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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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(Mark One)

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

For the quarterly period ended September 30, 2006

or



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

For the transition period from              to

Commission File Number 000-19462



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VERTICAL COMMUNICATIONS, INC.

(Exact Name of Registrant as Specified in Its Charter)



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

One Memorial Drive, Cambridge, Massachusetts 02142

(Address of Principal Executive Offices) (Zip Code)

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

Artisoft, Inc.
(Former Name)



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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of
accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.

Large Accelerated
Filer ̈Accelerated Filer ̈Non accelerated Filer  x

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

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



|                                        |  |                                          
|--------------------------------------- |  | -----------------------------------------
|Title of Class of Common
Stock          |  | Shares Outstanding as of November 1, 2006
|Common Stock, $0.01 par value per share |  | 47,016,918                               



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##### Table of Contents

VERTICAL COMMUNICATIONS, INC.

FORM 10-Q

TABLE OF CONTENTS



|        |  |                                                                                                                   |  |     
|------- |  | ----------------------------------------------------------------------------------------------------------------- |  | ----
|        |  |                                                                                                                   |  | Page
|PART I  |  | FINANCIAL INFORMATION                                                                                             |  | 3   
|        |  |                                                                                                                  
|        |  | Item 1. Condensed Consolidated Financial Statements                                                               |  | 3   
|        |  |                                                                                                                  
|        |  | Condensed Consolidated Balance Sheets as of September 30, 2006 (unaudited) and June 30, 2006                      |  | 3   
|        |  |                                                                                                                  
|        |  | Condensed Consolidated Statement of Operations for the three months ended September 30, 2006 and 2005 (unaudited) |  | 4   
|        |  |                                                                                                                  
|        |  | Condensed Consolidated Statement of Cash Flows for the three months ended September 30, 2006 and 2005 (unaudited) |  | 5   
|        |  |                                                                                                                  
|        |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                                  |  | 7   
|        |  |                                                                                                                  
|        |  | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations                     |  | 19  
|        |  |                                                                                                                  
|        |  | Item 3. Quantitative and Qualitative Disclosures about Market Risk                                                |  | 25  
|        |  |                                                                                                                  
|        |  | Item 4. Controls and Procedures                                                                                   |  | 26  
|        |  |                                                                                                                  
|PART II |  | OTHER INFORMATION                                                                                                 |  | 27  
|        |  |                                                                                                                  
|        |  | Item 1. Legal Proceedings                                                                                         |  | 27  
|        |  |                                                                                                                  
|        |  | Item 1A. Risk Factors                                                                                             |  | 27  
|        |  |                                                                                                                  
|        |  | Item 6. Exhibits                                                                                                  |  | 39  
|        |  |                                                                                                                  
|        |  | Signature                                                                                                         |  | 40  



2



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##### Table of Contents

PART IFINANCIAL INFORMATION

Item 1.FINANCIAL STATEMENTS

VERTICIAL COMMUNICATIONS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)



|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ------------- | - | ------- | -
|                                                                                                                                                                                                |  | September 30, 2006 (Unaudited) |         |   | June 30, 2006 |  
|ASSETS                                                                                                                                                                                          |  |                                |         |   |               |   |         |  
|Current assets:                                                                                                                                                                                 |  |                                |         |   |               |   |         |  
|Cash and cash equivalents                                                                                                                                                                       |  | $                              | 1,525   |   |               | $ | 4,726   |  
|Trade receivables, net of allowances of $319 and $322, respectively                                                                                                                             |  |                                | 8,162   |   |               |   | 10,510  |  
|Inventories, net                                                                                                                                                                                |  |                                | 6,899   |   |               |   | 6,071   |  
|Prepaid expenses                                                                                                                                                                                |  |                                | 2,367   |   |               |   | 2,855   |  
|Deferred costs                                                                                                                                                                                  |  |                                | 4,379   |   |               |   | 4,120   |  
|Restricted cash                                                                                                                                                                                 |  |                                | 389     |   |               |   | 389     |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Total current assets                                                                                                                                                                            |  |                                | 23,721  |   |               |   | 28,671  |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Property and equipment                                                                                                                                                                          |  |                                | 5,525   |   |               |   | 5,460   |  
|Less accumulated depreciation and amortization                                                                                                                                                  |  |                                | (3,650  | ) |               |   | (3,259  | )
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Net property and equipment                                                                                                                                                                      |  |                                | 1,875   |   |               |   | 2,201   |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Goodwill                                                                                                                                                                                        |  |                                | 25,759  |   |               |   | 25,759  |  
|Intangible assets, net of accumulated amortization                                                                                                                                              |  |                                | 6,179   |   |               |   | 6,567   |  
|Deferred costs, net of current portion                                                                                                                                                          |  |                                | 6,227   |   |               |   | 6,777   |  
|Other assets                                                                                                                                                                                    |  |                                | 86      |   |               |   | 104     |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Total assets                                                                                                                                                                                    |  | $                              | 63,847  |   |               | $ | 70,079  |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|LIABILITIES, CONVERTIBLE REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS EQUITY                                                                                                                    |  |                                |         |   |               |   |         |  
|Current liabilities:                                                                                                                                                                            |  |                                |         |   |               |   |         |  
|Accounts payable                                                                                                                                                                                |  | $                              | 5,102   |   |               | $ | 4,964   |  
|Accrued liabilities                                                                                                                                                                             |  |                                | 8,619   |   |               |   | 8,752   |  
|Deferred revenue                                                                                                                                                                                |  |                                | 10,646  |   |               |   | 10,409  |  
|Customer deposits                                                                                                                                                                               |  |                                | 175     |   |               |   | 175     |  
|Current portion of long term debt                                                                                                                                                               |  |                                | 7,633   |   |               |   | 10,805  |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Total current liabilities                                                                                                                                                                       |  |                                | 32,175  |   |               |   | 35,105  |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Deferred revenue, net of current portion                                                                                                                                                        |  |                                | 11,408  |   |               |   | 12,196  |  
|Deferred tax liability                                                                                                                                                                          |  |                                | 1,040   |   |               |   | 883     |  
|Long term debt, net of current portion                                                                                                                                                          |  |                                | 10      |   |               |   | 416     |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Total liabilities                                                                                                                                                                               |  |                                | 44,633  |   |               |   | 48,600  |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Series D convertible, redeemable preferred stock, $1.00 par value, 5,000 shares authorized, issued and outstanding at September 30, 2006;
liquidation preference of $5,255 including dividends. |  |                                | 3,720   |   |               |   | 3,555   |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Shareholders equity:                                                                                                                                                                           |  |                                |         |   |               |   |         |  
|Preferred stock, $1.00 par value, authorized 30,000,000 shares.                                                                                                                                 |  |                                |        |   |               |   |        |  
|Common stock, $.01 par value per share. Authorized 250,000,000 shares; issued and outstanding 47,016,918 shares at September 30, 2006 and
at June 30, 2006.                                     |  |                                | 470     |   |               |   | 470     |  
|Accumulated other comprehensive income (loss)                                                                                                                                                   |  |                                | (10     | ) |               |   | (15     | )
|Additional paid-in capital                                                                                                                                                                      |  |                                | 94,264  |   |               |   | 93,389  |  
|Accumulated deficit                                                                                                                                                                             |  |                                | (78,744 | ) |               |   | (75,410 | )
|Deferred Toshiba equity cost                                                                                                                                                                    |  |                                | (486    | ) |               |   | (510    | )
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Net shareholders equity                                                                                                                                                                        |  |                                | 15,494  |   |               |   | 17,924  |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  
|Total liabilities, convertible redeemable preferred stock and shareholders equity                                                                                                               |  | $                              | 63,847  |   |               | $ | 70,079  |  
|                                                                                                                                                                                                |  |                                |         |   |               |   |         |  

See notes to condensed consolidated financial statements.



3



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VERTICIAL COMMUNICATIONS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS

(in thousands, except per share amounts)



|                                                                       |  |                                  |        |   |      |   |        |  
|---------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                       |  | Three Months Ended September 30, |       
|                                                                       |  | 2006                             |        |   | 2005 |  
|Net revenue                                                            |  | $                                | 15,870 |   |      | $ | 9,887  |  
|Cost of sales                                                          |  |                                  | 7,754  |   |      |   | 3,646  |  
|                                                                       |  |                                  |        |   |      |   |        |  
|Gross profit                                                           |  |                                  | 8,116  |   |      |   | 6,241  |  
|                                                                       |  |                                  |        |   |      |   |        |  
|Operating expenses:                                                    |  |                                  |        |   |      |   |        |  
|Sales and marketing                                                    |  |                                  | 3,630  |   |      |   | 3,939  |  
|Product development                                                    |  |                                  | 3,070  |   |      |   | 2,995  |  
|General and administrative                                             |  |                                  | 4,097  |   |      |   | 2,423  |  
|Amortization of intangible assets                                      |  |                                  | 307    |   |      |   | 179    |  
|                                                                       |  |                                  |        |   |      |   |        |  
|Total operating expenses                                               |  |                                  | 11,104 |   |      |   | 9,536  |  
|                                                                       |  |                                  |        |   |      |   |        |  
|Loss from operations                                                   |  |                                  | (2,988 | ) |      |   | (3,295 | )
|Interest expense                                                       |  |                                  | (207   | ) |      |   |       |  
|Other income, net                                                      |  |                                  | 19     |   |      |   | 17     |  
|                                                                       |  |                                  |        |   |      |   |        |  
|Loss before provision for income tax                                   |  |                                  | (3,176 | ) |      |   | (3,278 | )
|Provision for income taxes                                             |  |                                  | 156    |   |      |   | 84     |  
|                                                                       |  |                                  |        |   |      |   |        |  
|Net loss                                                               |  |                                  | (3,332 | ) |      |   | (3,362 | )
|                                                                       |  |                                  |        |   |      |   |        |  
|Series D preferred stock accretion and dividends                       |  |                                  | 165    |   |      |   |       |  
|                                                                       |  |                                  |        |   |      |   |        |  
|Net loss applicable to common shareholders                             |  | $                                | (3,497 | ) |      | $ | (3,362 | )
|                                                                       |  |                                  |        |   |      |   |        |  
|Net loss applicable to common shareholders per sharebasic and diluted |  | $                                | (0.07  | ) |      | $ | (0.10  | )
|Weighted average common shares outstandingbasic and diluted           |  |                                  | 47,017 |   |      |   | 34,720 |  

See notes to condensed consolidated financial statements.



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VERTICIAL COMMUNICATIONS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH
FLOWS

(in thousands)



|                                                                                |  |                                  |        |   |      |   |         |  
|------------------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ---- | - | ------- | -
|                                                                                |  | Three Months Ended September 30, |       
|                                                                                |  | 2006                             |        |   | 2005 |  
|Cash flows from operating activities:                                           |  |                                  |        |   |      |   |         |  
|Net loss                                                                        |  | $                                | (3,332 | ) |      | $ | (3,362  | )
|Adjustments to reconcile net loss to net cash provided by operating activities: |  |                                  |        |   |      |   |         |  
|Depreciation and amortization                                                   |  |                                  | 780    |   |      |   | 480     |  
|Amortization of deferred Toshiba equity costs                                   |  |                                  | 24     |   |      |   | 27      |  
|Non-cash compensation                                                           |  |                                  | 1,040  |   |      |   | 1,168   |  
|Deferred tax provision                                                          |  |                                  | 156    |   |      |   | 80      |  
|Non-cash changes in accounts receivable allowance                               |  |                                  | (3     | ) |      |   | 5       |  
|Changes in assets and liabilities:                                              |  |                                  |        |   |      |   |         |  
|Trade receivables                                                               |  |                                  | 2,351  |   |      |   | (2,014  | )
|Inventories                                                                     |  |                                  | (828   | ) |      |   | (143    | )
|Prepaid expenses                                                                |  |                                  | 488    |   |      |   | 205     |  
|Deferred costs                                                                  |  |                                  | 291    |   |      |   | 528     |  
|Other assets                                                                    |  |                                  | 18     |   |      |   | (24     | )
|Accounts payable                                                                |  |                                  | 137    |   |      |   | (63     | )
|Accrued liabilities                                                             |  |                                  | (84    | ) |      |   | 214     |  
|Deferred revenue                                                                |  |                                  | (551   | ) |      |   | (111    | )
|                                                                                |  |                                  |        |   |      |   |         |  
|Net cash provided by (used in) operating activities                             |  |                                  | 487    |   |      |   | (3,010  | )
|                                                                                |  |                                  |        |   |      |   |         |  
|Cash flows from investing activities:                                           |  |                                  |        |   |      |   |         |  
|Cash used for acquisitions, net of cash acquired                                |  |                                  |       |   |      |   | (18,633 | )
|Purchases of property and equipment                                             |  |                                  | (65    | ) |      |   | (251    | )
|Restricted cash                                                                 |  |                                  |       |   |      |   | (99     | )
|                                                                                |  |                                  |        |   |      |   |         |  
|Net cash used in investing activities                                           |  |                                  | (65    | ) |      |   | (18,983 | )
|                                                                                |  |                                  |        |   |      |   |         |  
|Cash flows from financing activities:                                           |  |                                  |        |   |      |   |         |  
|Payments of capital lease obligations                                           |  |                                  | (6     | ) |      |   |        |  
|(Repayment) proceeds of bank term loan                                          |  |                                  | (400   | ) |      |   | 2,000   |  
|Net change in bank revolver facility                                            |  |                                  | (3,222 | ) |      |   | 7,000   |  
|Proceeds from issuance of common stock                                          |  |                                  |       |   |      |   | 12,853  |  
|                                                                                |  |                                  |        |   |      |   |         |  
|Net cash used in (provided by) financing activities                             |  |                                  | (3,628 | ) |      |   | 21,853  |  
|                                                                                |  |                                  |        |   |      |   |         |  
|Effect of foreign currency exchange rates                                       |  |                                  | 5      |   |      |   | (2      | )
|                                                                                |  |                                  |        |   |      |   |         |  
|Net decrease increase in cash and cash equivalents                              |  |                                  | (3,201 | ) |      |   | (142    | )
|Cash and cash equivalents at beginning of period                                |  |                                  | 4,726  |   |      |   | 4,880   |  
|                                                                                |  |                                  |        |   |      |   |         |  
|Cash and cash equivalents at end of period                                      |  | $                                | 1,525  |   |      | $ | 4,738   |  
|                                                                                |  |                                  |        |   |      |   |         |  
|SUPPLEMENTAL CASH FLOW INFORMATION:                                             |  |                                  |        |   |      |   |         |  
|Non cash dividend and accretion on Series D preferred stock                     |  |                                  | 165    |   |      |   |        |  
|Cash paid for interest                                                          |  |                                  | 146    |   |      |   |        |  



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On September 28, 2005 the Company acquired the assets of Comdial Corporation as
follows (see Note 3):



|                                                |  |                                  |   |      |   |         |  
|----------------------------------------------- |  | -------------------------------- | - | ---- | - | ------- | -
|                                                |  | Three Months Ended September 30, |  
|                                                |  | 2006                             |   | 2005 |  
|Accounts receivable                             |  | $                                |   |      | $ | 3,158   |  
|Inventory                                       |  |                                  |  |      |   | 4,540   |  
|Other current assets                            |  |                                  |  |      |   | 2,248   |  
|Property and equipment                          |  |                                  |  |      |   | 1,285   |  
|Other assets                                    |  |                                  |  |      |   | 150     |  
|Intangible assets                               |  |                                  |  |      |   | 4,300   |  
|Goodwill                                        |  |                                  |  |      |   | 9,190   |  
|Cash used in acquisitions, net of cash acquired |  |                                  |  |      |   | (19,249 | )
|                                                |  |                                  |   |      |   |         |  
|                                                |  |                                  |  |      |   | 5,622   |  
|Note payable to Comdial Corporation             |  |                                  |  |      |   | (2,500  | )
|                                                |  |                                  |   |      |   |         |  
|Accrued direct acquisition costs                |  |                                  |  |      |   |        |  
|                                                |  |                                  |   |      |   |         |  
|Liabilities assumed                             |  | $                                |  |      | $ | 3,122   |  
|                                                |  |                                  |   |      |   |         |  

See notes to condensed consolidated financial statements.



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VERTICIAL 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, 2006 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, 2006. 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, 2006 on file with the SEC. The results of operations for the three months ended September 30, 2006 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 the assets of Comdial Corporation 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 Vertical Networks Inc.

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

Acquisition of the Assets of Comdial Corporation

On
September 28, 2005, pursuant to approval of the United State Bankruptcy Court for the District of Delaware (the Bankruptcy Court), we, through our subsidiary Vertical Communications Acquisitions Corporation (Acquisition
Sub) acquired certain assets and assumed certain liabilities of Comdial Corporation (Comdial and the Comdial Acquisition). Comdial was a manufacturer and distributor of telephone systems targeted to small to midsize
businesses, branch or regional offices of large organizations, national retailers, government agencies, and education campuses. The operational results of this acquisition have been included in all periods since September 28, 2005, the date
that the Comdial Acquisition was consummated.



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(2) SIGNIFICANT ACCOUNTING POLICIES

Stock-Based Compensation

On July 1, 2005, we adopted the provisions of FASB Statement
No. 123 (revised 2004) Accounting for Stock-Based Compensation(SFAS No. 123R) and elected to use the modified prospective transition method. The modified prospective transition method requires that compensation cost be
recognized in the financial statements for all awards granted after the date of adoption as well as for existing awards for which the requisite service has not been rendered as of the date of adoption. As a part of this adoption method, prior
periods are not restated. Prior to July 1, 2005, the Company applied Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employeesin accounting for its stock incentive plan and accordingly,
compensation cost was recognized for its stock options in the financial statements when the exercise price was below the fair market value.

On October 20, 1994, the Companys shareholders approved the Companys 1994 Stock Incentive Plan (the 1994 Plan). The 1994 Plan provides for the grant of Incentive Stock Options, Nonqualified Stock Options, Stock
Appreciation Rights (Tandem and Free-standing), Restricted Stock, Deferred Stock, Performance Units and Performance Shares to officers, key employees, non-employee directors and certain consultants of the Company. This Plan was replaced by the 2004
Stock Incentive Plan (the 2004 Plan) that was approved by the Companys shareholders on March 15, 2004.

The 2004
Plan initially provided that the maximum number of options that could be granted would be 2,000,000 shares, plus the lesser of 150,000 shares of Common Stock or 1.5% of the number of shares of common stock issued and outstanding as of July 1 of
each year commencing on July 1, 2004 (the Evergreen clause). On September 28, 2004, the 2004 Plan was amended to provide that the maximum number of options that can be granted would be increased to 8,236,255 shares and the
Evergreen clause was removed from the plan so that the maximum number of shares that could be granted would no longer increase automatically each year. On April 3, 2006, the 2004 Plan was amended to provide that the maximum number of options
that can be granted would be increased to 10,768,865. Our policy is to issue shares upon option exercise from new shares that were previously authorized.

In the quarter ended September 30, 2006, the Company granted 980,500 options and in the quarter ended September 30, 2005, we granted 137,250 options.

The adoption of SFAS No. 123R increased loss from operations and net loss for the three months ended September 30, 2006 and 2005 by $1.0
million ($0.02 per basic and diluted share) and $1.2 million ($0.03 per basic and diluted share), respectively. As of September 30, 2006, $10.0 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 2.7 years.

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



|                           |  |                                  |       |      |   |      
|-------------------------- |  | -------------------------------- | ----- | ---- | - | -----
|                           |  | Three Months Ended September 30,
|                           |  | 2006                             |       | 2005
|Sales and marketing        |  | $                                | 349   |      | $ | 269  
|Product development        |  |                                  | 296   |      |   | 385  
|General and administrative |  |                                  | 395   |      |   | 514  
|                           |  |                                  |       |      |   |      
|Total                      |  | $                                | 1,040 |      | $ | 1,168
|                           |  |                                  |       |      |   |      

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:



|                        |  |                     |   |  |            |  
|----------------------- |  | ------------------- | - |  | ---------- | -
|                        |  | Year Ended June 30, |  
|                        |  | 2007                |   |  | 2006       |  
|Expected dividend yield |  | 0                   | % |  | 0          | %
|Volatility factor       |  | 116.5               | % |  | 113%-115   | %
|Risk free interest rate |  | 4.87                | % |  | 3.45%-5.03 | %
|Expected life           |  | 6 Years             |   |  | 6 Years    |  



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##### Table of Contents

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 following summarizes stock option activity for the three month period ended September 30, 2006:



|                                  |  |           |   |  |                                 |      |                                                     |    
|--------------------------------- |  | --------- | - |  | ------------------------------- | ---- | --------------------------------------------------- | ---
|Stock Options                     |  | Shares    |   |  | Weighted Average Exercise Price |      | Weighted Average Remaining Contractual Term (years)
|Outstanding at June 30, 2006      |  | 8,216,803 |   |  | $                               | 1.89 |                                                     |    
|Granted                           |  | 980,500   |   |  | $                               | 0.48 |                                                     |    
|Exercised                         |  |          |   |  | $                               | 0.00 |                                                     |    
|Forfeited                         |  | (309,175  | ) |  | $                               | 1.60 |                                                     |    
|                                  |  |           |   |  |                                 |      |                                                     |    
|Outstanding at September 30, 2006 |  | 8,888,128 |   |  | $                               | 1.75 |                                                     | 8.4
|Exercisable at September 30, 2006 |  | 3,183,171 |   |  | $                               | 2.99 |                                                     | 7.7

Goodwill

The Company accounts for its goodwill in accordance with the provisions of FASB Statement No. 142, Goodwill and Other Intangible Assets. This statement requires that goodwill be
periodically tested for impairment, with impaired assets written down to fair value. As of September 1, 2006, the Company conducted its annual impairment test of goodwill by comparing fair value to the carrying amount of its
underlying assets and liabilities. The Company determined that the fair value exceeded the carrying amount of the assets and liabilities, therefore no impairment existed as of the testing date.

(3) ACQUISITIONS

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. 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
million of non-refundable software license revenues collected by us from CVS Pharmacy, Inc. (CVS) in connection with a specific contract. We have paid $1.7 million of the earn-out provision and accrued an additional $0.4 million of the
earn-out provision through September 30, 2006. As of June 30, 2006, the entire $1.0 million in escrow was released to Vertical Networks.

Comdial Corporation

On September 28, 2005, we completed the acquisition of substantially all of the assets of Comdial
(the Comdial Assets) from 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.



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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 12), (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.

The following table represents the allocation of the purchase price for our acquisition of Comdial over the fair value of the assets acquired and
liabilities assumed at the date of acquisition (in millions):



|                          |  |             |      |  
|------------------------- |  | ----------- | ---- | -
|                          |  | Fair Values |     
|Cash                      |  | $           | 0.2  |  
|Accounts Receivable, net  |  |             | 3.2  |  
|Inventory, net            |  |             | 4.5  |  
|Other Current Assets      |  |             | 2.2  |  
|Property and Equipment    |  |             | 1.3  |  
|Intangible assets         |  |             | 4.3  |  
|Goodwill                  |  |             | 9.4  |  
|Accounts Payable          |  |             | (0.2 | )
|Accrued Expenses          |  |             | (1.0 | )
|Other Current Liabilities |  |             | (1.9 | )
|                          |  |             |      |  
|Net assets acquired       |  | $           | 22.0 |  
|                          |  |             |      |  

The values of current assets and liabilities were based upon their historical costs on the date of
acquisition due to their short-term nature. Property and equipment was also valued based upon its historical cost as there was no appreciated real estate and the historical costs of the office equipment, furniture and machinery most closely
approximated fair value. The identified intangible assets were valued at their fair value as of the acquisition date. The excess purchase price was recorded to goodwill based upon the following factors: the value acquired in the form of additional
scale and economies of scale resulting from the size of the combined entity, the value of the assembled workforce, especially the sales, engineering and operations personnel who have continued as part of the acquired business and the ability to
leverage existing, owned technology over the acquired products.

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



|                       |  |        |     |                 |   
|---------------------- |  | ------ | --- | --------------- | --
|                       |  | Amount |     | Life (In Years)
|Trade names/Trademarks |  | $      | 0.2 |                 | 1 
|Customer relationships |  |        | 3.3 |                 | 10
|Existing technology    |  |        | 0.8 |                 | 5 
|                       |  |        |     |                 |   
|                       |  | $      | 4.3 |                 |   
|                       |  |        |     |                 |   

The amounts assigned to identifiable intangible assets acquired was based on their respective fair
values determined as of the acquisition date. The excess of the purchase price over the tangible and identifiable intangible assets was recorded as goodwill and amounted to approximately $9.4 million.



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##### Table of Contents

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



|                                                        |  |                                                   |        |   |         |   |        |                      |  |   |                                |   |  |   |        |  
|------------------------------------------------------- |  | ------------------------------------------------- | ------ | - | ------- | - | ------ | -------------------- |  | - | ------------------------------ | - |  | - | ------ | -
|                                                        |  | Three Months Ended September 30, 2005 (unaudited) |       
|                                                        |  | Vertical                                          |        |   | Comdial |   |        | Pro Forma Adjustment |  |   | Combined Pro Forma as Adjusted |  
|Net product revenue                                     |  | $                                                 | 9,887  |   |         | $ | 8,969  |                      |  | $ |                               |   |  | $ | 18,856 |  
|Net loss                                                |  |                                                   | (3,362 | ) |         |   | (2,806 | )                    |  |   | (409                           | ) |  |   | (6,577 | )
|Net loss applicable to common shareholders              |  |                                                   | (3,362 | ) |         |   | (2,806 | )                    |  |   | (409                           | ) |  |   | (6,577 | )
|Net loss applicable to common stock  Basic and Diluted |  | $                                                 | (0.10  | ) |         |   |        |                      |  |   |                                |   |  | $ | (0.26  | )

The pro forma adjustments include the amortization expense for the acquired identifiable intangible assets, of
approximately $0.2 million per quarter, the interest expense for the amounts borrowed to finance the acquisition of approximately $0.2 million, and deferred income tax expense associated with the goodwill valuation of $9.4 million.

(4) INVENTORIES

Inventories, net, at
September 30, 2006 and June 30, 2006 are $6.9 million and $6.1 million, respectively, consisting of the following (in thousands):



|               |  |                   |       |              |   |      
|-------------- |  | ----------------- | ----- | ------------ | - | -----
|               |  | September 30,2006 |       | June 30,2006
|Raw Materials  |  | $                 | 307   |              | $ | 392  
|Finished Goods |  | $                 | 6,592 |              | $ | 5,679
|               |  |                   |       |              |   |      
|               |  | $                 | 6,899 |              | $ | 6,071
|               |  |                   |       |              |   |      

The increase in inventory held at September 30, 2006 is primarily due to an increase in the
number of phones on hand and to the timing of receipts of finished goods anticipated to be sold in the second fiscal quarter of 2007.

(5) INTANGIBLE
ASSETS

Intangible assets related to the acquisitions of Vertical Networks and Comdial at September 30, 2006 and June 30, 2006
consist of the following (in thousands):



|                                                   |  |                    |        |   |               |   |        |               |  |   
|-------------------------------------------------- |  | ------------------ | ------ | - | ------------- | - | ------ | ------------- |  | --
|                                                   |  | September 30, 2006 |        |   | June 30, 2006 |   |        | Life in Years
|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 
|                                                   |  |                    |        |   |               |   |        |               |  |   
|                                                   |  |                    | 8,600  |   |               |   | 8,600  |               |  |   
|Accumulated amortization                           |  |                    | (2,421 | ) |               |   | (2,033 | )             |  |   
|                                                   |  |                    |        |   |               |   |        |               |  |   
|                                                   |  | $                  | 6,179  |   |               | $ | 6,567  |               |  |   
|                                                   |  |                    |        |   |               |   |        |               |  |   

Amortization expense for the three months ending September 30, 2006 and 2005 was $0.4 million
and $0.2 million respectively, of which $80 thousand and $40 thousand, respectively, was included in cost of sales.



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(6) DEBT

The Company financed a portion of the purchase price for the Comdial Assets (the 2005 Debt Financing) by entering into a loan agreement with SVB on September 28, 2005 (the SVB Loan Agreement). The SVB Loan
Agreement terms provide the Company with a revolving line of credit in an amount not to exceed $7,000,000 (the Revolving Loan), as well as a $2,000,000 term loan (the Term Loan). The 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. In
addition, the credit limit was redefined as the lesser of (A) $7,000,000 less the amounts outstanding under the term loan and the amounts outstanding for letter of credit or cash management services, or (B) 80% of eligible accounts
receivable plus 20% of eligible inventory less the amounts outstanding under the term loan and the amounts outstanding for letter of credit or cash management services. The interest rate on the Revolving Loan was changed to the Prime
Rate plus 1.75% per annum and the interest rate on the Term Loan was changed to the Prime Rate plus 2.25% per annum. Certain of the provisions of the financial covenants were modified to eliminate the minimum cash
balances covenant and add a minimum equity raise covenant which specifies that the Company must receive a minimum of $5,000,000 in net proceeds from the issuance of equity securities and/or subordinated debt on or before November 1, 2006. In
addition the minimum earnings before interest, taxes, depreciation and amortization covenant was modified.

The Term Loan is 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.

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

On September 28, 2005 (the Closing Date) the Company also executed a secured promissory note in the aggregate principal amount of
$2,500,000 (the Comdial Note). The Comdial Note bears 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. The note was made subject to the minimum equity raise and minimum earnings before interest, taxes, depreciation and
amortization covenants contained in the SVB Revolving Loan modification dated September 27, 2006. In addition, the Company was required to pay an extension fee of $150,000 plus all accrued interest on the note through September 28, 2006 up
to a maximum of $400,000. If the Company pays off the Comdial Note in full prior to November 1, 2006, the extension fee will be reduced by $75,000.

The Comdial Note is secured by all of the Companys assets, and is junior in interest to any security interest granted with respect to any current or future indebtedness of the Company owed to SVB, including,
without limitation, amounts owing under the 2005 Debt Financing.

On October 18, 2006, the Company entered into a Senior Secured
Promissory Note with NEIPF, L.P. (see Note 12). The Company used proceeds from this loan to extinguish all of the outstanding loans with SVB and the Comdial Estate.

(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

2006 Financing Series D Preferred Stock

On February 9, 2006, the Company completed the sale
(the Series D Financing) of 5,000 shares of its newly designated 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 Warrants) of the Companys Common Stock pursuant to a Securities Purchase Agreement between the Company and certain investors (the Series D Investors) (the 2006 Securities Purchase
Agreement). The aggregate proceeds to the Company from the Series D Financing was $5.0 million.



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Obligation to Register Shares

Pursuant to the 2006 Securities Purchase Agreement, we agreed to register the shares of common stock issuable upon conversion of the Series D Preferred Stock and upon exercise of the Warrants (collectively, the
Issued Shares) for resale by the Series D Investors under the Securities Act. The Company also agreed to file with the SEC a registration statement with respect to the Issued Shares no later than March 27, 2006 (the
Filing Date), and to use our best efforts to cause the registration statement to become effective on or before the date that is the earlier of (1) in the event of no review by the SEC, within five days of being informed by the SEC
that the SEC has decided not to review the registration statement, but in no event later than 30 days after the Filing Date, (2) in the event of a review by the SEC, within five days of being informed by the SEC that the SEC has no further
comments on such registration statement, but in no event later than 90 days after the Filing Date (the earlier of (1) and (2), the Required Effective Date).

The Company is currently liable for liquidated damages to each Series D Investor because the registration statement was not filed on or before
March 27, 2006 (such an event, a Filing Default). As a result of the Filing Default, the Company must pay as liquidated damages to the Series D Investors, for each 30-day period of a default, an amount in cash equal to 1% of
the aggregate purchase price paid by the Series D Investor pursuant to the 2006 Securities Purchase Agreement; provided that in no event will the aggregate amount of cash to be paid as liquidated damages exceed 9% of the aggregate purchase
price paid by such Series D Investor. As of September 30, 2006, the Company has accrued $311,667 in liquidated damages as a result of the Filing Default.

Material Terms

The material terms of the Companys Series D Preferred Stock are summarized below.

Dividends. From the date of issuance, the Series D Preferred Stock accrues dividends at a rate of $80.00 per year and compounds annually. Dividends on the
Series D Preferred Stock may be declared and paid from time to time as determined by the Companys board of directors. The Company cannot declare, pay or set aside any dividends or distributions on any other shares of capital stock of the
Company unless the holders of Series D Preferred Stock first receive or simultaneously receive a dividend or distribution on each outstanding share of Series D Preferred Stock in such amounts as set forth in the Certificate of Powers,
Designation, Preferences and Rights of the Series D Preferred Stock (the Certificate of Designations).

Redemption. Beginning
February 9, 2009, the Series D Preferred Stock may be redeemed at a price equal to the Original Issue Price, plus all declared and unpaid dividends, provided that the holders of a majority of the issued and outstanding shares of
Series D Preferred Stock consent to such redemption. Commencing 30 days after the consent, the Series D Preferred Stock must be redeemed in three equal annual installments. If the Company fails to redeem the Series D Preferred Stock in
accordance with the Certificate of Designations, then interest will accrue on any unpaid amount at a rate of 1% per each 30-day period that such amounts remain unpaid.

Warrants

In addition to the issuance and 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 warrants have a term of exercise expiring on February 9, 2016. The number of shares issuable upon exercise and the per share
exercise price of the warrants is subject to adjustment in the case of any stock dividend, stock split, combination, capital reorganization, reclassification or merger or consolidation. Subject to limited exceptions, the number of shares of common
stock for which the warrant is exercisable is also subject to adjustment in the case of an issuance of shares of common stock or securities exercisable for or convertible into common stock, at a per share price less than the per share conversion
price of the Series D Preferred Stock then in effect. In the event of such an issuance, the number of shares of common stock for which the warrant is exercisable is increased in accordance with the formula set forth in the warrant. The
conversion price, as defined in the warrant, is also reduced to equal the purchase price of the new issuance of common stock (or securities convertible into common stock). The warrants are exercisable at any time prior to their expiration date by
delivering the warrant certificates to the Company, together with a completed election to purchase and the full payment of the exercise price or by means of a net exercise clause under which the Company does not receive any cash, but
rather, the number of shares issued upon exercise is net of the number of shares withheld by the Company in lieu of payment of the exercise price. This net exercise right is generally limited to times when the Company is not in compliance with its
obligations relating to the registration of the shares of common stock underlying the warrants for resale under the Companys registration rights agreement with respect to those shares.



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The Company allocated the proceeds between the stock and the warrants based upon their relative fair
values as of the closing date, resulting in $951 thousand being allocated to the warrants. We determined the fair value of the warrants using the Black-Scholes option pricing model with the following assumptions: no dividend yield; weighted average
risk free rate of 4.54%; volatility of 115% and a contractual life of 10 years. The Company recorded the portion of the proceeds attributable to the stock as mezzanine equity pursuant to EITF Topic D-98, Classification and Measurement of
Redeemable Securitiesafter determining the guidance in FAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equitydid not apply. The Company determined that the warrants meet the definition
of a derivative instrument as defined in SFAS 133, Accounting for Derivative Instruments and Hedging Activities, but do not require derivative treatment pursuant to the scope exception in paragraph 11(a) of SFAS 133. We recorded the proceeds
attributable to the warrants in permanent equity pursuant to guidance in EITF 00-19,Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Companys Own Stock, as the Company can settle the warrants in
unregistered shares and the liquidated damages are not believed to be uneconomic.

The Company evaluated whether the embedded
conversion feature in the stock required bifurcation and determined that the economic characteristics and risks of the embedded conversion feature in the stock were clearly and closely related to the stock and concluded that bifurcation was not
required under SFAS 133. We calculated the intrinsic value of the beneficial conversion feature embedded in the stock pursuant to the guidance in EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments. The
beneficial conversion of $659 thousand was recognized as an additional discount on the stock. The total discount on the stock resulting from the allocation of proceeds to the warrants and recording of the beneficial conversion feature will be
accreted over the period through the earliest possible redemption date.

We will reevaluate the classification of the stock and warrants in
each period to determine if reclassification is necessary. Our obligation to the Series D Preferred Stockholders, should they choose to redeem the stock at or after the redemption date is $5.0 million plus accrued but unpaid dividends.

(9) EQUITY

On September 28, 2004 and
October 1, 2004, we sold a total of 24,159,468 shares of our Common Stock at a per share purchase price of $1.1386 to several investors (the 2004 Investors), including M/C Venture Partners, under the terms of the 2004 Stock Purchase
Agreement. In connection with, or prior to the financing, the holders of all shares of our Series B and Series C Preferred Stock converted those shares into Common Stock.

On September 28, 2005 we sold a total of 11,329,785 shares of common stock at a per share purchase price of $1.1386, under the terms of the 2005 Stock Purchase Agreement.

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



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



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



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



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



| |  | the 2005 Stock Purchase Agreement.
|- |  | ----------------------------------

The 2004 Investors
and certain parties to the Prior Agreements (the Prior Investors) holding enough voting power to amend the 2004 Stock Purchase Agreement and the Prior Agreements, executed a consent, waiver, and release agreement, dated
September 28, 2005, pursuant to which the 2004 Investors and the Prior Investors consented to the execution of the 2005 Stock Purchase Agreement (the 2005 Stock Purchase Agreement) and executed agreements to



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amend the 2004 Stock Purchase Agreement and the Prior Agreements (collectively, the Amendments). The
Amendments effected, among other things, the following:



| |  |  | With respect to the 2004 Stock Purchase Agreement (i) tolled the liquidated damages accrued or accruing under the 2004 Stock Purchase Agreement through September 28, 2005
by reason of our failure to file and have declared effective by the SEC a registration statement covering the resale of the shares of our common stock purchased pursuant to the 2004 Stock Purchase Agreement (the Liquidated Damages) and
(ii) changing the time frame in which we are obligated to register the shares issued in the 2004 Agreements to match the time frame for registering shares under the 2005 Stock Purchase Agreement and (iii) agreed to issue new warrants to
the 2004 investors in lieu of payment of the Liquidated Damages.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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

The Company is currently liable for liquidated damages to the 2005 Investors and the 2004 Investors because the registration
statement was not declared effective on or before March 12, 2006 (such an event, an Effectiveness Default). As a result of the Effectiveness Default, the Company must pay as liquidated damages to the 2005 Investors and the 2004
Investors, for each 30-day period of a default, an amount in cash equal to 1% of the aggregate purchase price paid by the Investors; provided that in no event will the aggregate amount of cash to be paid as liquidated damages exceed 9% of the
aggregate purchase price paid by each Investor. As of September 30, 2006, the Company has accrued $1.9 million in liquidated damages as a result of the Effectiveness Default.

(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.



|                                                                                  |  |                                  |  |      
|--------------------------------------------------------------------------------- |  | -------------------------------- |  | -----
|                                                                                  |  | Three Months Ended September 30,
|                                                                                  |  | 2006                             |  | 2005 
|Antidilutive potential common shares excluded from net loss per share (thousands) |  | 11,236                           |  | 9,752

(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



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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

Funding Commitment

On October 12, 2006, the
Company and certain of its investors and its chief executive officer, entered into a binding, non-cancellable agreement wherein the investors and the chief executive officer committed to fund the operations of the Company, as and when needed, up to
$5.0 million, through September 30, 2007.

Vodavi Transaction

On October 18, 2006, the Company entered into an Agreement and Plan of Merger (the Merger Agreement) by and among the Company, Vodavi Technology, Inc., a Delaware corporation (Vodavi) and
Vertical Acquisition Sub Inc., a Delaware corporation and wholly-owned subsidiary of the Company (MergerSub), pursuant to which MergerSub shall be merged with and into Vodavi (the Merger), with Vodavi continuing its corporate
existence as a wholly-owned subsidiary of the Company (the Surviving Entity). Upon the effectiveness of the Merger, the certificate of incorporation, the bylaws, the directors and officers of MergerSub shall be the certificate of
incorporation, bylaws, directors and officers of the Surviving Entity. In accordance with Delaware law, all of the rights, privileges, powers, immunities, purposes and franchises of Vodavi and the MergerSub shall vest in the Surviving Entity.
Immediately prior to the effective time of the Merger, all outstanding options to purchase shares of Vodavi capital stock, whether vested or not vested, shall be exercised pursuant to a cashless exercise procedure and all equity incentive plans
administered by Vodavi shall be terminated.

At the effective time of the Merger, each issued and outstanding share of capital stock of
Vodavi, except for dissenting shares, will be converted into the right to receive $7.50 cash, without interest, on the terms specified in the Merger Agreement. The aggregate consideration payable by the Company to the stockholders of Vodavi will be
approximately $31.2 million in cash, obtained partly through the Series E Financing discussed below and partly through the Loan Transaction described below, subject to adjustment as provided in the Merger Agreement.

Series E Financing

On October 18, 2006, the
Company entered into a securities purchase agreement (the Securities Purchase Agreement) with certain investors (the Series E Investors) for the following (collectively the Series E Financing):



| |  |  | the sale of at least 22,000 shares of its newly designated Series E Convertible Preferred Stock, par value $1.00 per share (the Series E Preferred Stock) at a
purchase price of $1,000 per share (the Original Issue Price);
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the issuance of warrants (the Tranche I Warrants) to purchase an aggregate of 20,754,717 shares of the Companys common stock, par value $0.01 per share (the
Common Stock) at an exercise price of $0.58 per share; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the issuance of additional warrants (the Tranche II Warrants) to purchase an aggregate of 20,754,717 shares of the Companys Common Stock at an exercise price of
$0.58 per share.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The completion of the Series E Financing is conditioned upon the consummation of the Merger of Vodavi with
and into the Merger Sub pursuant to the terms and conditions of the Merger Agreement, with such date to be the Closing Date under the Securities Purchase Agreement. Upon consummation of the Series E Financing, the gross proceeds to
the Company will be $22.0 million.

Credit Agreement

The Company entered 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 agreed to (a) issue a senior secured promissory note payable to Lender
(the Initial Bridge Note) in the principal amount of up to $10.0 million; (b) so long as certain conditions are satisfied, issue a senior secured promissory note payable to Lender (the Subsequent Bridge Note) in the
principal amount of $5.0 million; (c) so long as certain conditions are satisfied, issue a senior secured promissory note payable to Lender (the Term Note and, together with the Initial Bridge Note and the Subsequent Bridge Note,
the Loans) in the principal amount of $15.0 million; and



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(d) upon the issuance of the Initial Bridge Note, issue to Lender (i) a Warrant to purchase 4,500,000 shares of
the Companys Common Stock at an exercise price equal to $0.01 per share on terms and conditions substantially similar to the Tranche I Warrant and (ii) an additional warrant for the purchase of 500,000 shares of the Companys Common
Stock at an exercise price equal to $0.01 per share on terms and conditions substantially similar to the Tranche II Warrant (collectively, the Lender Warrants). The principal amount of the Term Note and any accrued and unpaid interest
thereon, including a payment premium, is due and payable in full thirty six (36) months from the date of issuance of the Term Note. The principal amount of the Initial Bridge Note and the Subsequent Bridge Note and any accrued and unpaid
interest thereon is due and payable on July 1, 2007. The outstanding principal amount of the Initial Bridge Note and the Subsequent Bridge Note each bear interest at a rate per annum of fourteen percent (14%), payable in cash in arrears each
fiscal quarter. The outstanding principal amount of the Term Note bears interest at a rate per annum equal to the applicable federal rate for the term of the Term Note as most recently published in the Internal Revenue Code of 1986, as amended.

The Company received the proceeds of the Initial Bridge Note on October 18, 2006 and used these proceeds to extinguish all of the
outstanding loans with SVB and the Comdial Estate.

The Company is in the process of evaluating the appropriate accounting treatment for
these transactions.

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 lack of working capital which could have a significant negative impact on our current level of operations;
|- |  | --------------------------------------------------------------------------------------------------------------



| |  | the risk that the Company may be unable to finalize the transactions under the Merger Agreement, Series E Financing and the Credit Agreement;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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

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



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

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

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

Actual results could differ materially from any one or all of these estimates discussed above. For a more detailed explanation
of the judgments made in these areas, please refer to our annual report on Form 10-K for the year ended June 30, 2006.

Critical Accounting
Policies

Revenue Recognition

The Company recognizes revenue for the sale of its 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 products, where the Company has determined that the software is incidental, the Company follows Staff Accounting Bulletin (SAB) 104, Revenue
Recognition. Generally, the Company 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 statements. 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



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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 most 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 good 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 quarters ended September 30, 2006 and 2005 that was deferred at each quarter end (in thousands).



|                   |  |                  |       |                             |   |                       |  |   |      
|------------------ |  | ---------------- | ----- | --------------------------- | - | --------------------- |  | - | -----
|                   |  | Deferred Revenue |       | Deferred Cost of Goods Sold |   | Deferred Gross Profit
|September 30, 2006 |  | $                | 1,881 |                             | $ | 843                   |  | $ | 1,038
|September 30, 2005 |  |                  | 658   |                             |   | 293                   |  |   | 365  

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 periods ended September 30, 2006 and 2005 (in thousands).



|                   |  |                                                 |       |                                                            |   |                                                      |  |   |    
|------------------ |  | ----------------------------------------------- | ----- | ---------------------------------------------------------- | - | ---------------------------------------------------- |  | - | ---
|                   |  | Recognition of Revenue Deferred in Prior
Period |       | Recognition of Cost of Goods Sold Deferred in Prior Period |   | Recognition of Gross Profit Deferred in Prior Period
|September 30, 2006 |  | $                                               | 2,044 |                                                            | $ | 1,121                                                |  | $ | 923
|September 30, 2005 |  |                                                 | 1,227 |                                                            |   | 734                                                  |  |   | 493

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 in the future 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 mode, 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.



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Warranty

In most 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.

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 and Comdial 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 first quarter ended September 30, 2006. 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.



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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;
| | - |  | ------------------------------------



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



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



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

Cost of Sales

Cost of sales is generally comprised of materials, manufacturing, shipping and repair of our products. Prior to the acquisitions of Vertical Networks and
Comdial, cost of sales consisted primarily of materials for a limited amount of shrink wrap product including software CDs and manuals and also small amounts of amortization of purchased technology. As a result of the acquisition of Vertical
Networks and Comdial, cost of sales increased substantially due to the hardware costs associated with sales of the InstantOffice and Comdial product lines and due to additional amortization of technology-based intangible assets associated with the
acquisitions. Cost of sales also includes royalties paid to third parties.

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 and administrative expenses;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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

Results of Operations

Net Revenue

Net revenue was $15.9 million the quarter ended September 30, 2006, representing an increase of 60.5% from $9.9 million for the quarter ended September 30, 2005. The increase in net revenue is
primarily attributable to the acquisition of the Comdial Assets, which was completed on September 28, 2005.

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 September 30, 2006 and $0.4 million, or 4% of total revenue, for the three months ended
September 30, 2005.



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Gross Profit



|                 |  |                    |       |   |                    |   |       |        |  |   |      
|---------------- |  | ------------------ | ----- | - | ------------------ | - | ----- | ------ |  | - | -----
|                 |  | Three Months Ended |       |   |                   
|                 |  | September 30, 2006 |       |   | September 30, 2005 |   |       | Change
|Gross Profit     |  | $                  | 8,116 |   |                    | $ | 6,241 |        |  | $ | 1,875
|% of Net Revenue |  |                    | 51    | % |                    |   | 63    | %      |  |   |      

The decrease in gross profit as a percentage of net revenue for the quarter ended
September 30, 2006, compared to the corresponding period ended September 30, 2005, was due primarily to the addition of revenue and associated cost of sales from the acquisition of the assets of Comdial, which have a lower margin compared
to our other product lines.

Operating Expenses



|                                                                 |  |                    |        |   |                    |   |       |        |  |    |   
|---------------------------------------------------------------- |  | ------------------ | ------ | - | ------------------ | - | ----- | ------ |  | -- | --
|                                                                 |  | Three Months Ended |        |   |                    |  
|                                                                 |  | September 30, 2006 |        |   | September 30, 2005 |   |       | Change | 
|Sales and Marketing                                              |  | $                  | 3,630  |   |                    | $ | 3,939 |        |  | (8 | )%
|% of Net Revenue                                                 |  |                    | 23     | % |                    |   | 40    | %      |  |    |   
|Product Development                                              |  | $                  | 3,070  |   |                    | $ | 2,995 |        |  | 3  | % 
|% of Net Revenue                                                 |  |                    | 19     | % |                    |   | 30    | %      |  |    |   
|General and Administrative                                       |  | $                  | 4,097  |   |                    | $ | 2,423 |        |  | 69 | % 
|% of Net Revenue                                                 |  |                    | 26     | % |                    |   | 25    | %      |  |    |   
|Total Operating Expenses (including amortization of intangibles) |  | $                  | 11,104 |   |                    | $ | 9,536 |        |  | 16 | % 
|% of Net Revenue                                                 |  |                    | 70     | % |                    |   | 96    | %      |  |    |   

Sales and Marketing

The decrease in sales and marketing expense for the three months ended September 30, 2006, compared to the corresponding period ended September 30, 2005, was due primarily to reduced commissions and travel
expenses offset by increases in sales support personnel as a result of the acquisition of Comdial. For the three months ended September 30, 2006, sales and marketing expenses decreased by $0.3 million, and their costs as a percentage of revenue
decreased from 40% to 23%. This is primarily a result of the increase in revenue due to the acquisition of the Comdial assets. The acquisition of the assets of Comdial occurred on September 28, 2005, thus for the three months ended
September 30, 2006 there is a full quarter of such expenses. The Company employed 79 sales and marketing personnel throughout the quarter ended September 30, 2006. The Company employed 68 sales and marketing personnel throughout the
quarter ended September 30, 2005.

Product Development

The increase in product development expenses for the three months ended September 30, 2006, compared to the corresponding period ended September 30, 2005, was due primarily to the acquisition of the
operations of Comdial. For the three months ended September 30, 2006, product development expense increased by $0.1 million, whereas their costs as a percentage of revenue decreased from 30% to 19%. This is primarily a result of the increase in
revenue due to the acquisition of the Comdial assets. The increase in product development expenses for the three months ended September 30, 2006 compared to the same period ended September 30, 2005, was driven by increased payroll expenses
and employee related costs. The Company employed 68 product development personnel throughout the quarter ended September 30, 2006. The Company employed 72 product development personnel throughout the quarter ended September 30, 2005.

General and Administrative

The
increase in general and administrative expenses for the three months ended September 30, 2006, compared to the corresponding period ended September 30, 2005, was due primarily to the acquisition of the operations of Comdial. For the three
months ended September 30, 2006, general and administrative expense increased $1.7 million,



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and their costs as a percentage of revenue increased from 25% to 26% as compared with the same period ended
September 30, 2005. This is primarily a result of the increase in revenue attributable to sales of the Comdial products. The increase in general and administrative expenses for the three months ended September 30, 2006 compared to the same
period ended September 30, 2005, was driven by increased payroll expenses and employee related costs. The Company employed 43 general and administrative personnel throughout the quarter ended September 30, 2006. The Company employed 26
general and administrative personnel throughout the quarter ended September 30, 2005.

General and Administrative expense also
includes liquidated damages that we are accruing related to the 2004 Stock Purchase Agreement, the 2005 Stock Purchase Agreement and the 2006 Securities Purchase Agreement. Total liquidated damages recorded for the quarter ended September 30,
2006 was $613,000, representing an increase of $63,000 or 11%, compared with $550,000 accrued for the quarter ended September 30, 2005.

Operating
Loss

For the quarter ended September 30, 2006, our operating loss decreased $0.3 million, or 9 percent, to ($3.0) million on
revenue of $15.9 million, from an operating loss of ($3.3) million on revenue of $9.9 million for the quarter ended September 30, 2005. As discussed above, the factors affecting this decrease in operating loss were a $1.9 million increase in
gross profit offset by a $1.6 million increase in operating expense, both primarily a result of the acquisition of the Comdial operations.

Included in the operating loss are non-cash compensation expense related to stock option grants of $1.0 million in the quarter ended September 30, 2006 compared with $1.2 million in the quarter ended September 30, 2005 and
depreciation and amortization (for other than the acquired intangibles) expense of $0.4 million in the quarter ended September 30, 2006 compared with $0.3 million in the quarter ended September 30, 2005.

As mentioned above under the caption Revenue Recognition, we defer a significant 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.

Interest Expense

Interest expense for the quarter ended September 30, 2006 was $0.2 million compared with none in the same quarter of 2005. The increase in interest
expense relates to debt instruments incurred in order to finance the Comdial acquisition.

Income Tax Expense

While we incurred net losses in the quarters ended September 30, 2006 and 2005, 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 percent.

Financial Condition, Liquidity And Capital Resources

Despite the overall decrease in our operating expenses as a percentage
of revenue, we will be required to carefully manage our expenses to maximize our liquidity. We are continuing to review our integration plans and expect to continue to reduce expenses as we reduce redundancies and streamline our operations.



|                                        |  |                    |   |  |               |   |  |        |  
|--------------------------------------- |  | ------------------ | - |  | ------------- | - |  | ------ | -
|                                        |  | Positions at       |   |  |               |  
|                                        |  | September 30, 2006 |   |  | June 30, 2006 |   |  | Change |  
|Cash and cash equivalents               |  | 1,525              |   |  | 4,726         |   |  | (3,201 | )
|Working capital (excl. restricted cash) |  | (8,843             | ) |  | (6,823        | ) |  | (2,020 | )



|                                                |  |                                      |   |  |                                      |   |  |            |  
|----------------------------------------------- |  | ------------------------------------ | - |  | ------------------------------------ | - |  | ---------- | -
|                                                |  | Three Months Ended September 30,2006 |   |  | Three Months Ended September 30,2005 |   |  | Difference |  
|Cash provided by (used in) operating activities |  | 487                                  |   |  | (3,010                               | ) |  | 3,497      |  
|Cash used in investing activities               |  | (65                                  | ) |  | (18,983                              | ) |  | 18,918     |  
|Cash provided by (used in) financing activities |  | (3,628                               | ) |  | 21,853                               |   |  | (25,481    | )



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Net cash flows provided by operating activities were $0.5 million during the three months ended
September 30, 2006. The cash provided by operating activities was due primarily to a net loss of $3.3 million, offset by depreciation and amortization of $0.8 million, $1.0 million relating to a non-cash compensation charge and a
decrease of $2.4 million in our outstanding trade receivables balance. At September 30, 2006, compared to at June 30, 2006, inventory increased by $0.8 million and prepaid expenses decreased by $0.5 million. Accounts payable increased by
$0.1 million and accrued liabilities increased by $0.1 million during the same period.

Working capital, consisting of total current assets
minus current liabilities, was a deficit of $8.8 million at September 30, 2006. This compared to a working capital deficit of $6.8 million at June 30, 2006, representing a decrease of $2.0 million. The decrease in working capital
at September 30, 2006 is primarily due to the $2.3 million decrease in outstanding trade receivables during a period when accounts payable and the accrued liabilities remained relatively flat.

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 $78.7 million as of September 30, 2006. For the three months ended September 30, 2006 we incurred a net loss of approximately $3.3 million, which includes cash flows from operations of
approximately $0.5 million. Our management expects that operating losses will continue in the near future. As of June 30, 2006, our cash resources were not adequate to meet our short-term requirements through the end of the 2007 fiscal
year. Therefore in October, 2006, we obtained binding, non-cancellable commitments from certain of our investors and our chief executive officer to fund our operations, up to $5.0 million, through September, 2007. In addition we have entered into
agreements for additional debt and equity financing in conjunction with our planned acquisition of Vodavi (see Note 12 to the Condensed Consolidated Financial Statements). As a result, we anticipate that we will meet our anticipated cash
requirements for the next twelve months. A change in circumstance, such as a reduction in the demand for our products or the failure to close the Vodavi acquisition, 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



|                                    |  |                       |  |                  |  |           |  |           |  |                  
|----------------------------------- |  | --------------------- |  | ---------------- |  | --------- |  | --------- |  | -----------------
|                                    |  | Payment due by Period
|Contractual Obligations             |  | Total                 |  | Less than 1 year |  | 1-3 years |  | 3-5 years |  | More than 5 years
|Debt Obligations (1)                |  | 7,643                 |  | 7,633            |  | 10        |  |          |  |                 
|Operating Lease Obligations (2)     |  | 3,583                 |  | 1,337            |  | 1,522     |  | 724       |  |                 
|Open Purchase Order Commitments (3) |  | 11,796                |  | 11,796           |  |          |  |          |  |                 
|                                    |  |                       |  |                  |  |           |  |           |  |                  
|Total                               |  | 23,022                |  | 20,766           |  | 1,532     |  | 724       |  |                 

---

|(1) | Debt obligations include a revolving credit facility and term loan with SVB, the Comdial Note and capital equipment leases. Subsequent to September 30, 2006 the outstanding
loans with SVB and the Comdial Note were extinguished.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The Company leases office, product packaging, storage space and equipment warehouses under noncancelable operating lease agreements expiring through 2010.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | We outsource substantially all of our manufacturing requirements. As of September 30, 2006, we have outstanding purchase obligations of approximately $10.6 million with our
contract manufacturers that could not be canceled without significant penalties.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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.



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Item 4.CONTROLS AND PROCEDURES

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

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

Evaluation of Disclosure Controls and Procedures.

As of September 30, 2006, 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 Interim Chief Financial Officer concluded that, as of September 30, 2006, the design and
operation of these Disclosure Controls and Procedures were effective during the quarter ended September 30, 2006. We believe that we have adequate staffing in our finance group with the appropriate level of experience to effectively control the
increased level of transaction activity, address the complex accounting matters and manage the increased financial reporting complexities resulting from the acquisitions of Vertical Networks and Comdial and the associated integration activities.

We continue to evaluate our resources for addressing our financial reporting and making appropriate changes to provide sufficient
resources and time to prepare and file periodic reports within the time periods specified in the SECs rules and regulations and provide for reviews by our management, our audit committee and our board of directors. Our Chief Executive Officer
and Chief Financial Officer continue to review our personnel, resources and disclosure controls and procedures.

Changes in Internal Control Over
Financial Reporting.

There were no changes in the Companys internal control over financial reporting during the quarter ended
September 30, 2006, that materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.

Assessment of Internal Controls Over Financial Reporting.

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



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internal control and operations: we did not have adequate staffing in our finance group with the appropriate level of
experience to effectively control the increased level of transaction activity, address the complex accounting matters and manage the increased financial reporting complexities resulting from the acquisition of Vertical Networks and the associated
integration activities.

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

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

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

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

We had operating losses for the quarter ended September 30, 2006 and in each of the last 12 fiscal years. We also had minimal positive cash flow from
operating activities in the quarter ended September 30, 2006 and had negative cash flow in seven out of the last eleven fiscal years. If our revenues do not increase significantly, without a corresponding decrease in expenses, we may never
achieve profitability, on a sustained basis or at all, or generate positive cash flow in the future. In that case our business will fail. We expect to incur significant future operating losses and negative cash flows. Vertical Networks, Inc. also
incurred operating losses in each of their last three fiscal years prior to being acquired by us. Comdials revenues and operating results have experienced fluctuations in the past and may cause our revenues and operating results to vary in the
future. Comdials revenues and operating results have varied significantly in the past due to various factors, including changes in market acceptance of Comdials services, regulatory changes that may affect the marketability of
Comdials services, budgetary cycles of Comdials principal clients, the mix and timing of client projects, and one-time nonrecurring and unusual charges. As a result, the operations acquired from Vertical Networks and Comdial may not
consistently generate profits or positive cash flow, which would likely have a material negative impact on our business, our financial condition and our results of operations.

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

The Comdial acquisition consumed significant amounts of working capital and the Comdial Assets were acquired with limited working capital. As a result, we
had negative working capital at September 30, 2006, and we may require additional capital in the future to fund our operations, finance investments in product development and corporate



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infrastructure, expand in our various geographic markets and respond to competitive pressures and opportunities for
growth. Failure to obtain additional funding would prevent us from making expenditures that are needed to allow us to grow or maintain our operations. We cannot assure you that additional financing will be available on favorable terms, or at all. If
funds are not available when required for our working capital needs or other transactions, our ability to carry out our business plan will be adversely affected, and we may be required to scale back our growth and operations to reflect the extent of
available funding. If we are able to arrange for additional credit facilities from lenders, the debt instruments are likely to include limitations on our ability to incur other indebtedness, to pay dividends, to create liens, to sell or purchase our
capital stock, to sell assets or to make acquisitions or enter into other transactions. Such restrictions may adversely affect our ability to finance our future operations or capital needs or to engage in other business activities, including,
without limitation, acquisitions of additional businesses. We are already subject to such restrictions under the stock purchase agreement executed on September 28, 2004 (the 2004 Stock Purchase Agreement), the stock purchase
agreement executed on September 28, 2005 (the 2005 Stock Purchase Agreement), securities purchase agreement executed on February 9, 2006 (the 2006 Securities Purchase Agreement) and the Credit Agreement executed on
October 18, 2006. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our stockholders will be reduced. These securities would likely have rights, preferences or privileges senior to those
of our common stockholders. The inability to obtain substantial increases in our working capital resources will likely have a material negative impact on our business, our financial condition and our results of operations.

Our pending merger of Vodavi is an important part of our growth strategy. Failure to complete this acquisition could result in a significant delay in the
implementation of our strategy and could significantly slow our growth.

We have signed the Merger Agreement to acquire Vodavi by means
of its merger with and into Vertical Acquisition Sub, Inc. Assuming that we receive the Vodavi stockholder approval on a timely basis, we expect to close the merger in December 2006. The merger agreement is subject to a number of conditions. In
addition, each of Vodavi and the Company has the right to terminate the merger agreement under limited circumstances. If we do not complete this acquisition, the implementation of our business strategy could be substantially delayed and our growth
could slow significantly. This, in turn, could have an adverse effect on our expected earnings, financial condition and, possibly, on the market price of our common stock.

The merger is subject to a number of conditions to closing, including the receipt of required approvals from the shareholders of Vodavi. Some of the
conditions, such as the Vodavi shareholders approval, are outside of our control. If any condition to the merger is not satisfied, the merger will not be completed. If we do not complete the merger, the market price of our common shares may
fluctuate to the extent that the current market price of our common shares reflects a market assumption that the merger will be completed. We also have paid, and will be obligated to pay, certain fees and expenses in connection with the merger, even
if the merger is not completed. In addition, we have each diverted significant management resources in an effort to complete the merger. If the merger is not completed for any reason, we will have incurred costs including the diversion of management
resources, for which we will have received little or no benefit. The loss of such resources and time may have a material adverse effect on our financial condition and operations.

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

Our former independent registered public accounting firm, KPMG LLP (KPMG), advised our
management and our audit committee that, in connection with its review of our financial statements for the three and six month periods ended December 31, 2004, KPMG noted certain matters involving internal control and its operation that it
considered to be a material weakness that constituted reportable conditions under standards established by the American Institute of Certified Public Accountants. Reportable conditions are matters coming to an independent registered public
accounting firms attention that, in its judgment, relate to significant deficiencies in the design or operation of internal control and could adversely affect the organizations ability to record, process, summarize, and report financial
data consistent with the assertions of management in the financial statements. KPMG advised our management and our audit committee that it considered the following to constitute reportable conditions related to internal control and their operations:
we did not have adequate staffing in our finance group with the appropriate level of experience to effectively control the increased level of transaction activity, address the complex accounting matters and manage the increased financial reporting
complexities resulting from the acquisition of Vertical Networks and the associated integration activities.

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

We are also in the preliminary stages of preparing for our report on internal controls over financial reporting, which must be filed with the annual
report for our fiscal year ending June 30, 2009. The effectiveness of our controls and procedures may be limited by a variety of risks, including, without limitation, faulty human judgment and simple errors, omissions, or mistakes; the
collusion of two or more people or inappropriate management override of procedures; and imprecision in estimating and judging cost-benefit relationships in designing controls. At this point in



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the process, it is not possible to ascertain whether this report will disclose any significant deficiencies or material
weaknesses in our internal controls over financial reporting or even whether we will be able to conclude, after such analysis, that our internal controls are effective; however, our recent failure to timely file certain Exchange Act reports, as well
as the matters discussed above, resulted in our auditor determining that we have a material weakness in our internal controls system. Upon a determination that we have such a material weakness, we will be required to report that our internal
controls over financial accounting are not effective. If we fail to have effective internal controls and procedures for financial reporting in place, we could be unable to provide timely and reliable financial information.

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

We failed to timely file our Quarterly Reports on Form 10-Q for the quarters ended September 30, 2004, December 31,
2004, and March 31, 2005, our Annual Report on Form 10-K for the year ended June 30, 2006, an amendment to our Current Report on Form 8-K originally filed September 29, 2004 to disclose certain financial data in connection with our
acquisition of Vertical Networks, and our Current Report on Form 8-K relating to the execution of an office lease dated July 6, 2005. We filed the Quarterly Report for the quarter ended September 30, 2004 on January 25, 2005, filed
the Quarterly Report for the quarter ended December 31, 2004 on April 1, 2005, filed the Quarterly Report for the quarter ended March 31, 2005 on June 3, 2005, filed the Annual Report on Form 10-K for the year ended June 30,
2006 on October 16, 2006 and amended it on October 31, 2006 to include Part III information, filed our amendment to our Form 8-K on April 20, 2005, and our 8-K on July 14, 2005. If we cannot timely file our Exchange Act reports
in the future, we will remain ineligible to register our securities on Form S-3 until 12 months after the last late filed Exchange Act report, and ineligible to qualify for the safe harbor provisions for resale of restricted securities under Rule
144 of the Exchange Act. Inability to register securities on Form S-3 or sell restricted securities under the safe harbor provisions of Rule 144 limits the liquidity of our securities and restricts the market for our securities.

In addition, failure to remain current in our Exchange Act reporting requirements in the future may in the future result in our common stock being
de-listed from the OTC Bulletin Board and adversely affect our ability to list our common stock on a national exchange or the NASDAQ Stock Market in the future. If our common stock were to be de-listed from the OTC Bulletin Board, the market for our
common stock would become severely restricted and holders of our common stock may be unable to sell their shares. We have agreed in the 2004 and 2005 Stock Purchase Agreements and the 2006 Securities Purchase Agreement to seek a listing of our
common stock on a national exchange or the NASDAQ Stock Market. If we are unable to list our securities on a national exchange or the NASDAQ Stock Market because we have failed to remain current in our Exchange Act reporting requirements, we may be
subject to claims by M/C Venture Partners for indemnification, liability for breach of contract or other common law remedies.

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

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

As of September 30, 2006, M/C Venture Partners beneficially owned approximately 52.2%
of our common stock. Based upon its substantial voting power and their director rights, M/C Venture Partners is in a position to exert substantial influence over matters submitted to our stockholders for approval and our management and affairs,
including the election and removal of directors and any merger, consolidation or sale of all or substantially all of our assets. In addition, M/C Venture Partners currently maintains the contractual right to nominate two members to our seven member
board of directors and has a shared right with our board of directors to nominate an additional two members. Accordingly, such concentration of ownership and ability to appoint members to our board may have the effect of delaying, deterring or
preventing a change in control of our company, impeding a merger, consolidation, takeover or other business combination or discouraging a potential acquirer from making a tender offer or otherwise attempting to take control of our company, which in
turn could have a negative effect on the market price of our stock. These actions could also be adverse to our other stockholders interests.



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Because we failed to cause the registration statement filed on December 6, 2005 to be declared effective in
accordance with the timetables set forth in 2005 Stock Purchase Agreement and the 2004 Stock Purchase Agreement, as amended, we are subject to liquidated damages or liability for breach of contract.

Pursuant to the 2005 Stock Purchase Agreement and the 2004 Stock Purchase Agreement, as amended, we agreed to register the shares of our common stock
issued to the 2005 Investors and the 2004 Investors for resale under the Securities Act of 1933. We agreed to file a registration statement covering these shares no later than December 12, 2005. We filed this registration statement relating to
these shares of common stock, among others, on December 6, 2005 (the Filing Date). We further agreed to use our best efforts to cause the registration statement to become effective in certain events but no later than 90 days after
the Filing Date (referred to as the Required Effective date). We are liable for liquidated damages to each investor as a result of the Effectiveness Default.

We must pay as liquidated damages to the 2005 Investors, and the investors who were parties to the 2004 Stock Purchase Agreement for each 30-day period of the effectiveness default, an amount in cash equal to 1% of
the aggregate purchase price paid by the 2005 Investor or 2004 Investor as the case may be, pursuant to the 2005 Stock Purchase Agreement or the 2004 Stock Purchase Agreement, provided that in no event will the aggregate amount of cash to be paid as
liquidated damages exceed 9% of the aggregate purchase price paid by any respective 2005 Investor or 2004 Investor.

Should we be required
to make payment of these liquidated damages, it will likely have a material adverse effect on our liquidity, our financial position and our results of operations, particularly if we became obligated to make payment in full of all liquidated damages
potentially due and payable under these agreements.

Because we failed to file a registration statement in accordance with the timetable set forth in
the 2006 Securities Purchase Agreement, we are subject to liquidated damages and possibly liability for breach of contract.

Pursuant to
the 2006 Securities Purchase Agreement, we have agreed to register the shares of common stock issuable upon conversion of the Series D Convertible Preferred Stock (the Series D Preferred Stock) and upon exercise of the warrants for resale by the
2006 investors under the Securities Act. We agreed to file with the SEC a registration statement with respect to the Series D Preferred Stock and warrants no later than March 27, 2006 (the 2006 Filing Date), and to use our best
efforts to cause the registration statement to become effective on or before the date that is the earlier of (1) in the event of no review by the SEC, within five days of being informed by the SEC that the SEC has decided not to review the
Registration Statement, but in no event later than 30 days after the 2006 Filing Date, (2) in the event of a review by the SEC, within five days of being informed by the SEC that the SEC has no further comments on such registration statement,
but in no event later than 90 days after the 2006 Filing Date (the earlier of (1) and (2), the 2006 Required Effective Date).

Because we failed to file the registration statement by the 2006 Filing Date, we are obligated to pay as liquidated damages to the 2006 Investors, for each 30-day period of a 2006 Registration Default, an amount in cash equal to 1% of the
aggregate purchase price paid by the 2006 Investor pursuant to the 2006 Stock Purchase Agreement; provided that in no event will the aggregate amount of cash to be paid as liquidated damages exceed 9% of the aggregate purchase price paid by such
2006 Investor. We must pay the liquidated damages on the business day following the 2006 Filing Default, and each 30th day thereafter, until the registration statement has been filed with the SEC.

In addition to liquidated damages pursuant to the 2004 and 2005 Stock Purchase Agreements, our obligations to pay these liquidated damages will likely
have a material adverse effect on our liquidity, our financial position and our results of operations, particularly if we become obligated to make payment in full of all liquidated damages potentially due and payable under these agreements.

Restrictive covenants in the 2004 and 2005 Stock Purchase Agreements and the 2006 Securities Purchase Agreement may limit our ability to pursue our
business strategies.

We have agreed under the terms of the 2004 and 2005 Stock Purchase Agreements and the 2006 Securities Purchase
Agreement that we will not, without the prior consent of M/C Venture Partners, (1) enter into a transaction involving a change in control of our company; (2) incur indebtedness in excess of $3.0 million, subject to specified exceptions;
(3) create any security with an equity component unless that security is junior to the common stock; (4) issue any equity securities; (5) transfer our intellectual property; (6) repurchase, redeem or pay dividends on any shares
of capital stock (subject to limited exceptions); (7) grant stock options that are not authorized by a vote of the board of directors or its compensation committee; (8) liquidate or dissolve; (9) change the size of our board of
directors; (10) amend our Certificate of Incorporation or bylaws; (11) change the nature of the Companys business; (12) alter the voting rights of shares of our capital stock in a disparate manner; or (13) take any action
which would cause an adjustment to the exercise price or number of shares to be delivered under Section 8 of the warrants issued to the 2006 Investors.



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

Restrictive covenants in the Credit Agreement may limit our ability to
pursue our business strategies.

Under the terms of the Credit Agreement, we are not permitted to take certain actions without the prior
written consent of Investment Manager and Lender, including, without limitation, the following:



| |  |  | mortgage, assign, pledge, transfer or otherwise permit any lien, charge, security interest encumbrance or judgment to exist on any of the collateral pledged under the Credit
Agreement and related Security Agreement or our other assets, whether now owned or acquired later, except for certain permitted encumbrances;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | incur or create any indebtedness, except for certain permitted indebtedness;
| | - |  | ----------------------------------------------------------------------------



| |  |  | sell, lease, assign, transfer or otherwise dispose of (i) any collateral pledged under the Credit Agreement and Security Agreement, except for the sale of inventory and equipment in
the ordinary course of our business, or (ii) all or any substantial part of our assets that do not constitute collateral. We, however, may sell obsolete or surplus equipment if certain conditions specified in the Credit Agreement are met;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | merge or consolidate with any other entity, except as permitted by the Credit Agreement, change our structure or organizational form, reincorporate or reorganize in a new
jurisdiction, or enter into or engage in any operation or activity materially different from that presently being conducted by our company;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | pay any dividend or distribution of any kind on, or purchase, acquire, redeem or retire, any of its equity interests;
| | - |  | ---------------------------------------------------------------------------------------------------------------------



| |  |  | create any new subsidiary (other than to consummate certain acquisitions), make any advance or loan to, or any investment in any firm, entity, person or corporation, or acquire all
or substantially all of the assets of, or any capital stock or equity interests in any firm, entity or corporation, except our current investments in existing subsidiaries;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | enter into any transaction with any shareholder, officer, director, direct or indirect parent, direct or indirect subsidiary or other related person, except for certain permitted
transactions;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | make certain specified restricted payments described in the Credit Agreement;
| | - |  | -----------------------------------------------------------------------------



| |  |  | use proceeds of funds received under the Credit Agreement in any manner prohibited by the Credit Agreement;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | cause any encumbrance or restriction on the ability of our subsidiaries to make certain payments to us;
| | - |  | -------------------------------------------------------------------------------------------------------



| |  |  | engage in any business other than certain specified businesses;
| | - |  | ---------------------------------------------------------------



| |  |  | change or amend the terms of any of our subordinated debt for certain specified purposes; or
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | other customer restrictions.
| | - |  | ----------------------------

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

Certain restrictions in the certificates of designations for the Series D Preferred Stock and the Series E Preferred Stock may limit our ability to carry out our business plan.

Under the terms of the certificates of designation for our Series D Preferred Stock and our Series E Preferred Stock, we are not permitted to take certain
actions without the prior written consent of holders of a majority of the outstanding Series D Preferred Stock and Series E Preferred Stock (currently M/C Venture Partners for both series of preferred stock) including, without limitation, the
following:



| |  |  | amend, alter or repeal any right, preference or privilege of the Series D Preferred Stock or the Series E Preferred Stock, respectively, any provision of our certificate of
incorporation or bylaws, or any document executed in connection with the Series E Financing;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | create any additional class or series of shares of stock, or any convertible debt securities, unless it is subordinate to the Common Stock as to dividends and distribution of assets
on the liquidation, dissolution or winding up of our company;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | issue or agree to issue any equity security or any security that is convertible, exercisable or exchangeable for or into any equity security (including convertible debt securities)
except certain permitted issuances;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | change the number of shares of our capital stock reserved for grants or issuance to employees, directors, contractors or consultants under our equity incentive plans;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | approve or engage in any transaction for the acquisition of any other person, entity or organization, the business or substantially all of the assets of any other person, entity or
organization, except the acquisition of any of our subsidiaries;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | liquidate, dissolve or wind-up our business and affairs, effect any deemed liquidation event or consent to do any of the foregoing;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | purchase or redeem, or pay any dividend or make any distribution on, any shares of our capital stock or permit any subsidiary to do any of the foregoing except for certain permitted
dividends and redemptions; or
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | change the number of directors constituting the size of the Board of Directors.
| | - |  | -------------------------------------------------------------------------------

These restrictions may limit our ability to raise capital in the future or may limit our operations while they are in effect. If we take one of the above actions and fail to obtain the required consent of the
respective holders of our Series D Preferred Stock and Series E Preferred Stock, it may result in the prohibited transactions being voided and we may be liable for breach of contract and other common law remedies. Additionally, we may damage our
relationship with certain of our stockholders whose participation in future equity financings may be required for us to continue operations or consummate key transactions necessary for the success of our business. If these relationships are
irreparably damaged, we may be unable to consummate certain transactions that may be necessary for the operation of our business.

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

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



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



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



| |  |  | retaining existing customers of both companies and attracting additional customers;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | retaining strategic partners of each company and attracting new strategic partners; and
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | creating uniform standards, controls, procedures, policies and information systems.
| | - |  | -----------------------------------------------------------------------------------

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



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



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



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



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

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



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

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

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

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

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

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

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

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

A significant portion of our revenues are generated by a small number of customers. If we were to lose one or more of these
customers, our revenues would decline and our business and prospects would be materially harmed. We expect that even if we are successful in developing relationships with additional customers through the acquisition of the Comdial Assets, or through
additional sales of our historic products, our revenues will continue to be concentrated. We cannot assure you that we will be able to retain any of our current customers or that we will be able to obtain new customers.

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

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

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

We depend on distributors and resellers and system integrators to market and sell our products. If these customers do not
focus their marketing efforts on software- or server-based phone systems or focus on products competitive with our products our sales will be materially adversely affected. Failure of distributors, system integrators,



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and resellers to focus on software- or server-based phone systems may send a negative signal to current and potential
customers concerning the viability of our industry or our product offerings. We depend upon the availability of distribution outlets to market our products. Loss of these outlets will harm our ability to broaden our brand acceptance and enhance our
reputation in the market. In addition, our operating results would be adversely affected if one of our major distributors, resellers or original equipment manufacturers failed to timely and fully pay us for the products they purchased from us for
resale or integration, as the case may be.

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

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

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

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

Products in our Comdial inventory may become obsolete.

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

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

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



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

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



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



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



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



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



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



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



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



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

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

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

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

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

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

Our TeleVantage, Instant Office and Comdial products operate on or are comprised of hardware manufactured



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by third parties. We are dependent on the reliability of this hardware and, to the extent the hardware has defects, it
will affect the performance of our products. If the hardware becomes unreliable, does not perform in a manner that is acceptable to our customers or becomes more expensive, sales of our products could decline. Because many of our products run on
Microsoft software products and use other Microsoft Corporation technologies, we must depend on the reliability and quality of such products and technologies. Errors or vulnerabilities in Microsoft products could impair sales of some of our
products. Our customers may associate unreliability of the hardware and flaws in Microsoft products with a lack of quality of some of our products, which may cause us to lose customers and hurt future sales. Our ability to remedy malfunctions or
errors will depend on the timeliness and availability of repair solutions from the manufacturers. Future success of our products and any new products will depend on the ability of our hardware and software manufacturers to produce reliable products
in the future.

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

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

We are subject to risks associated with international operations.

We conduct business globally.
International sales accounted for approximately 3% of net sales for the quarter ended September 30, 2006 and 2% of net sales for the year ended June 30, 2006. We also acquire various raw materials and components from international
suppliers. We intend to expand our presence in international markets, and we cannot assure you that we will compete successfully in international markets or meet the service and support needs of foreign customers. Our future results could be harmed
by a variety of factors relating to international operations, including:



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



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



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



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



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



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



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

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

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

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

Several of these existing competitors have, and many of our future competitors may have, greater financial, personnel and capacity
resources than us and as a result, these competitors may be in a stronger position to respond



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

We are relying on our next generation product to launch in early 2007 and if we fail to achieve general release in that time period our
operations will be negatively impacted.

We are currently making a substantial investment in the unified engineering and product
management team that is working on our next-generation IP-PBX product family, which is expected to ship in 2007. This next-generation offering is designed to provide a smooth migration path for our current installed base, which includes customers of
our three product lines, with a mixture of digital and IP deployments. To ensure this smooth migration, the engineering organization is combining the best-of-breed elements of all three current product lines into the next-generation product, which
will use as its foundation an integrated communications platform with a dual backplane that will natively support both TDM and IP installations. Customers will therefore be able to upgrade readily to our next-generation platform while protecting and
leveraging their existing telephony investments. We believe that this approach will differentiate us competitively  especially from providers of IP-only systems  and we have calibrated our engineering investment to take advantage of this
opportunity. If there are delays in release or insurmountable problems with this next generation product, our operations will be negatively impacted as we require this new product to remain competitive in our market.

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

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

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

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

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

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

Certain provisions of our Certificate of Incorporation, as amended, could make a merger, tender offer or
proxy contest involving us difficult, even if such events would be beneficial to the interests of our stockholders. These provisions include a classified board of directors, restrictions on calling and holding stockholder meetings, and giving our
board the ability to issue preferred stock and determine the rights and designations of the preferred stock at any time



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without stockholder approval. The rights of the holders of our common stock will be subject to, and may be adversely
affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing flexibility in connection with possible acquisitions and other corporate purposes, could have the effect
of making it more difficult for a third party to acquire, or of discouraging a third party from acquiring, a majority of our outstanding voting stock. These factors and certain provisions of the Delaware General Corporation Law may have the effect
of deterring hostile takeovers or otherwise delaying or preventing changes in control or changes in our management, including transactions in which our stockholders might otherwise receive a premium over the fair market value of our common stock.

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

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

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

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

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

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



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

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

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

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

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



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



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

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

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

We frequently enter into contracts where we recognize only a portion of the total revenue under the contract in the
quarter in which we enter into the contract. For example, we may recognize revenue on a ratable basis over the life of the contract or enter into contracts where the recognition of revenue is conditioned upon delivery of future product or service
elements. This is the case with our contracts with CVS, Aramark and Household Financial. The portion of revenues that are deferred may vary significantly in any given quarter, and revenues in any given quarter are a function both of contracts signed
in such quarter and contracts signed in prior quarters. We anticipate that product revenues in future quarters will generally be more dependent on revenues from new customer contracts entered into in those quarters rather than from amortization or
recognition of product revenues deferred in prior quarters.

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

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



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

We generally warrant each of our products against defects in materials and workmanship for a period of 12 months from the date of shipment. If we
experience an increase in product returns or warranty claims, we could incur unanticipated additional expenditures for parts and service. In addition, our reputation and goodwill could be damaged, perhaps irreparably. While we have established
reserves for liability associated with product warranties, unforeseen warranty exposure in excess of those reserves could adversely affect our operating results.

Item 6EXHIBITS



|            |  |                                                                                                                                                  
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                      
|11.1        |  | Form of Funding Commitment Letter dated October 12, 2006.                                                                                        
|            | 
|31.1        |  | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended            
|            | 
|31.2        |  | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended            
|            | 
|32.1        |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|            | 
|32.2        |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002



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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: November 14, 2006 |  | /s/ William Y. Tauscher                                                            
|                         |  | William Y. Tauscher                                                                
|                         |  | Chief Executive Officer and Chairman of the Board                                  
|                         | 
|Dated: November 14, 2006 |  | /s/ Kenneth M. Clinebell                                                           
|                         |  | Kenneth M. Clinebell                                                               
|                         |  | Chief Financial Officer (Principal Financial Officer
and Chief Accounting Officer )



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