**UNITED STATES SECURITIES 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 September 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 AcceleratedFiler  o                  AcceleratedFiler  o                  Non-AcceleratedFiler  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 November 8, 2006** |
|--------------------------------|------------|---------------------------------------------------------|
| Common stock,  $0.01 par value |       | 17,527,649                                              |

 

 

----

 
| PART I  FINANCIAL INFORMATION |                                                                                                                                                                                                         |
|------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                               |                                                                                                                                                                                                         |   |
| Item 1.                            | Financial Statements (Unaudited)                                                                                                                                                                             |   |
|                               |                                                                                                                                                                                                         |   |
|                               | Condensed  Balance Sheets as of December 31, 2005 and September 30, 2006                                                                                                                                     |   |
|                               |                                                                                                                                                                                                         |   |
|                               | Condensed  Statements of Operations for the Three and Nine Months Ended  September 30, 2005 and September 30, 2006 and Cumulative for the period from  Inception (April 14, 1997) through September 30, 2006 |   |
|                               |                                                                                                                                                                                                         |   |
|                               | Condensed  Statements of Cash Flows for the Nine Months Ended September 30,  2005 and September 30, 2006 and Cumulative for the period from Inception  (April  14, 1997) through September 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                         |                                                                                                                                                                                                         |

 

2

----

**MathStar, Inc.(A development stage company)Condensed Balance Sheets(Unaudited)**
| ** **                                                                                                                                                                 | ** ** | **December 31,  2005**                                   | ** ** | **September 30,  2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **(in thousands,  except per share  amounts)** | ** ** |
| **Assets**                                                                                                                                                                 | ** ** | ** **                                                    | ** ** | ** **                   | ** ** |
| Current assets                                                                                                                                                             |       |                                                          |       |                         |       |
| Cash and cash  equivalents                                                                                                                                                 |       | $                                                             | 20,149     |                         | $          | 9,715 |   |
|                                                                                                                                                                       |       |                                                          |       |                         |       |
| Accounts  receivable                                                                                                                                                       |       | 75                                                            |       | 47                           |       |
|                                                                                                                                                                       |       |                                                          |       |                         |       |
| Prepaid expenses  and other current assets                                                                                                                                 |       | 1,480                                                         |       | 1,140                        |       |
| Total current  assets                                                                                                                                                      |       | 21,704                                                        |       | 10,902                       |       |
| Property and equipment,  net                                                                                                                                               |       | 347                                                           |       | 592                          |       |
| Other assets                                                                                                                                                               |       | 151                                                           |       | 67                           |       |
| Total assets                                                                                                                                                               |       | $                                                             | 22,202     |                         | $          | 11,561 |   |
|                                                                                                                                                                       |       |                                                          |       |                         |       |
| **Liabilities and Stockholders’  Equity**                                                                                                                             | ** ** | ** **                                                    | ** ** | ** **                   | ** ** |
| Current liabilities                                                                                                                                                        |       |                                                          |       |                         |       |
| Accounts payable                                                                                                                                                           |       | $                                                             | 734        |                         | $          | 413 |   |
| Accrued expenses                                                                                                                                                           |       | 1,294                                                         |       | 5,070                        |       |
| Total  liabilities                                                                                                                                                         |       | 2,028                                                         |       | 5,483                        |       |
| 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 17,742 shares issued  and outstanding at December 31, 2005 and September 30, 2006,  respectively |       | 175                                                           |       | 178                          |       |
| Additional  paid-in capital                                                                                                                                                |       | 105,717                                                       |       | 106,338                      |       |
| Unearned  compensation                                                                                                                                                     |       | (2,224                                                        | )          | —                       |       |
| Deficit  accumulated during the development stage                                                                                                                          |       | (83,494                                                       | )          | (100,438                     | )          |
| Total stockholders’  equity                                                                                                                                           |       | 20,174                                                        |       | 6,078                        |       |
| Total liabilities and  stockholders’ equity                                                                                                                           |       | $                                                             | 22,202     |                         | $          | 11,561 |   |

 

Theaccompanying notes are an integral part of these financial statements.

3

----

**MathStar, Inc.(A development stage company)Condensed Statements of Operations(Unaudited)**
| ** **                                            | ** ** | ** **                                                            | ** ** | ** **                                          | ** ** | ** **                                                  | ** ** | ** ** | ** ** | **Cumulative**               | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------------|------------|------------|------------|------------------------------|------------|
| ** **                                            | ** ** | ** **                                                            | ** ** | ** **                                          | ** ** | ** **                                                  | ** ** | ** ** | ** ** | **for the Period** | ** ** |
| ** **                                            | ** ** | ** **                                                            | ** ** | ** **                                          | ** ** | ** **                                                  | ** ** | ** ** | ** ** | **from Inception**      | ** ** |
| ** **                                            | ** ** | **Three Months Ended  September 30,**                  | ** ** | **Nine Months Ended  September 30,** | ** ** | **(April 14, 1997)  Through  September 30,** | ** ** |
| ** **                                            | ** ** | **2005**                                                              | ** ** | **2006**                                            | ** ** | **2005**                                                    | ** ** | **2006**   | ** ** | **2006**                     | ** ** |
| ** **                                            | ** ** | **(in thousands, except per share amounts)** | ** ** |
| ** **                                            | ** ** | ** **                                                            | ** ** | ** **                                          | ** ** | ** **                                                  | ** ** | ** ** | ** ** | ** **                   | ** ** |
| Revenue                                               |       | $                                                                     | 15         |                                                | $          | 28                                                          |       | $          | 55         |                         | $          | 46 |   | $ | 926 |   |
| Cost of goods sold                                    |       | —                                                                |       | 21                                                  |       | 15                                                          |       | 27         |       | 133                          |       |
| Gross margin                                          |       | 15                                                                    |       | 7                                                   |       | 40                                                          |       | 19         |       | 793                          |       |
| Operating expenses:                                   |       |                                                                  |       |                                                |       |                                                        |       |       |       |                         |       |
|                                                  |       |                                                                  |       |                                                |       |                                                        |       |       |       |                         |       |
| Research and  development                             |       | 1,693                                                                 |       | 4,267                                               |       | 6,026                                                       |       | 10,293     |       | 40,287                       |       |
| Selling, general  and administrative                  |       | 1,632                                                                 |       | 2,581                                               |       | 4,335                                                       |       | 7,132      |       | 26,378                       |       |
|                                                  |       | 3,325                                                                 |       | 6,848                                               |       | 10,361                                                      |       | 17,425     |       | 66,665                       |       |
| Operating loss                                        |       | (3,310                                                                | )          | (6,841                                              | )          | (10,321                                                     | )          | (17,406    | )          | (65,872                      | )          |
| Interest income                                       |       | 7                                                                     |       | 112                                                 |       | 7                                                           |       | 462        |       | 1,882                        |       |
| Interest expense                                      |       | (900                                                                  | )          | —                                              |       | (1,369                                                      | )          | —     |       | (4,591                       | )          |
| Other income, net                                     |       | —                                                                |       | —                                              |       | —                                                      |       | —     |       | 17                           |       |
| Net loss from  continuing operations                  |       | (4,203                                                                | )          | (6,729                                              | )          | (11,683                                                     | )          | (16,944    | )          | (68,564                      | )          |
| Loss from discontinued  operations                    |       | —                                                                |       | —                                              |       | —                                                      |       | —     |       | (31,874                      | )          |
| Net loss                                              |       | $                                                                     | (4,203     | )                                                   | $          | (6,729                                                      | )          | $          | (11,683    | )                            | (16,944    | ) | $ | (100,438 | ) |
|                                                  |       |                                                                  |       |                                                |       |                                                        |       |       |       |                         |       |
| Basic and diluted net  loss per share                 |       | $                                                                     | (0.37      | )                                                   | $          | (0.39                                                       | )          | $          | (1.04      | )                            | $          | (0.99 | ) | — |   |
| Weighted average basic and diluted shares outstanding |       | 11,233                                                                |       | 17,259                                              |       | 11,195                                                      |       | 17,112     |       | —                       |       |

 

Theaccompanying notes are an integral part of these financial statements.

4

----

**MathStar, Inc.(A development stage company)Condensed Statements of Cash Flows(Unaudited)**
| ** **                                                                                                           | ** ** | ** **                                          | ** ** | ** **                      | ** ** | **Cumulative  for the Period  from Inception  (April 14, 1997)** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **Nine Months Ended  September 30,** | ** ** | **Through  September 30,** | ** ** |
| ** **                                                                                                           | ** ** | **2005**                                            | ** ** | **2006**                        | ** ** | **2006**                                                                                  | ** ** |
| ** **                                                                                                           | ** ** | **(in thousands)**                             | ** ** |
| **Cash flows from operating  activities**                                                                            | ** ** | ** **                                          | ** ** | ** **                      | ** ** | ** **                                                                                | ** ** |
| Net loss                                                                                                             |       | $                                                   | (11,683    | )                               | $          | (16,944                                                                                   | )          | $ | (100,438 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities                                          |       |                                                |       |                            |       |                                                                                      |       |
| Depreciation                                                                                                         |       | 49                                                  |       | 99                              |       | 1,632                                                                                     |       |
| Amortization of  convertible notes discount - beneficial conversion feature and value of  warrants issued with notes |       | 1,061                                               |       | —                          |       | 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                                                                                            |       | 546                                                 |       | 2,288                           |       | 4,528                                                                                     |       |
| Goodwill  impairment                                                                                                 |       | —                                              |       | —                          |       | 13,306                                                                                    |       |
| Change in  operating assets and liabilities, net of effects of acquisition                                      |       | —                                              |       | —                          |       | —                                                                                    |       |
| Accounts  receivable                                                                                                 |       | (60                                                 | )          | 28                              |       | 98                                                                                        |       |
| Prepaid expenses  and other assets                                                                                   |       | (803                                                | )          | 424                             |       | (567                                                                                      | )          |
| Accounts payable                                                                                                     |       | 828                                                 |       | (321                            | )          | (40                                                                                       | )          |
| Accrued expenses                                                                                                     |       | 505                                                 |       | (24                             | )          | 1,042                                                                                     |       |
| Net cash used in  operating activities                                                                               |       | (9,557                                              | )          | (14,450                         | )          | (72,514                                                                                   | )          |
| **Cash flows from investing  activities**                                                                            | ** ** | ** **                                          | ** ** | ** **                      | ** ** | ** **                                                                                | ** ** |
| Cash used in  acquisition, net of cash acquired                                                                      |       | —                                              |       | —                          |       | (791                                                                                      | )          |
| Purchase of property  and equipment                                                                                  |       | —                                              |       | (343                            | )          | (2,063                                                                                    | )          |
| 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                                                                               |       | —                                              |       | (343                            | )          | (869                                                                                      | )          |
| **Cash flows from financing  activities**                                                                            | ** ** | ** **                                          | ** ** | ** **                      | ** ** | ** **                                                                                | ** ** |
| Proceeds from issuance  of common stock, net of offering costs                                                       |       | —                                              |       | 3,800                           |       | 69,847                                                                                    |       |
| 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                                                                                  |       | 223                                                 |       | 513                             |       | 3,421                                                                                     |       |
| Collection of  subscription receivable                                                                               |       | —                                              |       | —                          |       | 27                                                                                        |       |
| Proceeds from exercise  of stock options                                                                             |       | —                                              |       | 46                              |       | 47                                                                                        |       |
| 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                                                                           |       | 5,723                                               |       | 4,359                           |       | 83,098                                                                                    |       |
| Net (decrease)  increase in cash and cash equivalents                                                                |       | (3,834                                              | )          | (10,434                         | )          | 9,715                                                                                     |       |
| **Cash and cash equivalents**                                                                                        |       |                                                |       |                            |       |                                                                                      |       |
| Beginning of period                                                                                                  |       | 4,132                                               |       | 20,149                          |       | —                                                                                    |       |
| End of period                                                                                                        |       | $                                                   | 298        |                            | $          | 9,715                                                                                     |       | $ | 9,715 |   |
|                                                                                                                 |       |                                                |       |                            |       |                                                                                      |       |
| **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 subscription 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                                                                       |       | $                                                   | —     |                            | $          | (170                                                                                      | )          | $ | 148 |   |
| Conversion of notes payable and $230 of accrued interest into common  stock                                          |       | $                                                   | —     |                            | $          | —                                                                                    |       | $ | 5,430 |   |

 

Theaccompanying notes are an integral part of these financial statements.

5

----

**MathStar, Inc.(A development stage company)Notes to 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 financial statementsin conformity with accounting principles generally accepted in the UnitedStates of America requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and the disclosure ofcontingent assets and liabilities at the date of the financial statements andthe 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 annual periods.The interim financial statements should be read in conjunction with thefinancial statements in the Company’s Annual Report on Form 10-K filed with theSecurities 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 accompanying financialstatements have been prepared on a basis which assumes that the Company willcontinue as a going concern and which contemplates the realization of assetsand the satisfaction of liabilities and commitments in the normal course ofbusiness. The Company has a limited operating history and has incurred lossesand negative cash flows from operations since inception. We believe our cash onhand, combined with our existing capital resources are sufficient to meet ourcapital and operating needs through the fourth quarter of 2006.  However,the Company expects to incur additional losses past 2006 and may requireadditional funding to continue its operations. 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 theCompany’s ability 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 over-allotment 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.

On October 3, 2006, theCompany sold 3,143 shares in a private placement at $4.00 per share, generating$12,570 of gross proceeds before the payment of commissions and expenses.  Warrants were issued with the shares ofcommon stock in the private placement to purchase 1,367 shares with an exerciseprice of $6.00 and an expiration date of October 3, 2011.  The Company had received $3,800 of cashrelated to this private placement before September 30, 2006, which is recordedas an accrued liability as of September 30, 2006.

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.

6

----

**2.             New Accounting Pronouncements**

In December 2004,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), *Share-Based Payments*.  SFAS No. 123(R) revised SFASNo. 123 and superseded 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 Opinion No. 25and requires that the compensation costs relating to such transactions berecognized in the statement of operations based upon the grant-date fair valueof those instruments. The Company adopted SFAS No. 123(R) on January 1,2006.

In July 2006, the FASBissued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes* (“FIN 48”), which is aninterpretation of SFAS No. 109, *Accountingfor Income Taxes*.  FIN 48clarifies the accounting for uncertainty in income taxes recognized inaccordance with SFAS No. 109 and prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. Guidance isalso provided on de-recognition, classification, interest and penalties,accounting in interim periods, disclosure and transition. FIN 48 is effectivefor fiscal years beginning after December 15, 2006.  The Company iscurrently evaluating the impact of adopting FIN 48 on its consolidated financialposition and results of operations.

In September 2006, theFASB issued FAS 158, *Employers Accountingfor Defined Benefit Pension and Other Post Retirement Plans.*SFAS 158is effective for the years ending December15, 2006 and requires companies torecognize prospectively adjustments to assets, liabilities and shareholders’equity (through accumulated other comprehensive income) for the differencebetween the fair value of the plan’s assets and the benefit obligation ofpension and post retirement health care plans. Since the company has no definedbenefit pension or other post retirement plans, the Company believes it has noexpected impact.

In September 2006, theSecurities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No.108, *Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements*” (“SAB 108”).  SAB108 provides guidance on how the effects of the carryover or reversal of prioryear financial statement misstatements should be considered in quantifying acurrent year misstatement. The Company does not believe that the adoption ofSAB 108 will have any impact on our financial statements for the year endedDecember 31, 2006.

**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 the 2002 Plan were terminated in May2006 with the exception of options then outstanding under those plans.

7

----

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, 1,634shares of the Company’s common stock were reserved for the issuance ofrestricted stock, incentive and nonqualified stock options and otherstock-based awards to directors, officers and employees of and advisors to theCompany at exercise prices as determined by a committee of the Board ofDirectors on the dates of grants.

**StockOptions – 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 nine months ended September 30, 2006 was to record additional expenses of$78 and $159, respectively. Of these amounts, $35 and $67 was charged toresearch and development and $43 and $92 was charged to selling, general andadministrative expense for the three and nine months ended September 30, 2006,respectively.  This had an immaterial effect on net loss per share for thethree and nine months ended September 30, 2006. Including the charges forrestricted stock and cheap stock, the total stock compensation expense for thethree and nine months ended September 30, 2006 was $811 and $2,288,respectively.

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 theCompany does 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  September 30, 2006** | ** ** | **Nine Months Ended  September 30, 2006** | ** ** |
|-----------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
|                        |       |                                                           |       |                                                          |       |
| Expected option  term       |       | 6.25                                                           | Years      | 6.25                                                          | Years      |
|                        |       |                                                           |       |                                                          |       |
| Expected  volatility factor |       | 71.8                                                           | %          | 72.8                                                          | %          |
|                        |       |                                                           |       |                                                          |       |
| Expected  dividend yield    |       | 0                                                              | %          | 0                                                             | %          |
|                        |       |                                                           |       |                                                          |       |
| Risk free interest rate     |       | 4.74                                                           | %          | 4.63                                                          | %          |

 

8

----

Thefollowing table is a summary of option activity under the Company’s stockoption plans as of September 30, 2006 and changes during the nine months thenended: 
| **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 |   |
| Granted                            |       | 168        |       | 5.18                                    |       | 9.33                                                 |       |                            |       |
| Exercised                          |       | (23        | )          | 0.87                                    |       | 6.21                                                 |       |                            |       |
| Forfeited or  expired              |       | (59        | )          | 4.25                                    |       | 7.15                                                 |       |                            |       |
| Outstanding at  September 30, 2006 |       | 2,222      |       | $                                       | 5.40       |                                                 | 7.54       |                            | $          | 293 |   |
|                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Exercisable at  September 30, 2006 |       | 880        |       | $                                       | 5.34       |                                                 | 5.44       |                            | $          | 293 |   |

 

The weighted-averagegrant-date fair value of options granted during the three and nine months endedSeptember 30, 2006 was $3.54 and $3.60, respectively. The total intrinsic valueof options exercised during the three and nine months ended September 30, 2006was $96 and $228, respectively.

The following tableshows the status of the Company’s unvested shares as of September 30, 2006 andchanges during the nine months then ended: 
| 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       |   |
| Granted                         |       | 168        |       | 3.54                                                         |       |
| Vested                          |       | (121       | )          | 1.37                                                         |       |
| Forfeited                       |       | (35        | )          | 3.14                                                         |       |
| Unvested at September  30, 2006 |       | 1,342      |       | $                                                            | 2.34       |   |

 

As of September 30,2006, there was $1,806 of total unrecognized compensation cost related tounvested share-based compensation arrangements granted, including restrictedstock, under the Company’s stock option plans. That cost is expected to berecognized over a weighted-average period of 1.83 years. The total fair valueof shares vested during the three and nine months ended September 30, 2006 was$165 and $456, respectively.

9

----

**StockOptions – 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: 
|                                                                                                                            | ** ** | **Nine Months Ended  September 30, 2005** | ** ** | **Cumulative  for the Period  from Inception  (April 14, 1997)  Through  September 30,  2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------|------------|
| Net loss as  reported                                                                                                      |       | $                                                             | (11,683    | )                                                                                                                            | $          | (100,438 | ) |
| Add: Total  stock-based employee compensation expense included in net loss, as reported                                    |       | 138                                                           |       | 1,832                                                                                                                        |       |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all employee awards |       | (569                                                          | )          | (3,054                                                                                                                       | )          |
|                                                                                                                       |       |                                                          |       |                                                                                                                         |       |
| Pro forma net  loss                                                                                                        |       | $                                                             | (12,114    | )                                                                                                                            | $          | (101,660 | ) |
|                                                                                                                       |       |                                                          |       |                                                                                                                         |       |
| Basic and  diluted loss per share:                                                                                         |       |                                                          |       |                                                                                                                         |       |
| As reported                                                                                                                |       | $                                                             | (1.04      | )                                                                                                                            |       |   |
| Pro forma                                                                                                                  |       | $                                                             | (1.08      | )                                                                                                                            |       |   |

 

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:
|                             | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|-----------------------------|------------|-------------------------------------------------------|------------|
|                        |       |                                                  |       |
| Expected option  term       |       | 5                                                     | Years      |
| Expected  volatility factor |       | 0                                                     | %          |
| Expected  dividend yield    |       | 0                                                     | %          |
| Risk free interest rate     |       | 3.93                                                  | %          |

 

10

----

# **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 September 30, 2005, the Company’s Board of Directorselected to delay the vesting of all shares of restricted stock until one yearafter the effective date of the Company’s registration statement (which occurredon October 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 September 30, 2006. During the three and nine months endedSeptember 30, 2006, 0 and 40 restricted shares were forfeited, respectively.

The Company recognizedno compensation expense for the three and nine months ended September 30, 2005,$666 and $1,931 for the three and nine months ended September 30, 2006, respectively,and $2,378 cumulative for the period from inception (April 14, 1997) toSeptember 30, 2006. The Company will recognize approximately $219 ofcompensation expense related to outstanding restricted shares at September 30,2006 during 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 September30, 2006 and changes during the nine 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        |       |
| Granted                         |       | —     |       |
| Vested                          |       | —     |       |
| Forfeited                       |       | —     |       |
| Unvested at September 30,  2006 |       | 465        |       |

 

11

----

**4.             Selected Balance Sheet Information**

The following presentsprepaid expenses and other current assets: 
|                       | ** ** | **December 31,  2005** | ** ** | **September 30,  2006** | ** ** |
|-----------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **            | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Prepaid license  fees |       | $                           | 775        |                         | $          | 506 |   |
| Prepaid  insurance    |       | 165                         |       | 51                           |       |
| Prepaid rent          |       | 89                          |       | 110                          |       |
| Other                 |       | 451                         |       | 473                          |       |
|                  |       | $                           | 1,480      |                         | $          | 1,140 |   |

 

The following presentsproperty and equipment, net: 
|                                    | ** ** | **December 31,  2005** | ** ** | **September 30,  2006** | ** ** |
|------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Construction in  progress          |       | $                           | 107        |                         | $          | 113 |   |
| Equipment                          |       | 1,003                       |       | 1,192                        |       |
| Purchased  software                |       | 425                         |       | 533                          |       |
| Furniture and  fixtures            |       | 263                         |       | 304                          |       |
|                               |       | $                           | 1,798      |                         | $          | 2,142 |   |
| Less:  Accumulated depreciation    |       | (1,451                      | )          | (1,550                       | )          |
| Total property and  equipment, net |       | $                           | 347        |                         | $          | 592 |   |

 

Depreciation expense was$14 and $39 for the three months ended September 30, 2005 and 2006,respectively, $49 and $99 for the nine months ended September 30, 2005 and2006, respectively, and $1,633 cumulative for the period from inception (April14, 1997) to September 30, 2006.

The following presentsaccrued expenses: 
|                                                                                                                | ** ** | **December 31,  2005** | ** ** | **September 30,  2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                     | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Accrued rent                                                                                                   |       | $                           | 17         |                         | $          | 97 |   |
| Accrued  compensation                                                                                          |       | 417                         |       | 766                          |       |
| Accrued  professional fees                                                                                     |       | 320                         |       | 145                          |       |
| Proceeds from  private placement received in advanced (see 1 – Basis for Presentation and  Going Concern) |       |                        |       | 3,800                        |       |
| Other                                                                                                          |       | 440                         |       | 262                          |       |
| Total accrued expenses                                                                                         |       | $                           | 1,294      |                         | $          | 5,070 |   |

 

12

----

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

*Thefollowing Management’s Discussion and Analysis of Financial Condition andResults of Operations, as well as information contained in the Risk Factorssection described below and elsewhere in this report, contain forward-lookingstatements, which are provided under the “safe harbor” protection of thePrivate Securities Litigation Reform Act of 1995. Forward-looking statementsare generally written in the future tense and/or are preceded by words such as “will,”“may,” “should,” “could,” “expect,” “suggest,” “believe,” “anticipate,” “intend,”“plan,” or other similar words. Forward-looking statements include statementsregarding the commercial success of our new products; the growth prospects ofthe semiconductor industry and programmable logic market, including the fieldprogrammable object array (“FPOA”) and field programmable gate array (“FPGA”)product sub-segments; and trends in our future sales, including ouropportunities for growth by displacing FPGAs, application-specific integratedcircuits (“ASICs”) and other semiconductor alternatives.*

*Forward-lookingstatements are not guarantees of future performance and involve risks anduncertainties. The forward-looking statements contained in this report arebased on information that is currently available to us and expectations andassumptions that we deem reasonable at the time the statements were made. We donot undertake any obligation to update any forward-looking statements in thisreport or in any of our other communications, except as required by law. Allsuch forward-looking statements should be read as of the time the statementswere made and with the recognition that these forward-looking statements may notbe complete or accurate at a later date.*

*Manyfactors may cause actual results to differ materially from those expressed orimplied by the forward-looking statements contained in this report. Thesefactors include, but are not limited to, those risks described in our AnnualReport on Form 10-K filed on March 31, 2006.*

**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**

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 the 10-gigabitEthernet market. In August 2002, we decided to cease operations of the PMDsegment because of a severe downturn in the market for 10-gigabit Ethernetproducts. On November 15, 2002, we sold or disposed of the assets of ourPMD operating segment, including all of the valuable technology, property andequipment, licensed software and employees, for $1,752 in cash and the buyer’sassumption of $187 of liabilities. The results of operations of the PMD segmentare reported as discontinued operations in the cumulative period from inception(April 14, 1997) through September 30, 2006. From inception through September30, 2006, we had gross revenues of $926, a loss from continuing operations of$68,564, and a loss from our discontinued PMD operations of $31,874.

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.  The Company has named its first productfamily the ArrixTM FPOA family of chips.

13

----

***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 anddevelopment expenses consist primarily of salaries and related costs of ourengineering organization, fees paid to third party consultants and anallocation of facilities and depreciation expenses. We expense all research anddevelopment costs related to the development of our FPOA. Development ofcertain design tools and applications include the development of software. Suchresearch and development expenses are required to be expensed until thetechnological feasibility of the software is established. We determinetechnological feasibility based upon completion of a working model of thesoftware. To date, the period between technological feasibility and generalrelease of the software has been short, so virtually all of our softwaredevelopment costs relate to software development during the period beforetechnological feasibility. Accordingly, all such costs have been charged tooperations as incurred. We expect to incur significant additional research anddevelopment costs 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 September 30, 2005 and 2006***

*Revenuesand Cost of Goods Sold. *For the three months ended September 30,2006, our revenues were $28 compared to $15 for the same period last year.  Revenues for the three months ended September30, 2006 were from the sale of software licenses, and revenues for the threemonths ended September 30, 2005 were from the sale of FPOA developmentkits.  These product development kitsincluded software that we licensed from a third party for the development ofdesign tools for our FPOA chips. Costs of goods sold for the three months endedSeptember 30, 2005 and 2006 are primarily the cost of the third party softwarelicenses. The costs of producing our development kits are expensed as researchand development costs as incurred because we do not anticipate substantialsales of the current version of the chip we have produced and because the aggregatecost of the development kits we expect to sell is immaterial.

*Researchand Development.*  For the three months endedSeptember 30, 2006, our research and development expenses increased $2,574 or152% to $4,267 from $1,693 for the three months ended September 30, 2005.  The increase was the result of increasedpayroll costs ($450 which includes $110 of compensation costs related to stockoptions and restricted stock), increased outside engineering and design consultants($23), increased engineering materials and payments to third party vendorsrelated to the tapeout of the ArrixTM FPOA ($1,212), development of internalevaluation boards ($200), computer hardware and software ($121), travel andincreased overhead costs ($248) due to an allocation of certain overhead costs.The increase in payroll costs and the use of outside engineering and designconsultants is the result of increased staffing and efforts to complete theFPOA chip design and to continue development of our library of developmentalgorithms for use by our customers.

14

----

*Selling,General and Administrative.  *For thethree months ended September 30, 2006, our selling, general and administrativeexpenses increased 58% to $2,581 compared to $1,632 for the three months endedSeptember 30, 2005. The increase was primarily the result of increased salaries($851, which includes a net increase of $700 for charges related to non-cash compensation costs of stock optionsand restricted stock), and hired staff in the second half of 2005. Otherexpense increases include legal and audit ($145), consulting ($70), primarilyrelated to marketing and compliance with the Sarbanes-Oxley Act of 2002,increased recruiting and relocation expenses ($130), and increased insuranceexpenses ($37) due to being a public company. These increases were offsetby an allocation in the three months ended September 30, 2006 of certainoverhead costs ($248) to research and development.

*OtherIncome (Expense).  *For the three months ended September 30,2006, we had interest income of $112 as a result of interest earnings on cashdeposits on cash remaining from our initial public offering proceeds.  We had net interest expense of  $893 for the three months ended September 30,2005 as we issued convertible debt in April 2005.

***Nine Months Ended September 30, 2005 and 2006***

*Revenuesand Cost of Goods Sold. *For the nine months ended September 30,2006, we generated revenues of $46 compared to $55 for the nine months endedSeptember 30, 2005.  Revenues for thenine months ended September 30, 2006 were from software license fees andnon-recurring engineering fees, and revenues for the nine months endedSeptember 30, 2005 were from the sale of FPOA development kits.  These product development kits includedsoftware that we licensed from a third party for the development of designtools for our FPOA chips. Costs of goods sold for the nine months endedSeptember 30, 2005 and 2006 are the cost of the third party software licenses.The costs of producing our development kits are expensed as research anddevelopment costs as incurred because we do not anticipate substantial sales ofthe current version of the chip we have produced and because the aggregate costof the development kits we expect to sell are immaterial.

*Researchand Development.*  For the nine months ended September30, 2006, we incurredresearch and development costs of $10,293, an increase of $4,267 or 71% overresearch and development costs for the nine months ended September 30, 2005 of$6,026.  The increase was the result ofincreased payroll costs ($1,581, which includes $230 of charges related tocompensation costs related to stock options and restricted stock), increasedoutside engineering and design consultants ($725) and increased overhead costs($767), due to an allocation of certain overhead costs, computer software andlicenses ($310), engineering and tapeout related expenses ($410), EDA toollicenses ($44), ArrixTM FPOA evaluation board development ($200),recruiting and relocation expense ($139), and travel ($41). The increase inpayroll costs and the use of outside engineering and design consultants is theresult of increased staffing and efforts to complete the ArrixTM FPOA design, development of our library ofdevelopment algorithms for use by our customers, and future generations of FPOAchips.

*Selling,General and Administrative.*  For the nine months endedSeptember 30, 2006, selling, general and administrative costs increased $2,797or 64% to $7,132 from $4,335 for the nine months ended September 30, 2005.  The increase was primarily the result ofincreased salaries ($2,564, which includes $2,057 of charges related tocompensation costs related to expensing of stock options and restricted stock),as we hired a chief operating officer, chief financial officer and vicepresidents of marketing and engineering, a controller and other staff in thesecond half of 2005. Other expense increases include legal, auditing andconsulting  ($522), advertising ($60),increased recruiting and relocation expenses ($219), increased travel expenses($63) and increased insurance expenses ($111) due to being a publiccompany. These increases were offset by an allocation in the nine monthsended September 30, 2006 of certain overhead costs ($742) to research anddevelopment.

*OtherIncome (Expense). *For the nine months ended September 30,2006, we had interest income of $462 as a result of interest earnings on cashdeposits on cash remaining from our initial public offering proceeds.  We had net interest expense of $1,362 for thenine months ended September 30, 2005, as we issued convertible debt in April2005.

15

----

**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 September 30, 2006, we raised net proceeds of $71,465 from sales of commonstock and common stock warrants and $5,500 from sales of 8% convertible promissorynotes and common stock warrants.  During the nine month period endedSeptember 30, 2006, we received $513 from the exercise of certain warrants heldby investors and $46 from the exercise of stock options.  During the ninemonth period ended September 30, 2005, we raised $223 from the exercise ofcertain warrants held by investors.  OnOctober 3, 2006, the Company sold 3,143 shares in a private placement at $4.00per share, generating $12,570 of gross proceeds before the payment ofcommissions and expenses. Warrants were issued with the shares of common stockin the private placement to purchase 1,367 shares with an exercise price of$6.00 and an expiration date of October 3, 2011. The Company had received$3,800 of cash related to this private placement before September  30, 2006, which is recorded as an accruedliability as of September 30, 2006.

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 throughthe fourth quarter of 2006. Our long-term financing requirements will dependsignificantly on our ability to penetrate the market with our FPOA chiptechnology. If existing cash, cash equivalents and cash generated fromoperations are insufficient to satisfy our liquidity requirements, we may seekto sell additional equity or debt securities or obtain other financing. If weobtain 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 $9,557 and $14,450 for the nine months ended September30, 2005 and 2006.  Net cash used for operating activities for the ninemonths ended September 30, 2005 and 2006 was to fund our on-going research anddevelopment activities and our selling, general and administrative costs.

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

Net cash used byinvesting activities for the nine months ended September 30, 2006 of $343 wasfor the purchase of property and equipment. We had no investing activities forthe nine months ended September 30, 2005.

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

Net cash provided byfinancing activities was $5,723 and $4,359 for the nine months ended September30, 2005 and 2006.  For the nine months ended September 30, 2006, wereceived $513 from the exercise of warrants held by investors and $46 fromthe exercise of stock options. The Company also received $3,800 of cashrelated to the private placement before September  30, 2006, which is recorded as an accruedliability as of September 30, 2006.  Forthe nine months ended September 30, 2005, financing cash flows consisted of theproceeds from the issuance of $5,500 of our 8% convertible promissory notes and$223 from related common stock warrants and proceeds from the exercise ofwarrants, as discussed above.

16

----

**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 facilitatingoff-balance sheet arrangements or other contractually narrow or limitedpurposes. In addition, we do not engage in trading activities involvingnon-exchange traded contracts. As such, we are not materially exposed to anyfinancing, liquidity, market or credit risk that could arise if we had engagedin these relationships.

**Item 3.    Quantitative and Qualitative Disclosuresabout 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.

**Item 4.    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 rules and forms ofthe Securities and Exchange Commission. These controls and procedures are alsodesigned to ensure that such information is accumulated and communicated to theCompany’s management, including the Chief Executive Officer (CEO) and ChiefFinancial Officer (CFO), as appropriate to allow timely decisions regardingrequired disclosure. Internal controls are procedures designed to providereasonable assurance that transactions are properly authorized; assets aresafeguarded against unauthorized or improper use; and transactions are properlyrecorded and reported, to permit the preparation of our financial statements inconformity with generally 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 no assurancethat any design will succeed in achieving its stated goals under all potentialfuture conditions. Over time, a system of controls may become inadequatebecause of changes in conditions or deterioration in the degree of compliancewith its policies or procedures. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected. We continuously evaluate our internal controls and makechanges to improve them as necessary. Our intent is to maintain our disclosurecontrols 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 Securities Exchange Act of 1934. Based upon, and as of the date ofthis evaluation, the CEO and the CFO concluded that the Company’s disclosurecontrols and procedures were not effective because of the material weaknessdescribed below.

17

----

*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 twoconditions, in combination, constitute a material weakness in our internalcontrols.

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.

**Part II        Other Information**

**Item 1.       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 thisQuarterly Report on Form 10-Q also should be carefully considered. Therisks and uncertainties described in our Annual Report are not the only risksthe Company faces. Additional risks and uncertainties not presently known tothe Company or that the Company’s management currently deems immaterial alsomay impair its business operations. If any of the risks described were to occur,our business, financial condition, operating results and cash flows could bematerially adversely affected.

**Item 2.       Unregistered Sales of Equity Securitiesand Use of Proceeds**

(a) From the periodbeginning July 1 2006 and ending September 30, 2006, we issued the followingequity securities in the following transactions, which were not registeredunder the Securities Act of 1933 (the “Securities Act”):

1.               During theperiod from July 1, 2006 through September 30, 2006, the Company issued 50,003shares to eight 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 $112. These sales were made in reliance on theexemption provided by Section 4(2) of and Rule 506 of Regulation D under theSecurities Act of 1933. These issues do not include issuances previouslydisclosed in the Company’s Quarterly Reports on Form 10-Q for the quarter endedMarch 31, 2006 filed on May 15, 2006 and for the quarter ended June 30, 2006 filed on August 14, 2006.

18

----

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.

**Item 3.       Defaults Upon Senior Securities**

None.

**Item 4.       Submission of Matters to a Vote ofSecurity Holders.**

None.

**Item 5.       Other Information**

None.

**Item 6.       Exhibits**

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

19

----

**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: November  14, 2006 | By:            | /s/ James W. Cruckshank |   |
|                     |           | James W. Cruckshank |
|                     |           | Vice President of Administration and |
|                     |           | Chief Financial Officer |
|                     |           | (Principal Financial Officer and Principal |
|                     |           | Accounting Officer) |

 

20

----

**EXHIBITINDEX (To be reviewed)**
| 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).                                                                                                                                                                                                                                                  |

 

----

*              Indicatesa management contract or compensatory plan or arrangement.

21

----