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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q/A

(Amendment No. 1)



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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, 2004



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 Dr.,
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 ̈No  x



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 15, 2004
|Common Stock, $0.01 par value per share |  | 36,197,508                                



FORWARD-LOOKING
STATEMENTS



This Quarterly Report on Form 10-Q
includes 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 are subject to a number of risks and uncertainties. All statements, other than
statements of historical fact, included in this Quarterly Report on Form 10-Q, including statements regarding our strategy, future operations, financial position, estimated revenues, projected costs, prospects, plans and objectives of
management, are forward-looking statements. When used in this Quarterly Report on Form 10-Q, the words will, believe, anticipate, intend, estimate, expect,
project and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We cannot guarantee future results, levels of activity, performance or
achievements, and you should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any financings, future acquisitions, mergers, dispositions, joint ventures or strategic
alliances. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including the risks described in Managements Discussion and Analysis of Financial Condition
and Results of OperationsRisk Factors and elsewhere in this Quarterly Report on Form 10-Q. The forward-looking statements provided by Artisoft in this Quarterly Report on Form 10-Q represent Artisofts estimates as of the
date this report is filed with the SEC. Forward-looking statements contained herein do not reflect events transpiring subsequent to that date. We anticipate that subsequent events and developments will cause our estimates to change. However, while
we may elect to update our forward-looking statements in the future, we specifically disclaim any obligation to do so. Our forward-looking statements should not be relied upon as representing our estimates as of any date subsequent to the date this
report is filed with the SEC.



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EXPLANATORY NOTE



The purpose of this Form 10-Q/A is to amend the Form 10-Q filed on January 25, 2005 to:



(1) Restate financial statements for an adjustment to Operating Expense and Deferred
Compensation resulting from the reassessment of the appropriate value of stock based compensation in the form of stock options granted to new and continuing employees on the day that the Company acquired Vertical Networks, Inc. Originally no value
had been assigned to the stock option grants that occurred in September 2004; however, upon further review during the audit of our fiscal year, ended June 30, 2005 it was determined that the grants represented a significant amount of
stock-based compensation based on the intrinsic value of the underlying stock on the day of the grants as determined under the guidelines of APB 25, Accounting for Stock Issued to Employees. As a result, the Company is restating this
Form 10-Q to reflect the deferred compensation of $10.1 million represented by the stock options as valued using APB 25.



The Items of our Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2004, which are amended and restated herein, are:



- Items 1 and 2 of Part I



2



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ARTISOFT, INC.

QUARTERLY REPORT ON FORM 10-Q

INDEX



|                                                                                               |  |   
|---------------------------------------------------------------------------------------------- |  | --
|PART I  FINANCIAL INFORMATION                                                                 |  | 4 
|Item 1  FINANCIAL STATEMENTS                                                                  |  | 4 
|Item 2  MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |  | 13
|Item 3  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |  | 22
|Item 4  CONTROLS AND PROCEDURES                                                               |  | 23
|PART II  OTHER INFORMATION                                                                    |  | 23
|Item 2  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                           |  | 23
|Item 6  EXHIBITS                                                                              |  | 23



3



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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 30,2004 |         |   | June 30,2004 |  
|                                                                                                                                                                                                                             |  | As restated       |         |   |              |  
|ASSETS                                                                                                                                                                                                                       |  |                   |         |   |              |   |         |  
|                                                                                                                                                                                                                             |  |                  
|Current assets:                                                                                                                                                                                                              |  |                   |         |   |              |   |         |  
|                                                                                                                                                                                                                             |  |                  
|Cash and cash equivalents                                                                                                                                                                                                    |  | $                 | 7,256   |   |              | $ | 2,747   |  
|                                                                                                                                                                                                                             |  |                  
|Trade receivables, net of allowances of $772 and $80 at September 2004 and June 2004, respectively                                                                                                                           |  |                   | 6,135   |   |              |   | 1,334   |  
|                                                                                                                                                                                                                             |  |                  
|Other receivables                                                                                                                                                                                                            |  |                   | 17      |   |              |   |        |  
|                                                                                                                                                                                                                             |  |                  
|Inventories                                                                                                                                                                                                                  |  |                   | 1,537   |   |              |   | 15      |  
|                                                                                                                                                                                                                             |  |                  
|Prepaid expenses                                                                                                                                                                                                             |  |                   | 432     |   |              |   | 340     |  
|                                                                                                                                                                                                                             |  |                  
|Restricted cash                                                                                                                                                                                                              |  |                   | 1,000   |   |              |   |        |  
|                                                                                                                                                                                                                             |  |                  
|Total current assets                                                                                                                                                                                                         |  |                   | 16,377  |   |              |   | 4,436   |  
|                                                                                                                                                                                                                             |  |                  
|Property and equipment                                                                                                                                                                                                       |  |                   | 4,342   |   |              |   | 3,885   |  
|                                                                                                                                                                                                                             |  |                  
|Less accumulated depreciation and amortization                                                                                                                                                                               |  |                   | (3,663  | ) |              |   | (3,602  | )
|                                                                                                                                                                                                                             |  |                  
|Net property and equipment                                                                                                                                                                                                   |  |                   | 679     |   |              |   | 283     |  
|                                                                                                                                                                                                                             |  |                  
|Goodwill                                                                                                                                                                                                                     |  |                   | 15,817  |   |              |   |        |  
|                                                                                                                                                                                                                             |  |                  
|Other assets                                                                                                                                                                                                                 |  |                   | 514     |   |              |   | 379     |  
|                                                                                                                                                                                                                             |  |                  
|                                                                                                                                                                                                                             |  | $                 | 33,387  |   |              | $ | 5,098   |  
|                                                                                                                                                                                                                             |  |                  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                                                                                         |  |                   |         |   |              |   |         |  
|                                                                                                                                                                                                                             |  |                  
|Current liabilities:                                                                                                                                                                                                         |  |                   |         |   |              |   |         |  
|                                                                                                                                                                                                                             |  |                  
|Accounts payable                                                                                                                                                                                                             |  | $                 | 4,413   |   |              | $ | 486     |  
|                                                                                                                                                                                                                             |  |                  
|Accrued liabilities                                                                                                                                                                                                          |  |                   | 3,012   |   |              |   | 1,252   |  
|                                                                                                                                                                                                                             |  |                  
|Deferred revenue                                                                                                                                                                                                             |  |                   | 3,120   |   |              |   | 2,629   |  
|                                                                                                                                                                                                                             |  |                  
|Customer deposits                                                                                                                                                                                                            |  |                   | 176     |   |              |   | 179     |  
|                                                                                                                                                                                                                             |  |                  
|Note Payable                                                                                                                                                                                                                 |  |                   | 272     |   |              |   |        |  
|                                                                                                                                                                                                                             |  |                  
|Total current liabilities                                                                                                                                                                                                    |  |                   | 12,916  |   |              |   | 4,546   |  
|                                                                                                                                                                                                                             |  |                  
|Deferred Revenue-long term                                                                                                                                                                                                   |  |                   | 1,918   |   |              |   |        |  
|                                                                                                                                                                                                                             |  |                  
|Deferred tax liability                                                                                                                                                                                                       |  |                   | 5       |   |              |   |        |  
|                                                                                                                                                                                                                             |  |                  
|Total liabilities                                                                                                                                                                                                            |  |                   | 12,916  |   |              |   | 4,546   |  
|                                                                                                                                                                                                                             |  |                  
|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, 2004 and June 30,
2004                                                                                                  |  |                   |         |   |              |   |         |  
|Series B preferred stock. Authorized 2,800,000 shares; no shares issued or outstanding at September 30, 2004 and 2,800,000 issued and
outstanding at June 30, 2004 (aggregate liquidation value $7 million at June 30, 2004) |  |                   |        |   |              |   | 2,800   |  
|Series C preferred stock. Authorized 2,627,002 shares; no shares issued or outstanding at September 30, 2004, and 2,627,002 shares issued
and outstanding at June 30, 2004 (aggregate liquidation value $4 million)          |  |                   |        |   |              |   | 2,530   |  
|Common stock, $.01 par value per share. Authorized 50,000,000 shares; issued and outstanding 31,806,150 shares at September 30, 2004
and 6,085,488 at June 30, 2004                                                          |  |                   | 318     |   |              |   | 61      |  
|Additional paid-in capital                                                                                                                                                                                                   |  |                   | 146,096 |   |              |   | 109,649 |  
|                                                                                                                                                                                                                             |  |                  
|Accumulated deficit                                                                                                                                                                                                          |  |                   | (45,286 | ) |              |   | (43,880 | )
|                                                                                                                                                                                                                             |  |                  
|Deferred Compensation                                                                                                                                                                                                        |  |                   | (10,145 | ) |              |   |        |  
|                                                                                                                                                                                                                             |  |                  
|Deferred Toshiba equity cost                                                                                                                                                                                                 |  |                   | (832    | ) |              |   | (928    | )
|                                                                                                                                                                                                                             |  |                  
|Less treasury stock, at cost, 2,216,783 shares of common stock at September 30, 2004 and June 30, 2004                                                                                                                       |  |                   | (69,680 | ) |              |   | (69,680 | )
|                                                                                                                                                                                                                             |  |                  
|Net shareholders equity (deficit)                                                                                                                                                                                           |  |                   | 20,471  |   |              |   | 552     |  
|                                                                                                                                                                                                                             |  |                  
|                                                                                                                                                                                                                             |  | $                 | 33,387  |   |              | $ | 5,098   |  



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



UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS



(in thousands, except per share amounts)



|                                                                   |  |                                 |        |   |      |   |        |  
|------------------------------------------------------------------ |  | ------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                   |  | Three Months EndedSeptember 30, |       
|                                                                   |  | 2004                            |        |   | 2003 |  
|Net product revenue                                                |  | $                               | 2,934  |   |      | $ | 1,967  |  
|Cost of sales                                                      |  |                                 | 365    |   |      |   | 58     |  
|Gross profit                                                       |  |                                 | 2,569  |   |      |   | 1,909  |  
|Operating expenses:                                                |  |                                 |        |   |      |   |        |  
|Sales and marketing                                                |  |                                 | 1,798  |   |      |   | 1,349  |  
|Product development                                                |  |                                 | 873    |   |      |   | 781    |  
|General and administrative                                         |  |                                 | 1,302  |   |      |   | 775    |  
|Total operating expenses                                           |  |                                 | 3,973  |   |      |   | 2,905  |  
|Loss from operations                                               |  |                                 | (1,404 | ) |      |   | (996   | )
|Other income, net                                                  |  |                                 | 3      |   |      |   | 5      |  
|Net loss                                                           |  |                                 | (1,401 | ) |      |   | (991   | )
|Income tax                                                         |  |                                 | (5     | ) |      |   |       |  
|Net Loss after income tax                                          |  |                                 | (1,406 | ) |      |   | (991   | )
|Deemed dividend to series C preferred shareholders                 |  |                                 | (1,368 | ) |      |   | (2,009 | )
|Deemed dividend to series B preferred shareholders                 |  |                                 | (100   | ) |      |   | (1,088 | )
|Loss applicable to common shareholders                             |  | $                               | (2,874 | ) |      | $ | (4,088 | )
|Loss applicable to common shareholders per sharebasic and diluted |  | $                               | (0.61  | ) |      | $ | (1.30  | )
|Weighted average common shares outstandingbasic and diluted       |  |                                 | 4,707  |   |      |   | 3,141  |  



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, |        
|                                                                                         |  | 2004                            |         |   | 2003 |  
|Cash flows from operating activities:                                                    |  |                                 |         |   |      |   |        |  
|Net loss                                                                                 |  | $                               | (1,406  | ) |      | $ | (991   | )
|Adjustments to reconcile net loss to net cash used by operating activities:              |  |                                 |         |   |      |   |        |  
|Depreciation and amortization                                                            |  |                                 | 99      |   |      |   | 144    |  
|Amortization of deferred Toshiba equity costs                                            |  |                                 | 96      |   |      |   | 101    |  
|Non-cash changes in accounts receivable:                                                 |  |                                 |         |   |      |   |        |  
|Additions                                                                                |  |                                 | 60      |   |      |   | 46     |  
|Reductions                                                                               |  |                                 |        |   |      |   | (14    | )
|Changes in assets and liabilities:                                                       |  |                                 |         |   |      |   |        |  
|Trade accounts receivables                                                               |  |                                 | (1,208  | ) |      |   | (167   | )
|Inventories                                                                              |  |                                 | 60      |   |      |   | (99    | )
|Prepaid expenses                                                                         |  |                                 | 223     |   |      |   | 267    |  
|Accounts payable                                                                         |  |                                 | (668    | ) |      |   | 3      |  
|Accrued liabilities                                                                      |  |                                 | 222     |   |      |   | (361   | )
|Deferred revenue                                                                         |  |                                 | 122     |   |      |   | (255   | )
|Customer deposits                                                                        |  |                                 | (3      | ) |      |   | 311    |  
|Other assets                                                                             |  |                                 | (28     | ) |      |   | 4      |  
|Net cash used in operating activities                                                    |  |                                 | (2,431  | ) |      |   | (1,011 | )
|Cash used to acquire Vertical Networks net of cash acquired and net of acquisition costs |  |                                 | (13,227 | ) |      |   |       |  
|Purchases of property and equipment                                                      |  |                                 | (62     | ) |      |   | (46    | )
|Restricted cash                                                                          |  |                                 | (1,000  | ) |      |   |       |  
|Net cash used in investing activities                                                    |  |                                 | (14,289 | ) |      |   | (46    | )
|Cash flows from financing activities:                                                    |  |                                 |         |   |      |   |        |  
|Proceeds from issuance of series C preferred stock, net of expenses                      |  |                                 |        |   |      |   | 3,414  |  
|Proceeds from issuance of common stock, net of issue costs                               |  |                                 | 21,229  |   |      |   | 17     |  
|Net cash provided by financing activities                                                |  |                                 | 21,229  |   |      |   | 3,431  |  
|Net increase/(decrease) in cash and cash equivalents                                     |  |                                 | 4,509   |   |      |   | 2,374  |  
|Cash and cash equivalents at beginning of period                                         |  |                                 | 2,747   |   |      |   | 3,041  |  
|Cash and cash equivalents at end of period                                               |  |                                 | 7,256   |   |      |   | 5,415  |  
|SUPPLEMENTAL CASH FLOW INFORMATION FROM FINANCING ACTIVITIES:                            |  |                                 |         |   |      |   |        |  
|Non cash dividend to series C preferred shareholders                                     |  |                                 | 1,368   |   |      |   | 2,009  |  
|Non cash dividend to series B preferred shareholders                                     |  |                                 | 100     |   |      |   | 1,088  |  



The accompanying notes
are an integral part of the unaudited condensed

consolidated financial statements.



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ARTISOFT, INC. AND SUBSIDIARIES



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



(1) BASIS OF PRESENTATION



Artisoft, Inc., (Artisoft, the Company or the
Registrant) develops, markets and sells computer telephony software applications and integrated computer telephony products. The Companys principal products are TeleVantage and InstantOffice.



The Companys principal executive offices are located at 5 Cambridge
Center, Cambridge, Massachusetts 02142. The telephone number at that address is (617) 354-0600. The Company was incorporated in November 1982 and reincorporated by merger in Delaware in July 1991.



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



The accompanying unaudited condensed consolidated financial statements have been prepared by the Company 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) and the PCAOB. The balance sheet amounts at June 30, 2004 in this report were derived
from the Companys audited financial statements included in its Annual Report on Form 10-K for the fiscal year ended June 30, 2004. 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 the Company believes that the disclosures are adequate to make the information presented not misleading, the Company recommends that these financial statements be read in conjunction with the
consolidated financial statements and the notes thereto included in the Companys Annual Report on Form 10-K for the fiscal year ended June 30, 2004 on file with the SEC. The results of operations for the three months ended
September 30, 2004 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 Vertical
Networks Inc. (VNI) discussed below. Actual results could differ materially from these estimates. The accounting policies applied are consistent with those disclosed in the Companys Annual Report on Form 10-K as disclosed in
Note 1.



Acquisition of Vertical Networks Inc.



On September 28, 2004, Artisoft completed the acquisition of
substantially all of the assets, other than patents and patent rights, of Vertical Networks Inc., pursuant to the terms of an asset purchase agreement entered into on September 23, 2004. Vertical Networks is a leading provider of distributed
IP-PBX software and communications solutions to large enterprises. Artisoft has 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 purchased by Artisoft. In addition, Artisoft assumed specific liabilities of Vertical Networks. The operational results of this acquisition have been included herein since September 28, 2004, the date
that the acquisition was consummated.



(2) RESTATEMENT



In September 2004, Artisoft granted stock options to its executives and employees, including
new employees hired that month as a result of the acquisition of Vertical Networks. These options were granted with a strike price 15%, or 17 cents below the price of shares sold as part of the September 2004 Equity Financing which was completed at
the same time at a per share price of $1.1386 per share. Initially, no stock based compensation or deferred compensation expense was recorded for these grants, and the discount to the presumed basis of $1.1386 per share price was determined to
create a non-material stock based compensation expense under APB 25, Accounting for Stock Issued to Employees.



The Company has subsequently determined that under APB 25 the intrinsic value of stock options must be computed using the quoted market price of the
underlying common stock. Accordingly, the options granted in September 2004 should have been determined using the Companys common stock trading price on the OTC market the day of the grant, without any discount for liquidity, volume or other
factors. This value was determined to be $2.85 per share. This intrinsic value yields a discount of $1.88 per share for the options that were granted in September 2004. This substantial discount yields an initial deferred compensation of $10.1
million, and a stock-based compensation expense of $634 thousand per quarter based on the four year vesting schedule of the stock options in question.



The Company has restated the financial statements for the quarters ended September 30, 2004, December 31, 2004 and March 31, 2005 to reflect the
correct deferred compensation balance at the end of each quarter, as well as the stock-based compensation expense that should have been recorded in the quarters ended December 31, 2004 and March 31, 2005.



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The principal adjustments to restate the financial statements for the quarter ended
September 30, 2004 are as follows:



Balance Sheet



The Balance Sheet impact of the changes discussed above include an increase of Additional
Paid in Capital of $10.1 million, and the creation of a Deferred Compensation in Shareholders Equity of $10.1 million, all as of December 31, 2004.



(3) SIGNIFICANT ACCOUNTING POLICIES



Stock-Based Compensation



The Company applies APB Opinion No. 25 in accounting for its stock incentive plan and accordingly, compensation cost has been recognized for certain
of its stock options in the financial statements where the exercise price had been below the fair market value of the underlying stock on the grant date. Had the Company determined compensation cost based on the fair value at the grant date for its
stock options under SFAS No. 123, the Companys net loss and net loss per common equivalent share for the three-month period ended September 30, 2004 and 2003 would have been increased to the pro forma amounts indicated below (in
thousands, except per share amounts):



|                                                                                   |  |                                 |        |   |      |   |        |  
|---------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                   |  | Three MonthsEnded September 30, |       
|                                                                                   |  | 2004                            |        |   | 2003 |  
|Reported net loss applicable to common stock                                       |  | $                               | (2,874 | ) |      | $ | (4,088 | )
|Stock based compensation expense determined under fair value method for all awards |  | $                               | (411   | ) |      | $ | (333   | )
|Pro forma net loss applicable to common stock                                      |  | $                               | (3,285 | ) |      | $ | (4,421 | )
|Reported loss per share applicable to common stock                                 |  | $                               | (0.61  | ) |      | $ | (1.30  | )
|Pro forma loss per share applicable to common stock                                |  | $                               | (0.70  | ) |      | $ | (1.41  | )



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 2005 |   |  | Fiscal 2004 |  
|Expected dividend yield |  | 0           | % |  | 0           | %
|Volatility factor       |  | 115         | % |  | 111         | %
|Risk free interest rate |  | 3.45        | % |  | 3.3         | %
|Expected life           |  | 6 Years     |   |  | 6 years     |  



(4) ACQUISITION OF VERTICAL
NETWORKS AND FINANCING



On September 28, 2004,
Artisoft completed the acquisition of substantially all of the assets of Vertical Networks, a leading provider of distributed IP-PBX software and communications solutions to large enterprises, other than patents and patent rights, pursuant to the
terms of an asset purchase agreement entered into on September 23, 2004. Artisoft has 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 purchased by Artisoft. In addition, Artisoft assumed specified liabilities of Vertical Networks.



The acquisition of Vertical Networks provides Artisoft with a complementary product line and access to distributed large enterprise customers and a direct
sales channel through systems integrator partners including IBM and AT&T.



The purchase price for Vertical Networks consisted of: $13.5 million in cash, paid at closing except for $1.0 million held in escrow to secure Vertical Networks indemnification obligations to Artisoft,
the assumption of most liabilities of Vertical Networks and up to $5.5 million in cash payable under an earn-out provision in an amount equal to the first $5.5 million of non-refundable software license revenues received in cash by
Artisoft from CVS Pharmacy, Inc. with respect to various types of Vertical Networks software to be used by CVS in connection with a rapid prescription refill project that it plans to roll out to its stores and other projects. Neither the
$1.0 million held in escrow nor the $5.5 million earn-out provision were included in the total purchase price in the table below. The $1.0 million held in escrow is presented on the Balance Sheet as Restricted Cash and the
$5.5 million earn-out provision is not included in the accompanying financial statements. This contingent payment will be recorded as a component of the purchase price if and when the related contingency is resolved.



The acquisition was financed with a portion of the proceeds from a
$27.5 million common stock financing completed in two tranches on



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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. In connection with, or prior to the financing, the holders of all shares of Artisofts preferred stock converted those shares into common stock. Following the issuance and sale of common stock
in the financing and the conversions of Artisofts preferred stock to common stock, M/C Venture Partners is now the largest beneficial holder of Artisofts common stock, with a 51.69% beneficial ownership interest.



The stock purchase agreement for the financing provides that the size of
Artisofts board of directors be set at seven members, with the board initially consisting of (1) the chief executive officer of Artisoft (William Y. Tauscherclass II director), (2) one member designated by the former
holders of Artisofts series B preferred stock (Robert J. Majtelesclass II director), (3) one member designated by the former holders of Artisofts series C preferred stock (R. Randy Stolworthyclass II
director), (4) two members designated by M/C Venture Partners (John P. Ward and Matthew J. Rubinsclass III directors) and (5) two other directors designated by mutual agreement of M/C Venture Partners and Artisofts board
of directors (Michael P. Downey and Francis E. Girardclass I directors).



Following March 28, 2005, the stock purchase agreement provides that Artisofts board of directors will consist of (1) its chief executive officer (a class II director), (2) one member
designated by Special Situations Fund III, L.P. (an affiliate of Austin W. Marxe and David M. Greenhouse) so long as Special Situations Fund III, L.P. and its affiliates continue to beneficially own at least 50% of the shares of Artisofts
common stock acquired upon the conversion of their shares of Artisofts series B preferred stock, and otherwise, one member designated by the former holders of Artisofts series B preferred stock and series C preferred stock
(a class II director), (3) two members designated by M/C Venture Partners (class III directors) and (4) three directors with relevant industry experience designated by M/C Venture Partners and Artisofts board of directors
(class I directors).



The investors designees are
entitled to membership on the compensation and nominating committees of the board of directors.



Artisoft has agreed to register, under the Securities Act of 1933, the shares issued and sold under the stock purchase agreement for resale by the
investors. Artisoft has agreed to file with the Securities and Exchange Commission the registration statement with respect to this registration by November 12, 2004 and to use its best efforts to cause the registration statement to become
effective on or before December 31, 2004. Artisoft has not yet filed the registration statement. If the registration statement is not declared effective by the SEC on or prior to March 31, 2005 or if the registration statement, after being
declared effective, ceases to be effective and available 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, Artisoft will be required to pay each investor
in the financing liquidated damages in an amount equal to 1% of the aggregate purchase price paid by the investor under the purchase agreement (not to exceed 9% of such purchase price, in the aggregate). Artisoft has 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. As of the date of this filing, the Company
has not filed this registration statement, is in breach of its obligation to do so, and can make no assurance that the registration statement, when filed, will be declared effective on or before March 31, 2005.



Artisoft also agreed to several negative covenants under the stock purchase
agreement. Artisofts 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 Artisoft; 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 its 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 its compensation committee; liquidate or dissolve; change the size of Artisofts board of directors; amend
Artisofts certificate of incorporation or bylaws; change the nature of Artisofts business; or alter the voting rights of shares of Artisofts capital stock in a disparate manner.



As a result of the sale of common stock under the stock purchase agreement,
the exercise price of all of the warrants to purchase an aggregate of 466,664 shares of common stock issued in Artisofts 2001 financing and all of the warrants to purchase an aggregate of 2,627,002 shares of common stock issued in
Artisofts 2003 financing was reduced to $1.1386 per share pursuant to the terms of those warrants. Immediately prior to the sale of common stock under the purchase agreement, the exercise price of the warrants issued in 2001 was $1.50 per
share, and the exercise price of the warrants issued in 2003 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 sales of securities by Artisoft, except for customary adjustments for stock splits, dividends, recapitalizations and other organic changes. On
September 28, 2004 the Company completed the acquisition of the business operations of Vertical Networks. The transaction was structured such that the Company acquired substantially all the assets and assumed certain liabilities of VNI. The
results of VNI operations have been included in the consolidated financial statements of the Company for the period September 28, 2004 through September 30, 2004. The aggregate purchase price was $13.5 million, including
$1 million that was placed in escrow for a period of one year to secure certain VNI representations and warranties. This $1 million has been excluded from the purchase price in the table below and will be recorded if and when it is
released from escrow. Additionally, a payment of another $5.5 million may be required in the event of future revenues related to software product sales to one customer are realized. This amount has also been excluded from the purchase price in
the table below and will be recorded if and when the contingency is resolved.



The following table represents the preliminary allocation of the purchase price for our acquisition of Vertical Networks over the estimated fair value of the assets acquired and liabilities assumed at the date of
acquisition. Artisoft is in the process of assembling the information



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necessary for it to allocate the total purchase price and obtain supporting third party valuations of any tangible and intangible assets, assumed liabilities
and acquired deferred revenue. Thus, the allocation of the purchase price is subject to change upon completion of this assessment process.



|                          |  |                                                              |     
|------------------------- |  | ------------------------------------------------------------ | ----
|                          |  | Preliminary Estimated Values at September 28, 2004(millions)
|Cash                      |  | $                                                            | 0.3 
|Accounts Receivable net   |  | $                                                            | 3.6 
|Inventory net             |  | $                                                            | 1.6 
|Other Current Assets      |  | $                                                            | 0.5 
|Property and Equipment    |  | $                                                            | 0.4 
|Goodwill                  |  | $                                                            | 15.8
|Total assets acquired     |  | $                                                            | 22.2
|Accounts Payable          |  | $                                                            | 4.6 
|Accrued Expenses          |  | $                                                            | 2.5 
|Other Current Liabilities |  | $                                                            | 0.3 
|Deferred Revenue          |  | $                                                            | 2.3 
|Total liabilities assumed |  | $                                                            | 9.7 
|Net assets acquired       |  | $                                                            | 12.5



The estimated values
of current assets and liabilities were based upon their historical costs in the hands of the seller 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 most closely approximated fair value. 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. The preliminary 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 the Company to fulfill the contractual obligations acquired under various customer contracts plus a fair value profit margin. This estimate is subject to change once we complete a thorough analysis of
our post acquisition cost structure, particularly with respect to these contracts. Additionally, of the total acquired deferred revenue, only approximately $0.8 million will result in future cash in flows as the majority of these contracts were
prepaid when consummated in the pre-acquisition period.



In the
table above, we have assumed that the entire amount of the purchase price in excess of the value of the tangible assets acquired and liabilities assumed is allocable to goodwill and that there are no identifiable intangible assets. Upon completion
of a third party valuation of the tangible and intangible assets and liabilities acquired, certain identifiable intangible assets may be recorded that would be subject to amortization. Assuming a three-year life, every $1.0 million of
identifiable intangible assets recorded would result in approximately $333,000 of annual amortization expense in the pro forma statements of operations. Additionally, with respect to deferred revenue, for every $100,000 change in the recorded fair
value (increase or decrease), there will be an estimated corresponding increase or decrease in post acquisition revenue of approximately $2,000 per month.



Since Artisoft has not completed its valuation of the tangible and intangible assets and liabilities acquired, the final allocation of the excess of
purchase price over the book value of the net assets acquired could differ materially.



The deferred revenue associated with contracts acquired from Vertical Networks was valued at $5.8 million prior to the acquisition but has been written down to $2.3 million, which represents the cost basis
of the remaining obligations under those contracts uplifted for reasonable profit margin.



The following pro forma unaudited condensed financial information give effect to Artisofts acquisition of Vertical Networks as if it had occurred on July 1, 2003 for each period presented. The following
information is based on historical results of operations of Artisoft for the three months ended September 30, 2003 and 2004 and of Vertical Networks for the same historical periods. The pro forma financial information is presented for
illustrative purposes only and is not necessarily indicative of the future financial position or future results of operations of the consolidated company that would have actually occurred had the acquisition of Vertical Networks been effected as of
July 1 for each period presented.



|                                                  |  |          |        |   |                  |   |        |                       |  |        |                      |  |        |                      |  |        |  
|------------------------------------------------- |  | -------- | ------ | - | ---------------- | - | ------ | --------------------- |  | ------ | -------------------- |  | ------ | -------------------- |  | ------ | -
|Three Months Ended September 30, 2004             |  | Artisoft |        |   | VerticalNetworks |   |        | ConsolidatedPro Forma |  |        | Pro FormaAdjustments |  |        | Pro Formaas Adjusted | 
|Net product revenue                               |  | $        | 2,934  |   |                  | $ | 3,923  |                       |  | 6,857  |                      |  | (447   | )                    |  | 6,410  |  
|Net loss                                          |  |          | (1,401 | ) |                  |   | (1,181 | )                     |  | (2,582 | )                    |  | (307   | )                    |  | (2,889 | )
|Loss applicable to common stock                   |  |          | (2,874 | ) |                  |   | (1,181 | )                     |  | (4,055 | )                    |  | (307   | )                    |  | (4,362 | )
|Loss applicable to common stockBasic and Diluted |  |          | (0.61  | ) |                  |   | (0.25  | )                     |  | (0.86  | )                    |  | (0.07  | )                    |  | (0.93  | )
|                                                  |  |          |        |   |                 
|Three Months Ended September 30, 2003             |  |          |        |   |                  |   |        |                       |  |        |                      |  |        |                      | 
|Net product revenue                               |  |          | 1,967  |   |                  |   | 8,026  |                       |  | 9,993  |                      |  | (5,871 | )                    |  | 4,122  |  
|Net loss                                          |  |          | (991   | ) |                  |   | (370   | )                     |  | (1,361 | )                    |  | (3,072 | )                    |  | (4,433 | )
|Loss applicable to common stock                   |  |          | (4,088 | ) |                  |   | (370   | )                     |  | (4,458 | )                    |  | (3,072 | )                    |  | (7,530 | )
|Loss applicable to common stockBasic and Diluted |  |          | (1.30  | ) |                  |   | (0.12  | )                     |  | (1.42  | )                    |  | (0.98  | )                    |  | (2.40  | )



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The following adjustments have been reflected in the audited pro forma condensed combined statement of
operations:



(a) To adjust Verticals historical
reported revenues from the sale of telephone systems (systems) to the amount that would have been reported under Artisofts revenue recognition policy. In 2002 and 2003, Vertical 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s 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.



However, under Artisofts 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 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. The pro forma adjustment reduces revenues to the amount that would have been recognized under Artisofts 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.



(b) Prior to the Vertical Networks acquisition, 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. The Company evaluated their legal obligation that would have been assumed under these contracts if the acquisition had occurred on
July 1, 2003. The Company estimated the fair value of this assumed liability. The book value of the deferred revenue on July 1, 2003 was written down by $5.4 million to reflect the fair value of the assumed liabilities and the related
amortization was adjusted down by $.2 million per quarter.



(5)
LIQUIDITY



The Company has incurred losses and negative
cash flows from operations in every fiscal period since 1996 and has an accumulated deficit, including non-cash equity charges, of $46 million as of September 30, 2004. For the three months ended September 30, 2004 the Company
incurred a net loss of approximately $1.4 million, which includes negative cash flows from operations of approximately $2.4 million. Management expects that operating losses and negative cash flows will continue in the near future and
anticipates that losses will increase somewhat from current levels as a result of the cost of absorbing the operations acquired from Vertical Networks on September 28, 2004. The Company anticipates that it, with available cash of
$7.3 million at September 30, 2004 in addition to $5 million received on October 1, 2004 relating to the completion of the common stock financing, combined with increased revenues and cash-flows, will meet its anticipated cash
requirements during and through our fiscal 2005 year. The Company expects to increase its revenue and cash flows in the foreseeable future as the result of the acquisition of the InstantOffice product line and its resellers and systems
integrators.



There can be no assurance that the available cash
and increased revenues will be sufficient to meet the Companys cash requirements. If the Company is unable to satisfy such cash requirements from these sources, the Companys ability to continue as a going concern and to achieve its
intended business objectives could be adversely affected. In such case, the Company 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 the Companys capital stock. Additionally, changes in circumstances could necessitate that the Company 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 the Company to successfully achieve its operating plan or fund future investment in its TeleVantage and
InstantOffice product lines.



(6) PREFERRED STOCK



Prior to September 28, 2004, the Company 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, the Board of Directors of the Company 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 preferred stock in 2001, the
Companys Board of Directors terminated the Rights Agreement effective December 31, 2001.



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2001 Financing Series B Preferred Stock.In August and November 2001, Artisoft issued
and sold an aggregate of 2,800,000 shares of its 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
Artisofts common stock at an initial per share exercise price equal to $1.50. 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, Artisoft has 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
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 directors of the Company. In August 2002, the
holders of our series B preferred stock exercised this right, in part, to elect Robert J. Majteles as an Artisoft director.



The warrants will expire on September 30, 2006. The expiration date, the per share exercise price and the number of shares issuable upon exercise of
the warrants were initially subject to adjustment in certain events. Following the September 2004 financing, the per share exercise price of the warrants is $1.1386, and the per share exercise price and the number of shares issuable upon
exercise of the warrants are no longer subject to adjustment. The 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, Artisoft has the right to require the warrant holders to exercise their warrants for common stock.



The closing of the issuance and sale of shares of common stock in the September 2002 financing resulted in anti-dilution adjustments to the
series B preferred stock and the warrants issued in Artisofts 2001 financing. 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 warrant was reduced from
$3.75 to $1.05. These adjustments resulted in a significant increase in potential common shares outstanding. Prior to the September 2004 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.



In September 2003, Artisoft issued and sold an aggregate of 2,627,002 shares of its 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 Artisofts common stock at a per share exercise price equal to $1.88. 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 Artisofts stockholders. The holders of the series C preferred stock, as a class, were also entitled to elect a director of the Company. In September 2003, the holders of our series C preferred stock exercised this right to
elect Steven C. Zahnow as an Artisoft 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 a 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 the board of directors of the Company.
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
warrants will expire on June 27, 2010. The expiration date, the per share exercise price and the number of shares issuable upon exercise of the warrants were initially subject to adjustment in certain events. Following the September 2004
financing, the per share exercise price of the warrants is $1.1386, and the per share exercise price and the number of shares issuable upon exercise of the warrants are no longer subject to adjustment. Prior to the September 2004 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.



(7) GUARANTEES



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. Accordingly, we have no liabilities



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recorded for these agreements. Additionally, we warrant that our hardware products, those associated with the InstantOffice 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 Staples which have warranties that expire sixteen months
after the date of shipment. We have an extended warranty agreement with CVS Pharmacy that allows CVS Pharmacy to submit warranty claims after the initial one-year period. This agreement terminates on December 1, 2005. We have no liabilities
recorded for this agreement since any warranty claims will be expensed as they occur to match the associated deferred revenue. 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.



(8) 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,
|                                                                                  |  | 2004                            |  | 2003 
|Antidilutive potential common shares excluded from net loss per share (thousands) |  | 8,849                           |  | 3,666



(9) INVENTORIES



Inventories at September 30, 2004 and June 30, 2004 consist of the
following (in thousands):



|               |  |                   |       |              |   |   
|-------------- |  | ----------------- | ----- | ------------ | - | --
|               |  | September 30,2004 |       | June 30,2004
|Raw Materials  |  | $                 | 163   |              | $ | 4 
|Finished Goods |  | $                 | 1,374 |              | $ | 11
|               |  | $                 | 1,537 |              | $ | 15



The
aforementioned acquisition of Vertical Networks Inc. is the reason for the substantial increase in inventory.



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.



RESTATEMENT



Our previously issued consolidated balance sheets as of September 30, 2004 have been restated.



The following Managements Discussion and Analysis has been restated to
reflect the changes more fully described within note 2 of the notes to restated consolidated financial 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 Securities and Exchange Commission. 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 acquisition of Vertical Networks. The estimated values of current assets and liabilities were based upon their historical costs in the hands of the
seller 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 most closely approximated fair value. 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. The preliminary
estimated value of



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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 the Company to fulfill the contractual obligations acquired under various customer contracts plus a fair value profit margin. This estimate is likely to change once we complete a thorough analysis of our post
acquisition cost structure, particularly with respect to these contracts



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, 2004, as filed with the Securities and Exchange Commission on October 13, 2004.



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, 2004. 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.



The Company has 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 a software based 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,
TeleVantage Call Center Scoreboard, TeleVantage Call Classifier, TeleVantage Smart Dialer and TeleVantage Persistent Pager. 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, 2004, Artisoft had total net revenue
of approximately $2.9 million compared to total net revenue for the same period in fiscal year 2003 of approximately $2.0 million. The increase of approximately $1 million in revenue from year to year is attributable to an increase of
TeleVantage product revenue of $.5 million. We achieved this through an increase in the number of TeleVantage licenses sold. 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. We expect revenues to
increase in the quarter ending December 31, 2004 and in the fiscal year ending June 30, 2005 as a result of the acquisition of Vertical Networks, Inc.



Gross margins for the quarter ended September 30, 2004 decreased to 87.6%, compared to 97.1% 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 96.9% while the
InstantOffice products sold during the quarter had an average gross margin of 38.7%. The cost of goods for InstantOffice products includes several elements of telecommunication hardware, both of its own design and the design of third parties, which
is all manufactured by third parties. The Company expects over time, to decrease its sales of these hardware products and believes this will contribute to an increase in the Companys gross margins.



Operating expenses for the quarter ended September 30, 2004 increased
approximately 36.8%, compared to the same period in the prior fiscal year. Sales and marketing expenses increased by 33.3% due to costs associated with an increase in personnel in the sales and marketing organization resulting from an investment in
additional field personnel and an investment in increased lead generation activities.



Expenses in product development increased by 11.8% during the quarter ended September 30, 2004 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.



General and administrative expenses increased approximately 68% compared to the same period in the prior fiscal year. This
increase reflects approximately $.5 million in severance costs relating to the separation of our former President and CEO.



The Company expects operating expenses in all areas to increase significantly in the second quarter of fiscal year 2005 except for the $.5 million
severance costs associated with executive compensation incurred in the quarter ended September 30, 2004. The Company also expects operating expenses to increase for the balance of fiscal year 2005. These expected increases are as a result of
the acquisition of Vertical Networks 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, 2004. However, the Company
believes that it will be able to reduce some of these additional operating expenses over time as redundant operations are eliminated and overhead cost elements are reduced.



Results of Operations



Net Product Revenue



Net product revenue was $2.9 million for the quarter ended September 30, 2004, representing an increase of 49.2% from $2.0 million for the
quarter ended September 30, 2003.



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The increase in revenue in the quarter ended September 30, 2004 compared to the quarter ended
September 30, 2003 resulted from the growth in TeleVantage software sales of licenses for use by end-users by $0.4 million, and the addition of revenue of $0.5 million from the sale of InstantOffice products between September 28,
and September 30, 2004. The Company believes that the amount of this additional revenue from the sale of InstantOffice products over the last three days of the quarter was unusually large due to a temporary backlog for the InstantOffice
product.



End-user license sales of TeleVantage for the quarter
ended September 30, 2004 increased by 20.5%, over the quarter ended September 30, 2003.



We distribute our products both domestically and internationally. International product revenue was $.3 million, or 11.8% of total revenue, for the
quarter ended September 30, 2004 and $.3 million, or 18% of total revenue, for the quarter ended September 30, 2003.



In January 2000, Artisoft entered into an OEM and Reseller Agreement with Toshiba. Also in January 2000, Artisoft entered into an agreement with
Toshiba under which Toshiba acquired 16,666 shares of Artisoft common stock at a price of $41.964 per share and was issued warrants for an additional 8,333 shares of Artisoft common stock at an exercise price of $41.964 per share. The fair market
value of the Artisoft common stock on the date of execution of the definitive agreement was $129. The difference between the issuance price and fair market value of the Artisoft 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. Artisoft 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, 2004 and September 30, 2003 net product revenue was reduced by
amortization of Deferred Toshiba Equity Costs of $.1 million.



Gross Profit(in thousands, except percentages)



|                 |  |                    |   |  |                   |   |  |       
|---------------- |  | ------------------ | - |  | ----------------- | - |  | ------
|                 |  | Three Months Ended |   |  |                  
|                 |  | September 30,2004  |   |  | September 30,2003 |   |  | Change
|Gross Profit     |  | 2,569              |   |  | 1,909             |   |  | 660   
|% of Net Revenue |  | 87.6               | % |  | 97.1              | % |  |       



The decrease in gross
profit as a percentage of net revenue for the three-month period ended September 30, 2004, compared to the corresponding period ended September 30, 2003, was due primarily to the addition of revenue from InstantOffice sales for the three
days ended September 30, 2004. 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 for the three day period ended September 30, 2004 and was also due to a 25% increase in the sales of TeleVantage software licenses.



Operating Expenses(in thousands, except percentages)



|                           |  |                    |   |  |                   |   |  |        |  
|-------------------------- |  | ------------------ | - |  | ----------------- | - |  | ------ | -
|                           |  | Three Months Ended |   |  |                   |  
|                           |  | September 30,2004  |   |  | September 30,2003 |   |  | Change |  
|Sales and Marketing        |  | 1,798              |   |  | 1,349             |   |  | 33.3   | %
|% of Net Revenue           |  | 61.3               | % |  | 68.6              | % |  |        |  
|Product Development        |  | 873                |   |  | 781               |   |  | 11.8   | %
|% of Net Revenue           |  | 29.8               | % |  | 39.7              | % |  |        |  
|General and Administrative |  | 1,302              |   |  | 775               |   |  | 68     | %
|% of Net Revenue           |  | 44.4               | % |  | 39.4              | % |  |        |  
|Total Operating Expenses   |  | 3,973              |   |  | 2,905             |   |  | 36.8   | %
|% of Net Revenue           |  | 135.4              | % |  | 147.7             | % |  |        |  



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##### Table of Contents

Sales and Marketing



The decrease in sales and marketing expense as a percentage of total net revenue for the quarter ended September 30,
2004, compared to the corresponding period ended September 30, 2003, was due primarily to an increase in TeleVantage sales and incremental InstantOffice sales. While sales and marketing expenses increased, their costs as a percentage of revenue
decreased from 68.6% to 61.3%. However, InstantOffice net revenue during the three day period following the acquisition was associated with a very low percentage of related sales and marketing expense. The Company believes that this was an anomaly
created by a temporary backlog for the InstantOffice product. The increase in sales and marketing expenses in aggregate dollars for the three month ended September 30, 2004 compared to the corresponding period ended September 30, 2003 was
due primarily to an increase in payroll and related expenses due to increased personnel, along with a small increment of expenses related to InstantOffice sales and marketing following the acquisition. The Company employed 48 sales and marketing
personnel throughout the quarter ended September 30, 2004, and added 21 sales and marketing personnel with the acquisition of Vertical Networks. The Company employed 38 sales and marketing personnel throughout the quarter ended
September 30, 2003.



Product Development



The decrease in product development expenses as a
percentage of total revenue for the quarter ended September 30, 2004, compared to the corresponding period ended September 30, 2003, was due primarily to the increase in net product revenue. Product development expense grew 11.8% from
September, 2003 to September, 2004. The increase in product development expenses, during the quarter ended September 30, 2004, compared to the quarter ended September 30, 2003, was driven by increased payroll expenses and employee related
costs. The Company employed 26 product development personnel throughout the quarter ended September, 2004, and added 36 product and development personnel with the acquisition of Vertical Networks. The Company employed 24 product development
personnel throughout the quarter ended September 30, 2003.



General and Administrative



The increase in
general and administrative expenses as a percentage of total revenue for the quarter ended September 30, 2004, compared to the quarter ended September 30, 2003, was due primarily to approximately $.5 million in severance costs
relating to the separation of our former President and CEO. This amount accounted for 95% of the $527,000 increase in general and administrative expenses during the first fiscal quarter of 2005, compared to the first fiscal quarter of 2004. However,
general and administrative expenses as a percentage of revenue in the quarter ended September, 2004 increased by only 5% in comparison to the quarter ended September 30, 2003. This was primarily due to an increase in TeleVantage revenue and
incremental InstantOffice revenue for the three day period September 28 through September 30, 2004. The Company employed 11 general and administrative personnel throughout the quarter ended September 30, 2004, and added 10 general and
administrative personnel with the acquisition of Vertical Networks. The Company employed 10 general and administrative personnel throughout the quarter ended September 30, 2003.



Financial Condition, Liquidity And Capital Resources (in thousands)



|                                        |  |                   |  |              |   |  |       
|--------------------------------------- |  | ----------------- |  | ------------ | - |  | ------
|                                        |  | Positions at      |  |              |  
|                                        |  | September 30,2004 |  | June 30,2004 |   |  | Change
|Cash and cash equivalents               |  | 7,256             |  | 2,747        |   |  | 4,509 
|Working capital (excl. restricted cash) |  | 2,939             |  | (110         | ) |  | 3,049 



|                                      |  |                                      |   |  |                                      |   |  |           
|------------------------------------- |  | ------------------------------------ | - |  | ------------------------------------ | - |  | ----------
|                                      |  | Three Months EndedSeptember 30, 2004 |   |  | Three Months EndedSeptember 30, 2003 |   |  | Difference
|Cash used in operating activities     |  | (2,431                               | ) |  | (1,011                               | ) |  | 1,417     
|Cash used in investing activities     |  | (14,289                              | ) |  | (46                                  | ) |  | 14,243    
|Cash provided by financing activities |  | 21,229                               |   |  | 3,431                                |   |  | 17,798    



We believe that our
cash resources, including the additional $5 million which the Company raised on October 1, 2004 as the second tranche of the September 2004 financing, are adequate to meet our short term requirements. In the longer term, we believe that
revenues will increase and after taking into account the anticipated elimination of redundant operations and the reduction of overhead cost elements following our acquisition of Vertical Networks (which initiatives we may not successfully implement
and the result, which may not be as significant as we expect) that operating expenses will decrease as a percentage of net revenue, thereby reducing future operating losses. However, the rate at which these revenues may increase will be highly
dependent on, among other things, the overall telecommunications industry capital-spending environment, the rate of market acceptance of the TeleVantage and InstantOffice products and the success of our strategic relationships including those with
IBM, AT&T and Toshiba. See Risk Factors below.



If we require additional cash to meet future requirements, or if the level of growth of TeleVantage and InstantOffice revenue is insufficient to meet our long-term business objectives or if we determine we require additional capital for
other business reasons, such as to fund acquisitions or other strategic initiatives, we will need to pursue additional equity or debt financing. Such financings may not be available on terms acceptable to us or at all, may significantly affect our
stockholders, including for example, by substantially diluting their ownership interest in Artisoft.



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##### Table of Contents

We used cash of $2.4 million to fund operating activities during the three months ended
September 30, 2004. The cash used in operating activities was due primarily to a net loss of $1.4 million, offset by depreciation and amortization of $.1 million, and amortization of deferred Toshiba equity costs of $.1 million,
and $.1 million relating to a non-cash reserve charge. At September 30, 2004, compared to at June 30, 2004, trade receivables increased by $1.2 million and accounts payable decreased by $.7 million. These were offset by a
reduction in prepaid expenses of $.2 million, inventory of $.1 million, accrued liabilities increased by $.2 million and deferred revenue increased by $.1 million.



Working capital, consisting of total current assets minus current liabilities, was $2.9 million at September 30,
2004, 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 Artisoft. This compared to a
working capital deficit of $(.1) million at June 30, 2004, representing an increase of $3 million. The increase in working capital at September 30, 2004 reflects an increase of $3.5 million in cash and cash equivalents. The
increase in cash and cash equivalents of approximately $4.5 million was primarily a result of our receipt of $22.5 million from the sale of common stock in our September 2004 financing, less, during the three months ended
September 30, 2004, cash of $2.4 million used in operations, $1.3 million for expenses related to our September 2004 financing and $14.3 million expended in investing activities. Investing activities included
$14.2 million to acquire the assets and liabilities of Vertical Networks Inc. and the associated costs related to this acquisition. Increases in working capital were offset by an increase of $3.9 million in accounts payable,
$0.5 million in current deferred revenue and $1.8 million in accrued liabilities, including the acquired liabilities. Notes payable increased by $.3 million. The growth in working capital was aided by an increase in trade accounts
receivable and inventory of $4.8 million and $1.5 million respectively.



In January 2000, Artisoft entered into an OEM and Reseller Agreement with Toshiba. Also in January 2000, Artisoft entered into an agreement with Toshiba under which Toshiba acquired 16,666 shares of Artisoft
common stock at a price of $41.964 per share and was issued warrants for an additional 8,333 shares of Artisoft common stock at an exercise price of $41.964 per share. The fair market value of the Artisoft common stock on the date of execution of
the definitive agreement was $129. The difference between the issuance price and fair market value of the Artisoft 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. Artisoft 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 two quarters ended September 30, 2004 and September 30, 2003, revenue was reduced by the amortization of Deferred Toshiba Equity Costs $.1 million.



The Company leases office, product packaging, storage space
and equipment under noncancelable operating lease agreements expiring through 2005. The table below also includes those contractual payments acquired on the acquisition of Vertical Networks on September 28, 2004.



|                                           |  |                       |  |                  |  |           |  |           |  |                 
|------------------------------------------ |  | --------------------- |  | ---------------- |  | --------- |  | --------- |  | ----------------
|                                           |  | Payment due by Period
|Contractual Obligations                    |  | Total                 |  | Less than 1 year |  | 1-3 years |  | 3-5 years |  | More than5 years
|Long-term Debt ObligationsCurrent Portion |  | 272,000               |  | 272,000          |  |          |  |          |  |                
|Capital Lease Obligations                  |  |                      |  |                 |  |          |  |          |  |                
|Operating Lease Obligations                |  | 1,327,000             |  | 1,091,000        |  | 236,000   |  |          |  |                
|Total                                      |  | 1,599,000             |  | 1,363,000        |  | 236,000   |  |          |  |                



On September 28,
2004, Artisoft completed the acquisition of substantially all of the assets of Vertical Networks, a leading provider of distributed IP-PBX software and communications solutions to large enterprises, other than patents and patent rights, pursuant to
the terms of an asset purchase agreement entered into on September 23, 2004. Artisoft has 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 purchased by Artisoft. In addition, Artisoft assumed specified liabilities of Vertical Networks.



The purchase price for Vertical Networks consisted of: $13.5 million in cash, paid at closing except for $1.0 million held in escrow to secure
Vertical Networks indemnification obligations to Artisoft, the assumption of most liabilities of Vertical Networks and up to $5.5 million in cash payable under an earn-out provision in an amount equal to the first $5.5 million of
non-refundable software license revenues received in cash by Artisoft from CVS Pharmacy, Inc. with respect to various types of Vertical Networks software to be used by CVS in connection with a rapid prescription refill project that it plans to
roll out to its stores and other projects. The Company is also obligated to pay additional amounts which we estimate to be approximately $5 million, representing professional fees associated with the transaction and assumed liabilities acquired
in excess of expected working capital level.



The acquisition
was financed with a portion of the proceeds from a $27.5 million common stock financing also completed on September 28, 2004 and shortly thereafter, pursuant to which Artisoft sold a total 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. In connection with, or prior to the financing, the holders of all shares of Artisofts preferred stock converted those shares into common stock. Following the
issuance and sale of common stock in the financing and the conversions of Artisofts preferred stock to common stock, M/C Venture Partners is now the largest beneficial holder of Artisofts common stock, with a 51.69% beneficial ownership
interest.



Artisoft is required to register, under the
Securities Act of 1933, the shares issued and sold under the stock purchase agreement for resale



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by the investors. Artisoft has agreed to file with the Securities and Exchange Commission the registration statement with respect to this registration by
November 12, 2004 and to use its best efforts to cause the registration statement to become effective on or before December 31, 2004. Artisoft has not yet filed the registration statement. If the registration statement is not declared
effective by the SEC on or prior to March 31, 2005 or if the registration statement, after being declared effective, ceases to be effective and available 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, Artisoft will be required to pay each investor in the financing liquidated damages in an amount equal to 1% of the aggregate purchase price paid by the investor under the purchase agreement (not
to exceed 9% of such purchase price, in the aggregate). Artisoft has 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. As of the date of this filing, the Company has not filed this registration statement, is in breach of its obligation to do so, and can make no assurance that the registration statement, when filed,
will be declared effective on or before March 31, 2005.



Artisoft also agreed to several negative covenants under the stock purchase agreement. Artisofts 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 Artisoft; 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 its 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 its compensation committee;
liquidate or dissolve; change the size of Artisofts board of directors; amend Artisofts certificate of incorporation or bylaws; change the nature of Artisofts business; or alter the voting rights of shares of Artisofts
capital stock in a disparate manner.



As a result of the sale
of common stock under the stock purchase agreement, the exercise price of all of the warrants to purchase an aggregate of 466,664 shares of common stock issued in Artisofts 2001 financing and all of the warrants to purchase an aggregate of
2,627,002 shares of common stock issued in Artisofts 2003 financing was reduced to $1.1386 per share pursuant to the terms of those warrants. Immediately prior to the sale of common stock under the purchase agreement, the exercise price of the
warrants issued in 2001 was $1.50 per share, and the exercise price of the warrants issued in 2003 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.



Our common stock currently trades on the over-the-counter electronic bulletin board, also referred to as the OTCBB. The listing of our common stock on the OTCBB may reduce the price of our common stock and the levels of liquidity available
to our stockholders. In addition, the listing of our common stock on the OTCBB could materially adversely affect our access to the capital markets, and the limited liquidity and reduced price of our common stock could materially adversely affect our
ability to raise capital through alternative financing sources on terms acceptable to us or at all. Our listing on the OTCBB may have 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.



Furthermore, our failure to timely file our Exchange Act reports may result in our common stock being delisted from the OTC Bulletin Board and adversely affect our ability to list our common stock on a national
exchange or the NASDAQ Stock Market (See Risk FactorsWe are not current in our Exchange Act reports and may fail to timely file periodic Exchange Act reports in the future.)



We intend to continue investing in the sales, marketing and development of
our TeleVantage and InstantOffice 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.



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 Securities and Exchange Commission, press releases, communications with investors and oral
statements. Any or all of our forward-looking statements in this quarterly report on 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 Securities and Exchange Commission.



Our revenues are dependent upon sales of two families of products, and our business will fail if we do not increase sales of those products.



Our revenues are derived from sales of two families of products, TeleVantage
and InstantOffice. If we are not able to increase sales of these products, our business will fail. TeleVantage and InstantOffice are relatively new products in the emerging market for server-based phone systems and it is difficult to predict when or
if sales of TeleVantage and InstantOffice will increase substantially or at all. We face a substantial risk that our sales will continue to not cover our operating expenses and that we will continue to incur operating losses.



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



We had operating losses for the quarter ended September 30, 2004 and in
each of the last ten fiscal years. We also had negative cash flow from operating activities in the quarter ended September 30, 2004 and in five out of the last nine fiscal years. If our revenues do not increase significantly, without a
corresponding increase in expenses, we may never achieve profitability, on a sustained basis or at all, or generate



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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 its last three fiscal years, and had negative cash flow from operating activities many of which were acquired when the Company acquired most of the assets of Vertical Networks.
The operations acquired from Vertical Networks may not generate profits or positive cash flow.



Our operating results vary, making future operating results difficult to predict and adversely affecting the price of our common stock.



Our operating results have in the past fluctuated, and may in the future fluctuate, from quarter to quarter. The resulting
continued unpredictability of our operating results could depress the market price of our common stock, particularly if operating results do not meet the expectations of public market analysts or investors. Factors that contribute to fluctuations in
our operating results include:



| |  |  | the extent and timing of sales to significant customers, particularly Toshiba, Staples and CVS/pharmacy;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | our ability to develop, introduce and market enhancements to our TeleVantage and InstantOffice families of products;
| | - |  | --------------------------------------------------------------------------------------------------------------------



| |  |  | changes in pricing policies or price reductions by us or our competitors;
| | - |  | -------------------------------------------------------------------------



| |  |  | variations in sales by our value-added resellers and distributors; and
| | - |  | ----------------------------------------------------------------------



| |  |  | variations in product returns.
| | - |  | ------------------------------



Sales in any quarter are dependent primarily on orders booked and shipped in that quarter and are not predictable with any degree of certainty. In
addition, our expense levels are based, in part, on our expectations as to future revenues. If revenue levels are below our expectations, net loss may be disproportionately affected due to fixed costs related to generating our revenues.



We rely upon the availability of distributors, resellers, systems integrators and
original equipment manufacturers to market TeleVantage and the ability of these organizations to pay for the products they purchase from us.



If distributors, resellers, systems integrators and original equipment manufacturers in the software industry choose not to focus their marketing efforts
on software-based phone systems or on products competitive with TeleVantage, our sales efforts will be materially adversely affected. In the quarter ended September 30, 2004, our distributor, Paracon accounted for 22% of our total net sales and
Staples accounted for 16%. In fiscal year 2004, our distributor, Paracon, accounted for 37% of our total net sales. In fiscal year 2003, Paracon accounted for 42% of our total net sales. We depend upon the availability of distribution outlets
similar to these relationships to market TeleVantage. In addition, our operating results would be adversely affected if one of our major distributors, resellers or original equipment manufacturers fails to pay us for the products they purchase from
us. At June 30, 2004, Paracon represented approximately 31% of our outstanding trade receivables. At June 30, 2003, Paracon represented approximately 36% of our outstanding trade receivables. Our relationship with Paracon is through its
subsidiary Scansource, which is doing business as Catalyst Telecom.



If we
lose the services of our Chief Executive Officer we may not be able to implement our business model successfully, which could harm our ability to remain competitive in our market.



Our future success depends to a significant extent on the continued service of and effective working relationship with
William Tauscher, our Chairman of the Board, President and Chief Executive Officer. Our business may suffer if we lose the services of Mr. Tauscher.



The integration of Artisofts and Vertical Networks businesses may distract management from achieving its operational objectives which could limit
Artisofts ability to retain its employees.



The
integration of Artisofts and Vertical Networks businesses will require the dedication of management resources. This may distract managements attention from the day-to-day business of Artisoft. Employee uncertainty and lack of focus
during integration may also disrupt the business of Artisoft. The retention by Artisoft of key employees is critical to ensure continued advancement, development and support of Artisofts technologies as well as on-going sales and marketing
efforts. During the integration phase, competitors may intensify their efforts to recruit key employees. Artisoft may not be able to retain key technical, sales or marketing personnel, which would adversely affect Artisofts business.



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If Artisoft and Vertical Networks cannot be successfully integrated, the anticipated advantages of the recent
acquisition of Vertical Networks may not be realized.



In
order to maintain and increase profitability Artisoft will need to successfully integrate and streamline overlapping functions of Vertical Networks. The desired cost savings may not be achieved and the integration of Artisofts and Vertical
Networks operations may not be accomplished smoothly, expeditiously or successfully.



We are not current in our Exchange Act reports and may fail to timely file periodic Exchange Act reports in the future.



We failed to timely file our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2004. We also failed to timely file
an amendment to our Current Report on Form 8-K originally filed September 29, 2004, to disclose the pro forma financial statements of Vertical Networks. As a result, we are not current in our Exchange Act reports and will be ineligible to
register our securities on Form S-3 for the next twelve months 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 may result in our common stock being
delisted 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 stock were to be delisted from the OTC Bulletin Board, the market for our common
stock would become severely restricted and you 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 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 delisted 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 tends to be less liquid and subject to volatile stock prices.



We may need to procure additional third party financing, but financing may not be available when needed or upon terms acceptable to us.



In order to obtain the funds to continue our operations
and meet future working capital requirements, we may require additional equity financing or debt financing. The proceeds from our September 2004 common stock financing may not be sufficient to meet our future business needs. Any additional
financing may not be available to us on terms acceptable to us or at all.



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



We compete with other phone system companies, many of which have substantially greater financial, technological, production, sales and marketing and other
resources, as well as greater name recognition and larger customer bases, than does Artisoft. Given the greater financial resources of many of our competitors, our products may not be successful or even accepted. The computer telephony industry is
highly competitive and is characterized by rapidly evolving industry standards. We believe that the principal competitive factors affecting the markets we serve include:



| |  |  | product architecture, functionality and features;
| | - |  | -------------------------------------------------



| |  |  | price;
| | - |  | ------



| |  |  | vendor and product reputation;
| | - |  | ------------------------------



| |  |  | quality of product and support; and
| | - |  | -----------------------------------



| |  |  | effectiveness of sales and marketing efforts.
| | - |  | ---------------------------------------------



Our competitors may be able to respond more quickly and effectively than can Artisoft to new or emerging technologies and changes in customer requirements
or to devote greater resources than can Artisoft to the development, promotion, sales and support of their products.



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



Our product lines, TeleVantage and InstantOffice, compete
in the newly emerging server-based phone system market, as well as existing traditional, proprietary hardware solutions offered by companies such as Avaya Communications, Nortel Networks Corporation and Siemens Corporation. We do not know if markets
will migrate toward server-based phone system solutions. If server-based phone systems do not achieve widespread acceptance or widespread acceptance is delayed, sales of TeleVantage and InstantOffice will not increase and may decline. We may then be
unable to continue our operations.



Variability in product returns makes it
difficult to predict our revenue.



We are exposed to the
risk of product returns from our systems integrators, distributors and value-added resellers, which are estimated and recorded by us as a reduction in sales. Actual returns in any period may exceed our estimates, thereby making it difficult to
predict our revenues. To the extent we may, in the future, introduce new products, the predictability and timing of sales to end-users and the management of returns to us of unsold products by distributors and volume purchasers may become more
complex.



Our market is subject to changing preferences and technological
change; our failure to keep up with these changes would result in our losing market share.



The introduction of products incorporating new technologies and the emergence of new industry standards could render our products obsolete and
unmarketable. If this occurs, we would likely lose market share. The markets for computer telephony solutions are characterized by rapid technological change, changing customer needs, frequent product introductions and evolving industry standards
within the markets for computer technology solutions. Our future success will depend upon our ability 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.



M/C Venture Partners has acquired a substantial interest in Artisoft and may be able to exert substantial influence over Artisofts actions.



Based upon its substantial stock ownership and their director rights, M/C
Venture Partners may be able 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. As of October 1, 2004, M/C Venture Partners beneficially owned approximately 51.69% of our common stock. In addition to its beneficial ownership interest in Artisofts common stock, the stock purchase
agreement governing M/C Venture Partners September 2004 investment in Artisoft provides for significant board of directors rights, and other privileges, for M/C Ventures.



The stock purchase agreement provides that, initially, (1) M/C Venture Partners may designate two members of
Artisofts board of directors and (2) M/C Venture Partners and Artisofts board of directors may designate by mutual agreement two other directors. Pursuant to these provisions, M/C Venture Partners has designated John P. Ward and
Matthew J. Rubins, each a general partner of M/C Venture Partners, as Artisoft directors, and M/C Venture Partners and Artisofts board of directors have mutually agreed to designate Michael P. Downey and Francis E. Girard, each an existing
Artisoft director, Artisoft directors. Following March 28, 2005, the stock purchase agreement provides that (1) M/C Venture Partners may designate two members of Artisofts board of directors and (2) M/C Venture Partners and
Artisofts board of directors may designate by mutual agreement three directors with relevant industry experience. M/C Venture Partners designees are entitled to membership on the compensation and nominating committees of the board of
directors.



Artisoft also agreed under the stock purchase
agreement that it would not, without the prior consent of M/C Venture Partners, take any of the following actions: enter into a transaction involving a change in control of Artisoft; 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 its 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 its compensation committee; liquidate or dissolve; change the size of Artisofts board of directors; amend Artisofts
certificate of incorporation or bylaws; change the nature of Artisofts business; or alter the voting rights of shares of Artisofts capital stock in a disparate manner.



M/C Venture Partners may elect to sell all or a substantial portion of their Artisoft securities to one or more third
parties. In that case, a third party with whom we have no prior relationship could exercise the same degree of control over us as M/C Venture Partners presently does.



If the employment of our Senior Vice President of Development is terminated prior to December 2006 without cause or by the executive
for good reason, we will be required to provide substantial benefits to that officer.



We have a change in control agreement with our Senior Vice President of Development, Christopher H. Brookins that provides that in the event of termination of Mr. Brookins employment within two years of a
change in control either without cause or by Mr. Brookins for good reason, such as a reduction in duties and responsibilities:



| |  |  | all of Mr. Brookins unvested options vest and become exercisable in full; and
| | - |  | ------------------------------------------------------------------------------



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| |  |  | Artisoft will pay Mr. Brookins a lump sum equal to one years base salary plus bonus.
| | - |  | -------------------------------------------------------------------------------------



Due to open market purchases of our common stock, a change in control, within the meaning of the change in control
agreement, occurred in December 2002. Therefore, Mr. Brookins will receive benefits under his change in control agreement in the event his employment at Artisoft is terminated prior to December 2006 either without cause or for good
reason. Mr. Brookins current annual salary is $180,000 and he did not receive a bonus during the 2004 fiscal year.



Software errors may damage our reputation, cause loss of customers and increase customer support costs.



Telecommunications products as complex as TeleVantage and InstantOffice may
contain undetected errors. This could result in damage to our reputation, loss of customers, delay of market acceptance of our products or all of these consequences. We, or our customers may find errors in TeleVantage or InstantOffice 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.



We rely on third-party technology and hardware products. This technology may contain undetected errors, be superseded or may become unavailable, thereby limiting our
ability to sell, and the performance of, our products.



TeleVantage operates on hardware manufactured by Intel. To the extent that this hardware becomes unavailable or in short supply we could experience delays in shipping TeleVantage to our customers. In addition, we are dependent on the
reliability of this hardware and to the extent the hardware has defects it will affect the performance of TeleVantage. If the hardware becomes unreliable, does not perform in a manner that is acceptable to our customers or becomes more expensive,
sales of TeleVantage could fall.



Because our products run only
on Microsoft Windows NT servers and use other Microsoft Corporation technologies, including the Microsoft Data Engine, a decline in market acceptance for Microsoft technologies or the increased acceptance of other server technologies could cause us
to incur significant development costs and could have a material adverse effect on our ability to market our current products.



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



Our success is dependent upon our software code base, our programming
methodologies and other intellectual properties. If we are unable to protect these properties, we will not be able to remain technologically competitive and our business will suffer. To protect our proprietary technology, we rely primarily on a
combination of trade secret laws and nondisclosure, confidentiality, and other agreements and procedures, as well as copyright and trademark laws. These laws and actions may afford only limited protection. We may not be able to deter
misappropriation of our proprietary information or to prevent the successful assertion of an adverse claim to software utilized by us. In addition, we may not be able to detect unauthorized use and take effective steps to enforce our intellectual
property rights. In selling our products, we rely primarily on shrink wrap licenses that are not signed by licensees and, therefore, may be unenforceable under the laws of some jurisdictions. In addition, the laws of some foreign
countries provide substantially less protection to our proprietary rights than do the laws of the United States.



If we are not able to hire and retain qualified personnel, we will be hindered in our efforts to maintain and expand our business.



We are dependent on our ability to identify, hire, train, retain and
motivate high quality personnel, especially highly skilled engineers involved in the ongoing research and development required to develop and enhance our software products and introduce enhanced future products. If we are not able to hire and retain
qualified personnel, we will be hindered in our efforts to maintain and expand our business. The computer telephony industry is characterized by rapid technological change, changing customer needs, frequent product introductions and evolving
industry standards. These characteristics require a high degree of industry-specific technological and operational understanding. A high level of employee mobility and aggressive recruiting of skilled personnel characterize our industry. There can
be no assurance that our current employees will continue to work for us or that we will be able to hire additional employees on a timely basis or at all. We expect to grant additional stock options and provide other forms of incentive compensation
to attract and retain key technical and executive personnel. These additional incentives will lead to higher compensation costs in the future and may adversely affect our future results of operations.



Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Market Risk.During the normal course of business Artisoft is 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. Artisoft currently assesses these risks and has established policies and practices to protect against the adverse effects of these and other potential exposures.
Although Artisoft does 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.Artisoft may be exposed to interest rate risk on certain of its cash equivalents. The value of
certain of the Companys investments may be adversely affected in a rising interest rate investment environment. Although Artisoft does 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.



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Item 4CONTROLS AND PROCEDURES



Artisofts management, with the participation of Artisofts chief executive officer and chief financial officer, evaluated the effectiveness of Artisofts disclosure controls and procedures (as defined in Rules 13a-15(e)
and 15d-15(e) under the Exchange Act) as of September 30, 2004. Based on this evaluation, Artisofts chief executive officer and chief financial officer concluded that, as of September 30, 2004, Artisofts disclosure controls and
procedures were (1) designed to ensure that material information relating to Artisoft, including its consolidated subsidiaries, is made known to Artisofts chief executive officer and chief financial officer by others within those
entities, particularly during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be disclosed by Artisoft in the reports that it files or submits under
the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms.



The Companys independent auditors, KPMG LLP, have advised management and the Audit Committee that, in connection with KPMGs review of the
financial statements of the Company for the three month period ended September 30, 2004, it noted certain matters involving internal control and its operation that constituted reportable conditions under standards established by the American
Institute of Certified Public Accountants. Reportable conditions are matters coming to an independent auditors 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. KPMG advised management and the Audit Committee that it considered
the following to constitute reportable conditions related to internal control and their operations: the Company did not have adequate staffing in its 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, Inc. and the associated integration activities.



The Company is still in the process of assessing the findings of its
independent auditors. As noted above, however, the Company has made and is continuing to make changes in its controls and procedures, including its internal control over financial reporting, aimed at enhancing their effectiveness and ensuring that
the Companys systems evolve with, and meet the needs of, the Companys business. The Company is also continually striving to improve its management and operational efficiency and the Company expects that its efforts in that regard will
enhance and strengthen the Companys controls and procedures, including its internal control over financial reporting. For example, the Company has recently added to its accounting staff and expects to hire additional professionals to upgrade
and reinforce the technical resources available to the staff. The Company is also continuing its efforts to upgrade its information technology capabilities and is preparing for the implementation of a uniform and consolidated accounting system at
all of its business units. The Company will also hire an outside firm, not affiliated with its independent auditors, to complete an objective review of internal controls and provide recommendations for continued improvement of financial processes
and controls, in preparation for Sarbanes-Oxley compliance testing.



No change in Artisofts internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2004 that has materially affected,
or is reasonably likely to materially affect, Artisofts internal control over financial reporting.



PART IIOTHER INFORMATION



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



On September 28, 2004, Artisoft 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 its common stock at a per share cash purchase price of $1.1386. Artisoft received gross
proceeds from the sale of $22.5 million. On October 1, 2004, Artisoft sold the remaining 4,391,358 shares of its 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. Artisoft 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.



Item 6EXHIBITS



The
Exhibits filed as part of this quarterly report on Form 10-Q for the quarter ended September 30, 2004 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. Artisofts 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: October 13, 2005 |  | By             |  | /s/ WILLIAM Y. TAUSCHERWilliam Y. Tauscher Chief Executive Officer and Chairman of the Board                         
|                       |  |               
|Date: October 13, 2005 |  | By             |  | /s/ DUNCAN G. PERRYDuncan G. Perry Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer)



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EXHIBIT INDEX



|            |  |                                                                                                                                                                                               
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                   
|10.1        |  | Sublease, dated January 7, 2000, by and between Vertical Networks Inc. and MMC Networks Inc., filed as Exhibit 10.1 of the Registrants Form 10-Q filed on January 25,
2005.                  
|            | 
|+10.2       |  | Software Purchase Agreement, dated August 20, 2004 by and between Vertical Networks Inc. and CVS Pharmacy Inc., filed as Exhibit 10.2 of the Registrants Form 10-Q filed on
January 25, 2005.
|            | 
|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 Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                             

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|+ | Confidential materials omitted and filed separately with the Commission
|- | -----------------------------------------------------------------------



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