**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

**(MarkOne)**
| **x**                                                   | **Quarterly report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**  |
|---------------------------------------------------------|-----------------------------------------------------------------------------------------------|
|                                                    |
| ** **                                              |
| **For the quarterly period ended  September 30, 2007.** |
| ** **                                              |
| **OR**                                                  |
| ** **                                              |
| **o**                                                   | **Transition report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934** |
|                                                    |
|                                                    |                                                                                          |   |

 

**For the transition period from                to**

**Commission file number 000-51560**

**MathStar, Inc.**

(Exact name of registrant as 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 telephone number, including area code)

**N/A**

(Former name, former address, and former fiscal year, if changed sincelast report)

Indicate by checkmark whether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  x  Yes    o  No

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  See definition of “accelerated filer” and “largeaccelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one.)
| Large Accelerated Filer  o | Accelerated Filer  x | Non-Accelerated Filer  o |
|--------------------------------------|--------------------------------|------------------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  o  Yes    x  No

Shares outstanding of the Registrant’s common stock:
| **Class**                     | ** ** | **Outstanding at September  30, 2007** |
|-------------------------------|------------|--------------------------------------------------|
| Common stock, $0.01 par value |       | 45,906,890                                       |

 

 

 

----

 

 
| PART I   FINANCIAL INFORMATION | 1         |
|-------------------------------------|-----------|
|                                |      |   |
|                                | Item 1.   | Financial Statements  (Unaudited) | 1 |
|                                |      | Condensed Balance Sheets  as of December 31, 2006 and September 30, 2007 | 1 |
|                                |      | Condensed  Statements of Operations for the Three and Nine Months Ended  September 30, 2006 and 2007 | 2 |
|                                |      | Condensed  Statements of Cash Flows for the Nine Months Ended September 30, 2006 and  2007 | 3 |
|                                |      | Notes  to Condensed Consolidated Financial Statements | 4 |
|                                |      |   |   |
|                                | Item 2    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 7 |
|                                | Item 3    | Quantitative  and Qualitative Disclosures about Market Risk | 12 |
|                                | Item 4    | Controls and  Procedures | 12 |
|                                |      |   |
| PART  II  OTHER INFORMATION    | 12        |
|                                | Item 1.   | Legal Proceedings | 12 |
|                                | Item  1A. | Risk  Factors | 12 |
|                                | Item 2.   | Unregistered  Sales of Equity Securities and Use of Proceeds | 13 |
|                                | Item 3.   | Defaults Upon  Senior Securities | 13 |
|                                | Item 4.   | Submission of  Matters to a Vote of Security Holders | 13 |
|                                | Item 5.   | Other Information | 13 |
|                                | Item  6.  | Exhibits | 13 |
|                                |      |   |   |
| Signatures                          |      | 13 |

 

----

 

 

 

**Part I**

**Financial Information**

**Item 1.  Financial Statements**

**MathStar, Inc.**

**CondensedBalance Sheets**

**(Unaudited)**

**(in thousands)**
| ** **                                                                                                                                                                | ** ** | **December 31,  2006** | ** ** | **September 30,  2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| **Assets**                                                                                                                                                                |       |                        |       |                         |       |
| Current assets                                                                                                                                                            |       |                        |       |                         |       |
| Cash and cash equivalents                                                                                                                                                 |       | $                           | 12,891     |                         | $          | 14,283 |   |
| Restricted cash                                                                                                                                                           |       | 103                         |       | 106                          |       |
| Investment securities— short term                                                                                                                                    |       | -                           |       | 14,250                       |       |
| Accounts receivable                                                                                                                                                       |       | 14                          |       | 144                          |       |
| Inventory                                                                                                                                                                 |       | 610                         |       | 702                          |       |
| Prepaid expenses and other current assets                                                                                                                                 |       | 1,231                       |       | 796                          |       |
| Total current assets                                                                                                                                                      |       | 14,849                      |       | 30,281                       |       |
| Property and equipment, net                                                                                                                                               |       | 487                         |       | 430                          |       |
| Investment securities — long term                                                                                                                                    |       | -                           |       | 5,431                        |       |
| Other assets                                                                                                                                                              |       | 278                         |       | 454                          |       |
| Total assets                                                                                                                                                              |       | $                           | 15,614     |                         | $          | 36,596 |   |
|                                                                                                                                                                      |       |                        |       |                         |       |
| **Liabilities and Stockholders’  Equity**                                                                                                                            |       |                        |       |                         |       |
| Current liabilities                                                                                                                                                       |       |                        |       |                         |       |
| Accounts payable                                                                                                                                                          |       | $                           | 1,791      |                         | $          | 410 |   |
| Deferred revenue                                                                                                                                                          |       | —                      |       | 162                          |       |
| Accrued expenses                                                                                                                                                          |       | 1,206                       |       | 1,216                        |       |
| Total liabilities                                                                                                                                                         |       | 2,997                       |       | 1,788                        |       |
| 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;  20,922 and 45,907 shares issued and outstanding at December 31, 2006 and  September 30, 2007, respectively |       | 209                         |       | 459                          |       |
| Additional paid-in capital                                                                                                                                                |       | 118,545                     |       | 154,881                      |       |
| Accumulated deficit                                                                                                                                                       |       | (106,137                    | )          | (120,532                     | )          |
| Total stockholders’ equity                                                                                                                                           |       | 12,617                      |       | 34,808                       |       |
| Total liabilities and stockholders’ equity                                                                                                                           |       | $                           | 15,614     |                         | $          | 36,596 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

 

1

----

 

**MathStar, Inc.**

**CondensedStatements of Operations**

**(Unaudited)**

**(in thousands except for per shareamounts)**
| ** **                                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                            | ** ** | **2006**                                             | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                                            | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                               |       | $                                                    | 28         |                                                | $          | 63 |   | $ | 46 |   | $ | 275 |   |
| Cost of goods sold                                    |       | 21                                                   |       | 58                                                  |       | 27 |   | 181 |   |
| Gross margin                                          |       | 7                                                    |       | 5                                                   |       | 19 |   | 94 |   |
| Operating expenses:                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Research and development                              |       | 4,267                                                |       | 2,655                                               |       | 10,293 |   | 8,387 |   |
| Selling, general and administrative                   |       | 2,581                                                |       | 2,164                                               |       | 7,132 |   | 6,733 |   |
|                                                  |       | 6,848                                                |       | 4,819                                               |       | 17,425 |   | 15,120 |   |
| Operating loss                                        |       | (6,841                                               | )          | (4,814                                              | )          | (17,406 | ) | (15,026 | ) |
| Interest income                                       |       | 112                                                  |       | 426                                                 |       | 462 |   | 652 |   |
| Other income /(loss), net                             |       | —                                               |       | (5                                                  | )          | — |   | (21 | ) |
| Net loss                                              |       | $                                                    | (6,729     | )                                                   | $          | (4,393 | ) | $ | (16,944 | ) | $ | (14,395 | ) |
|                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and diluted net loss per share                  |       | $                                                    | (0.39      | )                                                   | $          | (0.10 | ) | $ | (0.99 | ) | $ | (0.47 | ) |
| Weighted average basic and diluted shares outstanding |       | 17,259                                               |       | 45,907                                              |       | 17,112 |   | 30,405 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

2

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**MathStar, Inc.**

**CondensedStatements of Cash Flows**

**(Unaudited)**

**(in thousands)**
| ** **                                                                  | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                  | ** ** | **September 30,**          | ** ** |
| ** **                                                                  | ** ** | **2006**                        | ** ** | **2007** | ** ** |
| ** **                                                                  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Cash flows from operating  activities**                                   |       |                            |       |   |   |
| Net loss                                                                    |       | $                               | (16,944    | ) | $ | (14,395 | ) |
| Adjustments to reconcile net loss to net cash used in  operating activities |       |                            |       |   |   |
| Depreciation and amortization                                               |       | 99                              |       | 133 |   |
| Loss on asset disposal                                                      |       |                            |       | 5 |   |
| Stock-based compensation                                                    |       | 2,288                           |       | 83 |   |
| Foreign currency translation                                                |       |                            |       | 11 |   |
| Change in operating assets and liabilities                                  |       |                            |       |   |   |
| Accounts receivable                                                         |       | 28                              |       | (130 | ) |
| Inventory                                                                   |       | 22                              |       | (92 | ) |
| Prepaid expenses and other assets                                           |       | 402                             |       | 542 |   |
| Accounts payable                                                            |       | (321                            | )          | (1,381 | ) |
| Deferred revenue                                                            |       |                            |       | 162 |   |
| Accrued expenses                                                            |       | (24                             | )          | 4 |   |
| Net cash used in operating activities                                       |       | (14,450                         | )          | (15,058 | ) |
| ** **                                                                  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Cash flows from investing  activities**                                   |       |                            |       |   |   |
| Purchase of property and equipment                                          |       | (252                            | )          | (69 | ) |
| Purchase of capitalized application software                                |       | (91                             | )          | (292 | ) |
| Purchase of investment securities                                           |       |                            |       | (19,684 | ) |
| Restricted cash                                                             |       |                            |       | (3 | ) |
| Net cash used in investing activities                                       |       | (343                            | )          | (20,048 | ) |
| ** **                                                                  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Cash flows from financing  activities**                                   |       |                            |       |   |   |
| Proceeds from issuance of common stock, net of offering  costs              |       | 3,800                           |       | 36,473 |   |
| Proceeds from exercise of warrants                                          |       | 513                             |       | 21 |   |
| Proceeds from exercise of stock options                                     |       | 46                              |       | 9 |   |
| Net cash provided by financing activities                                   |       | 4,359                           |       | 36,503 |   |
| Effect of exchange rate changes on cash                                     |       |                            |       | (5 | ) |
| Net (decrease) increase in cash and cash equivalents                        |       | (10,434                         | )          | 1,392 |   |
|                                                                        |       |                            |       |   |   |
| **Cash and cash equivalents**                                               |       |                            |       |   |   |
| Beginning of period                                                         |       | 20,149                          |       | 12,891 |   |
| End of period                                                               |       | $                               | 9,715      |   | $ | 14,283 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

 

3

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** **

**MathStar, Inc.**

**Notes toFinancial Statements**

**(Unaudited)**

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

**1.****            ****Basis of Presentation and GoingConcern**

Theaccompanying interim condensed financial statements of MathStar, Inc. (“MathStar”or the “Company”) have been prepared in conformity with United States (“U.S.”)generally accepted accounting principles (“GAAP”), consistent in all materialrespects with those applied to the financial statements in the Company’s AnnualReport on Form 10-K filed with the Securities and Exchange Commission (“SEC”)on March 14, 2007. The year-end condensed balance sheet was derived fromaudited financial statements, but does not include all disclosures required byU.S. GAAP. The preparation of financial statements in conformity with U.S. GAAPrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and the disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period. Actual results could differfrom those estimates.

Theinterim financial information is unaudited, but it reflects all normaladjustments that are, in the opinion of management, necessary to provide a fairstatement of results for the interim periods presented. The interim financialresults are not necessarily indicative of results to be expected in futureinterim or annual periods. The interim financial statements should be read inconjunction with the financial statements in the Company’s Annual Report onForm 10-K filed with the Securities and Exchange Commission on March 14, 2007.

Forthe year ended December 31, 2006, MathStar reported as a “development stagecompany” as prescribed in Statement of Financial Accounting Standards (“SFAS”)No.7, *Accounting and Reporting byDevelopment Stage Enterprises.*During that time, MathStar’s majoremphasis was on planning, research and development, recruitment and developmentof a management and technical staff, and raising capital. These developmentstage activities were completed during the first quarter of 2007. MathStar hasits management team and organizational structure in place with its primaryfocus on the sale and commercialization of its current product. MathStar hasproduction products placed within its distribution channel and has soldproduction chips and development systems to end customers. As such, MathStar nolonger considers itself a development stage company.

Theaccompanying financial statements have been prepared on a basis which assumesthat the Company will continue as a going concern and which contemplates therealization of assets and the satisfaction of liabilities and commitments inthe normal course of business. The Company has a limited operating history andhas incurred losses and negative cash flows from operations since inception,which raise substantial doubt about the Company’s ability to continue as agoing concern. Although the Company successfully completed a $40,000 follow-onoffering during the quarter ended June 30, 2007, it expects to incur additionallosses while the Company continues to develop its sales. Given the lack ofoperating profitability, the Company will continue to disclose a substantialdoubt about its ability to continue as a going concern.

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

TheCompany adopted the provisions of the Financial Accounting Standards Board (“FASB”)Interpretation No. 48, *Accounting forUncertainty in Income Taxes*, on January 1, 2007.  This adoptiondid not have a material effect on the Company’s consolidated financial positionor results of operations.  As of September 30, 2007, the Company had$38,304 of deferred tax assets; however, valuation allowances have beenestablished to fully offset these deferred tax assets due to the uncertaintyabout the Company’s ability to generate the future taxable income necessary torealize these deferred tax assets, particularly in light of the Company’srecent history of significant operating losses. The Company records interestand penalties, if any, within operating expenses as a tax expense.

 

4

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InFebruary 2007, the FASB issued SFAS No. 159, “*The Fair Value Option for Financial Assets and Liabilities—includingAmendment of FAS No. 115”.*SFAS No. 159 gives companiesthe option of recording certain financial assets and liabilities at fair value.SFAS No. 159 is effective for the Company in the first quarter of 2008.The Company is evaluating the potential impact of the standard.

InSeptember 2006, the FASB issued SFAS No. 157, “*Fair Value Measurements*” (“SFAS No. 157”).SFAS No. 157 defines fair value, establishes a framework for measuring fairvalue in U.S. GAAP, and expands disclosures about fair value measurements. SFASNo. 157 is effective for financial statements issued for fiscal years beginningafter November 15, 2007 and interim periods within those fiscal years. TheCompany will be required to adopt SFAS No. 157 in the first quarter of 2008.Management is currently evaluating the requirements of SFAS No. 157 and has notyet determined the impact on the Company’s consolidated financial statements.

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

MathStarcontinues to issue options as a means to incent potential employees to join andretain certain existing employees.  The Company accounts for optionsgranted under SFAS No. 123R (revised 2004), “*Share-BasedPayment*,” utilizing the Black-Scholes pricing model.  The tablebelow discloses options granted to new and existing employees and the totaloptions outstanding as of September 30, 2007.
| **Options**                            | ** ** | **Shares**         | ** ** | **Weighted-Average  Exercise Price** | ** ** | **Weighted-Average  Remaining Contractual Term** | ** ** | **Aggregate Intrinsic  Value** | ** ** |
|----------------------------------------|------------|--------------------|------------|--------------------------------------|------------|--------------------------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **(in thousands)** | ** ** | ** **                           | ** ** | ** **                                       | ** ** | **(in thousands)**             | ** ** |
| Outstanding at  December 31, 2006 |       | 2,178              |       | $                                    | 5.46       |                                             | 5.45       |                           | $          | 169 |   |
| Granted new employees                  |       | 213                |       | 2.94                                 |       |                                             |       |                           |       |
| Granted replenishment options          |       | 985                |       | 1.52                                 |       |                                             |       |                           |       |
| Exercised                              |       | (10                | )          | 0.87                                 |       |                                             |       |                           |       |
| Forfeited or expired                   |       | (325               | )          | 5.33                                 |       |                                             |       |                           |       |
| Outstanding at September 30, 2007      |       | 3,041              |       | $                                    | 4.03       |                                             | 7.93       |                           | $          | 5 |   |
|                                   |       |               |       |                                 |       |                                             |       |                           |       |
| Exercisable at September 30, 2007      |       | 1,085              |       | $                                    | 5.58       |                                             | $          | 5.62                           |       | $ | 5 |   |
|                                        |            |                    |            |                                      |            |                                                  |            |                                |            |  |  |  |

 
| ** **                                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months  Ended**      | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| **2007 Stock Based Compensation Expense** | ** ** | **September 30,   2007**    | ** ** | **September 30, 2007** | ** ** |
| Employee stock based compensation                             |       | $                                | 189        |                             | $          | 517 |   |
| Nonemployee adjustments                                       |       | (55                              | )          | (434                             | )          |
| Net stock based compensation                                  |       | $                                | 134        |                             | $          | 83 |   |

 

For the first nine months of 2007, the Companyrecorded  $517 in non-cash stock basedcompensation expense related to awards to employees. The remaining compensationexpense associated with these awards is $1,913 with a weighted averagecontractual term of 3.63 years. The Company also grants awards tonon-employees, the Company revalues non-employee awards based on the marketvalue of the stock at the end of each quarter, which resulted in year-to-daterecapturing of previous year’s expenses of $434.

 

5

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

**RestrictedCash**

The Company has pledged$106 as collateral to secure the balances on Company-issued credit cards. TheCompany cannot use the restricted cash in the normal course of business untilthe credit cards are cancelled or the bank releases the funds. The credit cardsare issued to certain Company employees for the purpose of Company-related traveland purchases.

 

**Investment****Securities**

** **
| ** **                                      | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2007**               | ** ** |
| Government securities — notes (short term) |       | $                     | —     |                   | $          | 8,702 |   |
| Government securities — bonds (short term) |       | —                |       | 5,548                  |       |
| Government securities — bonds (long term)  |       | —                |       | 5,431                  |       |
|                                            |       | $                     | —     |                   | $          | 19,681 |   |

 

 

The Company has aninvestment policy that restricts investments to government securities and highquality investments.  The Company’sinvestments generally mature between three and fifteen months. Investments withmaturities beyond one year are classified as long-term investments. All of ourinvestments are classified as held-to-maturity and are carried at amortizedcost as the Company has the intent and ability to hold these securities tomaturity.

 

 

**Inventory**

** **
| ** **                                      | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2007**               | ** ** |
| Raw materials                                   |       | $                     | 49         |                   | $          | 60 |   |
| Sub-assembly                                    |       | —                |       | 33                     |       |
| Finished goods                                  |       | 662                   |       | 726                    |       |
| ** **                                      |       | $                     | 711        |                   | $          | 819 |   |
| Less: reserve for excess and obsolete inventory |       | (101                  | )          | (117                   | )          |
| Total inventory, net                            |       | $                     | 610        |                   | $          | 702 |   |

 

 

The increase in the valuation reserve was charged tocost of sales.

** **

**Prepaid and Other Current Assets**

 
| ** **                             | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|----------------------------------------|------------|------------------|------------|-------------------|------------|
| ** **                             | ** ** | **2006**         | ** ** | **2007**          | ** ** |
| EDA licenses                           |       | $                | 695        |              | $          | 330 |   |
| Interest Receivable                    |       |             |       | 212               |       |
| Prepaid insurance                      |       | 239              |       | 73                |       |
| Prepaid rent                           |       | 111              |       | 30                |       |
| Other                                  |       | 186              |       | 151               |       |
| Total prepaid and other current assets |       | $                | 1,231      |              | $          | 796 |   |

 

 

**Property and Equipment**

** **
| ** **                        | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-----------------------------------|------------|------------------|------------|-------------------|------------|
| ** **                        | ** ** | **2006**         | ** ** | **2007**          | ** ** |
| Computer equipment                |       | $                | 1,003      |              | $          | 144 |   |
| Purchased software                |       | 533              |       | 533               |       |
| Equipment                         |       | 106              |       | 106               |       |
| Furniture and fixtures            |       | 365              |       | 314               |       |
|                              |       | $                | 2,007      |              | $          | 1,097 |   |
| Less: Accumulated depreciation    |       | (1,520           | )          | (667              | )          |
| Total property and equipment, net |       | $                | 487        |              | $          | 430 |   |

 

6

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Depreciation expense was$39 and $43 for the three months ended September 30, 2006 and 2007,respectively, and $99 and $123 for the nine months ended September 30, 2006 and2007, respectively.  The reduction in gross property and equipment andaccumulated depreciation is due to disposal of excess and idle assets from theprevious Minneapolis location.  The disposal resulted in a noncash chargeof $5 to operating results.

 

 

**Other Assets**

 
| ** **                             | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|----------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                             | ** ** | **2006**              | ** ** | **2007**               | ** ** |
| Capitalized application software (net) |       | $                     | 134        |                   | $          | 417 |   |
| Other                                  |       | 144                   |       | 37                     |       |
|                                   |       | $                     | 278        |                   | $          | 454 |   |

 

 

Amortization expenseassociated with capitalized software was $0 and $5 for the three months endedSeptember 30, 2006 and 2007, respectively, and $0 and $7 for the nine monthsended September 30, 2006 and 2007, respectively.

 

**Accrued Expenses**

 
| ** **                | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|---------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                | ** ** | **2006**              | ** ** | **2007**               | ** ** |
| Accrued rent              |       | $                     | 77         |                   | $          | 46 |   |
| Accrued compensation      |       | 480                   |       | 778                    |       |
| Accrued professional fees |       | 226                   |       | 101                    |       |
| Other                     |       | 423                   |       | 291                    |       |
| Total accrued expenses    |       | $                     | 1,206      |                   | $          | 1,216 |   |

 

 

**Item 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

*This Quarterly Report on Form 10-Qcontains forward-looking statements, which are being provided under the “safeharbor” protection of the Private Securities Litigation Reform Act of 1995.Forward-looking statements are generally written in the future tense and/or arepreceded by words such as “will,” “may,” “should,” “could,” “expect,” “suggest,”“believe,” “anticipate,” “intend,” “plan,” or other similar words.Forward-looking statements include statements regarding the commercial successof our new products; the growth prospects of the semiconductor industry andprogrammable logic market, including the field programmable object array (“FPOA”)and field programmable gate array (“FPGA”) product sub-segments;and trends in our future sales, including our opportunities for growth bydisplacing FPGAs, application-specific integrated circuits (“ASICs”) and othersemiconductor alternatives.*

 

7

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*Forward-looking statements are not guarantees of futureperformance and involve risks and uncertainties. The forward-looking statementscontained in this report are based on information that is currently availableto us and expectations and assumptions that we deem reasonable at the time thestatements were made. We do not undertake any obligation to update anyforward-looking statements in this report or in any of our othercommunications, except as required by law. All such forward-looking statementsshould be read as of the time the statements were made and with the recognitionthat these forward-looking statements may not be complete or accurate at alater date.*

*Many factors may cause actual results to differ materiallyfrom those expressed or implied by the forward-looking statements contained inthis report. These factors include, but are not limited to, those risksdescribed in our Annual Report on Form 10-K filed on March 14, 2007.*

**BusinessOverview**

Weare a 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 established a sales network anddistribution channel, sold and shipped a limited quantity of our firstproduction field programmable object array, or FPOA, chip, and provided asecond release of our design tools to customers.  Current activities arefocused on the sale of current products and developing enhanced and follow-onproducts.

Oursales cycle begins when a prospective customer decides to introduce a newproduct or change or upgrade an existing product.  Generally, theprospective customer will survey new and existing technology to determine ifthere are technological advances that it needs need to integrate into itsproduct lines. At this point, if there appears to be a fit, the prospectivecustomer will engage with us to determine if our FPOA can solve its productneeds.  Typically, one of our field application engineers (FAEs) will workwith the prospective customer’s engineers to create an application assessmentthat documents the advantages of using an FPOA in the customer’s product. At this point, the prospective customer will make a technology decision. If the decision is to use an FPOA, the customer will buy an FPOA evaluationsystem and an FPOA design software tools license from us to develop a prototypeof its application on our FPOA.  Once the customer has developed andtested its FPOA design, the customer will develop prototypes of its new product. The customer will then sell prototypes or limited production versions of itsnew product to its customers.  Assuming the customer achieves marketacceptance, it will ramp its design in production and start purchasingproduction quantities of FPOAs. Our sales cycle can be as short as six monthsand as long as 18 months, except in the case of the military/aerospace markets,in which the development cycle can be three to five years.

Ourproduction FPOA is currently in inventory and for sale at our warehouse, aworldwide electronics component distributor and an e-commercedistributor.  Our revenue for the first half of 2007 was primarily fromsales of production chips, evaluation systems, tools, nonrecurring engineeringfees (NRE) and application licenses which are the key components of thebeginning of the sales cycle.  As more of our customers move theirproducts into production, more of our revenues will be from the sale of FPOAs.

**FinancialOperations Overview**

***Revenue and Costs***

The Company recognizes revenue for products whenpersuasive evidence of an arrangement exists, delivery has occurred, the salesprice is fixed or determinable, collection is reasonably assured and there areno post-delivery obligations. Costs associated with product revenue consist of themanufacturing costs of the evaluation units and chips, subcontracted expensesassociated with NRE revenue and software license fees and recorded in cost ofsales.  Revenue and costs associated with sales to distributors aredeferred until MathStar receives notice from the distributor that the producthas been sold to an end user.  The amount reflected on MathStar’s balancesheet is the net margin from the deferred revenue and associated costs. Revenueand costs for chips held at distributors are deferred because of thedistributors’ ability to return unsold chips for refund or credit.

 

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***Research and Development***

Researchand development expenses represent costs incurred for designing and engineeringour FPOA chips and developing design tools and applications to enable customersto more easily program our chip. Research and development expenses consistprimarily of salaries and related costs of our engineering organization; feespaid to third party consultants associated with chip development; an allocationof facilities; and depreciation expenses. We expense all research anddevelopment costs related to the development of our FPOA chips. 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 to be the point at which a feasibility assessment iscomplete and a detailed technical design document is established. We expect toincur significant additional research and development costs as we develop morechips using our FPOA technology.

 

***Selling, General and AdministrativeExpenses***

Selling,general and administrative expenses consist primarily of salaries and relatedcosts of our sales and marketing and administrative staff, commissions paid todirect sales staff and manufacturing representatives, general corporateactivities and an allocation of facilities and depreciation expenses. Weanticipate that our selling, general and administrative costs will increase asa result of increasing our sales and marketing and administrativestaff and commissions to support sales of FPOA chips in worldwide marketsand to support our growth and operation as a public company.

**RecentlyIssued Accounting Pronouncements**

SeeNote 2 of Notes to Financial Statements included in Part I, Item 1 of thisQuarterly Report on Form 10-Q.

**CriticalAccounting Policies**

TheCompany has updated the disclosure related to critical accounting policiessince its Annual Report on Form 10-K for the year ended December 31, 2006 toinclude capitalized application software.

**Capitalizationof Application Software**

TheCompany is developing certain applications of known algorithms for use on itsFPOA chips.  The accounting for development costs of these applications iscovered under SFAS No. 86, “*Research andDevelopment Costs of Computer Software.”*Judgment is required indetermining when technological feasibility is established. Because these areestablished algorithms, we define technological feasibility of an applicationdevelopment project to be the point at which a feasibility assessment iscomplete and a detailed technical design document is established. All costsincurred prior to establishing technological feasibility are expensed whenincurred. Costs after that date are capitalized and then amortized based on thegreater of a straight-line basis over the useful life of the applications orthe ratio of current sales to the total current and anticipated future sales.

**InvestmentSecurities**

**               **The Company invests idle funds in government securities,money market funds and high quality securities. The investment criteria isbased on the desire to preserve capital, maintain adequate balances to meetobligations, minimize risk of principle loss, and yield maximization within theinvestment guidelines. Current investments are classified as securities to beheld-to-maturity and are reported at the amortized cost.

**Resultsof Operations**

***Three Months Ended September 30, 2006 and 2007***

*Revenue and Cost of Goods Sold.*For the three months ended September 30,2007, we generated revenue of $63,000 compared to $28,000 for the same periodlast year. Revenue for the three months ended September 30, 

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2007 was from thesale of development systems, licensed software and NRE fees. Revenue for thethree months ended September 30, 2006 was from the sale of software licenses.Costs of goods sold for the three months ended September 30, 2007 and 2006were $58,000 and $21,000, respectively. Costs of goods sold in the thirdquarter of 2007 include evaluation system manufacturing costs, subcontractedservices associated with NRE revenue and the cost of third party softwarelicenses.  Costs of goods sold for the third quarter of 2006 consist ofthe cost of third party software licenses. During the three months endingSeptember 30, 2007, the Company completed and invoiced the first phase of amultiple element transaction for $78,000. The amount has not been recognized asrevenue during the quarter as certain criteria for revenue recognition were notmet. The Company will recognize the full value of the arrangement, totaling$156,000, upon completion of the other elements which is expected to occur inthe fourth quarter.

*Research and Development.* For the three months ended September 30, 2007,research and development expenses decreased $1,612,000 or 38% to $2,655,000from $4,267,000 for the three months ended September 30, 2006. The decrease wasthe result of reductions in design tools ($46,000), engineering material($1,297,000) due to the tapeout of the Arrix chip in the prior year, internalboard development ($223,000), building rent ($235,000) and other developmentcosts ($169,000). These decreases were partially offset by increases inemployee related expenses ($214,000) and contracted services ($144,000). Research and development spending will continue to fluctuate based on thetiming in the chip design cycle and application development projects.

*Selling, General and Administrative. *For the three months ended September 30,2007, selling, general and administrative expenses decreased $417,000 or 16% to$2,164,000 from $2,581,000 for the three months ended September 30, 2006. Thedecrease was the result of lower employee related expenses ($300,000), whichwas the result of a $320,000 increase in compensation expenses less theelimination of restricted stock charges of $620,000 recorded in the priorperiods, reduction in recruiting fees ($66,000), professional fees($24,000),  advertising andcommunications ($20,000), and other general business expenses ($7,000). Futureselling, general and administrative expense increases will be primarily insales and commission expenses as revenues grow.

*Other Income (Expense).*For the three months ended September 30, 2007, we hadnet other income of $421, 000 compared to of $112,000 for the three monthsended September 30, 2006. The increase was primarily in interest income offunds invested from the secondary offering.

***Nine Months Ended September 30, 2006 and 2007***

*Revenue and Cost of Goods Sold. *For the nine months ended September 30,2007, we generated revenue of $275,000 compared to $46,000 for the nine monthsended September 30, 2006.  Revenue for the nine months ended September 30,2007 was from the sale of production FPOA chips, software license fees and NREfees. Revenue for the nine months ended September 30, 2006 was from the sale ofsoftware license fees and NRE. These product development kits includedsoftware that we licensed from a third party for the development of designtools for our FPOA chips. Cost of goods sold for the nine months endedSeptember 30, 2007 and 2006 were $181,000 and $27,000, respectively. Cost ofgoods sold for the nine months ended September 30, 2007 were frommanufacturing costs of the chips and evaluation systems, the cost of the thirdparty software licenses and subcontracted NRE services. Cost of goods sold forthe nine months ended September 30, 2006 was for the cost of third partysoftware licenses. During the nine months ending September 30, 2007, theCompany completed and invoiced the first phase of a multiple elementtransaction for $78,000. The amount has not been recognized as revenue duringthe quarter as certain criteria for revenue recognition were not met. TheCompany will recognize the full value of the arrangement, totaling $156,000,upon completion of the other elements which is expected to occur in the fourthquarter.

*Research and Development.*  For the nine months ended September 30, 2007,we incurred research and development costs of $8,387,000, a decrease of$1,906,000 or 19% from research and development costs for the nine months endedSeptember 30, 2006 of $10,293,000.  The decrease was the result of lowercontractor and outside service expense ($99,000), design tool licenses ($281,000),engineering material ($1,268,000) due to the tapeout of the Arrix chip in theprior year, allocated building rent ($330,000), board development costs($241,000), maintenance contracts ($150,000) and recruiting and other expenses($91,000).  These were offset by higher employee related expenses($554,000) due to having a more developed research and development staff.Research 

 

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and developmentexpenses will fluctuate depending on the development cycle of future chips andapplication projects.

*Selling, General and Administrative.*  For the nine months endedSeptember 30, 2007, selling, general and administrative expenses decreased$399,000 or 6% to $6,733,000 from $7,132,000 for the nine months endedSeptember 30, 2006.  This decrease was a result of lower employee relatedexpenses ($845,000), which are the net results of an increase in compensationexpenses of $986,000 and the elimination of restricted stock charges of   $1,831,000 recorded in the prior period.  The decrease was offset by increases intravel ($91,000), advertising and promotions ($24,000), commissions ($22,000)product samples and development systems ($76,000), consultants and outsideservices ($100,000), rent ($52,000), and other infrastructure costs ($81,000).Growth in spending will continue to be directed towards sales and productpromoting activities.

*Other Income (Expense). *For the nine months endedSeptember 30, 2007 and September 30, 2006, we had net other income$631,000 and $462,000, respectively.  Theother income was primarily from interest earned on invested cash.

**Liquidityand Capital Resources**

InJune 2007, MathStar completed a registered follow-on public offering of25,000,000 shares of its common stock at a price to the public of $1.60 pershare, netting $36,473,000 in cash after commissions and offering costs. Webelieve that our cash and investment securities on hand and cash resulting from the saleof product and services will be sufficient to fund operations and meet our capitalneeds and do not anticipate needing to raise additional funds. However, ourfuture capital requirements will depend on many factors, including our salesgrowth, further market acceptance of our existing and new FPOA chips, theamount and timing of our research and development expenditures, the timing ofour introduction of new chips, the expansion of our sales and marketing effortsand working capital needs.

 

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

Netcash used in operating activities was $15,058,000 and $14,450,000 for the ninemonths ended September 30, 2007 and 2006, respectively. Net cash used inoperating activities was to fund chip development, fund the promotion ofcurrent products and pay general and administrative costs.

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

Netcash used by investing activities for the nine months ended September 30, 2007was $20,048,000. Investing activities were for the purchase of equipment, thedevelopment of applications for resale and the purchase of investmentsecurities. Investing activities for the nine months ended September 30, 2006was $343,000. Investing activities were for the purchase of equipment and thedevelopment of applications for resale.

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

Netcash provided by financing activities was $36,503,000 and $4,359,000 for thenine months ended September 30, 2007 and 2006, respectively. For the nine monthperiod ended September 30, 2007, cash was provided from a registered follow-onpublic offering ($36,473,000) and warrants ($21,000) and stock options($9,000). For the nine month period ended September 30, 2006, cash provided byfinancing activities was from the exercise of warrants ($513,000) and stockoptions ($46,000) and the sale of registered securities ($3,800,000).

**Off-BalanceSheet Arrangements**

Wedo not have any relationships with unconsolidated entities or financialpartnerships, such as entities often referred to as structured finance orspecial purpose entities, which would have been established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes. In addition, we do not 

 

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engage in tradingactivities involving non-exchange traded contracts. As such, we are notmaterially exposed to any financing, liquidity, market or credit risk thatcould arise if we had engaged in these relationships.

**Item 3. Quantitative and Qualitative Disclosures about MarketRisk**

Ourexposure to market risk is confined to our cash equivalents and investments. Wehave invested in high-quality financial instruments, primarily money marketfunds, federal agency notes and asset-backed securities, which we believe aresubject to limited credit risks. The Company investments are matched to forecastedcash needs such that investments will not be sold prior to maturity andexposing the Company to losses due to interest rate changes.

**Item 4. Controls and Procedures**

*Evaluationof Disclosure Controls and Procedures*

Duringthe fiscal period covered by this report, the Company’s management, with theparticipation of the Chief Executive Officer and Chief Financial Officer,completed an evaluation of the effectiveness of the design and operation of theCompany’s disclosure controls and procedures, as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”). Basedupon this evaluation, the Company’s Chief Executive Officer and Chief FinancialOfficer have concluded that, as of the end of the fiscal period covered by thisreport, the Company’s disclosure controls and procedures were effective toensure that information required to be disclosed by the Company in reports thatit files or submits under the Exchange Act is recorded, processed, summarizedand reported within the time periods specified by the rules and forms of theSecurities and Exchange Commission and that such information is accumulated andcommunicated to management, including the Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosures.

 

 

*Changes in Internal Control over Financial Reporting*

Therewere no changes in the Company’s internal control over financial reportingduring the fiscal quarter covered by this report that have materially affected,or are reasonably likely to materially affect, the Company’s internal controlover financial reporting.

**Part II**

**Other Information**

**Item 1.   Legal Proceedings**

Weare currently not a party to any legal proceedings.

**Item 1A.   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 4 of our Annual Report on Form10-K filed with the Securities and Exchange Commission on March 14, 2007. Otherinformation included in this Quarterly Report on Form 10-Q also should becarefully considered. The risks and uncertainties described in our AnnualReport are not the only risks the Company faces.  Additional risks and uncertainties notpresently known to the Company or that the Company’s management currently deemsimmaterial also may impair its business operations. If any of the risksdescribed were to occur, our business, financial condition, operating resultsand cash flows could be materially adversely affected.

 

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**Item 2. Unregistered Sales of Equity Securities and Use ofProceeds**

None.

**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**

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

**SIGNATURES**

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

|                    |   |                                                            |   |   |   |   |   | MathStar,  Inc. |
|-------------------------|--------|-----------------------------------------------------------------|--------|--------|--------|--------|--------|-----------------|
|                    |   |                                                            |   |   |   |   |   | (Registrant)    |
|                    |   |                                                            |
| Date:  November 7, 2007 |   |                                                            |   |   |   |   |   | By:             | /s/  James W. Cruckshank |
|                    |   | James  W. Cruckshank                                            |
|                    |   | Vice  President of Administration and Chief Financial Officer   |
|                    |   | (Principal  Financial Officer and Principal Accounting Officer) |

 

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**EXHIBIT INDEX**
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                      | ** ** | **Page**   |
|----------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **           | ** ** | ** **                                                                                                                                                                                                                                                                                                                                | ** ** | ** ** |
| 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                 |       | 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 filed by  MathStar, Inc. with the SEC on May 17, 2007).                                                                                                                                  |       |       |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |       |
| 31.1                 |       | Certification  of Chief Executive Officer pursuant to Rules 13a-14(a)/15d-14(a) under the  Securities Exchange Act of 1934 (filed herewith electronically).                                                                                                                                                                               |       |       |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |       |
| 31.2                 |       | Certification  of Chief Financial Officer pursuant to Rules 13a-14(a)/15d-14(a) under the  Securities Exchange Act of 1934 (filed herewith electronically).                                                                                                                                                                               |       |       |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |       |
| 32.1                 |       | Section  1350 Certification of Chief Executive Officer (filed herewith  electronically).                                                                                                                                                                                                                                                  |       |       |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |       |
| 32.2                 |       | Section  1350 Certification of Chief Financial Officer (filed herewith  electronically).                                                                                                                                                                                                                                                  |       |       |

 

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