**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.  20549**

 

**FORM 10-Q**

 

| **(Mark  One)**                                                                                                                                                                                                                                                                                         |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                    |
| **ý**                                                                                                                                                                                                                                                                                              |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                                    |   |   |
| **For  the quarterly period ended September 30, 2003**                                                                                                                                                                                                                                                  |
|                                                                                                                                                                                                                                                                                                    |
| **OR**                                                                                                                                                                                                                                                                                                  |
|                                                                                                                                                                                                                                                                                                    |
| **o**                                                                                                                                                                                                                                                                                                   |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                                    |   |   |
| **For  the transition period from                         to                       ** |

 

**CommissionFile Number 000-19462**

 

**ARTISOFT, INC.**

(Exact Name ofRegistrant as Specified in Its Charter)

 

| **Delaware**                                                                        |   | **86-0446453**                        |
|-------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or Other  Jurisdiction of  Incorporation or Organization)                    |   | (I.R.S. Employer  Identification No.) |
|                                                                                |   |                                  |
| **5  Cambridge Center, Cambridge, Massachusetts 02142**                             |
| (Address of  Principal Executive Offices) (Zip Code)                                |
|                                                                                |
| Registrant’s  telephone number, including area code:   **(617) 354-0600** |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

**Yes **ý**  No **o

 

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

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.

 

| **Title of Class of Common Stock**       |   | **Shares Outstanding as of November 13, 2003** |
|------------------------------------------|--------|------------------------------------------------|
| Common Stock,  $0.01 par value per share |   | 3,655,620                                      |

** **

** **

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** **

**FORWARD-LOOKINGSTATEMENTS**

** **

This Quarterly Report on Form 10-Q includesforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933 and Section 21E of the Securities Exchange Act of 1934 that aresubject to a number of risks and uncertainties.  All statements, other than statements of historical fact,included in this Quarterly Report on Form 10-Q, including statements regarding ourstrategy, future operations, financial position, estimated revenues, projectedcosts, prospects, plans and objectives of management, are forward-lookingstatements.  When used in this QuarterlyReport on Form 10-Q, the words “will”, “believe”, “anticipate”, “intend”,“estimate”, “expect”, “project” and similar expressions are intended toidentify forward-looking statements, although not all forward-lookingstatements contain these identifying words. We cannot guarantee future results, levels of activity, performance orachievements, and you should not place undue reliance on our forward-lookingstatements.  Our forward-lookingstatements do not reflect the potential impact of any future acquisitions,mergers, dispositions, joint ventures or strategic alliances.  Our actual results could differ materiallyfrom those anticipated in these forward-looking statements as a result ofvarious factors, including the risks described in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations - Risk Factors” andelsewhere in this Quarterly Report on Form 10-Q.  The forward-looking statements provided by Artisoft in thisQuarterly Report on Form 10-Q represent Artisoft’s estimates as of the datethis report is filed with the SEC.  Weanticipate that subsequent events and developments will cause our estimates tochange.  However, while we may elect toupdate our forward-looking statements in the future, we specifically disclaimany obligation to do so.  Ourforward-looking statements should not be relied upon as representing our estimatesas of any date subsequent to the date this report is filed with the SEC.

** **

**ARTISOFT,INC. QUARTERLY REPORT ON FORM 10-Q**

**INDEX**

** **
| PART I - FINANCIAL INFORMATION                                                                         |   |
|--------------------------------------------------------------------------------------------------------|--------|
| Item 1. - FINANCIAL  STATEMENTS                                                                        | 3      |
| Item  2. - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS  OF OPERATIONS | 10     |
| Item  3. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                  | 19     |
| Item 4. - CONTROLS  AND PROCEDURES                                                                     | 19     |
| PART II - OTHER  INFORMATION                                                                           |   |
| Item  2. - CHANGES IN SECURITIES AND USE OF PROCEEDS                                                   | 20     |
| Item  4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                         | 21     |
| Item 5. -  EXHIBITS AND REPORTS ON FORM 8-K                                                            | 21     |

 

2

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# **PART I - FINANCIAL INFORMATION**

## ** **

## **Item1. - FINANCIAL STATEMENTS**

** **

**ARTISOFT,INC. AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)**

** **
|                                                                                                                                                                                                                 |   | **September  30, 2003** |   | **June 30,  2003** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|--------------------|--------|
|                                                                                                                                                                                                                 |   |                    |   |               |   |
| ASSETS                                                                                                                                                                                                               |   |                    |   |               |   |
| Current  assets:                                                                                                                                                                                                     |   |                    |   |               |   |
| Cash  and cash equivalents                                                                                                                                                                                           |   | $                       | 5,415  |               | $      | 3,041 |   |
|                                                                                                                                                                                                                 |   |                    |   |               |   |
| Trade  receivables, net of allowances of $211 and $182 at September 2003 and June  2003, respectively                                                                                                                |   | 973                     |   | 838                |   |
|                                                                                                                                                                                                                 |   |                    |   |               |   |
| Inventories                                                                                                                                                                                                          |   | 117                     |   | 18                 |   |
| Prepaid  expenses                                                                                                                                                                                                    |   | 101                     |   | 368                |   |
| Total  current assets                                                                                                                                                                                                |   | 6,606                   |   | 4,265              |   |
|                                                                                                                                                                                                                 |   |                    |   |               |   |
| Property  and equipment                                                                                                                                                                                              |   | 3,802                   |   | 3,756              |   |
| Less  accumulated depreciation and amortization                                                                                                                                                                      |   | (3,403                  | )      | (3,296             | )      |
|                                                                                                                                                                                                                 |   |                    |   |               |   |
| Net  property and equipment                                                                                                                                                                                          |   | 399                     |   | 460                |   |
|                                                                                                                                                                                                                 |   |                    |   |               |   |
| Other  assets                                                                                                                                                                                                        |   | 228                     |   | 269                |   |
|                                                                                                                                                                                                                 |   | $                       | 7,233  |               | $      | 4,994 |   |
| LIABILITIES  AND SHAREHOLDERS’ EQUITY                                                                                                                                                                           |   |                    |   |               |   |
| Current  liabilities:                                                                                                                                                                                                |   |                    |   |               |   |
| Accounts  payable                                                                                                                                                                                                    |   | $                       | 399    |               | $      | 396 |   |
| Accrued  liabilities                                                                                                                                                                                                 |   | 1,788                   |   | 2,149              |   |
| Deferred  revenue                                                                                                                                                                                                    |   | 2,513                   |   | 2,768              |   |
| Customer  deposits                                                                                                                                                                                                   |   | 311                     |   | —             |   |
| Total  current liabilities                                                                                                                                                                                           |   | 5,011                   |   | 5,313              |   |
|                                                                                                                                                                                                                 |   |                    |   |               |   |
| Commitments  and contingencies                                                                                                                                                                                       |   | —                  |   | —             |   |
| Shareholders’  equity:                                                                                                                                                                                          |   |                    |   |               |   |
| Preferred  stock, $1.00 par value.  Authorized  11,433,600 shares;                                                                                                                                              |   | —                  |   | —             |   |
| Series  A preferred stock, $1.00 par value.   Authorized 50,000 series A shares; no series A shares issued at  September 30, 2003 and June 30, 2003                                                             |   |                    |   |               |   |
| Series  B preferred stock, $1.00 par value.   Authorized 2,800,000 series B shares; issued 2,800,000 series B shares  at September 30, 2003 and June 30, 2003 (aggregate liquidation value $7  million)         |   | 2,800                   |   | 2,800              |   |
| Series  C Preferred Stock, $1.00 par value.   Authorized 2,627,002 series C shares; issued 2,627,002 series C shares  at September 30, 2003 and none at June 30, 2003 (aggregate liquidation value  $4 million) |   | 2,627                   |   | —             |   |
| Common  stock, $.01 par value.  Authorized  50,000,000 shares; issued 5,872,403 common shares at September 30, 2003 and  5,206,243 at June 30, 2003                                                             |   | 58                      |   | 52                 |   |
| Additional  paid-in capital                                                                                                                                                                                          |   | 109,303                 |   | 108,505            |   |
| Accumulated  deficit                                                                                                                                                                                                 |   | (41,717                 | )      | (40,726            | )      |
| Deferred  Toshiba equity cost                                                                                                                                                                                        |   | (1,169                  | )      | (1,270             | )      |
| Less  treasury stock, at cost, 2,216,783 shares at September 30,2003 and June 30,  2003                                                                                                                              |   | (69,680                 | )      | (69,680            | )      |
| Net  shareholders’ equity/(deficit)                                                                                                                                                                             |   | 2,222                   |   | (319               | )      |
|                                                                                                                                                                                                                 |   | $                       | 7,233  |               | $      | 4,994 |   |

 

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

 

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**ARTISOFT,INC. AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)**

** **
|                                                               |   | **Three  Months Ended  September 30,** |   |
|--------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                               |   | **2003**                               |   | **2002** |   |
|                                                               |   |                                   |   |   |   |
| Net  product revenue                                               |   | $                                      | 1,967  |   | $ | 1,442 |   |
|                                                               |   |                                   |   |   |   |
| Cost  of sales                                                     |   | 58                                     |   | 36 |   |
|                                                               |   |                                   |   |   |   |
| Gross  profit                                                      |   | 1,909                                  |   | 1,406 |   |
|                                                               |   |                                   |   |   |   |
| Operating  expenses:                                               |   |                                   |   |   |   |
| Sales  and marketing                                               |   | 1,349                                  |   | 1,392 |   |
| Product  development                                               |   | 781                                    |   | 800 |   |
| General  and administrative                                        |   | 775                                    |   | 1,653 |   |
| Total  operating expenses                                          |   | 2,905                                  |   | 3,845 |   |
|                                                               |   |                                   |   |   |   |
| Loss  from operations                                              |   | (996                                   | )      | (2,439 | ) |
|                                                               |   |                                   |   |   |   |
| Other  income, net                                                 |   | 5                                      |   | 22 |   |
|                                                               |   |                                   |   |   |   |
| Net  loss                                                          |   | (991                                   | )      | (2,417 | ) |
|                                                               |   |                                   |   |   |   |
| Deemed  dividend to series C preferred shareholders                |   | (2,009                                 | )      | — |   |
| Deemed  dividend to series B preferred shareholders                |   | (1,088                                 | )      | (2,006 | ) |
|                                                               |   |                                   |   |   |   |
| Loss  applicable to common shareholders                            |   | $                                      | (4,088 | ) | $ | (4,423 | ) |
|                                                               |   |                                   |   |   |   |
| Net loss applicable to  common shareholders—basic and diluted |   | $                                      | (1.30  | ) | $ | (1.67 | ) |
|                                                               |   |                                   |   |   |   |
| Weighted  average common shares outstanding—basic and diluted |   | 3,141                                  |   | 2,655 |   |

 

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

** **

**4**

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**ARTISOFT,INC. AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)**

** **
|                                                                         |   | **Three  Months Ended  September 30** |   |
|------------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                         |   | **2003**                              |   | **2002** |   |
| Cash  flows from operating activities:                                       |   |                                  |   |   |   |
| Net  loss                                                                    |   | $                                     | (991   | ) | $ | (2,417 | ) |
| Adjustments  to reconcile net loss to net cash used by operating activities: |   |                                  |   |   |   |
| Depreciation  and amortization                                               |   | 144                                   |   | 173 |   |
| Amortization  of deferred Toshiba equity costs                               |   | 101                                   |   | 72 |   |
| Non-cash  changes in accounts receivable, rotation and inventory allowances: |   |                                  |   |   |   |
| Additions                                                                    |   | 46                                    |   | 15 |   |
| Reductions                                                                   |   | (14                                   | )      | (5 | ) |
| Changes  in assets and liabilities:                                          |   |                                  |   |   |   |
| Receivables                                                                  |   |                                  |   |   |   |
| Trade  accounts                                                              |   | (167                                  | )      | 143 |   |
| Other  receivables                                                           |   | —                                |   | (1 | ) |
| Inventories                                                                  |   | (99                                   | )      | 12 |   |
| Prepaid  expenses                                                            |   | 267                                   |   | 105 |   |
| Accounts  payable                                                            |   | 3                                     |   | (14 | ) |
| Accrued  liabilities                                                         |   | (361                                  | )      | 744 |   |
| Deferred  revenue                                                            |   | (255                                  | )      | (164 | ) |
| Customer  deposits                                                           |   | 311                                   |   | 201 |   |
| Other  assets                                                                |   | 4                                     |   | 41 |   |
|                                                                         |   |                                  |   |   |   |
| Net  cash used in operating activities                                       |   | (1,011                                | )      | (1,095 | ) |
|                                                                         |   |                                  |   |   |   |
| Cash  flows from investing activities:                                       |   |                                  |   |   |   |
| Purchases  of property and equipment                                         |   | (46                                   | )      | (30 | ) |
|                                                                         |   |                                  |   |   |   |
| Net  cash used in investing activities                                       |   | (46                                   | )      | (30 | ) |
|                                                                         |   |                                  |   |   |   |
| Cash  flows from financing activities:                                       |   |                                  |   |   |   |
| Proceeds  from issuance of preferred stock, net of expenses                  |   | 3,414                                 |   | — |   |
| Proceeds  from issuance of common stock, net of expenses                     |   | 17                                    |   | 1,854 |   |
|                                                                         |   |                                  |   |   |   |
| Net  cash provided by financing activities                                   |   | 3,431                                 |   | 1,854 |   |
|                                                                         |   |                                  |   |   |   |
| Net  increase in cash and cash equivalents                                   |   | 2,374                                 |   | 729 |   |
| Cash  and cash equivalents at beginning of period                            |   | 3,041                                 |   | 6,020 |   |
|                                                                         |   |                                  |   |   |   |
| Cash  and cash equivalents at end of period                                  |   | 5,415                                 |   | 6,749 |   |
|                                                                         |   |                                  |   |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION FROM FINANCING ACTIVITIES:               |   |                                  |   |   |   |
| Non  cash dividend to series C preferred shareholders                        |   | 2,009                                 |   |   |   |
| Non  cash dividend to series B preferred shareholders                        |   | 1,088                                 |   | 2,006 |   |
|                                                                              |        |                                       |        |  |  |  |  |

 

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

 

5

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**ARTISOFT,INC. AND SUBSIDIARIES**

** **

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

** **

### **(1)  BASIS OF PRESENTATION**

 

Artisoft, Inc., (“Artisoft”, the “Company” or the“Registrant”) develops, markets and sells computer telephony softwareapplication products and associated services.

 

The Company’s principal executive offices are locatedat 5 Cambridge Center, Cambridge, Massachusetts 02142.  The telephone number at that address is(617) 354-0600.  The Company wasincorporated in November 1982 and reincorporated by merger in Delaware in July1991.

 

The condensed consolidated financial statementsinclude the accounts of Artisoft, Inc., and its three wholly ownedsubsidiaries.  All significantintercompany balances and transactions have been eliminated in consolidation.

 

The accompanying unaudited condensed consolidatedfinancial statements have been prepared by the Company in accordance with accountingprinciples generally accepted in the United States of America and pursuant tothe rules and regulations of the Securities and Exchange Commission (the“SEC”).  The balance sheet amounts atJune 30, 2003 in this report were derived from the Company’s audited financialstatements included in its Annual Report on Form 10-K for the fiscal year endedJune 30, 2003.  In the opinion ofmanagement, the accompanying financial statements include all adjustments (of anormal recurring nature), which are necessary for a fair presentation of thefinancial results for the interim periods presented.  Certain information and footnote disclosures normally included infinancial statements have been condensed or omitted pursuant to such rules andregulations.  Although the Companybelieves that the disclosures are adequate to make the information presentednot misleading, it is suggested that these financial statements be read inconjunction with the consolidated financial statements and the notes theretoincluded in the Company’s Annual Report on Form 10-K for the fiscal year endedJune 30, 2003 on file with the SEC.  Theresults of operations for the three months ended September 30, 2003 are notnecessarily indicative of the results to be expected for the full year or anyother future periods.

 

The preparation of these financial statements requiresus to make estimates and judgments that affect the reported amount of assetsand liabilities at the date of the financial statements and revenues andexpenses during the reported period. Areas where significant judgments are made include, but are not limitedto revenue recognition.  Actual resultscould differ materially from these estimates.

### ** **

### **(2)  SIGNIFICANT ACCOUNTING POLICIES**

 

**Stock-Based Compensation**

 

The Company applies APB Opinion No. 25 in accountingfor its stock incentive plan and accordingly, no compensation cost has beenrecognized for its stock options in the financial statements.  Had the Company determined compensation costbased on the fair value at the grant date for its stock options under SFAS No.123, the Company’s net loss and net loss per common equivalent share for thethree month periods ended September 30, 2003 and 2002 would have been increasedto the pro forma amounts indicated below (in thousands, except per shareprices):

 

6

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|                                                                                 |   | **Three  Months Ended  September 30,** |   |
|--------------------------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                                                 |   | **2003**                               |   | **2002** |   |
| Reported  net loss applicable to common stock                                        |   | $                                      | (991   | ) | $ | (2,417 | ) |
| Stock  based compensation expense determined under fair value method for all rewards |   | $                                      | (333   | ) | $ | (578 | ) |
| Pro forma net loss  applicable to common stock                                       |   | $                                      | (1,324 | ) | $ | (2,995 | ) |

 

Generally, options become exercisable over a four-yearperiod commencing on the date of the grant and vest 25% at the firstanniversary of the grant date with the remaining 75% vesting in equal monthlyincrements over the remaining three years of the vesting period.  The fair value of options granted wascalculated using the Black-Scholes option-pricing model with the followingweighted average assumptions

 
|                     |   | **Fiscal  2004** |   | **Fiscal  2003** |   |
|--------------------------|--------|------------------|--------|------------------|--------|
| Expected  dividend yield |   | 0                | %      | 0                | %      |
| Volatility  factor       |   | 123              | %      | 111              | %      |
| Risk  free interest rate |   | 3.3              | %      | 3.3              | %      |
| Expected  life           |   | 6 Years          |   | 6 years          |   |

 

**Recent Accounting Pronouncements**

 

In November 2002, theEmerging Issues Task Force (EITF) issued EITF No. 00-21, “Revenue Arrangementswith Multiple Deliverables,” which provides guidance on the timing and methodof revenue recognition for sales arrangements that include the delivery of morethan one product or service. EITF No. 00-21 is effective prospectively forarrangements entered into in fiscal periods beginning after June 15, 2003. Theadoption of EITF No. 00-21 did not have a significant impact on ourconsolidated financial statements

 

In January 2003, the FASB issued Interpretation No.46, Consolidation of Variable Interest Entities, and Interpretation of ARB No.51.  Interpretation No. 46 clarifiesAccounting Research Bulletin (ARB) No. 51, Consolidated Financial Statements, relatedto whether companies should consolidate certain entities, called variableinterest entities.  Interpretation No.46 is effective immediately for variable interest entities created afterJanuary 31, 2003 and for interim periods beginning after June 15, 2003 forwhich a variable interest was in place prior to February 1, 2003.  The adoption of this Interpretation did nothave a material impact on our financial condition or results of operations.

 

In May 2003, the FASB issued SFAS 150, “Accounting ForCertain Financial Instruments with Characteristics of Both Liabilities andEquity” which establishes standards for how an issuer of financial instrumentsclassifies and measures certain financial instruments with characteristics ofboth liabilities and equity.  Itrequires that an issuer classify a financial instrument that is within itsscope as a liability (or an asset in some circumstances) if, at inception, themonetary value of the obligation is based solely or predominantly on a fixedmonetary amount at inception, variations in something other than the fair valueof the issuer’s equity shares or variations inversely related to changes in thefair value of the issuer’s equity shares. SFAS No. 150 is effective for financial instruments entered into or modifiedafter May 31, 2003 and otherwise is effective at the beginning of the firstinterim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material impact on our financialposition or results of operations.

 

7

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### **(3)  TAX EXPOSURE**

 

In the course of a review of various compensationplans for the quarter ended September 30 2002, it was determined that Artisofthad a potential tax exposure for prior period activity.  Based on initial estimates, the amountaccrued at that time was $.7 million. This accrual was subsequently reduced to $.4 million during the quarterended March 31, 2003 to reflect management’s estimate of continuingexposure.  The accrual is based oncurrently available information and represents management’s best estimate.  The impact of the ultimate resolution ofthis issue could differ materially from the amount of the established reserve.

### ** **

### **(4)  PREFERRED STOCK**

* *

*September 2003 Financing*.  In September 2003, Artisoft issued and soldan aggregate of 2,627,002 shares of its series C convertible preferred stock toinvestors in a private placement at a per share price equal to $1.50.  The investors also received warrants topurchase up to 2,627,002 shares of Artisoft’s common stock at a per shareexercise price equal to $1.88.  Proceedsfrom the financing were $3.4 million, net of related expenses of $.5million.

 

The shares of series C preferred stock are initiallyconvertible into a like number of shares of common stock, subject toadjustment.  Each share of series Cpreferred stock generally receives .8152 of a vote, subject to adjustment, whenvoting on matters presented for the approval of Artisoft’s stockholders.  The holders of the series C preferred stock,as a class, are also entitled to elect a director of the Company.  In September 2003, the holders of our seriesC preferred stock exercised this right to elect Steven C. Zahnow as an Artisoftdirector.

 

If we liquidate, dissolve or wind up, then the holdersof series C preferred stock will be entitled, before any distributions are madeto the holders of common stock, to an amount equal to $1.50 per share, subjectto adjustment.  For purposes of thisliquidation preference, the series C preferred stock will rank on a parity withthe series B preferred stock, which carries a similar liquidation preference inthe amount of $2.50 per share.  Anacquisition of Artisoft by merger, consolidation or sale of substantially allassets will generally be treated as a liquidation, unless the liquidationpreference is waived by the holders of a majority of the series C preferredstock then outstanding.

 

The holders of the series C preferred stock areentitled to receive dividends only when and if declared by the board ofdirectors of the Company.  Any suchdividends would be paid to the holders of the series C preferred stock andseries B preferred stock prior to any distribution to holders of common stock,on a per share basis equal to the number of shares of common stock into whicheach share of preferred stock is then convertible.

 

The warrants will expire on June 27, 2010.  The expiration date, the per share exerciseprice and the number of shares issuable upon exercise of the warrants aresubject to adjustment in certain events.

 

As a result of Artisoft’s September 2003 financing onthese purchase price adjustment terms, Artisoft issued an additional 660,327shares of common stock to the investors in its September 2002 financing underthe common shares purchase price adjustment terms of the September 2002financing.

 

Following the September 2003 financing, the series Bconvertible preferred stock warrants’ per share exercise price was adjusted from $6.30 per share to $1.50 pershares.  The warrants have a callprovision that provides that if the closing per share bid price of the commonstock exceeds $45.00 for 30 consecutive trading days and certain otherconditions are met, Artisoft has the right to require the warrant holders toexercise their warrants for common stock.

 

The investors in each of the September 2003, September2002 and 2001 financings have the right to participate in future nonpubliccapital raising transactions by Artisoft. This right, as held by the investors in the September 2002 financing, isnot exercisable unless and until the expiration in full of the similar rightsof the investors in the September 2003 and 2001 financings.

 

We registered for resale in each of our September2003, September 2002 and 2001 financings the shares of common stock issued inthose financings or issuable upon the conversion or exercise, as the case maybe, of the preferred stock and warrants issued in those financings under theSecurities Act of 1933.  Theseregistrations include

 

8

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shares of common stock wemay issue or which may be issued as a result of the purchase price adjustmentterms of our September 2002 financing or antidilution protection terms of ourseries B and series C preferred stock. We were subject to cash penalties if we did not file the registrationstatements with respect to these registrations, and if those registrationstatements are not declared effective by the SEC, within the prescribed timeperiods set forth in the applicable registration rights agreements.  Our registration statement with respect to317,466 shares of common stock issued in our September 2002 financing was notdeclared effective within the prescribed time period imposed by the applicableregistration rights agreement. Under the terms of that agreement, we aretherefore required to pay the investors in our September 2002 financing apenalty in the aggregate amount of $.3 million.

 

The fair market value of the warrants issued onSeptember 10, 2003 as calculated using the Black Scholes pricing model wasestimated at $8.2 million.  The proceedsallocated to the warrants of $1.7 million was recorded as a credit toshareholders equity.  The value of thebeneficial conversion feature embedded in the shares of Series C preferredissued on September 10, 2003 based upon the proceeds allocated to the Series CPreferred stock is approximately $2.0 million and was recorded as an immediatenon-cash deemed dividend to the Series C Preferred stockholders in the firstquarter fiscal 2004, and will be included in the computation of the lossavailable to common stockholders and in the loss per share in the fiscal firstquarter of fiscal year ended June 30, 2004, as well as the cumulative periodsresults for fiscal 2004.  The excess ofthe aggregate fair value of the beneficial conversion feature over the proceedsallocated amounted to $4.2 million and it will not be reflected in the resultsof operations or financial position of the Company as of and for the year endedJune 30, 2004.

 

The effects of the September 2003 financing on thepurchase price adjustment terms of our September 2002 financing and on theantidilution protection provisions of our series B preferred stock resulted ina significant increase in potential common shares outstanding and a significantnon cash deemed dividend to the Series B preferred shareholders and thereforeresulted in an approximate $1.1 million increase in our loss per shareavailable to common shareholders in the first quarter of fiscal year ended 2004as well as the cumulative periods results for fiscal 2004.  The excess of the adjusted aggregate fairvalue of the beneficial conversion feature over the proceeds allocated to thepreferred shares amounted to $6.8 million and this excess will not be reflectedin the results of operations or financial position of the Company as of and forthe year ended June 30, 2004.

### ** **

### **(5)  GUARANTEES**

 

We enter into standard indemnification agreements inour ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree toreimburse the indemnified party for losses suffered or incurred by theindemnified party, generally our business partners or customers, in connectionwith any patent or any copyright or other intellectual property infringementclaim by any third party with respect to our products.  The term of these indemnification agreementsis generally perpetual.  The maximumpotential amount of future payments we could be required to make under theseindemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims relatedto these indemnification agreements. Accordingly, we have no liabilities recorded for these agreements.

 

We warrant that our software products will perform inall material respects in accordance with our standard published specificationsin effect at the time of delivery of the licensed products to the customer for90 days.  Additionally, we warrant thatour maintenance services will be performed consistent with generally acceptedindustry standards through completion of the agreed upon services.  If necessary, we would provide for theestimated cost of product and service warranties based on specific warrantyclaims and claim history, however, we have never incurred any significantexpenses under our product or service warranties.  Accordingly, we have no liabilities recorded for theseagreements.

** **

**(6) COMPUTATION OF NET LOSS PER SHARE**

 

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

 

9

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|                                                                               |   | **Three  Months ended  September 30,** |   |
|------------------------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                                               |   | **2003**                               |   | **2002** |   |
|                                                                               |   |                                   |   |   |   |
| Antidilutive potential common shares excluded from  net loss per share (thousands) |   | 3,666                                  |   | 1,306 |   |

 

## **Item2. - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

* *

*You should read the followingdiscussion together with the consolidated financial statements and relatednotes appearing elsewhere in this quarterly report on Form 10-Q.  This item, including, without limitation,the information set forth under the heading “Future Results”, containsforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933 and Section 21E of the Securities and Exchange Act of 1934 thatinvolve risks and uncertainties.  Actualresults may differ materially from those included in such forward-lookingstatements.  Factors which could causeactual results to differ materially include those set forth under “RiskFactors” commencing on page 15, as well as those otherwise discussed in thissection and elsewhere in this quarterly report on Form 10-Q.  See “Forward-Looking Statements”.*

 

Our discussion and analysis of our financial conditionand results of operations are based upon our condensed consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States. The preparation of these financial statements requires us to make estimatesand judgments that affect the reported amount of assets and liabilities at thedate of the financial statements and revenues and expenses during the reportingperiod.  Areas where significantjudgments are made include, but are not limited to revenue recognition.  Actual results could differ materially fromthese estimates.  For a more detailedexplanation of the judgments made in these areas, please refer to our AnnualReport on Form 10-K for the year ended June 30, 2003, as filed with theSecurities and Exchange Commission on September 29th, 2003.

** **

**Results of Operations**

** **

**Net Product Revenue**

 

Net product revenue was $2 million and $1.4 millionrespectively for each of the quarters ended September 30, 2003 and 2002,respectively. In the first quarter of fiscal year 2004, sales of TeleVantagelicenses increased by approximately 36% in comparison to the first quarter offiscal year 2003.

 

We distribute our products both domestically andinternationally.  International productrevenue was $.3 million and $.1 million for the quarters ended September 30,2003 and 2002, respectively, or 18% and 7% of total net revenue,respectively.  Domestic revenue was $1.7million for the quarter ended September 30, 2003 and $1.3 million for thequarter ended September 30, 2002.

** **

**Gross Profit**

* *

Gross profit from net product revenue was $1.9 millionand $1.4 million for the quarters ended September 30, 2003 and 2002,respectively, or 97.1% and 97.5% of net product revenue.  The increase in gross profit for the quarterended September 30, 2003 compared to the quarter ended September 30, 2002 wasdue primarily to an increase in revenue from higher TeleVantage software sales.

 

10

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**Sales And Marketing**

 

Sales and marketing expenses were $1.3 million and$1.4 million for the quarters ended September 30, 2003 and 2002, respectively,or 68.5% and 96.5% of total net product revenue, respectively.  The decrease in sales and marketing expensesas a percentage of total net product revenue for the quarter ended September30, 2003 compared to the quarter ended September 30, 2002 was due primarily toan increase in net product revenue.

** **

**Product Development**

 

Product development expenses were $.8 million for thequarters ended September 30, 2003 and 2002, or 39.7% and 55.5% of total net productrevenue, respectively.  The decrease inproduct development expense as a percentage of total net product revenue forthe quarter ended September 30, 2003 compared to the quarter ended September30, 2002 was due primarily to an increase in net product revenue.

** **

**General andAdministrative**

 

General and administrative expenses were $.8 millionand $1.7 million for the quarters ended September 30, 2003 and 2002,respectively, or 39.4% and 114.6% of total net product revenue,respectively.  During the quarter endedSeptember 30, 2002 a $.7 million accrual was established for a tax contingencyrelated to the company’s stock option plan. The decrease in general and administrative expenses in aggregate dollarsand as a percentage of total net product revenue for the quarter endedSeptember 30, 2003 compared to the quarter ended September 30, 2002 isprimarily due to the aforementioned reserve of $.7 million in the prior periodand a $.2 million decrease in occupancy, communications and employeebenefits related expenses, combined with an increase in net product revenue inthe current period.

** **

**Other Income, Net**

 

For the quarter ended September 30, 2003, other incomewas $.0 million and, remained consistent with the quarter ended September 30,2002.

** **

**Financial Condition,Liquidity And Capital Resources**

 

We had cash and cash equivalents of $5.4 million atSeptember 30, 2003 compared to $3.0 million at June 30, 2003.  Working capital, consisting of currentassets minus current liabilities, was $1.6 million at September 30, 2003compared to a working capital deficit of $1.0 million at June 30, 2003, anincrease of $2.6 million.  The increasein working capital reflects an increase of $2.4 million in cash and cashequivalents, an increase in trade accounts receivable of $.2 million and anincrease in inventory of $.1 million. This increase in inventory is aresult of hardware purchased for pilot installations for a specific enterprisesales opportunity.  Inventory may be purchasedfor pilots for enterprise sales opportunities from time to time.  Accrued liabilities decreased by $.4 millionand deferred revenue decreased by $.3 million. These increases in working capital were partially offset by a reductionin prepaid expenses of $.3 million and an increase of $.3 million in customerdeposits.  The increase in cash and cashequivalents of approximately $2.4 is primarily a result of receipt of $3.4million, net from the sale of preferred stock on September 10, 2003, less cashof $1.0 million used in operations and of $.05 million for the purchase ofproperty and equipment

 

We used cash of $1 million to fund operatingactivities during the quarter ended September 30, 2003.  The cash used in operating activities wasprincipally the result of $1 million in net loss offset by depreciation andamortization of $.2 million and a net decrease in non-cash working capital of$.3 million.

 

For the past 4 quarters we have received payment of$.4 million from Toshiba under the terms of our OEM agreement.  We are scheduled to receive the finalpayment of $.3 million during the quarter ending December 31, 2003.  Toshiba and Artisoft may elect to extend thecurrent OEM sales agreement and the impact on cashflow will be determined bythe terms of any extension.

 

We lease office, product packaging, storage space andequipment under noncancelable operating lease agreements expiring throughfiscal year 2006.

 

11

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The approximate minimum rental commitments undernoncancelable operating leases that have remaining noncancelable lease terms inexcess of one year at September 30, 2003 were as follows: 

 

| **YEARS  ENDING  JUNE 30** |   | **FUTURE  MINIMUM  LEASE PAYMENTS (IN THOUSANDS)** |   |
|----------------------------|--------|----------------------------------------------------|--------|
| 2004                       |   | $                                                  | 863    |   |
| 2005                       |   | 1,151                                              |   |
| 2006                       |   | 236                                                |   |
|                       |   |                                               |   |
| Total                      |   | $                                                  | 2,250  |   |

** **

**Preferred Stock Financing**

 

In September 2003, Artisoft issued and sold anaggregate of 2,627,002 shares of its series C convertible preferred stock toinvestors in a private placement at a per share price equal to $1.50.  The investors also received warrants topurchase up to 2,627,002 shares of Artisoft’s common stock at a per shareexercise price equal to $1.88. Proceeds from the financing were $3.4 million,net of related expenses of $.5 million.

 

The shares of series C preferred stock are initiallyconvertible into a like number of shares of common stock, subject toadjustment.  Each share of series Cpreferred stock generally receives .8152 of a vote, subject to adjustment, whenvoting on matters presented for the approval of Artisoft’s stockholders.  The holders of the series C preferred stock,as a class, are also entitled to elect a director of the Company.  In September 2003, the holders of our seriesC preferred stock exercised this right to elect Steven C. Zahnow as an Artisoftdirector.

 

If we liquidate, dissolve or wind up, then the holdersof series C preferred stock will be entitled, before any distributions are madeto the holders of common stock, to an amount equal to $1.50 per share, subjectto adjustment.  For purposes of thisliquidation preference, the series C preferred stock will rank on a parity withthe series B preferred stock, which carries a similar liquidation preference inthe amount of $2.50 per share.  Anacquisition of Artisoft by merger, consolidation or sale of substantially allassets will generally be treated as a liquidation, unless the liquidationpreference is waived by the holders of a majority of the series C preferredstock then outstanding.

 

The holders of the series C preferred stock areentitled to receive dividends only when and if declared by the board ofdirectors of the Company.  Any suchdividends would be paid to the holders of the series C preferred stock andseries B preferred stock prior to any distribution to holders of common stock,on a per share basis equal to the number of shares of common stock into whicheach share of preferred stock is then convertible.

 

The warrants will expire on June 27, 2010.  The expiration date, the per share exerciseprice and the number of shares issuable upon exercise of the warrants are subjectto adjustment in certain events.

 

As a result of Artisoft’s September 2003 financing onthese purchase price adjustment terms, Artisoft issued an additional 660,327shares of common stock to the investors in its September 2002 financing underthe common shares purchase price adjustment terms of the September 2000financing.

 

Following the September 2003 financing, the series Bconvertible preferred stock warrants’ per share exercise price was adjusted from $6.30 per share to $1.50 pershares.  The warrants have a callprovision that provides that if the closing per share bid price of the commonstock exceeds $45.00 for 30 consecutive trading days and certain otherconditions are met, Artisoft has the right to require the warrant holders toexercise their warrants for common stock.

 

The investors in each of the September 2003, September2002 and 2001 financings have the right to participate in future nonpubliccapital raising transactions by Artisoft. This right, as held by the investors in the September 2002 financing, isnot exercisable unless and until the expiration in full of the similar rightsof the investors in the September 2003 and 2001 financings.

 

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We registered for resale in each of our September2003, September 2002 and 2001 financings the shares of common stock issued inthose financings or issuable upon the conversion or exercise, as the case maybe, of the preferred stock and warrants issued in those financings under theSecurities Act of 1933.  Theseregistrations include shares of common stock we may issue or which may beissued as a result of the purchase price adjustment terms of our September 2002financing or antidilution protection terms of our series B and series Cpreferred stock.  We were subject tocash penalties if we did not file the registration statements with respect tothese registrations, and if those registration statements are not declaredeffective by the SEC, within the prescribed time periods set forth in theapplicable registration rights agreements. Our registration statement with respect to 317,466 shares of commonstock issued in our September 2002 financing was not declared effective withinthe prescribed time period imposed by the applicable registration rights agreement.Under the terms of that agreement, we are therefore required to pay theinvestors in our September 2002 financing a penalty in the aggregate amount of$.3 million.  This amount is reflectedas a component of accrued expenses at September 30, 2003 and June 30, 2003.

 

The fair market value of the warrants issued onSeptember 10, 2003 as calculated using the Black Scholes pricing model wasestimated at $8.2 million. The proceeds allocated to the warrants of $1.7million was recorded as a credit to shareholders equity.  The value of the beneficial conversionfeature embedded in the shares of Series C preferred issued on September 10,2003 based upon the proceeds allocated to the Series C Preferred stock is approximately$2 million and was recorded as an immediate non-cash dividend to the Series CPreferred stockholders in the first quarter fiscal 2004, and will be includedin the computation of the loss available to common stockholders and in the lossper share in the fiscal first quarter of fiscal year ended June 30, 2004, aswell as the cumulative periods results for the second, third and fourthquarters of fiscal 2004.  The excess ofthe aggregate fair value of the beneficial conversion feature over the proceedsallocated amounted to $4.2 million and it will not be reflected in the resultsof operations or financial position of the Company at June 30, 2004.

 

The effects of the September 2003 financing on thepurchase price adjustment terms of our September 2002 financing and on theantidilution protection provisions of our series B preferred stock resulted ina significant increase in potential common shares outstanding and a significantnon cash dividend to the Series B preferred shareholders and therefore resultedin approximately a $1.1 million increase in our loss per share available tocommon shareholders in the first quarter of fiscal year ended 2004 as well asthe cumulative periods results for the second, third and fourth quarters offiscal 2004.  The excess of the adjustedaggregate fair value of the beneficial conversion feature over the proceedsallocated to the preferred shares amounted to $6.8 million and this excess willnot be reflected in the results of operations or financial position of theCompany at June 30, 2004.

 

We anticipate that existing cash balances at September30, 2003, together with cash generated from sales of our product, will beadequate to meet the Company’s current and expected cash requirements for thenext twelve months, including the impact of the tax exposure issue related toour option plan discussed in note (3) and the liability associated with ourfailure to timely register certain preferred shares as discussed in note (4) toour unaudited condensed consolidated financial statements. However, a change incircumstance, such as a reduction in the anticipated growth of demand for ourproducts, could necessitate that the Company seek additional debt or equitycapital. The Company believes that future TeleVantage revenues will increaseand thereby reduce future operating losses. However, the rate at which theserevenues may increase will be highly dependent on the overalltelecommunications industry capital spending environment, the rate of marketacceptance of TeleVantage and the success of the Company’s strategic relationshipwith Toshiba. The Company does not presently meet the minimum stockholderequity requirement of $2.5 million for continued listing on the NASDAQ SmallCapMarket. The Company may seek equity financing to increase its shareholders’equity in order to satisfy this requirement. In addition, the Company may fromtime to time seek debt or equity financing for various business reasons. Therecan be no assurance that any additional financing will be available when neededor on acceptable terms to allow the Company to successfully achieve itsoperating plan or to fund future investment in its TeleVantage product line. Inthe event the Company seeks and successfully receives additional equitycapital, such additional financing may result in significant stockholderdilution.

 

Our common stock may be delisted from the NASDAQSmallCap Market at any time. If our common stock is delisted from the NASDAQSmallCap Market, the listing of our common stock may be transferred to theover-the-counter electronic bulletin board, also referred to as the OTCBB, orthe Pink Sheets. The listing of our common stock on the OTCBB or the PinkSheets would materially reduce the liquidity of our common stock and couldresult in a corresponding material reduction in the price of our common stock.In addition, such delisting

 

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would materiallyadversely affect our access to the capital markets, and the limited liquidityand reduced price of our common stock would materially adversely affect ourability to raise capital through alternative financing sources on termsacceptable to us or at all.

 

Under the continuing listing requirement applicable toour listing on the NASDAQ SmallCap Market, we are required to maintain aminimum stockholders’ equity of $2.5 million. At September 30, 2003, ourstockholders’ equity was $2.2 million. In response to our previousnoncompliance with the minimum stockholders’ equity requirement as disclosed inour annual report on Form 10-K for the year ended June 30, 2003, a NASDAQListing Qualifications Panel advised us that it will continue to monitor ourquarterly compliance with the minimum listing requirements. Based upon ourcurrent noncompliance with the minimum stockholders’ equity requirement, theListing Qualifications Panel could take any of several actions, includingimmediately delisting our common stock from the NASDAQ SmallCap Market orimposing additional requirements for the continued listing of our common stockon the NASDAQ SmallCap Market.

 

**Future Results**

 

The Company intends to continue investing in thesales, marketing and development of its software-based phone system,TeleVantage.  The Company expectsoperating expenditures will continue at levels consistent with the amountsincurred in the first quarter of fiscal year 2004 and throughout the currentfiscal year.

 

The Company believes that future TeleVantage revenueswill increase and thereby reduce future operating losses.  However, the rate at which these revenuesmay increase will be highly dependent on the overall telecommunicationsindustry capital spending environment, the rate of market acceptance ofTeleVantage and the success of the Company’s strategic relationships includingToshiba and Intel.  See “Risk Factors”below.

 

Specifically, through an original equipmentmanufacturer development arrangement with Artisoft, Toshiba is marketingTeleVantage 5.0 under the Strata CS brand, which is being distributed andsupported through Toshiba’s established dealer channel.  Under the terms of the agreement, Toshibawill purchase licenses of customized versions of the TeleVantage softwareproduct to be integrated with its digital handsets and communications serverproduct offerings.  Any significantdelay, cancellation, or termination of this arrangement with Toshiba will havea material adverse effect on the Company’s future results of operations.  However, any such events will be mitigatedto the extent of the minimum revenue guarantees provided to us by Toshiba for atotal remaining amount of $.3 million expected to be paid through December 31,2003.  The agreement expires in December2003.

 

**Risk Factors**

* *

*We caution you that the followingimportant factors, among others, in the future could cause our actual resultsto differ materially from those expressed in forward-looking statements made byor on behalf of us in filings with the Securities and Exchange Commission,press releases, communications with investors and oral statements.  Any or all of our forward-looking statementsin this Quarterly Report on Form 10-Q, and in any other public statements wemake may turn out to be wrong.  They canbe affected by inaccurate assumptions we might make or by known or unknownrisks and uncertainties.  Many factorsmentioned in the discussion below are important in determining futureresults.  We undertake no obligation topublicly update any forward-looking statements, whether as a result of newinformation, future events or otherwise. You are advised, however, to consult any further disclosures we make inour reports filed with the Securities and Exchange Commission.*

** **

**Our revenues aredependent upon sales of a single family of products, and our business willfail, if we do not increase sales of those products.**

 

Our revenues are derived from sales of a single familyof products, TeleVantage. If we are not able to increase sales of theseproducts, our business will fail. TeleVantage is a relatively new product inthe emerging

 

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market for software-basedphone systems and it is difficult to predict when or if sales of TeleVantagewill increase substantially or at all. We face a substantial risk that oursales will continue to not cover our operating expenses and that we willcontinue to incur operating losses.

** **

**We have a history oflosses and expect to incur future losses.**

 

We had operating losses for the quarter endedSeptember 30, 2003, for the fiscal year ended June 30, 2003 and in each ofthe last nine fiscal years. We also had negative cash flow from operatingactivities in four out of the last eight fiscal years. If our revenues do notincrease significantly we may never achieve profitability, on a sustained basisor at all, or generate positive cash flow in the future. In that case ourbusiness will fail. We expect to incur significant future operating losses andnegative cash flows but we anticipate that existing cash balances at September30, 2003, together with cash generated from sales of our product, will beadequate to meet the Company’s current and expected cash requirements for thenext twelve months.

** **

**Our operating resultsvary, making future operating results difficult to predict and adverselyaffecting the price of our common stock.**

 

Our operating results have in the past fluctuated, andmay in the future fluctuate, from quarter to quarter. The resulting continuedunpredictability of our operating results could depress the market price of ourcommon stock, particularly if operating results do not meet the expectations ofpublic market analysts or investors. Factors that contribute to fluctuations inour operating results include:

 

•                                          the extentand timing of sales recognized from significant customers, particularlyToshiba;

 

•                                          our abilityto develop, introduce and market enhancements to our TeleVantage family ofproducts;

 

•                                          changes inpricing policies or price reductions by us or our competitors;

 

•                                          variations insales by our value-added resellers and distributors; and

 

•                                          variations inproduct returns.

 

Sales in any quarter are dependent primarily on ordersbooked and shipped in that quarter and are not predictable with any degree ofcertainty. In addition, our expense levels are based, in part, on ourexpectations as to future revenues. If revenue levels are below ourexpectations, net loss may be disproportionately affected due to fixed costsrelated to generating our revenues.

** **

**We rely upon theavailability to market Televantage of distributors, resellers and originalequipment manufacturers and the ability of these organizations to pay for theproducts they purchase from us.**

 

If distributors,resellers and original equipment manufacturers in the software industry choosenot to focus their marketing efforts on software-based phone systems or onproducts competitive with TeleVantage, our sales efforts will be materiallyadversely affected. In the quarter ended September 30, 2003, our distributor,Paracon, accounted for 37% of our total net product revenue. In the fiscal year2003, Paracon accounted for 42% of our total net product revenue. In fiscal year2002, Paracon accounted for 32% of our total net product revenue. We dependupon the availability of distribution outlets similar to these relationships tomarket TeleVantage. In addition, our operating results would be adverselyaffected if one of our major distributors, resellers or original equipmentmanufacturers fails to pay us for the products they purchase from us. AtSeptember 30, 2003, Paracon represented approximately 33% of our outstandingtrade receivables, and at June 30, 2003, Paracon represented approximately36% of our outstanding trade receivables. Our relationship with Paracon isthrough its subsidiary Scansource, which is doing business as Catalyst Telecom.

 

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**Our common stock may bedelisted from the NASDAQ SmallCap Market and transferred to theover-the-counter electronic bulletin board or the Pink Sheets, which wouldreduce the liquidity of our common stock and may depress the price of ourcommon stock.**

 

If our common stock isdelisted from the NASDAQ SmallCap Market, the listing of our common stock maybe transferred to the over-the-counter electronic bulletin board, also referredto as the OTCBB, or the Pink Sheets. The listing of our common stock on theOTCBB or the Pink Sheets would materially reduce the liquidity of our commonstock and could result in a corresponding material reduction in the price ofour common stock. In addition, such delisting would materially adversely affectour access to the capital markets, and the limited liquidity and reduced priceof our common stock would materially adversely affect our ability to raisecapital through alternative financing sources on terms applicable to us or atall.

 

Under the continuinglisting requirement applicable to our listing on the NASDAQ SmallCap Market, weare required to maintain a minimum stockholders’ equity of $2.5 million.At September 30, 2003, our stockholders’ equity was $2.2 million. Inresponse to our previous noncompliance with the minimum stockholders’ equityrequirement as disclosed in our annual report on Form 10-K for the year endedJune 30, 2003, a NASDAQ Listing Qualifications Panel advised us that it willcontinue to monitor our quarterly compliance with the minimum listingrequirements. Based upon our current noncompliance with the minimumstockholders’ equity requirement, the Listing Qualifications Panel could takeany of several actions, including immediately delisting our common stock fromthe NASDAQ SmallCap Market or imposing additional requirements for thecontinued listing of our common stock on the NASDAQ SmallCap Market.

** **

**We may need to procureadditional third party financing, but financing may not be available whenneeded or upon terms acceptable to us.**

 

In order to obtain thefunds to continue our operations and meet our working capital requirements, wemay require additional equity financing or debt financing. The proceeds fromour series C preferred stock financing completed in September 2003may not be sufficient to meet our business needs. Any additional financing maynot be available to us on terms acceptable to us or at all.

 

**The**issuance and sale of our securities could have theeffect of substantially diluting the interests of our current stockholders.

 

If we issue securities ofArtisoft, our current stockholders may experience substantial dilution of theirownership in Artisoft. The holders of our series B preferred stock, theholders of common stock issued pursuant to our September 2002 financingand the holders of our series C preferred stock have price-relatedantidilution protection in the event of future issuances of securities by us.These provisions could substantially dilute your interest in Artisoft in theevent of a future financing transaction. In addition, those same investors allhave the right to participate in future capital raising transactions byArtisoft. The existence of this right may substantially reduce Artisoft’sability to establish terms with respect to, or enter into, any financing withparties other than the investors. The terms of any additional financing we mayenter into may impose substantial constraint on our ability to operate ourbusiness as we deem appropriate.  InSeptember 2003, Artisoft completed a financing which resulted in theregistration of 8,225,437 common shares. Of these, 2,971,433 resulted from the antidilution rights of the SeriesB preferred stockholders and the holders of common stock issued pursuant to ourSeptember 2002 financing.

** **

**Our market is highlycompetitive; if we fail to compete successfully, our products will not besuccessful.**

 

•                  We compete with other phone systemcompanies, many of which have substantially greater financial, technological,production, sales and marketing and other resources, as well as greater namerecognition and larger customer bases, than does Artisoft. Given the greaterfinancial resources of many of our competitors, our products may not besuccessful or even accepted. The computer telephony industry is highlycompetitive and is characterized by rapidly evolving industry standards. Webelieve that the principal competitive factors affecting the markets we serveinclude: product architecture, functionality and features;

 

•                  price;

 

16

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•                  vendor and product reputation;

 

•                  quality of product and support; and

 

•                  effectiveness of sales and marketingefforts.

 

Our competitors may beable to respond more quickly and effectively than can Artisoft to new oremerging technologies and changes in customer requirements or to devote greaterresources than can Artisoft to the development, promotion, sales and support oftheir products. For example, our competitors could develop products compatiblewith the Intel SoftSwitch Framework that could displace TeleVantage CTM Suite.

** **

**If software-based phonesystems do not achieve widespread acceptance, we may not be able to continueour operations.**

 

Our sole product line,TeleVantage, competes in the newly emerging software-based phone system market,as well as existing traditional, proprietary hardware solutions offered bycompanies such as Avaya Communications, Nortel Networks Corporation and SiemensCorporation. We do not know if markets will migrate toward software-based phonesystem solutions. If software-based phone systems do not achieve widespreadacceptance or widespread acceptance is delayed, sales of TeleVantage will notincrease and may decline. We may then be unable to continue our operations.

** **

**Our market is subject tochanging preferences and technological change; our failure to keep up withthese changes would result in our losing market share.**

 

The introduction ofproducts incorporating new technologies and the emergence of new industrystandards could render TeleVantage obsolete and unmarketable. If this occurs,we would likely lose market share. The markets for computer telephony solutionsare characterized by rapid technological change, changing customer needs,frequent product introductions and evolving industry standards within themarkets for computer technology solutions. Our future success will depend uponour ability to develop and introduce new computer telephony products, includingnew releases and enhancements, on a timely basis that keep pace withtechnological developments and emerging industry standards and address the increasinglysophisticated needs of our customers.

** **

**Some of our stockholdershave acquired a substantial interest in Artisoft and may be able to exertsubstantial influence over Artisoft’s actions.**

 

Based upon theirsubstantial stock ownership and their director rights, Austin W. Marxe andDavid M. Greenhouse may be able to exert substantial influence over matterssubmitted to our stockholders for approval and our management and affairs,including the election and removal of directors and any merger, consolidationor sale of all or substantially all of our assets. As of July 31, 2003 andallowing for the antidilutive effects of our September 2003 series Cpreferred stock financing, Austin W. Marxe and David M. Greenhouse beneficiallyowned approximately 65.5% of our common stock. In addition, Austin W. Marxe andDavid M. Greenhouse, through their affiliates, have the right to elect twodirectors and the right to designate an additional director. Effective as ofAugust 28, 2002, the holders of our series B preferred stock electedRobert J. Majteles to our board of directors. Mr. Majteles was selectedfor election by an affiliate of Austin W. Marxe and David M. Greenhouse underan agreement among the holders of the series B preferred stock.

 

Austin W. Marxe and DavidM. Greenhouse may elect to sell all or a substantial portion of their Artisoftsecurities to one or more third parties. In that case, a third party with whomwe have no prior relationship could exercise the same degree of control over usas Austin W. Marxe and David M. Greenhouse presently do.

 

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**If the employment of either of ourChief Executive Officer or our Chief Technology Officer is terminated prior toOctober 2004 without cause or by the executive for good reason, we will berequired to provide substantial benefits to that officer.**

 

We have change in controlagreements with two of our executive officers that provide that in the event oftermination of employment of an executive officer within two years of thechange in control either without cause or by the executive for “good reason,”such as a reduction in duties and responsibilities:

 

•                  all of the executive’s unvestedoptions vest and become exercisable in full; and

 

•                  Artisoft will pay the executive alump sum equal to one year’s, or two years’ in the case of the Chief ExecutiveOfficer, base salary plus bonus.

 

Due to open marketpurchases of our common stock, a change in control, within the meaning of thechange in control agreements, occurred in October 2002. Therefore, each ofthe executives set forth in the table below will receive benefits under hischange in control agreement in the event his employment at Artisoft isterminated prior to 2004 either without cause or for good reason. The salaryand bonus of each executive for Artisoft’s 2003 fiscal year ended June 30,2002 is also set forth on the table below. 

 
| **Name**              |   | **Title**                                                   |   | **Fiscal  2003 Salary** |    | **Fiscal  2003  Bonus** |   |
|-----------------------|--------|-------------------------------------------------------------|--------|-------------------------|---------|-------------------------|--------|
|                  |   |                                                        |   |                    |    |                    |   |
| Steven  G. Manson     |   | President and Chief  Executive Officer                      |   | $                       | 210,000 |                    | — |   |
| Christopher  Brookins |   | Vice President of  Development and Chief Technology Officer |   | $                       | 166,400 |                    | — |   |

** **

**Software errors maydamage our reputation, cause loss of customers and increase customer supportcosts.**

 

Software products ascomplex as TeleVantage may contain undetected errors. This could result indamage to our reputation, loss of customers, delay of market acceptance of ourproducts or all of these consequences. We or our customers may find errors inTeleVantage or any new products after commencement of commercial shipments. Inaddition, if our products are flawed, or are difficult to use, customer supportcosts could rise.

** **

**We rely on third-partytechnology and hardware products. This technology may contain undetectederrors, be superseded or may become unavailable, thereby limiting our abilityto sell, and the performance of, our products.**

 

Our TeleVantage operateson hardware manufactured by Intel. To the extent that this hardware becomesunavailable or in short supply we could experience delays in shippingTeleVantage to our customers. In addition, we are dependent on the reliabilityof this hardware and to the extent the hardware has defects it will affect theperformance of TeleVantage. If the hardware becomes unreliable, does notperform in a manner that is acceptable to our customers or becomes moreexpensive, sales of TeleVantage could fall.

 

Because our products runonly on Microsoft Windows NT servers and use other Microsoft Corporationtechnologies, including the Microsoft Data Engine, a decline in marketacceptance for Microsoft technologies or the increased acceptance of otherserver technologies could cause us to incur significant development costs andcould have a material adverse effect on our ability to market our currentproducts.

** **

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

 

Our success is dependentupon our software code base, our programming methodologies and otherintellectual properties. If we are unable to protect these properties, we willnot be able to remain technologically competitive and our business will suffer.To protect our proprietary technology, we rely primarily on a combination oftrade secret laws and nondisclosure, confidentiality, and other agreements andprocedures, as well as copyright and trademark laws. These laws and actions mayafford only limited protection. We may not be able to deter misappropriation ofour proprietary information or to prevent the successful assertion of anadverse claim to software utilized by us. In addition, we may not be able todetect unauthorized use and take effective steps to enforce our intellectualproperty rights. In selling our products, we rely primarily on “shrink wrap”licenses that are

 

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not signed by licenseesand, therefore, may be unenforceable under the laws of some jurisdictions. Inaddition, the laws of some foreign countries provide substantially lessprotection to our proprietary rights than do the laws of the United States.

** **

**If we are not able tohire and retain qualified personnel, we will be hindered in our efforts tomaintain and expand our business.**

 

We are dependent on ourability to identify, hire, train, retain and motivate high quality personnel, especiallyhighly skilled engineers involved in the ongoing research and developmentrequired to develop and enhance our software products and introduce enhancedfuture products. If we are not able to hire and retain qualified personnel, wewill be hindered in our efforts to maintain and expand our business. Thecomputer telephony industry is characterized by rapid technological change,changing customer needs, frequent product introductions and evolving industrystandards. These characteristics require a high degree of industry-specifictechnological and operational understanding. A high level of employee mobilityand aggressive recruiting of skilled personnel characterize our industry. Therecan be no assurance that our current employees will continue to work for us orthat we will be able to hire additional employees on a timely basis or at all.We expect to grant additional stock options and provide other forms ofincentive compensation to attract and retain key technical and executivepersonnel. These additional incentives will lead to higher compensation costsin the future and may adversely affect our future results of operations.

## ** **

## **Item3. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

* *

*MarketRisk*.  During thenormal course of business Artisoft is routinely subjected to a variety ofmarket risks, examples of which include, but are not limited to, interest ratemovements and collectability of accounts receivable.  Artisoft currently assesses these risks and has establishedpolicies and practices to protect against the adverse effects of these andother potential exposures.  AlthoughArtisoft does not anticipate any material losses in these risk areas, noassurances can be made that material losses will not be incurred in these areasin the future.

* *

*InterestRate Risk. *Artisoftmay be exposed to interest rate risk on certain of its cash equivalents.  The value of certain of our investments maybe adversely impacted in a rising interest rate investment environment.  Although Artisoft does not anticipate anymaterial losses from such a movement in interest rates, no assurances can bemade that material losses will not be incurred in the future.

## ** **

## **Item4. - CONTROLS AND PROCEDURES**

 

Artisoft’s management,with the participation of Artisoft’s chief executive officer and chieffinancial officer, evaluated the effectiveness of Artisoft’s disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theExchange Act) as of September 30, 2003. Based on this evaluation, Artisoft’s chief executive officer and chieffinancial officer concluded that, as of September 30, 2003, Artisoft’sdisclosure controls and procedures were (1) designed to ensure that materialinformation relating to Artisoft, including its consolidated subsidiaries, ismade known to Artisoft’s chief executive officer and chief financial officer byothers within those entities, particularly during the period in which thisreport was being prepared and (2) effective, in that they provide reasonableassurance that information required to be disclosed by Artisoft in the reportsthat it files or submits under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms.

 

No change in Artisoft’sinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) occurred during the fiscal quarter endedSeptember 30, 2003 that has materially affected, or is reasonably likely tomaterially affect, Artisoft’s internal control over financial reporting.

 

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**PART II- OTHER INFORMATION**

 

Item 2. - CHANGES IN SECURITIES AND USE OF PROCEEDS

 

On September 10, 2003, weissued and sold to several investors, including R.R. Stolworthy, Inc.andcertain entities and affiliates of Jon D. Gruber, Perkins Capital Management,Inc., Whitebox Advisors and Constable Capital QP, LLC, an aggregate of2,627,002 shares of series C convertible preferred stock at a per sharepurchase price equal to $1.50 and warrants to purchase an aggregate of2,627,002 shares of common stock at an initial per share price equal to$1.88.  The aggregate offering price forthe sale of the series C convertible preferred stock was $3.9 million.  No underwriters were involved in theforegoing sale of securities. Such sale was made in reliance upon an exemptionfrom the registration provisions of the Securities Act set forth in Section4(2) thereof, relative to sales by an issuer not involving any public offering,and the rules and regulations thereunder.

* *

*Conversionof Series C Preferred. *Theholders of the series C preferred stock have the right, at any time and attheir option, to convert each share of series C preferred stock into anumber of shares of our common stock determined by dividing the then-applicableper share liquidation preference of the series C preferred stock by thethen-applicable per share conversion price of the series C preferredstock. The conversion price is be subject to adjustment in the case of anystock dividend, stock split, combination, capital reorganization,reclassification, merger or consolidation by Artisoft. With limited exceptions,the conversion price is also subject to adjustment in the case of an issuanceof shares of our common stock, or securities exercisable for or convertibleinto our common stock, at a per share price less than the conversion price thenin effect. In the event that this occurs, the conversion price will be reducedto equal the per share price of the issued securities. As of the date of thisQuarterly Report on Form 10-Q, the conversion price of our series Cpreferred stock was $1.50.

 

The number of shares ofcommon stock that a holder of series C preferred stock may acquire uponconversion of series C preferred stock is limited to the extent necessaryto ensure that, following such conversion (or other issuance), the total numberof shares of common stock then beneficially owned by the holder does not exceed9.999% of the total number of issued and outstanding shares of common stock.This provision does not apply, however, to any holder of series Cpreferred stock whose beneficial ownership of common stock as of June 27,2003 exceeded 9.999% of the total number of issued and outstanding shares ofcommon stock as of such date until such time as the beneficial ownership ofcommon stock of such holder does not exceed 9.999% of the total number ofissued and outstanding shares of common stock.

* *

*Exerciseof Warrants.*  Thewarrants have a term of exercise expiring on June 27, 2010. The number ofshares issuable upon exercise and the per share exercise price of the warrantsis 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 per share exercise price of the warrants isalso subject to adjustment in the case of an issuance of shares of common stockor securities exercisable for or convertible into common stock, at a per shareprice less than the per share exercise price of the warrants then in effect. Inthe event of such an issuance, the per share exercise price of the warrantswill be reduced to equal the per share price of that issuance. The warrants areexercisable at any time prior to their expiration date by delivering thewarrant certificates to us, together with a completed election to purchase andthe full payment of the exercise price or by means of a “net exercise” featureunder which Artisoft does not receive any cash, but rather, the number ofshares issued upon exercise is net of the number of shares withheld by Artisoftin lieu of payment of the exercise price. This net exercise right is generallylimited to times when Artisoft is not in compliance with its obligationsrelating to the registration of the shares of common stock underlying thewarrants for resale under Artisoft’s registration rights agreement with respectto those shares.

 

The number of shares ofcommon stock that a warrant holder may acquire upon exercise of a warrant islimited to the extent necessary to ensure that, following such exercise (orother issuance), the total number of shares of common stock then beneficiallyowned by the holder does not exceed 9.999% of the total number of issued andoutstanding shares of common stock. This provision does not apply, however, toany warrant holder whose beneficial ownership of common stock as ofJune 27, 2003 exceeded 9.999% of the total number of issued andoutstanding shares of common stock as of such date until such time as thebeneficial ownership of common stock of such holder does not exceed 9.999% ofthe total number of issued and outstanding shares of common stock.

 

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Item 4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

On September 10, 2003,Artisoft held a special meeting of stockholders.  At the meeting, the votes cast for and against the matterspresented to Artisoft’s stockholders, as well as the number of abstentions andbroker non-votes, were as follows:

 

To authorize the issuance and sale under the terms ofa purchase agreement dated June 27, 2003 of (1) 2,627,002 shares of Artisoft’sSeries C Convertible Preferred Stock, $1.00 par value per share, at a per shareprice equal to $1.50 and (2) warrants to purchase an aggregate of 2,627,002shares of common stock, $.01 par value per share, at an initial per shareexercise price of $1.88.

 

| **VOTES FOR** |   | **VOTES  AGAINST** |   | **VOTES  ABSTAINING** |   | **BROKER  NON-  VOTES** |   |
|---------------|--------|--------------------|--------|-----------------------|--------|-------------------------|--------|
| 2,032,673     |   | 101,733            |   | 8,822                 |   | 0                       |   |

 

## **Item5. - EXHIBITS AND REPORTS ON FORM 8-K**

 

#### a.  Exhibits

 

The Exhibits filed aspart of this Form 10-Q for the quarter ended September 30, 2003 are listed onthe Exhibit Index immediately preceding such Exhibits, which Exhibit Index isincorporated herein by reference.  Documentslisted on such Exhibit Index, except for documents identified by footnotes, arebeing filed as exhibits herewith. Documents identified by footnotes are not being filed herewith and,pursuant to Rule 12b-32 under the Securities Exchange Act of 1934, reference ismade to such documents as previously filed as exhibits filed with theSecurities and Exchange Commission. Artisoft’s file number under the Securities Exchange Act of 1934 is000-19462.

####  

#### b.  Reports on Form 8-K

 

On July 22, 2003,Artisoft filed a Current Report on Form 8-K dated July 22, 2003 forthe purpose of filing under Item 5 (Other Events) with the Securities andExchange Commission as an exhibit thereto Artisoft’s press release datedJuly 22, 2003, announcing that its stock will continue to be listed on theNASDAQ SmallCap Market via a temporary exception from the minimum shareholders’equity continued listing requirement.

 

On August 7, 2003,Artisoft furnished a Current Report on Form 8-K dated August 7, 2003for the purpose of furnishing under Item 12 (Results of Operation and FinancialCondition) to the Securities and Exchange Commission as an exhibit theretoArtisoft’s press release dated August 7, 2003, announcing Artisoft’sfinancial results for the fiscal year and quarter ended June 30, 2003.

 

On September 18,2003, Artisoft filed a Current Report on Form 8-K dated September 10,2003 for the purpose of (i) reporting under Item 1 (Change in Control ofthe Registrant) with the Securities and Exchange Commission that a change incontrol of Artisoft may be deemed to have occurred following to the issuanceand sale of an aggregate of 2,627,002 shares of series C convertiblepreferred stock of Artisoft at a per share purchase price of $1.50 and warrantsto purchase up to 2,627,002 shares of common stock at a per share purchaseprice of $1.88 on September 10, 2003, (ii) filing under Item 5 (OtherEvents) with the Securities and Exchange Commission as an exhibit theretoArtisoft’s press release dated September 11, 2003, announcing the closingof the issuance and sale of the series C convertible preferred stock andwarrants to purchase shares of common stock on September 10, 2003 and(iii) filing under Item 5 (Other Events) with the Securities and ExchangeCommission a description of the capital stock of Artisoft.

 

On September 24, 2003,Artisoft furnished a Current Report on Form 8-K dated September 24, 2003in order to comply with the terms of its temporary listing exception on theNASDAQ SmallCap Market and furnished under Item 9 (Regulation FD Disclosure) tothe Securities and Exchange Commission as an exhibit thereto Artisoft’sunaudited consolidated balance sheets at August 31, 2003 and the unaudited consolidatedbalance sheets at August 31, 2003, as adjusted to reflect Artisoft’sreceipt of the gross proceeds from its September 10, 2003 financing andArtisoft’s payment of the estimated costs relating to that financing.

 

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**SIGNATURES**

** **

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
| **ARTISOFT,  INC.**             |
|---------------------------------|
|                            |   |
| *Date:  November 14, 2003* | *By  /s/ STEVEN G. MANSON* |   |
|                            | *Steven  G. Manson* |
|                            | *President  and Chief Executive Officer* |
|                            |   |
| *Date:  November 14, 2003* | *By  /s/ DUNCAN G. PERRY* |   |
|                            | *Duncan  G. Perry* |
|                            | *Chief  Financial Officer (Principal Financial Officer and  Chief Accounting Officer)* |

 

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**EXHIBITINDEX**

 
| **Designation** |   | **Description**                                                                                                                                     |
|-----------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                                                                |
| 31.1            |   | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a)/Rule 15d-14(a) of the Securities Exchange                                      |
|            |   |                                                                                                                                                |
| 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 |

** **

**23**

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