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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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(Mark One)

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



For the quarterly period ended September 30, 2005



or



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from              to



Commission File Number 000-19462



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ARTISOFT, INC.

(Exact Name of Registrant as Specified in Its Charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 86-0446453                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



One Memorial Drive,
Cambridge, Massachusetts 02142

(Address of Principal Executive Offices) (Zip Code)



Registrants telephone number, including area code:
(617) 354-0600



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



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



Indicate by check mark whether
the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)    Yes ̈No  x



Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.



|                                        |  |                                          
|--------------------------------------- |  | -----------------------------------------
|Title of Class of Common Stock          |  | Shares Outstanding as of November 1, 2005
|Common Stock, $0.01 par value per share |  | 45,777,309                               



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##### Table of Contents

ARTISOFT, INC.

QUARTERLY REPORT ON FORM 10-Q

INDEX



|                                                                                               |  |   
|---------------------------------------------------------------------------------------------- |  | --
|PART I  FINANCIAL INFORMATION                                                                 |  | 1 
|Item 1 
FINANCIAL STATEMENTS                                                                  |  | 1 
|Item 2 
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |  | 15
|Item 3 
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |  | 32
|Item 4 
CONTROLS AND PROCEDURES                                                               |  | 32
|PART II  OTHER INFORMATION                                                                    |  | 34
|Item 2 
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                           |  | 34
|Item 6 
EXHIBITS                                                                              |  | 34



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##### Table of Contents

PART IFINANCIAL INFORMATION



Item 1FINANCIAL STATEMENTS



ARTISOFT, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)



|                                                                                                                                                                     |  |                   |         |   |              |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ------------ | - | ------- | -
|                                                                                                                                                                     |  | September 30,2005 |         |   | June 30,2005 |  
|ASSETS                                                                                                                                                               |  |                   |         |   |              |   |         |  
|Current assets:                                                                                                                                                      |  |                   |         |   |              |   |         |  
|Cash and cash equivalents                                                                                                                                            |  | $                 | 4,738   |   |              | $ | 4,880   |  
|Trade receivables, net of allowances of $404 and $423 at September 2005 and June 2005, respectively                                                                  |  |                   | 10,843  |   |              |   | 5,887   |  
|Other receivables                                                                                                                                                    |  |                   | 211     |   |              |   |        |  
|Inventories                                                                                                                                                          |  |                   | 6,369   |   |              |   | 1,686   |  
|Prepaid expenses                                                                                                                                                     |  |                   | 2,882   |   |              |   | 737     |  
|Deferred costs                                                                                                                                                       |  |                   | 3,002   |   |              |   | 2,738   |  
|Restricted cash                                                                                                                                                      |  |                   | 1,394   |   |              |   | 1,145   |  
|                                                                                                                                                                     |  |                   |         |   |              |   |         |  
|Total current assets                                                                                                                                                 |  |                   | 29,439  |   |              |   | 17,073  |  
|                                                                                                                                                                     |  |                   |         |   |              |   |         |  
|Property and equipment                                                                                                                                               |  |                   | 7,184   |   |              |   | 6,115   |  
|Less accumulated depreciation and amortization                                                                                                                       |  |                   | (4,419  | ) |              |   | (4,663  | )
|                                                                                                                                                                     |  |                   |         |   |              |   |         |  
|Net property and equipment                                                                                                                                           |  |                   | 2,765   |   |              |   | 1,451   |  
|                                                                                                                                                                     |  |                   |         |   |              |   |         |  
|Goodwill                                                                                                                                                             |  |                   | 22,997  |   |              |   | 13,020  |  
|Intangible assets, net of accumulated amortization                                                                                                                   |  |                   | 7,730   |   |              |   | 3,648   |  
|Deferred costs  long term                                                                                                                                           |  |                   | 6,451   |   |              |   | 7,243   |  
|Other assets                                                                                                                                                         |  |                   | 146     |   |              |   | 263     |  
|                                                                                                                                                                     |  |                   |         |   |              |   |         |  
|Total Assets                                                                                                                                                         |  | $                 | 69,528  |   |              | $ | 42,698  |  
|                                                                                                                                                                     |  |                   |         |   |              |   |         |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                                 |  |                   |         |   |              |   |         |  
|Current liabilities:                                                                                                                                                 |  |                   |         |   |              |   |         |  
|Accounts payable                                                                                                                                                     |  | $                 | 5,285   |   |              | $ | 4,134   |  
|Accrued liabilities                                                                                                                                                  |  |                   | 6,941   |   |              |   | 3,473   |  
|Deferred revenue                                                                                                                                                     |  |                   | 8,117   |   |              |   | 7,697   |  
|Customer deposits                                                                                                                                                    |  |                   | 176     |   |              |   | 176     |  
|Notes Payable                                                                                                                                                        |  |                   | 9,920   |   |              |   |        |  
|                                                                                                                                                                     |  |                   |         |   |              |   |         |  
|Total current liabilities                                                                                                                                            |  |                   | 30,439  |   |              |   | 15,480  |  
|Deferred Revenue-long term                                                                                                                                           |  |                   | 12,196  |   |              |   | 12,727  |  
|Deferred tax liability                                                                                                                                               |  |                   | 341     |   |              |   | 257     |  
|Note payable  long term                                                                                                                                             |  |                   | 1,633   |   |              |   |        |  
|                                                                                                                                                                     |  |                   |         |   |              |   |         |  
|Total liabilities                                                                                                                                                    |  |                   | 44,609  |   |              |   | 28,464  |  
|                                                                                                                                                                     |  |                   |         |   |              |   |         |  
|Shareholders equity:                                                                                                                                                |  |                   |         |   |              |   |         |  
|Preferred stock, $1.00 par value per share. Authorized 11,433,600 shares;                                                                                            |  |                   |         |   |              |   |         |  
|Series A preferred stock. Authorized 50,000 shares; no shares issued or outstanding at September 30, 2005 and June 30,
2005                                          |  |                   |        |   |              |   |        |  
|Series B preferred stock. Authorized 2,800,000 shares; no shares issued or outstanding at September 30, 2005 and June 30,
2005                                       |  |                   |        |   |              |   |        |  
|Series C preferred stock. Authorized 2,627,002 shares; no shares issued or outstanding at September 30, 2005, and June 30,
2005                                      |  |                   |        |   |              |   |        |  
|Common stock, $.01 par value per share. Authorized 50,000,000 shares; issued and outstanding 45,777,309 shares at September 30, 2005
and 36,612,765 at June 30, 2005 |  |                   | 458     |   |              |   | 366     |  
|Accumulated other comprehensive income                                                                                                                               |  |                   | 2       |   |              |   | 4       |  
|Additional paid-in capital                                                                                                                                           |  |                   | 87,849  |   |              |   | 151,842 |  
|Accumulated deficit                                                                                                                                                  |  |                   | (62,773 | ) |              |   | (59,411 | )
|Deferred compensation                                                                                                                                                |  |                   |         |   |              |   | (8,243  | )
|Deferred Toshiba equity cost                                                                                                                                         |  |                   | (617    | ) |              |   | (644    | )
|Less treasury stock, at cost, no shares of common stock at September 30, 2005 and 2,216,783 shares at June 30, 2005                                                  |  |                   |        |   |              |   | (69,680 | )
|Shareholders equity (deficit)                                                                                                                                       |  |                   | 24,918  |   |              |   | 14,234  |  
|                                                                                                                                                                     |  |                   |         |   |              |   |         |  
|Total Liabilities and Shareholders Equity                                                                                                                           |  | $                 | 69,528  |   |              | $ | 42,698  |  
|                                                                                                                                                                     |  |                   |         |   |              |   |         |  



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



1



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##### Table of Contents

ARTISOFT, INC. AND SUBSIDIARIES



UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS



(in thousands, except per share amounts)



|                                                                                                        |  |                                 |        |   |      |   |        |  
|------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                                        |  | Three Months EndedSeptember 30, |       
|                                                                                                        |  | 2005                            |        |   | 2004 |  
|Net product revenue                                                                                     |  | $                               | 9,887  |   |      | $ | 2,934  |  
|Cost of sales                                                                                           |  |                                 | 3,646  |   |      |   | 365    |  
|                                                                                                        |  |                                 |        |   |      |   |        |  
|Gross profit                                                                                            |  |                                 | 6,241  |   |      |   | 2,569  |  
|                                                                                                        |  |                                 |        |   |      |   |        |  
|Operating expenses:                                                                                     |  |                                 |        |   |      |   |        |  
|Sales and marketing                                                                                     |  |                                 | 3,670  |   |      |   | 1,798  |  
|Product development                                                                                     |  |                                 | 2,610  |   |      |   | 873    |  
|General and administrative                                                                              |  |                                 | 1,909  |   |      |   | 1,302  |  
|Non-Cash Compensation (1)                                                                               |  |                                 | 1,168  |   |      |   |       |  
|Amortization of Intangible Assets                                                                       |  |                                 | 179    |   |      |   |       |  
|                                                                                                        |  |                                 |        |   |      |   |        |  
|Total operating expenses                                                                                |  |                                 | 9,536  |   |      |   | 3,973  |  
|                                                                                                        |  |                                 |        |   |      |   |        |  
|Loss from operations                                                                                    |  |                                 | (3,295 | ) |      |   | (1,404 | )
|Other income, net                                                                                       |  |                                 | 17     |   |      |   | 3      |  
|                                                                                                        |  |                                 |        |   |      |   |        |  
|Loss before provision for income taxes                                                                  |  |                                 | (3,278 | ) |      |   | (1,401 | )
|                                                                                                        |  |                                 |        |   |      |   |        |  
|Provision for income tax                                                                                |  |                                 | 84     |   |      |   | 5      |  
|                                                                                                        |  |                                 |        |   |      |   |        |  
|Net Loss                                                                                                |  |                                 | (3,362 | ) |      |   | (1,406 | )
|                                                                                                        |  |                                 |        |   |      |   |        |  
|Deemed dividend to series C preferred shareholders                                                      |  |                                 |       |   |      |   | (1,368 | )
|Deemed dividend to series B preferred shareholders                                                      |  |                                 |       |   |      |   | (100   | )
|                                                                                                        |  |                                 |        |   |      |   |        |  
|Loss applicable to common shareholders                                                                  |  | $                               | (3,362 | ) |      | $ | (2,874 | )
|                                                                                                        |  |                                 |        |   |      |   |        |  
|Loss applicable to common shareholders per sharebasic and diluted                                      |  | $                               | (0.10  | ) |      | $ | (0.61  | )
|Weighted average common shares outstandingbasic and diluted                                            |  |                                 | 34,720 |   |      |   | 4,707  |  
|(1)    The following
summarizes the allocation of stock-based compensation from employee stock options: |  |                                 |        |   |      |   |        |  
|Sales and marketing                                                                                     |  | $                               | 269    |   |      | $ |       |  
|Product development                                                                                     |  | $                               | 385    |   |      |   |       |  
|General and administrative                                                                              |  | $                               | 514    |   |      |   |       |  
|Total                                                                                                   |  | $                               | 1,168  |   |      | $ |       |  



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



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ARTISOFT, INC. AND SUBSIDIARIES



UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS



(in thousands)



|                                                                                                                                                         |  |                                 |         |   |      |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                                                                                         |  | Three Months EndedSeptember 30, |        
|                                                                                                                                                         |  | 2005                            |         |   | 2004 |  
|Cash flows from operating activities:                                                                                                                    |  |                                 |         |   |      |   |         |  
|Net loss                                                                                                                                                 |  | $                               | (3,362  | ) |      | $ | (1,406  | )
|Adjustments to reconcile net loss to net cash used by operating activities:                                                                              |  |                                 |         |   |      |   |         |  
|Depreciation and amortization                                                                                                                            |  |                                 | 480     |   |      |   | 99      |  
|Amortization of deferred Toshiba equity costs                                                                                                            |  |                                 | 27      |   |      |   | 96      |  
|Stock based compensation expense                                                                                                                         |  |                                 | 1,168   |   |      |   |        |  
|Deferred tax liability                                                                                                                                   |  |                                 | 80      |   |      |   |        |  
|Non-cash changes in accounts receivable                                                                                                                  |  |                                 | 5       |   |      |   | 60      |  
|Changes in assets and liabilities, net of amounts acquired:                                                                                              |  |                                 |         |   |      |   |         |  
|Trade receivables                                                                                                                                        |  |                                 | (2,014  | ) |      |   | (1,208  | )
|Inventories                                                                                                                                              |  |                                 | (143    | ) |      |   | 60      |  
|Prepaid expenses                                                                                                                                         |  |                                 | 205     |   |      |   | 223     |  
|Deferred costs                                                                                                                                           |  |                                 | 528     |   |      |   |        |  
|Other assets                                                                                                                                             |  |                                 | (24     | ) |      |   | (28     | )
|Accounts payable                                                                                                                                         |  |                                 | (63     | ) |      |   | (668    | )
|Accrued liabilities                                                                                                                                      |  |                                 | (214    | ) |      |   | 222     |  
|Deferred revenue                                                                                                                                         |  |                                 | (111    | ) |      |   | 122     |  
|Customer deposits                                                                                                                                        |  |                                 |        |   |      |   | (3      | )
|                                                                                                                                                         |  |                                 |         |   |      |   |         |  
|Net cash used in operating activities                                                                                                                    |  |                                 | (3,010  | ) |      |   | (2,431  | )
|                                                                                                                                                         |  |                                
|Cash used for acquisitions net of cash acquired                                                                                                          |  |                                 | (18,633 | ) |      |   | (13,227 | )
|Purchases of property and equipment                                                                                                                      |  |                                 | (251    | ) |      |   | (62     | )
|Restricted cash                                                                                                                                          |  |                                 | (99     | ) |      |   | (1,000  | )
|                                                                                                                                                         |  |                                 |         |   |      |   |         |  
|Net cash used in investing activities                                                                                                                    |  |                                 | (18,983 | ) |      |   | (14,289 | )
|                                                                                                                                                         |  |                                 |         |   |      |   |         |  
|Cash flows from financing activities:                                                                                                                    |  |                                 |         |   |      |   |         |  
|Proceeds from debt facilities                                                                                                                            |  |                                 | 9,000   |   |      |   |        |  
|Proceeds from issuance of common stock, net of issue costs                                                                                               |  |                                 | 12,853  |   |      |   | 21,229  |  
|                                                                                                                                                         |  |                                 |         |   |      |   |         |  
|Net cash provided by financing activities                                                                                                                |  |                                 | 21,853  |   |      |   | 21,229  |  
|                                                                                                                                                         |  |                                 |         |   |      |   |         |  
|Effect of foreign currency exchange rates                                                                                                                |  |                                 | (2      | ) |      |   |        |  
|Net increase (decrease) in cash and cash equivalents                                                                                                     |  |                                 | (142    | ) |      |   | 4,509   |  
|Cash and cash equivalents at beginning of period                                                                                                         |  |                                 | 4,880   |   |      |   | 2,747   |  
|Cash and cash equivalents at end of period                                                                                                               |  |                                 | 4,738   |   |      |   | 7,256   |  
|SUPPLEMENTAL CASH FLOW INFORMATION FROM FINANCING ACTIVITIES:                                                                                            |  |                                 |         |   |      |   |         |  
|Non cash dividend to series B and C preferred shareholders                                                                                               |  |                                 |        |   |      |   | 1,468   |  
|Cash paid for taxes                                                                                                                                      |  |                                 |        |   |      |   |        |  
|Cash paid for interest                                                                                                                                   |  |                                 |        |   |      |   |        |  
|                                                                                                                                                         |  |                                
|On September 28, 2004 the Company acquired Vertical Networks, and on September 28, 2005 the Company acquired Comdial Corporation as
follows (see Note 3) |  |                                 |         |   |      |   |         |  
|Accounts Receivable                                                                                                                                      |  |                                 | 3,158   |   |      |   | 3,792   |  
|Inventory                                                                                                                                                |  |                                 | 4,540   |   |      |   | 1,308   |  
|Other current assets                                                                                                                                     |  |                                 | 2,248   |   |      |   | 315     |  
|Property and Equipment                                                                                                                                   |  |                                 | 1,285   |   |      |   | 395     |  
|Other assets                                                                                                                                             |  |                                 | 150     |   |      |   | 89      |  
|Intangible assets                                                                                                                                        |  |                                 | 4,300   |   |      |   | 4,300   |  
|Goodwill                                                                                                                                                 |  |                                 | 9,170   |   |      |   | 13,020  |  
|Cash used in acquisitions, net of cash acquired                                                                                                          |  |                                 | (18,613 | ) |      |   | (13,227 | )
|                                                                                                                                                         |  |                                 |         |   |      |   |         |  
|                                                                                                                                                         |  |                                 | 6,238   |   |      |   | 9,992   |  
|Note payable to Comdial Corporation                                                                                                                      |  |                                 | (2,500  | ) |      |   |        |  
|Accrued direct acquisition costs                                                                                                                         |  |                                 | (617    | ) |      |   | (7      | )
|                                                                                                                                                         |  |                                 |         |   |      |   |         |  
|                                                                                                                                                         |  |                                
|Liabilities assumed                                                                                                                                      |  |                                 | 3,121   |   |      |   | 9,985   |  



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



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##### Table of Contents

ARTISOFT, INC. AND SUBSIDIARIES



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



(1) BASIS OF PRESENTATION



Artisoft, Inc., currently doing business as Vertical Communications,
Inc. (the Company, we, our, us or the Registrant), develops, markets and sell business phone systems; software, hardware and associated services. We sell our products through distributors,
resellers and system integrators such as AT&T, Fujitsu, and IBM, and we engage in alliances with those parties and other technology vendors to assist us in selling and marketing our products. Most of our end user customers rely upon resellers or
systems integrators to implement our products, and these resellers and systems integrators can significantly influence our customers purchasing decisions. We market and sell our products in the United States, Europe and Latin America. We also
have distributor relationships in Africa, Asia, Australia and Middle East.



The unaudited condensed consolidated financial statements include the accounts of the Company and our wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in
consolidation.



The accompanying unaudited condensed
consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and pursuant to the rules and regulations of the Securities and Exchange Commission (the
SEC). The balance sheet amounts at June 30, 2005 in this report were derived from our audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2005. In the opinion of
management, the accompanying financial statements include all adjustments of a normal recurring nature, which are necessary for a fair presentation of the financial results for the interim periods presented. Certain information and footnote
disclosures normally included in financial statements have been condensed or omitted pursuant to such rules and regulations. Although we believe that the disclosures are adequate to make the information presented not misleading, we recommend that
these financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2005 on file with the SEC. The results of
operations for the three months ended September 30, 2005 are not necessarily indicative of the results to be expected for the full year or any other future periods.



The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of
assets and liabilities at the date of the financial statements and revenues and expenses during the reported period. Areas where significant judgments are made include, but are not limited to, revenue recognition, as well as the accounting for our
recent acquisition of the assets of Comdial Corporation discussed below. Actual results could differ materially from these estimates. The accounting policies applied are consistent with those disclosed in our Annual Report on Form 10-K as disclosed
in Note 1.



Acquisition of Vertical Networks Inc.



On September 28, 2004, we completed the acquisition of substantially
all of the assets, other than patents and patent rights, of Vertical Networks Inc. (Vertical Networks), pursuant to the terms of an asset purchase agreement entered into on September 23, 2004. Vertical Networks was a leading
provider of distributed IP-PBX software and communications solutions to large enterprises. We also received a patent license for the use of all of Vertical Networks patents and patent applications other than Vertical Networks rights
under specified patents that do not relate to the business we purchased. In addition, we assumed specific liabilities of Vertical Networks. The operational results of this acquisition have been included in all periods since September 28, 2004,
the date that the acquisition was consummated.



Acquisition of Comdial
Corporation Assets



On September 28, 2005, pursuant to approval of
the United State Bankruptcy Court for the District of Delaware (the Bankruptcy Court), we, through our subsidiary Vertical Communications Acquisitions Corporation (Acquisition Sub) acquired certain assets and assumed certain
liabilities of Comdial Corporation (Comdial and the Comdial Acquisition)



Comdial was a manufacturer and distributor of telephone systems targeted to small to midsize businesses, branch or regional offices of large organizations, national retailers, government agencies, and education
campuses. The purchase price consisted of $18.5 million in cash plus a $2.5 million 8% secured subordinated promissory note which matures in one year (the Comdial Note). The Comdial Note is secured by all of our assets, and is junior in
interest to any security interest granted with respect to any of our current or future indebtedness owed to Silicon Valley Bank (SVB), including, without limitation, amounts owing under the debt financing, up to $9 million plus principal
amounts in connection with any existing cash secured credit extensions (including letters of credit and cash management services) in an amount not to exceed $0.5 million. The operational results of this acquisition have been included in all periods
since September 28, 2005, the date that the Comdial Acquisition was consummated.



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##### Table of Contents

(2) SIGNIFICANT ACCOUNTING POLICIES



Stock-Based Compensation



On July 1, 2005, we adopted the provisions of FASB Statement No. 123 (revised 2004) Accounting for Stock-Based Compensation (SFAS
No. 123R) and elected to use the modified prospective transition method. The modified prospective transition method requires that compensation cost be recognized in the financial statements for all awards granted after the date of
adoption as well as for existing awards for which the requisite service has not been rendered as of the date of adoption and requires that prior periods not be restated. Prior to the adoption of SFAS No. 123R, we used the intrinsic-value based
method to account for stock options and made charges against earnings with respect to options granted.



Prior to July 1, 2005, the Company applied Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employeesin accounting for its stock incentive plan and
accordingly, compensation cost was recognized for its stock options in the financial statements when the exercise price was below the fair market value. No stock-based compensation cost was recognized during the period ended September 30, 2004.
Had the Company determined compensation cost in all periods based on the fair value at the grant date for its stock options under SFAS No. 123R, , the Companys net loss and net loss per common equivalent share for the three months ended
September 30, 2005, and 2004 would have been increased to the pro forma amounts indicated below (in thousands, except per share prices):



|                                                                                              |  |                                  |        |   |      |   |        |  
|--------------------------------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                              |  | Three Months Ended September 30, |       
|                                                                                              |  | 2005                             |        |   | 2004 |  
|Reported net loss applicable to common stock                                                  |  | $                                | (3,362 | ) |      | $ | (2,874 | )
|Stock based compensation expense determined under fair value method for all awards            |  |                                  | (1,168 | ) |      |   | (411   | )
|Stock based compensation expense included in the reported net loss applicable to common stock |  |                                  | 1,168  |   |      |   |       |  
|Pro forma net loss applicable to common stock                                                 |  | $                                | (3,362 | ) |      | $ | (3,285 | )
|Reported loss per share applicable to common stock                                            |  | $                                | (0.10  | ) |      | $ | (0.61  | )
|Pro forma loss per share applicable to common stock                                           |  | $                                | (0.10  | ) |      | $ | (0.70  | )



The adoption of SFAS
No. 123R reduced income from operations and net income for the first quarter of fiscal 2006 by $1.2 million ($.03 per basic and diluted share). The adoption of this Statement had no effect on the Statement of Cash Flows for the three months
ended September 30, 2005.



Generally, options become
exercisable over a four-year period commencing on the date of the grant. Options granted prior to September 28, 2004 vest 25% at the first anniversary of the grant date with the remaining 75% vesting in equal monthly increments over the
remaining three years of the vesting period. Options granted on September 28, 2004 vest 2.08333% monthly. The fair value of options granted was calculated using the Black-Scholes option-pricing model with the following weighted average
assumptions:



|                        |  |             |   |  |             |  
|----------------------- |  | ----------- | - |  | ----------- | -
|                        |  | Fiscal 2006 |   |  | Fiscal 2005 |  
|Expected dividend yield |  | 0           | % |  | 0           | %
|Volatility factor       |  | 115         | % |  | 115         | %
|Risk free interest rate |  | 4.1         | % |  | 3.45        | %
|Expected life           |  | 6 Years     |   |  | 6 Years     |  



Goodwill



The Company accounts for its goodwill in accordance with the provisions of FASB Statement
No. 142, Goodwill and Other Intangible Assets. This statement requires that goodwill be periodically tested for impairment, with impaired assets written down to fair value. As of September 1, 2005, the
Company conducted its annual impairment test of goodwill by comparing fair value to the carrying amount of its underlying assets and liabilities. The Company determined that the fair value exceeded the carrying amount of the assets and liabilities,
therefore no impairment existed as of the testing date.



(3)
ACQUISITIONS AND RELATED FINANCINGS



Vertical Networks,
Inc.



On September 28, 2004, we acquired substantially all of the
assets, other than patents and patent rights, of Vertical Networks. Vertical Networks was a leading provider of distributed IP-PBX software and communications solutions to large enterprises. We also received a patent license for the use of all of
Vertical Networks patents and patent applications other than Vertical Networks rights under specified patents that do not relate to the business we purchased. In addition, we assumed specific liabilities of Vertical Networks.



The purchase price for Vertical Networks consisted of: $12.5 million in cash, paid at
closing, with an additional $1.0 million held in escrow to secure Vertical Networks indemnification obligations to us, $1.0 million in transaction costs, the assumption of most liabilities of Vertical



5



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##### Table of Contents

Networks and an earnout provision of up to $5.5 million. The earnout obligation is equal to the first $5.5 million of
non-refundable software license revenues collected by us from CVS Pharmacy, Inc. (CVS) in connection with a specific contract which provided CVS with software to be used in connection with, among other things, a rapid prescription refill
project that CVS is implementing. The $1.0 million held in escrow is not included in the total purchase price in the table below. We have paid $0.7 of the earn-out provision and accrued and additional $0.8 million of the earn-out provision to date
as $1.6 million of the earn-out contingency was met by September 30, 2005, all of which is included in the purchase price table below. The balance of the potential earn-out, $3.9 million has been excluded. The $1.0 million held in escrow is
presented on the Consolidated Balance Sheet as Restricted Cash.. The remaining contingent payments will be recorded as a component of the purchase price if and when the related contingencies are resolved.



The acquisition was financed with a portion of the proceeds from a common stock financing
completed pursuant to a stock purchase agreement executed on September 28, 2004 (the 2004 Stock Purchase Agreement) in two tranches on September 28, 2004 and October 1, 2004 (the 2004 Equity Financing). We sold
a total of 24,159,468 shares of our common stock at a per share purchase price of $1.1386 per share to several investors, including M/C Venture Partners V, L.P. and its affiliates (collectively M/C Venture Partners), for net proceeds of
$25.8 million, net of issuance costs of $1.7 million, of which $1.3 million was cash-based and $0.4 million was in the form of a warrant. The warrant was to purchase 168,542 shares of common stock, has an exercise price of $2.85 per share, and
expires 5 years from the date of issuance. The warrant was payment in lieu of cash for investment banking services performed during the 2004 Equity Financing. We recorded the fair value of the warrant, $0.4 million, as a reduction of the proceeds
from the 2004 Equity Financing. We determined the fair value of the warrants using the Black-Scholes option pricing model with the following assumptions: no dividend yield; weighted average risk free rate of 3.45%; volatility of 115% and a
contractual life of 5 years.



In connection with, or prior to the 2004 Equity
Financing, the holders of all shares of our preferred stock converted those shares into common stock. Following the issuance and sale of common stock in the 2004 Equity Financing and the conversions of our preferred stock to common stock, as at
September 30, 2005, M/C Venture Partners is the largest beneficial holder of our common stock, currently with a 48.5% beneficial ownership interest.



We agreed to register, under the Securities Act of 1933, as amended (the Securities Act), the shares issued and sold in the 2004 Equity Financing, for resale
by the investors in this financing (the 2004 Investors). We agreed to file with the SEC the registration statement with respect to this registration by November 12, 2004 and to use our best efforts to cause the registration
statement to become effective on or before December 31, 2004. We have not yet filed the registration statement. Since the registration statement was not declared effective by the SEC prior to March 31, 2005, We were required to pay each
2004 Investor, monthly liquidated damages in an amount equal to 1% per month of the aggregate purchase price paid by each investor under the purchase agreement (not to exceed 9% of such purchase price, in the aggregate). Commencing in April,
2005, the fee resulting from each month of delay in achieving effective registration of the shares is $275,000 per month, and accordingly, we have recorded an expense and corresponding accrual of $1,375,000 through August 2005.



In lieu of a payment of the accrued liquidated damages under the 2004 Equity Financing, we
issued warrants for the purchase of our common stock on September 28, 2005 to the 2004 Investors (the New Warrants). Each New Warrant has a term of exercise expiring on September 28, 2010. The number of shares issuable upon
exercise is subject to adjustment in the case of any stock dividend, stock split, combination, capital reorganization, reclassification or merger or consolidation. The New Warrants are exercisable at any time prior to the expiration date by
delivering the warrant certificate to us, together with a completed election to exercise and payment of the exercise price, which is equal to $0.01 per share of common stock. The New Warrants contain a net exercise feature under which we
do not receive any cash, but rather, the number of shares issued upon exercise is net of the number of shares withheld by us pursuant to a formula, with the result that if all holders of New Warrants elect to use the net exercise feature, we would
issue an aggregate of 1,202,728 shares of common stock. Upon the filing of the certificate of amendment to effect an amendment to our Certificate of Incorproation to increase the authorized number of our common stock to 250,000,000 shares, allowing
us to issue shares to fulfill the exercise of the New Warrants (the Capitalization Amendment), the New Warrants will be automatically exercised in a cashless exercise. If the Capitalization Amendment is not completed by April 15,
2006 the holders of the New Warrants will be entitled to a cash settlement in the amount of $1,375,000 in lieu of warrants. In accordance with Emerging Issues Task Force Issue 00-19 Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in a Companys Own Stock we have recorded the New Warrants as an accrued liability at September 30, 2005.



We also made other customary agreements regarding this registration, including matters relating to indemnification; maintenance of the registration statement; payment of
expenses; and compliance with state blue sky laws.



We also agreed
to several negative covenants under the 2004 Stock Purchase Agreement. Our negative covenants relate to obligations not to, without the prior consent of M/C Venture Partners, enter into a transaction involving a change in control of our company;
incur indebtedness in excess of $3.0 million; create any security with an equity component unless that security is junior to the common stock or, subject to specified exceptions, issue any equity securities; transfer our intellectual property;
repurchase, redeem or pay dividends on any shares of capital stock (subject to limited exceptions); grant stock options that are not authorized by a vote of the board of directors or our compensation committee; liquidate or dissolve; change the size
of our board of directors; amend our certificate of incorporation or bylaws; change the nature of our business; or alter the voting rights of shares of our capital stock in a disparate manner. We believe that we are in compliance with all covenants
other than the registration covenant described above.



6



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##### Table of Contents

The following table represents the allocation of the purchase price for our acquisition of Vertical Networks over the
fair value of the assets acquired and liabilities assumed at the date of acquisition. The fair value of the identified intangible assets and the deferred revenue below were obtained using third party valuations.



|                          |  |                            |      |  
|------------------------- |  | -------------------------- | ---- | -
|                          |  | Values atSeptember 30,2005 |     
|                          |  | (millions)                 |     
|Cash                      |  | $                          | 0.3  |  
|Accounts receivable net   |  |                            | 3.8  |  
|Inventory, net            |  |                            | 1.3  |  
|Other current assets      |  |                            | 0.3  |  
|Property and equipment    |  |                            | 0.4  |  
|Other Assets              |  |                            | 0.1  |  
|Intangible assets         |  |                            | 4.3  |  
|Goodwill                  |  |                            | 13.8 |  
|Accounts payable          |  |                            | (4.8 | )
|Accrued expenses          |  |                            | (2.3 | )
|Other current liabilities |  |                            | (0.3 | )
|Deferred revenue          |  |                            | (2.6 | )
|                          |  |                            |      |  
|Net Assets Acquired       |  | $                          | 14.3 |  
|                          |  |                            |      |  



The values of current assets and
liabilities were based upon their historical costs in the hands of the seller, Vertical Networks, on the date of acquisition due to their short-term nature. Property and equipment was also estimated based upon its historical cost as there was no
appreciated real estate and the historical costs of the office equipment, furniture and machinery closely approximated fair value. The estimated value of deferred revenue was based upon the guidance in EITF 01-03, Accounting in a Business
Combination for Deferred Revenue of an Acquiree,and was calculated as the estimated cost for us to fulfill the contractual obligations acquired under various customer contracts plus a fair value profit margin. Of the sellers recorded
deferred revenue of $6.6 million, we determined that only $2.6 million met the standard set by EITF 01-03 as representing assumed legal obligations; the balance of the deferred revenue, representing mostly customer payments with no remaining
obligations, was not recorded by us. The excess purchase price was allocated to goodwill based upon the following factors: the value acquired in the form of additional scale and economies of scale resulting from the size of the combined entity, and
the value of the assembled workforce, especially the engineering and sales talent personnel who have continued as part of the acquired operation. The benefits of added scale and the economics resulting there from was a primary reason for the
acquisition, along with the talents of the acquired personnel and the ability to leverage existing, owned technology over the acquired products.



The following pro forma unaudited condensed financial information gives effect to our acquisition of Vertical Networks as if it had occurred on July 1, of each
period presented. The following information is based on historical results of our operations for the three months ended September 30, 2005 and 2004 and of Vertical Networks for the same historical period. The pro forma financial information is
presented for illustrative purposes only and is not necessarily indicative of the results of operations of the consolidated company that would have actually occurred had the acquisition of Vertical Networks been effected as of July 1, 2004.



|                                                  |  |                                               |   |  |                     |   |  |                     |   |  |                      |  
|------------------------------------------------- |  | --------------------------------------------- | - |  | ------------------- | - |  | ------------------- | - |  | -------------------- | -
|                                                  |  | 3 Months Ended September 30, 2004 (unaudited) |  
|                                                  |  | Artisoft                                      |   |  | VerticalNetworks(a) |   |  | Pro FormaAdjustment |   |  | Pro Forma asAdjusted |  
|Net product revenue                               |  | 2,934                                         |   |  | 3,923               |   |  | (449                | ) |  | 6,408                |  
|Net loss after income tax                         |  | (1,406                                        | ) |  | (3,148              | ) |  | (744                | ) |  | (5,297               | )
|Loss applicable to common stock                   |  | (1,406                                        | ) |  | (3,148              | ) |  | (744                | ) |  | (6,765               | )
|Loss applicable to common stockBasic and Diluted |  | (0.61                                         | ) |  |                     |   |  |                     |   |  | (1.44                | )

---

|(a) | For the period prior to the acquisition.
|--- | ----------------------------------------



7



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##### Table of Contents

The following adjustments have been reflected in the above pro forma condensed financial information to adjust Vertical
Networks historical reported revenues from the sale of telephone systems to the amount that would have been reported under our revenue recognition policy:



In 2002 and 2003, Vertical Networks entered into multiple element arrangements consisting of an extended warranty arrangement, software
license agreements with rights for updates and upgrades on a when and if available basis and an agreement to specify pricing of uncommitted future telephone systems. Under Vertical Networks policy, the extended warranty and software license
arrangements were recognized over the term of the arrangements. The telephone system pricing agreement was assessed for significant and incremental discounts and future telephone systems were recognized upon shipment if all other revenue recognition
criteria of SAB 104 had been met.



(i) Under our revenue recognition policy,
the software license agreement for the telephone systems core software that provides when and if available updates and upgrades (extended software support arrangement) and the telephone system sales are considered multiple element
arrangements. The extended software support agreement would apply to all previous and future system sales. As Vertical Networks had not historically sold extended software support separately to other customers or on a renewal basis, sufficient
vendor-specific objective evidence of fair value does not exist to allocate the arrangement fee to the systems and the extended software support arrangement. Accordingly, the fee for previous and future system sales considered to be part of a
multiple element arrangement, or combined unit of accounting, with the extended software support arrangement is recognized ratably over the term of the extended software support arrangement along with the extended support fee and related costs of
these sales. The pro forma adjustment reduces revenues and net income (loss) to the amount that would have been recognized under our policy in order to provide a better indication of what the results of operations would have been had the transaction
occurred at the beginning of the period presented. For historical reporting purposes the deferred revenue and related deferred costs which are approximately $16.9 million and $9.6 million, for the year ended June 30, 2005 will be amortized over
a period of up to sixteen quarters or four years.



(ii) Prior to the our
acquisition of Vertical Networks, Vertical Networks had deferred revenue relating to certain software licenses, extended software support arrangements and an extended hardware warranty arrangement over the terms of the support arrangements. We
evaluated its legal obligation that would have been assumed under these contracts if the acquisition had occurred on July 1, 2003 and estimated the fair value of this assumed liability. In arriving at the pro forma adjusted numbers above, the
recorded value of the deferred revenue on July 1, 2003 was reduced by $5.4 million to reflect the fair value of the deferred revenue and the related amortization to revenue was similarly reduced by $0.2 million per quarter.



(iii) The value of intangible assets we acquired as part of the acquisition of Vertical
Networks was based upon an independent valuation of those assets. Three amortizable intangible assets were identified: existing technology, existing customer contracts, and other anticipated revenue from existing customers. The total amortizable
intangible assets value was determined to be $4.3 million, and each of the three elements of the intangible assets were determined to have a 5 year life. Accordingly, these intangible assets will be amortized over a 5 year period starting
September 28, 2004. The pro-forma adjustment reflects this amortization over the periods presented.



(iv) An income tax expense has been recorded against earnings to reflect the tax benefit received from amortizing goodwill for income tax purposes over a 15 year life. All periods presented include this tax charge.



Comdial Corporation



On September 28, 2005, we completed the acquisition of the Comdial Assets from Comdial,
pursuant to the terms of an asset purchase agreement entered into on September 1, 2005.



The assets acquired include all of Comdials intellectual property, fixed assets, equipment, inventories, accounts receivable, rights under contracts and leases, cash and other current assets.



In exchange for the acquired assets, we (i) delivered $14.5 million in cash,
(ii) executed an 8% secured promissory note in the aggregate principal amount of $2.5 million to Comdial which matures on the first anniversary of the closing date, (iii) repaid $1.7 million of debtor-in-possession financing incurred to
fund operations of Comdial prior to the closing, (iv) repaid an amended and restated note dated May 25, 2005, issued by Comdial to Dialcom Acquisition, LLC, in the principal amount of $1.9 million and (v) paid $0.4 million and assumed
$0.2 million of Comdials remaining obligations under a key employee retention plan with Comdials employees, as approved by an order of the Bankruptcy Court. In addition, we incurred approximately $0.8 million in transaction costs related
to the acquisition.



We also assumed certain liabilities of Comdial such as
post petition ordinary course trade payables outstanding as of the acquisition date, certain employee related obligations, and certain customer related obligations and liabilities related to certain assumed executory contracts. In addition, we
assumed pre-petition and post petition obligations under remaining unfulfilled purchase orders outstanding as of the closing date. The estimated amount of the liabilities we assumed as of September 28, 2005 was approximately $8.9 million, which
includes $6.0 million in open purchase order obligations.



8



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##### Table of Contents

The following table represents the estimated allocation of the purchase price for our acquisition of Comdial over the
estimated fair value of the assets acquired and liabilities assumed at the date of acquisition.



|                          |  |                                                     |      |  
|------------------------- |  | --------------------------------------------------- | ---- | -
|                          |  | EstimatedFair Values atSeptember 28,2005 (millions) |     
|Cash                      |  | $                                                   | 0.2  |  
|Accounts Receivable, net  |  |                                                     | 3.2  |  
|Inventory, net            |  |                                                     | 4.5  |  
|Other Current Assets      |  |                                                     | 2.2  |  
|Property and Equipment    |  |                                                     | 1.3  |  
|Intangible assets         |  |                                                     | 4.3  |  
|Goodwill                  |  |                                                     | 9.2  |  
|Accounts Payable          |  |                                                     | (0.2 | )
|Accrued Expenses          |  |                                                     | (1.0 | )
|Other Current Liabilities |  |                                                     | (1.9 | )
|                          |  |                                                     |      |  
|Net assets acquired       |  | $                                                   | 21.8 |  
|                          |  |                                                     |      |  



The estimated values of current assets
and liabilities were based upon their historical costs on the date of acquisition due to their short-term nature. Inventory was valued at estimated selling prices less the sum of (i) the cost of disposal and (ii) a reasonable profit allowance for
the selling effort. Property and equipment was also estimated based upon its historical cost as there was no appreciated real estate and the historical costs of the office equipment, furniture and machinery most closely approximated fair value. The
fair value of the identified intangible assets was obtained using a third party valuation analysis. The excess purchase price was recorded to goodwill based upon the following factors: the value acquired in the form of additional scale and economies
of scale resulting from the size of the combined entity, the value of the assembled workforce, especially the sales, engineering and operations personnel who have continued as part of the acquired business and the ability to leverage existing, owned
technology over the acquired products.



The following are the identifiable
intangible assets acquired and the respective periods over which the assets will be amortized on a straight-line basis:



|                       |  |                |       |            |   
|---------------------- |  | -------------- | ----- | ---------- | --
|                       |  | AMOUNT         |       | LIFE      
|                       |  | (IN THOUSANDS) |       | (IN YEARS)
|Trade names/Trademarks |  | $              | 200   |            | 1 
|Customer relationships |  | $              | 3,300 |            | 10
|Existing technology    |  |                | 800   |            | 5 
|                       |  |                |       |            |   
|                       |  | $              | 4,300 |            |   
|                       |  |                |       |            |   



The preliminary amounts assigned to
identifiable intangible assets acquired was based on their respective fair values determined as of the acquisition date, by a third party valuation analysis, using a discounted cash flow analysis and reverse royalty methodology. The valuation is
preliminary and is subject to change. The excess of the purchase price over the tangible and identifiable intangible assets was recorded as goodwill and amounted to approximately $9.2 million. In accordance with current accounting standards, the
goodwill is not being amortized and will be tested for impairment annually in the fourth quarter of our fiscal year, as required by SFAS No. 142 or more often if impairment indicators arise.



The following pro forma unaudited condensed financial information gives effect to our
acquisition of Comdial as if it had occurred on July 1, of each period presented. The following information is based on historical results of our operations for the three months ended September 30, 2005 and 2004 and of Comdial for the same
historical period. The pro forma financial information is presented for illustrative purposes only and is not necessarily indicative of the results of operations of the consolidated company that would have actually occurred had the acquisition of
Comdial been effected as of July 1 for each period presented. The unaudited pro forma combined financial data and related notes thereto should be read in conjunction with our Managements Discussion and Analysis of Financial Condition and
Results of Operations as previously filed on our Form 10-K for the year ended June 30, 2005 and the historical consolidated financial statements of Comdial as filed in our Form 8-K/A filed November 14, 2005.



|                                                  |  |                                               |   |  |                                               |   |  |                      |   |  |                      |   |  |          |   |  |                    |   |  |                     |   |  |                      |  
|------------------------------------------------- |  | --------------------------------------------- | - |  | --------------------------------------------- | - |  | -------------------- | - |  | -------------------- | - |  | -------- | - |  | ------------------ | - |  | ------------------- | - |  | -------------------- | -
|                                                  |  | 3 Months Ended September 30, 2005 (unaudited) |   |  | 3 Months Ended September 30, 2004 (unaudited) |  
|                                                  |  | Artisoft                                      |   |  | ComdialCorporation(a)                         |   |  | Pro FormaAdjustments |   |  | Pro Forma asAdjusted |   |  | Artisoft |   |  | ComdialCorporaiton |   |  | Pro FormaAdjustment |   |  | Pro Forma asAdjusted |  
|Net product revenue                               |  | 9,899                                         |   |  | 8,969                                         |   |  |                     |   |  | 18,868               |   |  | 2,934    |   |  | 11,913             |   |  |                    |   |  | 14,847               |  
|Net loss after income tax                         |  | (3,362                                        | ) |  | (2,806                                        | ) |  | (336                 | ) |  | (6,504               | ) |  | (1,406   | ) |  | (632               | ) |  | (348                | ) |  | (2,386               | )
|Loss applicable to common stock                   |  | (3,362                                        | ) |  | (2,806                                        | ) |  | (336                 | ) |  | (6,504               | ) |  | (1,406   | ) |  | (632               | ) |  | (348                | ) |  | (2,386               | )
|Loss applicable to common stockBasic and Diluted |  | (0.10                                         | ) |  |                                               |   |  |                      |   |  | (0.19                | ) |  | (0.61    | ) |  |                    |   |  |                     |   |  | (1.04                | )

---

|(a) | For the period prior to the acquisition.
|--- | ----------------------------------------



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##### Table of Contents

The pro forma adjustments include the amortization expense for the acquired identifiable intangible assets, of
approximately $0.1 million per quarter, and the interest expense for the amounts borrowed to finance the acquisition of approximately $0.2 million.



(4) LIQUIDITY



We have incurred losses and negative cash flows from operations in every fiscal period since 1996 and have an accumulated deficit, including non-cash
equity charges, of $62 million as of September 30, 2005. For the three months ended September 30, 2005 we incurred a net loss of approximately $3.3 million, which includes negative cash flows from operations of approximately
$3.0 million. Our management expects that operating losses and negative cash flows will continue in the near future. We anticipate that, with available cash of $4.7 million at September 30, 2005, combined with increased revenues and
cash-flows, we will meet our anticipated cash requirements during and through our fiscal 2006 year. We will also utilize available borrowing under a revolving line of credit which has been established to facilitate the Comdial Acquisition.
Please see Note 7 Debt for details on this line of credit. We expect to increase our revenue and cash flows in the foreseeable future as the result of the acquisition of the Comdial Assets, including product lines and its resellers and
distributors.



There can be no assurance that the available
cash and increased revenues will be sufficient to meet our cash requirements. If we are unable to satisfy such cash requirements from these sources, our ability to continue as a going concern and to achieve our intended business objectives could be
adversely affected. In such case, we could be required to adopt one or more alternatives, such as reducing or delaying marketing and promotional activities, reducing or delaying capital expenditures, developing restructuring plans to reduce
discretionary costs deemed nonessential, and selling additional shares of our capital stock. Additionally, changes in circumstances could necessitate that we seek additional debt or equity capital. There can be no assurance that any such additional
financing will be available when needed or on acceptable terms to allow us to successfully achieve our operating plan or fund future investment in our TeleVantage and InstantOffice product lines.



(5) PREFERRED STOCK



Prior to September 28, 2004, we had authorized 11,433,600 shares of preferred stock par value $1.00 per share, of which 5,427,002
shares had been issued as of June 30, 2004. On December 6, 1994, our board of directors authorized the designation and reservation of 50,000 shares of preferred stock as Series A Participating Preferred Stock subject to a
Rights Agreement dated December 23, 1994. The reserved shares were to be automatically adjusted to reserve such number of shares as may be required in accordance with the provisions of the Series A Participating Preferred Stock and the Rights
Agreement. The Rights Agreement was to expire in December 2004. In connection with the issuance of the Series B convertible preferred stock in 2001, our board of directors terminated the Rights Agreement effective December 31, 2001.



2001 Financing Series B Preferred Stock.In August and November 2001, we issued and
sold an aggregate of 2,800,000 shares of our Series B convertible preferred stock to investors in a private placement at a per share price equal to $2.50. The investors also received warrants to purchase up to 466,666 shares of our common stock at
an initial per share exercise price equal to $1.50 (the 2001 Warrants). Gross proceeds from the financing were $7.0 million.



Each share of Series B preferred stock was initially convertible into one-sixth of a share of common stock, subject to adjustment. Under certain circumstances, we had the
right to effect the automatic conversion of the series B preferred stock to common stock in the event the closing per share bid price of the common stock exceeds $30.00 for 30 consecutive trading days. Prior to the financing transaction of
September 28, 2004 all shares of Series B preferred stock were converted to common stock.



The holders of the Series B preferred stock, as a class, were also initially entitled to elect two of our directors. In August 2002, the holders of our series B preferred stock exercised this right, in part, to elect
Robert J. Majteles one of our directors.



The warrants will expire on
September 30, 2006. The expiration date, the per share exercise price and the number of shares issue-able upon exercise of the 2001 Warrants were initially subject to adjustment in certain events. Following the 2004 Equity Financing, the per
share exercise price of the 2001 Warrants is $1.1386, and the per share exercise price and the number of shares issue-able upon exercise of the 2001 Warrants are no longer subject to adjustment. The 2001 Warrants have a call provision that provides
that if the closing per share bid price of the common stock exceeds $45.00 for 30 consecutive trading days and certain other conditions are met, we have the right to require the 2001 Warrant holders to exercise their warrants for common stock.



The closing of the issuance and sale of shares of common stock in our
September 2002 financing, a private placement of restricted common stock, resulted in anti-dilution adjustments to the Series B preferred stock and the 2001 Warrants. As a result of these anti-dilution adjustments, each share of Series B preferred
stock was convertible into approximately 2.38 shares of common stock. Prior to the issuance and sale of shares of common stock under this agreement each share of Series B preferred stock was convertible into one share of common stock. In addition,
the per share exercise price of each 2001 Warrant was reduced from $3.75 to $1.05. These adjustments resulted in a significant increase in potential common shares outstanding. Prior to the 2004 Equity Financing, the remaining outstanding Series B
preferred stock was converted into common stock at a rate of approximately 1.22 shares of common stock for each share of Series B preferred stock.



10



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##### Table of Contents

2003 Financing, Serices C Preferred Stock. In September 2003, we issued and sold an aggregate of 2,627,002 shares
of Series C convertible preferred stock to investors in a private placement at a per share price equal to $1.50. The investors also received warrants to purchase up to 2,627,002 shares of our common stock at a per share exercise price equal to $1.88
(the 2003 Warrants). Gross proceeds from the financing were $3.9 million.



The shares of Series C preferred stock were initially convertible into a like number of shares of common stock, subject to adjustment. Each share of Series C preferred stock generally received .8152 of a vote, subject to adjustment, when
voting on matters presented for the approval of our stockholders. The holders of the Series C preferred stock, as a class, were also entitled to elect one of our directors. In September 2003, the holders of our Series C preferred stock exercised
this right to elect Steven C. Zahnow as a director.



The holders of Series C
preferred stock were entitled, before any distributions were made to the holders of common stock, to an amount equal to $1.50 per share, subject to adjustment. For purposes of this liquidation preference, the Series C preferred stock ranked on
parity with the Series B preferred stock, which carried a similar liquidation preference in the amount of $2.50 per share.



The holders of the Series C preferred stock were entitled to receive dividends only when and if declared by our board of directors. Any such dividends were to be paid to
the holders of the Series C preferred stock and Series B preferred stock prior to any distribution to holders of common stock, on a per share basis equal to the number of shares of common stock into which each share of preferred stock is then
convertible.



The 2003 Warrants will expire on June 27, 2010. The
expiration date, the per share exercise price and the number of shares issueable upon exercise of the 2003 Warrants were initially subject to adjustment in certain events. Following the September 2004 financing, the per share exercise price of the
2003 Warrants is $1.1386, and the per share exercise price and the number of shares issue-able upon exercise of the 2003 Warrants are no longer subject to adjustment. Prior to the 2004 Equity Financing, the remaining outstanding Series C preferred
stock was converted into common stock at a rate of one share of common stock for each share of Series C preferred stock.



As a result of the sale of common stock in the 2004 Equity Financing, the exercise price of all of the 2001 and 2003 Warrants was reduced to $1.1386 per share pursuant to
the terms of those warrants. Immediately prior to the sale of common stock under the 2004 Stock Purchase Agreement, the exercise price of the 2001 Warrants was $1.50 per share, and the exercise price of the 2003 Warrants was $1.88 per share. The
reduction of the exercise price of these warrants resulted in the recording of a non-cash deemed dividend equal to approximately $1.5 million in the first quarter of fiscal 2005. Additionally, under a consent, amendment and waiver agreement, all
warrants issued in the 2001 and 2003 financings were amended to delete the price protection provisions of those warrants. Therefore, as so amended, the per share exercise price of those warrants will no longer be subject to adjustment in the event
of future sales of our securities, except for customary adjustments for stock splits, dividends, recapitalizations and other similar transactions.



(6) EQUITY



On September 28, 2004 and October 1, 2004. Artisoft sold a total of 24,159,468 shares of its common stock at a per share purchase price of $1.1386 to several investors, including M/C Venture Partners, under
the terms of the 2004 Stock Purchase Agreement. In connection with, or prior to the financing, the holders of all shares of our preferred stock converted those shares into common stock.



On September 28, 2005 and September 30, 2005 we sold a total of 11,329,785 shares of common stock at a per share purchase price
for the Issued Shares of $1.1386, under the terms of a stock purchase agreement closed on September 28, 2005 (the 2005 Stock Purchase Agreement). Following the issuance and sale of common stock in the financing and the conversions
of ours preferred stock to common stock, M/C Venture Partners is now the largest beneficial holder of our common stock, with a 48.7% beneficial ownership interest.



As a result of these and previous financings we entered into arrangements with certain parties to register shares of our
common stock pursuant to the following agreements:



| |  | Registration Rights Agreement, dated August 8, 2001 (the 2001 Agreement) related to the Series B preferred equity financing;
|- |  | ------------------------------------------------------------------------------------------------------------------------------



| |  | Registration Rights Agreement, dated September 27, 2002 (the 2002 Agreement);
|- |  | -------------------------------------------------------------------------------



| |  | Registration Rights Agreement, dated June 27, 2003, (the 2003 Agreement, together with the 2001 Agreement and the 2002 Agreement, the Prior Agreements)
related to the Series C preferred equity financing; and
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the 2004 Stock Purchase Agreement
|- |  | ---------------------------------



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The 2004 Investors and certain parties to the Prior Agreements (the Prior Investors) holding
enough voting power to amend the 2004 Stock Purchase Agreement and the Prior Agreements, executed a consent, waiver, and release agreement, dated September 28, 2005, pursuant to which the 2004 Investors and the Prior Investors consented to the
execution of the 2005 Stock Purchase Agreement (the 2005 Stock Purchase Agreement) and executed agreements to amend the 2004 Stock Purchase Agreement and the Prior Agreements (collectively, the Amendments). We agreed, among
other things, to propose the Capitalization Amendment. The Amendments effected, among other things, the following:



| |  |  | With respect to the 2004 Stock Purchase Agreement (i) tolled the liquidated damages accrued or accruing under the 2004 Stock Purchase Agreement through September 28, 2005
by reason of our failure to file and have declared effective by the SEC a registration statement covering the resale of the shares of our common stock purchased pursuant to the 2004 Stock Purchase Agreement (the Liquidated Damages);
(ii) amended provisions relating to rights of first refusal, issuances of equity securities and restrictions on indebtedness with respect to the entry into the agreements with SVB, solely for purposes of effecting the transactions contemplated
by the 2005 Stock Purchase Agreement; (iii) changing the time frame in which we are obligated to register the shares issued in the 2004 Agreements to match the time frame for registering shares under the 2005 Stock Purchase Agreement; and
(iv) in lieu of the cash payment of the Liquidated Damages, we agreed to issue the New Warrants to the 2004 Investors.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | With respect to the Prior Agreements, amended the registration rights provisions of the Prior Agreements including, among other things, (i) releasing us from any liability and
waiving in full, the application of the Prior Agreements with respect to the payment of liquidated damages and permanently, irrevocably and unconditionally waived in full, any right to the payment of the liquidated damages, whether accrued or
accruing, under the Prior Agreements, and (ii) changed the time frame in which we are obligated to register the shares issued in the Prior Agreements to match the time frame for registering shares under the 2005 Stock Purchase Agreement.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Further, if (1) the Capitalization Amendment is not
effective as of April 15, 2006, and (2) M/C Venture Partners and Special Situations Fund and its affiliates (collectively SSF) have voted their shares of common stock in favor of the Capitalization Amendment, which they are
obligated to do under the terms and conditions of voting agreements each of M/C Venture Partners and SSF entered into with us (the Voting Agreements), then the Liquidated Damages will be paid in cash by wire transfer of immediately
available funds to each of the parties and upon payment thereof, and the New Warrants issued in satisfaction of the Liquidated Damages will expire unexercised. If the Capitalization Amendment is not completed by April 15, 2006 the holders of
the New Warrants will be entitled to a cash settlement in the amounts of $1,375,000 in lieu of warrants.



(7) DEBT



The Company financed a
portion of the purchase price for the Comdial Assets (the 2005 Debt Financing) by entering into a loan agreement with SVB on September 28, 2005 (the SVB Loan Agreement). The SVB Loan Agreement terms provide the Company
with a revolving line of credit in an amount not to exceed $7,000,000 (the Revolving Loan), as well as a $2,000,000 term loan (the Term Loan). The Company will make monthly payments of all outstanding and accrued interest on
the Revolving Loan beginning on September 30, 2005. The Revolving Loan matures and the principal balance thereof is payable in full, on September 27, 2006. The Term Loan is payable in monthly principle installments of $133,333.33 plus
interest, due beginning July 31, 2006 through and until the maturity date of September 26, 2007. Borrowing availability under the Revolving Loan is based on the amount of the Companys and Acquisition Subs accounts receivable.



For both the Term Loan and the Revolving Loan, interest shall accrue at a rate
per annum equal to the Prime Rate in effect from time to time, plus 1.50% per annum. However during the period beginning on September 28, 2005 and continuing until September 30, 2006, interest under the Term Loan interest
shall accrue a rate per annum equal to the Prime Rate in effect from time to time plus 2.00% per annum. Thereafter, interest shall accrue on the Term Loan at a rate equal to the Prime Rate in effect from time to time,
plus (a) 2.00% per annum if the Companys previous quarters Fixed Charge Coverage Ratio (FCCR) is less than or equal to 2.00 to 1.00, or (b) 1.50% per annum if the Companys previous quarters
FCCR is greater than or equal to 2.00 to 1.00, each as determined by SVB in accordance with generally accepted accounting principles. Pricing adjustments shall be effective no later than three business days after SVBs receipt of satisfactory
financial reporting and shall remain effective until receipt by SVB of financial statements for such next successive quarter. Interest in all circumstances shall be calculated on the basis of a 360-day year for the actual number of days elapsed.
Prime Rate means the greater of (i) 6.50%, or (ii) the rate announced from time to time by SVB as its prime rate; it is a base rate upon which other rates charged by SVB are based, and it is not necessarily the best
rate available at SVB. The interest rate applicable to the outstanding obligations shall change on each date there is a change in the Prime Rate. Regardless of the amount of obligations that may be outstanding from time to time under the SVB Loan
Agreement, the Company is obligated to make minimum monthly interest payments to SVB equal to $15,000 during the term of this Agreement.



The Companys obligations under the SVB Loan Agreement are secured by all of the assets of the Company and Acquisition Sub, including the Comdial Assets. These
include accounts receivable, inventory, equipment, intellectual property, all claims, credit balances, proceeds (including proceeds of any insurance policies, proceeds of proceeds and claims against third parties), and all products, books and
records related to such assets.



On September 28, 2005 (the Closing
Date) we also executed a secured promissory note in the aggregate principal amount of $2,500,000. The Comdial Note bears interest at the rate of 8% per annum and matures on the first anniversary of the Closing Date. The Comdial Note is
secured by all our assets, and is junior in interest to any security interest granted with respect to any current or future indebtedness of the Company owed to SVB, including, without limitation, amounts owing under the 2005 Debt Financing, up to
$9,000,000 plus principal amounts in connection with any existing cash secured credit extensions (including letters of credit and cash management services) in an amount not to exceed $500,000.



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(8) GUARANTEES



We are subject to lawsuits and other claims arising in the ordinary course of our operations. In the opinion of management, based on consultation with legal counsel, the
effect of such matters will not have a material adverse effect on our financial position or results of operations.



We enter into standard indemnification agreements in our ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse
the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with any patent or any copyright or other intellectual property infringement claim by any third party with
respect to our products.



The term of these indemnification agreements is
generally perpetual. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification
agreements. Accordingly, we have no liabilities recorded for these agreements.



We warrant that our software products will perform in all material respects in accordance with our standard published specifications in effect at the time of delivery of the licensed products to the customer for 90 days. We warrant that our
maintenance services will be performed consistent with generally accepted industry standards through completion of the agreed upon services. Additionally, we warrant that our hardware products will perform in all material respects in accordance with
our standard published specifications in effect at the time of delivery of the products to the customer for one year, with the exception of shipments to one customer which was offered warranties that expire sixteen months after the date of shipment,
and there is an extended warranty agreements with other customers that allows those customers to submit warranty claims after the initial one-year period. We have no liabilities recorded for these agreements since any warranty claims will be
expensed as they occur to match the associated deferred revenue amortization. We provide for the estimated cost of hardware product warranties based on specific warranty claims and claim history. If necessary, we would provide for the estimated cost
of the software and services warranties based on specific warranty claims and claim history, however, we have never incurred any significant expenses under our product or service warranties.



(9) COMPUTATION OF NET LOSS PER SHARE



Net loss per basic and diluted share are based upon the weighted average
number of common shares outstanding. Common equivalent shares, consisting of outstanding stock options, convertible preferred shares and warrants to purchase common stock are included in the diluted per share calculations where the effect of their
inclusion would be dilutive. Common stock equivalents have been excluded for all periods presented as they are antidilutive.



|                                                                                  |  |                                 |  |      
|--------------------------------------------------------------------------------- |  | ------------------------------- |  | -----
|                                                                                  |  | Three Months EndedSeptember 30,
|                                                                                  |  | 2005                            |  | 2004 
|Antidilutive potential common shares excluded from net loss per share (thousands) |  | 9,752                           |  | 8,849



(10) INVENTORIES



Inventories at September 30, 2005 and June 30, 2005 consist of the
following (in thousands):



|               |  |                    |       |              |   |      
|-------------- |  | ------------------ | ----- | ------------ | - | -----
|               |  | September 30, 2005 |       | June 30,2005
|Raw Materials  |  | $                  | 346   |              | $ | 156  
|Finished Goods |  | $                  | 6,023 |              | $ | 1,530
|               |  |                    |       |              |   |      
|               |  | $                  | 6,369 |              | $ | 1,686
|               |  |                    |       |              |   |      



The Comdial Acquisition is the primary
reason for the substantial increase in inventory, having added $4.5 million in inventory as of September 30, 2005.



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FORWARD-LOOKING STATEMENTS



This Quarterly Report on Form 10-Q, including, without limitation, the section entitled Managements Discussion
and Analysis of Financial Condition and Results of Operations, contains forward-looking statements. These statements relate to future events or to our future financial performance, and involve known and unknown risks, uncertainties and other
factors that may cause our actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements.
In some cases, you can identify forward-looking statements by the use of words such as expect, intend, may, would, could, plan, seek, potential,
continue, or the negative of these terms or other comparable terminology. You should not place undue reliance on forward-looking statements since they involve known and unknown risks, uncertainties and other factors which are, in some
cases, beyond our control and which could materially affect actual results, levels of activity, performance or achievements. Factors that may cause actual results to differ materially from current expectations, which we describe in more detail
elsewhere in this Quarterly Report on Form 10-Q under the heading Risk Factors, include, but are not limited to:



| |  | failure to increase the sales of our products;
|- |  | ----------------------------------------------



| |  | the loss of any of our key customers;
|- |  | -------------------------------------



| |  | failure to successfully integrate the Comdial Assets into our business;
|- |  | -----------------------------------------------------------------------



| |  | the introduction of competitive products, including other software- or server-based phone systems;
|- |  | --------------------------------------------------------------------------------------------------



| |  | slower than expected development of the software- or server-based phone system market or any event that causes software- or server-based phone systems to be less attractive to
customers;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | continued failure to timely file our reports under the Exchange Act;
|- |  | --------------------------------------------------------------------



| |  | continued failure to have adequate disclosure controls in place;
|- |  | ----------------------------------------------------------------



| |  | continued lapses of internal controls;
|- |  | --------------------------------------



| |  | the finding by our independent registered public accounting firm that we have a material weakness in our internal controls over financial reporting;
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------



| |  | possible delisting from the OTC Bulletin Board for failure to remain current in our Exchange Act reporting obligations;
|- |  | -----------------------------------------------------------------------------------------------------------------------



| |  | continued inability to achieve profitability;
|- |  | ---------------------------------------------



| |  | failure to protect our intellectual property;
|- |  | ---------------------------------------------



| |  | deteriorating financial performance;
|- |  | ------------------------------------



| |  | failure to achieve the anticipated benefits from our acquisitions of Comdial and Vertical Networks, including, without limitation, failing to obtain the desired benefits for the
Companys dealers and customers;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | failure to retain our rights to certain patents that we acquired through a license agreement resulting from the Vertical Networks Acquisition
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------



| |  | the assumptions about the future performance of the Comdial Assets may prove to be incorrect;
|- |  | ---------------------------------------------------------------------------------------------



| |  | the inability to achieve the desired synergies and economies of scale after the acquisition of the Comdial Assets;
|- |  | ------------------------------------------------------------------------------------------------------------------



| |  | the inability to become a significant player within the IP-PBX telephony market;
|- |  | --------------------------------------------------------------------------------



| |  | the risk that the Company may be unable to meet its future obligations resulting from the acquisition of the Comdial Assets including but not limited to its obligations to meet its
financial covenants under the SVB Loan Agreement or meet its deadlines to register the shares of its Common Stock issued in the 2005 Equity Financing; and
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the loss of any of its key dealers or customers or Comdials key dealers or customers.
|- |  | --------------------------------------------------------------------------------------



If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results
may vary significantly from what we projected. Any forward-looking statement you read in this Quarterly Report on Form 10-Q reflects our current views with respect to future events and is subject to these and other risks, uncertainties and
assumptions relating to our operations, results of operations, growth strategy and liquidity. We assume no obligation to publicly update or revise these forward-looking statements for any reason, or to update the reasons actual results could differ
materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.



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Item 2MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



You should read the following discussion together with the consolidated financial statements and related notes appearing elsewhere in this quarterly
report on Form 10-Q. This item contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that involve risks and uncertainties. Actual
results may differ materially from those included in such forward-looking statements. Factors which could cause actual results to differ materially include those set forth under Risk Factors commencing on page 23, as well as those
otherwise discussed in this section and elsewhere in this quarterly report on Form 10-Q. See Forward-Looking Statements.



Our discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements,
which have been prepared in accordance with accounting principles generally accepted in the United States and the rules and regulations of the SEC. The preparation of these financial statements requires us to make estimates and judgments that affect
the reported amount of assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Areas where significant judgments are made include, but are not limited to revenue recognition and values
attributed to the assets and liabilities acquired pertaining to the Comdial Acquisition. The estimated values of current assets and liabilities and property and equipment were based upon their historical costs in the hands of the seller on the date
of acquisition due to their short-term nature. This amount may be adjusted subsequently when we complete our assessment of the property and equipment that will be utilized in the combined operations and those that will be disposed.



Actual results could differ materially from any one or all of these estimates
discussed above. For a more detailed explanation of the judgments made in these areas, please refer to our annual report on Form 10-K for the year ended June 30, 2005, as filed with the Securities and Exchange Commission on
October 13, 2005.



Summary



The following is a summary of the areas that management believes are
important in understanding the results of the fiscal first quarter ended September 30, 2005. This summary is not a substitute for the detail provided in the following pages or for the consolidated financial statements and notes that appear
elsewhere in this document.



Prior to the Comdial Acquisition
on September 28, 2005, we had two families of products, TeleVantage, a shrink-wrap software-based phone system that runs on a Windows server platform and Intel communications hardware, and InstantOffice an advanced phone system that runs on a
Windows server platform and proprietary hardware. TeleVantage has an optional Call Center module, and add-ons, such as TeleVantage Conference Manager. All modules are fully integrated and represent shrink-wrap software. InstantOffice also supports
software applications such as custom IVR applications, and telecommunications network management applications including MultiSite Manager and MultiSite Reporter which facilitate remote management of large networks of InstantOffice installations.



For the quarter ended September 30, 2005, we had total
net revenue of approximately $9.9 million compared to total net revenue for the same period in fiscal year 2004 of approximately $2.9 million. The increase of approximately $7 million in revenue from year to year is attributable to an
increase of InstantOffice product revenue of $6.2 million. This increase is largely the result of a full quarter of sales during the quarter ended September 2005. Since the acquisition of Vertical Networks was completed on September 28,
2004, our results also include revenue and expenses for the three days September 28 through September 30, 2004 related to Vertical Networks. The three days activity contributed approximately $.5 million in net revenue related to
InstantOffice. The results for the quarter ended September 2005 also reflect three days of revenue and expenses related to the operations of Comdial Corporation acquired September 28, 2005. The three days activity contributed approximately
$.4 million in net revenue related to Comdial products. We expect revenues to increase in the quarter ending December 31, 2005 and in the fiscal year ending June 30, 2006 as a result of the Comdial Acquisition.



Gross margins for the quarter ended September 30, 2005 decreased to
63.1%, compared to 87.6% in the same period in the prior fiscal year. This decrease was primarily the result of the cost of hardware included in the net revenue related to the InstantOffice product line. The TeleVantage net revenues during the
period had an average gross margin of 97% while the InstantOffice products sold during the quarter had an average gross margin of 54.2%. The cost of goods for InstantOffice products includes several elements of telecommunication hardware, both of
our own design and the design of third parties, which is all manufactured by third parties. We expect over time, to decrease our sales of these hardware products and believe this will contribute to an increase in our gross margins.



Operating expenses for the quarter ended September 30, 2005 increased
approximately 142.1%, compared to the same period in the prior fiscal year. The increase was largely the result of the addition of the acquired operations of Vertical Networks, combined with non-cash compensation expenses of $1.1 million resulting
from the implementation of SFAS No. 123R, $0.6 million of liquidated damages penalties resulting from the failure to fulfill registration rights obligations arising from the September 2004 financing associated with the Vertical Networks
acquisition, and $0.2 million in amortization of intangibles resulting from the Vertical Networks acquisition.



Sales and marketing expenses increased by 108.8% due to costs associated with an increase in personnel in the sales and marketing organization resulting from the acquisition of Vertical Networks sales operations, an
increase of 21 personnel and associated expenses.



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##### Table of Contents

Expenses in product development increased by 199.0% during the quarter ended September 30, 2005
compared to the same period in the prior fiscal year. This increase reflects an increase in expenses due to increased activity in TeleVantage product development, and additional development costs resulting from the acquisition of Vertical
Networks product development operations, which added 36 personnel and associated expenses.



General and administrative expenses increased approximately 46.6% compared to the same period in the prior fiscal year. This increase reflects
approximately $.6 million in liquidated damages costs relating to the failure to fulfill registration rights obligations guaranteed in the stock purchase agreement for the financing associated with the September 2004 acquisition of Vertical
Networks. On September 28, 2005 we entered into an agreement to settle these damages, and no additional accrual for liquidated damages costs relating to the aforementioned registration rights is anticipated. A decrease in severance costs of
$0.5 million which resulted from the severance of our former CEO and President in 2004 was offset by the addition of Vertical Networks general and administrative operations, which added 10 personnel, and a significant new location in California with
its associated overhead costs.



We expect operating expenses in
all areas to increase significantly in the second quarter of fiscal year 2006. We also expect operating expenses to increase for the balance of fiscal year 2006. These expected increases are solely as a result of the acquisition of Comdial
Corporation operations and the impact of a full period of those expenses when compared to only three days of expenses resulting from the acquisition during the period ended September 30, 2005. However, we believe that we will be able to reduce
some of these additional operating expenses over time as redundant operations are eliminated and overhead cost elements are reduced. Excluding the acquired operations of Comdial we expect our operating expenses in all areas to decrease.



The Comdial Acquisition



The Acquisition. On September 28, 2005, pursuant to Bankruptcy
Court approval, we acquired certain assets and assumed certain liabilities of Comdial. Comdial was a manufacturer and distributor of telephone systems targeted to small to midsize businesses, branch or regional offices of large organizations,
national retailers, government agencies, and education campuses. The purchase price consisted of $18.5 million in cash plus a $2.5 million 8% secured promissory note which matures in one year (the Comdial Note). This price included the
assumption of the debtor in possession financing and an existing note from secured creditors, along with the settlement of certain obligations under Comdials key employee retention plan. We also assumed liabilities totaling $3.1 miilion
including certain payables and accrued liabilities. The Comdial Note is secured by all of our assets, and is junior in interest to any security interest granted with respect to any of our current or future indebtedness owed to Silicon Valley Bank,
including, without limitation, amounts owing under the a debt financing, up to $9 million plus principal amounts in connection with any existing cash secured credit extensions (including letters of credit and cash management services) in an amount
not to exceed $0.5 million. The operational results of this acquisition have been included in all periods since September 28, 2005, the date that the acquisition was consummated.



The Comdial Note and Security Agreement.In connection with the closing of the Comdial acquisition, we executed the
Comdial Note on the September 28, 2005, the same date that the 2005 Equity Financing was consummated (referred to as the Closing Date). The Comdial Note is in the original principal amount of $2,500,000 and bears interest at the
rate of 8% per annum maturing on the first anniversary of the Closing Date. The Comdial Note is secured by all our assets and Vertical Communications Acquisition Corporation, and is junior in interest to the security interest granted with
respect to any of our current or future indebtedness or Vertical Communications Acquisition Corporation owed to Silicon Valley Bank, including, without limitation, amounts owing under the 2005 Debt Financing, up to $9,000,000 plus principal amounts
in connection with any existing cash secured credit extensions (including letters of credit and cash management services) in an amount not to exceed $500,000.



In connection with the Comdial Note, on the Closing Date, the Comdial bankruptcy estate entered into a security agreement (the Security
Agreement) with us and Vertical Communications Acquisition Corporation, a wholly owned subsidiary of Artisoft, Inc., wherein we and Vertical Communications Acquisition Corporation granted a security interest to the estate in all of our assets
and those of Vertical Communications Acquisition Corporation, including the Comdial assets. In connection with the Security Agreement, the Comdial bankruptcy estate also entered into a Subordination Agreement with Silicon Valley Bank, pursuant to
which the estate agreed to subordinate our obligations and those of Vertical Communications Acquisition Corporation under the Comdial Note, and its security interest under the Security Agreement, to the current and future obligations of us and
Vertical Communications Acquisition Corporation to Silicon Valley Bank, including, without limitation, amounts owing under the 2005 Debt Financing, up to $9,000,000 plus principal amounts in connection with any existing cash secured credit
extensions (including letters of credit and cash management services) in an amount not to exceed $500,000.



The 2005 Equity Financing.Under the 2005 Stock Purchase Agreement, we received a total of $12.9 million from the 2005 Investors in exchange for
the issuance of 11,329,785 shares of common stock (the Issued Shares). The per share purchase price for the Issued Shares was $1.1386. Certain of our directors are designees of entities who participated in the 2005 Equity Financing as
investors (the 2005 Investors). Therefore, our board of directors formed a special committee of directors (the Special Committee) to negotiate and finalize the terms of the 2005 Equity Financing. Among other things, the
Special Committee (1) negotiated the terms of the agreements related to the 2005 Equity Financing, (2) engaged a financial consultant to provide an estimate of the indicated fair value of our companys post acquisition equity,
(3) approved the sale of shares of common stock to the 2005 Investors and (4) authorized and directed our officers to place the Capitalization Amendment on our proxy statement for our 2005 annual meeting (the Annual Meeting).



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##### Table of Contents

Our Obligation to Register Shares.Pursuant to the 2005 Stock Purchase Agreement, we agreed to
register the Issued Shares for resale by the 2005 Investors under the Securities Act. We agreed to file with the Commission a registration statement (the Registration Statement) with respect to the Issued Shares no later than
December 12, 2005, and to use our best efforts to cause the Registration Statement to become effective on or before the date that is the earlier of (1) in the event of no review by the Commission, within five days of being informed by the
Commission that the Commission has decided not to review the Registration Statement, but in no event later than 30 days after the Filing Date, (2) in the event of a review by the Commission, within five days of being informed by the Commission
that the Commission has no further comments on such Registration Statement, but in no event later than 90 days after the Filing Date (the earlier of (1) and (2), the Required Effective Date). We will be liable for liquidated damages
to each 2005 Investor under the following circumstances:



| |  |  | if the Registration Statement is not filed on or before December 12, 2005 (such an event, a Filing Default);
| | - |  | --------------------------------------------------------------------------------------------------------------



| |  |  | if the Registration Statement is not declared effective by the Commission on or prior to the Required Effective Date (the Effectiveness Deadline) (such an event, an
Effectiveness Default); or
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | if the Registration Statement (after its effectiveness date) ceases to be effective and available to the 2005 Investors for any continuous period that exceeds 30 days or for one or
more periods that exceed in the aggregate 60 days in any 12-month period (such an event, a Suspension Default and together with a Filing Default and an Effectiveness Default, a Registration Default).
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In the event of a Registration Default, we will pay as liquidated damages
to the 2005 Investors, for each 30-day period of a Registration Default, an amount in cash equal to 1% of the aggregate purchase price paid by the 2005 Investor pursuant to the 2005 Stock Purchase Agreement; provided that in no event will the
aggregate amount of cash to be paid as liquidated damages exceed 9% of the aggregate purchase price paid by such 2005 Investor. We will pay the liquidated damages as follows:



| |  |  | in connection with a Filing Default, on the business day following the Filing Default, and each 30th day thereafter, until the Registration Statement has been filed with the
Commission;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | in connection with an Effectiveness Default, on the business day following the Effectiveness Deadline, and each 30thday thereafter until the Registration Statement is declared effective by the Commission; or
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | in connection with a Suspension Default, on either (a) the 31stconsecutive day of any Suspension or (b) the 61stday (in the aggregate) of any
Suspensions in any 12-month period, and each 30th day thereafter until the Suspension is terminated in accordance with the 2005 Stock Purchase Agreement.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



All periods described above will be tolled during delays directly caused by the action or inaction of any 2005 Investor, and
we will have no liability to any 2005 Investor in respect of any such delay. The liquidated damages payable under the 2005 Stock Purchase Agreement will apply on a pro rata basis for any portion of a 30-day period of a Registration Default.



Our Obligation to Hold a Meeting.We agreed to hold the
Annual Meeting on or before April 15, 2006, for, among other purposes, considering the approval of an amendment to our certificate of incorporation to effect, among other things, the elimination of all authorized shares of our Series B
preferred stock, par value $1.00 per share, and our Series C preferred stock, par value $1.00 per share (the Preferred Stock Amendment), and the Capitalization Amendment.



The Voting Agreements.In connection with the 2005 Stock Purchase Agreement, we and the 2005 Investors entered into
the Voting Agreements, pursuant to which the 2005 Investors agreed to vote all of their shares of common stock in favor of the Capitalization Amendment.



Affirmative Covenants Under the 2005 Stock Purchase Agreement.We made certain affirmative and negative covenants under the 2005 Stock Purchase
Agreement. Our affirmative covenants include obligations related to (1) providing the 2005 Investors with a right of first refusal on our future issuances of securities; (2) seeking a listing of our common stock on the NASDAQ National
Market, NASDAQ SmallCap Marketplace or the American Stock Exchange at such time that we are so eligible; (3) using the proceeds from the 2005 Equity Financing for our acquisition of the Comdial assets; (4) maintaining specified insurance
coverage; (5) indemnifying and reimbursing the expenses of directors; (6) removing the legends on the certificates representing the Issued Shares; (7) providing information required by Rule 144 under the Securities Act;
(8) amending our certificate of incorporation to the extent necessary to reflect the transactions contemplated by the 2005 Stock Purchase Agreement; (9) fixing the board of directors at seven and nominating directors in accordance with the
terms of the 2005 Stock Purchase Agreement; (10) holding an annual meeting of our stockholders on or before April 15, 2006; and (11) altering the vesting schedules for employee stock option grants.



Negative Covenants Under the 2005 Stock Purchase Agreement.Our
negative covenants relate to obligations not to, without the prior consent of M/C Venture Partners, (1) enter into a transaction involving a change in control; (2) incur indebtedness in excess of $3.0 million, subject to specified
exceptions; (3) create any security with an equity component unless that security is junior to the common stock; (4) issue any equity securities; (5) transfer our intellectual property; (6) repurchase, redeem or pay dividends on
any shares of capital stock (subject to limited exceptions); (7) grant stock options that are not authorized by a vote of our board of directors or its compensation committee; (8) liquidate or dissolve; (9) change the size of our
board of directors; (10) amend our certificate of incorporation or bylaws, other than to effect the Capitalization Amendment and the Preferred Stock Amendment; (11) change the nature of our business; (12) alter the voting rights of
shares of our capital stock in a disparate manner; or (13) take any action which would cause an adjustment to the exercise price or number of shares to be delivered under Section 8 of the New Warrants, as defined below.



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Our Board of Directors.As of November 11, 2005, our board of directors consists of
(1) our chief executive officer serving as a Class II director (currently William Y. Tauscher); (2) one member serving as a Class II director designated by the written consent of the majority-in-interest of the shares of common stock held
by the investors (including the affiliated assignees of such investors, the Series B Investors) that are parties to the Series B Purchase Agreement, dated as of August 8, 2001, that were acquired upon the conversion of the shares of
Series B preferred stock held by them, pursuant to the terms of a Consent, Waiver and Amendment Agreement, dated September 25, 2004 (the 2004 Consent), acting as a single class (currently Robert J. Majteles); (3) one member
serving as a Class II director designated by the written consent of the majority-in-interest of the shares of common stock held by the investors (including the affiliated assignees of such investors, the Series C Investors), that are
parties to the Series C Purchase Agreement, dated as of June 27, 2003, as amended, that were acquired upon the conversion of the shares of Series C preferred stock held by them, pursuant to the terms of the 2004 Consent, acting as a single
class (currently R. Randy Stolworthy); (4) two members serving as Class III directors designated in writing by M/C Venture Partners (currently John P. Ward and Matthew J. Rubins); and (5) two non-executive members serving as Class I
directors designated by the mutual agreement of M/C Venture Partners and our board of directors (reflected by approval of the board of directors (or its nominating or corporate governance committee) of a written designation by M/C Venture Partners),
provided that each such non-executive member has relevant industry (each, an Industry Director) (currently Michael P. Downey and Francis E. Girard).



After March 28, 2006, the members of our board of directors shall consist of (and we agree to nominate for election) (1) our the chief
executive officer who will serve as a Class II director, (2) one member who will serve as a Class II director designated by the written consent of (a) Special Situations Fund, (SSF), so long as SSF and its affiliates continue
to beneficially own at least 50% of the shares of common stock acquired by SSF and its affiliates upon the conversion of the shares of Series B preferred stock held by them, pursuant to the terms of the 2004 Consent or (b) in the event that SSF
is not entitled to appoint a director pursuant to clause (a), the majority-in-interest of the shares of common stock held by the Series B and Series C Investors that were acquired by them upon the conversion, pursuant to the terms of the 2004
consent, of the shares of Series B preferred stock and Series C preferred stock held by them, acting as a single class, (3) two members who will serve as Class III directors designated in writing by M/C Venture Partners and (4) three
industry directors who will serve as Class I directors designated by the mutual agreement of M/C Venture Partners and our board of directors.



Amendments of the 2004 Stock Purchase Agreement and Prior Agreements.



The 2004 Investors and prior investors holding enough voting power to amend the 2004 Stock Purchase Agreement and the Prior
Agreements, executed a Consent, Waiver, and Release Agreement, dated September 28, 2005, pursuant to which the 2004 Investors and the Prior Investors consented to the execution of the 2005 Stock Purchase Agreement and executed agreements to
amend the 2004 Stock Purchase Agreement and the Prior Agreements (collectively, the Amendments). We agreed, among other things, to propose the Capitalization Amendment. The Amendments effected, among other things, the following



| |  |  | With respect to the 2004 Stock Purchase Agreement (i) tolled the Liquidated Damages; (ii) amended provisions relating to rights of first refusal, issuances of equity
securities and restrictions on indebtedness with respect to the entry into the agreements with Silicon Valley Bank, solely for purposes of effecting the transactions contemplated by the 2005 Stock Purchase Agreement; (iii) changing the time
frame in which we are obligated to register the shares issued in the 2004 Agreements to match the time frame for registering shares under the 2005 Stock Purchase Agreement; and (iv) in lieu of the cash payment of the Liquidated Damages, we
agreed to issue the New Warrants to the 2004 Investors.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | With respect to the Prior Agreements, amended the registration rights provisions of the Prior Agreements including, among other things, (i) releasing us from any liability and
waiving in full, the application of the Prior Agreements with respect to the payment of liquidated damages and permanently, irrevocably and unconditionally waived in full, any right to the payment of the liquidated damages, whether accrued or
accruing, under the Prior Agreements, and (ii) changing the time frame in which we are obligated to register the shares issued in the Prior Agreements to match the time frame for registering shares under the 2005 Stock Purchase Agreement.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Further, if (1) the Capitalization
Amendment is not effective as of April 15, 2006, and (2) the 2005 Investors affiliated with M/C Venture Partners and SSF have voted their shares of common stock in favor of the Capitalization Amendment, which they are obligated to do under
the terms and conditions of the Voting Agreement, then the Liquidated Damages will be paid in cash by wire transfer of immediately available funds to each of the parties and upon payment thereof, and the New Warrants issued in satisfaction of the
Liquidated Damages will expire unexercised. If the Capitalization Amendment is not completed by April 15, 2006 the holders of the New Warrants will be entitled to a cash settlement in the amounts of $1,375,000 in lieu of warrants.



The 2005 Debt Financing.We entered into the SVB Loan Agreement
with Silicon Valley Bank on September 28, 2005. The SVB Loan Agreement terms provide us with a revolving line of credit in an amount not to exceed $7,000,000 (the Revolving Loan), as well as a $2,000,000 term loan (the Term
Loan). We will make monthly payments of all outstanding and accrued interest on the Revolving Loan beginning on October 31, 2005. The Revolving Loan matures and the principal balance thereof is payable in full, on September 27, 2006.
The Term Loan is payable in monthly principle installments of $133,333.33 plus interest, due beginning July 31, 2006 through and until the maturity date of September 26, 2007. Borrowing availability under the Revolving Loan is based on the
amount of the accounts receivable held



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by us and our acquisition subsidiary. Our obligations under the SVB Loan Agreement are secured by all of our assets and
the assets of Vertical Communications Acquisition Corporation, including the Comdial Assets. These include accounts receivable, inventory, equipment, intellectual property, all claims, credit balances, proceeds (including proceeds of any insurance
policies, proceeds of proceeds and claims against third parties), and all products, books and records related to such assets.



For both the Term Loan and the Revolving Loan, interest shall accrue at a rate per annum equal to the Prime Rate in effect from time to time,
plus 1.50% per annum. However during the period beginning on September 28, 2005 and continuing until September 30, 2006, interest under the Term Loan interest shall accrue a rate per annum equal to the Prime Rate in effect
from time to time plus 2.00% per annum. Thereafter, interest shall accrue on the Term Loan at a rate equal to the Prime Rate in effect from time to time, plus (a) 2.00% per annum if our previous quarters Fixed Charge
Coverage Ratio (FCCR) is less than or equal to 2.00 to 1.00, or (b) 1.50% per annum if our previous quarters FCCR is greater than or equal to 2.00 to 1.00, each as determined by Silicon Valley Bank in accordance with generally
accepted accounting principles. Pricing adjustments shall be effective no later than three business days after Silicon Valley Banks receipt of satisfactory financial reporting and shall remain effective until receipt by Silicon Valley Bank of
financial statements for such next successive quarter. Interest in all circumstances shall be calculated on the basis of a 360-day year for the actual number of days elapsed. Prime Rate means the greater of (i) 6.50%, or
(ii) the rate announced from time to time by Silicon Valley Bank as its prime rate; it is a base rate upon which other rates charged by Silicon Valley Bank are based, and it is not necessarily the best rate available at Silicon
Valley Bank. The interest rate applicable to the outstanding obligations shall change on each date there is a change in the Prime Rate. Regardless of the amount of obligations that may be outstanding from time to time under the SVB Loan Agreement,
we are obligated to make minimum monthly interest payments to Silicon Valley Bank equal to $15,000 during the term of this Agreement. As of September 30, 2005, we have borrowed $2.0 million under the Term Loan and $7.0 under the Revolving Loan.



Results of Operations



Net Product Revenue



Net product revenue was $9.9 million for the quarter ended September 30, 2005, representing an increase of 241%
from $2.9 million for the quarter ended September 30, 2004.



The increase in revenue in the quarter ended September 30, 2005 compared to the quarter ended September 30, 2004 resulted from the growth in TeleVantage software sales of licenses for use by end-users by $0.2 million, the
growth in InstantOffice products sales of $6.2 million, and the addition of revenue of $0.4 million from the sale of Comdial products between September 28 and September 30, 2005. InstantOffice products which were only sold between
between September 28, and September 30, 2004 and therefore only contributed $0.5 million in net product revenue to the earlier period.



We distribute our products both domestically and internationally. International product revenue was $0.4 million, or 4.0% of total revenue, for the
quarter ended September 30, 2005 and $.3 million, or 11.8% of total revenue, for the quarter ended September 30, 2004.



In January 2000, we entered into an OEM and Reseller Agreement with Toshiba. Also in January 2000, we entered into an agreement with Toshiba
under which Toshiba acquired 16,666 shares of our common stock at a price of $41.964 per share and was issued warrants for an additional 8,333 shares of our common stock at an exercise price of $41.964 per share. The fair market value of our common
stock on the date of execution of the definitive agreement was $129. The difference between the issuance price and fair market value of our common stock, and the fair value of the warrants (which were valued based upon the Black Scholes Options
Pricing Model) amounted to $2.3 million. We determined that the $2.3 million charge should be deferred within equity as Deferred Toshiba Equity Costs with an offsetting increase to additional paid-in capital and should be
amortized as a reduction of product revenue in proportion to revenue recognized relating to the OEM and reseller agreement. Each quarter, as revenue from Toshiba OEM sales are recognized, the balance of Deferred Toshiba Equity Costs are reduced by
an amount equal to 45.79% of Toshiba OEM sales, while revenues are reduced by the same amount. For the quarters ended September 30, 2005 and September 30, 2004 net product revenue was reduced by amortization of Deferred Toshiba Equity
Costs of less than $0.1 million and $0.1 million respectively.



Gross Profit(in thousands, except percentages)



|                 |  |                    |   |  |                   |   |  |       
|---------------- |  | ------------------ | - |  | ----------------- | - |  | ------
|                 |  | Three Months Ended |   |  |                  
|                 |  | September 30,2005  |   |  | September 30,2004 |   |  | Change
|Gross Profit     |  | 6,241              |   |  | 2,569             |   |  | 3,672 
|% of Net Revenue |  | 63.1               | % |  | 87.6              | % |  |       



The decrease in gross
profit as a percentage of net revenue for the three-month period ended September 30, 2005, compared to the corresponding period ended September 30, 2004, was due primarily to the substantial increase in revenue from InstantOffice products
which were sold for a full quarter in 2005 and were sold for only three days in the quarter ended September 30, 2004. The TeleVantage net revenues during the period had an average gross margin of 97% while the InstantOffice products sold during
the quarter had an average gross margin of



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54.2%. InstantOffice revenue includes the resale of hardware products manufactured by third parties. The increase in
gross profit in absolute dollars resulted both from the hardware and software revenue associated with InstantOffice sales, plus an additional $70 thousand of gross profit contributed by the acquired operation of Comdial during the three days in
which they were owned by us.



Operating Expenses(in
thousands, except percentages)



|                            |  |                    |   |  |                   |   |  |        |  
|--------------------------- |  | ------------------ | - |  | ----------------- | - |  | ------ | -
|                            |  | Three Months Ended |   |  |                   |  
|                            |  | September 30,2005  |   |  | September 30,2004 |   |  | Change |  
|Sales and Marketing         |  | 3,670              |   |  | 1,798             |   |  | 104.1  | %
|% of Net Revenue            |  | 37.1               | % |  | 61.3              | % |  |        |  
|                            |  |                    |  
|Product Development         |  | 2,610              |   |  | 873               |   |  | 199.0  | %
|% of Net Revenue            |  | 26.4               | % |  | 29.8              | % |  |        |  
|                            |  |                    |  
|General and Administrative  |  | 1,909              |   |  | 1,302             |   |  | 46.6   | %
|% of Net Revenue            |  | 19.3               | % |  | 44.4              | % |  |        |  
|                            |  |                    |  
|Stock Based Compensation    |  | 1,168              |   |  |                  |   |  |        |  
|% of Net Revenue            |  | 11.8               | % |  |                   |   |  |        |  
|                            |  |                    |  
|Amortization of Intangibles |  | 179                |   |  |                  |   |  |        |  
|% of Net Revenue            |  | 1.8                | % |  |                   |   |  |        |  
|                            |  |                    |  
|Total Operating Expenses    |  | 9,536              |   |  | 3,973             |   |  | 142.1  | %
|% of Net Revenue            |  | 96.4               | % |  | 135.4             | % |  |        |  



Sales and
Marketing



The decrease in sales and marketing expense as
a percentage of total net revenue for the quarter ended September 30, 2005, compared to the corresponding period ended September 30, 2004, was due primarily to an increase in InstantOffice sales. While sales and marketing expenses
increased, their costs as a percentage of revenue decreased from 61.3% to 37.1%. The increase in sales and marketing expenses in aggregate dollars for the three month ended September 30, 2005 compared to the corresponding period ended
September 30, 2004 was due primarily to an increase in payroll and related expenses due to the full period of expenses for the operations related to InstantOffice. We employed 68 sales and marketing personnel throughout the quarter ended
September 30, 2005, and added 44 sales and marketing personnel with the acquisition of Comdial. We employed 48 sales and marketing personnel throughout the quarter ended September 30, 2004, but added 21 employees with the acquisition of
Vertical Networks for only the final three days of the period.



Product Development



The decrease in product
development expenses as a percentage of total revenue for the quarter ended September 30, 2005, compared to the corresponding period ended September 30, 2004, was due to the increase in net product revenue. Product development expense grew
199.0% from September 2004 to September 2005. The increase in product development expenses, during the quarter ended September 30, 2005 was driven by increased payroll expenses and employee related costs. We employed 72 product development
personnel throughout the quarter ended September, 2005, and added 21 product development personnel with the acquisition of Comdial. We employed 36 product development personnel throughout the quarter ended September 30, 2004 and added 36
product development personnel with the acquisition of Vertical Networks.



General and Administrative



The decrease in general and administrative expenses as a percentage of total revenue for the quarter ended September 30, 2005, compared to the quarter ended September 30, 2004, was due primarily to the significant increase in
total revenue. General and Administrative expenses were increased in the period ended September 2005 by approximately $.6 million in liquidated damages expenses relating to the failure to fulfill registration rights incorporated in the
financing completed in September 2004. We employed 26 general and administrative personnel throughout the quarter ended September 30, 2005, and added 31 general and administrative personnel with the acquisition of Comdial. We employed 11
general and administrative personnel throughout the quarter ended September 30, 2004, and added 10 with the acquisition of Vertical Networks.



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Financial Condition, Liquidity And Capital Resources(in thousands)



|                                        |  |                                       |   |  |                                       |   |  |            |  
|--------------------------------------- |  | ------------------------------------- | - |  | ------------------------------------- | - |  | ---------- | -
|                                        |  | Positions at                          |   |  |                                       |  
|                                        |  | September 30, 2005                    |   |  | June 30, 2005                         |   |  | Change     |  
|Cash and cash equivalents               |  | 4,738                                 |   |  | 4,880                                 |   |  | (142       | )
|Working capital (excl. restricted cash) |  | (2,794                                | ) |  | 448                                   |   |  | (3,242     | )
|                                        |  |                                       |  
|                                        |  | Three Months Ended September 30, 2005 |   |  | Three Months Ended September 30, 2004 |   |  | Difference |  
|Cash used in operating activities       |  | (3,010                                | ) |  | (2,431                                | ) |  | (579       | )
|Cash used in investing activities       |  | (18,983                               | ) |  | (14,289                               | ) |  | (4,694     | )
|Cash provided by financing activities   |  | 21,853                                |   |  | 21,229                                |   |  | 624        |  



We used cash of
$3.0 million to fund operating activities during the three months ended September 30, 2005. The cash used in operating activities was due primarily to a net loss of $3.3 million plus an increase in trade accounts receivable of $2.0
million, offset by depreciation and amortization of $0.5 million, $1.1 million relating to stock based compensation of employees under SFAS No. 123R, and $0.6 million related to a non-cash settlement of liquidated damages relating to
the delayed registration of shares issued in the September 2004 financing. Trade receivables increased by $2.0 million, inventories increased $0.1 million, deferred revenue increased by $0.1 million, and accounts payable decreased by
$0.1 million. At September 30, 2005, compared to at June 30, 2005, excluding the impact of the acquisition of Comdial Corporations assets and assumed liabilities, prepaid expenses reduced $0.2 million, and accrued liabilities
increased by $0.3 million.



Working capital, consisting of
total current assets minus current liabilities, was $(2.8) million at September 30, 2005, which excludes $1.0 million of restricted cash relating to the acquisition of Vertical Networks that was paid at closing and is held in escrow
to secure Vertical Networks indemnification obligations to Vertical. This compared to working capital of $.4 million at June 30, 2005, representing a decrease of $3.2 million. The decrease in working capital at September 30,
2005 reflects an increase of $4.7 million in inventory resulting primarily from the acquisition of Comdial Corporation, an increase in trade receivables of $5.0 million of which $3.4 was attributable to the acquisition of Comdial Corporation,
$1.0 million for expenses related to our September 2005 financing and $19.0 million expended in investing activities. Investing activities included $18.6 million to acquire the assets and some of the liabilities of Comdial
Corporation and the associated costs related to this acquisition. Increases in these elements of working capital were offset by an increase of $1.2 million in accounts payable, $0.4 million in current deferred revenue and $3.5 million
in accrued liabilities of which $2.6 million was attributable to the acquisition of Comdial Corporation, and the addition of $9.9 million in notes payable resulting from the debt portions of the financing to accomplish the Comdial Acquisition. The
result of these changes is that we will have limited working capital in the near term.



We have incurred losses and negative cash flows from operations in every fiscal period since 1996 and have an accumulated deficit, including non-cash equity charges, of $62 million as of September 30, 2005.
For the three months ended September 30, 2005 we incurred a net loss of approximately $3.3 million, which includes negative cash flows from operations of approximately $3.0 million. We anticipate that, with available cash of
$4.7 million at September 30, 2005, combined with increased revenues and cash-flows, we will meet our anticipated cash requirements during and through our fiscal 2006 year. We will also utilize available borrowing under a revolving
line of credit which has been established to facilitate the Comdial acquisition. We expect to increase our revenue and cash flows in the foreseeable future as the result of the acquisition of the Comdial assets, including product lines and our
resellers and distributors.



There can be no assurance that the
available cash and increased revenues will be sufficient to meet ours cash requirements. If we are unable to satisfy such cash requirements from these sources, our ability to continue as a going concern and to achieve our intended business
objectives could be adversely affected. In such case, we could be required to adopt one or more alternatives, such as reducing or delaying marketing and promotional activities, reducing or delaying capital expenditures, developing restructuring
plans to reduce discretionary costs deemed nonessential, and selling additional shares of our capital stock. Additionally, changes in circumstances could necessitate that we seek additional debt or equity capital. There can be no assurance that any
such additional financing will be available when needed or on acceptable terms to allow us to successfully achieve our operating plan or fund future investment in our TeleVantage and InstantOffice product lines.



We lease office, product packaging, storage space and equipment under
non-cancelable operating lease agreements expiring through 2011. The table below also includes those contractual payments acquired on the acquisition of Comdial on September 28, 2005.



|                            |  |                       |  |                 |  |           |  |           |  |                 
|--------------------------- |  | --------------------- |  | --------------- |  | --------- |  | --------- |  | ----------------
|                            |  | Payment due by Period
|Contractual Obligations     |  | Total                 |  | Less than1 year |  | 1-3 years |  | 3-5 years |  | More than5 years
|Long-term Debt Obligations  |  | 11,553                |  | 9,920           |  | 1,633     |  |          |  |                
|Capital Lease Obligations   |  |                      |  |                |  |          |  |          |  |                
|Operating Lease Obligations |  | 3,481                 |  | 1,262           |  | 1,278     |  | 941       |  |                
|                            |  |                       |  |                 |  |           |  |           |  |                 
|Total                       |  | 15,034                |  | 11,182          |  | 2,911     |  | 941       |  |                
|                            |  |                       |  |                 |  |           |  |           |  |                 



We intend to continue
investing in the sales, marketing and development of our TeleVantage, InstantOffice and Comdial products. We may incur increases in research and development expenditures in response to customer requirements for features or functionality in future
releases of the product.



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RISK FACTORS



We caution you that the following important factors, among others, in the future could cause our actual results to differ materially from
those expressed in forward-looking statements made by, or on behalf of, us in filings with the SEC, press releases, communications with investors and oral statements. Any or all of our forward-looking statements in this Form 10-Q, and in any other
public statements we make may turn out to be wrong. They can be affected by inaccurate assumptions we might make or by known or unknown risks and uncertainties. Many factors mentioned in the discussion below are important in determining future
results. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make in our reports filed with
the SEC.



RISKS RELATED TO OUR HISTORIC BUSINESS OPERATIONS



We have a history of losses and expect to incur future losses.



We had operating losses for the year ended September 30, 2005 and in each of the last
12 fiscal quarters. We also had negative cash flow from operating activities in the year ended June 30, 2005 and in six out of the last ten fiscal years. If our revenues do not increase significantly, without a corresponding decrease in
expenses, we may never achieve profitability, on a sustained basis or at all, or generate positive cash flow in the future. In that case our business will fail. We expect to incur significant future operating losses and negative cash flows. Vertical
Networks, Inc. also incurred operating losses in each of our last three fiscal years, and had negative cash flow from operating activity many of which were acquired when we acquired most of the assets of Vertical Networks. Comdials revenues
and operating results have experienced fluctuations in the past and may cause our revenues and operating results to vary in the future. Comdials revenues and operating results have varied significantly in the past due to various factors,
including changes in market acceptance of Comdials services, regulatory changes that may affect the marketability of Comdials services, budgetary cycles of Comdials principal clients, the mix and timing of client projects, and
one-time nonrecurring and unusual charges. As a result, the operations acquired from Vertical Networks and Comdial may not consistently generate profits or positive cash flow, which would likely have a material negative impact on our business, our
financial condition and our results of operations.



We may need additional
working capital, the lack of which would likely have a significant negative impact on our current level of operations.



The Comdial Acquisition consumed significant amounts of working capital and the Comdial Assets were acquired with limited working capital, as a result we had negative
working capital at September 30, 2005, and we may require additional capital in the future to fund our operations, finance investments in product development and corporate infrastructure, expand in our various geographic markets and respond to
competitive pressures and opportunities for growth. Failure to obtain additional funding could prevent us from making expenditures that are needed to allow us to grow or maintain our operations. We cannot assure you that additional financing will be
available on favorable terms, or at all. If funds are not available when required for our working capital needs or other transactions, our ability to carry out our business plan could be adversely affected, and we may be required to scale back our
growth and operations to reflect the extent of available funding. If we are able to arrange for additional credit facilities from lenders, the debt instruments are likely to include limitations on our ability to incur other indebtedness, to pay
dividends, to create liens, to sell or purchase our capital stock, to sell assets or to make acquisitions or enter into other transactions. Such restrictions may adversely affect our ability to finance our future operations or capital needs or to
engage in other business activities, including, without limitation, acquisitions of additional businesses. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our stockholders will be reduced.
These securities would likely have rights, preferences or privileges senior to those of our Common Stockholders. In addition, we may seek to obtain a working capital or other traditional loan facility from a bank or other lending source. The
inability to obtain substantial increases in our working capital resources will likely have a material negative impact on our business, our financial condition and our results of operations.



Our disclosure controls and procedures are not effective.



Our Chief Executive Officer and Chief Financial Officer have determined that as of
September 30, 2005, our disclosure controls and procedures were not effective to ensure that information we are required to disclose in our Exchange Act reports is recorded, processed, summarized and reported within the time specified by the
SECs rules and forms. This determination was made, in part, because we failed to timely file our Quarterly Reports on Form 10-Q for the quarters ended September 30, 2004, December 31, 2004, and March 31, 2005, an amendment
to our Current Report on Form 8-K originally filed September 29, 2004 to disclose certain financial data in connection with our acquisition of Vertical Networks, and our Current Report on Form 8-K relating to the execution of an office lease
dated July 6, 2005. Our management also believes that we currently lack sufficient resources to address the financial reporting related to significant and complex business transactions.



Our former and current independent registered public accounting firms have indicated that
we have certain reportable conditions with our internal controls and as a result, our internal controls over financial reporting may not be effective.



Our former independent registered public accounting firm, KPMG LLP (KPMG), advised our management and our audit committee that, in connection with its review
of our financial statements for the three month period ended December 31, 2004, KPMG noted certain matters



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involving internal control and its operation that it considered to be a material weakness that constituted reportable
conditions under standards established by the American Institute of Certified Public Accountants. Reportable conditions are matters coming to an independent registered public accounting firms attention that, in its judgment, relate to
significant deficiencies in the design or operation of internal control and could adversely affect the organizations ability to record, process, summarize, and report financial data consistent with the assertions of management in the financial
statements. KPMG advised our management and our audit committee that it considered the following to constitute reportable conditions related to internal control and their operations: we did not have adequate staffing in our finance group with the
appropriate level of experience to effectively control the increased level of transaction activity, address the complex accounting matters and manage the increased financial reporting complexities resulting from the acquisition of Vertical Networks
and the associated integration activities.



Our current independent registered
public accounting firm, Vitale Caturano and Company Ltd. (VCC) advised our management and our audit committee that, in connection with their audit of our financial statements for the year ended June 30, 2005, VCC noted certain
matters involving internal control and its operation that it considered to be material weaknesses that constituted reportable conditions under standards established by the American Institute of Certified Public Accountants. VCC advised our
management and our audit committee that it considered the following to constitute a material weakness in internal control and operations: we did not have adequate staffing in our accounting and finance group with the appropriate level of experience
to effectively accomplish timely and accurate closings, control the increased level of transaction activity, address the complex accounting matters and manage the increased financial reporting complexities resulting from recent acquisitions.



We are also in the preliminary stages of preparing for our report on internal
controls over financial reporting, which must be filed with the annual report for our fiscal year ending June 30, 2008. The effectiveness of our controls and procedures may be limited by a variety of risks, including, without limitation, faulty
human judgment and simple errors, omissions, or mistakes; the collusion of two or more people or inappropriate management override of procedures; and imprecision in estimating and judging cost-benefit relationships in designing controls. At this
point in the process, it is not possible to ascertain whether this report will disclose any significant deficiencies or material weaknesses in our internal controls over financial reporting or even whether we will be able to conclude, after such
analysis, that our internal controls are effective; however, our recent failure to timely file certain Exchange Act reports, as well as the matters discussed above, resulted in our auditor determining that we have a material weakness in our internal
controls system. Upon a determination that we have such a material weakness, we will be required to report that our internal controls over financial accounting are not effective. If we fail to have effective internal controls and procedures for
financial reporting in place, we could be unable to provide timely and reliable financial information.



We have not timely filed several of our periodic reports under the Securities Exchange Act of 1934 and may fail to timely file periodic Exchange Act reports in the future.



We failed to timely file our Quarterly Reports on Form 10-Q for the quarters ended
September 30, 2004, December 31, 2004, and March 31, 2005, an amendment to our Current Report on Form 8-K originally filed September 29, 2004 to disclose certain financial data in connection with our acquisition of Vertical
Networks, and our Current Report on Form 8-K relating to the execution of an office lease dated July 6, 2005. We filed the Quarterly Report for the quarter ended September 30, 2004 on January 25, 2005, filed the Quarterly Report for
the quarter ended December 31, 2004 on April 1, 2005, filed the Quarterly Report for the quarter ended March 31, 2005 on June 3, 2005, filed our amendment to our Form 8-K on April 20, 2005, and our 8-K on July 14, 2005.
As a result, we will be ineligible to register our securities on Form S-3 until 12 months after July 14, 2005, and ineligible to qualify for the safe harbor provisions for resale of restricted securities under Rule 144 of the Exchange Act.
Inability to register securities on Form S-3 or sell restricted securities under the safe harbor provisions of Rule 144 limits the liquidity of our securities and restricts the market for our securities.



In addition, failure to remain current in our Exchange Act reporting requirements in the
future may in the future result in our Common Stock being de-listed from the OTC Bulletin Board and adversely affect our ability to list our Common Stock on a national exchange or the NASDAQ Stock Market in the future. If our Common Stock was to be
de-listed from the OTC Bulletin Board, the market for our Common Stock would become severely restricted and holders of our Common Stock may be unable to sell your shares. We have agreed in the stock purchase agreement to seek a listing of our Common
Stock on a national exchange or the NASDAQ Stock Market. If we are unable to list our securities on a national exchange or the NASDAQ Stock Market because we have failed to remain current in our Exchange Act reporting requirements, we may be subject
to claims by M/C Venture Partners for indemnification, liability for breach of contract or other common law remedies.



If we do not resume trading on a national exchange or the NASDAQ Stock Market and if we are de-listed from the OTC Bulletin Board, trading in our Common Stock may only be
conducted based on trading information referenced on the Pink Sheets. Being quoted on the Pink Sheets could damage our general business reputation and could impair our ability to raise additional capital. Securities quoting
on the Pink Sheets tend to be less liquid and subject to volatile stock prices.



Our stockholders could be adversely affected if M/C Venture Partners use their influence in a manner adverse to our stockholders interests.



As of October 1, 2005, M/C Venture Partners beneficially owned approximately 48.5% of our Common Stock. Based upon its substantial
stock ownership and their director rights, M/C Venture Partners is in a position to exert substantial influence over matters submitted to our stockholders for approval and our management and affairs, including the election and removal of directors
and any merger, consolidation or sale of all or substantially all of our assets. In addition, M/C Venture Partners currently maintains the contractual right to nominate two members to our seven member board of directors and has a shared right with
our board of directors to nominate an additional two members.



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Accordingly, such concentration of ownership and ability to appoint members to our board may have the effect of delaying,
deterring or preventing a change in control of our company, impeding a merger, consolidation, takeover or other business combination or discouraging a potential acquirer from making a tender offer or otherwise attempting to take control of our
company, which in turn could have a negative effect on the market price of our stock. These actions could also be adverse to our other stockholders interests.



If we fail to meet our obligations under the Comdial Note, our payment obligations may be accelerated.



Under the terms of the Comdial Note, if certain events occur, including, without limitation,
our failure to pay any installment of principal or interest due under the Comdial Note, then the Comdial bankruptcy estate may, among other things, elect to accelerate our obligations under the Comdial Note and declare the outstanding principal
balance of and accrued but unpaid interest immediately due and payable. It could also elect to increase the interest rate of the Comdial Note from 8% to 10% per year. Should we be unable to make immediate repayment of the Comdial Note at the
time of an acceleration demand, the Comdial bankruptcy estate could elect to pursue its rights under the Security Agreement, which secured our obligations under the Comdial Note by granting a security interest on all of our assets and the assets of
Acquisition Sub, subject to a subordination agreement with SVB. In the event that the Comdial bankruptcy estate declares the Comdial Note immediately due and payable or seeks to foreclose on any of our assets under the Security Agreement, it would
likely have a material adverse affect on our financial position and our results of operations.



If we fail to meet certain covenants under our 2005 Debt Financing, our payment obligations may be accelerated.



We are obligated to make certain payments of principal and interest for both the Term Loan and The Revolving Loan under the SVB Loan Agreement. In addition, we are
obligated to take certain actions and refrain from taking certain actions during the term of the SVB Loan Agreement, including, without limitation, meeting certain financial covenants, some of which are not completely within our ability to control.
Should we fail to meet our payment obligations, fail to comply with any affirmative or negative covenant, or should any other situation arise which constitutes an Event of Default under the SVB Loan Agreement, SVB could elect, among
other things, to accelerate our indebtedness under the Term Loan and the Revolving Loan, or to take possession of, sell, lease, or otherwise dispose of any of our assets, including the Comdial Assets, which were pledged as collateral under the SVB
Loan Agreement. In the event that SVB declares the Term Loan and/or Revolving Loan immediately due and payable or seeks to foreclose on any of our assets, it would likely have a material adverse affect on our financial position and our results of
operations.



If we fail to file meet our obligations to file a registration
statement on Form S-1 by December 12, 2005, or fail to cause such registration statement to be declared effective in accordance to the timetable set forth in the Stock Purchase Agreement, we will be subject to liquidated damages or liability
for breach of contract.



Pursuant to the Stock Purchase Agreement, we
agreed to register the Issued Shares for resale by the 2005 Investors under the Securities Act. We agreed to file a registration statement covering the Issued Shares no later than December 12, 2005 (the Filing Date), and to use our
best efforts to cause the Registration Statement to become effective in certain events but no later than 90 days after the Filing Date (the Required Effective Date). We will be liable for liquidated damages to each 2005 Investor
(a) if the Registration Statement is not filed on or before December 12, 2005 (such an event, a Filing Default); (b) if the Registration Statement is not declared effective by the Commission on or prior to the Required
Effective Date (the Effectiveness Deadline) (such an event, an Effectiveness Default); or (c) if the Registration Statement (after its effectiveness date) ceases to be effective and available to the 2005 Investors for
any continuous period that exceeds 30 days or for one or more periods that exceed in the aggregate 60 days in any 12-month period (such an event, a Suspension Default and together with a Filing Default and an Effectiveness Default, a
Registration Default). Our schedule to register shares under the 2004 Agreement and the Prior Agreements, as amended, is identical to the schedule for registration under the 2005 Stock Purchase Agreement.



In the event of a Registration Default, we shall pay as liquidated damages to the 2005
Investors, and the 2004 Investors for each 30-day period of a Registration Default, an amount in cash equal to 1% of the aggregate purchase price paid by the 2005 Investor or 2004 Investor, as the case may be, pursuant to the Stock Purchase
Agreement or the 2004 Agreement, as amended; provided that in no event will the aggregate amount of cash to be paid as liquidated damages exceed 9% of the aggregate purchase price paid by such 2005 Investor or 2004 Investor.



Should we become obligated to make payment of these liquidated damages, it could have a
material adverse affect on our financial position and our results of operations, particularly if we became obligated to make payment in full of all liquidated damages potential due and payable under these agreements.



If we fail to effect our Capitalization Amendment on or before April 15, 2006, we
will be obligated to make a $1.375 million cash payment to the 2004 Investors.



Under the terms of Amendment Number 1 to the 2004 Agreement, we issued the New Warrants to the 2004 Investors and agreed to present the Capitalization Amendment for consideration at a meeting of our stockholders to be held on or before
April 15, 2006 in lieu of making a cash payment in the amount of $1.375 million for liquidated damages under the 2004 Agreement accrued through August 31, 2005 (the Accrued Liquidated Damages). In the event the Capitalization
Amendment is not effective on or before April 15, 2006 and M/C Venture Partners and SSF have voted their shares in favor of the Capitalization Amendment, which they are obligated to do under the terms of the Voting Agreement, then we will be
required to make a cash payment of the Accrued Liquidated Damages to the 2004 Investors, at which time the New Warrants issued in satisfaction of the Accrued Liquidated Damages which will expire unexercised. Should we become obligated to make
immediate payment of these amounts to the 2004 Investors, it would reduce our available working capital and likely have a material adverse affect on our liquidity, our financial condition and our results of operations.



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Restrictive covenants in the Stock Purchase Agreement and the 2004 Agreement may limit our ability to pursue our
business strategies.



We have agreed under the terms of the Stock Purchase
Agreement that we will not, without the prior consent of M/C Venture Partners, (1) enter into a transaction involving a change in control of our company; (2) incur indebtedness in excess of $3.0 million, subject to specified exceptions;
(3) create any security with an equity component unless that security is junior to the Common Stock; (4) issue any equity securities; (5) transfer our intellectual property; (6) repurchase, redeem or pay dividends on any shares
of capital stock (subject to limited exceptions); (7) grant stock options that are not authorized by a vote of the board of directors or its compensation committee; (8) liquidate or dissolve; (9) change the size of our board of
directors; (10) amend ourCertificate of Incorporation or bylaws, other than to effect the Capitalization Amendment and the Preferred Stock Amendment, (11) change the nature of the Companys business; (12) alter the voting rights
of shares of our capital stock in a disparate manner; or (13) take any action which would cause an adjustment to the exercise price or number of shares to be delivered under the Section 8 of the New Warrants.



We have agreed under the 2004 Agreement that we will not, without the prior consent of M/C
Venture Partners, (1) enter into a transaction involving a change in control; (2) incur indebtedness in excess of $3.0 million; (3) create any security with an equity component unless that security is junior to the Common Stock or,
subject to specified exceptions, issue any equity securities; (4) transfer our intellectual property; (5) repurchase, redeem or pay dividends on any shares of capital stock (subject to limited exceptions); (6) grant stock options that
are not authorized by a vote of our board of directors or our compensation committee; (7) liquidate or dissolve; (8) change the size of our board of directors; (9) amend our certificate of incorporation or bylaws; (10) change the
nature of our business; or (11) alter the voting rights of shares of our capital stock in a disparate manner.



If we do not comply with these covenants, we could be subject to claims for indemnification, liability for breach of contract and other common law remedies. Compliance
with these covenants may limit our ability to pursue growth opportunities or address concerns with our operations. Our ability to comply with these covenants and restrictions may be affected by changes in the economic or business conditions or
events beyond our control.



Restrictive Covenants in the SVB Loan Agreement
may limit our ability to pursue our business strategies.



Under the terms
of the SVB Loan Agreement, we are not permitted to take certain actions, without the prior written consent of SVB, including, without limitation, the following: (1) merge or consolidate with another corporation or entity except that we may
merge with Acquisition Sub; (2) acquire any assets, except in the ordinary course of business; (3) enter into any other transaction outside the ordinary course of business; (4) sell or transfer any collateral pledged to SVB under the
SVB Loan Agreement, except for the sale of finished inventory in the ordinary course of our business, and except for the sale of obsolete or unneeded equipment in the ordinary course of business and transfers between us and Acquisition Sub;
(5) store any inventory or other collateral with any warehouseman or other third party; (6) sell any inventory on a sale-or-return, guaranteed sale, consignment, or other contingent basis; (7) except for advances in the ordinary
course of business not exceeding $100,000 in the aggregate outstanding at any time, make any loans of any money or other assets; (8) incur any debts outside the ordinary course of business other than debts outstanding as of the date the SVB
Loan Agreement; (9) guarantee or otherwise become liable with respect to the obligations of another party or entity; (10) pay or declare any dividends on our Common Stock (except for dividends payable solely in our capital stock) or
dividends paid by Acquisition Sub to us; (11) redeem, retire, purchase or otherwise acquire, directly or indirectly, any of our stock; (12) make any change in our capital structure which would have a material adverse effect on us or on the
prospect of repayment of the our obligations under the SVB Loan Agreement; (13) engage, directly or indirectly, in any business other than the business we currently engage in; or (14) dissolve or elect to dissolve.



If we do not comply with these covenants, we could be subject to claims for indemnification,
liability for breach of contract and other common law remedies. Compliance with these covenants may limit our ability to pursue growth opportunities or address concerns with our operations. Our ability to comply with these covenants and restrictions
may be affected by changes in the economic or business conditions or events beyond our control.



Failure to successfully integrate the acquired operations of Vertical Networks and Comdial could have a material adverse effect on our combined operations.



Our decisions to acquire the operations of both Vertical Networks and Comdial were based in
part, on our belief in the growth opportunities and cost savings we hope to achieve from the integration of those operations into our operations and our plans to expand our product offerings to our customers and future customers. Our success in
realizing these and other anticipated benefits could be adversely affected by a number of factors, many of which are outside our control. These challenges include the timely, efficient and successful execution of a number of post-acquisition events,
including:



| |  | integrating the operations and technologies of the two companies;
|- |  | -----------------------------------------------------------------



| |  | retaining and assimilating the key personnel of each company;
|- |  | -------------------------------------------------------------



| |  | retaining existing customers of both companies and attracting additional customers;
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| |  | retaining strategic partners of each company and attracting new strategic partners; and
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| |  | creating uniform standards, controls, procedures, policies and information systems.
|- |  | -----------------------------------------------------------------------------------



The execution of these post-acquisition events will involve considerable risks and may not be successful.



These risks include:



| |  | the potential disruption of the combined companys ongoing business and distraction of its management;
|- |  | ------------------------------------------------------------------------------------------------------



| |  | the potential strain on our financial and managerial controls and reporting systems and procedures;
|- |  | ---------------------------------------------------------------------------------------------------



| |  | unanticipated expenses and potential delays related to integration of the operations, technology and other resources of the two companies; and
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------



| |  | the impairment of relationships with employees, suppliers and customers as a result of the integration of personnel and any reductions in force.
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------



The combined company may not succeed in addressing these risks or any other problems
encountered in connection with these acquisitions. The inability to successfully integrate our operations, technology and personnel with those of Vertical Networks and Comdial, or any significant delay in achieving integration, could have a material
adverse effect on the combined company after the acquisition and, as a result, on the market price of our Common Stock.



We may experience difficulties marketing our products following the acquisitions of Vertical Networks and Comdial.



With the acquisition of Vertical Networks, we now market a significant amount of products,
primarily InstantOffice and its family of products, to several large enterprise customers, including CVS and Staples. We have little experience marketing our products to, or establishing and maintaining customer relationships with, such large
enterprise customers. If we are unable to maintain what are essentially new customers, it would likely result in a decline in sales of InstantOffice, which would likely have a material adverse effect on our ability to generate revenues. If we are
unable to add additional large enterprise customers, we may have difficulty in our efforts to increase our revenues and achieve profitability.



The former customers of Comdial may not continue their current buying patterns following our acquisition of the Comdial Assets. Any significant delay or reduction in
orders for the Comdial Products could harm the combined companys business, financial condition and results of operations. Former customers of Comdial may defer purchasing decisions as they evaluate the likelihood of successful integration of
our products with those of Comdial, and the combined companys future product strategy, or consider purchasing products of our competitors. Former Comdial customers may also seek to modify or terminate existing agreements, or prospective
customers may delay entering into new agreements or purchasing our products. In addition, by increasing the breadth of our business, the acquisition may make it more difficult for the combined company to enter into relationships, including customer
relationships, with strategic partners, some of whom may view the combined company as a more direct competitor than either entity as an independent company.



Integrating our companies may divert managements attention away from our operations.



Successful integration of our operations, products and personnel with those of Comdial may place a significant burden on our management and
our internal resources. The diversion of management attention and any difficulties encountered in the transition and integration process could harm our business, financial condition and operating results.



If we fail to retain key employees, the benefits of the acquisitions could be diminished.



The successful acquisition of the Comdial Assets will depend in part on
the retention of key personnel. As a result of the acquisition, our employees and those of Comdial could experience uncertainty about their future roles within our continuing operations. This uncertainty may adversely affect our ability to attract
and retain key management, sales, marketing and technical personnel. There can be no assurance that we will be able to retain our key management, technical, sales and customer support personnel or those of Comdial. If we fail to retain such key
employees, we may not realize the anticipated benefits of the acquisition.



Our revenues are highly concentrated among a small number of customers and the loss of one of these customers would harm our business and prospects, perhaps materially.



A significant portion of our revenues is generated by a small number of customers. If we were to lose one or more of these customers, our
revenues would decline and our business and prospects would be materially harmed. We expect that even if we are successful in developing relationships with additional customers through the acquisition of the Comdial Assets, or through additional
sales of our Historic Products, our revenues will continue to be concentrated. We cannot assure you that we will be able to retain any of our current customers or that we will be able to obtain new customers. Scansource, Inc., through its division
Paracon, accounted for 19% of net revenue for the year ended June 30, while CVS accounted for 92% of deferred revenue as of June 30, 2005.



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We do not have long-term contracts with a majority of our customers, which renders our sales channels particularly
unstable.



We do not have any long-term agreements with our customers who
acquire our products. Accordingly, our customers are not contractually obligated to buy from us in the future. Our customers are not required to make minimum purchases from us or make purchases at any particular time and are free to purchase from
our competitors. Also, our customers can stop purchasing our products at any time without penalty. If our customers do not purchase our products in sufficient quantities or on a recurring basis, our business and prospects will suffer. Even if our
customers are willing to purchase our products, we cannot assure you that we will be able to sell our products at prices that are favorable to us.



We rely on others to promote and sell our products, and their failure to do so may seriously harm our business.



We depend on distributors and resellers and system integrators to market and sell our
products. If these customers do not focus their marketing efforts on software- or server-based phone systems or focus on products competitive with our products our sales will be materially adversely affected. Failure of distributors, system
integrators, and resellers to focus on software- or server-based phone systems may send a negative signal to current and potential customers concerning the viability of our industry or our product offerings. We depend upon the availability of
distribution outlets to market our products. Loss of these outlets will harm our ability to broaden our brand acceptance and enhance our reputation in the market. In addition, our operating results would be adversely affected if one of our major
distributors, resellers or original equipment manufacturers failed to timely and fully pay us for the products they purchased from us for resale or integration, as the case may be.



If software- and server-based phone systems do not achieve widespread acceptance, we may not be able to continue our operations.



The market for software- and server-based business phone systems is
relatively new and rapidly evolving. Businesses have invested substantial resources in the existing telecommunications infrastructure, including traditional private telephone systems, and may be unwilling to replace these systems in the near term or
at all. Businesses also may be reluctant to adopt computer telephony systems because of their concern about the current limitations of data networks, including the Internet. For example, end-users sometimes experience delays in receiving calls and
reduced voice quality during calls when routing calls over data networks. Moreover, businesses that begin to route calls over the same networks that currently carry only their data also may experience these problems if the networks do not have
sufficient capacity to carry all of these communications at the same time. We cannot assure you that businesses will migrate toward computer telephony systems or that computer telephony systems will gain widespread acceptance.



Rapid technological change creates a dependence on development of new products.



The market for telecommunications systems and products has been
characterized by rapid technological change and continuing demand for new products and features. Accordingly, the timely introduction of new products and product features, as well as new telecommunications applications are expected to continue to be
major factors in our future success. Market needs and expectations will require us to continue to identify, develop, and sell new products and features that keep pace with technological developments and competitive pressures. In addition,
technological difficulties occasionally inherent in new products and the time necessary to stabilize new product manufacturing costs may adversely affect operating costs. There can be no assurance that our products will achieve market acceptance, or
that we will be able to continue to develop new products, technologies, and applications as required by changing market needs in the future.



Products in our new Comdial inventory may become obsolete.



Comdial offered a variety of communications products which included technologies that are enhanced rapidly in todays business environment. Comdial measured its
product inventories on hand at the lower of costs or market. Comdial also provided allowances for excess and obsolete inventory equal to the difference between the cost of inventory and the estimated market value based on assumptions about product
life cycles, product demand and market conditions. The technologies incorporated into our new Comdial products are periodically modified in reaction to both customer requirements and to market conditions. This rapid technology change potentially
impacts the carrying value of our new Comdial inventory on hand due to obsolescence.



Disruption in supplies of certain essential components will impair our ability to manage our inventory with distributors and resellers.



As a result of the acquisitions of Vertical Networks, we now design and distribute the hardware on which many of our products, particularly our InstantOffice products
operate including phones and custom server hardware. If we are unable to obtain supplies necessary to the manufacture of our hardware, our ability to maintain inventory with our distributors and resellers will be harmed. Continued sales of our
hardware-based products are dependent upon continued availability of the commercially available components used to manufacture the custom hardware incorporated into the product, as well as continued cooperation by the manufacturers involved in
assembling the custom servers used by the product. We may not be able to secure enough components at reasonable prices or of acceptable quality to build new products in a timely manner in the quantities or configurations needed. Accordingly, our
revenues and gross margins could suffer until other sources can be developed. Our operating results would also be adversely affected if, anticipating greater demand than actually develops, we commit to the purchase of more components than we need.
We cannot assure you that we will not encounter these problems in the future. Although in many cases we use standard parts and components for our products, certain components are presently available only from a single source or limited sources. We
may not be able to diversify sources in a timely manner, which could harm our ability to deliver products to customers and seriously impact present and future sales.



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We do not manufacture the hardware utilized by InstantOffice and hold in-house only limited amounts of inventory for
purposes of replacements of systems or parts as required for field support. Should we experience a disruption in the supply of these components, it could have a material adverse effect on our ability to sell and service our InstantOffice product
line. The fact that we do not own our manufacturing facilities could have an adverse impact on the supply of our products and on operating results. Financial problems of contract manufacturers on whom we rely, or reservation of manufacturing
capacity by other companies, inside or outside of our industry, could either limit supply or increase costs.



As part of its restructuring program, Comdial outsourced substantially all of its manufacturing requirements. Outsourced manufacturing is carried out in three principal locations: Asia, Mexico and the United States.
Outsourcing, particularly with international manufacturers, carries certain risks which include, but may not be limited to:



| |  | the outsourcing contractors ability to manufacture products that meet our technical specification and that have minimal defects;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  | the outsourcing contractors ability to honor their product warranties;
|- |  | -----------------------------------------------------------------------



| |  | the financial solvency, labor concerns and general business condition of our outsourcing contractors;
|- |  | -----------------------------------------------------------------------------------------------------



| |  | unexpected changes in regulatory requirements;
|- |  | ----------------------------------------------



| |  | inadequate protection of intellectual property in foreign countries;
|- |  | --------------------------------------------------------------------



| |  | political and economic conditions in overseas locations;
|- |  | --------------------------------------------------------



| |  | risks of fire, flood or acts of God affecting manufacturing facilities; and
|- |  | ---------------------------------------------------------------------------



| |  | our ability to meet our financial obligations with our outsourcing contractors.
|- |  | -------------------------------------------------------------------------------



In addition, our new outsourcing contractors acquire component parts from various suppliers. Similar risks are involved in such procurement
efforts. Due to our new dependency on outsourced manufacturing and the inherent difficulty in replacing outsourced manufacturing capacity in an efficient or expeditious manner, the occurrence of any condition preventing or hindering the manufacture
or delivery of manufactured goods by any one or more of our outsourcing contractors would have a material adverse affect on our business in the short term and may have a material adverse affect in the long term. In calendar 2002, Comdial experienced
significant problems associated with a principal outsource manufacturer. Faulty component parts used by the manufacturer in the production of a principal product caused a significant shortfall in product inventory, and lead to Comdials
inability to meet product orders, negatively impacting sales and revenues. In addition, Comdial was adversely affected by a port strike that resulted in the temporary closure of certain ports on the West Coast of the United States.



During the third quarter of 2002, Comdial experienced difficulties in fulfilling certain
product orders as a result of the production transition from Virginia to the outsourcing partners, and a backlog that has been built up with one of the United States outsourcing partners. Also in 2002, Comdial was forced to terminate its
relationship with a principal outsource manufacturer and transition that work to other contractors. The terminated manufacturer was unable to meet substantially all of Comdials product delivery orders because of financial and operational
problems. That inability caused further problems for Comdial in meeting customer orders and resulted in a substantial backlog, potential lost business and other losses. Comdial filed an arbitration action against that manufacturer in 2002 in order
to seek recovery of the losses caused by their failure in performance. While these problems with these contract manufacturers have been addressed by Comdial, we cannot give assurances that they will not continue to have an impact on sales and
revenues, or that similar or other significant problems will not occur in the future.



Undetected flaws in our products may damage our reputation, cause loss of customers and increase customer support costs.



Telecommunications products as complex as our products may contain undetected errors or flaws. The presence of any such errors or flaws could result in damage to our
reputation, loss of customers, delay of market acceptance of our products or all of these consequences. Our customers or we may find errors in current or any new products after commencement of commercial shipments. In addition, if our products are
flawed or are difficult to use, customer support costs could rise. If we are unable to timely and effectively correct flaws in our products, we will lose customers and our ability to make future sales will be adversely affected. If we are unable to
produce reliable products, our reputation will suffer, perhaps irreparably, and our business could fail.



Malfunctions or errors in third-party technology may limit our ability to sell our products and may damage the reputation of our products, perhaps materially.



Our Historic Products and the Comdial Products operate on hardware manufactured by third
parties. We are dependent on the reliability of this hardware and, to the extent the hardware has defects, it will affect the performance of our products. If the hardware becomes unreliable, does not perform in a manner that is acceptable to our
customers or becomes more expensive, sales of our products could decline. Because many of



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our products run on Microsoft software products and use other Microsoft Corporation technologies, we must depend on the
reliability and quality of such products and technologies. Errors or vulnerabilities in Microsoft products could impair sales of some of our products. Our customers may associate unreliability of the hardware and flaws in Microsoft products with a
lack of quality of some of our products, which may cause us to lose customers and hurt future sales. Our ability to remedy malfunctions or errors will depend on the timeliness and availability of repair solutions from the manufacturers. Future
success of our products and any new products will depend on the ability of our hardware and software manufacturers to produce reliable products in the future.



Many of our products incorporate technology licensed or acquired from third parties.



We sell products in markets that are characterized by rapid technological changes, evolving industry standards, frequent new product
introductions, short product life cycles and increasing levels of integration. Our ability to keep pace with this market depends on our ability to obtain technology from third parties on commercially reasonable terms to allow our products to remain
in a competitive posture. If licenses to such technology are not available on commercially reasonable terms and conditions, and we cannot otherwise integrate such technology, our products or our customers products could become unmarketable or
obsolete, and we could lose market share. In such instances, we could also incur substantial unanticipated costs or scheduling delays to develop substitute technology to deliver competitive products.



We are in a dispute regarding patent licenses we obtained when we acquired the
assets of Vertical Networks.



As part of our agreement to acquire the
assets of Vertical Networks, we entered into a separate agreement with Vertical Networks on September 28, 2004 (the License Agreement). The License Agreement, among other things, granted us the license to use certain patents held by
Vertical Networks (the Licensed Patents). On November 4, 2005, we received a notice from CIPH claiming that we have materially breached certain terms under the License Agreement. Should this dispute result in the termination of the
License Agreement and our inability to use the Licensed Patents, it would limit our ability to produce and sell our InstantOffice products, or may necessitate licensing or developing alternate technology, any of which would have a material adverse
effect on our financial condition and results of operations.



We are subject
to risks associated with international operations.



We conduct business
globally. International sales accounted for approximately 8% of net sales for the year ended June 30, 2005, and 15% the year ended June 30, 2004. We also acquire various raw materials and components from international suppliers. We intend
to expand our presence in international markets, and we cannot assure you that we will compete successfully in international markets or meet the service and support needs of foreign customers. Our future results could be harmed by a variety of
factors relating to international operations, including:



| |  | difficulties in enforcing agreements and collecting receivables through the legal systems of foreign countries;
|- |  | ---------------------------------------------------------------------------------------------------------------



| |  | the longer payment cycles associated with many foreign customers;
|- |  | -----------------------------------------------------------------



| |  | the possibility that foreign countries may impose additional withholding taxes or otherwise tax our foreign income, impose tariffs or adopt other restrictions on foreign trade;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | fluctuations in exchange rates, which may affect product demand and adversely affect the profitability in U.S. dollars of products and services provided by us in foreign markets
where payment is made in local currency;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our ability to obtain U.S. export licenses and other required export or import licenses or approvals;
|- |  | -----------------------------------------------------------------------------------------------------



| |  | changes in the political, regulatory or economic conditions in a country or region; and
|- |  | ---------------------------------------------------------------------------------------



| |  | difficulty protecting our intellectual property in foreign countries.
|- |  | ---------------------------------------------------------------------



Our market is highly competitive, and if we fail to compete successfully our products will not be successful.



We compete with other companies offering proprietary private branch exchanges, such as
Nortel Networks Corporation, Siemens AG, and Avaya, Inc. As we focus on the development and marketing of computer telephony systems, we face intense competition from providers of voice communications systems as well as from data networking companies
such as Cisco Systems, Inc. and 3Com Corp. In addition, because the market for our products is subject to rapid technological change, as the market evolves we may face competition in the future from companies that do not currently compete in the
software- and server-based phone systems market, including companies that currently compete in other sectors of the technology, communications and software industries. Competition from these potential market entrants may take many forms, including
offering products and applications similar to those we offer as part of a larger, bundled offering.



Comdial competed with approximately 25 companies, many of which have significantly greater financial, marketing, and technical resources than we do. In addition, we must compete to attract and retain dealers for our
new Comdial Products. There can be no assurance that we will be able to compete successfully in the marketplace or that we will be able to maintain Comdials prior dealer network.



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Several of these existing competitors have, and many of our future competitors may have, greater financial, personnel and
capacity resources than us and as a result, these competitors may be in a stronger position to respond quickly to potential acquisitions and other market opportunities, new or emerging technologies and changes in customer requirements. Competitors
with greater financial resources also may be able to offer lower prices, additional products or services or other incentives that we cannot match or do not offer. We cannot predict with precision which competitors may enter our markets in the future
or what form such competition may take. In order to effectively compete with any new market entrant, we may need to make additional investments in our business or use more capital resources than our business currently requires.



The failure of our products to perform properly could result in a number of significant
negative consequences to us, including a claim for substantial damages, the diversion of managements attention and resources, and damage to our reputation. In addition, current and prospective customers may become discouraged from purchasing
our products.



Because customers purchasing our products rely on them for
the communication needs of their respective businesses, we may be exposed to potential claims for damages, including special or consequential damages, as a result of an actual or perceived failure of our products. Our failure or inability to meet a
customers expectations in the performance of our products, or failure to address any failure of our products in a timely manner, regardless of our responsibility for failure, could (1) result in a claim for substantial damages against us;
(2) divert managements attention and resources; (3) damage our business reputation; and (4) discourage other customers from purchasing our products in the future.



We maintain certain contractual limitations of liability and insurance against some of these risks; however, there can be no assurance that
such provisions would be enforced or effective or that such insurance would be sufficient to cover the cost of damages. Further, we cannot assure you that insurance will continue to be available at commercially reasonable rates. If we are unable to
rely on our contractual limitations of liability and/or maintain sufficient insurance, our business could be harmed.



Our market is subject to changing preferences and technological change, and our failure to keep up with these changes would harm our business and prospects, perhaps
materially.



The introduction of products incorporating new technologies
and the emergence of new industry standards could render our products obsolete and unmarketable. If we are unable to stay current or ahead of changes in the technology or industry standards, our business and prospects will suffer, perhaps
materially. We cannot assure you that we will be able to respond to rapid technological change, changing customer needs, frequent product introductions and evolving industry standards within the markets for computer telephony solutions. We may be
unable to develop and introduce new computer telephony products (including new releases and enhancements) on a timely basis that keep pace with technological developments and emerging industry standards and address the increasingly sophisticated
needs of our customers.



We have adopted anti-takeover defenses that could
make it difficult for another company to acquire control of our company or limit the price investors might be willing to pay for our stock.



Certain provisions of our Certificate of Incorporation, as amended, could make a merger, tender offer or proxy contest involving us difficult, even if such events would
be beneficial to the interests of our stockholders. These provisions include a classified board of directors, restrictions on calling and holding stockholder meetings, and giving our board the ability to issue preferred stock and determine the
rights and designations of the preferred stock at any time without stockholder approval. The rights of the holders of our Common Stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be
issued in the future. The issuance of preferred stock, while providing flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire, or of
discouraging a third party from acquiring, a majority of our outstanding voting stock. These factors and certain provisions of the Delaware General Corporation Law may have the effect of deterring hostile takeovers or otherwise delaying or
preventing changes in control or changes in our management, including transactions in which our stockholders might otherwise receive a premium over the fair market value of our Common Stock.



Our protection of intellectual property may not allow us to effectively prevent others
from using our business model or our technology.



Our success is dependent
upon our software code base, our programming methodologies and other intellectual property. We rely on copyright protection for such works of authorship and trade secret protection for our technical know-how and other confidential information. We do
not currently maintain patent protection for our business model or our technology and we currently do not plan significant patent applications in the future. We generally enter into confidentiality agreements with our employees, vendors and
consultants and with our clients and corporations with whom we have strategic relationships; however, the terms of these agreements vary and may not provide us with adequate protection against non-disclosure. In addition, we attempt to maintain
control over, access to, and distribution of our intellectual property and technical know-how; however, despite these efforts, unauthorized parties may attempt to copy aspects of our service offering or the documentation used by us in delivering
such services or to obtain and use other information that we regard as proprietary.



Monitoring infringement of intellectual property rights is difficult and we cannot be certain that the steps we have taken will prevent unauthorized use of our intellectual property and technical know-how, particularly in foreign countries
where the laws may not protect our proprietary rights as fully as in the United States. Accordingly, other parties, including competitors, may duplicate our product offerings.



Furthermore, Comdial has, from time to time, been subject to proceedings alleging infringement of the intellectual property rights of
others. We may find ourselves defending infringement claims related to intellectual property assets that are included in the Comdial Assets. Such



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proceedings could require us to expend significant sums in litigation, pay significant damages, develop non-infringing
technology, or acquire licenses to the technology which is the subject of the asserted infringement, any of which could have a material adverse effect on our business. Moreover, Comdial has relied in the past upon intellectual property rights to
protect its proprietary rights in its products and software. There can be no assurance that these protections will be adequate to deter misappropriation of our new Comdial technologies or independent third-party development of potentially infringing
technologies.



We may become involved in intellectual property or other
disputes that could cause us to incur substantial costs, divert the efforts of our management, and require us to pay substantial damages or require us to obtain licenses, which may not be available on commercially reasonable terms, if at all.



Third parties, including competitors, may already have patents on
inventions, or may obtain patents on new inventions in the future, that could limit our ability to market and sell the products we provide now or new products we may offer in the future. Such third parties may claim that our products infringe their
patent rights and assert claims against us. In addition, we have agreed in some of our contracts, and may in the future agree in other contracts, to indemnify third parties for any expenses or liabilities resulting from claimed infringements of the
proprietary rights of third parties as it relates to the products we provide. We, or third parties that we are obligated to indemnify, may receive notifications alleging infringements of intellectual property rights relating to our business or the
products previously sold by us. Litigation with respect to patents or other intellectual property matters, whether with or without merit, could be time-consuming to defend, result in substantial costs and diversion of management and other resources,
cause delays or other problems in the marketing and sales of our products, or require us to enter into royalty or licensing agreements, any or all of which could have a material adverse effect on our business, operating results and financial
condition. If any infringement claim is successful against us, we may be required to pay substantial damages or we may need to seek and obtain a license of the other partys intellectual property rights. We may be unable to obtain such a
license on commercially reasonable terms, if at all. We may be required to redesign those products that use the infringed technology. Moreover, we may be prohibited from selling, using, or providing any of our products that use the challenged
intellectual property. Although we carry general liability insurance, our insurance may not cover potential claims of this type or may not be adequate to cover us for all liability that may be imposed.



Our Common Stock has a limited trading market, which could limit the liquidity of our
Common Stock and our access to capital markets.



Our Common Stock is
currently quoted on both the over-the-counter electronic bulletin board, also referred to as the OTC Bulletin Board, and the National Quotation Service Bureau, also known as the Pink Sheets. There is only limited trading activity in our securities.
We do not know if a market for our Common Stock will be re-established or that, if re-established, a market will be sustained. This could limit the liquidity of our Common Stock and reduce our stock price. The limited liquidity and reduced price of
our Common Stock could have a material adverse effect on our ability to raise capital through alternative financing sources on terms acceptable to us or at all. The limited trading market may also result in other negative implications, including the
potential loss of confidence by suppliers, customers and employees, the loss of institutional investor interest and fewer business development opportunities.



Our Common Stock is subject to additional regulation as a penny stock, which may reduce the liquidity of our Common Stock.



The SEC has adopted regulations that generally define a penny stock to be any
security that is priced under five dollars. These regulations may have the effect of reducing the level of trading activity in our Common Stock and investors in our Common Stock may find it difficult to sell their shares. We cannot assure you that
you will be able to resell our Common Stock and may lose your investment.



In
addition, since the trading price of our Common Stock is less than $5.00 per share, trading in our Common Stock is also subject to the requirements of Rule 15g-9 of the Exchange Act. Under Rule 15g-9, brokers who recommend our Common Stock to
persons who are not established customers and accredited investors, as defined in the Exchange Act, must satisfy special sales practice requirements, including requirements that they:



| |  | make an individualized written suitability determination for the purchaser; and
|- |  | -------------------------------------------------------------------------------



| |  | receive the purchasers written consent prior to the transaction.
|- |  | -----------------------------------------------------------------



The Securities Enforcement Remedies and Penny Stock Reform Act of 1990 also requires additional disclosures in connection with any trades involving a penny stock,
including the delivery, prior to any penny stock transaction, of a disclosure schedule explaining the penny stock market and the risks associated with that market. Such requirements may severely limit the market liquidity of our Common Stock and the
ability of purchasers of our equity securities to sell their securities in the secondary market. For all of these reasons, an investment in our equity securities may not be attractive to our potential investors.



Revenues in any quarter may vary to the extent recognition of revenue is deferred when
contracts are signed. As a result, revenues in any quarter may be difficult to predict and are unreliable indicators of future performance trends.



We frequently enter into contracts where we recognize only a portion of the total revenue under the contract in the quarter in which we enter into the contract. For
example, we may recognize revenue on a ratable basis over the life of the contract or enter into contracts where the recognition of revenue is conditioned upon delivery of future product or service elements. This is the case with our contracts with
CVS, Aramark and Household Financial. The portion of revenues that are deferred may vary significantly in any given quarter, and revenues in any



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given quarter are a function both of contracts signed in such quarter and contracts signed in prior quarters. We
anticipate that product revenues in future quarters will generally be more dependent on revenues from new customer contracts entered into in those quarters rather than from amortization or recognition of product revenues deferred in prior quarters.



We sometimes experience long implementation cycles, which may increase our
operating costs and delay recognition of revenues.



Our products are
sophisticated systems that are generally deployed with many users. Implementation of these systems by enterprises is complex, time consuming and expensive. Long implementation cycles may delay the recognition of revenue as some of our customers
engage us to perform system implementation services, which can defer revenue recognition for the related product revenue. In addition, when we experience long implementation cycles, we may incur costs at a higher level than anticipated, which may
reduce the anticipated profitability of a given implementation.



Our costs
could substantially increase if we receive a significant number of warranty claims.



We generally warrant each of our products against defects in materials and workmanship for a period of 12 months from the date of shipment. Further, we have entered into a long-term service agreement with a
certain customer pursuant to which we have agreed to provide all necessary maintenance and services for a fixed fee. If we experience an increase in product returns or warranty claims, we could incur unanticipated additional expenditures for parts
and service. In addition, our reputation and goodwill could be damaged, perhaps irreparably. While we have established reserves for liability associated with product warranties, unforeseen warranty exposure in excess of those reserves could
adversely affect our operating results.



We depend on distributors and
resellers to market and sell our products.



If distributors and resellers
in the software industry do not focus their marketing efforts on software- or server-based phone systems or on products competitive with TeleVantage or InstantOffice, our sales will be materially adversely affected. Failure of distributors and
resellers to focus on software- or server-based phone systems may send a negative signal to current and potential customers concerning the viability our industry or product offering. We depend upon the availability of distribution outlets to market
our products. Loss of these outlets will harm our ability to broaden our brand acceptance and enhance our reputation in the market. In addition, our operating results would be adversely affected if one of our major distributors, resellers or
original equipment manufacturers failed to timely and fully pay us for the products they purchased from us for resale or integration, as the case may be.



Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Market Risk.During the normal course of business we are routinely subjected to a variety of market risks, examples of which include, but are not
limited to, interest rate movements and collectability of accounts receivable. We currently assess these risks and have established policies and practices to protect against the adverse effects of these and other potential exposures. Although we do
not anticipate any material losses in these risk areas, no assurances can be made that material losses will not be incurred in these areas in the future.



Interest Rate Risk.We may be exposed to interest rate risk on certain of our cash equivalents. The value of certain of our investments may be
adversely affected in a rising interest rate investment environment. Although we do not anticipate any material losses from such a movement in interest rates, no assurances can be made that material losses will not be incurred in the future.



Item 4CONTROLS AND PROCEDURES



Disclosure Controls and Procedures are defined in Exchange Act Rules 13a-15(e) and 15d-15(e) as the controls and procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the
reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported, within the time period specified by the SECs rules and forms. Disclosure Controls and Procedures include, without limitation, controls
and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuers management, including our principle
executive and principal financial officers to all timely decisions regarding disclosure.



We have endeavored to design our Disclosure Controls and Procedures and Internal Controls Over Financial Reporting to provide reasonable assurances that their objectives will be met. However, management and our audit
committee do not expect that our disclosure controls or internal controls over financial reporting will prevent all errors or all instances of fraud or a material weakness. A control system, no matter how well designed and operated, can provide only
reasonable, not absolute, assurance that the control systems objectives will be met. All control systems are subject to inherent limitations, such as resource constraints, the possibility of human error, lack of knowledge or awareness, and the
possibility of intentional circumvention of these controls. Furthermore, the design of any control system is based, in part, upon assumptions about the likelihood of future events, which assumptions may ultimately prove to be incorrect. As a result,
we cannot assure you our control system will detect every error or instance of fraudulent conduct, including an error or instance of fraudulent conduct that could have a material adverse impact on our operations or results.



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Evaluation of Disclosure Controls and Procedures.



As of September 30, 2005, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated
the effectiveness of our Disclosure Controls and Procedures. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2005, the design and operation of these disclosure controls and
procedures were not effective during the quarter ended September 30, 2005.



This determination was made because of our Chief Executive Officers and Chief Financial Officers belief that our companys resources were insufficient to address our financial reporting requirements in a timely fashion
during the quarter ended September 30, 2005. We failed to timely file our Quarterly Reports on Form 10-Q for the quarters ended September 30, 2004, December 31, 2004 and March 31, 2005 an amendment to our Current Report on Form
8-K originally filed September 29, 2004 to disclose certain financial data in connection with our acquisition of Vertical Networks, and our Current Report on Form 8-K relating to the execution of an office lease dated July 6, 2005, and the
filing of our Annual Reports on Form 10-K. Our management, including our Chief Executive Officer and Chief Financial Officer, believes that, during the quarter ended September 30, 2005, our company lacked the resources to address the financial
reporting related to significant and complex business transactions.



Assessment of Internal Controls Over Financial Reporting.



Our
former independent registered public accounting firm, KPMG, advised management and the audit committee that, in connection with their review of our financial statements for the three month period ended December 31, 2004, KPMG noted certain
matters involving internal control and its operation that it considered to be material weaknesses that constituted reportable conditions under standards established by the American Institute of Certified Public Accountants. Reportable conditions are
matters coming to an independent registered public accounting firms attention that, in their judgment, relate to significant deficiencies in the design or operation of internal control and could adversely affect the organizations ability
to record, process, summarize, and report financial data consistent with the assertions of management in the financial statements. Further, a material weakness is a reportable condition in which the design or operation of one or more internal
control components does not reduce to a relatively low level the risk that errors or fraud in amounts that would be material in relation to the financial statements being audited may occur and not be detected within a timely period by employees in
the normal course of performing their assigned functions. KPMG advised management and the audit committee that it considered the following to constitute a material weakness in internal control and operations: we did not have adequate staffing in our
finance group with the appropriate level of experience to effectively control the increased level of transaction activity, address the complex accounting matters and manage the increased financial reporting complexities resulting from the
acquisition of Vertical Networks and the associated integration activities.



Our current independent registered public accounting firm, Vitale Caturano and Company LTD. (VCC) advised our management and our audit committee that, in connection with their audit of our financial statements for the year ended
June 30, 2005, VCC noted certain matters involving internal control and its operation that it considered to be material weaknesses that constituted reportable conditions under standards established by the American Institute of Certified Public
Accountants. VCC advised our management and our audit committee that it considered the following to constitute a material weakness in internal control and operations: we did not have adequate staffing in our accounting and finance group with the
appropriate level of experience to effectively accomplish timely and accurate closings, control the increased level of transaction activity, address the complex accounting matters and manage the increased financial reporting complexities resulting
from recent acquisitions.



We continue to evaluate our resources for addressing
our financial reporting and making appropriate changes to provide sufficient resources and time to prepare and file periodic reports within the time periods specified in the SECs rules and regulations and provide for reviews by our management,
our audit committee and our board of directors. Our Chief Executive Officer and Chief Financial Officer continue to review our personnel, resources and disclosure controls and procedures. We are taking steps that are intended to lead to changes that
will ensure that our disclosure controls are effective at a reasonable assurance level. Specifically, beginning in the quarter ended September 30, 2005 we took a number of corrective actions to address the material weaknesses discussed above,
including:



| |  |  | Engaged a full-time contract senior finance professional to supplement our accounting and financial reporting resources;
| | - |  | ------------------------------------------------------------------------------------------------------------------------



| |  |  | Hired a new senior corporate controller with extensive software industry experience in November 2005;
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | Migrated the accounting systems of our operations in California and Massachusetts onto a common general ledger system;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



These steps are aimed at ensuring that our disclosure controls are effective for gathering,
analyzing and disclosing in a timely manner the information we are required to disclose in our reports filed under the Securities Exchange Act of 1934.



Changes in Internal Control Over Financial Reporting.



There have been no changes in our internal control over financial reporting that occurred during our most recent quarter that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting. However, as noted above, we intend to take certain actions designed to enhance our internal control over financial reporting and our disclosure controls and procedures.



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PART IIOTHER INFORMATION



Item 1Legal



On September 27,
2005 we delivered a claim to Consolidated IP Holdings, Inc. (CIPH), the former Vertical Networks, Inc. making claims against the escrow established as a part of the acquisition of the assets of Vertical Networks on September 28,
2004. We have asserted claims that $0.6 million of the $1 million escrow should be retained by us as a result of a failure by CIPH to meet certain terms and conditions under Asset Purchase Agreement entered into September 23, 2004. We have
subsequently received a Response to Claim notice from CIPH, wherein they dispute our claims. According to the terms of the escrow agreement, we are working with CIPH in good faith to resolve this dispute, which may include, among other options,
submitting the issue to arbitration.



As part of our agreement
to acquire the assets of Vertical Networks, we entered into a separate agreement with Vertical Networks on September 28, 2004 (the License Agreement). The License Agreement, among other things, granted us the license to use certain
patents held by Vertical Networks (the Licensed Patents). On November 4, 2005, we received a notice from CIPH claiming that we have materially breached certain terms of the License Agreement. We dispute the claims made by CIPH, and
we are preparing our response to this claim with the hope of amicably resolving this dispute. Should this dispute result in the termination of the License Agreement and our inability to use the Licensed Patents, it would limit our ability to produce
and sell our InstantOffice products, which would have a material adverse effect on our financial condition and results of operations.



Item 2UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS



On September 28, 2004, we issued and sold to several accredited investors, including affiliates of M/C Venture Partners, affiliates of Austin W.
Marxe and David M. Greenhouse, Perkins Capital Management, Inc., Constable Advisors, LLC and Pathfinder Ventures, an aggregate of 19,768,110 shares of our common stock at a per share cash purchase price of $1.1386. We received gross proceeds
from the sale of $22.5 million. On October 1, 2004, we sold the remaining 4,391,358 shares of our common stock to be sold under the stock purchase agreement at a per share cash purchase price of $1.1386 in a private placement to affiliates
of M/C Venture Partners. We received gross proceeds from that sale of $5.0 million. No underwriters were involved in the foregoing sales of securities. The foregoing sales were made in reliance upon an exemption from the registration provisions
of the Securities Act set forth in Section 4(2) thereof, relative to sales by an issuer not involving any public offering, and the rules and regulations thereunder.



On September 28, 2005, We issued and sold to several accredited investors, including affiliates of M/C Venture Partners, affiliates of
Austin W. Marxe and David M. Greenhouse and Pathfinder Ventures, an aggregate of 8,782,715 shares of its common stock at a per share cash purchase price of $1.1386. We received gross proceeds from the sale of $10.0 million. On September 30,
2005, we sold the remaining 2,546,988 shares of our common stock to be sold under the stock purchase agreement at a per share cash purchase price of $1.1386 in a private placement to Coral Capital Management. We received additional gross proceeds
from the sale of $2.9 million. No underwriters were involved in the foregoing sales of securities. The foregoing sales were made in reliance upon an exemption from the registration provisions of the Securities Act set forth in Section 4(2)
thereof, relative to sales by an issuer not involving any public offering, and the rules and regulations thereunder.



In lieu of a payment of accrued Liquidated Damages under the 2004 Stock Purchase Agreement, we issued the New Warrants for the purchase of our common stock on
September 28, 2005 to the 2004 Investors. Each New Warrant has a term of exercise expiring on September 28, 2010. The number of shares issuable upon exercise is subject to adjustment in the case of any stock dividend, stock split,
combination, capital reorganization, reclassification or merger or consolidation. The New Warrants are exercisable at any time prior to the expiration date by delivering the warrant certificate to us, together with a completed election to exercise
and payment of the exercise price, which is equal to $0.01 per share of common stock. The New Warrants contain a net exercise feature under which we do not receive any cash, but rather, the number of shares issued upon exercise is net of
the number of shares withheld by us pursuant to a formula, with the result that if all holders of New Warrants elect to use the net exercise feature, we would issue an aggregate of 1,202,728 shares of common stock. Upon the filing of the certificate
of amendment to effect the Capitalization Amendment, the New Warrants will be automatically exercised in a cashless exercise.



Item 6EXHIBITS



The
Exhibits filed as part of this quarterly report on Form 10-Q for the quarter ended September 30, 2005 are listed on the Exhibit Index immediately preceding such Exhibits, which Exhibit Index is incorporated herein by reference. Documents
listed on such Exhibit Index, except for documents identified by footnotes, are being filed as exhibits herewith. Documents identified by footnotes are not being filed herewith and, pursuant to Rule 12b-32 under the Securities Exchange Act of
1934, reference is made to such documents as previously filed as exhibits filed with the Securities and Exchange Commission. Our file number under the Securities Exchange Act of 1934 is 000-19462.





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SIGNATURES



Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.



|                        |  |                |  |                                                                                                   
|----------------------- |  | -------------- |  | --------------------------------------------------------------------------------------------------
|                        |  | ARTISOFT, INC.
|                        |  |               
|Date: November 16, 2005 |  | By             |  | /s/ WILLIAM Y. TAUSCHER                                                                           
|                        |  |                |  | William Y. Tauscher Chief Executive Officer
and Chairman of the Board                             
|                        |  |               
|Date: November 16, 2005 |  | By             |  | /s/ DUNCAN G. PERRY                                                                               
|                        |  |                |  | Duncan G. Perry Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer)



EXHIBIT INDEX



|            |  |                                                                                                                                                  
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                      
|31.1        |  | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended            
|            | 
|31.2        |  | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended            
|            | 
|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 Executive 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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