | )          | (19,637 | ) |
| Net deferred tax asset                              |       | $                      | —     |   | $ | — |   |

 

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Areconciliation between the Company’s effective tax rate and the U.S. statutoryrate is as follows:

| ** **                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Tax at federal  statutory rate |       | 35.0     | %          | 35.0     | %          | (35.0    | )%         |
| Tax exempt investment  income  |       |     |       |     |       |     |       |
| Change in  valuation allowance |       | (31.0    | )          | (94.0    | )          | 34.7     |       |
| Other                          |       | (4.0     | )          | 59.0     |       | 1.3      |       |
| Tax credits                    |       | —   |       | —   |       | (1.0     | )          |
| Provision for income taxes     |       | 0.0      | %          | 0.0      | %          | 0.0      | %          |

 

As of September 30, 2005, we had cumulative netoperating loss carryforwards for federal and state income tax reportingpurposes of approximately $43.9 million and $18.3 million,respectively, which expire on various dates from 2010 to 2025. Under currenttax law, net operating loss carryforwards available in any given year may belimited upon the occurrence of certain events, including significant changes inownership interest. The annual use of our net operating loss and creditcarryforwards would be limited according to these provisions. Management hasnot yet determined the extent of such limitations. Such limitations may resultin the loss of carryforwards benefits due to their expiration.

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, 2005 and 2004 we had no significantdeferred tax liabilities.

We did not incur anyincome tax expenses from our foreign subsidiaries, AltiGen Korea and AltiGenChina as of September 30, 2005.

**8. EQUITY IN LOSS OF INVESTEE**

Wehave a 23% vested interest in AliGen Korea. The total equity in netlosses of Korea investee was approximately $52,000 of which 23%, or $12,000, isreflected in the fourth quarter of fiscal year 2005.

**9. RELATED PARTY TRANSACTION**

In July 2004, wepurchased 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.

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**10.SELECTED QUARTERLY 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,          |       |                                                               |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| 2005:                                          |       |                                                               |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Revenues, 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 |   |   |
| 2004:                                          |       |                                                               |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Revenues, net                                  |       |                                                               | $          | 3,630                   |       |                   |       | $                       | 3,293      |   |   |   | $ | 3,883 |   |   |   | $ | 4,036 |   |   |
| Gross profit                                   |       |                                                               | 2,192      |                    |       |                   | 2,043      |                    |       |   | 2,403 |   |   |   | 2,597 |   |   |
| Net income (loss)                              |       |                                                               | (46        | )                       |       |                   | (246       | )                       |       |   | 185 |   |   |   | 135 |   |   |
| Basic and diluted net  income (loss) per share |       |                                                               | (0.00      | )                       |       |                   | (0.02      | )                       |       |   | 0.01 |   |   |   | 0.01 |   |   |

 

 

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**ALTIGENCOMMUNICATIONS, INC. AND SUBSIDIARY**

**SCHEDULEII—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: |       |                    |       |                                                     |       |                                          |       |           |         |                                               |       |   |   |   |   |   |   |
| 2005                              |       |                    | $          | 35                                                  |       |                                          |       | $              | 34      |                                               |       |   | $ | (29  | ) |   |   | $ | 40  |   |   |
| 2004                              |       |                    | $          | 60                                                  |       |                                          |       | $              | 35      |                                               |       |   | $ | (60  | ) |   |   | $ | 35  |   |   |
| 2003                              |       |                    | $          | 227                                                 |       |                                          |       | $              | (3      | )                                                  |       |   | $ | (164  | ) |   |   | $ | 60  |   |   |
| Inventory  reserve:               |       |                    |       |                                                     |       |                                          |       |           |         |                                               |       |   |   |   |   |   |   |
| 2005                              |       |                    | $          | 2,625                                               |       |                                          |       | $              | —  |                                               |       |   | $ | (167  | ) |   |   | $ | 2,458  |   |   |
| 2004                              |       |                    | $          | 2,918                                               |       |                                          |       | $              | —  |                                               |       |   | $ | (293  | ) |   |   | $ | 2,625  |   |   |
| 2003                              |       |                    | $          | 3,319                                               |       |                                          |       | $              | —  |                                               |       |   | $ | (401  | ) |   |   | $ | 2,918  |   |   |

 

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 27, 2005 | 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 27, 2005  |
| Gilbert Hu               |       | executive officer) and  Director    |       |                    |
| /s/ PHILIP M. MCDERMOTT  |       | Chief Financial  Officer (principal |       | December 27,  2005 |
| Philip McDermott         |       | financial and accounting  officer)  |       |                    |
| /s/ KENNETH TAI          |       | Director                            |       | December 27,  2005 |
| Kenneth Tai              |       |                                |       |                    |
| /s/ RICHARD BLACK        |       | Director                            |       | December 27,  2005 |
| Richard Black            |       |                                |       |                    |
| /s/ TACHENG CHESTER WANG |       | Director                            |       | December 27,  2005 |
| Tacheng Chester Wang     |       |                                |       |                    |
| /s/ MIKE MON  YEN TSAI   |       | Director                            |       | December 27,  2005 |
| 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.                                                                                                       |
| 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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