**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM10-Q**
| **(Mark One)**                                                                                                                                                                                                                                         |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                                                             |
| **x**                                                                                                                                                                                                                                                  | ** ** | **Quarterly report pursuant to Section 13 or 15(d)  of the Securities Exchange Act of 1934** |
| ** **                                                                                                                                                                                                                                             | ** ** | ** ** |
| **For the  quarterly period ended June 30, 2006.**                                                                                                                                                                                                     |
| ** **                                                                                                                                                                                                                                             | ** ** | ** ** |
| **OR**                                                                                                                                                                                                                                                 |
| ** **                                                                                                                                                                                                                                             | ** ** | ** ** |
| **o**                                                                                                                                                                                                                                                  | ** ** | **Transition report pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934** |
| ** **                                                                                                                                                                                                                                             | ** ** | ** ** |
| **For the  transition period from                     to                  ** |

 

**Commissionfile number 000-51560**

**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) has filed 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)has been subject to such filing requirements for the past 90 days.  x  Yes   o  No

Indicate by check mark whether the registrant isa large accelerated filer, an accelerated filer, or a non-acceleratedfiler.  See definition of “accelerated filer” and “large accelerated filer”in Rule 12b-2 of the Exchange Act.  (Check one.) 

| Large Accelerated Filer  o |   | Accelerated  Filer  o |   | Non-Accelerated  Filer  x |
|--------------------------------------|--------|---------------------------------|--------|-------------------------------------|

 

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

Shares outstanding ofthe Registrant’s common stock:

| **Class**                      |   | **Outstanding at August 4, 2006** |
|--------------------------------|--------|-------------------------------------------------------|
| Common stock,  $0.01 par value |   | 17,527,649                                            |

 

 

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| PART I  FINANCIAL INFORMATION |   |
|------------------------------------|--------|
|                               |   |
|                               |   | Item 1. |   | Financial Statements (Unaudited) |   |
|                               |   |   |   |   |   |
|                               |   |   |   | Condensed Balance  Sheets as of December 31, 2005 and June 30, 2006 |   |
|                               |   |   |   |   |   |
|                               |   |   |   | Condensed  Statements of Operations for the Three and Six Months Ended June 30,  2005 and June 30, 2006 and Cumulative for the period from Inception  (April 14, 1997) through June 30, 2006 |   |
|                               |   |   |   |   |   |
|                               |   |   |   | Condensed  Statements of Cash Flows for the Six Months Ended June 30, 2005 and June 30,  2006 and Cumulative for the period from Inception (April 14, 1997) through  June 30, 2006 |   |
|                               |   |   |   |   |   |
|                               |   |   |   | Notes to Condensed  Consolidated Financial Statements |   |
|                               |   |   |   |   |   |
|                               |   | Item 2. |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|                               |   |   |   |   |   |
|                               |   | Item 3. |   | Quantitative  and Qualitative Disclosures about Market Risk |   |
|                               |   |   |   |   |   |
|                               |   | Item 4. |   | Controls and  Procedures |   |
|                               |   |   |   |   |   |
| PART II  OTHER  INFORMATION   |   |
|                               |   |
|                               |   | Item 1. |   | Legal Proceedings |   |
|                               |   |   |   |   |   |
|                               |   | Item  1A. |   | Risk  Factors |   |
|                               |   |   |   |   |   |
|                               |   | Item 2. |   | Unregistered  Sales of Equity Securities and Use of Proceeds |   |
|                               |   |   |   |   |   |
|                               |   | Item 3. |   | Defaults  Upon Senior Securities |   |
|                               |   |   |   |   |   |
|                               |   | Item 4. |   | Submission  of Matters to a Vote of Security Holders |   |
|                               |   |   |   |   |   |
|                               |   | Item 5. |   | Other Information |   |
|                               |   |   |   |   |   |
|                               |   | Item  6. |   | Exhibits |   |
|                               |   |   |   |   |   |
| SIGNATURES                         |   |

 

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**MathStar, Inc.**

**(Adevelopment stage company)**

**CondensedBalance Sheets**

**(Unaudited)**
| ** **                                                                                                                                                            | ** ** | **December 31,**          | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2005**                       | ** ** | **2006**          | ** ** |
| ** **                                                                                                                                                            | ** ** | **(in thousands,**        | ** ** |
| ** **                                                                                                                                                            | ** ** | **except per share** | ** ** |
| ** **                                                                                                                                                            | ** ** | **amounts)**                   | ** ** |
| **Assets**                                                                                                                                                            |       |                           |       |              |       |
| Current assets                                                                                                                                                        |       |                           |       |              |       |
| Cash  and cash equivalents                                                                                                                                            |       | $                              | 20,149     |              | $          | 11,778 |   |
| Accounts  receivable                                                                                                                                                  |       | 75                             |       | 10                |       |
| Prepaid  expenses and other current assets                                                                                                                            |       | 1,480                          |       | 1,332             |       |
| Total  current assets                                                                                                                                                 |       | 21,704                         |       | 13,120            |       |
| Property and equipment,  net                                                                                                                                          |       | 347                            |       | 496               |       |
| Other assets                                                                                                                                                          |       | 151                            |       | 81                |       |
| Total  assets                                                                                                                                                         |       | $                              | 22,202     |              | $          | 13,697 |   |
|                                                                                                                                                                  |       |                           |       |              |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                        |       |                           |       |              |       |
| Current liabilities                                                                                                                                                   |       |                           |       |              |       |
| Accounts  payable                                                                                                                                                     |       | $                              | 734        |              | $          | 773 |   |
| Accrued  expenses                                                                                                                                                     |       | 1,294                          |       | 1,043             |       |
| Total  liabilities                                                                                                                                                    |       | 2,028                          |       | 1,816             |       |
| Commitments and  contingencies                                                                                                                                        |       |                           |       |              |       |
| Stockholders’ equity                                                                                                                                             |       |                           |       |              |       |
| Preferred  stock, $0.01 par value; 10,000 shares authorized; no shares issued and  outstanding                                                                        |       | —                         |       | —            |       |
| Common  stock, $0.01 par value; 90,000 shares authorized; 17,415 and 17,670 shares  issued and outstanding at December 31, 2005 and June 30, 2006,  respectively |       | 175                            |       | 178               |       |
| Additional  paid-in capital                                                                                                                                           |       | 105,717                        |       | 105,412           |       |
| Unearned  compensation                                                                                                                                                |       | (2,224                         | )          | —            |       |
| Deficit  accumulated during the development stage                                                                                                                     |       | (83,494                        | )          | (93,709           | )          |
| Total  stockholders’ equity                                                                                                                                      |       | 20,174                         |       | 11,881            |       |
| Total  liabilities and stockholders’ equity                                                                                                                      |       | $                              | 22,202     |              | $          | 13,697 |   |

 

Theaccompanying notes are an integral part of these financial statements.

1

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**MathStar, Inc.**

**(Adevelopment stage company)**

**CondensedStatements of Operations**

**(Unaudited)**
| ** **                                             | ** ** | ** **                                                            | ** ** | ** **                                    | ** ** | ** **                                             | ** ** | ** ** | ** ** | **Cumulative**               | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------------------------------|------------|------------|------------|------------------------------|------------|
| ** **                                             | ** ** | ** **                                                            | ** ** | ** **                                    | ** ** | ** **                                             | ** ** | ** ** | ** ** | **for the Period** | ** ** |
| ** **                                             | ** ** | ** **                                                            | ** ** | ** **                                    | ** ** | ** **                                             | ** ** | ** ** | ** ** | **from Inception**      | ** ** |
| ** **                                             | ** ** | **Three Months Ended  June 30,**                            | ** ** | **Six Months Ended  June 30,** | ** ** | **(April 14, 1997)  Through  June 30,** | ** ** |
| ** **                                             | ** ** | **2005**                                                              | ** ** | **2006**                                      | ** ** | **2005**                                               | ** ** | **2006**   | ** ** | **2006**                     | ** ** |
| ** **                                             | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Revenue                                                |       | $                                                                     | 25         |                                          | $          | 10                                                     |       | $          | 40         |                         | $          | 18 |   | $ | 898 |   |
| Cost of goods sold                                     |       | 8                                                                     |       | 5                                             |       | 15                                                     |       | 6          |       | 112                          |       |
| Gross margin                                           |       | 17                                                                    |       | 5                                             |       | 25                                                     |       | 12         |       | 786                          |       |
| Operating expenses:                                    |       |                                                                  |       |                                          |       |                                                   |       |       |       |                         |       |
| Research and development                               |       | 1,884                                                                 |       | 3,200                                         |       | 4,333                                                  |       | 6,026      |       | 36,020                       |       |
| Selling, general and administrative                    |       | 1,557                                                                 |       | 2,348                                         |       | 2,703                                                  |       | 4,551      |       | 23,797                       |       |
|                                                   |       | 3,441                                                                 |       | 5,548                                         |       | 7,036                                                  |       | 10,577     |       | 59,817                       |       |
| Operating loss                                         |       | (3,424                                                                | )          | (5,543                                        | )          | (7,011                                                 | )          | (10,565    | )          | (59,031                      | )          |
| Interest income                                        |       | —                                                                |       | 160                                           |       | 7                                                      |       | 350        |       | 1,770                        |       |
| Interest expense                                       |       | (476                                                                  | )          | —                                        |       | (476                                                   | )          | —     |       | (4,591                       | )          |
| Other income, net                                      |       | —                                                                |       | —                                        |       | —                                                 |       | —     |       | 17                           |       |
| Net loss from continuing operations                    |       | (3,900                                                                | )          | (5,383                                        | )          | (7,480                                                 | )          | (10,215    | )          | (61,835                      | )          |
| Loss from discontinued operations                      |       | —                                                                |       | —                                        |       | —                                                 |       | —     |       | (31,874                      | )          |
| Net loss                                               |       | $                                                                     | (3,900     | )                                             | $          | (5,383                                                 | )          | $          | (7,480     | )                            | $          | (10,215 | ) | $ | (93,709 | ) |
|                                                   |       |                                                                  |       |                                          |       |                                                   |       |       |       |                         |       |
| Basic and diluted net loss per share                   |       | $                                                                     | (0.35      | )                                             | $          | (0.31                                                  | )          | $          | (0.67      | )                            | $          | (0.60 | ) | — |   |
| Weighted average basic and diluted shares  outstanding |       | 11,192                                                                |       | 17,104                                        |       | 11,173                                                 |       | 17,037     |       | —                       |       |

 

Theaccompanying notes are an integral part of these financial statements.

2

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**MathStar, Inc.**

**(Adevelopment stage company)**

**CondensedStatements of Cash Flows**

**(Unaudited)**
| ** **                                                                                                          | ** ** | ** **                     | ** ** | **Cumulative**                 | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                          | ** ** | ** **                     | ** ** | **for the Period**   | ** ** |
| ** **                                                                                                          | ** ** | ** **                     | ** ** | **from Inception**        | ** ** |
| ** **                                                                                                          | ** ** | ** **                     | ** ** | **(April 14, 1997)** | ** ** |
| ** **                                                                                                          | ** ** | **Six Months Ended** | ** ** | **Through**                    | ** ** |
| ** **                                                                                                          | ** ** | **June 30,**              | ** ** | **June 30,**              | ** ** |
| ** **                                                                                                          | ** ** | **2005**                       | ** ** | **2006**                       | ** ** | **2006** | ** ** |
| ** **                                                                                                          | ** ** | **(in thousands)**        | ** ** |
| **Cash flows from operating activities**                                                                            |       |                           |       |                           |       |   |   |
| Net loss                                                                                                            |       | $                              | (7,480     | )                              | $          | (10,215 | ) | $ | (93,709 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities                                         |       |                           |       |                           |       |   |   |
| Depreciation                                                                                                        |       | 36                             |       | 61                             |       | 1,594 |   |
| Amortization of convertible notes discount -  beneficial conversion feature and value of warrants issued with notes |       | 368                            |       |                           |       | 3,628 |   |
| Amortization of discount on held-to-maturity securities                                                             |       |                           |       |                           |       | (233 | ) |
| Acquired in-process research and development                                                                        |       |                           |       |                           |       | 4,300 |   |
| Interest expense settled with common stock                                                                          |       |                           |       |                           |       | 230 |   |
| Stock-based compensation                                                                                            |       | 365                            |       | 1,477                          |       | 3,717 |   |
| Goodwill impairment                                                                                                 |       |                           |       |                           |       | 13,306 |   |
| Change in operating assets and liabilities, net of  effects of acquisition                                     |       |                           |       |                           |       |   |   |
| Accounts receivable                                                                                                 |       | (21                            | )          | 65                             |       | 135 |   |
| Prepaid expenses and other assets                                                                                   |       | (578                           | )          | 218                            |       | (773 | ) |
| Accounts payable                                                                                                    |       | 300                            |       | 39                             |       | 320 |   |
| Accrued expenses                                                                                                    |       | 276                            |       | (251                           | )          | 815 |   |
| Net cash used in operating activities                                                                               |       | (6,734                         | )          | (8,606                         | )          | (66,670 | ) |
| **Cash flows from investing activities**                                                                            |       |                           |       |                           |       |   |   |
| Cash used in acquisition, net of cash acquired                                                                      |       |                           |       |                           |       | (791 | ) |
| Purchase of property and equipment                                                                                  |       |                           |       | (209                           | )          | (1,929 | ) |
| Proceeds from sale of discontinued operations                                                                       |       |                           |       |                           |       | 1,752 |   |
| Purchases of held-to-maturity securities                                                                            |       |                           |       |                           |       | (10,000 | ) |
| Sales of held-to-maturity securities                                                                                |       |                           |       |                           |       | 10,233 |   |
| Net cash used in investing activities                                                                               |       |                           |       | (209                           | )          | (735 | ) |
| **Cash flows from financing activities**                                                                            |       |                           |       |                           |       |   |   |
| Proceeds from issuance of common stock, net of  offering costs                                                      |       |                           |       |                           |       | 66,047 |   |
| Proceeds from issuance of convertible notes                                                                         |       | 5,500                          |       |                           |       | 5,500 |   |
| Payments on convertible notes                                                                                       |       |                           |       |                           |       | (300 | ) |
| Proceeds from issuance of warrants to purchase  common stock, net of offering costs                                 |       |                           |       |                           |       | 5,304 |   |
| Proceeds from exercise of warrants                                                                                  |       | 176                            |       | 417                            |       | 3,325 |   |
| Collection of subscription receivable                                                                               |       |                           |       |                           |       | 27 |   |
| Proceeds from exercise of stock options                                                                             |       |                           |       | 27                             |       | 28 |   |
| Principal payments on notes receivable from  stockholders                                                           |       |                           |       |                           |       | 245 |   |
| Principal payments on notes payable to stockholders                                                                 |       |                           |       |                           |       | (250 | ) |
| Repurchase of common stock                                                                                          |       |                           |       |                           |       | (257 | ) |
| Payments on capital lease obligations                                                                               |       |                           |       |                           |       | (486 | ) |
| Net cash provided by financing activities                                                                           |       | 5,676                          |       | 444                            |       | 79,183 |   |
| Net (decrease) increase in cash and cash equivalents                                                                |       | (1,058                         | )          | (8,371                         | )          | 11,778 |   |
| **Cash and cash equivalents**                                                                                       |       |                           |       |                           |       |   |   |
| Beginning of period                                                                                                 |       | 4,132                          |       | 20,149                         |       | — |   |
| End of period                                                                                                       |       | $                              | 3,074      |                           | $          | 11,778 |   | $ | 11,778 |   |
|                                                                                                                |       |                           |       |                           |       |   |   |
| **Cash paid during period for interest**                                                                            |       | $                              | —     |                           | $          | — |   | $ | 26 |   |
| **Significant noncash transactions**                                                                                |       |                           |       |                           |       |   |   |
| Common stock, options and warrants issued in  connection with Digital MediaCom, Inc. acquisition                    |       | $                              | —     |                           | $          | — |   | $ | 18,384 |   |
| Exercise of warrants for subscriptions receivable                                                                   |       | $                              | —     |                           | $          | — |   | $ | 27 |   |
| Capital lease obligation incurred for acquisition of  fixed assets                                                  |       | $                              | —     |                           | $          | — |   | $ | 426 |   |
| Repurchase of common stock with notes payable                                                                       |       | $                              | —     |                           | $          | — |   | $ | 250 |   |
| Prepaid licenses included in accrued expenses                                                                       |       | $                              | —     |                           | $          | (51 | ) | $ | 318 |   |
| Conversion of notes payable and $230 of accrued  interest into common stock                                         |       | $                              | —     |                           | $          | — |   | $ | 5,430 |   |

 

Theaccompanying notes are an integral part of these financial statements.

3

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**MathStar, Inc.**

**(Adevelopment stage company)**

**Notesto Financial Statements**

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

**1.****            ****Basis of Presentation and Going Concern**

The accompanying interimcondensed financial statements of MathStar, Inc. (“MathStar” or the “Company”)have been prepared in conformity with United States (U.S.) generally acceptedaccounting principles, 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 31, 2006. The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and the disclosureof contingent assets and liabilities at the date of the financial statementsand the reported amounts of revenues and expenses during the reporting period.Actual results could differ from those estimates.

The interim financialinformation is unaudited, but it reflects all normal adjustments that are, inthe opinion of management, necessary to provide a fair statement of results forthe interim periods presented. The interim financial results are notnecessarily indicative of results to be expected in future interim or annualperiods. The interim financial statements should be read in conjunction withthe financial statements in the Company’s Annual Report on Form 10-K filed withthe Securities and Exchange Commission on March 31, 2006.

The Company wasincorporated as a Minnesota corporation in April 1997 and reincorporatedunder Delaware law in June 2005. Since its inception, the Company has devotedsubstantially all of its efforts to business planning, research anddevelopment, recruitment of management and technical staff, acquiring operatingassets and raising capital. The Company has generated only nominal revenuesfrom the sale of development kits that support customer development ofapplications for one of the Company’s products, the sale of product prototypesand contractual research and development services. Accordingly, the Company isconsidered to be in the development stage as defined by Statement of FinancialAccounting Standards (“SFAS”) No. 7, *Accountingand Reporting by Development Stage Enterprises*.

The accompanyingfinancial statements have been prepared on a basis which assumes that theCompany will continue as a going concern and which contemplates the realizationof assets and the satisfaction of liabilities and commitments in the normalcourse of business. The Company has a limited operating history and hasincurred losses and negative cash flows from operations since inception. TheCompany expects to incur additional losses at least through 2006. We believeour cash on hand, combined with out existing capital resources, is sufficientto meet our capital and operating needs through 2006.  However, the Company expects to incuradditional losses past 2006 and will require additional funding to continue itsoperations.  Management intends to seekadditional equity financing during 2006. However, there can be no assurancethat such additional funding will be available on terms acceptable to theCompany or at all. These circumstances raise substantial doubt about the Company’sability to continue as a going concern.

In November 2005, theCompany closed on its initial public offering of 4,000 shares of its commonstock at $6.00 per share and, in December 2005, the Company closed on theunderwriter’s overallotment option of 600 shares of the Company’s common stockat $6.00 per share, resulting in net proceeds to the Company of approximately$24,633.

Certain prior yearamounts have been reclassified to conform to the current year presentation.These changes had no impact on previously reported results of operations orshareholders’ equity.

4

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**2.****            ****New Accounting Pronouncements**

In December 2004,the FASB issued SFAS No. 123 (R), *Share-BasedPayment*. SFAS No. 123(R) revised SFAS No. 123 andsuperseded Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees* (“APBOpinion No. 25”). The revised statement addresses the accounting forshare-based payment transactions with employees and other third parties,eliminates the ability to account for share-based payments using APB OpinionNo. 25 and requires that the compensation costs relating to suchtransactions be recognized in the statement of operations based upon thegrant-date fair value of those instruments. The Company adopted SFASNo. 123(R) on January 1, 2006.

In July 2006, the FASBissued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN48”) - an interpretation of SFAS No. 109, *Accountingfor Income Taxes*. FIN 48 clarifies the accounting for uncertainty inincome taxes recognized in accordance with SFAS No. 109 and prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina return. Guidance is also provided on de-recognition, classification, interestand penalties, accounting in interim periods, disclosure and transition. FIN 48is effective for fiscal years beginning after December 15, 2006.  The Company is currently evaluating the impactof adopting FIN 48 on its consolidated financial position and results ofoperations.

**3.****            ****Stock-Based Compensation**

In January 2002,the Company and its stockholders adopted the 2002 Combined Incentive andNonstatutory Stock Option Plan (the “2002 Plan”). In April 2000, theCompany and its stockholders adopted the 2000 Combined Incentive andNonstatutory Stock Option Plan (the “2000 Plan”). Under the 2002 Plan and the2000 Plan, 1,000 and 333 shares of the Company’s common stock were reserved forissuance of incentive and nonqualified stock options to directors, officers andemployees of and advisers to the Company at exercise prices as determined bythe Board of Directors on the date of grant. These options have exercise pricesand vesting terms established by a committee of the Board of Directors at thetime of each grant. Vesting terms of outstanding options are generally fouryears. In no event are the options exercisable more than ten years after thedate of grant.  The 2000 Plan and the2002 Plan were terminated in May 2006 with the exception of options outstandingunder those plans.

In October 2004,the Company adopted and in June 2005 its stockholders approved the 2004Amended and Restated Long-Term Incentive Plan (the “2004 Plan”). In May 2006,the Company and its stockholders amended the 2004 Plan to increase the numberof shares available under the plan by 300. Under the 2004 Plan, 1,634 shares of the Company’s common stock werereserved for the issuance of restricted stock, incentive and nonqualified stockoptions and other stock based awards to directors, officers and employees ofand advisors to the Company at exercise prices as determined by a committee ofthe Board of Directors on the dates of grants.

**Stock Options – SFAS No. 123(R)**

The Company adopted SFASNo. 123(R) on January 1, 2006. The Company had historically followed the “minimumvalue” method permitted by SFAS No. 123. The Company elected to use themodified prospective method which requires the Company to record compensationexpense only for options issued after adoption of SFAS No. 123(R). As aresult of choosing the modified prospective method of adoption, there are nocumulative effects on the Company’s previously reported income from continuingoperations, income before income taxes, net income, cash flow from operations,cash flow from financing activities or basic and diluted earnings per share.The impact of adopting SFAS 123 (R) on the results of operations for the threeand six months ended June 30, 2006 was to record additional expenses of $50 and$81, respectively. Of these amounts, $24 and $32 was charged to research anddevelopment and $26 and $49 was charged to selling, general and administrativeexpense for the three and six months ended June 30, 2006, respectively.  This had an immaterial effect on net loss pershare for the three and six months ended June 30, 2006. Including the chargesfor restricted stock and cheap stock, the total stock compensation expense forthe three and six months ended June 30, 2006 was $749 and $1,477, respectively.

5

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The Company has chosento use the Black-Scholes option-pricing model to determine the fair value ofoptions. The Black-Scholes model variables are stock price volatility, averageoption life, risk free interest rate and dividend rate. The Company hasdeveloped an index based on six comparable companies within the semiconductorindustry to use as a volatility index due to the short period of time it hasbeen public. Average option life has been calculated using the “safe harbor”method prescribed in SEC Staff Accounting Bulletin 107. The Company anticipatesusing this average life through 2007 or until it has enough history tocalculate a meaningful life. The Company uses the treasury bill ratecorresponding with the average life. The dividend rate used is zero, as the Companydoes not in the near future have any plans to pay dividends. SFAS No. 123(R) requires the Company to estimate forfeitures in calculating the expenserelating to stock-based compensation as opposed to recognizing theseforfeitures and the corresponding reduction in expense as they occur.

The following tablesummarizes the weighted average assumptions used by the Company in theBlack-Scholes option-pricing model:
|                             | ** ** | **Three Months Ended  June 30, 2006** | ** ** | **Six Months Ended  June 30, 2006** | ** ** |
|-----------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
|                        |       |                                                      |       |                                                    |       |
| Expected option term        |       | 6.25                                                      | Years      | 6.25                                                    | Years      |
|                        |       |                                                      |       |                                                    |       |
| Expected volatility  factor |       | 73.3                                                      | %          | 73.3                                                    | %          |
|                        |       |                                                      |       |                                                    |       |
| Expected dividend yield     |       | 0                                                         | %          | 0                                                       | %          |
|                        |       |                                                      |       |                                                    |       |
| Risk free interest rate     |       | 5.03                                                      | %          | 4.57                                                    | %          |

 

The following table is asummary of option activity under the Company’s stock option plans as of June30, 2006 and changes during the six months then ended:
| **Options**                      | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|----------------------------------|------------|------------|------------|-----------------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at December 31, 2005 |       | 2,037      |       | $                                       | 5.49       |                                                 | 8.03       |                            |       |   |
|                             |       |       |       |                                    |       |                                                 |       |                            |       |
| Granted                          |       | 268        |       | 5.33                                    |       | 9.85                                                 |       |                            |       |
|                             |       |       |       |                                    |       |                                                 |       |                            |       |
| Exercised                        |       |       |       |                                    |       |                                                 |       |                            |       |
| Forfeited or expired             |       | (150       | )          | 7.84                                    |       | 7.73                                                 |       |                            |       |
| Outstanding at March 31, 2006    |       | 2,155      |       | $                                       | 5.30       |                                                 | 8.05       |                            | $          | 982 |   |
| Granted                          |       | 44         |       | 4.91                                    |       | 9.86                                                 |       |                            |       |
| Exercised                        |       | (31        | )          | 0.86                                    |       | 6.46                                                 |       |                            |       |
| Forfeited or expired             |       | (32        | )          | 5.69                                    |       | 7.75                                                 |       |                            |       |
| Outstanding at June 30, 2006     |       | 2,136      |       | $                                       | 5.35       |                                                 | 7.87       |                            | $          | 1,781 |   |
|                             |       |       |       |                                    |       |                                                 |       |                            |       |
| Exercisable at June 30, 2006     |       | 805        |       | $                                       | 5.12       |                                                 | 5.90       |                            | $          | 1,044 |   |

 

The weighted-averagegrant-date fair value of options granted during the three and six months endedJune 30, 2006 was $3.41 and $3.63, respectively. The total intrinsic value ofoptions exercised during the three and six months ended June 30, 2006 was $0and $132 respectively.

The following table isthe status of the Company’s unvested shares as of June 30, 2006 and changesduring the six months then ended:

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| Unvested Options         | ** ** | **Shares** | ** ** | **Weighted Average  Grant Dated Fair  Value** | ** ** |
|-------------------------------|------------|------------|------------|--------------------------------------------------------------|------------|
| Unvested at December 31, 2005 |       | 1,321      |       | $                                                            | 1.69       |   |
| Granted                       |       | 268        |       | 3.67                                                         |       |
| Vested                        |       | (96        | )          | 0.85                                                         |       |
| Forfeited                     |       | (61        | )          | 0.36                                                         |       |
| Unvested at March 31, 2006    |       | 1,432      |       | $                                                            | 2.24       |   |
| Granted                       |       | 44         |       | 3.41                                                         |       |
| Vested                        |       | (128       | )          | 1.63                                                         |       |
| Forfeited                     |       | (18        | )          | 2.77                                                         |       |
| Unvested at June 30, 2006     |       | 1,330      |       | $                                                            | 2.18       |   |

 

As of June 30, 2006,there was $1,833 of total unrecognized compensation cost related to unvestedshare-based compensation arrangements granted, including restricted stock,under the Company’s stock option plans. That cost is expected to be recognizedover a weighted-average period of 1.63years. The total fair value of shares vested during the three and six monthsended June 30, 2006 was $208 and $290, respectively.

**Stock Options – SFAS No. 123**

The following tablepresents the pro forma effect on net loss, for prior periods, if the Companyhad applied the fair value recognition provisions for SFAS No. 123(minimum value method) to stock-based employee compensation for options issuedprior to January 1, 2006:
|                                                                                                                           | ** ** | **Six Months Ended  June 30, 2005** | ** ** | **Cumulative  for the Period  from Inception  (April 14, 1997)  Through  June 30, 2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|------------|
| Net loss as reported                                                                                                      |       | $                                                       | (7,480     | )                                                                                                                           | $          | (93,709 | ) |
| Add: Total stock-based employee compensation expense  included in net loss, as reported                                   |       | 177                                                     |       | 1,687                                                                                                                       |       |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all employee awards |       | (357                                                    | )          | (2,909                                                                                                                      | )          |
|                                                                                                                      |       |                                                    |       |                                                                                                                        |       |
| Pro forma net loss                                                                                                        |       | $                                                       | (7,660     | )                                                                                                                           | $          | (94,931 | ) |
|                                                                                                                      |       |                                                    |       |                                                                                                                        |       |
| Basic and diluted loss per share:                                                                                         |       |                                                    |       |                                                                                                                        |       |
| As reported                                                                                                               |       | $                                                       | (0.67      | )                                                                                                                           |       |   |
| Pro forma                                                                                                                 |       | $                                                       | (0.69      | )                                                                                                                           |       |   |

 

For the purpose ofdetermining fair values using the minimum value method for employee grants asprescribed by SFAS No. 123, the Company used the Black-Scholesoption-pricing model with the following weighted average assumptions:
|                            | ** ** | **Six Months  Ended  June 30, 2005** | ** ** |
|----------------------------|------------|-----------------------------------------------------|------------|
|                       |       |                                                |       |
| Expected option term       |       | 5                                                   | Years      |
| Expected volatility factor |       | 0                                                   | %          |
| Expected dividend yield    |       | 0                                                   | %          |
| Risk free interest rate    |       | 4.46                                                | %          |

 

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# **Restricted Stock**

As of December 31, 2005,the Company had outstanding 445 shares of restricted stock to certain employeesof the Company under its Amended and Restated 2004 Long-Term Incentive Plan.The restricted stock terms provided for vesting upon either a “change ofcontrol “(as defined by the restricted stock agreement) of the Company or aninitial public offering of the Company’s common stock. However, the restrictedstock terms also provide that the Company has the power to delay the vesting ofthe restricted stock up to one year after a change in control or an initialpublic offering of the Company’s common stock. Under these provisions, duringthe three months ended June 30, 2005, the Company’s Board of Directors electedto delay vesting of all shares of restricted stock until one year after theeffective date of the Company’s registration statement (which occurred onOctober 26, 2005). In accordance with APB 25, the Company is recordingcompensation expense of up to $2,741 related to these restricted shares over aone-year vesting period of these shares, beginning on the November 1,2005 closing date of the Company’s initial public offering.

During the three monthsended March 31, 2006, the Company granted 60 shares of restricted stock thatvest 50% in one year from the date of grant and 50% two years from the date ofgrant. In accordance with SFAS No.123 (R), the Company is recording compensationexpense of up to $342 related to these restricted shares over the vestingperiod of these shares. There were no restricted stock grants during the threemonths ended June 30, 2006. During the three and six months ended June 30,2006, 10 and 40 restricted shares were forfeited, respectively.

The Company recognizedcompensation expense of $0 and $0 for the three and six months ended June 30,2005, respectively, $633 and $1,265 for the three and six months ended June 30,2006, respectively, and $1,712 cumulative for the period from inception (April14, 1997) to June 30, 2006. The Company will recognize approximately $885 ofcompensation expense related to outstanding restricted shares at June 30, 2006during the remainder of 2006, $171 during 2007 and $4 during 2008.

The following table isthe status of the Company’s unvested shares of restricted stock as of June 30,2006 and changes during the six months then ended:
| Unvested Shares           | ** ** | **Shares** | ** ** |
|--------------------------------|------------|------------|------------|
| Unvested at  December 31, 2005 |       | 445        |       |
| Granted                        |       | 60         |       |
| Vested                         |       | —     |       |
| Forfeited                      |       | (30        | )          |
| Unvested at  March 31, 2006    |       | 475        |       |
| Granted                        |       | —     |       |
| Vested                         |       | —     |       |
| Forfeited                      |       | (10        | )          |
| Unvested at June 30,  2006     |       | 465        |       |

 

The fair value ofrestricted stock granted in the three months ended March 31, 2006 was $342.

**4.****            ****Selected Balance Sheet Information**

The following presentsprepaid expenses and other current assets:
|                       | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-----------------------|------------|-----------------------|------------|-------------------|------------|
| ** **            | ** ** | **2005**              | ** ** | **2006**          | ** ** |
| ** **            | ** ** | ** **            | ** ** | ** **        | ** ** |
| Prepaid license  fees |       | $                     | 775        |              | $          | 556 |   |
| Prepaid  insurance    |       | 165                   |       | 90                |       |
| Prepaid rent          |       | 89                    |       | 101               |       |
| Other                 |       | 451                   |       | 585               |       |
|                  |       | $                     | 1,480      |              | $          | 1,332 |   |

 

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The following presentsproperty and equipment, net:
|                                    | ** ** | **December 31,**                                                                                                              | ** ** | **June 30,**                                                                                                                  | ** ** |
|------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                                                                                                      | ** ** | **2006**                                                                                                                      | ** ** |
| Construction in progress           |       | 107                                                                                                                           |       | 85                                                                                                                            |       |
| Computer  equipment                |       | $                  1,003                 |       | $                  1,003                 |       |
| Purchased  software                |       | 425                                                                                                                           |       | 534                                                                                                                           |       |
| Furniture  and fixtures            |       | 263                                                                                                                           |       | 386                                                                                                                           |       |
|                                    |       | $                  1,798                 |       | $                  2,008                 |       |
| Less:  Accumulated depreciation    |       | (1,451                                                                                                                        | )          | (1,512                                                                                                                        | )          |
| Total  property and equipment, net |       | $                     347 |       | $                     496 |       |

 

Depreciation expense was$15 and $34 for the three months ended June 30, 2005 and 2006, respectively,$36 and $60 for the six months ended June 30, 2005 and 2006, respectively,and $1,594 cumulative for the period from inception (April 14, 1997) to June30, 2006.

The following presentsaccrued expenses:
|                            | ** ** | **December 31,**                                                                                                              | ** ** | **June 30,**                                                                                                                  | ** ** |
|----------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **2005**                                                                                                                      | ** ** | **2006**                                                                                                                      | ** ** |
| ** **                 | ** ** | ** **                                                                                                                    | ** ** | ** **                                                                                                                    | ** ** |
| Accrued  rent              |       | $                     117 |       | $                     116 |       |
| Accrued  compensation      |       | 417                                                                                                                           |       | 473                                                                                                                           |       |
| Accrued  professional fees |       | 320                                                                                                                           |       | 98                                                                                                                            |       |
| Other                      |       | 440                                                                                                                           |       | 356                                                                                                                           |       |
| Total  accrued expenses    |       | $                  1,294                 |       | $                  1,043                 |       |

 

**Item 2.    MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

*The following Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, as well as information containedin the Risk Factors section described below and elsewhere in this report,contain forward-looking statements, which are provided under the “safe harbor”protection of the Private Securities Litigation Reform Act of 1995.Forward-looking statements are generally written in the future tense and/or arepreceded by words such as “will,” “may,” “should,” “could,” “expect,” “suggest,”“believe,” “anticipate,” “intend,” “plan,” or other similar words.Forward-looking statements include statements regarding the commercial successof our new products; the growth prospects of the semiconductor industry andprogrammable logic market, including the field programmable object array (“FPOA”)and field programmable gate array (“FPGA”) product sub-segments;and trends in our future sales, including our opportunities for growth bydisplacing FPGAs, application-specific integrated circuits (“ASICs”) and othersemiconductor alternatives.*

*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 actual results to differ materially from thoseexpressed or implied by the forward-looking statements contained in thisreport. These factors include, but are not limited to, those risks described inour Annual Report on Form 10-K filed on March 31, 2006.*

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**Business Overview**

We are a developmentstage fabless semiconductor company engaged in the development, marketing andselling of our high-performance, programmable platform chips and design toolsrequired to program our chips. We have demonstrated working versions of ourfirst chip and provided an early release of our design tools to a limitednumber of customers. To date, we have recognized only nominal revenue fromresearch services provided under grants from governmental agencies, engineeringservices and sales of prototype chips and our field programmable object array,or FPOA, development kits.

**Financial Operations Overview**

From inception throughJune 30, 2006, we had gross revenues of $898,000, a loss from continuingoperations of $61,835,000, and a loss from our discontinued PMD operations of$31,874,000.

We are a developmentstage fabless semiconductor company engaged in the development, marketing andselling of our high-performance, programmable platform chips and design toolsrequired to program our chips. We have demonstrated working versions of ourfirst chip and provided an early release of our design tools to a limitednumber of customers. To date, we have recognized only nominal revenue fromresearch services provided under grants from governmental agencies, engineeringservices and sales of prototype chips and our FPOA, development kits.

We were incorporated inApril 1997. In August 2001, we acquired Digital MediaCom, Inc.and began a new and separate operating segment, the physical media dependent,or PMD, segment. The primary business objective of the PMD segment was todevelop in-process technology in high-speed serial interface chips for the10-gigabit Ethernet market. In August 2002, we decided to cease operationsof the PMD segment because of a severe downturn in the market for 10-gigabitEthernet products. On November 15, 2002, we sold or disposed of the assetsof our PMD operating segment, including all of the valuable technology,property and equipment, licensed software and employees, for $1,752,000 in cashand the buyer’s assumption of $187,000 of liabilities. The results ofoperations of the PMD segment are reported as discontinued operations in thecumulative period from inception (April 14, 1997) through June 30, 2006.

In January 2002, wedecided to cease the development of the fixed-function chips that had been thegoal of our research and development efforts until then and to switch to thedevelopment of a family of programmable platform chips. In November 2003,we initiated the fabrication of the first version of our FPOA chip with TaiwanSemiconductor Manufacturing Company, or TSMC, our chip fabrication contractor.In March 2004, TSMC delivered to us the first working silicon of thatchip. Since that time, we have been principally engaged in further developmentsof our FPOA products and in marketing and selling our first FPOA to a smallnumber of early customers. Although there can be no assurance, we expect toproduce FPOA chips that will be ready for a broader market release, and webelieve we will begin selling to customers in the fourth quarter of 2006.

***Research and Development***

Research and developmentexpenses represent costs incurred for designing and engineering our FPOA chipand developing design tools and applications to enable customers to more easilyprogram our chip. Research and development expenses consist primarily ofsalaries and related costs of our engineering organization, fees paid to thirdparty consultants and an allocation of facilities and depreciation expenses. Weexpense all research and development costs related to the development of ourFPOA. Development of certain design tools and applications include thedevelopment of software. Such research and development expenses are required tobe expensed until the technological feasibility of the software is established.We determine technological feasibility based upon completion of a working modelof the software. To date, the period between technological feasibility andgeneral release of the software has been short, so virtually all of oursoftware development costs relate to software development during the periodbefore technological feasibility. Accordingly, all such costs have been chargedto operations as incurred. We expect to incur

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significant additional research and developmentcosts as we develop more chips using our FPOA technology.

***Selling, General and Administrative Expenses***

Selling, general andadministrative expenses consist primarily of salaries and related costs of oursales and marketing and administrative staff, general corporate activities andan allocation of facilities and depreciation expenses. We anticipate thatselling, general and administrative costs will increase as a result ofincreasing our sales and marketing and administrative staff to support sales ofFPOA chips in worldwide markets and to support our growth and operation as apublic company.

***Recently issued Accounting Pronouncements***

See Note 2 of Notes toFinancial Statements included in Part I, Item 1 of this Quarterly Report ofForm 10-Q.

**Resultsof Operations**

***Three Months Ended June 30, 2005 and 2006***

*Revenueand Cost of Goods Sold. *For the three months ended June 30, 2006,our revenues were $10,000 compared to $25,000 for the same period lastyear.  Revenues for the three months endedJune 30, 2006 were from the sale of software licenses and non-recurringengineering fees, and revenues for the three months ended June 30, 2005 werefrom the sale of FPOA development kits. These product development kits included software that we licensed from athird party for the development of design tools for our FPOA chips. Costs ofgoods sold for the three months ended June 30, 2005 and 2006 are primarilythe cost of the third party software licenses. The costs of producing ourdevelopment kits are expensed as research and development costs as incurredbecause we do not anticipate substantial sales of the current version of thechip we have produced and because the aggregate cost of the development kits weexpect to sell are immaterial.

*Researchand Development.*  For the three months ended June30, 2006, our research and development expenses increased $1,316,000 or 70% to$3,200,000 from $1,884,000 for the three months ended June 30, 2005.  The increase was the result of increasedpayroll costs ($541,000, which includes $64,000 of compensation costs relatedto stock options and restricted stock), increased outside engineering anddesign consultants ($265,000), increased engineering materials and electronicdesign software tools ($194,000) and increased overhead costs ($232,000), dueto an allocation of certain overhead costs). The increase in payroll costs andthe use of outside engineering and design consultants is the result ofincreased staffing and efforts to complete the FPOA chip design and to continuedevelopment of our library of development algorithms for use by our customers.

*Selling,General and Administrative.  *For thethree months ended June 30, 2006, our selling, general and administrativeexpenses increased $792,000 or 51% to $2,348,000 compared to $1,557,000 for thethree months ended June 30, 2005.  Theincrease was primarily the result of increased salaries ($631,000, whichincludes a net increase of $520,000 for charges related to non-cash compensationcosts of stock options and restricted stock), as we hired a chief financialofficer in the second quarter of 2005 and a controller and other staff in thesecond half of 2005. Other expense increases include legal and audit($120,000), consulting ($58,000, primarily related to marketing and compliancewith the Sarbanes-Oxley Act of 2002), advertising ($50,000), increasedrelocation expenses ($40,000), increased travel expenses ($32,000) andincreased insurance expenses ($37,000) due to being a publiccompany. These increases were offset by an allocation in the three monthsended June 30, 2006 of certain overhead costs ($232,000) to research anddevelopment.

*OtherIncome (Expense).  *For the three months ended June 30,2006, we had interest income of $160,000 as a result of interest earnings oncash deposits on cash remaining from our initial public offering proceeds.  We had net interest expense of $476,000 forthe three months ended June 30, 2005 as we issued convertible debt in April2005.

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***Six Months Ended June 30, 2005 and 2006***

*Revenueand Cost of Goods Sold. *For the six months ended June 30, 2006,we generated revenues of $18,000 compared to $40,000 for the six months endedJune 30, 2005.  Revenues for the sixmonths ended June 30, 2006 were from software license fees and non-recurring engineeringfees, and revenues for the six months ended June 30, 2005 were from the sale ofFPOA development kits.  These productdevelopment kits included software that we licensed from a third party for thedevelopment of design tools for our FPOA chips. Costs of goods sold for the sixmonths ended June 30, 2005 and 2006 are the cost of the third partysoftware licenses. The costs of producing our development kits are expensed asresearch and development costs as incurred because we do not anticipate substantialsales of the current version of the chip we have produced and because theaggregate cost of the development kits we expect to sell are immaterial.

*Research and Development.* For the six monthsended June 30, 2006, we incurred research and development costs of $6,026,000,an increase of $1,693,000 or 39% over research and development costs for thesix months ended June 30, 2005 of $4,333,000. The increase was the result of increased payroll costs ($1,131,000, whichincludes $120,000 of compensation costs related to stock options and restrictedstock), increased outside engineering and design consultants ($702,000) andincreased overhead costs ($489,000, due to an allocation of certain overheadcosts). These were offset by lower engineering material costs ($802,000, as weincurred the cost of taping out a chip in the six months ended June 30, 2005and did not tape out a chip during the six months ended June 30, 2006).  The increase in payroll costs and the use of outsideengineering and design consultants is the result of increased staffing andefforts to complete the FPOA chip design and to continue development of ourlibrary of development algorithms for use by our customers.

*Selling,General and Administrative.*  For the six months ended June 30,2006, selling, general and administrative costs increased $1,848,000 or 68% to$4,551,000 from $2,703,000 for the six months ended June 30, 2005.  The increase was primarily the result ofincreased salaries ($1,712,000, which includes $1,357,000 of compensation costsrelated to expensing of stock options and restricted stock), as we hired achief operating officer, chief financial officer, vice presidents of marketingand engineering and a controller and other staff in the second half of 2005.Other expense increases include legal and auditing ($243,000), consulting($201,000, primarily related to marketing and Sarbanes-Oxley), advertising($43,000), increased relocation expenses ($40,000), increased travel expenses($63,000) and increased insurance expenses ($74,000) due to being a publiccompany. These increases were offset by an allocation in the six monthsended June 30, 2006 of certain overhead costs ($489,000) to research anddevelopment.

*OtherIncome (Expense). *For the six months ended June 30,2006, we had interest income of $350,000 as a result of interest earnings oncash deposits on cash remaining from our initial public offering proceeds.  We had net interest expense of $469,000 forthe six months ended June 30, 2005, as we issued convertible debt in April2005.

**Liquidityand Capital Resources**

Since inception onApril 14, 1997, we have funded our cash flow needs principally throughsales of our common stock, rights to purchase our common stock and 8%convertible promissory notes.  During the period from April 14, 1997to June 30, 2006, we raised net proceeds of $71,351,000 from sales ofcommon stock and common stock warrants and $5,500,000 from sales of 8%convertible promissory notes and common stock warrants.  During the sixmonth period ended June 30, 2006, we raised $417,000 from the exercise ofcertain warrants held by investors and $27,000 from the exercise of stockoptions.  During the six month period ended June 30, 2005, we raised$176,000 from the exercise of certain warrants held by investors.

Our future capitalrequirements will depend on many factors, including our sales growth, marketacceptance of our existing and new FPOA chips, the amount and timing of ourresearch and development expenditures, the timing of our introduction of newchips, the expansion of our sales and marketing efforts and working capitalneeds. We believe that our cash on hand, combined with our existing capitalresources, will be sufficient to meet our capital and operating needs through2006. We anticipate seeking additional financing during 2006. Our long-termfinancing requirements will depend significantly on our ability to penetratethe market with our FPOA chip technology. If existing cash, cash equivalentsand cash generated from operations are insufficient to satisfy our liquidityrequirements, we may seek to sell additional equity

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or debt securities or obtain other financing. Ifwe obtain additional funds through the issuance of debt or equity securities,these securities may have rights senior to those associated with our commonstock, and they could contain covenants that would restrict our operations. Ifwe are unable to obtain additional financing or successfully market ourproducts on a timely basis, we would have to slow our product development andmarketing efforts and may be unable to continue our operations.

***Net Cash Used in Operating Activities***

Net cash used inoperating activities was $6,734,000 and $8,606,000 for the six months endedJune 30, 2005 and 2006.  Net cash used for operating activities forthe six months ended June 30, 2005 and 2006 was to fund our on-goingresearch and development activities and our selling, general and administrativecosts.

***Net Cash Used by Investing Activities***

Net cash used byinvesting activities for the six months ended June 30, 2006 of $209,000  was for the purchase of property andequipment. We had no investing activities for the six months ended June 30,2005.

***Net Cash Provided by Financing Activities***

Net cash provided byfinancing activities was $5,676,000 and $444,000 for the six months endedJune 30, 2005, and 2006.  For the six months ended June 30, 2006, weraised $417,000 from the exercise of certain warrants held by investors and$27,000  from the exercise of stockoptions.  For the six months ended June 30, 2005, financing cash flowsconsisted of the proceeds from the issuance of $5,500,000 of our 8% convertiblepromissory notes and $176,000 related common stock warrants and proceeds fromthe exercise of warrants, as discussed above.

**Off-Balance Sheet Arrangements**

We do not currently haveany relationships with unconsolidated entities or financial partnerships, suchas entities often referred to as structured finance or special purposeentities, which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. Inaddition, we do not engage in trading activities involving non-exchange tradedcontracts. As such, we are not materially exposed to any financing, liquidity,market or credit risk that could arise if we had engaged in theserelationships.

**Item3.    Quantitative and Qualitative Disclosures about Market Risk**

Our exposure to marketrisk is confined to our cash equivalents. We have invested in high-qualityfinancial instruments, primarily money market funds, federal agency notes andasset-backed securities, which we believe are subject to limited credit risks.The effective duration of the portfolio is less than three months, and noindividual investment has an effective duration in excess of three months. Wecurrently do not hedge interest rate exposure. Due to the short-term nature ofour investments, we do not believe we have any material exposure to interestrate risk arising from our investments.

**Item4.    Controls and Procedures**

*Evaluation of DisclosureControls and Procedures*

We maintain a system ofdisclosure controls and procedures designed to ensure that information requiredto be disclosed in our reports filed or submitted under the Securities ExchangeAct of 1934, as amended (“Exchange Act”), is recorded, processed, summarizedand reported within the time periods specified in the SEC rules and forms.These controls and procedures are also designed to ensure that such informationis accumulated and communicated to the Company’s management, including theChief Executive Officer (CEO) and Chief Financial Officer (CFO), as appropriateto allow timely decisions regarding required disclosure. Internal controls areprocedures designed to provide reasonable assurance that transactions areproperly authorized; assets are safeguarded against unauthorized or improperuse; and

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transactions are properly recorded and reported,to permit the preparation of our financial statements in conformity withgenerally accepted accounting principles.

A control system, nomatter how well designed and operated, can provide only reasonable, notabsolute, assurance that the control system’s objectives will be met. Further,the design of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within the Company have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty and that breakdowns can occur because of simple errors ormistakes. Controls can also be circumvented by the individual acts of somepersons, by collusion of two or more people, or by management override of thecontrols. The design of any system of controls is based in part upon certainassumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions. Over time, a system of controls may becomeinadequate because of changes in conditions or a deterioration in the degree ofcompliance with its policies or procedures. Because of the inherent limitationsin a cost-effective control system, misstatements due to error or fraud mayoccur and not be detected. We continuously evaluate our internal controls andmake changes to improve them as necessary. Our intent is to maintain ourdisclosure controls as dynamic systems that change as conditions warrant.

As of the end of theperiod covered by this report, the Company carried out an evaluation, under thesupervision and with the participation of Company management, including its CEOand the CFO, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e)under the Exchange Act. Based upon, and as of the date of this evaluation, theCEO and the CFO concluded that the Company’s disclosure controls and procedureswere not effective because of the material weakness described below.

*Changes in Internal ControlOver Financial Reporting*

As described in ourAnnual Report on Form 10-K for the year ended December 31, 2005 filed on March31, 2006, in connection with its audit of our financial statements for the yearended December 31, 2005, our independent registered public accounting firmreported two conditions, which together constitute a material weakness in theinternal controls over our ability to produce financial statements free frommaterial misstatements. A material weakness is a control deficiency, orcombination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. Our independent registered publicaccounting firm reported to our board of directors that we do not have asufficient number of financial personnel with adequate training and experiencein accounting or financial reporting, and our controls do not ensure thatoperating expenses and stock compensation transactions are identified andrecorded accurately and in the appropriate accounting period. These two conditions,in combination, constitute a material weakness in our internal controls.

As described in ourAnnual Report on Form 10-K for the year ended December 31, 2005 filed on March31, 2006, our board of directors agrees that the conditions identified by ourindependent registered public accounting firm constitute a material weakness.The Company has developed a plan to address this material weakness thatincludes the addition of our new chief financial officer, controller and staffaccountant, as well as the performance of an assessment of our currentaccounting and reporting policies and procedures, assessment of our financialaccounting and reporting staff requirements, implementation of supervisoryreviews by our chief financial officer and controller, implementation of newaccounting policies and procedures, and the hiring and training of additionalfinancial accounting and reporting staff. We hired a new chief financialofficer in June 2005, a new controller in July 2005 and a staff accountant inDecember 2005. In addition to this plan, our new chief financial officer andcontroller are assessing our system of internal controls over financialreporting and intend to implement and are implementing controls designed toassure that, among other things, operating expenses and stock compensationtransactions are identified and accurately recorded. The Company will bereviewing and testing the steps described above throughout fiscal 2006. TheCompany believes that these steps will correct the material weakness describedabove.

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**PartII    Other Information**

**Item1.    Legal Proceedings**

We are currently not aparty to any legal proceedings.

**Item1A.   Risk Factors**

The semiconductorindustry is characterized by rapid technological change, intense competitionand cyclical market patterns which contribute to create factors that may affectour future operating results. The risk factors are described in the sectionentitled “Risk Factors” beginning on page 16 of our Annual Report on Form10-K for the year ended December 31, 2005 filed with the Securities andExchange Commission on March 31, 2006. Other information included in this Quarterly Report on Form 10-Qalso should be carefully considered. The risks and uncertainties described inour Annual Report are not the only risks the Company faces. Additional risksand uncertainties not presently known to the Company or that the Company’smanagement currently deems immaterial also may impair its business operations.If any of the risks described were to occur, our business, financial condition,operating results and cash flows could be materially adversely affected.

**Item2.    Unregistered Sales of Equity Securities and Use ofProceeds**

(a) From the periodbeginning April 1, 2006 and ending June 30, 2006, we issued the following equitysecurities in the following transactions, which were not registered under theSecurities Act of 1933 (the “Securities Act”):

1.  Duringthe period April 1, 2006 through May 22, 2006, the Company granted options topurchase 44,000 shares of common stock to four employees at an exercise pricerange of $4.77 to $5.89 per share under its Amended and Restated 2004 Long-TermIncentive Plan. These grants were made in reliance on the exemption provided bySection 4(2) of and Rule 506 of Regulation D under the Securities Act. Grantsof options to employees on or after May 23, 2006 are registered under our registrationstatement on Form S-8 filed with the Securities and Exchange Commission on thatdate.

2.  Duringthe period April 26, 2006 through June 30, 2006, the Company issued 117,339shares to 26 investors, who represented in writing that they were accreditedinvestors, at a price of $2.25 per share, upon the exercise of warrants,resulting in gross proceeds of $264,012. These sales were made in reliance onthe exemption provided by Section 4(2) of and Rule 506 of Regulation D underthe Securities. These issues do not include issues previously disclosed in theForm 10-Q dated March 31, 2006 filed on May 15, 2006.

The purchasers ofsecurities described above represented to us in written subscription agreementsor other written agreements that, among other things, they acquired thesecurities for their own account and not with a view to any distributionthereof to the public.  The certificates evidencing the securitiesdescribed above bear legends providing that the shares are not to be offered,sold or transferred other than pursuant to an effective registration statementunder the Securities Act or an exemption from such registration requirements.

**Item3.    Defaults Upon Senior Securities**

None.

**Item4.    Submission of Matters to a Vote of Security Holders.**

On May 18, 2006, at ourAnnual Meeting of Stockholders, the stockholders voted on three proposals.  The vote on each of those proposals issummarized below.

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**Proposal No. 1**

The following incumbentdirectors were re-elected to our Board of Directors by the following vote:
| Nominee            | ** ** | **For**    | ** ** | **Withheld/Against** | ** ** | **Broker Non-Votes** | ** ** |
|--------------------|------------|------------|------------|----------------------|------------|---------------------------|------------|
|               |       |       |       |                 |       |                      |       |
| Douglas M. Pihl    |       | 11,784,052 |       | 46,477               |       | —                    |       |
| Benno G. Sand      |       | 11,783,952 |       | 46,577               |       | —                    |       |
| Merrill A.  McPeak |       | 11,783,952 |       | 46,577               |       | —                    |       |
| Morris Goodwin, Jr |       | 11,780,618 |       | 49,911               |       | —                    |       |

 

**Proposal No. 2**

The stockholdersapproved amending the Company’s 2004 Plan as described in the proxy statementfor the Annual Meeting by the following vote:

| For       | ** ** | **Against** | ** ** | **Withheld** | ** ** | **Broker Non-Votes** | ** ** |
|-----------|------------|-------------|------------|--------------|------------|---------------------------|------------|
|      |       |        |       |         |       |                      |       |
| 8,448,342 |       | 429,154     |       | 314,486      |       | 2,636,547                 |       |

 

**Proposal No. 3**

The stockholdersratified the selection of PricewaterhouseCoopers LLP as our independentaccountants by the following vote:

| For        | ** ** | **Against** | ** ** | **Withheld** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|-------------|------------|--------------|------------|---------------------------|------------|
|       |       |        |       |         |       |                      |       |
| 11,787,982 |       | 27,459      |       | 15,088       |       | —                    |       |

 

**Item5.    Other Information**

None.

**Item6.    Exhibits**

The exhibits aredescribed on the Exhibit Index to this Quarterly Report on Form 10-Q.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                        |   | Mathstar, Inc. |
|------------------------|--------|----------------|
|                   |   | (Registrant)   |
|                   |   |           |
|                   |   |           |
| Date: August 11,  2006 |   | By:            |   | /s/ James W. Cruckshank |   |
|                   |   |           |   | James W. Cruckshank |
|                   |   |           |   | Vice President of Administration and |
|                   |   |           |   | Chief Financial Officer |
|                   |   |           |   | (Principal Financial Officer and Principal |
|                   |   |           |   | Accounting Officer) |

 

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**EXHIBITINDEX**
| 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).                                                                                                                                                                                                 |
|             |       |                                                                                                                                                                                                                                                                                                                                     |
| 10.1             |       | First Amendment to the Standard Commercial Lease dated  as of July 22, 2005 by and between Parkway Point Joint Venture and  MathStar, Inc. (incorporated by reference to Exhibit 10.11 to the  Registration Statement).                                                                                                   |
|             |       |                                                                                                                                                                                                                                                                                                                                     |
| 10.2             |       | Schedule of Executive Officer Compensation and  Director Compensation for 2006 (incorporated by reference to  Exhibit 10.17 to the Annual Report on Form 10-K filed by MathStar, Inc.  with the SEC on March 31, 2006.*                                                                                                        |
|             |       |                                                                                                                                                                                                                                                                                                                                     |
| 10.3             |       | Amendment No.1 to Strategic Partnership Agreement  dated August 11, 2005 by and between MathStar, Inc. and Valley Technologies,  Inc. (incorporated by reference to Exhibit 10.20 to Amendment No. 1  to the Registration Statement on Form S-1 filed by MathStar, Inc. with  the SEC on September 9, 2005).         |
|             |       |                                                                                                                                                                                                                                                                                                                                     |
| 10.4             |       | MathStar, Inc. Amended and Restated 2004 Long-Term  Incentive Plan (incorporated by reference to Exhibit 10.1 to the Current  Report on Form 8-K dated May 18, 2006 filed by MathStar, Inc. with the SEC on  May 22, 2006). *                                                                                                            |
|             |       |                                                                                                                                                                                                                                                                                                                                     |
| 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).                                                                                                                                                                                                                                                  |

 

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*              Indicates a management contract or compensatory plan orarrangement.

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