Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND 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 thequarterly period ended September 30, 2008.**

 

**OR**

 
| **o** |   | **Transition  report pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934** |
|-------|--------|----------------------------------------------------------------------------------------------------------|

 

**For thetransition period from              to**

 

**Commissionfiles number 000-51560**

 

**MathStar, Inc.**

(Exact name of registrantas specified in its charter)

 

| **Delaware**                                                  | ** ** | **41-1881957**      |
|---------------------------------------------------------------|------------|---------------------|
| (State or other  jurisdiction of                              |       | (I.R.S. Employer    |
| incorporation or  organization)                               |       | Identification No.) |
|                                                          |       |                |
| **19075  NW Tanasbourne, Suite 200, Hillsboro,  Oregon** | ** ** | **97124**           |
| (Address of principal  executive offices)                     |       | (Zip  Code)    |

 

**(503)726-5500**

(Registrant’s telephonenumber, including area code)

 

**N/A**

(Former name, formeraddress, and former fiscal year, if changed since last report)

 

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

 

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

 
| Large accelerated filer o                     |   | Accelerated filer x         |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer o                       |   | Smaller reporting company o |
| (Do not check if a smaller reporting company) |   |                             |

 

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

 

Shares outstanding of theRegistrant’s common stock:

 

| **Class**                      | ** ** | **Outstanding at September 30,  2008** |
|--------------------------------|------------|-------------------------------------------------------|
| Common stock, $0.01 par  value |       | 9,181,497                                             |

 

 

 

----

Table of Contents

 
| PART I   FINANCIAL INFORMATION | 1                                                                                                        |
|------------------------------------------|----------------------------------------------------------------------------------------------------------|
|                                     |                                                                                                     |   |
| Item 1.                                  | Consolidated Financial  Statements (Unaudited)                                                           | 1 |
|                                     | Condensed Balance Sheets as of December 31, 2007  and September 30, 2008                       | 1 |
|                                     | Condensed Statements of Operations for the Three and  Nine Months Ended September 30, 2007 and 2008 | 2 |
|                                     | Condensed Statements of Cash Flows for the Nine Months  Ended September 30, 2007 and 2008           | 3 |
|                                     | Notes to Condensed Consolidated Financial Statements                                                     | 4 |
|                                     |                                                                                                     |   |
| Item 2                                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations              | 11 |
| Item 3                                   | Quantitative  and Qualitative Disclosures about Market Risk                                              | 14 |
| Item 4                                   | Controls and  Procedures                                                                                 | 14 |
|                                     |                                                                                                     |   |
| PART II   OTHER INFORMATION    | 15                                                                                                       |
| ** **                               |                                                                                                     |
| Item 1.                                  | Legal Proceedings                                                                                        | 15 |
| Item 1A.                                 | Risk Factors                                                                                             | 15 |
| Item 2.                                  | Unregistered  Sales of Equity Securities and Use of Proceeds                                             | 16 |
| Item 3.                                  | Defaults Upon  Senior Securities                                                                         | 16 |
| Item 4.                                  | Submission of  Matters to a Vote of Security Holders                                                     | 16 |
| Item 5.                                  | Other Information                                                                                        | 16 |
| Item 6.                                  | Exhibits                                                                                                 | 16 |
|                                     |                                                                                                     |   |
| Signatures                               |                                                                                                     | 17 |

 

----

Table of Contents

 

**Part I**

**Financial Information**

 

**Item 1.  Financial Statements**

 

**MathStar, Inc.**

**CondensedConsolidated Balance Sheets**

**(Unaudited)**

**(in thousands, except per share data)**

 
| ** **                                                                                                                                           | ** ** | **December 31,  2007** | ** ** | **September 30,  2008** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
|                                                                                                                                                 |       |                        |       |                         |       |
| **Assets**                                                                                                                                           |       |                        |       |                         |       |
| Current assets                                                                                                                                       |       |                        |       |                         |       |
| Cash and cash equivalents                                                                                                                            |       | $                           | 4,339      |                         | $          | 6,824 |   |
| Restricted cash                                                                                                                                      |       | 107                         |       | —                       |       |
| Investments in marketable securities –  short term                                                                                              |       | 22,200                      |       | 7,942                        |       |
| Accounts receivable                                                                                                                                  |       | 271                         |       | 130                          |       |
| Inventory                                                                                                                                            |       | 623                         |       | —                       |       |
| Prepaid expenses and other current assets                                                                                                            |       | 1,326                       |       | 221                          |       |
| Total current assets                                                                                                                                 |       | 28,866                      |       | 15,117                       |       |
| Property and equipment, net                                                                                                                          |       | 557                         |       | 76                           |       |
| Investments in marketable securities – long  term                                                                                               |       | 2,599                       |       | 799                          |       |
| Other assets                                                                                                                                         |       | 435                         |       | 25                           |       |
| Total assets                                                                                                                                         |       | $                           | 32,457     |                         | $          | 16,017 |   |
|                                                                                                                                                 |       |                        |       |                         |       |
| **Liabilities and Stockholders’ Equity**                                                                                                        |       |                        |       |                         |       |
| Current liabilities                                                                                                                                  |       |                        |       |                         |       |
| Accounts payable                                                                                                                                     |       | $                           | 930        |                         | $          | 26 |   |
| Deferred revenue                                                                                                                                     |       | 162                         |       | —                       |       |
| Accrued expenses                                                                                                                                     |       | 1,416                       |       | 536                          |       |
| Total current liabilities                                                                                                                            |       | 2,508                       |       | 562                          |       |
| Other long term liabilities                                                                                                                          |       | 453                         |       | 302                          |       |
| Total liabilities                                                                                                                                    |       | 2,961                       |       | 864                          |       |
|                                                                                                                                                 |       |                        |       |                         |       |
| Stockholders’ equity                                                                                                                            |       |                        |       |                         |       |
| Preferred stock, $0.01 par value; 10,000  shares authorized; no shares issued and outstanding                                                        |       | —                      |       | —                       |       |
| Common stock, $0.01 par value; 18,000  shares authorized; 9,181 shares issued and outstanding at December 31,  2007 and September 30, 2008 |       | 459                         |       | 92                           |       |
| Additional paid-in capital                                                                                                                           |       | 155,539                     |       | 155,909                      |       |
| Accumulated deficit                                                                                                                                  |       | (126,502                    | )          | (140,819                     | )          |
| Accumulated other comprehensive loss                                                                                                                 |       | —                      |       | (29                          | )          |
| Total stockholders’ equity                                                                                                                      |       | 29,496                      |       | 15,153                       |       |
|                                                                                                                                                 |       |                        |       |                         |       |
| Total liabilities and stockholders’ equity                                                                                                      |       | $                           | 32,457     |                         | $          | 16,017 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

1

----

Tableof Contents

 

**MathStar, Inc.**

**CondensedConsolidated Statements of Operations**

**(Unaudited)**

**(in thousands, except per share data)**

 
| ** **                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                   | ** ** | **2007**                                             | ** ** | **2008**                                            | ** ** | **2007** | ** ** | **2008** | ** ** |
|                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Revenue                                                      |       | $                                                    | 63         |                                                | $          | 80 |   | $ | 275 |   | $ | 360 |   |
| Cost of sales                                                |       | 58                                                   |       | —                                              |       | 181 |   | 1,195 |   |
| Gross profit (loss)                                          |       | 5                                                    |       | 80                                                  |       | 94 |   | (835 | ) |
| Operating expenses:                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Research and development                                     |       | 2,655                                                |       | 165                                                 |       | 8,387 |   | 7,259 |   |
| Selling, general and administrative                          |       | 2,164                                                |       | 666                                                 |       | 6,733 |   | 4,228 |   |
|                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Restructuring and impairment charges                         |       | —                                               |       | 17                                                  |       | — |   | 2,618 |   |
|                                                         |       | 4,819                                                |       | 848                                                 |       | 15,120 |   | 14,105 |   |
| Operating loss                                               |       | (4,814                                               | )          | (768                                                | )          | (15,026 | ) | (14,940 | ) |
| Interest income                                              |       | 426                                                  |       | 132                                                 |       | 652 |   | 622 |   |
| Other income, net                                            |       | (5                                                   | )          | (25                                                 | )          | (21 | ) | 1 |   |
| Net loss                                                     |       | $                                                    | (4,393     | )                                                   | $          | (661 | ) | $ | (14,395 | ) | $ | (14,317 | ) |
|                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and diluted loss per share from  continuing operations |       | $                                                    | (0.48      | )                                                   | $          | (0.07 | ) | $ | (2.37 | ) | $ | (1.56 | ) |
|                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted average basic and diluted shares  outstanding       |       | 9,181                                                |       | 9,181                                               |       | 6,081 |   | 9,181 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

2

----

Tableof Contents

 

**MathStar, Inc.**

**CondensedConsolidated Statements of Cash Flows**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                  | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2007**                                            | ** ** | **2008** | ** ** |
|                                                                        |       |                                                |       |   |   |
| **Cash flows from operating activities**                                    |       |                                                |       |   |   |
| Net loss                                                                    |       | $                                                   | (14,395    | ) | $ | (14,317 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities |       |                                                |       |   |   |
| Depreciation and amortization                                               |       | 133                                                 |       | 155 |   |
| Loss on asset disposal                                                      |       | 5                                                   |       | 58 |   |
| Asset impairment charges                                                    |       |                                                |       | 1,006 |   |
| Amortization of discount on  held-to-maturity securities                    |       |                                                |       | 63 |   |
| Loss on sale of available-for-sale  securities                              |       |                                                |       | 7 |   |
| Non-cash changes in inventory                                               |       |                                                |       | 734 |   |
| Stock-based compensation                                                    |       | 83                                                  |       | 3 |   |
| Restructuring charges                                                       |       |                                                |       | 563 |   |
| Gain on sale of marketable securities                                       |       |                                                |       | (42 | ) |
| Foreign currency remeasurement                                              |       | 11                                                  |       | (17 | ) |
| Change in operating assets and liabilities                                  |       |                                                |       |   |   |
| Accounts receivable                                                         |       | (130                                                | )          | 141 |   |
| Inventory                                                                   |       | (92                                                 | )          | (111 | ) |
| Prepaid expenses and other assets                                           |       | 542                                                 |       | 803 |   |
| Accounts payable                                                            |       | (1,381                                              | )          | (904 | ) |
| Deferred revenue                                                            |       | 162                                                 |       | (162 | ) |
| Accrued expenses                                                            |       | 4                                                   |       | (1,570 | ) |
| Net cash used in operating activities                                       |       | (15,058                                             | )          | (13,590 | ) |
|                                                                        |       |                                                |       |   |   |
| **Cash flows from investing activities**                                    |       |                                                |       |   |   |
| Purchase of property and equipment                                          |       | (69                                                 | )          | (50 | ) |
| Proceeds from sale of equipment                                             |       |                                                |       | 23 |   |
| Purchase of capitalized application  software                               |       | (292                                                | )          |   |   |
| Proceeds from sale of held-to-maturity  securities                          |       |                                                |       | 17,158 |   |
| Proceeds from sale of available-for-sale  securities                        |       |                                                |       | 4,460 |   |
| Purchase of held-to-maturity securities                                     |       | (19,684                                             | )          | (2,931 | ) |
| Purchase of available-for-sale securities                                   |       |                                                |       | (2,685 | ) |
| Restricted cash                                                             |       | (3                                                  | )          | 107 |   |
| Net cash used in investing activities                                       |       | (20,048                                             | )          | 16,082 |   |
|                                                                        |       |                                                |       |   |   |
| **Cash flows from financing activities**                                    |       |                                                |       |   |   |
| Proceeds from issuance of common stock, net  of offering costs              |       | 36,473                                              |       |   |   |
| Proceeds from exercise of warrants, net of  costs                           |       | 21                                                  |       | — |   |
| Proceeds from exercise of stock options                                     |       | 9                                                   |       | — |   |
| Net cash provided by financing activities                                   |       | 36,503                                              |       | — |   |
| Effect of exchange rate changes on cash                                     |       | (5                                                  | )          | (7 | ) |
| Net decrease in cash and cash equivalents                                   |       | 1,392                                               |       | 2,485 |   |
| **Cash and cash equivalents**                                               |       |                                                |       |   |   |
| Beginning of period                                                         |       | 12,891                                              |       | 4,339 |   |
| End of period                                                               |       | $                                                   | 14,283     |   | $ | 6,824 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

3

----

Tableof Contents

 

**MathStar, Inc.**

**Notes toConsolidated Financial Statements**

**(inthousands, except per share data)**

 

**1.****            ****Basis of Presentation**

 

The accompanying interim condensed consolidatedfinancial statements of MathStar, Inc. (“MathStar” or the “Company”) havebeen prepared in conformity with United States generally accepted accountingprinciples (U.S. GAAP), consistent in all material respects with those appliedin the Company’s Annual Report on Form 10-K filed with the Securities andExchange Commission (“SEC”) on March 14, 2008. The year-end condensedconsolidated balance sheet was derived from audited financial statements,but does not include all disclosure required by U.S. GAAP. The preparation offinancial statements in conformity with U.S. GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and the disclosure of contingent assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.

 

The interim financial information is unaudited, butit reflects all normal adjustments that are, in the opinion of management,necessary to provide a fair statement of results for the interim periodspresented. The interim financial results are not necessarily indicative ofresults to be expected in future interim or annual periods. The interim financialstatements should be read in conjunction with the financial statements in theCompany’s Annual Report on Form 10-K filed with the Securities andExchange Commission on March 14, 2008.

 

The accompanying financial statements have beenprepared on a basis which assumes that the Company will continue as a goingconcern and which contemplates the realization of assets and the satisfactionof liabilities and commitments in the normal course of business. During thethree months ended March 31, 2008, sales did not materialize as expected,and development of the next generation of FPOA fell even further behindschedule. As a result, on May 20, 2008, the Board of Directors voted tosuspend research and development activities and ongoing operations whileanalyzing strategic alternatives to protect the value to the stockholders. TheBoard of Directors continues to explore these strategic alternatives, whichcould include merger, acquisition, increasing operations in another structureor liquidation. MathStar has engaged a third party investment  banking firm to explore the sale ofintellectual property and patents.

 

The Company’s stockholders approved a one-for-fivereverse stock split, effective May 23, 2008. The accompanying financialstatements and related notes give retrospective effect to this split onrecorded share amounts and earnings per share information.

 

On October 15, 2008, the Company received aletter from The NASDAQ Stock Market (“Nasdaq”) which stated that based onNasdaq staff’s review of MathStar, and pursuant to Marketplace Rule 4300,Nasdaq staff believes that MathStar is a “public shell” and as such no longermeets Nasdaq’s listing requirements. Accordingly, Nasdaq indicated in the letter that trading of MathStar’scommon stock on The Nasdaq Global Market would be suspended at the opening ofbusiness on October 23, 2008. MathStar elected not to appeal the decisionand has been delisted from The NASDAQ Global Market.

 

**2.****            ****Restructuring and ImpairmentCharges**

 

During the three months ended June 30, 2008,the Company announced a curtailment of operations as it evaluated strategicalternatives to preserve shareholder value.  This decision resulted inrestructuring and impairment charges of $3,500 for the nine months ended September 30,2008.  Management determined that it was highly likely that certainoperational assets would not be used and no alternatives existed. In accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 144, “*Accounting for the Impairment or Disposal ofLong-Lived Assets*” issued by the Financial Accounting StandardsBoard (“FASB”), these assets were deemed to be impaired and eitherheld-for-sale or abandoned and written down to their fair market value.  Aplan to locate potential buyers was put in place for their disposal, and nofurther depreciation expense will be charged to the Company’s operatingactivity. In addition, the Company evaluated assets that were not abandoned orheld-for-sale and determined that the estimated useful lives of these assetsshould be shortened. Accordingly, higher depreciation expense has been incurredsince May 20, 2008. As well, in accordance with SFAS No. 146 issuedby the FASB, “*Accounting for CostsAssociated with Exit or Disposal Activities”*, certain one-timecharges relating to severance to terminated employees, and fees associated withearly contract terminations no longer used and giving economic benefit to theCompany, were recorded. As the liabilities for these charges are settled,payment will be made against the liability, and there will not be any furtherimpact on the Company’s operating results.

 

4

----

Table of Contents

 

During the quarter ended September 30, 2008,the Company ceased all operations in Minnesota and is no longer utilizing thefacility covered under a non-cancellable lease arrangement. MathStar recognizeda restructuring charge of $17 for the potential liability of this lease.

 

Management believes that no further charges will beincurred for this activity, except for potential termination of non-cancelablelease liabilities for the Hillsboro, Oregon facility, which will depend on thestrategic direction chosen by the Company. The amount of the potential leasetermination liability will not be known until the strategic direction isidentified. Below is the detail of restructuring and impairment charges.

 
| ** **                                                             | ** ** | **Nine Months  Ended September 30,  2008** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Inventory abandoned                                                    |       | $                                                         | 349        |   |
| Increase in excess and obsolete reserve                                |       | 533                                                       |       |
| Charged to cost of sales                                               |       | 882                                                       |       |
|                                                                   |       |                                                      |       |
| Severance                                                              |       | 1,506                                                     |       |
| Fair market adjustment of assets  held-for-sale                        |       | 328                                                       |       |
| Contract termination                                                   |       | 57                                                        |       |
| Assets abandoned                                                       |       | 727                                                       |       |
| Charged to operating expenses as  restructuring and impairment charges |       | 2,618                                                     |       |
|                                                                   |       |                                                      |       |
| Total charges for restructuring and  impairment                        |       | $                                                         | 3,500      |   |

 

Severance expense of $1,506 impacted approximately75 employees, which accounted for a majority of the Company’s workforce. The following is a rollforward of the restructuring liability for the ninemonths ended September 30, 2008.

 
| ** **                              | ** ** | **Restructuring  Liability** | ** ** |
|-----------------------------------------|------------|------------------------------|------------|
| Liability as of March 31, 2008     |       | $                            | —     |   |
| Additions                               |       | 1,506                        |       |
| Payments                                |       | 943                          |       |
| Liability as of June 30, 2008      |       | $                            | 563        |   |
| Additions                               |       | 17                           |       |
| Payments                                |       | 568                          |       |
| Liability as of September 30, 2008 |       | $                            | 12         |   |

 

Management believes that no further charges will beincurred for this activity, except for the potential termination of thenon-cancellable lease for the Hillsboro facility. The lease for the facilityextends through August 31, 2011 and the annual lease payments amount to $326,000.The amount of the potential termination liability will not be known until wediscontinue utilizing the facility.

 

5

----

Table of Contents

 

**3.****            ****New AccountingPronouncements**

 

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements” (SFAS No. 157), which defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair value measurements.SFAS No. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007 and interim periods within those fiscalyears.

 

Relative to SFAS No. 157, the FASB issued FASBStaff Positions (FSP) 157-1, 157-2 and 157-3. FSP 157-1 amends SFAS No. 157to exclude SFAS No. 13, “Accounting for Leases,” and its relatedinterpretive accounting pronouncements that address leasing transactions. FSPSFAS No. 157-2 delays the effective date of the application of SFAS No. 157to fiscal years beginning after November 15, 2008 for all nonfinancialassets and liabilities except for those that are recognized or disclosed atfair value in the financial statements on a recurring basis. FSP 157-3clarifies the application of SFAS No. 157 in a market that is not active.

 

 The adoptionof this accounting pronouncement did not have a material effect on the Company’sconsolidated financial statements for financial assets and liabilities and anyother assets and liabilities carried at fair value, although we expanded thedisclosure requirements to comply with SFAS No. 157.  TheCompany is currently in the process of evaluating the impact of adopting thispronouncement for other non-financial assets or liabilities.

 

SFAS No. 157 defines fair value as the pricethat would be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants at the measurement date (exitprice). SFAS No. 157 classifies the inputs used to measure fair value intothe following hierarchy:

 
| Level 1 |   | Unadjusted quoted prices in active markets for identical assets or  liabilities                                                                                                                                                                                               |
|---------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                                                                                                                                          |
| Level 2 |   | Unadjusted quoted prices in active markets for similar assets or  liabilities, or unadjusted quoted prices for identical or similar assets or  liabilities in markets that are not active, or inputs other than quoted  prices that are observable for the asset or liability |
|    |   |                                                                                                                                                                                                                                                                          |
| Level 3 |   | Unobservable inputs for the asset or liability                                                                                                                                                                                                                                |

 

We endeavor to utilize the best availableinformation in measuring fair value. Financial assets and liabilities areclassified in their entirety based on the lowest level of input that issignificant to the fair value measurement.

 

In February 2007, the FASB issued SFAS No. 159,“The fair value option for Financial Assets and Liabilities—including Amendment*of FAS No. 115”.*SFAS No. 159gives companies the option of recording certain financial assets andliabilities at fair value. SFAS No. 159 was effective for the Companycommencing January 1, 2008. The Company’s adoption of SFAS No. 159did not have an impact on its financial statements, as the Company did notelect to record eligible items at fair value.

 

In December 2007, the FASB issued SFAS No. 141(revised 2007), “Business Combinations,” and SFAS No. 160, “NoncontrollingInterests in Consolidated Financial Statements”.  These standards aim toimprove, simplify and converge internationally the accounting for businesscombinations and the reporting of noncontrolling interests in consolidatedfinancial statements.  The provisions of SFAS No. 141(R) andSFAS No. 160 apply to business combinations for which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after December 31, 2008.  The Company does not expect theprovisions of SFAS No. 141(R) and SFAS No. 160 will have aneffect on its consolidated financial position and results of operations.

 

6

----

Table of Contents

 

**4.****    ****Stock-Based Compensation**

 

MathStar has issued options as a means to incentpotential employees to join and retain certain existing employees.  The Companyaccounts for options granted under SFAS No. 123R (revised 2004), “*Share-Based Payment*,” utilizing theBlack-Scholes pricing model.  The table below discloses option activityduring the nine months ended September 30, 2008 and the total options outstandingas of September 30, 2008, as adjusted for the one-for-five reverse stocksplit effective on May 23, 2008.

 
| ** **                             | ** ** | ** **     | ** ** | ** **    | ** ** | **Weighted-**       | ** ** | ** **     | ** ** |
|----------------------------------------|------------|----------------|------------|---------------|------------|---------------------|------------|----------------|------------|
| ** **                             | ** ** | ** **     | ** ** | ** **    | ** ** | **Average**         | ** ** | **Aggregate**  | ** ** |
| ** **                             | ** ** | ** **     | ** ** | **Weighted-** | ** ** | **Remaining**       | ** ** | **Intrinsic**  | ** ** |
| ** **                             | ** ** | **Shares**     | ** ** | **Average**   | ** ** | **Contractual**     | ** ** | **Value**      | ** ** |
| ** **                             | ** ** | **(in**        | ** ** | **Exercise**  | ** ** | **Term**            | ** ** | **(in**        | ** ** |
| **Options**                            | ** ** | **thousands)** | ** ** | **Price**     | ** ** | **(in years)** | ** ** | **thousands)** | ** ** |
| Outstanding at December 31, 2007  |       | 670            |       | $             | 18.15      |                | 8.01       |           | $          |   |   |
| Granted                                |       | 26             |       | 2.58          |       |                |       |           |       |
| Exercised                              |       | —         |       | —        |       |                |       |           |       |
| Forfeited or expired                   |       | (596           | )          | 16.74         |       | 7.97                |       |           |       |
|                                   |       |           |       |          |       |                |       |           |       |
| Outstanding at September 30, 2008 |       | 100            |       | $             | 22.37      |                | 5.77       |           | $          |   |   |
|                                   |       |           |       |          |       |                |       |           |       |
| Exercisable at September 30, 2008 |       | 72             |       | $             | 25.26      |                | 4.81       |           | $          | 0 |   |
|                                        |            |                |            |               |            |                     |            |                |            |  |  |  |

 

For the first nine months of 2008, the Companyrecorded a net non-cash expense of $3 resulting from expenses incurred for tworemaining employees and the members of the Board of Directors lessrecaptured  expenses on forfeitedunvested options of terminated employees.  In the first nine months of2007, the Company had $83 in non-cash stock-based compensation expense.

 

**5.****    ****Selected Balance SheetInformation**

 

**Restricted Cash**

 

The Company had pledged cash as collateral to securethe balances on Company issued credit cards. The Company could not use therestricted cash in the normal course of business until the credit cards were cancelledor the bank released the funds. During the three months ended September 30,2008, all Company issued credit cards were cancelled, and the bank released therestricted funds.

 

7

----

Table of Contents

 

**Investment Securities**

 
| ** **                   | ** ** | **December 31,  2007** | ** ** | **September 30,  2008** | ** ** |
|------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Short-term                   |       |                        |       |                         |       |
| Available-for-sale           |       | $                           |       |                         | $          |   |   |
| Municipal securities         |       | 2,605                       |       |                         |       |
| Auction preferred securities |       |                        |       |                         |       |
| Held-to-maturity             |       |                        |       |                         |       |
| Government securities        |       | 19,595                      |       | 5,403                        |       |
| Corporate bonds and notes    |       |                        |       | 2,539                        |       |
| Total short-term investments |       | 22,200                      |       | 7,942                        |       |
|                         |       |                        |       |                         |       |
| Long-term                    |       |                        |       |                         |       |
| Available-for-sale           |       |                        |       |                         |       |
| Municipal securities         |       |                        |       |                         |       |
| Auction preferred securities |       |                        |       | 799                          |       |
| Held-to-maturity             |       |                        |       |                         |       |
| Government securities        |       |                        |       |                         |       |
| Corporate bonds and notes    |       | 2,599                       |       |                         |       |
| Total long-term investments  |       | 2,599                       |       | 799                          |       |
|                         |       |                        |       |                         |       |
| Total investments            |       | $                           | 24,799     |                         | $          | 8,741 |   |

 

Investments classified as held-to-maturity havetimed maturities to meet forecasted cash needs, which range from October 2008to February 2009 and are reported at amortized cost, as the Company hasthe ability and intent to hold these securities to maturity. Amortized costapproximates fair value for held-to-maturity investments. Investments withmaturities beyond one year are classified as long-term investment securities.

 
| ** **                    | ** ** | ** **  | ** ** | **Fair Value Measurement at Reporting Date  Using**    | ** ** |
|-------------------------------|------------|-------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                    | ** ** | ** **  | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
| **Description**               | ** ** | **9/30/08** | ** ** | **(Level 1)**                                                              | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
|                          |       |        |       |                                                                            |       |   |   |   |   |
| Available-for-sale securities |       | $           | 799        |                                                                            | —     |   | — |   | $ | 799 |   |
| Total                         |       | $           | 799        |                                                                            | —     |   | — |   | $ | 799 |   |

 

We have auction preferred securities (APS), whichare preferred equity instruments in a closed-end mutual fund that provideliquidity through an auction process conducted by an independent auction agentthat resets the applicable dividend rate at pre-determined calendar intervals,generally every 28 days.  These instruments are senior equity securitiesthat have a liquidation preference of $25,000 per share plus the amount ofaccumulated but unpaid dividends. Upon the liquidation, dissolution or windingup of the fund, APS holders are entitled to receive their liquidationpreference before any distribution or payment is made to holders of the fund’scommon shares. Dividends declared and payable on the APS have a priority overdividends on the fund’s common shares. Outstanding APS may be redeemed at theoption of the fund upon giving notice to APS holders.

 

The Company generally invests in these securities aspart of its overall cash management program. During the first quarter of 2008,the Company’s APS failed to auction due to sell orders exceeding buyorders. The funds associated with failed auctions will not be accessibleuntil a successful auction occurs, the fund redeems outstanding APS or anactive secondary market is created and a buyer is identified outside of theauction process.

 

At September 30, 2008, there was insufficientobservable APS market information available to determine the fair value of theCompany’s investments in APS. Therefore, the Company estimated Level 3 fairvalues for these securities by incorporating assumptions that marketparticipants would use in their estimates of fair value. Despite the failedauctions, the Company’s APS continue to be highly rated by the ratingagencies.  Of the original $2,680 in APS purchased, $1,850 was redeemed onMay 27, 2008 at face value.   Based upon these factors, the Companyadjusted the September 30, 2008 carrying value of these securitiesdownward to fair value by the amount of $29. The entire adjustment amount,which resulted from the limited liquidity of those investments, was consideredtemporary and was recorded in other comprehensive income. The APS underlyingthis temporary adjustment amount were classified as non-current as of September 30,2008 due to the unknown redemption date by the issuer or liquidation by theseller of the security. These funds are not required to meet the Company’scurrent operating activities or to satisfy its outstanding liabilities.

 

8

----

Table of Contents

 

Asfurther required by SFAS No. 157, provided below is a reconciliation ofthe beginning and ending balances for each type of security valued using aLevel 3 valuation at September 30, 2008.

 
| ** **                                                                                     | ** ** | **Fair Value Measurement Using Significant  Unobservable Inputs (Level 3)** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                     | ** ** | **Auction  Preferred  Securities**                                                                             | ** ** |
| Beginning balance as of December 31,  2007                                                |       | $                                                                                                              | 0          |   |
| Total gains or losses realized/unrealized  included in earnings/included in comprehensive loss |       | (29                                                                                                            | )          |
| Purchases, issuance and settlements                                                            |       | 828                                                                                                            |       |
| Ending balance as of September 30,  2008                                                  |       | $                                                                                                              | 799        |   |

 

**Inventory**

 
| ** **                                       | ** ** | **December 31,  2007** | ** ** | **September 30,  2008** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Raw materials and sub assemblies                 |       | $                           | 113        |                         | $          | 0 |   |
| Finished goods                                   |       | 717                         |       | 543                          |       |
|                                             |       | $                           | 830        |                         | $          | 543 |   |
| Less: reserve for excess and obsolete  inventory |       | (207                        | )          | (543                         | )          |
| Total inventory, net                             |       | $                           | 623        |                         | $          | 0 |   |

 

**Prepaid and Other Current Assets**

 
| ** **                             | ** ** | **December 31,  2007** | ** ** | **September 30,  2008** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Design licenses (short term)           |       | $                           | 729        |                         | $          | — |   |
| Interest receivable                    |       | 307                         |       | 129                          |       |
| Prepaid insurance                      |       | 189                         |       | 26                           |       |
| Prepaid rent                           |       | 33                          |       | 27                           |       |
| Other                                  |       | 68                          |       | 39                           |       |
| Total prepaid and other current assets |       | $                           | 1,326      |                         | $          | 221 |   |

 

**Property and Equipment**

 
| ** **                        | ** ** | **December 31,  2007** | ** ** | **September 30,  2008** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Computer equipment                |       | $                           | 144        |                         | $          | 50 |   |
| Purchased software                |       | 533                         |       | 91                           |       |
| Equipment                         |       | 207                         |       | —                       |       |
| Furniture and fixtures            |       | 387                         |       | 198                          |       |
|                              |       | $                           | 1,271      |                         | $          | 339 |   |
| Less: Accumulated depreciation    |       | (714                        | )          | (263                         | )          |
| Total property and equipment, net |       | $                           | 557        |                         | $          | 76 |   |

 

9

----

Table of Contents

 

Depreciation expense was $43 and $44 for the threemonths ended September 30, 2007 and 2008, respectively, and $123 and $146for the nine months ended September 30, 2007 and 2008, respectively.

 

Under SFAS No. 144, *“Accounting for the Impairment or Disposal of Long Lived Assets”,*assetsthat are no longer used in operations and held for sale should be written downto the expected fair market value and depreciation ceased as of thedetermination date. The depreciation of assets remaining in service wasaccelerated and the assets will be fully depreciated in October 2008.

 

**Other Assets**

 
| ** **                                                                                                                                                | ** ** | **December 31,  2007** | ** ** | **September 30,  2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Deposits                                                                                                                                                  |       | $                           | 36         |                         | $          | 25 |   |
| Design licenses (long-term)                                                                                                                               |       | 347                         |       | —                       |       |
| Capitalized intellectual property, net of  accumulated amortization of $12 and $0 as of December 31, 2007 and  September 30, 2008, respectively |       | 52                          |       | —                       |       |
| Total other assets                                                                                                                                        |       | $                           | 435        |                         | $          | 25 |   |

 

Amortization expense associated with capitalizedapplication software was $5 and $0 for the three months ended September 30,2007 and 2008, respectively, and $7 and $9 for the nine months ended September 30,2007 and 2008, respectively.

 

**Accrued Expenses**

 
| ** **                    | ** ** | **December 31,  2007** | ** ** | **September 30,  2008** | ** ** |
|-------------------------------|------------|-----------------------------|------------|------------------------------|------------|
|                          |       |                        |       |                         |       |
| Accrued rent                  |       | $                           | 48         |                         | $          | 48 |   |
| Accrued compensation          |       | 702                         |       | —                       |       |
| Accrued professional fees     |       | 161                         |       | 135                          |       |
| Accrued license contracts     |       | 389                         |       | 334                          |       |
| Accrued restructuring charges |       | —                      |       | 12                           |       |
| Other                         |       | 116                         |       | 7                            |       |
| Total accrued expenses        |       | $                           | 1,416      |                         | $          | 536 |   |

 

**Comprehensive Income**

 
| ** **                               | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                               | ** ** | **2007**                                                | ** ** | **2008** | ** ** |
| Net loss                                 |       | $                                                       | (14,395    | ) | $ | (14,317 | ) |
| Unrealized loss on marketable securities |       | —                                                  |       | (29 | ) |
| Comprehensive loss                       |       | $                                                       | (14,395    | ) | $ | (14,346 | ) |

 

10

----

Table of Contents

 

**Item 2.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*ThisQuarterly Report on Form 10-Q contains forward-looking statements, whichare being provided under the “safe harbor” protection of the Private SecuritiesLitigation Reform Act of 1995. Forward-looking statements are generally writtenin the future tense and/or are preceded by words such as “will,” “may,” “should,”“could,” “expect,” “suggest,” “believe,” “anticipate,” “intend,” “plan,” orother similar words. Forward-looking statements are not guarantees of futureperformance and involve risks and uncertainties. The forward-looking statementscontained in this report are based on information that is currently availableto us and expectations and assumptions that we deem reasonable at the time thestatements were made. We do not undertake any obligation to update anyforward-looking statements in this report or in any of our othercommunications, except as required by law. All such forward-looking statementsshould be read as of the time the statements were made and with the recognitionthat these forward-looking statements may not be complete or accurate at alater date.*

 

*Many factors may cause actualresults to differ materially from those expressed or implied by theforward-looking statements contained in this report. These factors include, butare not limited to, those risks described in our Annual Report on Form 10-Kfiled on March 14, 2008, as updated in our Quarterly Report on Form 10-Qfiled on August 11, 2008 and in this Quarterly Report.*

 

**Business Overview**

 

During 2008, sales of our field programmable objectarray, or FPOA, did not materialize as expected, and development of the nextgeneration of FPOA fell even further behind schedule. As a result, on May 20,2008, the Board of Directors voted to suspend research and developmentactivities and ongoing operations while analyzing strategic alternatives toprotect the remaining value and increase the liquidity to the stockholders. TheBoard of Directors continues to explore these strategic alternatives, whichcould include merger, acquisition, increasing operations in another structureor liquidation.

 

**Recently Issued Accounting Pronouncements**

 

See Note 2 of Notes to Financial Statements includedin Part I, Item 1 of this Quarterly Report on Form 10-Q.

 

**Critical Accounting Policies**

 

There were no changes in critical accountingpolicies in the three months ended September 30, 2008.

 

**Results ofOperations**

 

***Three Months Ended September 30, 2007 and 2008***

 

*Revenue.*For the three months ended September 30,2008, we generated revenue of $80,000 compared to $63,000 for the same periodlast year. Revenue for the three months ended September 30, 2008 was fromthe sale of FPOA chips left in our inventory. Revenue for the three monthsended September 30, 2007 was from the sale of development systems andlicenses of $32,000, and licensed software and non-recurring engineering (NRE)fees of $31,000. Although we have suspended operations and established reservesfor all unsold production chips in inventory, we are still working with activecustomers and process orders as requested.

 

*Cost of Sales.* Cost of sales for the three months ended September 30,2008 and 2007 were $0 and $58,000, respectively. As the value of inventory waspreviously written down, no cost of sales were associated with sales in thethird quarter of 2008. The cost of sales for the three months ended September 30,2007 consisted of production costs of development systems and license fees of$31,000, external costs of engineering services and application intellectualproperty (IP) of $14,000, and other costs of $13,000.

 

*Research and Development.* During the three months ended September 30,2008, research and development expenses were essentially terminated whichresulted in a $2,490,000 or 94% decrease in research and development expensesto $165,000 for the three months ended September 30, 2008 from $2,655,000for the three months ended September 30, 2007.

 

11

----

Table of Contents

 

Theresearch and development expenses incurred during the three months ended September 30,2008 included $99,000 in employee related expenses, $56,000 for outsideservices and consulting, and $10,000 in other costs for the completion of thedesign documentation phases of current chip development. The research anddevelopment expenses for the three months ended September 30, 2007included $1,509,000 in employee related expenses, $771,000 in outside servicesand consulting, $209,000 in design tool expenses, $37,000 in engineering tools,$26,000 in travel and $103,000 in infrastructure and other charges used in thedevelopment phase of the FPOA chip design development.

 

*Selling, General and Administrative. *For the three months ended September 30,2008, selling, general and administrative expenses decreased $1,498,000 or 69%to $666,000, compared to $2,164,000 for the three months ended September 30,2007. The decrease was primarily the result of reduced employee relatedexpenses of $1,211,000, travel expenses of $128,000, outside service andprofessional services of $118,000, and infrastructure and other charges of$41,000.  Our selling, general and administrative infrastructure isreduced to key individuals necessary to sustain the corporate structure andactivities and plan our strategic direction.

 

*Restructuring and Impairment Charges:*For the three months ended September 30,2008, we recorded restructuring and impairment charges of $17,000. Thesecharges consisted of future rent payments for the Minnesota facility coveredunder a non-cancellable lease agreement which is no longer being utilized.These payments will be made upon a settlement for the early termination of thelease or as payments are due over the remaining lease term.

 
| ** **                              | ** ** | **Restructuring  Liability** | ** ** |
|-----------------------------------------|------------|------------------------------|------------|
| Liability as of June 30, 2008      |       | $                            | 563,000    |   |
| Additions                               |       | 17,000                       |       |
| Payments                                |       | 568,000                      |       |
| Liability as of September 30, 2008 |       | $                            | 12,000     |   |

 

*Other Income (Expense).*For the three months ended September 30,2008, other income decreased by $314,000 or 75% to $107,000 compared to$421,000 for the three months ended September 30, 2007. The decrease wasthe result of $294,000 less interest income earned on lower investment balancesand a combined loss on foreign currency translation and loss on asset sale of$20,000.

 

***Nine Months EndedSeptember 30, 2007 and 2008***

 

*Revenue.*For the nine months ended September 30, 2008, we generated revenueof $360,000 compared to $275,000 for the same period last year. Revenue for thenine months ended September 30, 2008 was from the sale of production FPOAchips of $356,000 and development products of $4,000. Revenue for the ninemonths ended September 30, 2007 was from the sale of production FPOA chipsof $16,000, evaluation systems and licenses of $140,000 and software licensefees and NRE fees of $119,000.   Althoughwe have curtailed operations and established reserves for all unsold productionchips in inventory, we are still working with active customers and processorders as requested.

 

*Cost of Sales.* Cost of sales for the nine months ended September 30,2008 and 2007 were $1,195,000 and $181,000, respectively. Cost of sales for thenine months ended September 30, 2008 include product costs of $36,000, anon-cash charge of $734,000 for excess and obsolete inventory, scrap costsassociated with tool licenses and raw material write-offs of $370,000, andother costs of $55,000.  Costs of sales for the nine months ended September 30,2007 were from manufacturing costs of the chips of $1,000, evaluation systemsand license fees of $87,000, the cost of the third party software licenses andsubcontracted NRE services of $39,000, and other costs of $54,000.

 

12

----

Table of Contents

 

*Research and Development.* For the nine months ended September 30,2008, research and development expenses decreased $1,128,000 or 13% to$7,259,000 from $8,387,000 for the nine months ended September 30, 2007.The decrease is the result of lower employee related expenses of $1,382,000,consulting and contractor expense of $639,000, development tool expense of$41,000, travel of $53,000, building and equipment rent of $317,000 and othercharges of $203,000.   The decreasewas partially offset by increases in application IP expense of $515,000 and NREcharges paid to outside firms for development of the next chip design of$992,000. Research and development activities now have been completed, and allassociated costs have been eliminated.

 

*Selling, General and Administrative. *For the nine months ended September 30,2008, selling, general and administrative expenses decreased $2,505,000 or 37%to $4,228,000, compared to $6,733,000 for the nine months ended September 30,2007. The decrease was primarily the result of reduced  employee relatedexpenses of $1,716,000,  advertisingcosts of $51,000, the costs of consulting and outside services of $185,000, travelexpenses of $203,000, insurance costs of $37,000, and infrastructure and othercharges of $313,000.  Our selling, general and administrativeinfrastructure is reduced to two key individuals and support contractorsnecessary to sustain the Company’s corporate structure and plan its strategicdirection.

 

*Restructuring and Impairment Charges:*For the nine months ended September 30,2008, we recorded restructuring and impairment charges of $2,618,000.  See further discussion of these restructuring and impairment charges above inNote 2.

 

*Other Income (Expense).*For the nine months ended September 30,2008, other income decreased by $8,000 or 1% to $623,000 compared to $631,000for the nine months ended September 30, 2007. The decrease was the resultof $30,000 less in interest income on lower investment balances and a $22,000improvement on foreign currency translation.

 

**Liquidity and Capital Resources**

 

Inresponse to the Board of Director’s decision to suspend operations and evaluateour strategic alternatives, staff was reduced to two key individuals andsupport contractors needed to sustain the Company’s corporate structure andactivities and plan its strategic direction. We have sufficient cash andinvestments to satisfy all outstanding obligations and to initiate actionsbased on the strategic direction when determined by the Board of Directors.

 

InJanuary 2008, we purchased $2.6 million of investments comprised ofauction preferred securities (APS). All of our APS are AAA rated by one of themajor credit rating agencies.  Since mid-February 2008, we haveexperience failed auctions for our entire APS portfolio, resulting in ourinability to sell these securities. A failed auction results in a lack ofliquidity in the securities but does not signify a default by the issuer. Upon an auction failure, the interest rates on the APS do not reset at a marketrate but instead reset based on a formula contained in the APS, which generallyis higher than the current market rate. The issuer of the APS redeemed$1.85 million of the securities on May 27, 2008 and is actively putting aplan in place to redeem the remainder. Our APS were purchased through UBSFinancial Services. On August 8, 2008, UBS announced that it reached asettlement with the New York Attorney General, the Massachusetts SecuritiesDivision, the Securities and Exchange Commission and other regulatory agenciesto restore liquidity to holders of APS.  We do not currently need thesefunds to satisfy outstanding obligations or meet short-term operating requirements.

 

Weclassified our APS as available-for-sale, which resulted in the $29,000adjustment to the carrying value of our APS to mark them to fair value, whichwas recorded in other comprehensive loss. If uncertainties in the creditand capital markets continue, if the credit worthiness of the issuerdeteriorates, if UBS does not comply with the settlement provisions or if we nolonger have the ability to hold these investments, we may be required torecognize impairment charges or additional unrealized losses on our APSholdings or a loss on their disposition.

 

13

----

Table of Contents

 

***Net Cash Used inOperating Activities***

 

Netcash used in operating activities was $13,590,000 and $15,058,000 for the ninemonths ended September 30, 2008 and 2007, respectively. Net cash used foroperating activities for the nine months ended September 30, 2008 was topay for the completion of the design of our next generation of FPOA chip, payour selling, general and administrative costs, pay severance payments toemployees whose employment was terminated, fund contract termination expensesand maintain the corporate shell until completion of the strategic transaction.Net cash used for the nine months ended September 30, 2007 was to fundchip development, fund the promotion of current products and pay general andadministrative costs.

 

***Net Cash Provided(Used) by Investing Activities***

 

Netcash provided by investing activities for the nine months ended September 30,2008 was $16,082,000. Cash used in investing activities for the nine monthsended September 30, 2007 was $20,048,000. Net cash provided by investingactivities for the nine months ended September 30, 2008 was from theproceeds from the sale of investments of $16,002,000, $23,000 from the sale ofequipment, $50,000 used to purchase capital equipment and $107,000 in thedecrease of restricted cash. Net cash used in the nine months ended September 30,2007 was for the purchase of held-to-maturity securities of $19,684,000,$292,000 for the purchase of capitalized intellectual property, $69,000 for thepurchase of equipment, and $3,000 for the increase of restricted cash.

 

***Net Cash Providedby Financing Activities***

 

Therewere no financing activities for the nine months ended September 30,2008.  Net cash provided by financingactivities was $36,503,000 for the nine months ended September 30, 2007.For the nine months ended September 30, 2007, the cash provided byfinancing activities was from proceeds from the exercise of options andwarrants of $30,000 and $36,473,000 from the issuance of common stock, net ofoffering costs.

 

**Off-Balance Sheet Arrangements**

 

Wedo not have any relationships with unconsolidated entities or financialpartnerships, such as entities often referred to as structured finance orspecial purpose entities, which would have been established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes. In addition, we do not engage in trading activities involvingnon-exchange traded contracts. As such, we are not materially exposed to anyfinancing, liquidity, market or credit risk that could arise if we had engagedin these relationships.

 

**Item 3. Quantitative and Qualitative Disclosures aboutMarket Risk**

 

Ourexposure to market risk is confined to our cash equivalents and investments. Wehave invested in high-quality financial instruments, primarily money marketfunds, federal agency notes and asset-backed securities, which we believe aresubject to limited credit risks. Our investments were matched to forecastedcash needs such that investments will not be sold prior to maturity and exposeus to losses due to interest rate changes.  Included in our investmentsare APS. The APS auctions have historically provided a liquid market for thesesecurities, as investors could readily sell their investments at auction. Withthe liquidity issues experienced in global credit and capital markets, the APSheld by us have experienced failed auctions, beginning on February 19,2008, as the amount of securities submitted for sale has exceeded the amount ofpurchase orders, making the liquidity of the securities questionable. Despitethe failed auctions, our APS continue to be highly rated by the ratingagencies. We believe we will have full redemption of all APS at par. If all APSare not redeemed, it could have a negative effect on the liquidity of our fundsavailable for strategic alternatives.

 

**Item 4. Controls and Procedures**

 

*Evaluation of Disclosure Controls and Procedures*

 

Duringthe fiscal period covered by this report, our management, with theparticipation of the Chief Executive Officer and Chief Financial Officer,completed an evaluation of the effectiveness of the design and operation of ourdisclosure controls and procedures, as defined in Rules 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934 (“Exchange Act”). Basedupon this evaluation, our Chief Executive Officer and Chief Financial Officerhas concluded that, as of the end of the fiscal period covered by this report,our disclosure controls and procedures were effective to ensure thatinformation required to be disclosed by us in reports that we file or submitunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified by the rules and forms of the Securities andExchange Commission and that such information is accumulated and communicatedto management, including our Chief Executive Officer and Chief FinancialOfficer, as appropriate, to allow timely decisions regarding requireddisclosures.

 

14

----

Table of Contents

 

*Changes in Internal Control OverFinancial Reporting*

 

Becauseof the change in MathStar’s business strategy and the termination ofsubstantially all of its employees, its internal control over financialreporting for the quarter ended September 30, 2008 has been materiallyaffected. MathStar’s two contract employees and its Chief Accounting Officerenable it to maintain appropriate internal control over financialreporting.  In addition, MathStar’s ChiefExecutive Officer and Chief Financial Officer reviews and approves all of itsfinancial statements. MathStar believes there are controls in place to ensuresafeguarding of Company assets and transactions are approved, processed andrecorded properly. Management has concluded that MathStar’s two contractemployees, its Chief Accounting Officer, and its Chief Executive Officer andChief Financial Officer are able to maintain effective internal control overfinancial reporting within established guidelines of the Securities andExchange Commission (SEC).

 

**Part II**

**OtherInformation**

 

**Item 1.   Legal Proceedings**

 

Weare currently not a party to any legal proceedings.

 

**Item 1A.   Risk Factors**

 

Thereare many factors that may affect our future operating results and financialcondition. Some of these risk factors are described in the section entitled “RiskFactors” beginning on page 4 of our Annual Report on Form 10-K filedwith the SEC on March 14, 2008 (“2007 Form 10-K”), as updated in thesection entitled “Risk Factors” on page 13 of our Quarterly Report on Form 10-Qfor the quarter ended June 30, 2008 filed with the SEC on August 11,2008 (“2008 second Quarter Form 10-Q”) and in this Quarterly Report onForm 10-Q. Other information included in this Quarterly Report on Form 10-Qalso should be carefully considered. The risks and uncertainties described inour 2007 Form 10-K, our 2008 Second Quarter Form 10-Q and thisQuarterly Report are not the only risks we face. Additional risks anduncertainties not presently known to us or that our management currently deemsimmaterial also may impair our business operations and financial condition. Ifany of the risks described were to occur, our business, financial condition,operating results and cash flows could be materially adversely affected.

 

Thefollowing updates the section entitled “Risk Factors” included in our 2007 Form 10-K,as updated in our 2008 Second Quarter Form 10-Q:

 

**As of September 30, 2008, we had $828,000invested in auction preferred securities (APS).  Since mid-February 2008,the auctions for these APS have been failing, which adversely affects theirliquidity.  If we must record impairment charges on the recorded value ofthese APS, recognize additional unrealized losses, or recognize a loss on thedisposition of our APS, our financial condition would be adversely affected.**

 

InJanuary 2008, we purchased $2.68 million of investments comprised ofAPS.  All of our APS are AAA rated by one of the major credit ratingagencies.  Since mid-February 2008, we have experienced failedauctions for our entire APS portfolio, resulting in our inability to sell thesesecurities.  A failed auction results in a lack of liquidity in thesecurities but does not signify a default by the issuer.  Upon an auctionfailure, the interest rates on the APS do not reset at a market rate butinstead reset based on a formula contained in the APS, which generally ishigher than the current market rate.  The issuer of the APS redeemed $1.85million of the securities on May 27, 2008 at face value and is activelyputting a plan in place to redeem the remainder.  Our APS were purchasedthrough UBS Financial Services. On August 8, 2008, UBS announced that itreached a settlement with the New York Attorney General, the MassachusettsSecurities Division, the SEC and other regulatory agencies to restore liquidityto holders of APS. We do not need these funds to satisfy outstandingobligations or meet short-term operating requirements.

 

15

----

Table of Contents

 

Weclassified our APS as available-for-sale, which resulted in a $29,000adjustment to the carrying value of our APS to mark them to fair value, whichwas recorded in other comprehensive loss.  If uncertainties in the creditand capital markets continue, if the credit worthiness of the issuerdeteriorates, UBS does not restore liquidity, or if we no longer have theability to hold these investments, we may be required to recognize impairmentcharges or additional unrealized losses on our APS or a loss on theirdisposition.

 

**We are currently considering various strategicalternatives and may not be able to complete the one we decide to pursue, whosefailure could result in increased expenses and/or a delay in finally completingthe selected strategy, or pursuing and completing another alternative.**

 

OnMay 20, 2008, the Board of Directors voted to curtail research anddevelopment activities and ongoing operations while analyzing alternatives toprotect the value to the stockholders. Alternatives could include merger,acquisition, increasing operations in another structure or liquidation. We mayselect a strategic alternative that we may not be able to complete for variousreasons, including a decision of our principal stockholders not to approve suchalternative, our inability to obtain regulatory approval, actions, includingbut not limited to, the inability of other companies to secure adequatefinancing or possible litigation involving the selected alternative or other matters.The inability to complete a selected alternative may adversely affect us orlimit other strategic alternatives still available to us, including adverselyaffecting our financial results, or deterring other companies from enteringinto a merger or acquisition with us.

 

**Item 2. Unregistered Sales of Equity Securities andUse of Proceeds**

 

None.

 

**Item 3.   Defaults Upon SeniorSecurities**

 

None.

 

**Item 4.   Submission of Matters to aVote of Security Holders**

 

None

 

**Item 5.   Other Information**

 

OnOctober 15, 2008, the Company received a letter from The NASDAQ StockMarket (“Nasdaq”) which stated that based on Nasdaq staff’s review of MathStar,and pursuant to Marketplace Rule 4300, Nasdaq staff believes that MathStaris a “public shell” and as such no longer meets Nasdaq’s listingrequirements.  Accordingly, Nasdaqindicated in the letter that trading of MathStar’s common stock on The NasdaqGlobal Market would be suspended at the opening of business on October 23,2008 unless MathStar requested an appeal of the determination on or before October 21,2008, which request would stay the suspension of MathStar’s common stock.  MathStar does not intend to request an appealof Nasdaq’s decision to delist its securities under Marketplace Rule 4300.  On November 4, 2008, the Companyreceived notice from Nasdaq that Nasdaq intends to file a Form 25 with theSecurities and Exchange Commission, which filing will remove the Company’scommon stock from listing and registration on The Nasdaq Global Market. The delisting will become effective ten days after the filing of the Form 25.  Asa result of delisting, MathStar’s common stock will no longer be eligible forquotation on Nasdaq, thereby reducing the liquidity of its common stock;however, MathStar’s common stock may be eligible for quotation on the PinkSheets by broker-dealers or for quotation on the OTC Bulletin Board. At thistime, MathStar’s common stock is quoted on the Pink Sheets. While MathStar’scommon stock is currently eligible for quotation on the Pink Sheets bybroker-dealers, MathStar cannot provide assurances that any broker willcontinue to make a market in MathStar’s common stock.

 

**Item 6.   Exhibits**

 

Theexhibits are described on the Exhibit Index to this Quarterly Report on Form 10-Q.

 

16

----

Table of Contents

 

**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                         | MathStar, Inc. |
|------------------------------|---------------------|
|                         | (Registrant)        |
|                         |                |
|                         |                |
| Date:  November 7, 2008 | By:                 | /s/  Douglas M. Pihl |
|                         |                | Douglas  M. Pihl |
|                         |                | Chief  Executive Officer and Chief  Financial Officer |

 

17

----

Table of Contents

 

**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                           |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **           | ** ** | ** **                                                                                                                                                                                                                                                                                                                                     |
| 3.1                  |       | Certificate  of Incorporation of MathStar, Inc. (incorporated by reference to  Exhibit 3.1 to the Registration Statement on Form S-1 filed by  MathStar, Inc. with the Securities and Exchange Commission (“SEC”) on  August 3, 2005 (File No. 333-127164) (the “Registration  Statement”)). |
|                 |       |                                                                                                                                                                                                                                                                                                                                           |
| 3.2                  |       | By-laws  of MathStar, Inc. (incorporated by reference to Exhibit 3.2 to the  Registration Statement).                                                                                                                                                                                                                                |
|                 |       |                                                                                                                                                                                                                                                                                                                                           |
| 4.1                  |       | Form of  common stock certificate of MathStar, Inc. (incorporated by reference to  Exhibit 4.1 to the Registration Statement).                                                                                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                                                           |
| 31.1                 |       | Certification  of Chief Executive Officer pursuant to  Rules 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934  (filed herewith electronically).                                                                                                                                                                         |
|                 |       |                                                                                                                                                                                                                                                                                                                                           |
| 31.2                 |       | Certification  of Chief Financial Officer pursuant to  Rules 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934  (filed herewith electronically).                                                                                                                                                                         |
|                 |       |                                                                                                                                                                                                                                                                                                                                           |
| 32.1                 |       | Section 1350  Certification of Chief Executive Officer (filed herewith electronically).                                                                                                                                                                                                                                                   |
|                 |       |                                                                                                                                                                                                                                                                                                                                           |
| 32.2                 |       | Section 1350  Certification of Chief Financial Officer (filed herewith electronically).                                                                                                                                                                                                                                                   |

 

18

----