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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549





FORM 10-Q

(Mark One)

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

For the quarterly period ended December 31, 2007

or



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

For the transition period from  to

Commission File Number 000-19462





VERTICAL COMMUNICATIONS, INC.

(Exact Name of Registrant as Specified in Its Charter)



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

Ten Canal Park, Cambridge, Massachusetts 02141

(Address of Principal Executive Offices) (Zip Code)

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

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

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

Large
Accelerated Filer   ̈        Accelerated Filer   ̈        Non accelerated
Filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act.)

Yes   ̈ No  x

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



|                                        |  |                                           
|--------------------------------------- |  | ------------------------------------------
|Title of Class of Common Stock          |  | Shares Outstanding as of February 15, 2008
|Common Stock, $0.01 par value per share |  | 52,373,522                                









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VERTICAL COMMUNICATIONS, INC.

FORM 10-Q

TABLE OF CONTENTS



|        |  |                                                                                                                          |  |     
|------- |  | ------------------------------------------------------------------------------------------------------------------------ |  | ----
|        |  |                                                                                                                          |  | Page
|PART I  |  | FINANCIAL INFORMATION                                                                                                    |  | 3   
|        |  |                                                                                                                         
|        |  | Item 1. Condensed Consolidated Financial Statements                                                                      |  | 3   
|        |  |                                                                                                                         
|        |  | Condensed Consolidated Balance Sheets as of December 31, 2007 (unaudited) and June 30, 2007                              |  | 3   
|        |  |                                                                                                                         
|        |  | Condensed Consolidated Statement of Operations for the three and six months ended December 31, 2007 and 2006 (unaudited) |  | 4   
|        |  |                                                                                                                         
|        |  | Condensed Consolidated Statement of Cash Flows for the six months ended December 31, 2007 and 2006 (unaudited)           |  | 5   
|        |  |                                                                                                                         
|        |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                                         |  | 6   
|        |  |                                                                                                                         
|        |  | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations                            |  | 19  
|        |  |                                                                                                                         
|        |  | Item 3. Quantitative and Qualitative Disclosures about Market Risk                                                       |  | 27  
|        |  |                                                                                                                         
|        |  | Item 4. Controls and Procedures                                                                                          |  | 27  
|        |  |                                                                                                                         
|PART II |  | OTHER INFORMATION                                                                                                        |  | 28  
|        |  |                                                                                                                         
|        |  | Item 1. Legal Proceedings                                                                                                |  | 28  
|        |  |                                                                                                                         
|        |  | Item 1A. Risk Factors                                                                                                    |  | 28  
|        |  |                                                                                                                         
|        |  | Item 3. Defaults Upon Senior Securities                                                                                  |  | 28  
|        |  |                                                                                                                         
|        |  | Item 6. Exhibits                                                                                                         |  | 30  
|        |  |                                                                                                                         
|        |  | Signature                                                                                                                |  | 31  



2



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PART I  FINANCIAL INFORMATION

Item 1.  FINANCIAL STATEMENTS

VERTICAL COMMUNICATIONS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)



|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------- | -------- | - | ------------ | - | ------- | -
|                                                                                                                                                                                                           |  | December 31,2007(Unaudited) |          |   | June 30,2007 |  
|ASSETS                                                                                                                                                                                                     |  |                             |          |   |              |   |         |  
|Current assets:                                                                                                                                                                                            |  |                             |          |   |              |   |         |  
|Cash and cash equivalents                                                                                                                                                                                  |  | $                           | 3,620    |   |              | $ | 8,019   |  
|Trade receivables, net of allowances of $335 and $354, respectively                                                                                                                                        |  |                             | 11,172   |   |              |   | 13,678  |  
|Inventories, net                                                                                                                                                                                           |  |                             | 13,394   |   |              |   | 12,818  |  
|Prepaid expenses                                                                                                                                                                                           |  |                             | 1,484    |   |              |   | 1,745   |  
|Deferred costs                                                                                                                                                                                             |  |                             | 4,599    |   |              |   | 4,437   |  
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|Total current assets                                                                                                                                                                                       |  |                             | 34,269   |   |              |   | 40,697  |  
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|                                                                                                                                                                                                           |  |                            
|Property and equipment                                                                                                                                                                                     |  |                             | 8,102    |   |              |   | 6,848   |  
|Less accumulated depreciation and amortization                                                                                                                                                             |  |                             | (5,238   | ) |              |   | (4,603  | )
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|Net property and equipment                                                                                                                                                                                 |  |                             | 2,864    |   |              |   | 2,245   |  
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|                                                                                                                                                                                                           |  |                            
|Goodwill                                                                                                                                                                                                   |  |                             | 35,363   |   |              |   | 40,336  |  
|Intangible assets, net of accumulated amortization                                                                                                                                                         |  |                             | 14,858   |   |              |   | 16,265  |  
|Deferred costs, net of current portion                                                                                                                                                                     |  |                             | 1,134    |   |              |   | 3,291   |  
|Other assets                                                                                                                                                                                               |  |                             | 379      |   |              |   | 471     |  
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|Total assets                                                                                                                                                                                               |  | $                           | 88,867   |   |              | $ | 103,305 |  
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|LIABILITIES, CONVERTIBLE REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS EQUITY                                                                                                                               |  |                             |          |   |              |   |         |  
|Current liabilities:                                                                                                                                                                                       |  |                             |          |   |              |   |         |  
|Accounts payable                                                                                                                                                                                           |  | $                           | 5,084    |   |              | $ | 6,238   |  
|Accrued liabilities                                                                                                                                                                                        |  |                             | 10,524   |   |              |   | 10,049  |  
|Trade accounts payable to a stockholder                                                                                                                                                                    |  |                             | 3,599    |   |              |   | 2,419   |  
|Deferred revenue                                                                                                                                                                                           |  |                             | 10,894   |   |              |   | 10,294  |  
|Customer deposits                                                                                                                                                                                          |  |                             | 175      |   |              |   | 175     |  
|Current portion of long term debt                                                                                                                                                                          |  |                             | 22,699   |   |              |   | 6,681   |  
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|Total current liabilities                                                                                                                                                                                  |  |                             | 52,975   |   |              |   | 35,856  |  
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|                                                                                                                                                                                                           |  |                            
|Deferred revenue, net of current portion                                                                                                                                                                   |  |                             | 2,100    |   |              |   | 6,043   |  
|Deferred tax liability                                                                                                                                                                                     |  |                             | 1,919    |   |              |   | 5,761   |  
|Long term debt, net of current portion                                                                                                                                                                     |  |                             | 2        |   |              |   | 16,014  |  
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|Total liabilities                                                                                                                                                                                          |  |                             | 56,996   |   |              |   | 63,674  |  
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|                                                                                                                                                                                                           |  |                            
|Series D convertible, redeemable preferred stock, $1.00 par value, 5,000 shares authorized, 4,921 issued and outstanding at December 31, 2007
and 5,000 at June 30, 2007; liquidation preference of $5,585 |  |                             | 1,798    |   |              |   | 1,238   |  
|Series E convertible, redeemable preferred stock, $1.00 par value, 30,000 shares authorized, 27,400 shares issued and outstanding at
December 31, 2007; liquidation preference of $30,373                  |  |                             |         |   |              |   |        |  
|                                                                                                                                                                                                           |  |                            
|Shareholders equity:                                                                                                                                                                                      |  |                             |          |   |              |   |         |  
|Preferred stock, $1.00 par value, authorized 30,000,000 shares.                                                                                                                                            |  |                             |         |   |              |   |        |  
|Common stock, $.01 par value per share. Authorized 250,000,000 shares; issued and outstanding 52,373,522 shares at December 31, 2007 and
52,084,483 at June 30, 2007.                                      |  |                             | 524      |   |              |   | 521     |  
|Accumulated other comprehensive income (loss)                                                                                                                                                              |  |                             | (40      | ) |              |   | (52     | )
|Additional paid-in capital                                                                                                                                                                                 |  |                             | 132,532  |   |              |   | 129,793 |  
|Accumulated deficit                                                                                                                                                                                        |  |                             | (102,513 | ) |              |   | (91,429 | )
|Deferred Toshiba equity cost                                                                                                                                                                               |  |                             | (430     | ) |              |   | (440    | )
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|Net shareholders equity                                                                                                                                                                                   |  |                             | 30,073   |   |              |   | 38,393  |  
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  
|Total liabilities, convertible redeemable preferred stock and shareholders equity                                                                                                                          |  | $                           | 88,867   |   |              | $ | 103,305 |  
|                                                                                                                                                                                                           |  |                             |          |   |              |   |         |  

See notes to condensed consolidated financial statements.



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VERTICAL COMMUNICATIONS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)



|                                                                       |  |                                |        |   |                              |   |        |      |  |   |         |   |  |   |        |  
|---------------------------------------------------------------------- |  | ------------------------------ | ------ | - | ---------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                       |  | Three Months EndedDecember 31, |        |   | Six Months EndedDecember 31, |  
|                                                                       |  | 2007                           |        |   | 2006                         |   |        | 2007 |  |   | 2006    |  
|Net revenue                                                            |  | $                              | 18,711 |   |                              | $ | 18,080 |      |  | $ | 38,418  |   |  | $ | 33,950 |  
|Cost of sales                                                          |  |                                | 10,056 |   |                              |   | 9,423  |      |  |   | 20,785  |   |  |   | 17,177 |  
|                                                                       |  |                                |        |   |                              |   |        |      |  |   |         |   |  |   |        |  
|Gross profit                                                           |  |                                | 8,655  |   |                              |   | 8,657  |      |  |   | 17,633  |   |  |   | 16,773 |  
|Operating expenses:                                                    |  |                                |        |   |                              |   |        |      |  |   |         |   |  |   |        |  
|Sales and marketing                                                    |  |                                | 4,926  |   |                              |   | 3,645  |      |  |   | 9,911   |   |  |   | 7,275  |  
|Product development                                                    |  |                                | 4,104  |   |                              |   | 3,064  |      |  |   | 7,867   |   |  |   | 6,134  |  
|General and administrative                                             |  |                                | 3,795  |   |                              |   | 3,932  |      |  |   | 7,742   |   |  |   | 8,029  |  
|Amortization of intangible assets                                      |  |                                | 609    |   |                              |   | 364    |      |  |   | 1,218   |   |  |   | 671    |  
|                                                                       |  |                                |        |   |                              |   |        |      |  |   |         |   |  |   |        |  
|Total operating expenses                                               |  |                                | 13,434 |   |                              |   | 11,005 |      |  |   | 26,738  |   |  |   | 22,109 |  
|                                                                       |  |                                |        |  
|Loss from operations                                                   |  |                                | (4,779 | ) |                              |   | (2,348 | )    |  |   | (9,106  | ) |  |   | (5,336 | )
|Interest expense                                                       |  |                                | (720   | ) |                              |   | (1,220 | )    |  |   | (1,357  | ) |  |   | (1,427 | )
|Other income, net                                                      |  |                                | 23     |   |                              |   | 93     |      |  |   | 68      |   |  |   | 112    |  
|                                                                       |  |                                |        |   |                              |   |        |      |  |   |         |   |  |   |        |  
|                                                                       |  |                                |        |  
|Loss before provision for income tax                                   |  |                                | (5,476 | ) |                              |   | (3,475 | )    |  |   | (10,395 | ) |  |   | (6,651 | )
|Provision for income taxes                                             |  |                                | (660   | ) |                              |   | (189   | )    |  |   | (686    | ) |  |   | (345   | )
|                                                                       |  |                                |        |   |                              |   |        |      |  |   |         |   |  |   |        |  
|                                                                       |  |                                |        |  
|Net loss                                                               |  |                                | (6,136 | ) |                              |   | (3,664 | )    |  |   | (11,081 | ) |  |   | (6,996 | )
|                                                                       |  |                                |        |   |                              |   |        |      |  |   |         |   |  |   |        |  
|                                                                       |  |                                |        |  
|Series D preferred stock accretion and dividends                       |  |                                | 386    |   |                              |   | 202    |      |  |   | 729     |   |  |   | 367    |  
|                                                                       |  |                                |        |   |                              |   |        |      |  |   |         |   |  |   |        |  
|Net loss applicable to common shareholders                             |  | $                              | (6,522 | ) |                              | $ | (3,866 | )    |  | $ | (11,810 | ) |  | $ | (7,363 | )
|                                                                       |  |                                |        |   |                              |   |        |      |  |   |         |   |  |   |        |  
|Net loss applicable to common shareholders per sharebasic and diluted |  | $                              | (0.13  | ) |                              | $ | (0.08  | )    |  | $ | (0.23   | ) |  | $ | (0.16  | )
|Weighted average common shares outstandingbasic and diluted           |  |                                | 52,359 |   |                              |   | 47,017 |      |  |   | 52,285  |   |  |   | 47,017 |  



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



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VERTICAL COMMUNICATIONS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                            |  |                              |         |   |      |   |         |  
|--------------------------------------------------------------------------- |  | ---------------------------- | ------- | - | ---- | - | ------- | -
|                                                                            |  | Six Months EndedDecember 31, |        
|                                                                            |  | 2007                         |         |   | 2006 |  
|Cash flows from operating activities:                                       |  |                              |         |   |      |   |         |  
|Net loss                                                                    |  | $                            | (11,081 | ) |      | $ | (6,996  | )
|Adjustments to reconcile net loss to net cash used by operating activities: |  |                              |         |   |      |   |         |  
|Depreciation and amortization                                               |  |                              | 2,057   |   |      |   | 1,593   |  
|Amortization of deferred Toshiba equity costs                               |  |                              | 10      |   |      |   | 45      |  
|Non-cash interest                                                           |  |                              | 104     |   |      |   | 597     |  
|Non-cash compensation                                                       |  |                              | 3,286   |   |      |   | 2,040   |  
|Deferred tax provision                                                      |  |                              | 686     |   |      |   | 345     |  
|Non-cash changes in accounts receivable allowances                          |  |                              | 19      |   |      |   | (3      | )
|Changes in assets and liabilities, net of acquisitions:                     |  |                              |         |   |      |   |         |  
|Trade accounts receivables                                                  |  |                              | 2,537   |   |      |   | 1,691   |  
|Inventories                                                                 |  |                              | (576    | ) |      |   | 223     |  
|Prepaid expenses                                                            |  |                              | 261     |   |      |   | 2,804   |  
|Deferred costs                                                              |  |                              | 1,994   |   |      |   | 1,188   |  
|Other assets                                                                |  |                              | (26     | ) |      |   | 70      |  
|Accounts payable                                                            |  |                              | 27      |   |      |   | (4,271  | )
|Accrued liabilities                                                         |  |                              | 1,686   |   |      |   | (432    | )
|Deferred revenue                                                            |  |                              | (3,343  | ) |      |   | (2,425  | )
|                                                                            |  |                              |         |   |      |   |         |  
|Net cash used in operating activities                                       |  |                              | (2,359  | ) |      |   | (3,531  | )
|                                                                            |  |                              |         |   |      |   |         |  
|Cash flows from investing activities:                                       |  |                              |         |   |      |   |         |  
|Cash used for acquisitions net of cash acquired                             |  |                              |        |   |      |   | (24,591 | )
|Purchases of property and equipment                                         |  |                              | (1,255  | ) |      |   | (147    | )
|Increase in other restricted cash                                           |  |                              |        |   |      |   | (875    | )
|                                                                            |  |                              |         |   |      |   |         |  
|Net cash used in investing activities                                       |  |                              | (1,255  | ) |      |   | (25,613 | )
|                                                                            |  |                              |         |   |      |   |         |  
|Cash flows from financing activities:                                       |  |                              |         |   |      |   |         |  
|Payments of capital lease obligations                                       |  |                              | (11     | ) |      |   | (11     | )
|Payment of SVB term note                                                    |  |                              |        |   |      |   | (2,000  | )
|Payment of Comdial note                                                     |  |                              |        |   |      |   | (2,575  | )
|Net change in revolver facility                                             |  |                              | (842    | ) |      |   | (6,533  | )
|Proceeds from issuance of Columbia debt, net of issuance costs              |  |                              |        |   |      |   | 24,440  |  
|Proceeds from issuance of Series E preferred stock, net of issuance costs   |  |                              |        |   |      |   | 26,973  |  
|Proceeds from issuance of common stock, net of issuance costs               |  |                              | 56      |   |      |   |        |  
|                                                                            |  |                              |         |   |      |   |         |  
|Net cash (used in) provided by financing activities                         |  |                              | (797    | ) |      |   | 40,294  |  
|                                                                            |  |                              |         |   |      |   |         |  
|                                                                            |  |                             
|Effect of foreign currency exchange rates                                   |  |                              | 12      |   |      |   | 2       |  
|                                                                            |  |                              |         |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                        |  |                              | (4,399  | ) |      |   | 11,152  |  
|Cash and cash equivalents at beginning of period                            |  |                              | 8,019   |   |      |   | 4,726   |  
|                                                                            |  |                              |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                  |  | $                            | 3,620   |   |      | $ | 15,878  |  
|                                                                            |  |                              |         |   |      |   |         |  
|                                                                            |  |                             
|SUPPLEMENTAL CASH FLOW INFORMATION:                                         |  |                              |         |   |      |   |         |  
|Non cash dividend and accretion on series D preferred stock                 |  |                              | 729     |   |      |   | 367     |  
|Cash paid for interest                                                      |  |                              | 392     |   |      |   | 308     |  



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VERTICIAL COMMUNICATIONS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

(1) BASIS OF PRESENTATION

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

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

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America and pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC). The balance sheet amounts at June 30, 2007 in this report were derived from
our audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2007. In the opinion of management, the accompanying financial statements include all adjustments of a normal recurring nature
which are necessary for a fair presentation of the financial results for the interim periods presented. Certain information and footnote disclosures normally included in financial statements have been condensed or omitted pursuant to such rules and
regulations. Although we believe that the disclosures are adequate to make the information presented not misleading, we recommend that these financial statements be read in conjunction with the consolidated financial statements and the notes thereto
included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2007 on file with the SEC. The results of operations for the three and six months ended December 31, 2007 are not necessarily indicative of the results to
be expected for the full year or any other future periods.

The preparation of these financial statements requires us to make estimates and
judgments that affect the reported amount of assets and liabilities at the date of the financial statements and revenues and expenses during the reported period. Areas where significant judgments are made include, but are not limited to, revenue
recognition, as well as the accounting for our acquisition of Vodavi Technology, Inc. as discussed below. Actual results could differ materially from these estimates. The accounting policies applied are consistent with those disclosed in our Annual
Report on Form 10-K as disclosed in Note 2.

Acquisition of Vodavi Technology, Inc.

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

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

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

(2) SIGNIFICANT ACCOUNTING POLICIES

Stock-Based Compensation

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



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Stock Options

The Company currently grants stock options under one plan. Generally, options become exercisable over a four-year period commencing on the date of the grant. Options granted prior to and after September 28, 2004
vest 25% at the first anniversary of the grant date with the remaining 75% vesting in equal monthly increments over the remaining three years of the vesting period. Options granted on September 28, 2004 vest 2.08% monthly. In computing stock
based compensation, we apply an estimated forfeiture rate based on actual forfeitures in our recent history. The fair value of options granted was calculated using the Black-Scholes option-pricing model with the following weighted average
assumptions:



|                        |  |                               |   |  |           |  
|----------------------- |  | ----------------------------- | - |  | --------- | -
|                        |  | Six Months Ended December 31, |  
|                        |  | 2007                          |   |  | 2006      |  
|Expected dividend yield |  | 0                             | % |  | 0         | %
|                        |  |                              
|Volatility factor       |  | 117-120                       | % |  | 113-115   | %
|                        |  |                              
|Risk free interest rate |  | 3.92-4.41                     | % |  | 3.45-4.03 | %
|                        |  |                              
|Expected life           |  | 6 Years                       |   |  | 6 Years   |  

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

The following summarizes stock option activity for the three month period ended December 31, 2007:



|                                  |  |            |   |  |                                |      |                                                   |    
|--------------------------------- |  | ---------- | - |  | ------------------------------ | ---- | ------------------------------------------------- | ---
|Stock Options                     |  | Shares     |   |  | Weighted AverageExercise Price |      | Weighted AverageRemaining Contractual Term(years)
|Outstanding at September 30, 2007 |  | 19,019,997 |   |  | $                              | 1.01 |                                                   |    
|Granted                           |  | 50,000     |   |  | $                              | 1.15 |                                                   |    
|Exercised                         |  | (14,388    | ) |  | $                              | 0.83 |                                                   |    
|Cancelled                         |  |           |   |  |                                |     |                                                   |    
|Forfeited                         |  | (535,396   | ) |  | $                              | 1.12 |                                                   |    
|                                  |  |            |   |  |                                |      |                                                   |    
|Outstanding at December 31, 2007  |  | 18,520,213 |   |  | $                              | 1.02 |                                                   | 8.3
|Exercisable at December 31, 2007  |  | 4,951,394  |   |  | $                              | 1.37 |                                                   | 7.5

The following summarizes stock option activity for the six month period ended December 31,
2007:



|                                 |  |            |   |  |                                |      |                                                   |    
|-------------------------------- |  | ---------- | - |  | ------------------------------ | ---- | ------------------------------------------------- | ---
|Stock Options                    |  | Shares     |   |  | Weighted AverageExercise Price |      | Weighted AverageRemaining Contractual Term(years)
|Outstanding at June 30, 2007     |  | 19,415,983 |   |  | $                              | 1.90 |                                                   |    
|Granted                          |  | 602,000    |   |  | $                              | 1.25 |                                                   |    
|Exercised                        |  | (75,218    | ) |  | $                              | 0.78 |                                                   |    
|Cancelled                        |  |           |   |  |                                |     |                                                   |    
|Forfeited                        |  | (1,422,552 | ) |  | $                              | 0.99 |                                                   |    
|                                 |  |            |   |  |                                |      |                                                   |    
|Outstanding at December 31, 2007 |  | 18,520,213 |   |  | $                              | 1.02 |                                                   | 8.3
|Exercisable at December 31, 2007 |  | 4,951,394  |   |  | $                              | 1.37 |                                                   | 7.5

Restricted Stock

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

The Company will recognize compensation expense on these awards ratably over the vesting period. The fair value of the awards
was determined based on the market value of the underlying stock price at the grant date. The Company estimated a forfeiture rate of 20% based on projections related to whether the performance measures are likely to be achieved and the probability
of all



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awards vesting. The amount of compensation expense ultimately recognized will depend on whether the performance measures are met and all of the restricted
stock awards vest. The Company will assess its projections at each reporting period and, as a result, the amount of expense recorded from period to period may change.

Total stock-based compensation for both options and restricted stock awards increased loss from operations and net loss for the three and six months ended December 31, 2007 by $1.7 million ($0.03 per basic and
diluted share) and $3.3 million ($0.06 per basic and diluted share), respectively. As of December 31, 2007, $14.7 million of unvested stock-based compensation has not yet been recognized by the Company. The unvested stock-based compensation
balance is expected to be expensed over a weighted average period of 3.1 years.

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



|                           |  |                               |       |                             |   |       |  |      |       |  |   |      
|-------------------------- |  | ----------------------------- | ----- | --------------------------- | - | ----- |  | ---- | ----- |  | - | -----
|                           |  | Three MonthsEndedDecember 31, |       | Six MonthsEndedDecember 31,
|                           |  | 2007                          |       | 2006                        |   | 2007  |  | 2006
|Sales and marketing        |  | $                             | 638   |                             | $ | 345   |  | $    | 1,276 |  | $ | 694  
|Product development        |  | $                             | 532   |                             | $ | 287   |  | $    | 1,014 |  | $ | 583  
|General and administrative |  | $                             | 491   |                             | $ | 368   |  | $    | 996   |  | $ | 763  
|                           |  |                               |       |                             |   |       |  |      |       |  |   |      
|Total                      |  | $                             | 1,661 |                             | $ | 1,000 |  | $    | 3,286 |  | $ | 2,040

Goodwill

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

Income Taxes

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

Related Party Transactions

LG-Nortel Co. Ltd.
(LGN) owns approximately 24% of the Companys outstanding Series E Convertible Preferred Stock, par value $1.00 per share (the Series E Preferred Stock) at December 31, 2007 and has a designated member on
the Companys board of directors. The Company purchased approximately $3.6 million and $6.0 million, respectively, of key telephone systems, commercial grade telephones, and voice mail products from LGN and an affiliate of LGN during the
three and six months ended December 31, 2007. The Company owed LGN and its affiliate a total of $3.6 million for product purchases at December 31, 2007. The Companys payment terms with LGN and its affiliate are 90 days after
shipment, except for shipments of single line telephones, which are 30 days after shipment. Current balances are non-interest bearing.

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



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(3) ACQUISITIONS

Vertical Networks, Inc.

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

The purchase price for Vertical Networks consisted of: $12.5 million in cash, paid at closing, with an
additional $1.0 million held in escrow to secure Vertical Networks indemnification obligations to us, $1.0 million in transaction costs, the assumption of most liabilities of Vertical Networks and an earnout provision of up to $4.3 million.
The earnout obligation is equal to the first $4.3 million of non-refundable software license revenues collected by us from CVS Pharmacy, Inc. (CVS) in connection with a specific contract. We have paid $2.0 million of the earn-out
provision and accrued an additional $0.3 million of the earn-out provision through December 31, 2007.

Comdial Corporation

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

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

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

Vodavi Technology, Inc.

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

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

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

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



|                         |  |                                |     
|------------------------ |  | ------------------------------ | ----
|                         |  | EstimatedFair Values(millions)
|Cash                     |  | $                              | 6.9 
|Accounts Receivable, net |  |                                | 2.8 
|Inventory, net           |  |                                | 6.6 
|Other Current Assets     |  |                                | 2.3 
|Property and Equipment   |  |                                | 1.1 
|Intangible Assets        |  |                                | 12.0
|Goodwill                 |  |                                | 9.4 
|                         |  |                                |     



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|                          |  |   |      |  
|------------------------- |  | - | ---- | -
|Total assets acquired     |  |   | 41.1 |  
|                          | 
|Accounts Payable          |  |   | (6.5 | )
|Accrued Expenses          |  |   | (3.1 | )
|                          |  |   |      |  
|Total liabilities assumed |  |   | (9.6 | )
|                          |  |   |      |  
|                          | 
|Total purchase price      |  | $ | 31.5 |  
|                          |  |   |      |  

The estimated values of current assets, excluding inventory, and liabilities were based upon their
historical costs on the date of acquisition due to their short-term nature. Inventory was valued at estimated selling prices less the sum of (i) the cost of disposal and (ii) a reasonable profit allowance for the selling effort. Property
and equipment was also estimated based upon its historical cost as there was no appreciated real estate and the historical costs of the office equipment, furniture and machinery most closely approximated fair value. The identified intangible assets
were valued at their fair value as of the acquisition date. Initially, a deferred income tax liability was established in the amount of $4.5 million to account for timing differences associated with amortizing the identified intangible assets for
book purposes but not for income tax purposes. Upon completion of the Companys analysis of its ownership changes and the impact on the availability of the Companys deferred tax assets, we determined the deferred tax liability was not
required. The residual purchase price was recorded as goodwill.

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



|                               |  |                |        |            |  
|------------------------------ |  | -------------- | ------ | ---------- | -
|                               |  | AMOUNT         |        | LIFE      
|                               |  | (IN THOUSANDS) |        | (IN YEARS)
|Trade names/Trademarks         |  | $              | 690    |            | 4
|                               |  |               
|Customer relationships         |  |                | 10,440 |            | 9
|                               |  |               
|Customer relationships - other |  |                | 600    |            | 8
|                               |  |               
|Existing technology            |  |                | 220    |            | 4
|                               |  |                |        |            |  
|                               |  | $              | 11,950 |            |  

The amounts assigned to identifiable intangible assets acquired was based on their respective fair
values determined as of the acquisition date using a discounted cash flow analysis and relief from royalty methodology. The excess of the purchase price over the tangible and identifiable intangible assets was recorded as goodwill and amounted to
approximately $14.0 million. In accordance with current accounting standards, the goodwill is not being amortized and will be tested for impairment annually in the first quarter of our fiscal year, as required by SFAS No. 142 or more often if
impairment indicators arise.

The following unaudited pro forma condensed financial information gives effect to our acquisition of Vodavi
as if it had occurred on July 1, 2006. The results of Vodavi for the comparable periods in 2007 are included in the Companys consolidated results. The unaudited pro forma condensed financial information is presented for illustrative
purposes only and is not necessarily indicative of the consolidated financial position or consolidated results of operations of the Company that would have been reported had the merger occurred on the date indicated, nor does it represent a forecast
of the consolidated results of the operations of the Company for any future period. Furthermore, no effect has been given in the unaudited pro forma combined statements of income for operating benefits that may be realized through the combination of
the entities.



|                                                    |  |                                                 |   |  |        |   |  |                       |   |  |                       |  
|--------------------------------------------------- |  | ----------------------------------------------- | - |  | ------ | - |  | --------------------- | - |  | --------------------- | -
|                                                    |  | Three Months Ended December 31, 2006(unaudited) |  
|                                                    |  | Vertical                                        |   |  | Vodavi |   |  | Pro Forma Adjustments |   |  | Pro Forma as Adjusted |  
|Net product revenue                                 |  | 18,080                                          |   |  | 2,937  |   |  |                       |   |  | 21,017                |  
|Net (loss)/income                                   |  | (3,664                                          | ) |  | (2,802 | ) |  | (2,084                | ) |  | (8,550                | )
|                                                    |  |                                                 |   | 
|(Loss)/income applicable to common shareholders     |  | (3,866                                          | ) |  | (2,802 | ) |  | (2,084                | ) |  | (8,752                | )
|Loss applicable to common stock  Basic and Diluted |  | (0.08                                           | ) |  |        |   |  |                       |   |  | (0.19                 | )



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|                                                    |  |                                               |   |  |        |   |  |                       |   |  |                       |  
|--------------------------------------------------- |  | --------------------------------------------- | - |  | ------ | - |  | --------------------- | - |  | --------------------- | -
|                                                    |  | Six Months Ended December 31, 2006(unaudited) |  
|                                                    |  | Vertical                                      |   |  | Vodavi |   |  | Pro Forma Adjustments |   |  | Pro Forma as Adjusted |  
|Net product revenue                                 |  | 33,950                                        |   |  | 13,066 |   |  |                       |   |  | 47,016                |  
|Net (loss)/income                                   |  | (6,996                                        | ) |  | (2,601 | ) |  | (4,167                | ) |  | (13,764               | )
|                                                    |  |                                               |   | 
|(Loss)/income applicable to common shareholders     |  | (7,363                                        | ) |  | (2,601 | ) |  | (4,167                | ) |  | (14,131               | )
|Loss applicable to common stock  Basic and Diluted |  | (0.16                                         | ) |  |        |   |  |                       |   |  | (0.30                 | )

The pro forma adjustments include the amortization expense for the acquired identifiable
intangible assets of approximately $0.4 million per quarter and the interest expense for the amounts borrowed to finance the acquisition of approximately $1.7 million per quarter.

(4) INVENTORIES

Inventories, net, at December 31, 2007 and June 30, 2007 are $13.4
million and $12.8 million, respectively, consisting of the following (in thousands):



|               |  |                  |        |              |   |       
|-------------- |  | ---------------- | ------ | ------------ | - | ------
|               |  | December 31,2007 |        | June 30,2007
|Raw Materials  |  | $                | 689    |              | $ | 465   
|Finished Goods |  | $                | 12,705 |              | $ | 12,353
|               |  |                  |        |              |   |       
|               |  | $                | 13,394 |              | $ | 12,818
|               |  |                  |        |              |   |       

(5) INTANGIBLE ASSETS

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



|                                                   |  |                  |        |   |              |   |        |              |  |   
|-------------------------------------------------- |  | ---------------- | ------ | - | ------------ | - | ------ | ------------ |  | --
|                                                   |  | December 31,2007 |        |   | June 30,2007 |   |        | Life inYears
|Acquired technology-Vertical Networks              |  | $                | 800    |   |              | $ | 800    |              |  | 5 
|Acquired customers relationships-Vertical Networks |  |                  | 3,500  |   |              |   | 3,500  |              |  | 5 
|Trade names/trademarks-Comdial                     |  |                  | 200    |   |              |   | 200    |              |  | 1 
|Acquired customer relationships-Comdial            |  |                  | 3,300  |   |              |   | 3,300  |              |  | 10
|Acquired technology- Comdial                       |  |                  | 800    |   |              |   | 800    |              |  | 5 
|Trade names-Vodavi                                 |  |                  | 690    |   |              |   | 690    |              |  | 4 
|Customer relationships-Vodavi                      |  |                  | 10,440 |   |              |   | 10,440 |              |  | 9 
|Customer relationships, other-Vodavi               |  |                  | 600    |   |              |   | 600    |              |  | 8 
|Existing technology-Vodavi                         |  |                  | 220    |   |              |   | 220    |              |  | 4 
|                                                   |  |                  |        |   |              |   |        |              |  |   
|                                                   |  |                  | 20,550 |   |              |   | 20,550 |              |  |   
|Accumulated amortization                           |  |                  | (5,692 | ) |              |   | (4,285 | )            |  |   
|                                                   |  |                  |        |   |              |   |        |              |  |   
|                                                   |  | $                | 14,858 |   |              | $ | 16,265 |              |  |   
|                                                   |  |                  |        |   |              |   |        |              |  |   

Amortization expense for the three and six months ending December 31, 2007 was $0.7 million
and $1.4 million respectively, of which $94,000 and $188,000, respectively, was included in cost of sales. For the three and six months ending December 31, 2006, amortization expense was $0.5 million and $0.8 million respectively, of which
$94,000 and $175,000, respectively, was included in cost of sales.



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(6) DEBT

Debt
Related to Comdial Acquisition

We financed a portion of the purchase price for the Comdial Assets (the 2005 Debt
Financing) by entering into a loan agreement with Silicon Valley Bank (SVB) on September 28, 2005 (the SVB Loan Agreement). The SVB Loan Agreement terms provided the Company with a revolving line of credit in an
amount not to exceed $7,000,000 (the Revolving Loan), as well as a $2,000,000 term loan (the Term Loan). The Revolving Loan initially matured on September 27, 2006. On September 27, 2006, the Company entered into a
Third Loan Modification Agreement with SVB under which the maturity date of the Revolving Loan was extended from September 27, 2006 to October 31, 2006. The Term Loan was payable in monthly principal installments of $133,333 plus interest,
due beginning July 31, 2006 through and until the maturity date of September 26, 2007.

On September 28, 2005, the Company
also executed a secured promissory note in the aggregate principal amount of $2,500,000 (the Comdial Note). The Comdial Note was issued to the Comdial bankruptcy estate (the Comdial Estate) in connection with the acquisition
of the Comdial Assets. The Comdial Note was subject to interest at the rate of 8% per annum and initially matured on the first anniversary of the closing date. On September 28, 2006, the Company and the Comdial Estate entered into an
agreement which extended the maturity date of the Comdial Note from September 28, 2006 to November 1, 2006.

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

Debt Related to Vodavi Acquisition

On October 18, 2006, the Company entered into a Credit Agreement, a Security Agreement, a Pledge Agreement and an Intellectual Property Security Agreement by and among the Company, Investment Manager, and
the Lender. Pursuant to the Credit Agreement, the Company agreed to (a) issue a senior secured promissory note payable to Lender (the Initial Bridge Note) in the amount of $10.0 million, (b) provided certain conditions were
met, issue a senior secured promissory note payable to Lender (the Subsequent Bridge Note) in the principal amount of $5.0 million; (c) issue a senior secured promissory note payable to Lender (the Term Note and,
together with the Initial Bridge Note, the Loans) in the principal amount of $15.0 million; and (d) upon the issuance of the Initial Bridge Note, issue to Lender (i) a warrant to purchase 4,500,000 shares of the Companys
common stock at an exercise price equal to $0.01 per share (the Lender Warrant) and (ii) an additional warrant for the purchase of 500,000 shares of the Companys common stock at an exercise price equal to $0.01 per share. The
Subsequent Bridge Note was not issued and the additional warrant for the purchase of 500,000 shares of the Companys common stock became null and void when the Company reached a specified commitment level in the sale of its Series E
Preferred Stock (see Note 8).

The Loans are secured by substantially all of the assets of the Company including specifically
all rights in the outstanding shares of capital stock of VCAC held by the Company and certain intellectual property owned by the Company. Events of default under the Credit Agreement include failure by the Company to meet its obligations under the
Credit Agreement and any other outstanding indebtedness; breach of certain of its obligations and covenants under the Credit Agreement; breach of any representations and warranties made in any documents relating to the Loans; the Companys
insolvency and/or bankruptcy; the Companys incurrence of a final money judgment against its assets in excess of $250,000 per individual case or $1.0 million in the aggregate; the Companys receipt of an order requiring dissolution or
split up; and the Companys or any creditor of the Companys failure to comply with any subordination provisions in any document which benefit the Lender or Investment Manager. Should an Event of Default occur, remedies available to the
Lender include acceleration requiring immediate payment of all or any portion of the obligations under the Credit Agreement and, with prior written consent of the Investment Manager, the right to set off any of the Companys property held by
the Lender against the obligations.

The Credit Agreement initially contained certain financial covenants under which the Company must
(a) maintain cash, cash equivalents or available borrowing capacity of at least $5.0 million for each fiscal quarter beginning with the quarter ending March 31, 2007; (b) beginning with the trailing twelve month period ended
September 30, 2007 and for each quarter thereafter, maintain a minimum EBITDA of $1.00; (c) beginning with the trailing twelve month period ended September 30, 2007, maintain minimum total consolidated revenues of $80.0 million and
(d) for the six month period ended March 31, 2007, maintain minimum total consolidated revenues of $30.0 million and minimum EBITDA of ($2.0) million. On October 15, 2007, the Company entered into an amendment to the Credit Agreement
effective as of September 30, 2007, which modified certain of the financial covenants. The minimum cash or borrowing availability requirement was reduced to a range of $3.6 million to $5.0 million for defined periods in fiscal 2008. In
addition, the minimum EBITDA requirement for the quarter ended September 30, 2007 was eliminated and for the subsequent quarters in fiscal 2008 was reset to ($0.9) million, ($0.6) million and $1.1 million, respectively. Beginning with the
trailing three month period ended September 30, 2008, and for each quarter thereafter, the Company must maintain a minimum EBITDA of $1.00. In addition, the minimum revenue covenant for the quarter ended September 30, 2007 was eliminated
and for the subsequent quarters in fiscal 2008 was reset to $20.5 million, $20.4 million and $22.7 million, respectively.

At
December 31, 2007, the Company was not in compliance with the amended financial covenants related to minimum revenue and EBITDA. As a result of the default, Lender, at its election, may, among other remedies, require that the full amount of the
principal and accrued interest be paid immediately. Accordingly, the Company reclassified the total principal and interest due of $16.9 million to current portion of long term debt in the condensed consolidated balance sheet as of December 31,
2007. The



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##### Table of Contents

Company is currently negotiating with Investment Manager and Lender to obtain a waiver, forbearance or amendment to the Credit Agreement. See Note 12 for
additional information.

The Initial Bridge Note was issued on October 18, 2006 in the amount of $10.0 million and bore interest at
the rate of 14% per annum. Interest was paid quarterly in arrears. The principal amount and all unpaid interest were paid in full prior to the maturity date of July 1, 2007. The net proceeds from the Initial Bridge Note, after payment of
costs of approximately $0.2 million, were utilized to retire all previously outstanding debt with the remainder to supplement working capital. The Lender Warrant is exercisable by the holder at any time until its expiration on October 18, 2013
either by paying the exercise price of $.01 per share or on a cashless exchange basis. This net exercise right is generally limited to times when the Company is not in compliance with its obligations relating to the registration of the shares of
common stock underlying the warrants for resale under the Companys registration rights agreement with respect to those shares. The number of shares issuable upon exercise and the per share exercise price of the warrant is subject to adjustment
in the case of any stock dividend, stock split, combination, capital reorganization, reclassification or merger or consolidation.

The
Company allocated the proceeds between the debt and the warrant based upon their relative fair values as of the issuance date, resulting in $2.1 million being allocated to the warrants. The fair value of the warrants was determined using the
Black-Scholes option pricing model with the following assumptions: no dividend yield; weighted average risk free rate of 4.42%; volatility of 115% and a contractual life of 7 years. The proceeds attributable to the warrant were recorded as a
discount on the debt which will be accreted, with the deferred issuance costs and cash interest, over the term of the Initial Bridge Note using the effective interest method. On May 25, 2007, the Company entered into a Loan and Security
Agreement with SVB (see below). At that time, the Company satisfied all amounts owed under the Initial Bridge Note and this note was extinguished.

The Term Note was issued on December 1, 2006 in the amount of $15.0 million. A portion of the interest equal to .05% of the outstanding principal amount is payable quarterly in arrears. The Company is also obligated to pay the Lender a
premium equal to the amount required to provide the Lender with a rate of return of 13.5% per annum upon any payment or prepayment of any amount of the Term Note. This premium is subject to increase to 15.5% for any period in which an Event of
Default occurs and continues. The principal amount of the Term Note and any unpaid interest, including the payment premium, is payable in full on October 17, 2009. Cash interest, the premium and deferred issuance costs of $0.3 million will be
accreted over the life of term note using the effective interest method.

Silicon Valley Bank

On May 25, 2007, the Company entered into a Loan and Security Agreement (the Loan Agreement) with SVB providing for a line of credit of
up to $10,000,000 (the Line of Credit). The Loan Agreement terms provide the Company with a revolving line of credit in an amount not to exceed $10,000,000. The Line of Credit matures and the principal balance thereof is payable in full,
on May 24, 2009. Borrowing availability under the Line of Credit is based on the existence of stipulated percentages of the Companys eligible accounts receivable and inventory and is also subject to an additional $2,000,000 collateral
reserve requirement established by SVB. Amounts borrowed under the Line of Credit bear interest at a per annum rate equal to the Prime Rate in effect from time to time, plus 2% per year (10.25% at June 30, 2007). The Prime Rate
is the rate announced from time to time by SVB as its prime rate. The Company may also be obligated to pay a minimum monthly interest amount if the interest payable on the outstanding borrowed amounts is less than interest that would
have been payable calculated based upon fifteen percent (15%) of the maximum credit limit having been advanced and outstanding with respect to each month.

The Companys obligations under the Loan Agreement are secured by all of the Companys inventory, equipment, payment intangibles, letter-of-credit rights, supporting obligations, accounts, and general
intangibles, including, without limitation, all of the Companys intellectual property, deposit accounts, and all money, and all property now or at anytime in the future in SVBs possession, and all proceeds, all products and all books and
records related to such collateral. Events of default under the Loan Agreement include, among others, failure by the company to timely pay any principal or interest on any outstanding loan under the Line of Credit within five days of when due;
failure to maintain the total loans and other outstanding obligations at or below the credit limit; failure to comply with any of the financial covenants; allowing any levy, assessment, attachment, lien or encumbrance to be made on all or any part
of the collateral and dissolution, insolvency or business failure of the Company.

The Loan Agreement initially contained certain financial
covenants under which the Company must (a) maintain cash, cash equivalents or available borrowing capacity of at least $5.0 million for each fiscal quarter beginning with the quarter ending March 31, 2007; (b) beginning with the
trailing twelve month period ended September 30, 2007 and for each quarter thereafter, maintain a minimum EBITDA of $1.00; (c) beginning with the trailing twelve month period ended September 30, 2007, maintain minimum total
consolidated revenues of $80.0 million and (d) for the six month period ended March 31, 2007, maintain minimum total consolidated revenues of $30.0 million and minimum EBITDA of ($2.0) million. On October 15, 2007, the Company entered
into an amendment to the Loan Agreement effective as of September 30, 2007, which modified certain of the financial covenants. The minimum cash or borrowing availability requirement was reduced to a range of $3.6 million to $4.4 million for
defined periods in fiscal 2008. In addition, the minimum EBITDA requirement for the quarter ended September 30, 2007 was eliminated and for the subsequent quarters in fiscal 2008 was reset to ($0.9) million, ($0.6) million and $1.1 million,
respectively. Beginning with the trailing three



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month period ended September 30, 2008, and for each quarter thereafter, the Company must maintain a minimum EBITDA of $1.00. In addition, the minimum
revenue covenant for the quarter ended September 30, 2007 was eliminated and for the subsequent quarters in fiscal 2008 was reset to $20.5 million, $20.4 million and $22.7 million, respectively.

At December 31, 2007, the Company was not in compliance with the amended financial covenants related to minimum revenue and EBITDA. As a result of
the default, SVB, at its election, may, among other remedies, cease making loans and require that the full amount of the principal and accrued interest be paid immediately. The Company is currently negotiating with SVB to obtain a waiver,
forbearance or amendment to the Credit Agreement. See Note 12 for additional information.

In connection with the Line of Credit, NEIPF,
Columbia and SVB entered into a Subordination and Intercreditor Agreement (the Intercreditor Agreement), which was acknowledged by the Company. Under the Intercreditor Agreement, the parties agreed that SVB has a senior priority security
interest on all of the Companys accounts receivable and inventory, and any proceeds from the accounts receivable and inventory. The parties further agreed that SVB has a junior priority security interest on all other personal property
collateral of the Company. The parties agreed that Columbia and NEIPF maintains its senior priority security interest on all other personal property collateral of the Company and a junior priority security interest on accounts receivable, inventory
and the proceeds from accounts receivable and inventory.

(7) INCOME TAXES

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

(8) CONVERTIBLE REDEEMABLE PREFERRED STOCK

Series D
Preferred Stock

On February 9, 2006, the Company completed the sale (the Series D Financing) of 5,000 shares
of its Series D Convertible Preferred Stock, par value $1.00 per share (the Series D Preferred Stock) and warrants to purchase an aggregate of 1,041,667 shares (the Series D Warrants) of the Companys
common stock pursuant to a Securities Purchase Agreement (the 2006 Securities Purchase Agreement) between the Company and certain investors (the Series D Investors). The aggregate proceeds to the Company from the
Series D Financing was $5.0 million.

Obligation to Register Shares

Pursuant to the 2006 Securities Purchase Agreement, we agreed to register the shares of common stock issuable upon conversion of the Series D
Preferred Stock and upon exercise of the Series D Warrants (collectively, the Issued Shares) for resale by the Series D Investors under the Securities Act. The Company also agreed to file with the SEC a registration statement
with respect to the Issued Shares no later than March 27, 2006 (the Filing Date), and to use our best efforts to cause the registration statement to become effective within defined time periods as specified in the agreement.

The Company is currently liable for liquidated damages to each Series D Investor because the registration statement was not filed on
or before the Filing Date. The Company must pay as liquidated damages to the Series D Investors, for each 30-day period of a default, an amount in cash equal to 1% of the aggregate purchase price paid by the Series D Investor pursuant to
the 2006 Securities Purchase Agreement; provided that in no event will the aggregate amount of cash to be paid as liquidated damages exceed 9% of the aggregate purchase price paid by such Series D Investor. Through December 31, 2007, the
Company has accrued a total of $450,000 in liquidated damages and paid $135,000 in damages.

Material Terms

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

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

Anti-dilution Adjustments. In the event the Company issues additional shares of common stock (which includes certain options and convertible securities issued by the Company), except in limited circumstances, for no consideration or
for consideration



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per share that is less than the conversion price of the Series D Preferred Stock then in effect, the conversion price of the Series D Preferred
Stock will be reduced in accordance with the formula set forth in the Certificate of Designations.

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

Series D Warrants

In addition to the shares of Series D Preferred Stock, the Company
issued warrants to purchase an aggregate of up to 1,041,667 shares of common stock at a per share exercise price of $0.01. The Series D Warrants have a term of exercise expiring on February 9, 2016. The number of shares issuable upon
exercise and the per share exercise price of the Series D Warrants is subject to adjustment in the case of any stock dividend, stock split, combination, capital reorganization, reclassification or merger or consolidation. Subject to limited
exceptions, the number of shares of common stock for which the warrant is exercisable is also subject to adjustment in the case of an issuance of shares of common stock or securities exercisable for or convertible into common stock, at a per share
price less than the per share conversion price of the Series D Preferred Stock then in effect. The Series D Warrants are exercisable at any time prior to their expiration date.

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

The Company evaluated whether the embedded conversion feature in the stock required
bifurcation and determined that the economic characteristics and risks of the embedded conversion feature in the stock were clearly and closely related to the stock and concluded that bifurcation was not required under SFAS 133. We calculated the
intrinsic value of the beneficial conversion feature embedded in the stock pursuant to the guidance in EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments. The beneficial conversion of $659,000 was recognized as
an additional discount on the stock. The total discount on the stock resulting from the allocation of proceeds to the warrants and recording of the beneficial conversion feature will be accreted over the period through the earliest possible
redemption date.

As a result of the issuance of the Lender Warrant and the Series E Preferred Stock (see below), the anti-dilution
adjustments in the Series D Preferred Stock and the Series D Warrants were triggered. Accordingly, on December 1, 2006, the Company issued 539,787 additional Series D Warrants to the Series D Investors which increased the
portion of the proceeds allocable to the warrants to $1.3 million. In addition, the conversion price was adjusted to $0.79 which resulted in an increase in the value of the beneficial conversion feature to $2.8 million which was recorded as an
additional discount on the stock. The additional discounts recognized as a result of these adjustments will be accreted over the period through the earliest redemption date.

We will reevaluate the classification of the stock and warrants in each period to determine if reclassification is necessary. In August 2007, certain of
the holders of the Series D Preferred Stock elected to convert a portion of their preferred shares into shares of the Companys common stock. Our obligation to the Series D Preferred Stockholders, should they choose to redeem the
stock at or after the redemption date is $4.9 million plus accrued but unpaid dividends of $666,000.

Series E Preferred Stock

On December 1, 2006, the Company completed the sale (the Series E Financing) of 27,400 shares of its
Series E Preferred Stock and warrants to purchase an aggregate of 25,849,059 shares (the Series E Warrants) of the Companys common stock pursuant to the Amended and Restated Securities Purchase Agreement between the Company
and certain investors (the Series E Investors) (the Series E Securities Purchase Agreement). The aggregate proceeds to the Company from the Series E Financing was $27.4 million.



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Obligation to Register Shares

Pursuant to the Amended and Restated Securities Purchase Agreement, we agreed to register the shares of common stock issuable upon conversion of the Series E Preferred Stock and upon exercise of the Series E
Warrants (collectively, the Issued Shares) for resale by the Series E Investors under the Securities Act. The Company also agreed to file with the SEC a registration statement with respect to the Issued Shares no later than 210 days
after the effective time of the Merger, and to use our best efforts to cause the registration statement to become effective as promptly as reasonably practicable after (1) being informed by the SEC that the SEC has decided not to review the
registration statement or (2) being informed by the SEC that the SEC has no further comments on such Registration Statement.

Material Terms

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

Dividends. From the date of issuance, the Series E Preferred Stock accrues dividends at a rate of $100.00 per year and compounds annually.
Dividends on the Series E Preferred Stock may be declared and paid from time to time as determined by the Companys board of directors. The Company cannot declare, pay or set aside any dividends or distributions on any other shares of
capital stock of the Company unless the holders of Series E Preferred Stock first receive or simultaneously receive a dividend or distribution on each outstanding share of Series E Preferred Stock in such amounts as set forth in the
Certificate of Powers, Designation, Preferences and Rights of the Series E Preferred Stock (the Certificate of Designations).

Anti-dilution Adjustments. In the event the Company issues additional shares of common stock (which includes certain options and convertible securities issued by the Company), except in limited circumstances, for no consideration or
for consideration per share that is less than the conversion price of the Series E Preferred Stock then in effect, the conversion price of the Series E Preferred Stock will be reduced to equal the per share price of the newly issued
securities.

Redemption. Starting three years from the date the Series E Certificate of Designations was filed, the
Series E Preferred Stock may be redeemed in three equal annual installments commencing 30 days after any single holder of at least thirty percent (30%) of the issued and outstanding shares of Series E Preferred Stock consents to such
redemption. The Series E Preferred Stock may be redeemed at a price equal to the Original Issue Price, plus all declared but unpaid dividends. If the Company fails to redeem the Series E Preferred Stock in accordance with the Certificate
of Designations, then interest will accrue on any unpaid amount at a rate of 1% per each 30-day period that such amounts remain unpaid.

Series E Warrants

In addition to the shares of Series E Preferred Stock, the Company issued warrants to purchase
an aggregate of up to 25,849,059 shares of common stock at a per share exercise price of $0.58. The Series E Warrants have a term of exercise expiring on December 1, 2016. The number of shares issuable upon exercise and the per share
exercise price of the Series E Warrants is subject to adjustment in the case of any stock dividend, stock split, combination, capital reorganization, reclassification or merger or consolidation. Subject to limited exceptions, the number of
shares of common stock for which the warrant is exercisable is also subject to adjustment in the case of an issuance of shares of common stock or securities exercisable for or convertible into common stock, at a per share price less than the per
share conversion price of the Series E Preferred Stock then in effect. The Series E Warrants are exercisable at any time prior to their expiration date by delivering the warrant certificates to the Company.

The Company allocated the proceeds between the stock and the warrants based upon their relative fair values as of the closing date, resulting in
$11.8 million being allocated to the warrants. We determined the fair value of the warrants using the Black-Scholes option pricing model with the following assumptions: no dividend yield; weighted average risk free rate of 4.43%; volatility of 111%
and a contractual life of 10 years. The Company determined that the warrants meet the definition of a derivative instrument as defined in SFAS 133, Accounting for Derivative Instruments and Hedging Activities, but do not require
derivative treatment pursuant to the scope exception in paragraph 11(a) of SFAS 133. We recorded the proceeds attributable to the warrants in permanent equity pursuant to guidance in EITF 00-19,Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Companys Own Stock.

The Company evaluated whether the embedded conversion
feature in the stock required bifurcation and determined that the economic characteristics and risks of the embedded conversion feature in the stock were clearly and closely related to the stock and concluded that bifurcation was not required under
SFAS 133. We calculated the intrinsic value of the beneficial conversion feature embedded in the stock pursuant to the guidance in EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments. The beneficial conversion
value, as calculated, exceeds the amount of the proceeds allocated to the stock, thus is capped at $15.6 million allocated to the Series E Preferred Stock, which is recognized as an additional discount on the stock. The Company determined that
the portion of the proceeds attributable to the stock should be recorded as mezzanine equity pursuant to EITF Topic D-98, Classification and Measurement of Redeemable Securitiesafter determining the guidance in FAS 150, Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and Equitydid not apply. However, since the total discount on the stock resulting from the allocation of proceeds to the warrants and recording of the beneficial
conversion feature equals the face value of the Series E Preferred Stock, no initial value has been recognized in mezzanine equity for the Series E preferred stock. The total discount



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on the stock resulting from the allocation of proceeds to the warrants and recording of the beneficial conversion feature and the cash dividends will be
accreted over the period through the earliest possible redemption date using the effective interest method. Accretion of the discount and dividends for the fiscal years ended June 30, 2008, 2009 and 2010 will be approximately $7,000, $2.1
million and $33.5 million, respectively.

We will reevaluate the classification of the stock and warrants in each period to determine if
reclassification is necessary. Our obligation to the Series E Preferred Stockholders, should they choose to redeem the stock at or after the redemption date is $27.4 million plus accrued but unpaid dividends of $3.0 million.

A material relationship exists between certain of the Series E investors and the Company. Specifically, each of M/C Venture Partners V, L.P.
and its affiliates (collectively, M/C Venture Partners), Special Situations Fund III, L.P. and its affiliates, Pathfinder Ventures IV, L.L.C. and its affiliates and William Y. Tauscher, the Companys Chief Executive
Officer, President and Chairman of the Board, own shares of the Companys common stock. LG-Nortel Co., Ltd. is the primary supplier of the products sold in the Vodavi business. Additionally, Peter Bailey, through West Laurelhurst LLC, and Scott
Pickett are Series E Investors and executive officers of the Company. Mr. Bailey is a Senior Vice President of the Company and Mr. Pickett is the Companys Chief Technology Officer.

(9) SHAREHOLDERS EQUITY

On September 28,
2004 and October 1, 2004, we sold a total of 24,159,468 shares of our common stock at a per share purchase price of $1.1386 to several investors including M/C Venture Partners, under the terms of the 2004 Stock Purchase Agreement and on
September 28, 2005, we sold a total of 11,329,785 shares of common stock at a per share purchase price of $1.1386, under the terms of the 2005 Stock Purchase Agreement. As a result of these and previous financings, we entered into arrangements
with certain parties to register shares of our common stock.

The Company is currently liable for liquidated damages to the 2005 investors
and the 2004 investors because the registration statement has not been declared effective. As a result, the Company must pay as liquidated damages to the 2005 investors and the 2004 investors, for each 30-day period of a default, an amount in cash
equal to 1% of the aggregate purchase price paid by the Investors; provided that in no event will the aggregate amount of cash to be paid as liquidated damages exceed 9% of the aggregate purchase price paid by each Investor. As of December 31,
2007, the Company has accrued the full 9% ($2.2 million) in liquidated damages.

(10) COMPUTATION OF NET LOSS PER SHARE

Net loss per basic and diluted share are based upon the weighted average number of common shares outstanding. Common equivalent shares, consisting of
outstanding stock options, convertible preferred shares and warrants to purchase common stock are included in the diluted per share calculations where the effect of their inclusion would be dilutive. Common stock equivalents have been excluded for
all periods presented as they are antidilutive. For the periods ended December 31, 2007 and 2006, total common stock equivalents excluded are 108.0 million and 98.7 million, respectively.

(11) GUARANTEES

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

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

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

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



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necessary, we would provide for the estimated cost of the software and services warranties based on specific warranty claims and claim history, however, we
have never incurred any significant expenses under our product or service warranties.

(12) SUBSEQUENT EVENTS

On October 18, 2006, the Company entered into the Credit Agreement with Investment Manager, and Lender, pursuant to which the Company issued the
Term Note in the amount of $15.0 million which is payable in full on October 17, 2009. On May 25, 2007, the Company entered into the Loan Agreement with SVB providing for the Line of Credit which matures on May 24, 2009. Borrowing
availability under the Line of Credit is based on the existence of stipulated percentages of the Companys eligible accounts receivable. On October 15, 2007, the Company entered into amendments to the Credit Agreement and the Loan
Agreement effective as of September 30, 2007, which modified certain of the financial covenants contained in the original agreements (see Note 6 for additional detail). At December 31, 2007, the Company was not in compliance with the
amended financial covenants related to minimum revenue and EBITDA and as of January 31, 2008, the Company was not in compliance with the amended financial covenant related to the minimum cash or borrowing availability requirement.

As a result of the default, SVB, at its election, may cease making loans and require that the full amount of the principal and accrued interest be
paid immediately and Lender may require that the full amount of the principal and accrued interest be paid immediately. The Company is currently negotiating with SVB and Lender to obtain waivers, forbearance agreements and/or further amendments to
the Loan Agreement and Credit Agreement. In addition, the Company is currently seeking additional capital from equity (including our current shareholders) and debt opportunities to provide working capital.

On February 19, 2008, the Company and certain of its investors and its chief executive officer, entered into a binding, non-cancellable agreement
wherein the investors and the chief executive officer committed to fund the operations of the company, as and when needed up to $5.0 million, through June 30, 2008.



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

Forward-Looking
Statements

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



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



| |  |  | our default of our lending arrangements and our inability to repay our debt obligations if our lenders demand immediate repayment;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | our need for working capital;
| | - |  | -----------------------------



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



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



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



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



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



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



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



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



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



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



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



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

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



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Critical Accounting Policies

Revenue Recognition

The Company recognizes revenue for the sale of its Wave, InstantOffice and TeleVantage products pursuant to
Statement of Position (SOP) 97-2, Software Revenue Recognition, and SOP 98-9, Software Revenue Recognition With Respect to Certain Transactions. For revenue generated by the sale of Comdial and Vodavi products, where the Company has
determined that the software is incidental, the Company follows Staff Accounting Bulletin (SAB) 104, Revenue Recognition. Generally, the Company recognizes revenue when it is realized or realizable and earned. The Company considers revenue
realized or realizable and earned when persuasive evidence of an arrangement exists, the product has been shipped or the services have been provided to the customer, the sales price is fixed or determinable and collectability is reasonably assured.
The Company reduces revenue for estimated customer returns, rotations and sales rebates when such amounts are estimable. When not estimable, the Company defers revenue until the product is sold to the end customer or the customers rights
expire. As part of its product sales price, the Company provides telephone support, which is generally utilized by the customer shortly after the sale. The cost of the phone support is not significant but is accrued in the financial statement. In
addition to the aforementioned general policy, the following are the specific revenue recognition policies for each major category of revenue.

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

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

Due to the lengthy period of time over which we amortize the revenue and cost of goods sold related to these systems, the revenue and cost of goods
sold we report in any one period excludes most of the revenue and cost of goods sold relating to shipments in that period and includes revenue and costs of goods sold relating to shipments made in prior periods. As a result, our reported revenue and
costs of good sold may not necessarily be indicative of our ability to generate customer orders in a particular period. The difference between reported revenue and costs of goods sold and customer orders in any period could be either positive or
negative, and cannot be reliably predicted from period to period. The following table demonstrates this effect by showing the amount of revenue, cost of goods sold and gross profit from systems shipped during the three months ended December 31,
2007 and 2006 that was deferred at each quarter end (in thousands).



|                  |  |                  |     |                            |   |                      |  |   |    
|----------------- |  | ---------------- | --- | -------------------------- | - | -------------------- |  | - | ---
|                  |  | Deferred Revenue |     | Deferred Cost ofGoods Sold |   | Deferred GrossProfit
|December 31, 2007 |  | $                |    |                            | $ |                     |  | $ |   
|December 31, 2006 |  |                  | 469 |                            |   | 244                  |  |   | 225

The following table details the amount of revenue, cost of goods sold and gross profit from
systems shipped during prior reporting periods that was recognized at each quarter end for the three month period ended December 31, 2007 and 2006 (in thousands).



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##### Table of Contents

|                  |  |                                               |       |                                                         |   |                                                   |  |   |    
|----------------- |  | --------------------------------------------- | ----- | ------------------------------------------------------- | - | ------------------------------------------------- |  | - | ---
|                  |  | Recognition ofRevenue Deferredin Prior Period |       | Recognition of Costof Goods SoldDeferred in PriorPeriod |   | Recognition ofGross ProfitDeferred in PriorPeriod
|                  |  |                                               |      
|December 31, 2007 |  | $                                             | 2,075 |                                                         | $ | 1,154                                             |  | $ | 921
|                  |  |                                               |      
|December 31, 2006 |  |                                               | 2,122 |                                                         |   | 1,164                                             |  |   | 958

The following tables show the amount of revenue, cost of goods sold and gross profit from systems
shipped during the six months ended December 31, 2007 and 2006 that was deferred at each quarter end (in thousands).



|                  |  |                  |       |                            |   |                      |  |   |      
|----------------- |  | ---------------- | ----- | -------------------------- | - | -------------------- |  | - | -----
|                  |  | Deferred Revenue |       | Deferred Cost ofGoods Sold |   | Deferred GrossProfit
|                  |  |                  |      
|December 31, 2007 |  | $                | 490   |                            | $ | 273                  |  | $ | 217  
|                  |  |                  |      
|December 31, 2006 |  |                  | 2,350 |                            |   | 1,087                |  |   | 1,263

The following table details the amount of revenue, cost of goods sold and gross profit from
systems shipped during prior reporting periods that was recognized for the six month periods ended December 31, 2007 and 2006 (in thousands).



|                  |  |                                               |       |                                                         |   |                                                   |  |   |      
|----------------- |  | --------------------------------------------- | ----- | ------------------------------------------------------- | - | ------------------------------------------------- |  | - | -----
|                  |  | Recognition ofRevenue Deferredin Prior Period |       | Recognition of Costof Goods SoldDeferred in PriorPeriod |   | Recognition ofGross ProfitDeferred in PriorPeriod
|                  |  |                                               |      
|December 31, 2007 |  | $                                             | 4,076 |                                                         | $ | 2,266                                             |  | $ | 1,810
|                  |  |                                               |      
|December 31, 2006 |  |                                               | 4,166 |                                                         |   | 2,285                                             |  |   | 1,881

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

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

Warranty

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



21



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##### Table of Contents

Accounts Receivable

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

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

Inventory

We measure our inventories at lower of cost, on
a first-in first-out (FIFO) basis, or market. We also provide allowances for excess and obsolete inventory equal to the difference between the cost of our inventory and the estimated market value based upon assumptions about product life
cycles, product demand and market conditions. If actual product life cycles, product demand or market conditions are less favorable than those projected by management, additional inventory allowances or write-downs may be required.

Long-lived Assets, including Goodwill and Other Intangibles

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

SFAS No. 142, Goodwill and Other Intangible Assets includes requirements to test goodwill and indefinite lived intangible assets for
impairment rather than amortize them. Goodwill and other indefinite lived intangible assets must be tested for impairment on at least an annual basis. Our goodwill resulting from our acquisitions of Vertical Networks, Comdial and Vodavi will be
tested annually. Although the goodwill was deemed to not be impaired when it was tested in 2007, there can be no assurances that subsequent reviews will not result in material impairment charges. A considerable amount of judgment is required in
calculating this impairment analysis, principally in determining discount rates, financial forecasts and allocation methodology. Unanticipated changes in market conditions could have a material impact on our projected cash flows. Differences in
actual cash flows as compared to the projected discounted cash flows could require us to record an impairment loss.

Summary

The following is a summary of the areas that management believes are important in understanding the results of the fiscal quarter and six months ended
December 31, 2007. This summary is not a substitute for the detail provided in the following pages or for the condensed consolidated financial statements and notes that appear elsewhere in this document.

Revenues

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



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



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



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



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



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



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##### Table of Contents

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

Cost of Sales

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

Operating Expenses

Our operating expenses are comprised of:



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



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



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



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



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

Results of Operations

Net Revenue

Net revenue was $18.7 million and $38.4 million for the three and six months ended December 31, 2007, respectively, representing an increase of
3.5% and 13.2%, from $18.1 million and $34.0 million for the same fiscal periods from prior year. The increase in net revenue is primarily attributable to the acquisition of Vodavi, which was completed on December 1, 2006.

We distribute our products both domestically and internationally. International product revenue was $0.6 million, or 4% of total revenue, for the three
months ended December 31, 2007 and $0.7 million, or 4% of total revenue, for the three months ended December 31, 2006. International product revenue for the six months ended December 31, 2007 was $0.9 million, or 2% of total
revenue, and $1.0 million, or 6% of total revenue, for the six months ended December 31, 2006.

Gross Profit(in thousands, except percentages)



|                 |  |                    |       |   |                   |   |       |                  |  |    |                   |  |   |                   |   |  |        |        |   |  |    
|---------------- |  | ------------------ | ----- | - | ----------------- | - | ----- | ---------------- |  | -- | ----------------- |  | - | ----------------- | - |  | ------ | ------ | - |  | ---
|                 |  | Three Months Ended |       |   |                   |   |       | Six Months Ended |  |    |                  
|                 |  | December 31, 2007  |       |   | December 31, 2006 |   |       | Change           |  |    | December 31, 2007 |  |   | December 31, 2006 |   |  | Change
|Gross Profit     |  | $                  | 8,655 |   |                   | $ | 8,657 |                  |  | (2 | )                 |  | $ | 17,633            |   |  | $      | 16,773 |   |  | 860
|% of Net Revenue |  |                    | 46    | % |                   |   | 48    | %                |  |    |                   |  |   | 46                | % |  |        | 50     | % |  |    

Gross profit as a percentage of revenue decreased by 2% and 4%, respectively, for the three and six months ended
December 31, 2007 as compared with the same periods in 2006, primarily as a result of the acquisition of Vodavi. The Vodavi operations include lower margin product hardware sales.

Operating Expenses(in thousands, except percentages)



|                    |  |                    |       |   |                   |   |       |                  |  |    |                   |  |   |                   |   |  |        |       |   |  |    |  
|------------------- |  | ------------------ | ----- | - | ----------------- | - | ----- | ---------------- |  | -- | ----------------- |  | - | ----------------- | - |  | ------ | ----- | - |  | -- | -
|                    |  | Three Months Ended |       |   |                   |   |       | Six Months Ended |  |    |                   | 
|                    |  | December 31, 2007  |       |   | December 31, 2006 |   |       | Change           |  |    | December 31, 2007 |  |   | December 31, 2006 |   |  | Change |      
|Sales and Marketing |  | $                  | 4,926 |   |                   | $ | 3,645 |                  |  | 35 | %                 |  | $ | 9,911             |   |  | $      | 7,275 |   |  | 36 | %
|% of Net Revenue    |  |                    | 26    | % |                   |   | 20    | %                |  |    |                   |  |   | 26                | % |  |        | 21    | % |  |    |  
|Product Development |  | $                  | 4,104 |   |                   | $ | 3,064 |                  |  | 34 | %                 |  | $ | 7,867             |   |  | $      | 6,134 |   |  | 28 | %



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##### Table of Contents

|                                                                 |  |   |        |   |  |   |        |   |  |    |    |  |   |        |   |  |   |        |   |  |    |   
|---------------------------------------------------------------- |  | - | ------ | - |  | - | ------ | - |  | -- | -- |  | - | ------ | - |  | - | ------ | - |  | -- | --
|% of Net Revenue                                                 |  |   | 22     | % |  |   | 17     | % |  |    |    |  |   | 20     | % |  |   | 18     | % |  |    |   
|General and Administrative                                       |  | $ | 3,795  |   |  | $ | 3,932  |   |  | (3 | )% |  | $ | 7,742  |   |  | $ | 8,029  |   |  | (4 | )%
|% of Net Revenue                                                 |  |   | 20     | % |  |   | 22     | % |  |    |    |  |   | 20     | % |  |   | 24     | % |  |    |   
|Total Operating Expenses (including amortization of intangibles) |  | $ | 13,434 |   |  | $ | 11,005 |   |  | 22 | %  |  | $ | 26,738 |   |  | $ | 22,109 |   |  | 21 | % 
|% of Net Revenue                                                 |  |   | 72     | % |  |   | 61     | % |  |    |    |  |   | 70     | % |  |   | 65     | % |  |    |   

Sales and Marketing

For the three months ended December 31, 2007, sales and marketing expenses increased by $1.3 million, and their costs as a percentage of revenue
increased from 20% to 26% compared with the corresponding period in 2006. For the six months ended December 31, 2007, sales and marketing expenses increased by $2.6 million, and their costs as a percentage of revenue increased from 21% to 26%
compared with the corresponding period in 2006. The increase in sales and marketing expenses in aggregate dollars for the three and six months ended December 31, 2007 compared to the corresponding periods ended December 31, 2006 was due
primarily to increased personnel and travel expenses as a result of the acquisition of Vodavi and to increased marketing expenditures to promote our new product lines. The Company employed 113 sales and marketing personnel at December 31, 2007.
The Company employed 117 sales and marketing personnel at December 31, 2006, which included 43 sales and marketing personnel added as a result of the Vodavi acquisition.

Product Development

For the three
months ended December 31, 2007, product development expenses increased by $1.0 million, whereas their costs as a percentage of revenue increased from 17% to 22% compared with the corresponding period in 2006. For the six months ended
December 31, 2007, product development expense increased by $1.7 million, whereas their costs increased as a percentage of revenue from 18% to 20%. The increase in product development expenses in aggregate dollars for the three and six months
ended December 31, 2007 compared to the corresponding periods ended December 31, 2006 was due primarily to additional costs related to our next generation product development efforts. The Company employed 93 product development personnel
at December 31, 2007. The Company employed 96 product development personnel at December 31, 2006, which included 13 product development personnel added as a result of the Vodavi acquisition.

General and Administrative

For the
three months ended December 31, 2007, general and administrative expense decreased $0.1 million, and their costs as a percentage of revenue decreased from 22% to 20% as compared with the same period ended December 31, 2006. This is
primarily a result of elimination of expenses related to the acquisition of Vodavi. For the six months ended December 31, 2007, general and administrative expense decreased $0.2 million, whereas their costs as a percentage of revenue decreased
from 24% to 22% as compared with the same period ended December 31, 2006. The decrease in general and administrative expenses for the six month period ended December 31, 2007 compared to the same period ended December 31, 2006 was
primarily a result of the liquidated damages of $0.6 million accrued in 2006 (see below) offset by increases in personnel, travel and occupancy expenses as a result of the Vodavi acquisition. The Company employed 51 general and administrative
personnel at December 31, 2007. The Company employed 71 general and administrative personnel at December 31, 2006, which included 27 general and administrative personnel added as a result of the Vodavi acquisition.

General and Administrative expense includes liquidated damages that we accrued related to the 2004 Stock Purchase Agreement, the 2005 Stock Purchase
Agreement and the 2006 Securities Purchase Agreement. No liquidated damages were accrued for the three and six months ended December 31, 2007, compared with no and $0.6 million, respectively, accrued for the three and six months ended
December 31, 2006.

Operating Loss

For the quarter ended December 31, 2007, our operating loss increased $2.4 million, or 103%, to ($4.7) million on revenue of $18.7 million, from an operating loss of ($2.3) million on revenue of $18.1 million for the quarter ended
December 31, 2006. As discussed above, this increase in operating loss is primarily the result of an increase of $2.4 million in operating expenses. For the six months ended December 31, 2007, our operating loss increased $3.8 million, or
71%, to ($9.1) million on revenue of $38.4 million, from an operating loss of ($5.3) million on revenue of $34.0 million for the six months ended December 31, 2006. As discussed above, the factors affecting this increase in operating loss were
a $0.9 million increase in gross profit offset by a $4.6 million increase in operating expenses, both primarily a result of the acquisition of Vodavi.

Included in the operating loss are non-cash compensation expense related to stock option grants of $1.7 million and $3.3 million for the three and six months ended December 31, 2007, respectively, compared with
$1.0 million and $2.0 million in the three and six months ended December 31, 2006, respectively, and depreciation and amortization (for other than the acquired intangibles)



24



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##### Table of Contents

expense of $0.4 million and $0.7 million in the three and six months ended December 31, 2007, respectively, compared with $0.4 million and $0.7 million
in the three and six months ended December 31, 2006, respectively.

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

Interest Expense

Interest expense for the three and six months ended December 31, 2007 was $0.7 million and $1.4
million, respectively, compared with $1.2 million and $1.4 million, respectively, for the three and six months ended December 31, 2006. The decrease in interest expense relates to the retirement of debt instruments incurred in order to finance
the acquisition of Vodavi.

Income Tax Expense

While we incurred net losses in the three and six month periods ended December 31, 2007 and 2006, we recorded a deferred tax provision associated with the goodwill created and intangibles acquired with the Vertical Networks and Comdial
acquisitions. The effective tax rate utilized for the provision was 40.0 %.

Financial Condition, Liquidity And Capital Resources



|                          |  |                   |   |  |               |       |        |         |  
|------------------------- |  | ----------------- | - |  | ------------- | ----- | ------ | ------- | -
|                          |  | Positions at      |   |  |              
|                          |  | December 31, 2007 |   |  | June 30, 2007 |       | Change |        
|Cash and cash equivalents |  | 3,620             |   |  | $             | 8,019 |        | (4,399  | )
|Working capital           |  | (18,706           | ) |  | $             | 4,841 |        | (23,547 | )



|                                                |  |                                   |        |   |                                   |   |         |            |  |         |  
|----------------------------------------------- |  | --------------------------------- | ------ | - | --------------------------------- | - | ------- | ---------- |  | ------- | -
|                                                |  | Six Months EndedDecember 31, 2007 |        |   | Six Months EndedDecember 31, 2006 |   |         | Difference | 
|Cash used in operating activities               |  | $                                 | (2,359 | ) |                                   | $ | (3,531  | )          |  | 1,172   |  
|Cash used in investing activities               |  | $                                 | (1,255 | ) |                                   | $ | (25,613 | )          |  | 24,358  |  
|Cash (used in) provided by financing activities |  | $                                 | (797   | ) |                                   | $ | 40,294  |            |  | (41,091 | )

Net cash flows used in operating activities were $2.4 million during the six months ended
December 31, 2007. The cash used in operating activities was due primarily to a net loss of $11.1 million, offset by depreciation and amortization of $2.1 million and $3.3 million relating to a non-cash compensation charge.

Working capital, consisting of total current assets minus current liabilities, was ($18.7) million at December 31, 2007. This
compared to working capital of $4.8 million at June 30, 2007, representing a decrease of $23.5 million. The decrease in working capital at December 31, 2007 is primarily due to the $16.9 million reclassification of the long term
portion of our debt to current, the $4.4 million decrease in cash and the $2.5 million decrease in net receivables.

The consolidated
financial statements have been prepared assuming that we will continue as a going concern for a reasonable period. However, we have incurred losses and negative or minimal positive cash flows from operations in every fiscal period since 1996 and
have an accumulated deficit, including non-cash equity charges, of $102.5 million as of December 31, 2007. For the six months ended December 31, 2007 we incurred a net loss of approximately $11.1 million, which includes negative cash
flows from operations of approximately $2.4 million. Our management expects that operating losses will continue in the near future. As of December 31, 2007, we were not in compliance with the financial covenants contained in our debt
instruments, which defaults have not been waived by the creditors and, as a result, payment of such debt could be accelerated by the creditors. The negative operating trends experienced by us and the debt defaults have resulted in a working capital
deficiency of $18.7 million as of December 31, 2007.

We are currently involved in negotiations with our lenders to obtain waivers,
forbearance agreements and/or further amendments to our financial covenants. In addition, we are seeking additional capital from equity (including from our current shareholders) and debt opportunities and have taken actions to reduce our operating
costs to levels that can be supported by our available cash. Such additional financings may not be available on terms acceptable to us, or at all, and may significantly affect our stockholders, including for example, by substantially diluting their
ownership interest.

In February 2008, we obtained binding, non-cancellable commitments from certain of our investors and our chief
executive officer to fund our operations, up to $5.0 million, through June 30, 2008.



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##### Table of Contents

Significant Financing Arrangements

February 2006 Financing.On February 9, 2006, the Company completed the sale (the Series D Financing) of 5,000 shares of its newly designated Series D Convertible Preferred Stock and
warrants to purchase an aggregate of 1,041,667 shares of the Companys Common Stock pursuant to a Securities Purchase Agreement between the Company and certain investors. The aggregate proceeds to the Company from the Series D Financing
was $5.0 million and were used to fund ongoing operations.

October and December 2006 Financing.On October 18, 2006, the
Company entered into the Credit Agreement with Columbia Partners, L.L.C. Investment Management (Investment Manager), and NEIPF, L.P. (Lender), pursuant to which the Company issued (i) a senior secured promissory note
payable to Lender in the principal amount of $10.0 million (the Initial Bridge Note) ; and (ii) a senior secured promissory note payable to Lender in the principal amount of $15.0 million (the Term Note). The Initial
Bridge Note was issued on October 18, 2006 and was payable in full on July 1, 2007. The Term Note was issued on December 1, 2006 in the amount of $15.0 million and is payable in full on October 17, 2009. The Initial Bridge Note
was extinguished in May 2007.

On December 1, 2006, the Company completed the sale (the Series E Financing) of 27,400
shares of its Series E Convertible Preferred Stock, par value $1.00 per share (the Series E Preferred Stock) and warrants to purchase an aggregate of 25,849,059 shares (the Series E Warrants) of the Companys
common stock pursuant to the Amended and Restated Securities Purchase Agreement between the Company and certain investors (the Series E Investors) (the Series E Securities Purchase Agreement). The aggregate proceeds to
the Company from the Series E Financing was $27.4 million.

The Company used the proceeds of the Initial Bridge Note to extinguish the
Term Loan and the Revolving Loan and to fund working capital requirements. The proceeds of the Term Note and the Series E Financing were used in the acquisition of Vodavi.

Silicon Valley Bank Line of Credit. On May 25, 2007, the Company entered into a Loan and Security Agreement (the Loan Agreement)
with Silicon Valley Bank (SVB) providing for a line of credit of up to $10,000,000 (the Line of Credit). The Line of Credit matures and the principal balance thereof is payable in full, on May 24, 2009. Borrowing
availability under the Line of Credit is based on the existence of stipulated percentages of the Companys eligible accounts receivable and inventory and is also subject to an additional $2,000,000 collateral reserve requirement established by
SVB.

On October 15, 2007, the Company entered into amendments to the Credit Agreement and the Loan Agreement effective as of
September 30, 2007, which modified certain of the financial covenants. The minimum cash or borrowing availability requirement was reduced to a range of $3.6 million to $4.4 million for defined periods in fiscal 2008. In addition, the minimum
EBITDA requirement for the quarter ended September 30, 2007 was eliminated and for the subsequent quarters in fiscal 2008 was reset to ($0.9) million, ($0.6) million and $1.1 million, respectively. Beginning with the trailing three month period
ended September 30, 2008, and for each quarter thereafter, the Company must maintain a minimum EBITDA of $1.00. In addition, the minimum revenue covenant for the quarter ended September 30, 2007 was eliminated and for the subsequent
quarters in fiscal 2008 was reset to $20.5 million, $20.4 million and $22.7 million, respectively. At December 31, 2007, the Company was not in compliance with the amended financial covenants related to minimum revenue and EBITDA. As a result
of the default, SVB, at their election, may cease making loans and require that the full amount of the principal and accrued interest be paid immediately and Lender may require that the full amount of the principal and accrued interest be paid
immediately. The Company is currently negotiating with SVB and Lender to obtain waivers, forbearance agreements and/or further amendments to the Loan Agreement and Credit Agreement.

Contractual Obligations



|                                    |  |                       |        |                 |   |           |  |           |       |                  |   |       |  |   |  
|----------------------------------- |  | --------------------- | ------ | --------------- | - | --------- |  | --------- | ----- | ---------------- | - | ----- |  | - | -
|                                    |  | Payment due by Period
|Contractual Obligations             |  | Total                 |        | Less than1 year |   | 1-3 years |  | 3-5 years |       | More than5 years
|Debt Obligations (1)                |  | $                     | 22,701 |                 | $ | 22,699    |  | $         | 2     |                  | $ |      |  | $ | 
|Operating Lease Obligations (2)     |  |                       | 6,496  |                 |   | 1,704     |  |           | 3,457 |                  |   | 1,335 |  |   | 
|Open Purchase Order Commitments (3) |  |                       | 14,815 |                 |   | 14,815    |  |           |      |                  |   |      |  |   | 
|                                    |  |                       |        |                 |   |           |  |           |       |                  |   |       |  |   |  
|Total                               |  | $                     | 44,012 |                 | $ | 39,218    |  | $         | 3,459 |                  | $ | 1,335 |  | $ | 

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

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

(3) We outsource substantially all of our manufacturing requirements. As of December 31, 2007, we have outstanding purchase obligations of approximately $14.8 million with our contract manufacturers that could
not be cancelled without significant penalties.



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Item 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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

Item 4.CONTROLS AND PROCEDURES

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

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

Evaluation of Disclosure Controls and Procedures.

As of December 31, 2007, our management, with the participation of our Audit Committee, Chief Executive Officer and Chief Financial
Officer, evaluated the effectiveness of our Disclosure Controls and Procedures. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2007, the design and operation of these
disclosure controls and procedures were effective during the six months ended December 31, 2007.

Changes in Internal Control Over Financial
Reporting.

There were no changes in the Companys internal control over financial reporting during the six months ended
December 31, 2007, that materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.



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PART IIOTHER INFORMATION

Item 1Legal Proceedings

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

Item 1ARisk Factors

Below is the risk factor that has been revised since the filing of our annual
report on Form 10-K for the year ended June 30, 2007. We face significant additional risks, which are set forth in the other risk factors contained in the 2007 Form 10-K under the caption Risk Factors. You are urged to read these
risk factors in the 2007 Form 10-K, in addition to the following revised risk factor, before making an investment decision with regard to our securities.

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

The Comdial and Vodavi acquisitions and integration of their operations into Verticals consumed significant amounts of working capital; as a result, we will require additional capital in the future to fund our
operations, finance investments in product development and corporate infrastructure, expand in our various geographic markets and respond to competitive pressures and opportunities for growth. Failure to obtain additional funding will prevent us
from making expenditures that are needed to allow us to grow or maintain our operations. Although we have started the process of attempting to raise additional financing, we cannot assure you that additional financing will be available on favorable
terms, or at all. If funds are not available when required for our working capital needs or other transactions, our ability to carry out our business plan could be adversely affected, and we may be required to scale back our growth and operations to
reflect the extent of available funding. If we are able to arrange for additional credit facilities from lenders, the debt instruments are likely to include limitations on our ability to incur other indebtedness, to pay dividends, to create liens,
to sell or purchase our capital stock, to sell assets or to make acquisitions or enter into other transactions. Such restrictions may adversely affect our ability to finance our future operations or capital needs or to engage in other business
activities, including, without limitation, acquisitions of additional businesses. We are already subject to such restrictions under the stock purchase agreement executed on September 28, 2004 (the 2004 Stock Purchase Agreement), the
stock purchase agreement executed on September 28, 2005 (the 2005 Stock Purchase Agreement), the securities purchase agreement executed on February 9, 2006 (the 2006 Securities Purchase Agreement), the credit
agreement executed on October 18, 2006 (the Credit Agreement), the securities purchase agreement, executed on October 18, 2006, as amended and restated (the Series E Securities Purchase Agreement), and the loan and
security agreement executed on May 25, 2007 (the Loan Agreement). We will be required to raise additional capital as we were unable to remain in compliance with the amended covenants in the Credit Agreement and the Loan Agreement.
If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our stockholders may be reduced. These securities would likely have rights, preferences or privileges senior to those of our common
stockholders. The inability to obtain substantial increases in our working capital resources will likely have a material negative impact on our business, our financial condition and our results of operations.

Item 3Defaults Upon Senior Securities

On October 18, 2006, the Company entered into the
Credit Agreement with Investment Manager, and Lender, pursuant to which the Company issued the Term Note in the amount of $15.0 million which is payable in full on October 17, 2009. On May 25, 2007, the Company entered into the Loan
Agreement with SVB providing for the Line of Credit which matures on May 24, 2009. Borrowing availability under the Line of Credit is based on the existence of stipulated percentages of the Companys eligible accounts receivable.

On October 15, 2007, the Company entered into amendments to the Credit Agreement and the Loan Agreement effective as of
September 30, 2007, which modified certain of the financial covenants contained in the original agreements. The minimum cash or borrowing availability requirement was reduced to a range of $3.6 million to $4.4 million for defined periods in
fiscal 2008. In addition, the minimum EBITDA requirement for the quarter ended September 30, 2007 was eliminated and for the subsequent quarters in fiscal 2008 was reset to ($0.9) million, ($0.6) million and $1.1 million, respectively.
Beginning with the trailing three month period ended September 30, 2008, and for each quarter thereafter, the Company must maintain a minimum EBITDA of $1.00. In addition, the minimum revenue covenant for the quarter ended September 30,
2007 was eliminated and for the subsequent quarters in fiscal 2008 was reset to $20.5 million, $20.4 million and $22.7 million, respectively.



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At December 31, 2007, the Company was not in compliance with the amended financial covenants related
to minimum revenue and EBITDA. As a result of the default, SVB, at its election, may cease making loans and require that the full amount of the principal and accrued interest be paid immediately and Lender may require that the full amount of the
principal and accrued interest be paid immediately. The Company is currently negotiating with SVB and Lender to obtain waivers, forbearance agreements and/or further amendments to the Loan Agreement and Credit Agreement. In addition, we are seeking
additional capital from equity (including from our current shareholders) and debt opportunities to provide working capital.



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Item 6EXHIBITS



|           |  |                                                                                                                                                  
|---------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNo. |  | Description                                                                                                                                      
|           | 
|31.1       |  | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended            
|           | 
|31.2       |  | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended            
|           | 
|32.1       |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|           | 
|32.2       |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002



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SIGNATURES

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



|                         |  |                                                                                                         
|------------------------ |  | --------------------------------------------------------------------------------------------------------
|                         |  | VERTICAL COMMUNICATIONS, INC.                                                                           
|                         | 
|Dated: February 19, 2008 |  | /s/ William Y. Tauscher                                                                                 
|                         |  |                                                                                                         
|                         |  | William Y. Tauscher Chief Executive Officer
and Chairman of the Board                                   
|                         | 
|Dated: February 19, 2008 |  | /s/ Kenneth M. Clinebell                                                                                
|                         |  |                                                                                                         
|                         |  | Kenneth M. Clinebell Chief Financial
Officer (Principal Financial Officer and Chief Accounting
Officer )



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