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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549





FORM 10-Q





(Mark One)

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

For the quarterly period ended March 31, 2008

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





VERTICAL COMMUNICATIONS, INC.

(Exact Name of Registrant as Specified in
Its Charter)







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

Ten Canal Park, Cambridge, Massachusetts 02141

(Address of Principal Executive Offices) (Zip Code)

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





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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller
reporting company. See definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):



|                                              |  |                             
|--------------------------------------------- |  | ----------------------------
|Large Accelerated Filer   ̈                    |  | Accelerated Filer   ̈        
|Non accelerated Filer   ̈                     |  | Smaller Reporting Company  x
|(Do not check if a smaller reporting company) |  |                             

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 May 9, 2008
|Common Stock, $0.01 par value per share |  | 52,377,272                          









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##### Table of Contents

VERTICAL COMMUNICATIONS, INC.

FORM 10-Q

TABLE OF CONTENTS



|        |  |                                                                                                                        |  |     
|------- |  | ---------------------------------------------------------------------------------------------------------------------- |  | ----
|        |  |                                                                                                                        |  | Page
|PART I  |  | FINANCIAL INFORMATION                                                                                                  |  |     
|        |  |                                                                                                                       
|        |  | Item 1. Condensed Consolidated Financial Statements                                                                    |  | 3   
|        |  |                                                                                                                       
|        |  | Condensed Consolidated Balance Sheets as of March 31, 2008 (unaudited) and June 30, 2007                               |  | 3   
|        |  |                                                                                                                       
|        |  | Condensed Consolidated Statement of Operations for the three and nine months ended March 31, 2008 and 2007 (unaudited) |  | 4   
|        |  |                                                                                                                       
|        |  | Condensed Consolidated Statement of Cash Flows for the nine months ended March 31, 2008 and 2007 (unaudited)           |  | 5   
|        |  |                                                                                                                       
|        |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                                       |  | 6   
|        |  |                                                                                                                       
|        |  | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations                          |  | 14  
|        |  |                                                                                                                       
|        |  | Item 3. Quantitative and Qualitative Disclosures about Market Risk                                                     |  | 21  
|        |  |                                                                                                                       
|        |  | Item 4. Controls and Procedures                                                                                        |  | 21  
|        |  |                                                                                                                       
|PART II |  | OTHER INFORMATION                                                                                                      |  |     
|        |  |                                                                                                                       
|        |  | Item 1. Legal Proceedings                                                                                              |  | 22  
|        |  |                                                                                                                       
|        |  | Item 1A. Risk Factors                                                                                                  |  | 22  
|        |  |                                                                                                                       
|        |  | Item 6. Exhibits                                                                                                       |  | 23  
|        |  |                                                                                                                       
|        |  | Signature                                                                                                              |  | 24  



2



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##### Table of Contents

PART I  FINANCIAL INFORMATION

Item 1.  FINANCIAL STATEMENTS

VERTICAL COMMUNICATIONS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)



|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------ | -------- | - | ------------ | - | ------- | -
|                                                                                                                                                                                                         |  | March 31,2008(Unaudited) |          |   | June 30,2007 |  
|ASSETS                                                                                                                                                                                                   |  |                          |          |   |              |   |         |  
|Current assets:                                                                                                                                                                                          |  |                          |          |   |              |   |         |  
|Cash and cash equivalents                                                                                                                                                                                |  | $                        | 3,879    |   |              | $ | 8,019   |  
|Trade receivables, net of allowances of $178 and $354, respectively                                                                                                                                      |  |                          | 10,413   |   |              |   | 13,678  |  
|Inventories, net                                                                                                                                                                                         |  |                          | 13,936   |   |              |   | 12,818  |  
|Prepaid expenses                                                                                                                                                                                         |  |                          | 1,645    |   |              |   | 1,745   |  
|Deferred costs                                                                                                                                                                                           |  |                          | 4,940    |   |              |   | 4,437   |  
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|Total current assets                                                                                                                                                                                     |  |                          | 34,813   |   |              |   | 40,697  |  
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|Property and equipment                                                                                                                                                                                   |  |                          | 8,160    |   |              |   | 6,848   |  
|Less accumulated depreciation and amortization                                                                                                                                                           |  |                          | (5,582   | ) |              |   | (4,603  | )
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|Net property and equipment                                                                                                                                                                               |  |                          | 2,578    |   |              |   | 2,245   |  
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|                                                                                                                                                                                                         |  |                         
|Goodwill                                                                                                                                                                                                 |  |                          | 35,363   |   |              |   | 40,336  |  
|Intangible assets, net of accumulated amortization                                                                                                                                                       |  |                          | 14,155   |   |              |   | 16,265  |  
|Deferred costs, net of current portion                                                                                                                                                                   |  |                          |         |   |              |   | 3,291   |  
|Other assets                                                                                                                                                                                             |  |                          | 493      |   |              |   | 471     |  
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|Total assets                                                                                                                                                                                             |  | $                        | 87,402   |   |              | $ | 103,305 |  
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|LIABILITIES, CONVERTIBLE REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS EQUITY                                                                                                                             |  |                          |          |   |              |   |         |  
|Current liabilities:                                                                                                                                                                                     |  |                          |          |   |              |   |         |  
|Accounts payable                                                                                                                                                                                         |  | $                        | 6,109    |   |              | $ | 6,238   |  
|Accrued liabilities                                                                                                                                                                                      |  |                          | 11,440   |   |              |   | 10,049  |  
|Trade accounts payable to a stockholder                                                                                                                                                                  |  |                          | 2,666    |   |              |   | 2,419   |  
|Deferred revenue                                                                                                                                                                                         |  |                          | 11,555   |   |              |   | 10,294  |  
|Customer deposits                                                                                                                                                                                        |  |                          | 175      |   |              |   | 175     |  
|Convertible promissory notes, net of discount (see Note 6)                                                                                                                                               |  |                          |         |   |              |   |        |  
|Current portion of long term debt                                                                                                                                                                        |  |                          | 3,493    |   |              |   | 6,681   |  
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|Total current liabilities                                                                                                                                                                                |  |                          | 35,438   |   |              |   | 35,856  |  
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|                                                                                                                                                                                                         |  |                         
|Deferred revenue, net of current portion                                                                                                                                                                 |  |                          | 62       |   |              |   | 6,043   |  
|Deferred tax liability                                                                                                                                                                                   |  |                          | 2,091    |   |              |   | 5,761   |  
|Long term debt, net of current portion                                                                                                                                                                   |  |                          | 17,303   |   |              |   | 16,014  |  
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|Total liabilities                                                                                                                                                                                        |  |                          | 54,894   |   |              |   | 63,674  |  
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|                                                                                                                                                                                                         |  |                         
|Series D convertible, redeemable preferred stock, $1.00 par value, 5,000 shares authorized, 4,291 issued and outstanding at March 31,
2008 and 5,000 at June 30, 2007; liquidation preference of $5,683. |  |                          | 2,290    |   |              |   | 1,238   |  
|Series E convertible, redeemable preferred stock, $1.00 par value, 30,000 shares authorized, 27,400 shares issued and outstanding at
March 31, 2008; liquidation preference of $31,056.                  |  |                          | 1        |   |              |   |        |  
|                                                                                                                                                                                                         |  |                         
|Shareholders equity:                                                                                                                                                                                    |  |                          |          |   |              |   |         |  
|Preferred stock, $1.00 par value; authorized 30,000,000 shares.                                                                                                                                          |  |                          |         |   |              |   |        |  
|Common stock, $.01 par value per share; authorized 750,000,000 shares; issued and outstanding 52,377,272 shares at March 31, 2008 and
52,084,483 shares at June 30, 2007.                                |  |                          | 524      |   |              |   | 521     |  
|Accumulated other comprehensive income (loss)                                                                                                                                                            |  |                          | (23      | ) |              |   | (52     | )
|Additional paid-in capital                                                                                                                                                                               |  |                          | 138,790  |   |              |   | 129,793 |  
|Accumulated deficit                                                                                                                                                                                      |  |                          | (108,649 | ) |              |   | (91,429 | )
|Deferred Toshiba equity cost                                                                                                                                                                             |  |                          | (425     | ) |              |   | (440    | )
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|Net shareholders equity                                                                                                                                                                                 |  |                          | 30,217   |   |              |   | 38,393  |  
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  
|Total liabilities, convertible redeemable preferred stock and shareholders equity                                                                                                                        |  | $                        | 87,402   |   |              | $ | 103,305 |  
|                                                                                                                                                                                                         |  |                          |          |   |              |   |         |  

See notes to condensed consolidated financial statements.



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VERTICAL COMMUNICATIONS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)



|                                                                       |  |                             |        |   |                            |   |        |      |  |   |         |   |  |   |         |  
|---------------------------------------------------------------------- |  | --------------------------- | ------ | - | -------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                       |  | Three Months EndedMarch 31, |        |   | Nine Months EndedMarch 31, |  
|                                                                       |  | 2008                        |        |   | 2007                       |   |        | 2008 |  |   | 2007    |  
|Net revenue                                                            |  | $                           | 16,100 |   |                            | $ | 22,683 |      |  | $ | 54,518  |   |  | $ | 56,632  |  
|Cost of sales                                                          |  |                             | 8,320  |   |                            |   | 12,225 |      |  |   | 29,105  |   |  |   | 29,401  |  
|                                                                       |  |                             |        |   |                            |   |        |      |  |   |         |   |  |   |         |  
|Gross profit                                                           |  |                             | 7,780  |   |                            |   | 10,458 |      |  |   | 25,413  |   |  |   | 27,231  |  
|                                                                       |  |                             |        |   |                            |   |        |      |  |   |         |   |  |   |         |  
|Operating expenses:                                                    |  |                             |        |   |                            |   |        |      |  |   |         |   |  |   |         |  
|Sales and marketing                                                    |  |                             | 4,662  |   |                            |   | 4,677  |      |  |   | 14,574  |   |  |   | 11,952  |  
|Product development                                                    |  |                             | 4,038  |   |                            |   | 3,573  |      |  |   | 11,905  |   |  |   | 9,706   |  
|General and administrative                                             |  |                             | 3,796  |   |                            |   | 3,945  |      |  |   | 11,537  |   |  |   | 11,972  |  
|Amortization of intangible assets                                      |  |                             | 609    |   |                            |   | 619    |      |  |   | 1,828   |   |  |   | 1,290   |  
|                                                                       |  |                             |        |   |                            |   |        |      |  |   |         |   |  |   |         |  
|Total operating expenses                                               |  |                             | 13,105 |   |                            |   | 12,814 |      |  |   | 39,844  |   |  |   | 34,920  |  
|                                                                       |  |                             |        |   |                            |   |        |      |  |   |         |   |  |   |         |  
|                                                                       |  |                             |        |  
|Loss from operations                                                   |  |                             | (5,325 | ) |                            |   | (2,356 | )    |  |   | (14,431 | ) |  |   | (7,689  | )
|Interest expense                                                       |  |                             | (657   | ) |                            |   | (1,670 | )    |  |   | (2,014  | ) |  |   | (3,073  | )
|Other income (expense), net                                            |  |                             | 19     |   |                            |   | 151    |      |  |   | 87      |   |  |   | 239     |  
|                                                                       |  |                             |        |   |                            |   |        |      |  |   |         |   |  |   |         |  
|                                                                       |  |                             |        |  
|Loss before provision for income tax                                   |  |                             | (5,963 | ) |                            |   | (3,875 | )    |  |   | (16,358 | ) |  |   | (10,523 | )
|Provision for income taxes                                             |  |                             | (173   | ) |                            |   | (298   | )    |  |   | (859    | ) |  |   | (644    | )
|                                                                       |  |                             |        |   |                            |   |        |      |  |   |         |   |  |   |         |  
|                                                                       |  |                             |        |  
|Net loss                                                               |  |                             | (6,136 | ) |                            |   | (4,173 | )    |  |   | (17,217 | ) |  |   | (11,167 | )
|                                                                       |  |                             |        |   |                            |   |        |      |  |   |         |   |  |   |         |  
|                                                                       |  |                             |        |  
|Series D preferred stock accretion and dividends                       |  |                             | (492   | ) |                            |   | (213   | )    |  |   | (1,221  | ) |  |   | (580    | )
|Series E preferred stock accretion and dividends                       |  |                             | (1     | ) |                            |   |       |      |  |   | (1      | ) |  |   |        |  
|                                                                       |  |                             |        |   |                            |   |        |      |  |   |         |   |  |   |         |  
|Net loss applicable to common shareholders                             |  | $                           | (6,629 | ) |                            | $ | (4,386 | )    |  | $ | (18,439 | ) |  | $ | (11,747 | )
|                                                                       |  |                             |        |   |                            |   |        |      |  |   |         |   |  |   |         |  
|Net loss applicable to common shareholders per sharebasic and diluted |  | $                           | (0.13  | ) |                            | $ | (0.09  | )    |  | $ | (0.35   | ) |  | $ | (0.25   | )
|Weighted average common shares outstandingbasic and diluted           |  |                             | 52,384 |   |                            |   | 49,178 |      |  |   | 52,318  |   |  |   | 47,727  |  

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



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VERTICAL COMMUNICATIONS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                              |  |                            |         |   |      |   |         |  
|----------------------------------------------------------------------------- |  | -------------------------- | ------- | - | ---- | - | ------- | -
|                                                                              |  | Nine Months EndedMarch 31, |        
|                                                                              |  | 2008                       |         |   | 2007 |  
|Cash flows from operating activities:                                         |  |                            |         |   |      |   |         |  
|Net loss                                                                      |  | $                          | (17,217 | ) |      | $ | (11,167 | )
|Adjustments to reconcile net loss to net cash used by operating activities:   |  |                            |         |   |      |   |         |  
|Depreciation and amortization                                                 |  |                            | 3,109   |   |      |   | 2,617   |  
|Amortization of deferred Toshiba equity costs                                 |  |                            | 15      |   |      |   | 65      |  
|Non-cash interest                                                             |  |                            | 117     |   |      |   | 1,494   |  
|Non-cash compensation                                                         |  |                            | 4,784   |   |      |   | 3,354   |  
|Deferred tax provision                                                        |  |                            | 859     |   |      |   | 644     |  
|Non-cash changes in accounts receivable allowances                            |  |                            | 176     |   |      |   | 52      |  
|Changes in assets and liabilities, net of acquisitions:                       |  |                            |         |   |      |   |         |  
|Trade accounts receivables                                                    |  |                            | 3,139   |   |      |   | 2,033   |  
|Inventories                                                                   |  |                            | (1,118  | ) |      |   | (1,826  | )
|Prepaid expenses                                                              |  |                            | 100     |   |      |   | 3,055   |  
|Deferred costs                                                                |  |                            | 2,788   |   |      |   | 2,377   |  
|Other assets                                                                  |  |                            |        |   |      |   | (50     | )
|Accounts payable                                                              |  |                            | 118     |   |      |   | (1,468  | )
|Accrued liabilities                                                           |  |                            | 3,035   |   |      |   | (1,029  | )
|Deferred revenue                                                              |  |                            | (4,721  | ) |      |   | (4,757  | )
|                                                                              |  |                            |         |   |      |   |         |  
|Net cash used in operating activities                                         |  |                            | (4,816  | ) |      |   | (4,606  | )
|                                                                              |  |                            |         |   |      |   |         |  
|                                                                              |  |                           
|Cash flows from investing activities:                                         |  |                            |         |   |      |   |         |  
|Cash used for acquisitions, net of cash acquired                              |  |                            |        |   |      |   | (24,665 | )
|Purchases of property and equipment                                           |  |                            | (1,312  | ) |      |   | (267    | )
|Increase in restricted cash                                                   |  |                            |        |   |      |   | (885    | )
|                                                                              |  |                            |         |   |      |   |         |  
|Net cash used in investing activities                                         |  |                            | (1,312  | ) |      |   | (25,817 | )
|                                                                              |  |                            |         |   |      |   |         |  
|Cash flows from financing activities:                                         |  |                            |         |   |      |   |         |  
|Payments of capital lease obligations                                         |  |                            | (13     | ) |      |   | (16     | )
|Payments of SVB term note                                                     |  |                            |        |   |      |   | (2,000  | )
|Payment of Comdial note                                                       |  |                            |        |   |      |   | (2,575  | )
|Net change in SVB revolver facility                                           |  |                            | (3,177  | ) |      |   | (6,533  | )
|Proceeds from issuance of Columbia debt, net of issuance costs                |  |                            |        |   |      |   | 24,440  |  
|Proceeds from issuance of convertible promissory notes, net of issuance costs |  |                            | 5,091   |   |      |   |        |  
|Proceeds from issuance of Series E preferred stock, net of issuance costs     |  |                            |        |   |      |   | 26,926  |  
|Proceeds from issuance of common stock, net of issuance costs                 |  |                            | 58      |   |      |   | 5       |  
|                                                                              |  |                            |         |   |      |   |         |  
|Net cash provided by financing activities                                     |  |                            | 1,959   |   |      |   | 40,247  |  
|                                                                              |  |                            |         |   |      |   |         |  
|                                                                              |  |                           
|Effect of foreign currency exchange rates                                     |  |                            | 29      |   |      |   | (4      | )
|                                                                              |  |                            |         |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                          |  |                            | (4,140  | ) |      |   | 9,820   |  
|Cash and cash equivalents at beginning of period                              |  |                            | 8,019   |   |      |   | 4,726   |  
|                                                                              |  |                            |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                    |  | $                          | 3,879   |   |      | $ | 14,546  |  
|                                                                              |  |                            |         |   |      |   |         |  
|                                                                              |  |                           
|SUPPLEMENTAL CASH FLOW INFORMATION:                                           |  |                            |         |   |      |   |         |  
|Non cash dividend to Series D preferred shareholders                          |  | $                          | 492     |   |      | $ | 580     |  
|Non cash dividend to Series E preferred shareholders                          |  | $                          | 1       |   |      | $ |        |  
|Cash paid for interest                                                        |  | $                          | 499     |   |      | $ | 604     |  

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



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VERTICAL COMMUNICATIONS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

(1) BASIS OF PRESENTATION

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

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

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America and pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC). The balance sheet amounts at June 30, 2007 in this report were derived from
our audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2007. In the opinion of management, the accompanying financial statements include all adjustments of a normal recurring nature
which are necessary for a fair presentation of the financial results for the interim periods presented. Certain information and footnote disclosures normally included in financial statements have been condensed or omitted pursuant to such rules and
regulations. Although we believe that the disclosures are adequate to make the information presented not misleading, we recommend that these financial statements be read in conjunction with the consolidated financial statements and the notes thereto
included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2007 on file with the SEC. The results of operations for the three and nine months ended March 31, 2008 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 acquisition of Vodavi Technology, Inc. as discussed below. Actual results could differ materially from these estimates. The accounting policies applied are consistent with those disclosed in our Annual
Report on Form 10-K as disclosed in Note 2.

Acquisition of Vodavi Technology, Inc.

On December 1, 2006, we completed the acquisition of all of the outstanding securities of Vodavi Technology, Inc. (Vodavi) pursuant to an
Agreement and Plan of Merger dated as of October 18, 2006 (the Merger Agreement), by and among the Company, Vodavi and Vertical Acquisition Sub Inc., a Delaware corporation and wholly-owned subsidiary of the Company
(MergerSub). MergerSub was merged with and into Vodavi (the Merger), with Vodavi continuing its corporate existence as a wholly-owned subsidiary of the Company.

Vodavi is a provider of traditional and next-generation business telecommunications solutions, targeted to small and medium-sized business, primarily in
the United States. The aggregate consideration paid by the Company to the stockholders of Vodavi was approximately $31.1 million in cash (the Merger Consideration). In addition, the Company incurred approximately $0.4 million in
transaction costs related to the Merger.

The operational results of this acquisition are included in all periods since December 1,
2006, the date that the Merger was consummated.

(2) SIGNIFICANT ACCOUNTING POLICIES

Stock-Based Compensation

On July 1, 2005, we adopted the provisions of FASB Statement
No. 123 (revised 2004) Accounting for Stock-Based Compensation(SFAS No. 123R) and elected to use the modified prospective transition method as permitted under SFAS 123R. Under SFAS 123R, compensation cost recognized
includes compensation cost for all share-based payments, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R.



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Stock Options

The Company currently grants stock options under one plan. Generally, options become exercisable over a four-year period commencing on the date of the grant. Options granted prior to and after 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 2.08% monthly. In computing stock based compensation, we
apply an estimated forfeiture rate based on actual forfeitures in our recent history. The fair value of options granted was calculated using the Black-Scholes option-pricing model with the following weighted average assumptions:



|                        |  |                             |  |            
|----------------------- |  | --------------------------- |  | -----------
|                        |  | Nine Months Ended March 31,
|                        |  | 2008                        |  | 2007       
|Expected dividend yield |  | 0%                          |  | 0 %        
|Volatility factor       |  | 117-120 %                   |  | 113-115 %  
|Risk free interest rate |  | 3.92-4.41 %                 |  | 3.45-4.03 %
|Expected life           |  | 6 Years                     |  | 6 Years    

The risk-free interest rate is based upon the U. S. Treasury securities yield. The term of the
options grant is derived from historical data. The expected volatility is based upon the historical volatility of the Companys common stock over the period of time. The Company recognizes expense using the straight-line attribution method for
both pre- and post-adoption grants. The amount of option expense recognized during a period is based on the value of the portion of the awards that are ultimately expected to vest. SFAS 123R requires forfeitures to be estimated at the time of grant
and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company currently expects, based on analysis of its historical forfeitures, a forfeiture rate of approximately 3%.

The following summarizes stock option activity for the nine month period ended March 31, 2008:



|                              |  |            |   |  |                                |      |                                                   |    
|----------------------------- |  | ---------- | - |  | ------------------------------ | ---- | ------------------------------------------------- | ---
|Stock Options                 |  | Shares     |   |  | Weighted AverageExercise Price |      | Weighted AverageRemaining Contractual Term(years)
|Outstanding at June 30, 2007  |  | 19,415,983 |   |  | $                              | 1.90 |                                                   |    
|Granted                       |  | 1,222,000  |   |  | $                              | 1.12 |                                                   |    
|Exercised                     |  | (78,968    | ) |  | $                              | 0.67 |                                                   |    
|Cancelled                     |  |           |   |  |                                |     |                                                   |    
|Forfeited                     |  | (1,967,103 | ) |  | $                              | 1.51 |                                                   |    
|                              |  |            |   |  |                                |      |                                                   |    
|Outstanding at March 31, 2008 |  | 18,591,912 |   |  | $                              | 1.01 |                                                   | 8.1
|Exercisable at March 31, 2008 |  | 8,225,868  |   |  | $                              | 1.18 |                                                   | 8.2

Restricted Stock

In February 2007, the Company granted restricted stock to certain key executives. This restricted stock program is a performance based plan that awards shares of common stock of the Company at the end of a four year,
one month measurement period. Awards associated with this program cliff vest at the end of the measurement period subject to attainment of the defined performance measures associated with the performance of the Companys common stock and
operations.

The Company recognizes compensation expense on these awards ratably over the vesting period. The fair value of the awards was
determined based on the market value of the underlying stock price at the grant date. The Company estimated a forfeiture rate of 20% based on projections related to whether the performance measures are likely to be achieved and the probability of
all awards vesting. The amount of compensation expense ultimately recognized will depend on whether the performance measures are met and all of the restricted stock awards vest. The Company will assess its projections at each reporting period and,
as a result, the amount of expense recorded from period to period may change.

Total stock-based compensation for both options and
restricted stock awards increased loss from operations and net loss for the three and nine months ended March 31, 2008 by $1.5 million ($0.03 per basic and diluted share) and $4.8 million ($0.09 per basic and diluted share), respectively. As of
March 31, 2008, $13.2 million of unvested stock-based compensation has not yet been recognized by the Company. The unvested stock-based compensation balance is expected to be expensed over a weighted average period of 3.0 years.



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The following table summarizes the allocation of stock-based compensation included in operating expenses
by line item in the Unaudited Consolidated Condensed Statements of Operations for the periods indicated (in thousands):



|                           |      |                             |       |                            |      |       |      |   |       |  |   |      
|-------------------------- | ---- | --------------------------- | ----- | -------------------------- | ---- | ----- | ---- | - | ----- |  | - | -----
|                           |      | Three MonthsEnded March 31, |       | Nine Months EndedMarch 31,
|                           | 2008 |                             | 2007  |                            | 2008 |       | 2007
|Sales and marketing        |      | $                           | 559   |                            | $    | 504   |      | $ | 1,835 |  | $ | 1,198
|Product development        |      | $                           | 484   |                            | $    | 385   |      | $ | 1,498 |  | $ | 968  
|General and administrative |      | $                           | 455   |                            | $    | 425   |      | $ | 1,451 |  | $ | 1,188
|                           |      |                             |       |                            |      |       |      |   |       |  |   |      
|Total                      |      | $                           | 1,498 |                            | $    | 1,314 |      | $ | 4,784 |  | $ | 3,354

Goodwill

The Company accounts for its goodwill in accordance with the provisions of FASB Statement No. 142, Goodwill and Other Intangible Assets. This statement requires that goodwill be periodically tested
for impairment, with impaired assets written down to fair value. During September 2007, the Company conducted its annual impairment test of goodwill by comparing fair value to the carrying amount of its underlying assets and liabilities.
The Company determined that the fair value exceeded the carrying amount of the assets and liabilities, therefore no impairment existed as of the testing date.

Income Taxes

In June 2006, FASB issued FIN 48, Accounting for Uncertainty in Income Taxes (FIN 48) an
interpretation of SFAS No. 109, Accounting for Income Taxes (SFAS No. 109). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with SFAS
No. 109. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides
guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This guidance is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 effective
July 1, 2007. The Companys analysis of uncertain tax positions as required under FIN 48 determined that the Company had no material unrecorded liabilities and there was no cumulative effect on retained earnings of applying the provisions
of the interpretation. Interest and penalties accrued under FIN 48 will be classified as Interest Expense and General and Administrative Expense, respectively.

Related Party Transactions

LG-Nortel Co. Ltd. (LGN) owns approximately 24% of the Companys outstanding
Series E Convertible Preferred Stock, par value $1.00 per share (the Series E Preferred Stock) at March 31, 2008 and has a designated member on the Companys board of directors. The Company purchased approximately
$2.5 million and $8.5 million, respectively, of key telephone systems, commercial grade telephones, and voice mail products from LGN and an affiliate of LGN during the three and nine months ended March 31, 2008. The Company owed LGN and
its affiliate a total of $2.7 million for product purchases at March 31, 2008. The Companys payment terms with LGN and its affiliate are 90 days after shipment, except for shipments of single line telephones, which are 30 days
after shipment. Current balances are non-interest bearing.

The Company conducts joint development activities with LGN for the design and
development of hardware incorporated into some of the Companys existing and planned telephone systems and commercial grade telephones. Generally, LGN contributes the ongoing research and development costs for the product hardware and produces
the finished goods developed under the alliance, and the Company obtains the right to sell such products throughout North America and the Caribbean.

(3) ACQUISITIONS

Vertical Networks, Inc.

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

The purchase price for Vertical Networks consisted of: $12.5 million in cash, paid at closing, with an additional $1.0 million held in escrow to secure Vertical Networks indemnification obligations to us, $1.0
million in transaction costs, the assumption of most liabilities of Vertical Networks and an earnout provision of up to $4.3 million. The earnout obligation is equal to the first $4.3



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million of non-refundable software license revenues collected by us from CVS Pharmacy, Inc. (CVS) in connection with a specific contract. We have
paid $2.0 million of the earn-out provision and accrued an additional $0.3 million of the earn-out provision through March 31, 2008.

Comdial
Corporation

On September 28, 2005, we completed the acquisition of substantially all of the assets (the Comdial
Assets) of Comdial Corporation (Comdial) pursuant to the terms of an asset purchase agreement entered into on September 1, 2005. The Comdial Assets included all of Comdials intellectual property, fixed assets, equipment,
inventories, accounts receivable, rights under contracts and leases, cash and other current assets.

In exchange for the acquired assets,
we (i) delivered $14.5 million in cash, (ii) executed an 8% secured promissory note in the aggregate principal amount of $2.5 million to Comdial (see Note 6), (iii) repaid $1.7 million of debtor-in-possession financing incurred to
fund operations of Comdial prior to the closing, (iv) repaid an amended and restated note dated May 25, 2005, issued by Comdial to Dialcom Acquisition, LLC, in the principal amount of $1.9 million and (v) paid $0.4 million and assumed
$0.2 million of Comdials remaining obligations under a key employee retention plan with Comdials employees, as approved by an order of the Bankruptcy Court. In addition, we incurred approximately $0.8 million in transaction costs related
to the acquisition.

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

Vodavi Technology, Inc.

On December 1, 2006, we
completed the acquisition of all of the outstanding securities of Vodavi pursuant to the Merger Agreement by and among the Company, Vodavi and MergerSub wherein MergerSub was merged with and into Vodavi, with Vodavi continuing its corporate
existence as a wholly-owned subsidiary of the Company.

The aggregate consideration paid by the Company to the stockholders of Vodavi was
approximately $31.1 million in cash. In addition, the Company incurred approximately $0.4 million in transaction costs related to the Merger.

The Company obtained the Merger Consideration (a) through the sale of 27,400 shares of its newly designated Series E Preferred Stock at a purchase price of $1,000 per share to certain investors pursuant to a Securities Purchase
Agreement, as amended and restated (the Amended and Restated Securities Purchase Agreement), and (b) by entering into a Credit Agreement (the Credit Agreement) dated as of October 18, 2006, by and among the Company,
Vertical Communications Acquisition Corp., a Delaware corporation (VCAC), Columbia Partners, L.L.C. Investment Management (Investment Manager), and NEIPF, L.P. (Lender), pursuant to which the Company issued
(i) a senior secured promissory note payable to Lender in the principal amount of $10.0 million; and (ii) a senior secured promissory note payable to Lender in the principal amount of $15.0 million.

(4) INVENTORIES

Inventories, net, at March 31,
2008 and June 30, 2007 are $13.9 million and $12.8 million, respectively, consisting of the following (in thousands):



|               |  |               |        |              |   |       
|-------------- |  | ------------- | ------ | ------------ | - | ------
|               |  | March 31,2008 |        | June 30,2007
|Raw Materials  |  | $             | 717    |              | $ | 465   
|Finished Goods |  | $             | 13,219 |              | $ | 12,353
|               |  |               |        |              |   |       
|               |  | $             | 13,936 |              | $ | 12,818
|               |  |               |        |              |   |       

(5) INTANGIBLE ASSETS

Intangible assets related to the acquisitions of Vertical Networks, Comdial and Vodavi at March 31, 2008 and June 30, 2007 consist of the following (in thousands):



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|                                                   |  |               |        |   |              |   |        |              |  |   
|-------------------------------------------------- |  | ------------- | ------ | - | ------------ | - | ------ | ------------ |  | --
|                                                   |  | March 31,2008 |        |   | June 30,2007 |   |        | Life inYears
|Acquired technology-Vertical Networks              |  | $             | 800    |   |              | $ | 800    |              |  | 5 
|Acquired customers relationships-Vertical Networks |  |               | 3,500  |   |              |   | 3,500  |              |  | 5 
|Trade names/trademarks-Comdial                     |  |               | 200    |   |              |   | 200    |              |  | 1 
|Acquired customer relationships-Comdial            |  |               | 3,300  |   |              |   | 3,300  |              |  | 10
|Acquired technology- Comdial                       |  |               | 800    |   |              |   | 800    |              |  | 5 
|Trade names-Vodavi                                 |  |               | 690    |   |              |   | 690    |              |  | 4 
|Customer relationships-Vodavi                      |  |               | 10,440 |   |              |   | 10,440 |              |  | 9 
|Customer relationships, other-Vodavi               |  |               | 600    |   |              |   | 600    |              |  | 8 
|Existing technology-Vodavi                         |  |               | 220    |   |              |   | 220    |              |  | 4 
|                                                   |  |               |        |   |              |   |        |              |  |   
|                                                   |  |               | 20,550 |   |              |   | 20,550 |              |  |   
|Accumulated amortization                           |  |               | (6,395 | ) |              |   | (4,285 | )            |  |   
|                                                   |  |               |        |   |              |   |        |              |  |   
|                                                   |  | $             | 14,155 |   |              | $ | 16,265 |              |  |   
|                                                   |  |               |        |   |              |   |        |              |  |   

Amortization expense for the three and nine months ending March 31, 2008 was $0.7 million and
$2.1 million respectively, of which $94,000 and $282,000, respectively, was included in cost of sales. For the three and nine months ending March 31, 2007, amortization expense was $0.7 million and $1.5 million respectively, of which $84,000
and $258,000, respectively, was included in cost of sales.

(6) DEBT

Debt Related to Comdial Acquisition

We financed a portion of the purchase price for the Comdial
Assets (the 2005 Debt Financing) by entering into a loan agreement with Silicon Valley Bank (SVB) on September 28, 2005 (the SVB Loan Agreement). The SVB Loan Agreement terms provided the Company with a
revolving line of credit in an amount not to exceed $7.0 million (the Revolving Loan), as well as a $2.0 million term loan (the Term Loan). The Revolving Loan initially matured on September 27, 2006. On
September 27, 2006, the Company entered into a Third Loan Modification Agreement with SVB under which the maturity date of the Revolving Loan was extended from September 27, 2006 to October 31, 2006. The Term Loan was payable in
monthly principal installments of $133,333 plus interest, due beginning July 31, 2006 through and until the maturity date of September 26, 2007.

On September 28, 2005, the Company also executed a secured promissory note in the aggregate principal amount of $2.5 million (the Comdial Note). The Comdial Note was issued to the Comdial bankruptcy
estate (the Comdial Estate) in connection with the acquisition of the Comdial Assets. The Comdial Note was subject to interest at the rate of 8% per annum and initially matured on the first anniversary of the closing date. On
September 28, 2006, the Company and the Comdial Estate entered into an agreement which extended the maturity date of the Comdial Note from September 28, 2006 to November 1, 2006.

On October 18, 2006, the Company issued a Senior Secured Promissory Note to NEIPF, L.P. (see Debt Related to Vodavi Acquisition below
for additional detail). The Company used proceeds from this loan to extinguish all of the then outstanding loans with SVB and the Comdial Estate.

Debt
Related to Vodavi Acquisition

On October 18, 2006, the Company entered into a Credit Agreement with Columbia Partners, LLC
Investment Management (Columbia) and NEIPF, L.P. (Lender) in which the Company agreed to (a) issue a senior secured promissory note payable to Lender (the Initial Bridge Note) in the amount of $10.0 million,
(b) issue a senior secured promissory note payable to Lender (the Term Note and, together with the Initial Bridge Note, the Loans) in the principal amount of $15.0 million; and (c) upon the issuance of the Initial
Bridge Note, issue to Lender a warrant to purchase 4,500,000 shares of the Companys common stock at an exercise price equal to $0.01 per share (the Lender Warrant).

The Credit Agreement initially contained certain financial covenants related to minimum revenue, minimum EBITDA and cash availability. On
October 15, 2007, the Company entered into an amendment to the Credit Agreement effective as of September 30, 2007, which modified the financial covenants. At December 31, 2007, the Company was not in compliance with the amended
financial covenants related to minimum revenue and EBITDA. Accordingly, the Company reclassified the total principal and interest due of $16.9 million to current portion of long term debt in the condensed consolidated balance sheet at
December 31, 2007. On March 17, 2008, the Company entered into a second amendment to the Credit Agreement effective as of December 31, 2007, which modified the financial covenants. Pursuant to the second amendment of the Credit
Agreement, the Company must (a) maintain cash, cash equivalents or available borrowing capacity of specified amounts ranging from $4.0 million to $5.0 million as of the last day of each calendar month; (b) beginning with the trailing three
month period ended March 31, 2008 and for each quarter thereafter,



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maintain specified minimum EBITDA; and (c) beginning with the trailing three month period ended March 31, 2008, maintain specified minimum revenue.
As of March 31, 2008, the Company is in compliance with the financial covenants of the amended Credit Agreement.

Silicon Valley Bank

On May 25, 2007, the Company entered into a Loan and Security Agreement (the Loan Agreement) with SVB providing for a
line of credit of up to $10.0 million (the Line of Credit).

The Loan Agreement initially contained certain financial covenants
related to minimum revenue, minimum EBITDA and cash availability. On October 15, 2007, the Company entered into an amendment to the Credit Agreement effective as of September 30, 2007, which modified the financial covenants. At
December 31, 2007, the Company was not in compliance with the amended financial covenants related to minimum revenue and EBITDA. On March 17, 2008, the Company entered into a second amendment to the Loan Agreement effective as of
December 31, 2007, which modified the financial covenants. Pursuant to the second amendment of the Loan Agreement, the Company must (a) maintain cash, cash equivalents or available borrowing capacity of specified amounts ranging from $4.0
million to $5.0 million as of the last day of each calendar month; (b) beginning with the trailing three month period ended March 31, 2008 and for each quarter thereafter, maintain specified minimum EBITDA; and (c) beginning with the
trailing three month period ended March 31, 2008, maintain specified minimum revenue. As of March 31, 2008, the Company is in compliance with the financial covenants of the amended Loan Agreement.

Convertible Promissory Notes

On March 17, 2008,
the Company entered into a securities purchase agreement (the SPA) with certain investors (the Initial Investors) pursuant to which the Company agreed to (1) the issuance and sale of subordinated convertible promissory
notes (the Notes) and (2) upon conversion of the Notes, the issuance of a to-be-established series of the Companys preferred stock (the Series F Preferred Stock) and, if applicable, warrants (the Series F
Warrants) to purchase shares of the Companys common stock. Under the SPA, the Company received aggregate proceeds of $5,250,000 from the Initial Investors in exchange for the issuance and sale of the Notes. There are certain rights of
first refusal and rights offering provisions in the SPA which provide for the sale and issuance of additional notes up to an aggregate maximum principal amount of $7,500,000. The Notes accrue interest at the rate of 15% annually and mature on or
after twelve months. The Notes are subordinate to the Credit Agreement and the Loan Agreement.

On or before May 16, 2008 (the
Outside Date), the Notes will automatically convert into shares of Series F Preferred Stock. If there is a qualifying investment, defined as an investment by LG-Nortel, Inc. (LGN) that (a) closes on or before the Outside
Date, and (b) is pursuant to the SPA which LGN becomes a party to, and (c) LGN purchases a minimum of $1.0 million in principal amount of the Notes, then the Notes automatically convert into Section 5(a) preferred stock. If no
qualifying investment occurs prior to the Outside Date, then the Notes automatically convert into Section 5(b) preferred stock. The Notes convert into Series F Preferred Stock at a rate of one share per $1,000 of outstanding principal
and accrued interest (rounded to the nearest share). The initial conversion price of the Series F Preferred Stock to common stock is $0.05 per share.

The material terms of the Section 5(a) preferred stock are as follows:



| | 1. | With regard to the powers, designations, preferences and rights, the Section 5(a) preferred stock is substantially similar to the Series E Preferred Stock (see Note 8) and
ranks equally with respect to the payment of dividends, redemption and rights upon liquidation, dissolution or sale of the Company.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 2. | In connection with the automatic conversion of the Notes into Section 5(a) preferred stock, the holders will receive warrants to purchase common shares at an exercise price of
$0.01 per share. The number of shares for which the warrants are exercisable is calculated as the original principal amount of the Note divided by $0.05 (the conversion price of the Series F Preferred Stock into common stock).
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The material terms of the Section 5(b) preferred stock are as follows:



| | 1. | The Section 5(b) preferred stock ranks senior to all other classes or series of capital stock with respect to the payment of dividends, redemption and rights upon liquidation,
dissolution or sale of the Company.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 2. | The Section 5(b) preferred stock accrues a cash dividend at the rate of $120 per year per share payable before any dividend is paid on any other shares of the Companys
capital stock.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 3. | In the event of redemption, liquidation, dissolution or sale of the Company, the holders of the Section 5(b) preferred stock are entitled to receive an amount equal to three
times the purchase price per share plus all declared and unpaid dividends.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | 4. | Other than as noted above, the Section 5(b) preferred stock is substantially similar to the Series E Preferred Stock with regard to the powers, designations, preferences and
rights. No warrants will issue upon automatic conversion of the Notes into Section 5(b) preferred stock.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Events of
default under the Notes include the dissolution or termination of the Company; failure by the Company to pay all amounts payable under the Notes when due; involuntary or voluntary filing for a bankruptcy petition and a breach or default under any of
the Companys debt agreements. Should an event of default occur, remedies available to the Initial Investors include acceleration requiring immediate payment of all or any portion of the obligations under the Notes but only upon consent of the
holder or holders of at least a majority of the aggregate principal amount outstanding under the Notes and the holders have all rights and remedies generally afforded to creditors.

Under the SPA, the Company was required to have entered into amendments to both the Credit Agreement and the Loan Agreement on terms satisfactory to the
Initial Investors. In addition, the Company agreed to register the shares of common stock issuable upon conversion of the Series F Preferred Stock and Series F Warrants, if applicable, for resale by the Series F investors under the Securities
Act upon the request of the investors and to use its best efforts to cause the Registration Statement to become effective as promptly as possible.

In conjunction with the SPA, the Initial Investors entered into a Consent and Waiver Agreement under which they agreed to, among other things, a charter amendment to increase the number of authorized shares of common stock from
250 million to 750 million and to waive the anti-dilution provisions of the Series E Certificate of Designations with respect to both the conversion price of the Series E Preferred Stock and the warrants issued in conjunction with the
Series E Preferred Stock.

The Company evaluated the SPA and the Notes under the guidance in EITF Issue No. 00-19,
Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Companys Own Stock and APB Opinion No. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase
Warrants and determined that the financial instruments should be initially recorded as a liability as the investors can elect net-cash settlement of the Notes under certain circumstances that are outside the control of the Company. The
Company reviewed the guidance in FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities,to determine if the embedded conversion feature should be accounted for separately and determined that
under paragraph 11(a) and EITF Issue No. 00-19, the Company is not required to bifurcate the conversion feature as that feature on a standalone basis would be classified as an equity instrument of the Company. Therefore, pursuant to the guidance in
EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments, the Company determined that the intrinsic value of the beneficial conversion feature is greater than the value of the Notes and thus recorded a
discount on the debt equal to the face value, which will be accreted over the term of the Notes using the effective interest method.

(7) INCOME
TAXES

The Company has not recognized any current income tax expense in any period presented due to the Companys net losses.
However, in fiscal years beginning with 2005, the Company is recording a deferred tax provision and corresponding liability arising from the timing differences associated with amortizing goodwill for income tax purposes over a 15 year life.

(8) CONVERTIBLE REDEEMABLE PREFERRED STOCK

Series D Preferred Stock

On February 9, 2006, the Company completed the sale (the Series D
Financing) of 5,000 shares of its Series D Convertible Preferred Stock, par value $1.00 per share (the Series D Preferred Stock) and warrants to purchase an aggregate of 1,041,667 shares (the Series D
Warrants) of the Companys common stock pursuant to a Securities Purchase Agreement (the 2006 Securities Purchase Agreement) between the Company and certain investors (the Series D Investors). The aggregate
proceeds to the Company from the Series D Financing was $5.0 million. The Series D Preferred Stock accrues dividends at a rate of $80 per year and is subject to anti-dilution adjustments in the event the Company issues additional shares of
common stock for consideration that is less than the conversion price of the Series D Preferred Stock. Beginning February 9, 2009, the Series D Preferred Stock may be redeemed at a price equal to the Original Issue Price, plus unpaid dividends
provided that the holders of a majority of the outstanding shares consent to the redemption. In addition to the shares of Series D Preferred Stock, the Company issued warrants to purchase an aggregate of up to 1,041,667 shares of common stock
at a per share exercise price of $0.01. The Series D warrants are also subject to anti-dilution adjustments. Our obligation to the Series D Preferred Stockholders, should they choose to redeem the stock at or after the redemption date is $4.9
million plus accrued but unpaid dividends of $764,000.

Series E Preferred Stock

On December 1, 2006, the Company completed the sale (the Series E Financing) of 27,400 shares of its Series E Convertible
Preferred Stock, par value $1.00 per share (the Series E Preferred Stock) and warrants to purchase an aggregate of 25,849,059 shares (the Series E Warrants) of the Companys common stock pursuant to the Amended and
Restated Securities



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Purchase Agreement between the Company and certain investors (the Series E Investors) (the Series E Securities Purchase
Agreement). The aggregate proceeds to the Company from the Series E Financing was $27.4 million. The Series E Preferred Stock accrues dividends at a rate of $100 per year and is subject to anti-dilution adjustments in the event the
Company issues additional shares of common stock for consideration that is less than the conversion price of the Series E Preferred Stock. Beginning three years from the date of issuance, the Series E Preferred Stock may be redeemed at a price equal
to the Original Issue Price, plus unpaid dividends provided that any single holder of at least thirty percent (30%) of the outstanding shares consents to the redemption. In addition to the shares of Series E Preferred Stock, the Company
issued warrants to purchase an aggregate of up to 25,849,059 shares of common stock at a per share exercise price of $0.58. The Series E warrants are also subject to anti-dilution adjustments. Our obligation to the Series E Preferred Stockholders,
should they choose to redeem the stock at or after the redemption date is $27.4 million plus accrued but unpaid dividends of $3.7 million.

(10)
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. For the periods ended March 31, 2008 and 2007, total common stock equivalents excluded are 108.1 million and 109.1 million,
respectively.

(11) GUARANTEES

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

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

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

We warrant that our software products will perform in all
material respects in accordance with our standard published specifications in effect at the time of delivery of the licensed products to the customer for 90 days. We warrant that our maintenance services will be performed consistent with generally
accepted industry standards through completion of the agreed upon services. Additionally, we warrant that our hardware products will perform in all material respects in accordance with our standard published specifications in effect at the time of
delivery of the products to the customer for the specified periods as per our warranty policies and agreement. 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.

(12) SUBSEQUENT EVENTS

On April 16, 2008, the
Company entered into a Joinder Agreement with certain investors (the Additional Investors) to join as parties to the SPA entered into on March 17, 2008 with the Initial Investors. Pursuant to the Joinder Agreement, the Company
issued and sold additional Notes in an aggregate principal amount of $1,047,064. In conjunction with the SPA, the Additional Investors entered into a Consent and Waiver Agreement under which they agreed to, among other things, a charter amendment to
increase the number of authorized shares of common stock from 250 million to 750 million and to waive the anti-dilution provisions of the Series E Certificate of Designations with respect to both the conversion price of the Series E
Preferred Stock and the warrants issued in conjunction with the Series E Preferred Stock.



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

Forward-Looking
Statements

This Quarterly Report on Form 10-Q, including, without limitation, the section entitled Managements Discussion
and Analysis of Financial Condition and Results of Operations, contains forward-looking statements. These statements relate to future events or to our future financial performance, and involve known and unknown risks, uncertainties and other
factors that may cause our actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements.
In some cases, you can identify forward-looking statements by the use of words such as expect, intend, may, would, could, plan, seek, potential,
continue, or the negative of these terms or other comparable terminology. You should not place undue reliance on forward-looking statements since they involve known and unknown risks, uncertainties and other factors which are, in some
cases, beyond our control and which could materially affect actual results, levels of activity, performance or achievements. Factors that may cause actual results to differ materially from current expectations, which we describe in more detail
elsewhere in this Quarterly Report on Form 10-Q under the heading Item 1-A Risk Factors, include, but are not limited to:



| |  | our history of losses and expectation of incurring future losses;
|- |  | -----------------------------------------------------------------



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



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



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



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



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



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



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



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



| |  | the assumptions about the future performance of the Vodavi operations may prove to be incorrect;
|- |  | ------------------------------------------------------------------------------------------------



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



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

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

Critical Accounting Policies

Revenue Recognition

The Company
recognizes revenue for the sale of its Wave, InstantOffice and TeleVantage products pursuant to Statement of Position (SOP) 97-2, Software Revenue Recognition, and SOP 98-9, Software Revenue Recognition With Respect to Certain
Transactions. For revenue generated by the sale of Comdial and Vodavi products, where the Company has determined that the software is incidental, the Company follows Staff Accounting Bulletin (SAB) 104, Revenue Recognition. Generally, the
Company



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##### Table of Contents

recognizes revenue when it is realized or realizable and earned. The Company considers revenue realized or realizable and earned when persuasive evidence of
an arrangement exists, the product has been shipped or the services have been provided to the customer, the sales price is fixed or determinable and collectability is reasonably assured. The Company reduces revenue for estimated customer returns,
rotations and sales rebates when such amounts are estimable. When not estimable, the Company defers revenue until the product is sold to the end customer or the customers rights expire. As part of its product sales price, the Company provides
telephone support, which is generally utilized by the customer shortly after the sale. The cost of the phone support is not significant but is accrued in the financial statement. In addition to the aforementioned general policy, the following are
the specific revenue recognition policies for each major category of revenue.

The Company defers revenue on shipments to Toshiba until the
product is resold by Toshiba to its customers. The deferral of revenue is due to the Companys inability to reasonably estimate potential future stock rotations resulting from future product releases and their effect on future revenue as
Toshiba purchases the TeleVantage software and license keys in bulk amounts and maintains an inventory for future sales to customers. For all other TeleVantage license sales, assuming that all other revenue recognition criteria have been met,
revenue is recognized at the time of delivery of the software to the customer.

Revenue from delivered elements of one-time charge licensed
software is recognized at the inception of the license term using the residual method, provided we have vendor-specific objective evidence (VSOE) of the fair value of each undelivered element. Revenue is deferred for the fair value of
the undelivered elements based upon the price of these elements when sold separately. Revenue is also deferred for the entire arrangement if VSOE does not exist for each undelivered contract element. Examples of undelivered elements in which the
timing of delivery is uncertain include contractual elements that give customers rights to any future upgrades at no additional charge or future maintenance that is provided within the overall price. The revenue that is deferred for any contract
element is recognized when all of the revenue recognition criteria have been met for that element. Revenue for annual software subscriptions is recognized ratably over the length of the software subscription. Certain contracts for the sale of
telephone systems acquired with Vertical Networks in September 2004 were determined to be bundled with software subscriptions with lengths of up to five years from the date of acquisition. The revenue and cost of sales of the systems under these
contracts have been deferred and will be amortized ratably over the length of the associated software subscription, as the Company does not have VSOE for these subscription agreements.

Due to the lengthy period of time over which we amortize the revenue and cost of goods sold related to these systems, the revenue and cost of goods sold
we report in any one period excludes certain of the revenue and cost of goods sold relating to shipments in that period and includes revenue and costs of goods sold relating to shipments made in prior periods. As a result, our reported revenue and
costs of goods sold may not necessarily be indicative of our ability to generate customer orders in a particular period. The difference between reported revenue and costs of goods sold and customer orders in any period could be either positive or
negative, and cannot be reliably predicted from period to period. The following tables demonstrate this effect by showing the amount of revenue, cost of goods sold and gross profit from systems shipped during the three months ended March 31,
2008 and 2007 that was deferred at each quarter end (in thousands).



|               |  |                 |     |                            |   |                      |  |   |    
|-------------- |  | --------------- | --- | -------------------------- | - | -------------------- |  | - | ---
|               |  | DeferredRevenue |     | Deferred Cost ofGoods Sold |   | Deferred GrossProfit
|March 31, 2008 |  | $               | 649 |                            | $ | 369                  |  | $ | 280
|March 31, 2007 |  |                 | 56  |                            |   | 29                   |  |   | 27 

The following table details the amount of revenue, cost of goods sold and gross profit from
systems shipped during prior reporting periods that was recognized at each quarter end for the three month period ended March 31, 2008 and 2007 (in thousands).



|               |  |                                               |       |                                                         |   |                                                   |  |   |      
|-------------- |  | --------------------------------------------- | ----- | ------------------------------------------------------- | - | ------------------------------------------------- |  | - | -----
|               |  | Recognition ofRevenue Deferredin Prior Period |       | Recognition of Costof Goods SoldDeferred in PriorPeriod |   | Recognition ofGross ProfitDeferred in PriorPeriod
|March 31, 2008 |  | $                                             | 2,056 |                                                         | $ | 1,145                                             |  | $ | 911  
|March 31, 2007 |  |                                               | 2,222 |                                                         |   | 1,215                                             |  |   | 1,007



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The following tables show the amount of revenue, cost of goods sold and gross profit from systems shipped
during the nine months ended March 31, 2008 and 2007 that was deferred at each quarter end (in thousands).



|               |  |                 |       |                            |   |                      |  |   |      
|-------------- |  | --------------- | ----- | -------------------------- | - | -------------------- |  | - | -----
|               |  | DeferredRevenue |       | Deferred Cost ofGoods Sold |   | Deferred GrossProfit
|March 31, 2008 |  | $               | 1,139 |                            | $ | 642                  |  | $ | 497  
|March 31, 2007 |  |                 | 2,406 |                            |   | 1,106                |  |   | 1,300

The following table details the amount of revenue, cost of goods sold and gross profit from
systems shipped during prior reporting periods that was recognized for the nine month periods ended March 31, 2008 and 2007 (in thousands).



|               |  |                                               |       |                                                         |   |                                                   |  |   |      
|-------------- |  | --------------------------------------------- | ----- | ------------------------------------------------------- | - | ------------------------------------------------- |  | - | -----
|               |  | Recognition ofRevenue Deferredin Prior Period |       | Recognition of Costof Goods SoldDeferred in PriorPeriod |   | Recognition ofGross ProfitDeferred in PriorPeriod
|March 31, 2008 |  | $                                             | 6,132 |                                                         | $ | 3,411                                             |  | $ | 2,721
|March 31, 2007 |  |                                               | 6,388 |                                                         |   | 3,500                                             |  |   | 2,888

As a result of the significant revenue and cost of goods sold deferral related to current period
shipments of systems, the revenue and cost of goods sold reflected in our Condensed Consolidated Financial Statements may not be indicative of our ability to generate sales of our product into the marketplace in the current period. Likewise,
recognition in the current or a future period of revenue and cost of goods sold related to shipments of systems that occurred in prior years may cause the impression that we are generating a higher volume of sales of our telephone systems into the
market in that period than is the case.

Revenue from time and material service contracts is recognized as the services are provided.
Revenue from fixed price, long-term service or development contracts is recognized over the contract term, using a proportional performance method, based on the percentage of services that are provided during the period compared with the total
estimated services to be provided over the entire contract. Losses on fixed price contracts are recognized during the period in which the loss first becomes apparent.

Warranty

In many cases, we provide a one-year limited warranty to our customers, including repair or
replacement of defective equipment. For certain product lines and customers, we offer longer warranty periods or extended warranties. Our contract manufacturing partners are responsible for the first year of the warranty repair work. We provide for
the estimated cost of product warranties at the time the revenue is recognized. We calculate our warranty liability based on historical product return rates and estimated average repair costs. While we engage in various product quality programs and
processes, our warranty obligation may be affected by product failure rates and the ability of our contract manufacturers to satisfy warranty claims. The outcome of these items could differ from our estimates and revisions to the warranty estimates
could be required.

Accounts Receivable

We provide allowances for doubtful accounts for estimated losses from the inability of our customers to satisfy their accounts as originally contemplated at the time of sale. We calculate these allowances based on the detailed review of
certain individual customer accounts, historical collection rates and our estimation of the overall economic conditions affecting our customer base. If the financial condition of our customers were to deteriorate, resulting in an impairment of their
ability to make payments, additional allowances may be required.



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We also provide reserves for returns and sales incentives to reduce revenue and accounts receivable for
product returns and other credits we may grant to customers. Such reserves are recorded at the time of sale and are calculated based on the historical information (such as rates of product returns) and the specific terms of sales programs, taking
into account any other known information about likely customer behavior. If actual customer behavior differs from our expectations, additional reserves may be required. Also, if we determine that we can no longer accurately estimate amounts for
returns and sales incentives, we would not be able recognize revenue until the customers exercise their rights, or such rights lapse, whichever is later.

Inventory

We measure our inventories at lower of cost or market. For those items that are manufactured by our contract
manufacturers, cost is determined using standards that we believe approximate the first-in, first-out (FIFO) method. We also provide allowances for excess and obsolete inventory equal to the difference between the cost of our inventory
and the estimated market value based upon assumptions about product life cycles, product demand and market conditions. If actual product life cycles, product demand or market conditions are less favorable than those projected by management,
additional inventory allowances or write-downs may be required.

Long-lived Assets, including Goodwill and Other Intangibles

Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets
(SFAS No. 144) establishes a single accounting model for long-lived assets to be disposed of by sale. For long-lived assets that are held for use, when circumstances suggest that there may be an impairment, we compare the forecasted
undiscounted net cash flows to the carrying amount. If the long-lived asset is determined to be unable to recover the carrying amount, then it is written down to fair value. A considerable amount of judgment is required in calculating this
impairment charge, principally in determining financial forecasts. Unanticipated changes in market conditions could have a material impact on our projected cash flows. Differences in actual cash flows as compared to the projected cash flows could
require us to record an impairment.

SFAS No. 142, Goodwill and Other Intangible Assets includes requirements to test
goodwill and indefinite lived intangible assets for impairment rather than amortize them. Goodwill and other indefinite lived intangible assets must be tested for impairment on at least an annual basis. Our goodwill resulting from our acquisitions
of Vertical Networks, Comdial and Vodavi will be tested annually. Although the goodwill was deemed to not be impaired when it was tested in 2006, there can be no assurances that subsequent reviews will not result in material impairment charges. A
considerable amount of judgment is required in calculating this impairment analysis, principally in determining discount rates, financial forecasts and allocation methodology. Unanticipated changes in market conditions could have a material impact
on our projected cash flows. Differences in actual cash flows as compared to the projected discounted cash flows could require us to record an impairment loss.

Summary

The following is a summary of the areas that management believes are important in understanding the results of the
fiscal quarter and nine months ended March 31, 2008. This summary is not a substitute for the detail provided in the following pages or for the condensed consolidated financial statements and notes that appear elsewhere in this document.

Revenues

We derive revenues primarily
from sales of our hardware and software products. The timing and amount of our net revenues has been, and is expected to continue to be, influenced by a number of factors, including the following:



| |  |  | Product design, including our hardware, software and our bundled hardware and services where applicable;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | The demand for our current products;
| | - |  | ------------------------------------



| |  |  | Requirements of generally accepted accounting principles for deferral of certain product sales when combined with long-term maintenance services;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Acquisitions made by us, such as the acquisitions of the assets of Vertical Networks, Comdial and Vodavi;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | The length of our sales cycle; and
| | - |  | ----------------------------------



| |  |  | Budgeting cycles of our customers.
| | - |  | ----------------------------------

Cost of Sales

Cost of sales is primarily comprised of materials, manufacturing, shipping and repair of our products. In addition, amortization of
technology-based intangible assets associated with our acquisitions of Vertical Networks, Comdial and Vodavi and royalties paid to third parties are included in cost of sales.



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##### Table of Contents

Operating Expenses

Our operating expenses are comprised of:



| |  |  | Sales and marketing costs, which consist primarily of salaries and employee benefits for sales and marketing employees, travel, advertising, tradeshows and various
other marketing programs;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Product development costs, which consist primarily of salaries and employee benefits for engineering and technical personnel;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------



| |  |  | General and administrative expenses, which generally represent salaries and employee benefits costs of executive, administrative, operations, finance, human
resource and IT personnel, as well as professional fees, insurance costs, consulting fees, administrative expenses and depreciation;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Stock-based, non-cash compensation expense; and
| | - |  | -----------------------------------------------



| |  |  | Amortization of intangible assets acquired from Vertical Networks, Comdial and Vodavi.
| | - |  | --------------------------------------------------------------------------------------

Results of Operations

Net Revenue

Net revenue was $16.1 million and $54.5 million for the three and nine months ended March 31, 2008, respectively, representing a decrease of 29%
and 4%, from $22.7 million and $56.6 million for the same fiscal periods from prior year. The decrease in net revenue is primarily attributable to lower sales of our legacy products due to significant competitive pressures in the small to
medium business marketplace, lower sales of Xcelerator IP and to lower sales to one of our largest retail chain customers. Our recently launched next generation products (Wave IP 2500 and SBX IP350) were developed to provide more cost-effective
IP-based systems and applications and we expect these products to improve revenue momentum in the future.

We distribute our products both
domestically and internationally. International product revenue was $0.5 million, or 3% of total revenue, for the three months ended March 31, 2008 and $0.5 million, or 2% of total revenue, for the three months ended March 31,
2007. International product revenue for the nine months ended March 31, 2008 was $1.4 million, or 3% of total revenue, and $1.5 million, or 3% of total revenue, for the nine months ended March 31, 2007.

Gross Profit(in thousands, except percentages)



|                 |                |                    |       |                |        |   |        |                   |  |        |                |  |   |        |   |  |   |        |   |  |        |  
|---------------- | -------------- | ------------------ | ----- | -------------- | ------ | - | ------ | ----------------- |  | ------ | -------------- |  | - | ------ | - |  | - | ------ | - |  | ------ | -
|                 |                | Three Months Ended |       |                | Change |   |        | Nine Months Ended |  |        | Change         | 
|                 | March 31, 2008 |                    |       | March 31, 2007 |        |   |        | March 31, 2008    |  |        | March 31, 2007 |  |  
|Gross Profit     |                | $                  | 7,780 |                |        | $ | 10,458 |                   |  | (2,678 | )              |  | $ | 25,413 |   |  | $ | 27,231 |   |  | (1,818 | )
|% of Net Revenue |                |                    | 48    | %              |        |   | 46     | %                 |  |        |                |  |   | 47     | % |  |   | 48     | % |  |        |  

Gross profit as a percentage of revenue increased in the quarter ended March 31, 2008 as
compared with the same quarter of 2007, primarily as a result of the increased percentage of sales of our newer product lines which have a higher margin compared to our legacy products. The decrease in gross profit as a percentage of net revenue for
the nine months ended March 31, 2008, compared to the corresponding period ended March 31, 2007, was due primarily to the addition of revenue and associated cost of sales from the acquisition of Vodavi, which sales have a lower margin
compared to other of our product lines.

Operating Expenses(in thousands, except percentages)



|                                                                 |                |                    |        |                |        |   |        |                   |  |    |                |  |   |        |   |  |   |        |   |  |    |   
|---------------------------------------------------------------- | -------------- | ------------------ | ------ | -------------- | ------ | - | ------ | ----------------- |  | -- | -------------- |  | - | ------ | - |  | - | ------ | - |  | -- | --
|                                                                 |                | Three Months Ended |        |                | Change |   |        | Nine Months Ended |  |    | Change         | 
|                                                                 | March 31, 2008 |                    |        | March 31, 2007 |        |   |        | March 31, 2008    |  |    | March 31, 2007 |  |  
|Sales and Marketing                                              |                | $                  | 4,662  |                |        | $ | 4,677  |                   |  | 0  | %              |  | $ | 14,574 |   |  | $ | 11,952 |   |  | 22 | % 
|% of Net Revenue                                                 |                |                    | 29     | %              |        |   | 21     | %                 |  |    |                |  |   | 27     | % |  |   | 21     | % |  |    |   
|Product Development                                              |                | $                  | 4,038  |                |        | $ | 3,573  |                   |  | 13 | %              |  | $ | 11,905 |   |  | $ | 9,706  |   |  | 23 | % 
|% of Net Revenue                                                 |                |                    | 25     | %              |        |   | 16     | %                 |  |    |                |  |   | 22     | % |  |   | 17     | % |  |    |   
|General and Administrative                                       |                | $                  | 3,796  |                |        | $ | 3,945  |                   |  | (4 | )%             |  | $ | 11,537 |   |  | $ | 11,972 |   |  | (4 | )%
|% of Net Revenue                                                 |                |                    | 24     | %              |        |   | 17     | %                 |  |    |                |  |   | 21     | % |  |   | 21     | % |  |    |   
|Total Operating Expenses (including Amortization of intangibles) |                | $                  | 13,105 |                |        | $ | 12,814 |                   |  | 2  | %              |  | $ | 39,844 |   |  | $ | 34,920 |   |  | 14 | % 
|% of Net Revenue                                                 |                |                    | 81     | %              |        |   | 56     | %                 |  |    |                |  |   | 73     | % |  |   | 62     | % |  |    |   



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##### Table of Contents

Sales and Marketing

For the three months ended March 31, 2008, sales and marketing expenses remained essentially the same, while their costs as a percentage of revenue increased from 21% to 29% compared with the corresponding period
in 2007, as a result of the lower revenue in the current period. For the nine months ended March 31, 2008, sales and marketing expenses increased by $2.6 million, and their costs as a percentage of revenue increased from 21% to 27% compared
with the corresponding period in 2007. The increase in sales and marketing expenses in aggregate dollars for the nine months ended March 31, 2008 compared to the corresponding period ended March 31, 2007 was due primarily to increased
personnel and travel expenses as a result of the acquisition of Vodavi and to increased marketing expenditures to promote our new product lines. The Company employed 109 sales and marketing personnel in the quarter ended March 31, 2008.

Product Development

For the three months ended March 31, 2008, product development expenses increased by $0.5 million and such costs as a percentage of revenue increased from 16% to 25% compared with the corresponding period in 2007, primarily as a result
of the lower revenue in the current period. For the nine months ended March 31, 2008, product development expense increased by $2.2 million and such costs increased as a percentage of revenue from 17% to 22% compared with the corresponding
period in 2007. The increase in product development expenses in aggregate dollars for the three and nine months ended March 31, 2008 compared to the corresponding periods ended March 31, 2007 was due primarily to additional costs related
to our next generation product development efforts. The Company employed 96 product development personnel in the quarter ended March 31, 2008.

General and Administrative

For the three months ended March 31, 2008, general and administrative expense decreased
$0.1 million, whereas such costs as a percentage of revenue increased from 17% to 24% as compared with the same period in 2007, primarily as a result of the lower revenue in the current period. For the nine months ended March 31, 2008, general
and administrative expense decreased $0.4 million, whereas such costs as a percentage of revenue remained unchanged at 21% compared with the same period in 2007. The decrease in general and administrative expenses for the three and nine month
periods ended March 31, 2008 compared to the same periods ended March 31, 2007, was primarily driven by elimination of overhead redundancies following the acquisition of Vodavi. The Company employed 43 general and administrative personnel
in the quarter ended March 31, 2008.

Operating Loss

For the quarter ended March 31, 2008, our operating loss increased $3.0 million, or 126% to ($5.3) million on revenue of $16.1 million, from an operating loss of ($2.4) million on revenue of $22.7 million for the
quarter ended March 31, 2007. This was due to a decrease in gross profit of $2.7 million and an increase of $0.3 million in operating expense. For the nine months ended March 31, 2008, our operating loss increased $6.7 million, or 88%, to
($14.4) million on revenue of $54.5 million, from an operating loss of ($7.7) million on revenue of $56.6 million for the nine months ended March 31, 2007. The factors affecting this increase in operating loss were a $1.8 million decrease in
gross profit associated with lower revenue and a $4.9 million increase in operating expense, primarily a result of the operating expenses added as a result of the Vodavi acquisition and the expenses associated with development and promotion of our
new product lines.

Included in the operating loss are non-cash stock-based compensation expense of $1.5 million and $4.8 million in the
three and nine months ended March 31, 2008, respectively, compared with $1.3 million and $3.4 million in the three and nine months ended March 31, 2007, respectively, and depreciation and amortization expense of $1.0 million and $2.9
million in the three and nine months ended March 31, 2008, respectively, compared with $1.1 million and $2.6 million in the three and nine months ended March 31, 2007, respectively.

As mentioned above under the caption Revenue Recognition, we defer a portion of the revenue and cost of goods sold related to current period
shipments while recognizing revenue and cost of goods sold from shipments in prior periods.



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##### Table of Contents

Interest Expense

Interest expense for the three and nine months ended March 31, 2008 was $0.7 and $2.0 million, respectively, compared with $1.7 million and $3.1 million, respectively, for the three and nine months ended March 31, 2007. The
decrease in interest expense relates to retirement of debt instruments incurred in order to finance the acquisition of Vodavi.

Income Tax Expense

While we incurred net losses in the three and nine month periods ended March 31, 2008 and 2007, we recorded a deferred tax provision
associated with the goodwill created and intangibles acquired with the Vertical Networks and Comdial acquisitions. The effective tax rate utilized for the provision was 40.0 %.

Financial Condition, Liquidity And Capital Resources



|                                        |                |              |       |               |  |   |       |  |   |        |  
|--------------------------------------- | -------------- | ------------ | ----- | ------------- |  | - | ----- |  | - | ------ | -
|                                        |                | Positions at |       | Change        | 
|                                        | March 31, 2008 |              |       | June 30, 2007 | 
|Cash and cash equivalents               |                | $            | 3,879 |               |  | $ | 8,019 |  | $ | (4,140 | )
|Working capital (excl. restricted cash) |                | $            | (625  | )             |  | $ | 4,841 |  | $ | (5,466 | )



|                                      |  |                                 |        |   |                                 |   |         |            |  |   |         |  
|------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------- | - | ------- | ---------- |  | - | ------- | -
|                                      |  | Nine Months EndedMarch 31, 2008 |        |   | Nine Months EndedMarch 31, 2007 |   |         | Difference | 
|Cash used in operating activities     |  | $                               | (4,816 | ) |                                 | $ | (4,606  | )          |  | $ | (210    | )
|Cash used in investing activities     |  | $                               | (1,312 | ) |                                 | $ | (25,817 | )          |  | $ | 24,505  |  
|Cash provided by financing activities |  | $                               | 1,959  |   |                                 | $ | 40,247  |            |  | $ | (38,288 | )

Net cash flows used in operating activities were $4.8 million during the nine months ended
March 31, 2008. The cash used in operating activities was due primarily to a net loss of $17.2 million, offset by depreciation and amortization of $3.1 million and $4.8 million relating to a non-cash compensation charge.

Working capital, consisting of total current assets minus current liabilities, was ($0.6) million at March 31, 2008. This compared to a
working capital of $4.8 million at June 30, 2007, representing a decrease of $5.5 million. The decrease in working capital at March 31, 2008 is primarily due to the $4.1 million decrease in cash.

We have incurred losses and negative or minimal positive cash flows from operations in every fiscal period since 1996 and have an accumulated deficit,
including non-cash equity charges, of $108.6 million as of March 31, 2008. For the nine months ended March 31, 2008 we incurred a net loss of approximately $17.2 million and had negative cash flows from operations of $4.8
million. Our management expects that operating losses will continue in the near future. As of December 31, 2007, our cash resources were not adequate to meet our short-term requirements through the end of the 2008 fiscal year. In March 2008, we
closed the initial tranche of the Series F Financing (see Notes 6 and 12 to the Condensed Consolidated Financial Statements). As a result, we anticipate that we will meet our forecasted cash requirements for the next twelve months. A change in
circumstance, such as a reduction in the demand for our products, could necessitate that we seek additional debt or equity capital or take actions to reduce our operating costs to levels that can be supported by our available cash. Such additional
financings may not be available on terms acceptable to us, or at all, and may significantly affect our stockholders, including for example, by substantially diluting their ownership interest.

Contractual Obligations



|                                    |  |                       |        |                 |   |           |  |           |        |                  |   |    |  |   |  
|----------------------------------- |  | --------------------- | ------ | --------------- | - | --------- |  | --------- | ------ | ---------------- | - | -- |  | - | -
|(in thousands)                      |  | Payment due by Period
|Contractual Obligations             |  | Total                 |        | Less than1 year |   | 1-3 years |  | 3-5 years |        | More than5 years
|Debt Obligations (1)                |  | $                     | 26,127 |                 | $ | 8,824     |  | $         | 17,303 |                  | $ |   |  | $ | 
|Operating Lease Obligations (2)     |  |                       | 5,667  |                 |   | 1,738     |  |           | 3,878  |                  |   | 51 |  |   | 
|Open Purchase Order Commitments (3) |  |                       | 12,953 |                 |   | 12,953    |  |           |       |                  |   |   |  |   | 
|                                    |  |                       |        |                 |   |           |  |           |        |                  |   |    |  |   |  
|Total                               |  | $                     | 44,747 |                 | $ | 23,515    |  | $         | 21,181 |                  | $ | 51 |  | $ | 



|(1) | Debt obligations include a revolving credit facility with SVB, a term loan with Columbia Partners, notes payable to the Series F investors and capital equipment leases. See Note 6
to the Condensed Consolidated Financial Statements for additional information.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The Company leases office, product packaging, storage space and equipment warehouses under noncancelable operating lease agreements expiring through 2012.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | We outsource substantially all of our manufacturing requirements. As of March 31, 2008, we have outstanding purchase obligations of approximately $13.0 million with our
contract manufacturers that could not be cancelled without significant penalties.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Item 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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

Item 4.CONTROLS AND PROCEDURES

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

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

Evaluation of Disclosure Controls and Procedures.

As of March 31, 2008, our management, with the participation of our Audit Committee, Chief Executive Officer and Chief Financial Officer, evaluated
the effectiveness of our Disclosure Controls and Procedures. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of March 31, 2008, the design and operation of these disclosure controls and
procedures were effective during the nine months ended March 31, 2008.

Changes in Internal Control Over Financial Reporting.

There were no changes in the Companys internal control over financial reporting during the nine months ended March 31, 2008, that materially
affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.



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##### Table of Contents

PART IIOTHER INFORMATION

Item 1Legal Proceedings

From time to time we are involved in various claims and other legal
proceedings which arise in the normal course of our business. Such matters are subject to many uncertainties and outcomes that are not predictable. However, based on the information available to us and after discussions with legal counsel, we do not
believe any such proceedings will have a material adverse effect on our business, results of operations, financial position or liquidity. We cannot provide assurance, however that damages that result in a material adverse effect on our financial
position or results of operations will be not be imposed in these matters.

Item 1ARisk Factors

There are no material changes from the risk factors as previously disclosed in
the Companys Annual Report on Form 10-K for the year ended June 30, 2007, filed with the SEC on October 15, 2007 as amended on Form 10-K/A on October 29, 2007.



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Item 6EXHIBITS



|            |  |                                                                                                                                                  
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                      
|31.1        |  | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended            
|            | 
|31.2        |  | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended            
|            | 
|32.1        |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|            | 
|32.2        |  | Certification of Chief 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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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.



|                    |  |  |  |                                                                                    
|------------------- |  |  |  | -----------------------------------------------------------------------------------
|                    |  |  |  | VERTICAL COMMUNICATIONS, INC.                                                      
|                    |  | 
|Dated: May 15, 2008 |  |  |  | /s/ William Y. Tauscher                                                            
|                    |  |  |  | William Y. Tauscher                                                                
|                    |  |  |  | Chief Executive Officer and Chairman of the Board                                  
|                    |  | 
|Dated: May 15, 2008 |  |  |  | /s/ Kenneth M. Clinebell                                                           
|                    |  |  |  | Kenneth M. Clinebell                                                               
|                    |  |  |  | Chief Financial Officer (Principal Financial Officer and
Chief Accounting Officer )



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